Pricing vs cost advantages

[ikussain]

Hi everyone,

 

I have been reading McKinsey's Valuation book, and stumbled upon this:

 

"Price premiums offer any business the greatest scope for achieving an attractive ROIC, but they are usually more difficult to achieve than cost efficiencies."

 

It is not quite obvious to me 1. why cost advantages are easier to achieve than price advantages, and 2. why price premiums are more beneficial to company's returns than cost advantages.

 

Your help would be very much appreciated.

[DTEJD1997]

Hi everyone,

 

I have been reading McKinsey's Valuation book, and stumbled upon this:

 

"Price premiums offer any business the greatest scope for achieving an attractive ROIC, but they are usually more difficult to achieve than cost efficiencies."

 

It is not quite obvious to me 1. why cost advantages are easier to achieve than price advantages, and 2. why price premiums are more beneficial to company's returns than cost advantages.

 

Your help would be very much appreciated.

 

I have not read the valuation book, but I am going to take an educated guess at a few things:

 

A). Any fool can cut costs...use cheaper ingredients, cheaper suppliers, skimp on quality and so forth.  This is relatively easy to do.

 

B). If you can achieve a higher price for your product, you've likely got superior quality, branding, some other strategic advantage, or some combination of such.  This is MUCH harder to do than cutting costs or squeezing suppliers.  In my business, I am constantly struggling to achieve high sales points...but it is VERY hard to do.  Not impossible, but difficult.

 

C). In most cases, you can't cut your way to prosperity.  I have some friends/associates who are cheap.  I mean really damn CHEAP.  It is good and important to be mindful and frugal with your $$$, but some people take it too far. 

 

One guy I know almost never eats out/pays for a meal, and he frequently eats oatmeal at home, even for lunch/dinner.  That is fine & good, but even if he cut his food costs to nearly zero by hunting/eating roadkill/trash, that is still not going to make him rich.  Cutting food costs from $5/day to $1/day is not going to make him rich.  I try to impress upon them that they can't cut their way to prosperity.  He has got to go out and EARN money.  People and companies make the real returns when they can grow sales and grow profits, not so much cut costs.

 

So that is what I think the book is discussing.

[LC]

Exactly. Essentially, you can exert some control over costs. Pricing is much more dependent on your market of customers.

[LC]

Oh and think about it this way: it’s easier to eat out less and save cash than get a raise at work.

[wachtwoord]

Oh and think about it this way: it’s easier to eat out less and save cash than get a raise at work.

 

Depends who you ask in our consumption addicted world, but to me (and most value investors?)  that's very true.

[Guest longinvestor]

In my working experience, the pretensions about getting price run rampant. It’s quite sexy to pursue price; hire high salaried staff, consultants (just like McKinsey), invest in dubious technology etc. The company I worked for was quite good at squeezing out costs in operations. But Management fancied using the savings to “fund growth”; In other words paying for all the activities to get growth through price; Then we waited and waited. No growth came of course; just more cost cutting to pay for the expensive tastes of the McKinsies of the world.

 

Structural cost advantage is hard to achieve. Why there are so few cost leaders. In 1951, Buffett learned about Geico’s structural advantage which was created in 1936. It’s still intact. I would love to invest in the structural cost leader in every industry.

[Read the Footnotes]

Hi everyone,

 

I have been reading McKinsey's Valuation book, and stumbled upon this:

 

"Price premiums offer any business the greatest scope for achieving an attractive ROIC, but they are usually more difficult to achieve than cost efficiencies."

 

It is not quite obvious to me 1. why cost advantages are easier to achieve than price advantages, and 2. why price premiums are more beneficial to company's returns than cost advantages.

 

When a company starts cutting costs, high priced consultants might be one of the first costs cut. So from a consultant's perspective, cost cutting is a terrible strategy. On the other hand companies with excellent competitive position frequently start to bloat. That bloat, including wasting money on low ROI consultants, can frequently go unnoticed or tolerated because of their strong position.  :D

 

To be more serious . . .

 

I also think the passage frames the issue in a way that might confuse correlation with causation. The ability to price is driven by competitive position and that desirable competitive position or competitive landscape creates other benefits, too. In other words the ability to price is a symptom, not a cause. The willful creation of this type of competitive advantage is difficult and rare, but companies that possess this type of advantage are a rare type of needle the promise of which drives many of us to search through haystacks.

[ikussain]

Thank you all guys!

[nickenumbers]

Wow.  Great discussion.  I am a finance guy and I have not heard it articulated as well as you all did.

 

Special Kudos to DTEJD1997 and Read the Footnotes for your inputs.

 

"Old moats are getting filled in and new moats are harder to predict, so it's getting harder." Charlie Munger

 

As DTEJD1997 pointed out in the cost cutting example, ability to raise price because of your moat is critical for long term success..  Otherwise the company looks like a race horse, but it is more like a goat.  And you can't win the long term race on a goat.