Stories From the field # 7 - August, 2004
Making Pricing Decisions Using Lean Accounting
by Bruce Baggaley, Senior Partner, BMA Inc.
" Lean Accounting pricing requires careful analysis of the costs that are truly incremental to the decision to take on new business," Ralph DeWolf, Chief Financial Officer, Kromet International Inc/Alumabrite Anodizing Ltd.
One of the issues that companies contemplating the implementation of Lean Accounting struggle with is the strong preference to basing decisions on the contribution to value stream profitability. Those who oppose this position point out that following this method, while satisfactory for short-term decisions, may have disastrous effects if applied to decisions such as long term contracts, that affect the profitability over several years.
Ralph Dewolf, Chief Financial Officer of Kromet International Inc./Alumabrite Anodizing Ltd., a manufacturer of hardware for the home appliance market and selected other markets, has developed some guidelines that illustrate how the contribution approach to business can be applied in a lean environment. He comments as follows:
"We at Kromet believe that lean manufacturing and lean accounting are the best way to free up capacity and drive costs down. However, we believe that lean product pricing requires careful analysis of the costs that are truly incremental to the decision. Here is a scenario that illustrates what I mean:
In the 1960s companies began to recognize the flaws in full absorption costing and switched to pricing on the basis of materials and direct labor, accepting any business above that level. Over the short term there were increases in profit. However, as volumes increased, companies were forced to add shifts, equipment, and other resources to support the expanded business. They found to their dismay that the low margins would no longer support the increased scale, and business failures resulted.
The companies that survived were those that analyzed their costs and determined what the real incremental costs of taking on the new business were and factored them into their pricing equation. These companies factored in the increased maintenance, consumption of supplies, utilities, outside testing, tooling, extra supervision, quality control, material handling and other incremental cash expenditures that would be associated with taking on the new business, in addition to the increased materials and labour costs. They were able to assess prices using contribution margin and increase profit over the longer term. Although pricing to market needs, they took accounting of the true incremental cash costs as the basis for the price below which they would not take new business.
Here are some guidelines to use in making pricing decisions:
- For contracts that last one year or less, if there is free capacity, and labor is available without hiring additional people, such as is the case when implementing lean manufacturing, it makes sense to determine profitability of a new order or quote from the material cost plus other true incremental costs such as expected utilities and maintenance costs.
- For contracts that extend more than one year, and in cases where you can extend the use of older equipment through your lean efforts, then the expected profitability can be based on the incremental material, labor, supervision, quality assurance, benefits, utilities, maintenance and other cash out of pocket costs required to take on the business. Always keep in mind that the product price needs to support the longer-term profitability and overall cost base of the company.
- For contracts requiring the addition of plant and equipment, use costs that include the full costs of adding the additional capacity.
- Always consider strategic reasons for alternate pricing, such as the impacts of the new pricing on the entire market segment. There may be good reasons for accepting an order at a lower than usual price (for example), but you must take account of the wider issues of the market.
In summary, one has to be very careful in considering both the short-term and longer-term implications on value stream profitability of alternative approaches to product pricing."
At BMA we are interested in hearing from other companies how they are applying lean accounting to their pricing and business decisions.