The Price Is Definitely Not Right

by BILL WADDELL

Of all the tools in the Lean Accounting tool kit I am convinced that the most critical one is strategic pricing.  In the face of such a down economy just about every manufacturer has capacity to spare, and using standard costs to set prices just compounds the problem.  Ya gotta look at pricing and costs holistically or you are going to drive yourselves out of business.

Consider the following overly simple example:

Let's say manufacturer A - that's 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.

Now this is a problem everywhere in which standard costs are being used, but it is a very serious problem when you have unsold capacity on your constraint - like just about everyone does in the current economy.  You are very apt to be out beating your head against the wall trying to wring another nickel out of direct labor, or trying to squeeze a few pennies out of some poor supplier's prices, while you are leaving whole dollars on the table due to unused capacity.  Ya gotta stop doing that!

It is in areas like this that lean accounting, coupled with focusing on factory flow drive real bottom line results.  Kaizens on the shop floor won't get you to where you want lean to take you unless the accounting and sales folks are on board - the difference between lean manufacturing and lean enterprise.

Comments

[Emmer]

I guess you wouldn't agree with the new Whiz Kid approach at Ford, then?

http://www.detnews.com/article/20091009/AUTO01/910090402/Ford-taps-new--Whiz-Kids--to-help-navigate-road-to-success

The more things change, the more they stay the same...

[Bill Waddell]

You got that right, Emmer. It is the antithesis of lean thinking and a major disappointment to see how little Ford has learned from Toyota and Honda.

[Mark]

How do you get the sales folks on board? We have the Lean Manufacturing and Lean Accounting...but Operations is constantly battered by Sales that Lean is not working. Sales refuses to stand by their forecasts and then blasts Operations for every issue in manufacturing; from out-of-stock situations of standard items because of extremely unusal customer demand to the inability to handle a larger than normal amount of special/custom orders. How do you get Sales to understand the concepts of Lean?

[Bill Waddell]

Mark,

The quick answer to your question is that you get Sales and Marketing on board through education. You are right in that the sales and marketing functions are largely uninvolved in lean and that presents a huge obstacle to realizng the potential of lean. It also tends to indicate that the most senior people still do not see lean as a fully integrated management approach.

That said, your comments "Sales refuses to stand by their forecasts and then blasts Operations for every issue in manufacturing; from out-of-stock situations of standard items because of extremely unusal customer demand to the inability to handle a larger than normal amount of special/custom orders" indicate that operations still has a ways to go. The crux of lean is cycle time compression, which should significantly reduce dependence on forecasts, and shouls make the factory much more flexible and better equipped to handle unusual orders and the need for customization.

[Olivier]

This is why you adjust your production process to the sale forecast and the strategic marketing analysis and not the opposite.
But it's a fact worth remember.

[Andy Etnyre]

I agree that operations needs to be flexible, but how flexible?? According to what I read in the new book, "Toyota Supply Chain", if you want a car with options that are not already in the plan (forecast), you have to wait 90 days to get it. Toyota uses forecasts and flexibility, but it doesn't let the sales group get away with ordering whatever it wants, whenever it wants, in whatever quantity it wants.