Profit Give Back
Jul 17, 2014
I recently met with one of my manufacturing clients related to a request that was made by one of their customers to enter a program of annual cost givebacks, in this case over a three year period. The customer approached this manufacturing business with a demand that a certain percentage of the sales price on all of the parts that they were manufacturing for this customer be given back every year for the next three years. The customer’s point was that since they have provided $X of volume they were entitled to a specific return of profitability. Another variable to this is that my client operates in an environment where raw material prices are volatile and not dependable. This would mean any price givebacks would also have to be tied to some kind of a concession related to the amount of raw material increases that may be coming down the line that the they could not anticipate.
From their point of view any pre-agreed upon price give back has to be related to the overall profitability of the part, and in an environment where raw material prices can change 30% to 50% in a few months, the profitability of those parts can go either direction very quickly. Raw material fluctuations can make even modest price givebacks intolerable to the manufacturer and throw them into an operating loss irrespective of how efficient they might run their operations.
The frustrating part for this business owner was related to his inability to communicate with the customer relative to all components of the pricing structure in the family of parts he was manufacturing. His customer seemed to focus on only volume related profit improvements and how sustained volumes could lend themselves to improve profitability and make profit givebacks a viable concept.
It is true that high volume parts generally wind up gaining certain efficiencies that can maintain or improve profitability to such a fashion that some modest profit giveback is possible within the context of a sustained volume at stable pricing. However, in cases where product selling prices were set years before and there was high volatility in outside services or raw material that was beyond the control of the manufacturing business it is readily apparent that irregardless of the efficiencies and profitability achieved by the manufacturing business, the entire profit structure could be undermined in a few months.
The owner’s frustration with this very aggressive demand by their customer for price givebacks without any consideration whatsoever as to a comparable concession on raw material prices or purchase services pricing put this business owner in a unenviable position. His entire relationship could likely be at risk if he was unwilling to offer these price concessions, but the future profitability of the company would be equally at risk should price increases be forced upon him, especially without any ability to gain some concessions.
This scenario is increasingly more evident in a whole range of businesses and requires that business owners precisely know their cost per piece as well as what affects those prices, and how they are affected by increased volumes. As we mentioned many times in earlier blog posts business owners are unable to make improvements in their overall efficiency anywhere near the levels that are being demanded by customers on price rollback programs. Less and less of the selling price of the part are the conversion cost of today’s manufacturing businesses and more and more is related to raw material, purchase parts and services, and other costs beyond the control of today’s manufacturing business managers.
Categories: Cost Accounting