Accounting numbers are not enough to determine profit-maximizing prices, but help may be closer than you think.

In 1989, I found myself Group Manager of Planning for BOC, an international conglomerate whose main business lay in the production and sale of industrial gases. A bright Chinese student in his mid thirties called Qiang Xue (pronounced Chang Shwe) approached me after one recruitment presentation looking for a summer job. To set him a worthy challenge, I asked our UK gas company what was the toughest problem they faced. “Pricing nitrogen”, they replied.

Air is about one percent argon, 21 per cent oxygen and 78 per cent nitrogen. Thus, argon, oxygen and nitrogen are the joint products of an industrial air separation process. Gas companies can sell all the argon and oxygen they produce, but only some of the nitrogen. So they are obliged to vent off the unsold nitrogen. Our plant managers knew higher utilization meant lower unit costs, and had succeeded in increasing demand for nitrogen by lowering prices. The question they now posed was “how much further must we lower nitrogen prices to fully load the plant?”

Qiang clarified their question by asking the plant managers are you aiming, primarily, to increase profits or to reduce costs. “Increase profits, of course,” they replied.

Qiang knew that unconsciously, if not consciously, every pricing decision involves the trade-off between two factors: the break-even of the plant and the price sensitivity of the marketplace. Therefore, he asked two further questions “if we cut price, how much extra volume will we need to break-even again?” and, “if we cut price, how much extra volume will we get?”

The plant break-even is not obvious in a co-product situation because it depends what you view as your primary products. Product costs are, therefore, far from purely objective accounting numbers. In addition, there was insufficient marketing information for a statistically reliable analysis of price elasticity. However, Qiang pointed out, pricing decisions were being made all the time. The best available data, he argued, was the knowledge and experience of the company’s own sales and marketing people.

Nitrogen, a simple molecule, has many uses: from treating warts to blanketing inflammable liquids held in tanks. For each application, Qiang invited the people dealing daily in the market to estimate what would happen to sales volumes with various levels of price increase or decrease (plus five per cent, plus ten percent, minus five per cent, minus ten per cent, and so on). He asked them to do this under four scenarios – whether competitors followed or not, over the short term or the long term (where the long term was defined as the three years it would take competitors to bring new capacity on line).

Combining these estimates, he found that the company could make more money by putting up prices under all scenarios. Therefore, it raised nitrogen prices and its profits increased dramatically. Competitors followed its prices up and the company made even more money – even though it was now venting more nitrogen than ever before, its plant utilization was lower and consequently its unit production costs were higher!

The common mistake of individuals and organizations that need to change is that they neither seek the broader view that offers new choices, nor explore the unquestioned beliefs that perpetuate past and present dysfunctions.

To embrace the unknown, you need to raise the level at which a problem is addressed and managed. Expand the scope from a departmental perspective to the perspective of the whole firm, from local to global, from tactical to strategic, from short term to long term, from inside the company to the market and the industry, from static to evolutionary, from the details to the whole and, not least, from interface to complex relationship. Look for the boundaries, the interfaces, describe what you do not know, and then step across these barriers to find a new place to stand.

Why would a company fail to seek a profit-maximizing balance between supply and demand? At one level, the question is superfluous because increasing utilization to reduce costs seems so obvious. There is no conscious thought or decision behind it.

Qiang rejected the conventional wisdom that nitrogen price-elasticity is unknowable. He found it well known when he asked a set of carefully structured questions designed to draw out the knowledge of the company’s own people.

Similar opportunities for profit improvement are likely to exist wherever Production focus on unit cost and Sales focus on revenue.