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Stories From The Field

One Company Learns About Quoting & Sourcing
by Brian Maskell

One Company Facing Eroding Margins and Pressure from Low-Cost Countries

It is essential to have accurate and valid financial information when making important decisions . Unfortunately most manufacturing companies make their decisions using standard costs. The calculation of a standard cost for each product gives harmful and misleading information, and this leads to poor decision-making; sometimes catastrophic decisions. Lean manufacturers use value stream costing instead of standard costing. They calculate the costs and profitability of the value stream as a whole, not for the individual products within the value stream. Up-to-date information is available for the total costs and profitability of each value stream; usually every week. Value stream cost information is used for decisions relating to pricing, profitability, sourcing, make/buy, product rationalization, and so forth. Here’s a typical example.

 
#1: Using Target Costing to Increase Customer Value.
#2: Quoting Decision Without Standard Costs
#3: Value Streams for a Retail Products Manufacturer
#4: Value Streams for Plants With Many Product Families
#5: Make-Buy Decision Using Value Stream Costing
#6: Making Money from Lean Improvement
#7: Making Pricing Decisions based on Lean Accounting
#8: Value Stream Costing & Decision-Making Lead To Significant Business Growth
#9: One Company Learns About Quoting & Sourcing
#10 Making an Accounts Payable Service Center a Little More Lean

 

A Request for Quote

Puddleglum Corporation manufactures pumps, piping, and accessories used by farmers to keep marshy land dry. The company recently received a request for quote from one of their larger customers for a valve called an XJ2.The value is a small and straightforward product that Puddleglum has been manufacturing for many years. The customer - a large distributor in the area of the UK called East Anglia - wished to place orders for 3000 XJ2 per month. This large quantity was required to support a land restoration and reclamation project that was due to run for several years into the future. The customer stated a target price of $45 per unit.

Puddleglum’s standard cost for an XJ2 looks like this:

Labor Time to make an XJ2

750 seconds

Labor cost per hour

$24.73

Labor cost per unit

$5.15

Overhead rate

290.00%

Overhead cost

$14.94

Material costs for XJ2

$22.33

Standard Cost XJ2

$42.42

The customer had a stated price requirement of $45 per unit. The Puddleglum sales people worked with the customer to negotiate a higher price; but to no avail. The customer was firm on the $45 price. So Puddleglum turned down the order because it was not profitable. With a price of $45 and a cost of $42.42 the profit margin was less than 6% - and this was way outside the company’s 15% minimum margin rule.

In hind-sight, it was a good thing they turned down this sale because the factory did not have enough capacity to make an additional 3000 units per month. This represented an 11% increase in demand. But the sales people had never taken into account the plants ability to make the product.

Can We Out-Source this Valve?

The Puddleglum sales people were not to be deterred from their quest for profitable sale. The bought some time from the customer and got to work trying to find an alternative source; and they were successful. They found a supplier in the Far East that can provide the valve at a price significantly lower than the standard cost.

Price to the customer

$45.00

Cost from the Far Eastern supplier

$30.00

Overhead for in-coming logistics

7.5%

Total Inbound cost

$32.25

Monthly revenue for 3000 units

$135,000.00

Monthly cost for 3000 units

$96,750

Monthly profit

$38,250

Profit Margin

28.33%

 

The sales people quickly went back to the customer and told them Puddleglum was happy to meet their price and they set about ordering 30,000 units to be made and shipped to the UK from the orient.

The Plant Controller Takes a Second Look

The controller at the plant where the Puddleglum makes valves was not satisfied with the outsourcing decision. This plant had been on a lean journey now for a couple of years and the financial controller has become one of the 100% committed lean leaders. He has seen the value stream go from being a long-lead-time, high WIP, traditional production process to a truly lean-focused flow. They were still a long way from “being lean” - but they had made some progress.

The controller truly believed that their value stream could compete with anyone on the world; given the chance. He also hated the idea of huge inventories and complexity that will come from sourcing overseas. It was the opposite of lean thinking.

With this in mind the controller started to look at these decisions using the value stream costing information reported to the value stream manager each week.

Current Monthly Revenue

$1,042,631

Material Costs

$424,763

Production Employee Costs

$100,464

Support Employee Costs

$208,652

Machine Costs

$9,858

Other value stream costs

$73,115

Profit

$225,779

Return on Sales

21.65%

Working with the production management team, the plant controller learned that to create the additional volume required to support the 3000 units per month order required 2 more people and 2 more machines. He worked out how the value stream costs and profitability would change if they added these additional costs and revenues.

 

 

Current State

 

Incremental Costs

Value Stream with New Order

Current Monthly Revenue

$1,042,631

$135,000

$1,177,631

Material Costs

$424,763

$66,990

$491,753

Production Employee Costs

$100,464

$7,728

$108,192

Support Employee Costs

$208,652

 

$208,652

Machine Costs

$9,858

$939

$10,797

Other value stream costs

$73,115

 

$73,115

Profit

$225,779

 

$285,122

Return on Sales

21.65%

 

24.21%

The plant controller then summarized the three approaches; standard cost, outsourcing, or making in house.

 

STANDARD COST

OUT-SOURCE

MAKE IN-HOUSE

NO ORDER

TAKE THE ORDER

TAKE THE ORDER

Current Monthly Revenue

$1,042,631

$1,177,631

$1,177,631

Material Costs

$424,763

$514,763

$491,753

Production Employee Costs

$100,464

$100,464

$108,192

Support Employee Costs

$208,652

$208,652

$208,652

Machine Costs

$9,858

$9,858

$10,797

Other value stream costs

$73,115

$79,865

$73,115

Profit

$225,779

$264,029

$285,122

Return on Sales

21.65%

22.42%

24.21%

 

To most people’s surprise, the best course of action was to make the product inhouse rather than outsource it to the low-cost country. If Puddleglum make this product in-house, they will make more money and improve their overall profitability. In addition, the company is saving itself the headaches and additional costs of sourcing from suppliers from half-way across the world.

Puddleglum Corporation’s Conclusion

Here are the conclusions the Puddleglum Corporation senior management team came to after seeing this example:

a. Making an important decision using a standard cost is misleading and wrong. The fact that you can out-source an item for less the current standard cost is meaningless; it tells you nothing.

b. They did not abandon the idea of sourcing from overseas, but they recognized that they must make these decisions using valid and reliable financial information.

c. Valid and reliable financial information comes from up-to-date value stream direct costs and profitability. These are “real numbers”; not artificial accounting concepts.

d. Very few people in the company really understand the standard costing system, and using it leads to serious mistakes. Value stream costing is simple, readily understandable, and gives information that can be used reliably for decision-making.





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