How are prices determined? By Dr. Eliyahu Goldratt

Transcription

1 A report to the Goldratt Group, Feb 2007* How are prices determined? By Dr. Eliyahu Goldratt * The article was slightly modified to enable easy comprehension for readers who are not familiar with the Theory of Constraints. In one of my visits I audited a company that produces 60% of its region s consumption of plastic sheets that look like glass. I must have been in an extremely adventurous mood to accept this Company into the Viable Vision program because even that concise description sets two alarms bells ringing at full volume. One alarm bell should ring because of the large market share the Company already has. Even if the Company succeeds in building a decisive competitive edge, there is simply not enough easily accessible market to capitalize on the competitive edge. The other alarm bell should be ringing because of the Company s products plastic sheets. Production of plastic sheets is known to be one of the most difficult environments to manage. To realize the special difficulty associated with production of plastic sheets let s review an extract from Necessary-But-Not-Sufficient 1 : Another kind of complication I ve seen is even more difficult to handle. For example, take a company that deals with a special type of plastic. Imagine that in one work center you add the color. To move from producing one type of black parts to a different black part takes maybe five minutes; you just have to adjust some gadgets. But to move from producing black parts to producing white ones might take five hours; you have to almost disassemble the machine and clean it otherwise instead of white parts you ll get gray. This is what is called dependent set-up times. Of course they prefer to first produce all the parts of the same color before they move on to produce parts of another color. That s not the problem. In their case it gets really complicated because the work center that has to further process these parts also has dependent set-up time. Unfortunately, this dependence is not due to color but due to another property like grain or width. So what we face 1 Necessary-But-Not-Sufficient, Eliyahu M. Goldratt, P a g e

2 is two work centers each having their own preferred sequence. Now if you schedule according to the preferred sequence of the first work center, the second one will have to spend so much time doing set-ups that it will turn into a huge bottleneck. But if you schedule according to the second work center, the first one becomes a bottleneck. You understand? In such environments inventories are out of control, due-date performance is poor and even the total volume produced in a month is unpredictable. Of course, the larger the number of SKUs produced, the bigger the problem. Our Company produces close to 4,000 different SKUs. To get a feel for the level of uncertainty that is the outcome of a set of dependent setup times, here is the weekly total output of the Company: Weekly Production (Tons) Weeks Series1 To improve, a deep understanding of Drum-Buffer-Rope, coupled with an understanding of how to produce to availability and good technical abilities, is needed. Our team had what it takes, as is apparent by the continuation of the same graph (the whole production cycle lasts three weeks so seven weeks definitely shows the trend): Weekly Production (Tons) Weeks Series1 2 P a g e

3 Not only did the total volume reach new records but, even more importantly, the variability almost disappeared. On the majority of its products (still, on two lines out of twelve there is not yet enough protective capacity) the Company can now promise leadtimes of four weeks and meet its promised due-date over 99% of the time. Moreover, for up to 30% of its volume it can commit to two weeks (and even one week) and meet almost all its commitments. There is no doubt in my mind that compared to any other company in the world that produces a comparable spectrum of plastic sheet products this Company is now the best. Since both short lead times and reliable delivery on promised due-dates are important to customers, it is evident that the Company has built a decisive competitive edge. The problem is that there is not enough market left to fully capitalize on it. Unless unless we dare to go back to basics and ask, how are prices determined? Maybe the best way to clarify the last question is to deviate, for a short while, into the case of another company. This company is in another part of the world, producing another type of product and has only a small fraction of its market. Like so many other companies, it produces to orders which are augmented by internal stock orders. The overriding concern of production is to strive to achieve maximum efficiencies, which they interpret as achieving maximum tons per day. Six months ago I was notified that there was a crisis, that after a very good start it now seemed that it would be impossible for that company to reach its Viable Vision. The reason for the crisis was that the prices - prices that had been stable for the past five years had suddenly dropped by over 20%. No new competitor had entered the market. Overall demand was stable (even slightly increased). Raw-material prices had stayed about the same. Nothing in the market had changed except for the prices. What can explain it? Even more importantly, what can be done to improve the situation? The implementation started by improving the production and production was improved. The plants were able to produce almost 50% more than ever before (typical for their type of plants V-plant). What was not improved, in fact not changed at all, was the mentality under which production worked, the full-utilization mentality. To maintain full utilization and to break production records, more stock orders were introduced into the system. Finished goods warehouses were filled to the brim. Then the unavoidable happened. Management put huge pressure on sales to sell the finished goods and they reacted in the only way they know how: they increased sales by lowering the prices. (Such mistakes are one of the main reasons I insist that all 3 P a g e

4 management be thoroughly trained on the details of the entire improvement plan the Strategy and Tactic tree detailed to level 4.) Our Company the one that produces the plastic sheets - is also operating according to clients orders augmented by stock orders. In fact, since production is dominated by dependent set-up times, and since for many SKUs the total orders received in a month are for very small quantities, the Company must also continue to produce to stock. As we said before, in a production environment dominated by dependent set-ups, the total volume produced in a month is traditionally subject to very large variations. Couple this with fluctuations in the market demand and it must be that the finished goods of one SKU family or another were frequently considerably above normal. Whenever finished goods inventories are too high, it stands to reason that Sales are pushing out the finished goods by offering discounts. Operating in this mode for many years, one should expect that offering discounts is part of the Company s culture. A quick check provides the verification; for each SKU the Company has four levels of prices each differing by 5% and the bulk of the sales (over 50%) are of levels C and D - the lowest levels. Providing discounts by the dominant supplier has an effect on the market prices; the bigger the discounts the bigger the impact. Since in this case discounts are the norm, shouldn t the dominant company ask itself some penetrating questions? Questions like: are the current average prices that the Company faces in its market not the result of the Company s own mode of operation? Are these prices correct to start with? And the most important question: provided the Company changes its mode of operation, can the market prices be raised? As can be expected, based on the vast experience gained from operating under the conventional performance level and conventional pressures for so long, the sales force will be extremely reluctant to raise prices. If prices are to be increased, sales are the ones who will be blamed for the possible (in their eyes, almost guaranteed) drop in volume. Moreover, they are the ones who know how difficult it is to maintain sales at the current level, what a struggle it is to maintain good relationships with the clients and to what extent any attempt to raise prices will not be welcomed by the clients. It s no wonder that to protect the sales of the Company, before sales goes out to the market with the higher prices they will do their best to verbalize the reasons for their fears to verbalize their reservations. This attitude should not be regarded as conservatism or, even worse, as procrastination. It is genuine and as such their reservations should be addressed logically and systematically. Let me give an example of a typical reservation: 4 P a g e

5 Our Company is the largest producer in the region. It has 60% of the market but there are other local producers two of them - and the competitors performance has for years been much better than our Company s. They are delivering in as short as three days and they were remarkably reliable compared to our Company. Nevertheless their prices are 7.5% lower than our Company s prices. How can we contemplate asking for even higher prices? The proper way to answer such a reservation is not by trying to convince the sales force that the competitors are using us, the dominant supplier, as a reference and that their prices are X% of our prices, whatever our prices are. That will not be convincing enough. One should ask, how come the competitors were always so fast and so reliable? Aren t they using the same technology that we use? The long lead times and the unreliability were not because our Company was sloppy. It is inherent in the conventional way of managing dependent set-up times. How come the competitors were so much better? The only plausible answer is that while our Company is producing 4,000 SKUs the competitors restrict themselves to a much, much smaller number of SKUs. Our Company s sales force knows the market and knows the competitors. It didn t take them more than a few minutes to compile a very good estimate of the local producers offerings. And the answer is. The other local producers offer considerably less than 10% of our products and they compete only in one, relatively small, market segment. Actually, for the vast number of SKUs there are no other local producers and if they will try to compete with our Company on a larger range that will be good news for our Company. The competitors increasing the number of SKUs will directly deteriorate their performance; they will wipe themselves out. This last example should be taken as an indication that on one hand the extreme reluctance of the sales force to raise prices should not be a show-stopper, on the other hand, it should also be a warning that a full analysis must be carried out, that the risks and difficulties in resurrecting the market prices should be discussed. In general, when examining the possibility of raising prices one should examine the three other generic supply sources available to the market: 1. Other local producers 2. Imports 3. Alternative products 5 P a g e

6 In our case, we have already examined the local producers for the vast majority of the Company s market they are not a player. As for imports, the imported products are offered by three distributors importing mainly from Germany (which is not known to be a cheap source) and China. Transportation time from these two countries is, at best, six weeks. Even for one single SKU, holding inventory levels equal to just the transportation time means that good availability from the distributor is possible only if the demand is perfectly stable and that Murphy does not exist. When dealing with hundreds (not to mention thousands) of SKUs, for availability on the SKU level to be close to 90% the distributor must hold considerable (minimum three months) inventories. Since most customers orders are for five SKUs or more, even with such high inventories the availability on a customer order level will be at best (0.9x0.9x0.9x0.9x0.9=) 50%. In such a situation, how can distributors compete effectively with a local manufacturer that provides the full spectrum? The mystery is solved when one realizes that the distributors are our Company s biggest clients and, as the biggest clients, they demand and get the lowest prices. The distributors import just the SKUs they can get at attractive prices (opportunistic buys) and, in order to carry the full spectrum, augment with purchases from our Company. Our Company does not want to deal with very small clients or clients that buy only sporadically. In this sense, the distributors provide a necessary service but the current situation is that the Company actually actively helps the distributors to successfully compete with it on the larger clients. This situation can and should be changed. Before we examine the way to change it let s first discuss the third avenue. As for the alternative products, there might be cases where an alternative material will become acceptable when the Company increases its prices. Of course, the larger the increase in price, the bigger the effect of switching to alternative products will be. My impression is that as long as the increase is not too extreme these cases will be relatively rare since these glass-like plastic sheets have many unique properties and most users choose to use them due to more than one of their properties. Moreover, since most users are other manufacturers and the plastic sheet is a component of their product, one has to take into account the investment and cost to switch to an alternative material. Switching costs are considerable (this is definitely the case for an SKU which is client-specific developed to customer specifications). It looks like the fear that even a substantial increase in prices will trigger a significant move to alternative products is grossly exaggerated. 6 P a g e

7 In light of all the above, it is obvious that the Company should raise its prices but how does one go about increasing prices? Carefully, very carefully. Like porcupines making love. The Company has to overcome its addiction to negotiating discounts and therefore it should not start by asking for an increase in price: it should demand it! Still, one should always remember that to maintain good on-going relationships with the clients, increasing price should always be associated with a good enough reason for the increase. A common example of a good enough reason is the case where the price of raw material went up. As can be clearly seen from this example, good enough does not necessarily mean that the increase is due to an improvement that is good for the client. Good enough means only that the client does not feel that the increase is arbitrary, that he is at the mercy of an opportunistic supplier, that increases in prices can frequently happen and that he therefore must do whatever it takes to look for an alternative supplier. The remarkably improved performance of the Company provides such a good enough reason. As a matter of fact, it is better than just good enough since for most of the clients it gives substantial benefits. The increase in price should be (firmly) presented with an explanation along the lines of: Most of our clients, you included, were suffering from the fact that our technology did not enable us to provide reliable deliveries; our due-date performance was all over the map. We have invested a lot and we are convinced that we are now the most reliable manufacturer, to the extent that we are willing to do something that nobody else in our industry will even consider we are willing to guarantee our due-date promises with a penalty. This is a good enough reason for demanding higher prices (especially when the client does not have any viable alternative) because it removes the impression that the increase is arbitrary. How big should the demanded increase be? Rather than deciding on an increase in price of 10% or 30%, my view is that we should acknowledge that nobody knows what the prices can or should be. A price increase that almost all clients agree with is a net gain. We are actually looking for the increase in price that some clients will reject, an increase that will cause some reduction in volume. Once we find that price, the correct price should be slightly lower. Therefore, my recommendation is to start with a test. The Company should start with testing four groups, each containing five representative clients, and demand a 5% increase from the first group (coupled, of course, with the 7 P a g e

8 better guaranteed reliability), 10% for the second group, etc. A group in which only two companies agree to the increase in price gives an indication that at that level of price increase there is already a trade-off between price and volume. This also means that in the case where almost all the clients in the highest group (the 20% increase group) agree to the price increase, the test must continue for additional groups with higher percentage increases. Since with almost all clients the relationship is not a one-shot sale but long-term contracts, if almost all clients in a particular group refuse the increase, no real damage has been done. We can always come back to them after a while with a lower price. Considering that our Company has many hundreds of clients, this test should not represent a problem or risk. Based on the results of the test, the new formal price list should be set. That is the time to deal with the three distributors. Armed with the proof that prices are already up (actually the fact that the dominant supplier had increased the price is very good news to the distributors they will not hesitate to follow suit), new relationships with the distributors should be set; a relationship where it is understood that the Company will support the distributor only to service the small clients but will not collaborate with the distributor being a price-cutting competitor for the large clients ( Dear distributor, on the SKUs that you are selling to a large client do not expect our prices to you to be lower than those we charge that client ). Let s summarize the current situation. For years, the mode of operation of the Company was to strive to reach maximum production and rely on discounts to sell the resulting volumes. Since the Company is the dominant supplier, unavoidably, such a mode of operation lowered the market prices. If the Company will attempt now to increase prices there is the possibility that the Company will lose volume to the alternative sources of supply. The chance of losing volume to the other local suppliers is limited to a relatively small market segment. Moreover, even in that market the volume lost will be minimal since it is likely that the other local suppliers will follow the leader, as they are accustomed to doing, and raise prices as well. Considering the fact that the Company had actively helped the importers (the distributors) to compete also on price, there is enough evidence that almost half the sales of the distributors were material purchased from the Company, and that the tendency of distributors is to adjust to the market prices (especially when the prices are going up). These facts combined lead me to believe that when this eccentric practice of the Company regarding the distributors changes, there will be no loss but rather a gain in volume. 8 P a g e

9 As for alternative products, the test will tell us the price increase that will not lead to any significant loss of volume. Aren t you as eager as I am to find out what the average increase in price will be? Who is betting on a number higher than 25%? 9 P a g e

10 Dr. Eliyahu Goldratt ( ) Internationally recognized leader in the development of new business management philosophies and systems, Dr. Goldratt s work is carried out by consultants and educators around the world, and utilized by many of the world s largest corporations, including IBM, Procter & Gamble, AT&T, NV Philips, ABB and Boeing. Unconventional, stimulating, and a slayer of sacred cows, Dr. Goldratt exhorted his audience to examine and reassess their business practices with a fresh, new vision. THE GOAL, his best-selling business textbook written in novel form, illustrates Dr. Goldratt s Theory of Constraints (TOC), an overall framework for helping businesses determine: what to change not everything is broken, what to change to what are the simple, practical solutions, and how to cause the change overcoming the inherent resistance to change. Dr. Goldratt wrote numerous books on related topics, including IT S NOT LUCK and CRITICAL CHAIN. His book, THE CHOICE, rapidly became the #1 bestseller in Japan. Dr. Goldratt was a frequent contributor to scientific journals, magazines and business publications. Dr. Goldratt was the Founder and Chairman of Goldratt Consulting, which continues to take the Theory of Constraints practices to new heights with VIABLE VISION, a platform to improve business productivity and profitability. Viable Vision provides the strategy and specific tactics that deliver unprecedented performance and bottom-line results in all aspects of a company s operation. Goldratt Consulting Goldratt Consulting helps companies to immediately accelerate cash flow and profits, and with the same actions begin to strengthen the company for exponential growth. Our clients enjoy substantial increased liquidity within weeks and ongoing growth in profitability. Our approach is based on Theory of Constraints (TOC) - the time tested, logical, common sense solutions introduced by Dr. Eli Goldratt 25 years ago in his book, The Goal, which is still a best-seller today. TOC has been implemented in nearly every function in companies from $25 million family operations to top Fortune 500, in product and project manufacturers, and companies with simple and complex distribution networks. TOC is taught in hundreds of colleges and universities, and much has been published on the subject. Dr. Eli Goldratt founded Goldratt Consulting as part of The Goldratt Group. The company is headquartered in Israel and represented in every continent. Our leadership roster contains the most highly renowned TOC experts in the world. Goldratt Consulting is not a typical consultancy. We only work with companies that commit to reaching a level of performance they had previously considered unattainable. We only implement solutions that bring such performance without compromising long term for short term or one stakeholder group for another (shareholders, management, employees, customers). Instead of hourly or daily rates, our fees are based on the mutually agreed financial value that is generated through our efforts. The vast majority of payments are set to the client reaching specific financial performance milestones, which begin when the previously considered unattainable performance is surpassed. If you would like to learn how Goldratt Consulting can help your business reach new heights of performance, contact us to schedule a free initial evaluation with a Goldratt Executive P a g e