Small Differences in Cost and Margin Create Large Differences in Price

Small, seemingly insignificant differences in manufacturing costs or gross margin objectives between two competitors can translate into surprisingly large and often insurmountable differences in the price they must command in the marketplace.

This is a critical concept for understanding price competition, especially against competitors with different financial structures or strategic goals (e.g., Japanese companies with lower capital costs).

The Formula for Price Differential

The percentage price differential between a high-cost and a low-cost supplier can be calculated. A simplified way to understand the impact is through an example:

• Company A (High-Cost): Has a 10% manufacturing cost disadvantage compared to Company B.
• Company A's Goal: Requires a 40% gross margin to cover its overhead and meet profit goals.
• Company B's Goal: Is willing to operate at a 30% gross margin.

In this scenario, to meet its goals, Company A must establish a market price that is 30% higher than Company B's.

If Company B has a 20% manufacturing cost advantage and the same margin objectives apply, this translates into a 45% price advantage in the market for the lower-cost supplier.

Strategic Implication:

This demonstrates mathematically why competing on price is so difficult for a company that is not the lowest-cost producer. A small cost disadvantage, when compounded by different margin requirements, creates a massive price gap that is very difficult to overcome with product features alone. This is why, for commodities, Market Prices are Set by the Lowest-Cost Competitor.