Lowering Prices – The lure of higher capacity utilization

In the three components of effective price management I wrote about the need to maintain prices even in the presence of excess capacity. Managers are reluctant to have idle capacity and may be tempted to sell additional units at lower prices. Since the capacity costs are fixed, any additional units we can sell will add to the bottom line. The problem is worse if the managerial accounting systems are not set correctly. If the accounting system incorrectly allocated fixed costs to each unit then increasing volume sold will look very attractive as it would appear to increase gross margin.

The problem with lower prices to utilize capacity is that these sales at lower prices set a bad reference price for future sales.   Reference price is what the customer expects to pay based on past experiences and alternatives despite the value they get.  In the short run (for that financial quarter) the additional sales will help but after that the company stands to lose profit from the rest of the units as its customers will renegotiate and demand the lower prices they saw.

There are two possible ways to utilize excess capacity and protect margins

  1. Introduce new product version that can has induced product impairments. This helps to protect the margins on the previous versions sold.
  2. Use the capacity to enter new markets  – be it different industry size, end application or geography. Unbundle your prices and charge separately for delivery times, convenience, tech support etc.

But the best possible scenario would have been having no capacity investments at all – outsource all production operations like Nike does and hence have the flexibility of increasing or decreasing capacity at will. Outsourcing operations makes someone else bear the risk for you.

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