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The Stuart Daw Case History advocating the use of the
transactional method of setting prices, which was first taught at Western
University in London, is now being used in MBA programs in many foreign
countries.
PROFIT PRICING
Transactional Cost Analysis for OCS
© 1990 Stuart Daw
In the early 1960s, just prior to the
beginning of office coffee service, I became aware of the fact that as a
roaster, profit margins were tight and getting tighter. In fact from 1960-75 a
third of all North American coffee roasters went out of business.
One reason, unproven at the time, was that
in spite of higher selling prices to the small customers, they were really
being subsidized by the larger ones. After developing the "transactional”
method of costing I discovered that a disturbing number of the higher-priced,
small customers were getting coffee below the actual cost of doing business
with them, thus depressing overall profit performance.
TThe
error was the assumption that the pound of coffee was the true unit of cost
at the sales and distribution level. It was not. For if it cost, say, an
average of 24 cents per pound for the sale and distribution of coffee, the
10-pound-per-week customer cost $2.40 to deal with, while the 100-pound
customer cost 10 times as much. This would be fair if it cost 10 times as
much to service the 100-pound customer, which it obviously didn't. The large
customer may only cost marginally more, if at all, to deal with.
If OCS operators are to apply the
transactional analysis theory to their coffee pricing, they must not only
thoroughly understand it, they must apply it without exception if it is to
serve the operation well.
For the seed of the idea for transactional
analysis we are indebted to Peter Drucker who suggested it in his book
"The Practice of Management." He identified that in accounting,
businesses are often misled by using the wrong unit of cost. But Drucker
"never had to meet a payroll," thus it fell to someone to take his
abstractions and put them into actual practice by adapting to and expanding on
the basic concept.
Good exercise
The material below is a summary of the
theory as it applies to the coffee business. It has great significance for the
OCS operator and is a good exercise in knowing about the roasters' economics,
especially where a roaster may be competing on certain accounts. These
accounts are small potatoes for the roaster, but large potatoes to the OCS
operator.
The theory shows how an operator can compete
successfully with the roaster and deals with many questions, such as
"what do I do about allied products," or "what if I am in
vending (or water, or honor snacks) too?
Please note: the figures used here relate to coffee and
operating costs as they were in the mid-1960s. Wildly fluctuating green coffee
prices since that time, as well as an inflation rate that has nearly
tripled operating costs give us different numbers today, but the
principles apply just as they did then.
We will treat the OCS business here as a
one-product enterprise, with an insignificant amount of allied products sold.
If non-coffee sales are a real factor in a given business however, care
must be taken in integrating that fact into a broader pricing policy.
The need for the transactional theory found
its expression in the old restaurant/institutional roaster, who on instinct
refused to ever lose a large customer on price in spite of the accountant's
hounding to hold the line and not sell "below cost."
It found further expression in the classic
back-slapping salesman at the bar in a restaurant convention, buying drinks
for all and bragging that "we charge the same price for everybody."
The farthest that such a person could reach would be a vague understanding of
"volume discounting," totally out of the context of all the
variables in the cost/price equation.
True unit of cost
The key question that had to be asked before
a new approach to pricing could be developed or even deemed necessary was,
"Is the pound of coffee the true unit of cost?" To the coffee
roasters, everything was discussed in terms of pounds, and in fact they were
right in that the pound is indeed the true unit of cost at the roasting plant
level. After all, green coffee is bought by the pound, packaging materials are
stated in terms of cents-per-pound as are direct and indirect labor and
overhead. But is the pound the proper unit of cost beyond the roasting plant
door?
Let us look at a typical model of a
medium-sized coffee roaster, circa 1967, using for simplicity the actual
values of that era (See Chart 1). While as mentioned, green coffee and
all other elements of cost have grown to different levels through inflation,
the principles are what concern us here.
CHART 1
|
TYPICAL COFFEE COMPANY
30,000 sales transactions on 1,000 customers in the
year
|
| Pounds of coffee sold in a year |
1,000,000 |
| Average Selling Price |
$ 1.00 per lb. |
| Gross Sales |
$ 1,000,000 |
Green Coffee Costs
(after 16% shrinkage from roasting) |
$ 600,000 |
Plant Costs
(labor, packaging and overhead) |
$ 100,000 |
| Total Cost of Coffee & Production |
$ 700,000 |
| On 1,000,000 lbs., this represents |
$ .70 per lb. |
Now let us assume that the sales and
distribution division of the roasting company is right next door, to eliminate
"freight out to the branch" from consideration.
Sales dollars |
$
1,000,000 |
| Materials & production costs |
$ 700,000 |
| Dollars available for sales,
administration, profit |
$ 300,000 |
| Operating expense |
$ 240,000 |
| Pre-tax net profit |
$
60,000 |
|
(6% of sales) |
On this model it is true to say that the cost of operating
the business was 24 cents per pound (one million pounds for $240,000). It is equally true to say that, with
30,000 sales transactions in a year at a cost of $240,000, the average cost of
a transaction was $8.
The key question is, "if it costs, on
average, 24 cents per pound or $8 per transaction, which is the correct unit
of cost with respect to any individual account — the pound or the
transaction?"
The old roaster assumed costs were what the
income statement said they were, in this case 24 cents per pound. The more
sophisticated of them may have understood the concept of marginal contribution
and thus allowed for some flexibility, though even grasping that much still
left costing to any customer with complex supply requirements in a shambles.
If the pound was the proper unit of cost it
would have cost 24 cents per pound to handle any transaction. But it obviously
did not. An order going to a 10-pound outlet would in theory cost $2.40. But
for the restaurant next door buying 100 pounds per week, would it really cost
$24, or 10 times as much?
Let us track the two transactions. Each
order is telephoned in from the customers. It costs the same for the order
clerk to take the orders, type the invoices and move them to the warehouse. It
costs the same to throw the orders on the truck. It costs the same in labor
and truck expense to take the orders across town. It costs the same to drop
off the orders and have the invoice signed, and to send month-end statements
to each customer.
Now, is it correct to say that one customer
cost $2.40 to serve, while the other cost $24.00? Or did it really cost about
the same for both? If the answer is the latter then you have proof of the
correctness of the transactional theory. It is obvious the $8 per average
transaction is a superior measurement to the discredited 24 cents per average
pound.
If 24 cents is only an average and not
applicable to any given pound, the same is true of the transactional cost. It
is the average, but not necessarily precisely true of any given transaction.
It is far more reliable however, than the pound.
Indeed the real per-pound cost can be
arrived at by taking the transactional cost and dividing by the number of
pounds involved in a given delivery; i.e. in above model, a 20-pound delivery
would cost $8 divided by 20 pounds, or 40 cents per pound, not 24 cents as
indicated when the pound is the standard.
High and low
While the cost in a given company will not
be the same for every transaction, nonetheless the upper and lower parameters
are so close that for the run-of-the-mill customer it can safely be used as
the proper criterion. For any customer who is obviously more expensive to
service an incremental cost should be added. Conversely, for a customer who is
extremely easy to serve, a lower transactional cost can be applied.
For example, a customer requiring large
deliveries or who has a very inconvenient location, or who has peculiar
service demands that obviously increase the cost of doing business is going to
pay more. On the other hand a customer who pays cash for coffee and picks it
up at your warehouse door would deserve a better price.
Consider the exciting implications of the
theory as I first applied it to the two customers cited above. I leave it to
the reader to guess the long-range consequences of pursuing either of these
costing approaches consistently. When using the pound as the standard, the
little customer gets a big break, while he/she loses on the transactional
approach, as shown in the Chart 2.
CHART 2
|
POUND STANDARD |
|
10 lb. Customer |
100 lb. Customer |
| Coffee Cost |
$ 0.70 per lb. |
$ 0.70 per lb. |
| Sales & Distribution |
$ 0.24 per lb. |
$ 0.24 per lb. |
| Profit |
$ 0.06 per lb. |
$ 0.06 per lb. |
| Selling Price |
$ 1.00 per
lb. |
$ 1.00 per
lb. |
|
|
|
|
TRANSACTIONAL STANDARD |
|
10 lb. Customer |
100 lb. Customer |
| Coffee Cost |
$ 0.70 per lb. |
$ 0.70 per lb. |
| Sales & Distribution |
$ 0.80 per lb. |
$ 0.08 per lb. |
| Profit (6%) |
$ 0.10 per lb. |
$ 0.05 per lb. |
| Selling Price |
$ 1.60 per
lb. |
$ 0.83 per lb. |
When using the pound as the standard the
little customer gets a big break, while he/she loses on the transactional
approach. When using the pound as the standard, the little customer pays the
"cost averaging supplier" $1 per pound, but would be asked by the
company using the transactional approach to pay $1.60, including a 6% profit.
It's easy to guess from whom the customer would buy.
Conversely, the large buyer would pay 83 cents
per pound buying from the transactional company, but to the old roaster he would
be buying at "11 cents below cost," if by cost we mean the average
of 94 cents per pound that the income statement indicates.
In the long run the company using the
transactional theory winds up with the large customers while the company using
the pound, or cost averaging theory, winds up with the small ones.
What is the correct transactional cost to
apply today? It is hard to determine this unless one has access to a branch
system where many outlets can be compared.
Average equipment cost
A problem could
arise because operational costs may be higher or lower due to economic
conditions in a given city, or a given operation may have a substantial unused
capacity, the result of which will be a high present transactional cost.
Another reason could be as mentioned above, a large ratio of allied products.
On the other hand a company may be operating
at full capacity in a tightly run enterprise, with a correspondingly lower
transactional factor. When I first applied the theory to several branches, all
with differing transactional costs, I merely took the average of them all in
determining what factor to use in quoting to customers.
In fact, over time a given branch would
fluctuate from highest to lowest as it grew in size. Each new move into larger
premises meant increased overhead, which in the short run raised the
transactional cost. This cost became lower as the branch grew in customers and
number of transactions.
For the new operator, what transactional
factor should be used? In the absence of any other standard why not use the
industry average. In so doing, such an operator can avoid assuming that
"gross profit minus my van equals net profit." The operator can
price profitably from the start, avoiding the trauma of having to sell the
business after putting on the first 200 or so machines out of the home, or
having to drastically raise prices when moving from home to warehouse.
The industry would also benefit from correct
pricing by the neophyte. For example, when the new operator knows the true
long-range costs, the following hypothetical example of pricing a
one-kit-per-month customer might prevail today:
| Cost of coffee, filters |
$12 |
| Equipment cost monthly |
$ 8
|
| Transactional cost (1 per month) |
$20 |
| Total cost |
$40 |
Let's not forget our modest but necessary
profit requirements—say 15 percent. That brings the selling price to this
one kit user to $47.06.
Ridiculously high as that may seem to those
selling under the same circumstances for much less, it is "correct"
in that it covers everything; the coffee and equipment at actual cost, and the $20 which covers all overhead — rent, utilities, telephone, cars, trucks,
labor and all items on the expense end of the income statement.
CHART 3
|
CORRECT SELLING PRICE — 1 KIT USER |
| Kit Cost |
$ 12.00 |
| Equipment Cost |
$ 8.00 |
| Transactional Cost |
$ 20.00 |
| Total Cost |
$ 40.00 |
| Markup to Get 15% Net Profit |
$ 7.06 |
| Correct Selling Price (per
kit) |
$ 47.06 |
|
|
CORRECT SELLING PRICE — 2 KIT USER |
| Kit Cost |
$ 24.00 |
| Equipment Cost |
$ 8.00 |
| Transactional Cost |
$ 20.00 |
| Total Cost |
$52.00 |
| Markup to Get 15% Net Profit |
$ 9.17 |
| Correct Selling Price (2
kits) |
$ 61.17 |
| Per Kit Selling Price |
$ 30.59 |
|
|
CORRECT SELLING PRICE —
3 KIT USER |
| Kit Cost |
$ 36.00 |
| Equipment Cost |
$ 8.00 |
| Transactional Cost |
$ 20.00 |
| Total Cost |
$ 64.00 |
| Markup to Get 15% Net Profit |
$ 11.29 |
| Correct Selling Price (3
kits) |
$ 75.29 |
| Per Kit Selling Price |
$ 25.10 |
|
|
PER KIT |
| One Kit User |
$ 47.06 |
| Two Kit User |
$ 30.59 |
| Three Kit User |
$ 25.10 |
© 1990 Stuart Daw
Remember, the above material related to a marketing and administration cost
structure that through inflation has grown considerably, perhaps by as much as
three times.
For
help in applying the transactional concept in pricing for your particular
business, contact Stuart Daw by email
stuart@heritage-coffee.com.
Consultation is free for existing Heritage Coffee customers; $200 per hour for
non-customers.
