The price is definitely not right, Bill Waddell says, when you use standard costs — which spread fixed costs out — to set prices:
Let’s say [you] go through some sort of annual budgeting exercise and take your $24,000 fixed costs and spread them over the hours needed to meet the forecast on whatever machine is the capacity constraint in the value stream, then roll them back up into standard costs for each unit that is run on the machine. You come up with some number and that standard cost number gets goosed up to cover SG&A and the profit goal into a price.Now let’s say manufacturer B, your competitor across town, has the same machine constraining the same value stream set up and the same annual fixed costs. The only difference is that his forecast is higher than yours. He goes through the exact same standard cost and pricing arithmetic and comes up with his numbers. For absolutely no good reason other than a more optimistic forecast, his costs and prices are lower than yours.
Guess what? Your low forecast and his high forecast will very probably become self-fulfilling prophecies because your prices are higher — even though your basic cost structure is exactly the same. When you build fixed expenses into standard costs, this condistion can easily spiral out of control. Your standard costs keep going up and up because you keep trying to charge customers for more and more capacity they are not using.