Most service and/or product-based businesses define their prices using a cost-plus approach. This means that they calculate the direct and indirect costs to deliver a service and/or to produce a product, aka the break-even price. Then they add a reasonable profit margin to cover the risk capital for their initial and subsequent investments in the business.
While this strategy might make sense in geographically isolated areas, it does not take into consideration the fact that many products and services can be off-shored. Products and services can be produced elsewhere in the world, often for lower costs than in the US.
To explore the idea of margin pricing a bit more, let’s look at fuel prices. The price to extract a barrel of oil from the ground and ship it to a US-based refinery varies depending upon a huge number of factors.
According to a report from energy industry consultant Rystad Energy, for Saudi Arabia, it cost about $9 to produce a barrel of oil and ship it across the ocean to a US refinery. In the US it cost about $23 dollars to do the same. Lots of factors contribute to this cost differential, including the cost of labor, material, depth of extraction, and so on.
But what is important to understand is that if the entire world’s demand for oil could be met by the “cheap to produce” Saudi Arabian oil sources alone, the margin cost for a barrel of oil would drop to nine dollars per barrel and producers with higher cost structures, such as those in the US, would be kept out of the market. However, as global demand exceeds the supply of cheap to produce oil, whether the supply is physically restricted by production costs or strategically restricted by self-imposed OPEC supply limits, the margin price rises until demand is met.
The margin price as of the writing is about $70 per barrel of oil to meet the world’s demand. At $70 per barrel, a US-based company that can produce a barrel of oil for a cost of $23 per barrel can make $47 per barrel. A Saudi Arabia-based company can make $61 per barrel: $14 more profit in terms of real dollars on the same product. This gives Saudi Arabia and other countries/companies with lower cost structures considerable power and influence in the oil industry.
Margin pricing not only affects rising prices but also affects falling prices. Consider how a new Wal-Mart store drives smaller business with higher cost structures out of business. With the exception of a monopolized industry or organized union, unregulated market forces will bring prices down to the lowest level (the margin).
If prices in a particular industry rise, more businesses with higher cost structures will enter the market as the higher margin price makes it economical for them to do so. The increased competition will prevent prices from rising any further, reaching a sort of “price equilibrium”. Likewise, if supply can be met by either increased production capacity or lower demand, the margin price will fall.
Then companies with higher cost structures will no longer be able to compete on price and will likely be forced out of business unless they change their business and economic models.
Keep in mind that most industries are not completely unregulated. When providers or producers with lower cost structures feel at risk from the new competition they often use their very high-profit margins to protect their future profits by erecting barriers to newcomers or driving out competitors. For example, they may contribute cash generated from excess profits to the campaigns of lawmakers or Political Action Committees (PACs) that support increased regulation beneficial to them. Consider the tariffs on steel and aluminum enacted in early 2018.
They may also support creating unions that control new entrants into a market, thereby placing a lid on supply. Many factors are at play in establishing the margin price.
The successful entrepreneur is one that keeps his eyes and ears open and takes stock of events happening around him. This is important not only to determine the margin price but to consider the impact potential events could have on the margin price in the future and develop contingency plans to deal with them.
What events are happening around you that will affect the margin price in your industry?
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