Jack TenneyExtra Point

by Jack Tenney, Publisher

February 2000

The diference between cost and value

A very old (slightly reworked) joke: The waiter brings the check to a foursome of fellows trying very hard to impress each other. The first one, a recent retiree says, "I get a senior's discount here so we can save 10 percent if I pay."

The next, an independent rep, says, "Let me pay. I can write it off on my taxes and it'll only cost half."

"No, no! I'll pay and put it against my grant. That'll make it a free lunch," claims the research scientist.

"Whoa, Nellie!" cries the government contractor. "Let me have it. I've got a cost plus contract going. I'll make a profit."

Perhaps the punch line would work better if the last dude were the CEO of a fledgling Internet company who could somehow leverage his buddies' free lunch into a 20 percent increase in his stock price.

Whatever. The extra point is: There is a big difference between cost and value. Every bargain hunter intuitively knows the difference. The difference between the strikeout price and sale price has come to represent that difference. Years ago, I spent the better part of the day negotiating a price for 150,000 thingamajigs with a buyer who was constrained by margin requirements, price points and his open-to-buy. I finally had to agree to a unit price several cents under my margin, price and ability to produce targets. Gratefully, the buyer had no responsibility for freight, which I typically allowed so I could add that back to gross profit, but I was still a nickel short. (150,000 nickels could buy a pretty nice car back then!) What put the deal over the top was a 25 cent premium per unit for "ticketing."

Each unit manufactured to fill the order included a step at the packing station where a price tag was glued to the piece. The buyer supplied the tags and the engineering dudes figured a way to perform the task within the standard time allowed to pack the order. Translation: The premium was the profit!

Why do I remember? The tags were printed "$9.99," and each price was crossed out with a red felt tip marker and replaced with a handwritten price of "$5.99." I often wondered how much it cost to hand write those price tickets but never doubted the added value.

Another way to understand the difference between cost and value is to consider the difficulty faced by formula pricers. It's often easier to set a price by doubling one's cost than to find a price buyers are willing to pay.

My best example is the paper tube problem. A little division (called the Tube division) sold two kinds of paper tubes: spiral wound and convolute. Prices were set by formula (standard cost factored up equaled price). Every costing error was therefore magnified and the factory was constantly out of balance because the prices for spiral wound were typically several percentage points higher than market -- we got orders only for odd lots from bad credit risks -- while convolute prices low-balled the market (lots of orders, not much profit). Everyone screamed at the cost accountants to fix the problem when they should have yelled at the marketing department. Costs have nothing to do with value.

My absolute favorite example of the difference between cost and value: I once bought a billing machine that was a state-of-the-art, magnetic-strip-reader deal. I opted for the lower price CPU, saving several thousand dollars. After a year of use, it became clear we needed the larger processing unit to keep up with the volume. So I paid the several thousand and a technician came out. He took the back off the beast; the machine was big, loud and hot. He then flipped a little toggle and started to put the cover back on.

"What the heck was that all about?" I demanded.

Sheepishly, he replied, "All these models come with partitioned memory. To increase operating speeds, you just flip the extra switch."

Get it? It cost the manufacturer too much to make two memory boards so they put a switch in. The thing was much more valuable with the switch tripped. Tripping the switch didn't cost anything!