Average costs and the road to nowhere
In the world of pricing discussions, average costs—the total cost (fixed + incremental) divided by the number of units produced—just don’t matter when used to determine profitability or margins. They don’t matter for three reasons:
- Average costs take into account fixed (sunk) costs that have no relevancy to pricing decisions today and beyond. Sunk costs are just that; costs that have already been borne and have no effect whatsoever on the incremental profitability of a product or service.
- Average costs are backward looking. They take into account historical costs (costs, again that have already been incurred) and fail to look at the current costs resulting from a sale – the future cost of replacing sold inventory as opposed to the average cost of current inventory.
- Average costs are wildly subjective and in most cases, misleading. Allocating fixed costs across different product or service lines is imprecise at best. And at worse, it is subject to manipulation by the many stakeholders in the pricing process. Think garbage in, garbage out.
Here's the takeaway: Incremental profitability can only be determined by analyzing incremental costs. Don’t cloud the picture by including average costs in the equation. Doing so will actually not put you on the road to nowhere; it will put you on the road to unprofitability.