Let’s face it. Foundries are driven by strong margins. Are your margins acceptable? Or are your margins and return on sales (net income as a percentage of net sales) lower than you would like them to be? Or have you experienced a negative return due to net losses recently? In these cases, you most likely have an issue maintaining acceptable product margins through customer price increases as labor, material and overhead costs rise year over year.
Prices, costs and product margins are really a big deal for foundries. Let us be clear, even though we often hear “we know our costs,” most foundries have a poor track record of really knowing their costs. And if they don’t understand their true costs, they don’t know their product margins. Customers apply constant pressure to “lower your prices” or “we need cost downs!” It’s typically “David versus Goliath” and David is reluctant to upset Goliath with price increases in fear of losing him as a customer!
However, your customer needs you to be a profitable and viable business to ensure their supply chain has no “weak links.” When is the last time you raised prices?
So how do you know if you have a problem with customer pricing and margins? A macro review of your income statement and some analysis will pinpoint the areas to address. First, review your gross profit margins (as defined here as net revenue less total actual manufacturing costs) as a percentage of net sales. If that percentage (what we call gross margin) is not anywhere near your quoting profit margins and not at an acceptable level, you need to dig deeper. If your gross margin is not at an acceptable level and has dropped year over year, you need to review why. The first areas to examine are variable and fixed manufacturing costs. Have these costs as a percentage of net sales increased year over year? If so, which line items and why? And are you carrying the same level of fixed costs though revenue has declined? Many questions, frankly, need answers.
Let’s take materials and supplies costs, for example. Most companies will receive letters from suppliers if material costs are going to be increased. One can assume almost every year the costs of supplies and materials used in production are going to increase on par with the inflation rate. In recent years, that rate has averaged around 2%. One can also assume manufacturing overhead costs (utilities, rent, etc.) will increase by that same inflation rate. Labor costs (wages, salaries, and fringe benefits) used in production typically will rise annually as well. Most companies will target a 2%-3% increase in wages to ensure they remain competitive in the marketplace. Given these annual increases in variable and fixed costs, a company will need to increase its overall customer prices to maintain an acceptable gross profit margin. If not, you will experience what we call “gross margin erosion” and a real decline in the profitability of your company. In our foundry consulting work, we have seen many foundries forego increasing customer prices for several years, unfortunately. Under this scenario, gross margins can erode to single digits and even negative territory, creating an unsustainable foundry business if the situation is not corrected immediately.
Once you have identified a customer pricing problem at the macro level, you need to drill down on a part-by-part basis for each customer to see what your specific issues might be. This does require a strong cost accounting system.
Standard increases in costs do warrant price increases to customers to maintain margins. However, when reviewing margins on a part number basis, you can identify other issues that cause unnecessary costs and unacceptable margins on a particular part or set of parts. A common example is work being done to parts that was never quoted.
To ensure you are managing your prices effectively down to the part level, we recommend an annual review of certain customers and the parts produced for them. This analysis of part prices, costs and margins by customer is used to identify parts with unacceptable margins caused by inadequate prices or high costs (excessive scrap, labor, rework, poor tooling and molds, poor tooling design, etc.)—and is necessary to affect your long-term success. Such an analysis typically results in identified price increases for certain customer parts or potentially abandoning certain customer parts that generate losses for the foundry. Or you will identify necessary improvements in processes to eliminate waste/costs.
Without a doubt, acceptable customer pricing and product margins are one of the most critical areas we review in our foundry turnaround work. If you are struggling in this area, know that you are not alone, and help is available.
Robert Silhacek and Michael Wise
Originally Posted April 20th, 2021 at Modern Castings