For many years, I have worked in the glass industry and specifically in the fiberglass and glass wool insulation business. Like many other businesses, these are capital intensive operations. Furnaces are expensive to build, lass for ten years and cannot be shut down, and require intense capex for maintenance and potential upgrades. The nature of these businesses led to the adoption of hybrid pricing orientations composed of break-even analysis, absorption and capacity utilization models, and market share-driven tactics. Every year, at budget time, you would hear the same expressions and questions flying around:
- How much volume do we need to fill the line?
- What is the minimum contribution margin we can price at?
- How can we ramp up faster?
- We need to fill the lines!
- We need more tons!
- Depreciations are killing us!
If that resonates with you, you are also probably doing business in an industry that is capital intensive. Most firms have capacity utilization and absorption in their DNA and, because of this, they focus much more on cost-models, capacity models and break-even analysis than on customer willingness-to-pay analysis or customer value research. In these situations, pricing and marketing professionals are constantly confronted with dynamic requests for contribution margin analysis for volume opportunities, and for price sensitivity analysis at the expense of the rest of the pricing process. But are we looking at this the right way? How do you change the mentality and orientation of managers in these firms? How do we separate the engineering and finance discussion from the market-driven pricing discussion? I thought I would write this short essay to stimulate a discussion and share some of my thoughts on the question.
Business Strategy Matters
My view on the subject is that it all starts with a sound business strategy. Defining a 3-to-5 year robust and market-grounded strategy is a pre-requisite to a discussion on price versus capacity utilization. Getting it right during the strategic process leads to proper business planning, plant right-sizing and relevant marketing strategies. You match the asset planning with your overall positioning: differentiation, focus or low-cost strategies.
I have been in situations where plant and capacity planning was conducted in silos or outside of business strategy discussions. That is the case when industrially-minded managers “fall in love” with assets, develop grandiose expansion plans or focus on the best-of-the-best in technology, without defining marketing strategies to properly utilize the asset capacity pool. So what I am saying is that if you find yourself in a discussion during which you are trying to “fill the lines,” ask yourself why you are in this position. Did you oversize the assets? Did you build a Rolls Royce when a Peugeot was needed? Do you need the asset in the first place? Do your marketing strategies and asset planning strategies conflict or mismatch? Can we get the ROI and payback for this investment based on market-based pricing levels?
Flexible and Scalable Assets
The name of the game in these capital intensive industries is to be able to design assets that are somewhat flexible and scalable in nature. This is a real design challenge. Can you break up front-end depreciation expenses in “chunks” or waves, based on modular concept? Can you build large infrastructure components and then deploy smaller-scale investments over a period of ten years? Do you specialize your assets or do you make them multi-products? Can plants be flexible in their design for mass production for semi-customized products (advanced manufacturing concept)? This is the real discussion to be had. We have not yet discussed pricing. If your get the business strategy right and develop a unique and creative asset plan, then the pricing discussion becomes easier. Not the other way around. Pricing professionals cannot solve the problems of inappropriate asset design and capacity planning.
Business Strategy Shapes Pricing Orientation
I propose that if a firm adopts a pricing orientation based on customer value, capacity utilization and absorption become irrelevant. Costs do matter, but they do not enter into the price-setting process. Obviously, if a firm adopts an orientation based on cost or competition, then the discussion will be mostly focused on cost and market share models. Still, pricing is a separate discussion. Your pricing orientation should mirror your business strategy. If your firm is positioned as a differentiation player, then your assets should right sized, less specialized and more flexible. Then you might adopt a value-based orientation and focus on capturing value in the market. If your firm chooses a low-cost positioning, then your assets will be large, more specialized and highly automated with a reduced change-over period. The focus there will be on capacity utilization and manufacturing variances.
The bottom line is that pricing professionals can help measure the impact of depreciation on costs and margins. They can run all the contribution margin and sensitivity models in the world. But they should not be asked to solve manufacturing scaling and design issues. They should not be basing pricing decisions on absorption and capacity utilization unless your business has oversized its asset pool, or you experience a sudden reduction in demand. Even in that case, it might be better to mothball or idle the asset or to shut it down for good. The focus should be on capturing customer willingness-to-pay and maximizing margins.
Pricing power starts with an excellent business strategy followed by relevant business plans, asset plans and marketing plans. All of these are support by customer-centric pricing strategies. So the question should move from “how do we fill the line?” to “do we need this line?”+”how do I get more pricing from the market?”
The bottom line: It is a change in mentality.