The Situation
- You are a major manufacturer of medical diagnostic reagents. You make most yourself, but you have subcontracted manufacture of a minority of products to a supplier who has the necessary biochemistry knowledge. The contract includes materials and labor and the price is set at a ‘Per Item’ rate with quantity at your discretion. After 5 years the contract is up for renewal and you contact the subcontractor to confirm the price. You are enraged when the subcontractor insists on a 40% price rise across the board. You have no other source for the material which Marketing insists is essential to the business as a whole. Do you agree to the price rise or come up with another approach?
What Arguments Do You Have?
- Your search for clues: the existing contract states that the supplier must provide evidence of cost increases. They have not provided any, and do not appear to have a method for linking expenses to sales price outside standard cost accounting, the details of which they are reluctant to reveal because it contains information that is proprietary.
Use of 3rd Party
- A 3rd party can always help in a stalemate. You know one who has a method for evaluating manufacturing costs that can be done in just a few days at site. The method does not need to know about parts of the factory that deal with other products. The method is particularly applicable to batch manufacturing processes where batch related costs, such as QC testing are disproportionate to those that vary strictly with volume such as packaging materials. You will then see what is making costs vary and the supplier will obtain justification for its claims, in a way that conventional cost accounting does not do. They agree to allow a factory visit, provide the necessary information and will accept the analysis if it totals their own estimate.
What the Analysis Reveals
- 1. The marginal cost of manufacture of each component is relatively small
- 2. At current prices some of the products are not profitable and some are very much so
- 3. Changes in volumes required over the next 5 years will significantly change the unit manufacturing cost
- 4. The supplier has limited ability to reduce cost by increasing productivity
- 5. Batch size is the major driver of unit cost
The Negotiations
- You inform the supplier what you think their Gross Margin will be as volumes change. The supplier responds by saying that this is not enough. Cross-examination reveals that they worry about material cost inflation, labor cost inflation and that the actual volumes may fall short of your forecast. You add features to your ‘model’ of their operation to account for the inflation effects. You agree what these should be. Since Gross Margin is the criterion that the supplier insists on using, you discuss a minimum and maximum for this. You agree that prices should be set so that they are capped when the calculated margin reaches the maximum and boosted when the margin drops below the minimum. The key agreement is to use your cost model to perform the calculations.
The Result
- The cost model ‘calculator’ is part of the legal contract. By re-assuring the supplier that the real risks they face are built into the price, they agree to a lower Gross Margin, which amounts to a price rise much less than originally asked for. Your saving amounts to millions of dollars and you restore the relationship to one of mutual respect.
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