The Perfect Price
JANUARY 01, 1956 by BENJAMIN FAIRLESS
Filed Under : Free Market
Mr. Fairless is Chairman of the Executive Advisory Committee, United States Steel Corporation.
What determines the price of a ton of steel? Who sets it? Just what is the policy of United States Steel as to prices?
Along with other successful American industries, we in the steel business learned a long time ago that the following economic principle is true and sound: Each manufacturer must learn how to produce and sell his products as efficiently and cheaply as his competitors. If he doesn’t, he will soon find himself without customers because of the competitive struggle for markets in a free economy. Any successful business must necessarily conform to that fact of the market place if it is to prosper and fulfill its obligations to its employees, its owners and its customers. A by-product of this competition among producers is the best possible product and service at the lowest possible price.
Actually, I could state—simply and truly—that in the long run it is the customers who primarily set the price of steel as they set the price of everything else, and that—again in the long run—the opinions of government officials, the general public, the owners and even the management have astonishingly little to do with it. But that wouldn’t be the full story of the immediate market price of steel because a great many decisions must necessarily be made by a number of people before the price is presented to the customers for their final decision—against which there is no appeal.
But before explaining a few of the most important factors that play a part in determining the final market price of steel, I must mention one theory of pricing which, most definitely, we do not use. I refer to the cost-plus theory. I mention it because many people seem to be under the impression that manufacturers set the prices on their products by the process of adding an arbitrarily fixed markup to all costs. No business can be run successfully in that way as long as it has competitors in a free market.
It is true enough that a company must recover all its costs—plus a profit—if it is to stay in business. And, admittedly, our company does aim to recover all its costs, plus a profit, from the sale of its products. But we run into all sorts of problems and complications along the rugged path to that desired goal.
For example: It seems that almost every time U.S. Steel raises its prices, we are expected to justify the price increase to everybody except the people who are asked to pay it—our customers. Fortunately, they neither need nor want a long story; our customers know at first glance whether the price is right or not. And they render their combined verdict without any political speeches or vote-getting cliches. We are acutely aware of the fact that they can turn to any one of our numerous and eager competitors, or look for a substitute, or cut down on inventory, or even cut back on production. Whether the customer’s verdict on our prices is for us or against us, we still believe that it is the right verdict since it is delivered by a free person using his own money in a free market.
But the matter of price does not rest there. Government officials, union leaders, the public—as represented by certain newspaper columnists and radio commentators always show a keen interest in the price of steel, and we are always willing to explain to any interested person how we arrive at the prices we hope to get for our products.
Naturally, any explanation about prices must dwell at length on costs, since they are the first factors we must consider in arriving at a price that we hope will stand up in a competitive market. The largest cost of all is, of course, wages and salaries—including pensions, social security, insurance and other benefits—paid to or for the employees of the company. The second largest cost is the products and services bought by the company. Next comes the cost of government, in the form of taxes. There are other costs which I shall mention in a moment.
Time and again in the past, we have explained these three largest costs in great detail to anyone who would listen. Doubtless we will explain them time and again in the future. When we point out the obvious fact that these costs must be covered in the price of our products, everyone usually understands and approves. But there are two generally unrecognized dangers in this approach. First, as I have already mentioned, it frequently misleads the unwary into the fallacious belief that industry can and does operate exclusively on a cost-plus basis. This, of course, isn’t even remotely correct. Second, when we begin listing our costs of doing business, we run into the awkward fact that some people claim that many of the things we must pay for aren’t costs at all!
For example, you might think that everyone would agree that depreciation—that is, the using up of machinery during the process of production—is a cost of doing business. But the taxing policy long followed by Congress does not realistically recognize that fact. Under present circumstances, its rules on regular depreciation permit us to list as a cost only a fraction of the purchase price of an equivalent new machine which is to replace a worn-out or obsolete machine. Apparently the government still refuses to acknowledge the fact that its inflationary policies have caused prices for new equipment to double and treble since the old equipment was bought some twenty years or more ago. It permits us to recover approximately the same number of dollars originally invested, but it forbids us to recover the same amount of purchasing power.
The price of steel is also heavily influenced by another vital factor which is not generally given the consideration it deserves. I refer to growth and expansion and modernization. Everyone will agree that it costs money to modernize an old steel plant or to build a new one. But you can start an argument with almost anyone as to where that money is to come from. There are only: three possible sources. It must come from a realistic treatment of depreciation recovery which recognizes the reality of inflation; or it must come from the sale of stocks and bonds; or it must come from profits.
We have already examined the depreciation possibility—and found it wanting. Now let’s take a brief look at the possibility of raising the needed capital by the sale of stocks.
Here we must face this unhappy and persistent fact: Over the years, the profits and dividends of U.S. Steel have just not been sufficiently large to permit it to attract needed capital funds from stock purchasers! Investors just won’t buy ownership in our company in the form of stock at the price it now costs us to build the new plant and equipment. For example, take the Fairless Works—a fully integrated steel plant we recently built. Its cost to us was about $300 per ton of ingot capacity—or about $400 per ton of finished product.
Ownership in our plant and equipment and other assets can be purchased in the form of stock certificates on the open market. But the verdict of a free people in a free market who are using their own savings to buy stock is that (at the time of writing) they will pay only $79 for ownership of the facilities it would now cost us $300 and more to build! This is most discouraging—especially when so many people assume that steel companies are making enormous profits and paying tremendous dividends.
While there is no doubt that our company can raise capital funds through the sale of common stock, we have found it more advantageous either to borrow the money and pay it back out of future earnings or to use a portion of current earnings. And we have followed both courses. Last year, for example, we borrowed 300 million dollars. But mostly we get this new capital for expansion and modernization by ploughing back into the business about half of our earnings. Some of our owners aren’t convinced that this is the best policy, and often we have been advised to meet rising costs (and to pay more equitable dividends) by simply adding a few more dollars to the price the customer must pay for steel.
Those who make that suggestion evidently imagine that we can and do operate exclusively on a cost-plus basis. They seem totally unaware of the fact that, in a free economy, competition for customers insures not only the best possible product but also the lowest possible price. And even after that, the final fact remains that the customer can’t be forced to pay anything at all! In a free economy, the customer is still king.
So it is understandable why the one to whom we devote most of our thought and effort is the customer. Under normal conditions in a competitive market, the customer would laugh in our faces if we went to him with our problems and suggested that we do business on a straight cost-plus basis. If we did, he would probably tell us the old story of the three friends who met in wartime Washington and decided to have dinner together. When the check came, one man reached for it with this explanation: “Since I can deduct this for tax purposes as a business expense, it will actually cost me only about 20 per cent of the total.” But the second man grabbed it from him and said: “Let me pay it since I’m a salesman on an expense account and it won’t cost me anything at all.” Then the third man grabbed the check from the second man and carried the day with this announcement: “I’m a manufacturer with a cost-plus contract from the government. If I pay this bill, I’ll get my money back—plus 10 per cent!”
Our customer has problems of his own, and he’s just not interested in hearing ours. All he is interested in hearing from us is our asking price for the steel he wants—delivered when and where he wants it. If he doesn’t like our price or service, we lose a customer to our competitors. And the fact of the matter is that we do not enjoy losing customers.
So when we think about prices for our products, we must consider all of these problems I have listed. We naturally give much thought to the reaction of the general public since, understandably, they have considerable interest in the activities of such a basic industry as steel. And, admittedly, we have no choice but to take a look toward Washington and see what Congress is going to do about taxes, controls, investigations, inflation and other real political problems which all businessmen must consider today. Obviously we try to guess what the union leaders have up their sleeves for our next meeting. We also keep a close watch on the price, quality and service our competitors are offering. And since the stockholders own the business and can fire us if they wish, we do the best for them we can. Then we reach for our crystal ball and take a thoughtful look at both the domestic and foreign markets and the state of the world in general. After all those facts and figures and guesses have been digested, we finally ask ourselves this all-important question: Will the customer buy our products at the prices we have in mind?
For various reasons in the past, the answer to that question has sometimes been “no.” And we have had no choice but to reduce the price to what the customer would pay under competitive conditions—even if it meant a loss to us, which it sometimes did. If at all possible, we would prefer to keep our prices below the maximum the customer might be willing to pay. That is only good business, because as long as he knows he’s getting a bargain, he’ll be back for more.
In the free and competitive market which characterizes our economy—except, of course, when the government interferes—a price is perfect when the producer would rather have the money than the product, and when the consumer would rather have the product than the money. A perfect price is established when the seller and the buyer each improves his welfare by the trade. I am of the opinion that given a free and competitive market—with government confined to its proper role of protecting equally the life, liberty and property of its citizens—all prices for all products would be about as perfect as fallible human beings are capable of making them.