If you thought that manufacturing just “make what they are told to make”, have another think.

The Story

I heard this story recently.

The business in question supplies a range of diagnostic products. This range of tests needs to be extended in order to persuade a larger number of testing laboratories to buy the system. Marketing identified a new group of tests that would satisfy many more potential users and for which the overall sales volumes look good. However, the forecast sales volumes of each new product were small compared to the average of the existing range. When presented with this proposition, manufacturing management were lukewarm about it. This was because the unit cost of manufacture (UMC) would be high for the new products. This is why: small sales volumes mean small batch sizes. In this industry, quality assurance issues mean that there are high fixed costs associated with each batch, meaning that a noticeable increase in unit cost of manufacture with small batch sizes. The apparent effect is exacerbated by the Standard Costing method used which exaggerates the effect of QA overhead on the costing.

This is not the end of it. With a high apparent standard cost, the factory felt obliged to inflate its transfer price to the distributors. A high transfer price meant that the distributors’ sales margin would be slim.

So here’s the rub: what salesman tries to promote a new product with a much lower margin that its existing products? The result: almost zero sales of the first of these new products on the market!

You could say that manufacturing blocked sales.

Were They Justified?

Manufacturing were, of course, right to think that the small batch sizes would involve greater batch related expense. Further, they are judged on the overall UMC for the full range of products. The effect of the new products would appear to have increased this. By accepting the new product range, they would make themselves look bad to their superiors who would ultimately judge them on that figure. You can certainly understand their stance.

How Could They Have Behaved Differently?

However, by paying attention to Standard Cost rather than marginal cost, they were taking a too-gloomy view of the effect on Gross Profit. Marginal costs are actually material cost plus some direct quality control and batch release expense. Looked at this way, there was plenty of profit to be made.

Further, manufacturing (and quite possibly the whole organisation) was not aware that they could compete on their ability to make small batches for less money than the competition. As stated above, the small batches did indeed involve more expense than the average. This appears to be undesirable. However, the competitors’ cost structure may well have been such that they would have incurred even greater cost by trying to make these products at this scale. Recognising this would mean realising that the ability to make small batches relatively cheaply is actually a source of competitive advantage: to be exploited not shied away from.

First the business needs to realise its advantage. Then, the costing and transfer pricing policies need to be reviewed. Then the sales force needs to be provided with suitable incentives. Then the manufacturing manager needs to be let off his UMC hook.

James La Trobe-Bateman is a director of reMODEL Consultants International Ltd