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How a lean organisation thinks about price

How do you set the price of your products? It seems like a simple question yet like everything there are multiple answers to this question depending on which organisation you ask or indeed if you ask the accountant, the engineer, the marketing guy or the sales lady. As an engineer, I know that the sales team always want the lowest price for selling and are never happy with the number the engineer gives, which can be good but can be frustrating and sets up a bit of a niggle between these teams.

Traditional Product Pricing Options 

Some organisations take all the costs involved in building the product, add the costs of the raw material, add the costs for transport/logistics, the administration costs, advertising costs, a % of the overhead cost which would cover things like perhaps rates / electrical costs etc. Once they have all of those then they add a % for profit and boom there is the cost.

Another organisation may work based on what the market can stand, all the competitors have similar products and they sell it at $X, so if we want to make 21% profit then we have to make it for $Y. This then drives decisions on where to source parts from – it'll almost always be the cheapest option, internal costs will be kept as low as possible and you may try and build in bulk in the belief that the economies of scale/volume will make it cheaper (It won't but that's another story).

I admit that these examples are simplistic, but you get a general idea. Within the manufacturing processes, you have some options, you can do job costing where you assign specific costs to the specific manufacturing batch or job, this means your manufacturing costs for a product may vary with process variation. You may take a Process Costing option which is largely the 1st example above. There is of course also Direct costing & throughput costing (a better option!).

Irrespective of the method used you essentially have the same way... what's the target cost that we have to meet if we are going to sell at X to get us the profit we want or the to sell at X and make 21% profit, what's the target product cost.

Product cost in a lean enterprise 

 

When a lean enterprise organisation look at the situation, however, the question is a little different. they would look at the product and say Ok, we can make that and then ask the question what is the waste-free (muda) cost of the product is. By looking at what all the visible waste is involved in manufacturing the product and removing it, which then increases the flow you immediately drop the cost of the product even before attacking the invisible wastes. This is the Muda Free Cost of the product, the real target cost, and it is generally far below that of the competitor as described by Womack & Jones in their book Lean Thinking.

Since you now have this lower target cost you have a number of options to play with, you can obviously sell your product at a lower price, (which would increase volumes), add additional features to the products that your competitors don't have that would be used by the end customer which would again increase sales, what other bolt on services could you add, or, you could just take the additional profits and feed that profit into investment to improve the operation and your staff.

Understanding the Value Stream

To be able to do this you need to understand what your value stream for your products really are, what are the wasteful elements, where are the queues, the waiting times, the non-value add items, the polishing that gets done that doesn't need to get done. By taking this 30,000-foot view you get to understand the activities you use to manufacture your products and by  involving a wide team of people from each discipline to help build the value stream map you not only improve the process and hence reduce the costs but also build a better relationship between the departments and a better understanding of the true costs involved.

Summary 

Before you start costing your next product stop and ask as many as you can, how much waste is in our system that we could remove, if we did remove it what would the impact on cost be, on flow, on delivery performance. Then, and only then start thinking about what you want to charge your end client for and hence your final sales price.


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Monday, 19 August 2019

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