Pressure on Prices: How will you Respond?
Increased telecommunications technologies are making it easier for customers to shop globally for lower prices. While customers everywhere are enjoying more options and lower prices, here in North America, raw material and energy costs are rising, creating unprecedented challenges for manufacturers. Only a select few are able to pass the increased cost to their customers while most are sacrificing profits to stay in the game. How will you respond to this power shift?Before we begin I would like to say that I am honored as well as delighted on the invitation to be a part of this eJournal. The suggestion of exploring ideas that go beyond the applicability of the “Toyota Production System” is refreshing. In my opinion, this is a very important topic in multi-product and variable-demand environment often found in the SMB (small and medium-sized business) sector.
Where is the Opportunity?
When manufacturers are unable to pass the increased cost to their customers, they usually adopt one or both of the following strategies:
(1) To reduce the internal costs of producing products and services, and
(2) To discontinue the unprofitable products, services, channels or customers.
In either case, they first need an accurate measurement of costs to determine true profit margins for each product and service. Without a true assessment of the costs it is difficult to identify where the opportunities lie and what can be done about them. Furthermore the interest is less in what their costs were in the past and more in what they will be in the future for them to stay competitive.Most companies focus on tracking past performances and then tend to extrapolate from that to forecast future operational requirements and capabilities. Unfortunately, your past performance, no matter how successful, was based on different work requirements, demands, customer needs, and market conditions. Operating approaches and strategies that may have helped you in the past may not produce the desired result in the future because the environment has changed. In multi-product environments where demand fluctuates routinely, such as in high-variety and low-volume scenarios, this is an everyday event.Measuring revenues is not a problem but getting true cost of each product and service is.
Most companies keep good accounting data and the problem is not in adding up the cost. The problem is in distributing them to each product and service. If your product mix, demand volumes, and how you produce your products or services do not change significantly then you can use standard costing with variance analysis to get a fairly good assessment. But, that is not the environment in which the typical SMB operates. The high variety of products and fluctuating demands make the standard cost data misleading. The per-piece cost for each unit of product depends on the dynamics of the operating environment on the shop floor at the time that piece was produced. The product mix and the demand volumes impact the activities required to meet the demand. The activities composition plays the most important role in how to absorb the costs – in particular the costs of technology, capital investment, back office, design, maintenance, holding inventory, etc.
Today your operational environment is different from when the standard cost structure was developed. Today the product mix is different, the demand volumes are different, and in many cases, the policies and procedures are also different. A considerable constitution of the activities by people and machines required to deliver the products or services is new. Most companies in the SMB sector do not have the resources to update their cost structures frequently hence we find them to be out of date in great majority of situations. In some cases we have seen standard cost information to be more than several decades old. Clearly the company made a different set of products back then, than it does today.For the sake of discussion let us assume that we can overcome all these inadequacies, but the main problem still remains that this is historical information and not forward looking into the future. In your quest to respond to the price pressures when you make any significant change in your operating dynamics, you will be operating in a new and different environment. Your decisions on what to do must be made with the cost structures based on the yet unknown future. If they are based on the past cost structures then you are more than likely to go off course.
Uncertainty engenders partial solutions and misapplications
When faced with the rising pressure on prices, we find that managers often jump to conclusions – improve process efficiency, improve throughput, reduce inventory, reduce labor cost, outsource to a cheaper producer, etc. These are good things to do per se, so long as you are taking the cost out of the system and not merely shifting it to another area. In majority cases we find shifting costs to be the more common response. But, more importantly, the elimination in cost must be significant enough to make an impact. Very often managers forget to ask the four basic questions:
- Can it be done? Is it possible? If not, then what additional capabilities are needed?
- Will it be profitable?
- What is the impact of my decision across the product mix and the functional capabilities of the organization?
- How do I get to my desired future (the roadmap)?
In the absence of answers to these questions, the environment is fertile for half-baked ideas based on correlative thinking and rules-of-thumb, and misapplications of sound principles. Let us consider the implications of this uncertainty. The results are far reaching that affect not only the accountants and senior managers, but also the operations personnel. Process managers are asked to redesign the process and policies that will reduce costs and increase profits in future based on historical information. Without a reliable framework they do not know for sure whether their solutions will bear any fruit. They are left to use vague guidelines, which depend on inaccurate information, without questioning the accuracy and accepting on faith. They shoot in the dark and hope to kill. Misapplications are rampant throughout industry.
An example of misapplication and shifting costs
Let’s consider an example of a truck power-train component supplier. The company manufactured twenty four product families with several hundred individual SKUs. The demand of various products varied from a paltry 2 units for some to several thousand for others over a four-week long period. The plant operated in a batch fashion with two primary routings but no direct connecting flow between workstations. In other words, each work station continued to produce until it ran out of work to do. The plant financials were good with overall net income at almost 7% of sales. Unfortunately, WIP piled up everywhere. Management decided to convert the batch operation into a flow line to improve efficiency and reduce WIP.
Using an aggregated constraint capacity analysis tool they were convinced that their plan was feasible. They sized the buffers based on historical performance and line balancing showed a lot of promise. They estimated the WIP to decline precipitously with overall increase in bottleneck efficiency. Using the standard costing model, adjusted for the expected improvement in efficiency, they believed they were going to save a lot of money.
The reality unfortunately was not as they expected. Reduced WIP choked the flow and the machine utilization rates suffered significantly reducing the overall throughput by about 20%. The financial result was a disaster; the overall net income fell to negative 3% of sales. They not only lost on the bottom line but they also lost on the top line since they could not produce enough to meet the customer demand and had to outsource to fill the gap.
The problem was not in their objectives but in their analytical tools and the applicability of the principles. They were attempting to squeeze a square peg in a round hole. The problems emanated from two causes:
1. The processing requirements at workstations depended on individual product type, and
2. They did not understand how the machine failures would impact the dynamic interactions throughout the process.
If the processing requirements at workstations in a line depend on each product then with each change in product batch the dynamics of the entire line changes. Not having large enough buffers (WIP) in between workstations to attenuate the dynamics of the process flow caused the line to experience significant amount of blockage and starvation. They could not anticipate this because they used a static model of aggregated constraint capacity. These are steady-state models and cannot show the dynamic effects. A dynamic analysis was required for the job. Furthermore, they used the standard cost data from history but the activities composition was so different in the flow line that the old cost structure had no applicability at all.
Response to price pressures
The above situation is a common occurrence in any multi-product shop with high-demand variability. Static capacity models and standard costing or machine run-rate approaches to calculate individual product costs are not valid methodologies. Decisions made using these approaches will always be wrong. You may find partial successes but will never be able to tap your full potential. The activities based cost and management (ABC/M) techniques can help but only after the fact. After all, ABC is an accounting device and not a management tool to create the future. A similar situation would rarely exist in a low-variety with long-run setting. The solution requires a tool that assesses the dynamic changes in the process and the corresponding activities composition to build the resource requirements and financials for the future environment.
Profit Mapping is a tool for aligning operations with future profit and performance. It focuses on the activities performed by people and machines to improve process effectiveness and growth. Here we construct an activities composition of the process, understand the dynamics of how it changes over time, and tie this information to the resource requirements and the cost to produce products or services. As business conditions change – such as changes in product mix, demand, product or service delivery capabilities, vendor performance, business strategy, etc. – Profit Mapping reassesses the resource requirements and cost/profitability implications of the new and changed activities composition. The capability of Profit Mapping is in its ability to directly connect the controllable parameters to the business objectives within the capabilities and constraints of your organization. It is a radical yet intuitive enhancement to operational decision making process that is equally suitable from executive to shop floor decision making.
In subsequent issues of this journal I will explore with you several real-life examples of using Profit Mapping. We will identify parameters that we can control within our capabilities and constraints to reach our financial as well as other business objectives. This is one of the fundamental principles of the Profit Mapping methodology. In applying Profit Mapping we take an agnostic view towards the improvement philosophy and evaluate the consequences of decisions, irrespective of their origin or basis, from the process, resources and financial perspectives. Our focus is not on what happened in the past but to look forward to the future.
I believe the complexity in multi-product and high-variability in demand environment is immense where traditional single-focus methodologies and generic guidelines are not acceptable. A systematic approach focusing on the business goals – not on the intermediary issues such as efficiency, throughput, inventory levels etc. – is imperative.
Dr. Anil Menawat is the founder of Menawat & Co.
