Are you sure your costs to serve and price setting are reliable ?

 

Autor: Jan Kerremans

Jan is an associated Talent at Manager in Motion and an Interim Manager reputed for improving top-and bottom-line performance, building world-class teams, and driving business growth/success through innovative and efficient solutions, performance excellence, and ownership culture. Jan has an in depth experience in Supply Chain and Sales combined with different general management, P&L and budget responsibilities. As a result of this distinctive competence he has a track record of spotting business opportunities to go beyond the mission objectives.

Below you will find a relevant case example that illustrates optimizing cost to serve and price quoting for a large industrial construction player.

 

Perception is (not always) reality?

 

As first mover in the European market for steel buildings for industrial purposes, the company had built up a competitive advantage that it had been able to sustain for a long time, especially as they were the first to introduce a tool to design and quote rapidly and accurately the price proposition for a given building stucture and made that tool available to the dealer network. The Price setting was based on a calculation of manufacturing and raw material steel cost using empirically defined formulas 40 years ago and the other costs were added through a financial markup.

As the market  became more diversified and more demanding in complexity and differentiation of the requested solutions, the reliability of the costing and pricing started to deviate gradually from the reality.

During the last 20 years the EBIT % of the company dropped from a solid 10% till below 0%.

They believed that inefficiencies in their operations was the only root cause and I was recruited to optimise the operational processes and to eliminate all possible waste in these operations applying Lean principles.

I delivered action plans to reduce fixed costs and improve on operational efficiency but a simulation of the possible impact of this plan revealed that even an optimistic 15% fixed cost reduction and 10% efficiency gain would not deliver an EBIT% well above 0%. It became clear that their key issue wasn’t only operational efficiency.

The company’s project portfolio had drastically shifted from large scale (> 1500 m²) to small scale projects (< 500 m²) overtime and I was wondering what caused this shift and how it impacted the fixed cost absorption (SG&A) and the EBIT%.

So I proposed to extend the scope of the mission to include and focus on a review & redesign of the Costing and Pricing methodology in the Quoting Tool. The 6 month mission became a 15 months mission.

 

Objectives

 

• The first objective was to review and adapt the base cost calculation of the Quoting Tool applying principles of Activity Based Costing for the key activities in manufacturing, logistics and engineering
• The second objective was to foresee an automatic export of the calculated manhours and costs for direct and indirect manufacturing and engineering activities into a Project Evaluation sheet in Excell.
• The Project Evaluation Sheet to include a pragmatic and reliable SG&A cost allocation to the project in order to be able to define the EBIT and approval levels for each project instead of evaluation based on the often misleading Gross Profit Margin level
• Last objective was to modify the Sales Bonus scheme, to be based on EBIT and turnover target achievement instead of turnover target only. This in order to stimulate EBIT oriented behavior in the Sales force and the whole organisation.

 

Problem Analysis in depth

 

• Empirical formula’s used to estimate manufacturing costs were outdated and not representing anymore the current products, manufacturing processes and key performance parameters. The manufacturing cost lacked differentiation with size and complexity of the building
• Raw material Steel costs were inflated with a contingency factor close to 10% in order to take into account risks of RM price increase in the future.
• The calculated base cost X (RM and MFG) was multiplied by a Financial Markup and 3 Correction Factors were added throughout the years resulting in a total markup of +/- 2.

But probably the biggest issue was that they never dared to implement any kind of “activity driven” allocation of SG&A costs as it was perceived that this couldn’t be done properly and would always fail to be reconciled on a yearly basis. So projects were evaluated based on Gross Profit Margin instead of EBIT.

The BIG error evaluating projects based on Gross Profit Margin is that people unconsciously will evaluate this value versus a target including the fixed yearly SG&A %; SG&A % in this case as big as 21%.

Doing so big projects received outrageous amounts of SG&A in absolute value as compared to what common sense would judge to be applicable.

In combination with the exagerated contingency on RM Steel and the lack of low complexity favorable impact on cost this resulted structurally into almost 30% overestimations of price for « big size projects at low complexity » as we will illustrate later. Even intervening manually for each project in order to try to correct the price closer to market reality the final price proposal did not compensate enough for this 30% overestimation as people were reluctant to make such a big correction. And while heavily underestimating costs for « low size high complexity » projects they were very successfull attracting these « unprofitable » projects.

The Quoting tool would only show the Gross Profit Margin of a project for evaluation and the Sales bonus was only based on turnover so profitability of a project was not an objective as such.

The company with a strong Engineering DNA remained blind for this destructive evolution as the engineers were eager and exited to show to customers they could cope with the requested complexity and realise what competition was not “able” (“willing”) to do.

 

Solution : TABULA RASA of the Base cost

 

Step 1 : Review the Base cost for weight and direct Labor applying Activity Based Costing

• RM Steel price contingency taken out and included as conditions in the contracts with customers
• Principles of Time Driven Activity Based Costing were applied to direct costs in Manufacturing but also to indirect manufacturing costs and engineering costs previously all hidden in the Financial Markup.
• Real time registration was introduced to verify the standard times and adapt where needed.
• Exemple of ABC for manufacturing welding
  • Web Production Cost = Web Production Time * 1,15 (breaks, briefings .. 15%) * Charging_Rate (EUR/hour)

                  = {(Setup + Handling) + (Perimeter/Speed)} * 1,15 * Charging_Rate (EUR/hour)

                  = [12 * Nb of web plates + {0.5 min/m * (Member web depth start(m) + Member web depth end (m) +

                   2 * Member length (m) + 2 *  Total length of seam weld  (m))}] /60 * 1,15 * Charging_Rate(EUR/hour)

• • Web Assembly Cost = {9 * Nb of web plates}/60 * 1,15 * Charging_Rate (EUR/hour) <<< Nb of web plates > 1
  • As this company has only few orders at the same time in production (2 max 3), we neglected the possible positive impact of batches in combination with other projects and as such overestimated setup costs slightly versus reality. For organisations that handle many customer orders at the same time with high potential of creating batches across orders, the formula can be easily adapted applying a factor based on last year data.

-Exemple of ABC for engineering design (A) and drafting (B) based on standard times per special feature

• • Simple box without features : function of size of the building
  • Special Features (70 in total) : function of size of the building in most cases
  • Exemples of special features : Additional Frame, Jack Frame, Special anchorage etc…

Step 2 : Integrate Indirect costs in the Base Cost based on ABC cost drivers

• Indirect Costing defined assuming no headcount nor overtime tobe added at MAX (not current) Capacity
• Indirect ENGINEERING Cost allocation rule : 1 Team Leader for 10 max 12 Engineers
• Indirect Manufacturing & Purchasing allocation
  • Cost drivers per indirect activity. Exemple Number of SKU’s scheduled (Scheduling). We estimate that 1 scheduler (1650 manhours per year) can schedule up to 16500 SKU’s per year without adding overtime => 6 min per SKU
  • Similar to our approach for the machine setups in manufacturing we also ignore the possibility that two projects could result in one combined batch reducing slightly the cost for one single project as a consequence.
  • Exemple : 1 PO generated and costed per single project instead of different projects grouped in 1 PO

Step 3 : Define a reliable allocation for SG&A instead of a fixed % hidden in the Gross Profit Margin

• We decided to allocate SG&A to every single project as an absolute value instead of a %
• First we needed last year Turnover and budgeted next year (fictive figures)

• Second step was to allocate the total yearly SG&A cost per group of countries

1. Direct allocation to the SG&A country group for country specific headcount eg dedicated Sales force.
2. Allocation based on turnover pro rato the W-Europe turnover for SG&A shared in W- Europe eg Inside Sales
3. Allocation based on turnover pro rato the Europe turnover for SG&A shared by Europe such as R&D, Admin…

• Third step was to integrate the planned headcount reduction in the future numbers (corrections in red)

• Last step was the definition of the vital few and available cost drivers at moment of quoting.

• A benchmark and numerous discussions internally resulted in the selection of 3 cost drivers namely the calculated manhours for MFG, ENG A and ENG B available both at Quoting stage and in actuals for last year. In order to limit the size impact it was decided to give ENG manhours a bigger weight of the SG&A cost then the MFG hours : 2/3 Engineering in total versus 1/3 manufacturing (37,5%)

Step 4 : Export Cost details into an Excel sheet to allow controlled modifications and present the project P&L

• MFG costs and manhours, ENG costs and manhours as well as RM costs calculated in the Quoting Tool are exported automatically into a Project Modification and Evaluation Sheet

• The detailed information per SKU and ENG feature is downloaded in an Excell sheet and allows to modify manually SKU’s or features in case the design in the tool fails to be sufficiently accurate or complete but original values are always safeguarded in order to verify the manual modifications and avoid manipulations of costs

• The aplicable Country Group is selected and the SG&A and P&L calculated automatically incl. EBIT%

Step 5 : Define a new Bonus Scheme for Sales

• Sales Bonus as a function of realised EBIT per project still in combination with total turnover target.
• Sales People briefed and bonus system immediately put in place for one region in Europe

 

Results

 

Let’s compare the OLD vs NEW Costing & Pricing for 2 opposite projects (different in size and complexity)

1. OLD Model overpriced this project by almost 21%
2. OLD Model costing almost 9% higher (in fact 12% if we include ENG costs also in OLD as is the case in NEW model). Difference mainly caused by the RM contingency
3. SG&A % versus Price 13% LOWER in the NEW model (OLD model used the country average) !!!
   1. Average SG&A % for this Country Group Central Western Europe = 20,2 %
   2. New SG&A much lower 7,2 % <<< 20,2 % result of sum of 3 multiplifications eg 2123 MFG Hours * 39,8 € / manhour cfr previous table = 84495 etc => Total 233692 € SG&A / 3254562 € Price = 7,2%
4. EBIT% almost 20% higher if assuming the NEW Price as the reference for both scenarios
5. Massive loss of market share in this segment

1. Too high entrance price closed the door even before being able to negotiate
2. Too low EBIT estimation was preventing Dealers and Sales to give adequate discounts to win the project

1. OLD Model underpriced this project by 2,4%
2. OLD Model costing almost 16% LOWER then the NEW modeling, in despite of the RM Steel contingency of 10%,and this mainly due to lack of size and complexity differentiation
3. SG&A % versus Price almost 9 % HIGHER in the NEW model !!! High SG&A % caused by relatively high amount of ENG hours in comparison to size of project
4. EBIT% almost 17% lower if assuming the NEW Price as the reference for both scenarios
5. Massive gain of market share in this less profitable segment of low size high complexity

1. Too low entrance price already eating some of the foreseen EBIT% in the NEW price calculation
2. Too high EBIT estimation was inviting Dealers and Sales to give too high discounts to win the project

The final result was a huge market share growth in a less profitable segment and great loss in the more profitable segment. Due to the loss in that big size projects segment the company faced a growing issue to absorb the high fixed costs of R&D, marketing, Sales etc…

 

Conclusions

 

This business case clearly indicates how destructive it can be for a business to have non differentiated costing as a base for pricing and/or profitability calculations.

Defining a sufficiently differentiated model for costing and pricing for a company requires pragmacy on one hand but also in depth knowledge of all operational processes including sales in order to select the vital few differentiators and avoid too much detail and complaxity of the costing model.

In this specific case the exellent work done years ago at company’s start-up and the competitive advantage of fast accurate quoting on the market unfortunately prohibited the organisation to dare to question and review the existing model fundamentally.

The old model didn’t capture sufficiently the impact of size advantage and complexity disadvantage in cost and price and was favorising small size – high complexity projects and defavorising big size – low complexity projects, and this reinforced by the project evaluation based on the misleadung Gross Profit Margin %

The market segment of big and especially big size low complexity was given away to competition.

Fixed costs of R&D, marketing and engineering were no longer absorbed adequately so it was decided to reduce this fixed cost by early retirement and layoffs.

Unfortunately by doing so they lost a key asset of the company namely engineering skills which are always hard to find on the market and are taking long time to develop to internal standards. Unfortunately this expertise loss will negatively impact the speed to grow after the targeted process redesigns and optimisations.

To conclude the old costing and pricing methodology did not capture the market and complexity evolutions NOR did it use an adequate SG&A allocation which resulted in yearly EBIT destruction and the almost complete loss of the segment required to absorb the relative high SG&A costs. A negative spiral.

 

What’s in it for you ?

 

Are you sure your current model of costing, pricing and profitability is reliable, representing your market and process reality and aligned to your strategy ?

Would you like to get an in depth review of your costing and pricing followed by the development of an improved model and this within one year leadtime ?

Do not hesitate to contact Manager In Motion to get my support and benefit from my broad experience in the field. High return on investment guaranteed.