It may be evident to those closely connected with the foundry industry that a gap exists in the understanding of how contracts for equipment or other capital expenditures are priced between vendors and foundries and, in turn, between foundries and their customers. When dealing with major projects or improvements that can extend over a long period, those engaged in the bidding process could save big money by understanding the problems associated with extensive projects and how they are bid.
There is a difference, for example, between the views of a marketing/sales-driven company and an accounting-driven company. It’s not wise to assume stereotypes, but you might loosely liken this difference to a foundry run by foundry people, as opposed to one run by a financial holding company. Knowing which type of company you are and which type of companies with which you are dealing can help you become more competitive with your customers and smarter when dealing with your vendors. Here we will see why the marketing-driven entity is better, in the long run, than the accounting-driven one.
Understanding the difference between the marketing/sales view of pricing versus the accounting view, as well as knowing the long term effect pricing has on the industry, can offer savings. In an effort to fill the gap, here is some practical information to help raise the awareness and understanding of marketing and pricing as applied to long term, usually high value, contracts with suppliers or sellers bidding for business. The comments and considerations as presented may not apply to short term projects or off-the-shelf items.
Many foundries accept bids from (or submit bids to) other companies without understanding the bidding process. Otherwise, they would not accept half the bids they receive. Many in the foundry industry think of pricing as ‘cost plus a markup.’ This type of thinking is driven by accounting, and is not necessarily the approach one should take to bid successfully.
A bid price that is offered and ultimately accepted by or from a foundry should go much deeper than ‘cost plus mark up equals selling price.’ There are many factors that should be considered before a bid price is accepted, and knowing more about who you are and who your vendors are can be very helpful during the negotiating stages.
A bid price is given (or accepted) on a real project that is to be completed in a specific time period and tied to a predetermined set of terms and conditions. The bid price may be presented as: an adjustable price; a firm price; or a combination of the two.
An adjustable price is one quoted in current dollars, subject to an adjustment based on various published indices (steel costs, labor rates, etc.). The cost of a project will develop over a long period of time from bid date to completion date. However, most manufacturing costs are usually stable for at least six months. Over a long term contract, the exposure to risk is greater for the buyer because of the potential changes in the indices.
A firm price is not subject to adjustment and is fixed based on a delivery and installation time specified. The exposure to risk is equal for both buyer and the seller.
With these types of bids, a price can be broken down into components — material, and labor and/or installation. Both material and labor can be quoted as separate bid prices, each with separate terms and conditions. For example, the material price can be quoted part fixed and part variable, while the labor portion can be totally adjustable based on man-hours, labor rates, etc.
Obviously, there are costs involved with major projects, so it is important to understand what exactly cost is.
Cost is the sum total of the fixed and variable expenses to manufacture a product. Fixed costs include the expense of running the business (rent, utilities, office equipment, insurance, salaries, depreciation, and property taxes). Variable costs include raw materials, hourly wages paid to laborers and contractors, warehouse and shipping costs, and manufacturing efficiencies (covering things such as shop loading, employee attitudes, and the use of new or antiquated equipment).
The Role of Accounting
It is important for a company to review costs associated with a project’s bid price for two reasons: 1) to analyze the effect of theoretical costs on the projected bid price; and 2) to act as a watchdog on the accounting department.
We are all aware of recent disclosures in the media relating to accounting misreporting and improperly calculated projections of profit and loss. This would never have happened if these projections of profit and loss would have been reviewed, understood, and/or challenged by another independent group or internal department.
The Trouble with Cost-Only Pricing
What is wrong with a bid price that is based on cost only (price = cost + markup) versus a price based on a pricing strategy as described above?
First, a cost-only bid makes no distinction based on the magnitude of the project. It favors the smaller projects and overprices (and potentially loses) the larger projects.
For example, take an accounting-driven company that has established its standard markup to be 30 percent. Two-thirds of that markup (20 percent) covers general & administrative (G&A) costs, and one-third (10 percent) is profit. The numbers here are exaggerated to emphasize the point, but such a company would prefer to offer a price of $100,000 rather than $500,000 with a 15 percent markup. That’s because the accounting-driven supplier or contractor is more attracted to the rate of profit than to the actual profit volume. The smaller $30,000 gross profit ($100,000 x 30 percent) is more desirable in the accountants’ eyes than the gross profit amount of $75,000 ($500,000 x 15 percent) simply because of the percentages.
Secondly, a bid price based on cost may include accounting add-ons for covering the cost of shop inefficiencies and projected labor rate increases. A cost-based bid price could, for example, be affected by a labor rate increase (that will then be static for a semiannual or annual period), but would cause a current spike in costs.
A marketing-driven supplier, in contrast to the accounting-driven one, considers four simple rules and sets its pricing based on market value, market strategy, future opportunities and repeat business, and the company’s need to fill its shop. These rules are appropriate to the foundry as it bids on its jobs, and should be considered by foundry management as it reviews bids submitted for its consideration.
The four rules are:
Rule 1: An offered price should always ignore poor shop performance as a basis of cost structure. A supplier won’t stay competitive for long if it sells its inefficiencies to its customers.
Rule 2: A bid price should always reflect the ‘conditions’ of the day. This covers a range of factors, such as market and competitive conditions, manufacturing needs (shop loading), future business opportunities, corporate conditions (profits and cost recoveries), the bid price formula (the customer’s terms and conditions and your company’s cash flow), and economic conditions (inflation and interest rates). Typical questions that might be asked include: How many acceptable bidders are there and what are their needs for the contract? What is the number of contracts possible on the horizon? What are your needs for the contract?
Rule 3: A bid price must recognize design considerations. This rule covers such things as unit efficiency, inputs and outputs, and the advantages/disadvantages relative to competitor designs. Typical questions: What is the customer asking for? Why or how will the unit or equipment being offered meet the customer’s desires? How does the unit or equipment design requested by the customer compare with the supplier’s own standards? Do the specifications favor the competition? Does the bid meet the specifications?
Rule 4: A bid price must consider the customer’s financial position. This means that the price you offer should take into consideration the customer’s financial conditions and cash flow needs. It’s not that you want to take business at a loss, but you might offer advantageous pricing for a limited time to gain goodwill with the customer. Typical questions are: Will there be any up front payments or delayed terms? Can the customer pay for what is being offered? Does the customer understand the costs involved with what was specified? Will the customer accept and properly evaluate bid changes? Will the customer negotiate?
Night and Day
An accounting-driven company and a marketing-driven company are different as night and day. An important point to remember is that a price accepted can have a lasting effect upon the market, your relationship with your contractors or material suppliers, and maybe within your industry as a whole.
For example, a foundry have sought an outside contractor for its most recent brick and refractory design and installation problem. However, the real problem was actually their perception of cost and the type of contract that they had awarded to do the work. They may have awarded the project to the lowest bidder and made the contract time and material. This opened a whole set of new problems. The contractor’s productivity slowed to a snails pace and the foundry schedule was affected. The foundry had been provided with enough information (quantitative take-offs, specifications, drawings, and schedule) that would have allowed them to go out for bids on a firm price. Unfortunately, what they saw were dollars at the fixed amount that seemed much higher than what they thought the costs would be if they allowed the contractor to work on a time and material contract. This type of thinking occurs a lot in the foundry industry.
An understanding of the various aspects of the bid process and pricing is needed because the dollar amount of the bid price and the type of contract awarded has a direct affect upon the whole operation. It contributes to the market value (cost) of a new furnace or other piece of equipment, or even the brick, refractory, and insulation required in the melt shop.
A major project requires in-depth understanding of marketing strategy, engineering, manufacturing, and labor costs. The structuring of a bid price for these long term projects should not be a cost plus markup approach, as is used for off-the-shelf goods. Reducing the cost to the foundry industry will help reduce their initial capital cost.
This means that good competitive pricing is needed from all sectors (manufactures, contractors, material suppliers, etc.). Foundries need to take a long look at the bid prices they accept. The industry and all other companies involved hold some measure of responsibility to help keep costs down. It begins with understanding the foundry market and the pricing that is accepted or presented.
Gary Bases is president of BRIL, inc., an independent consulting firm specializing in brick, refractory, insulation and lagging for the iron, steel, and aluminum industry. Contact him at Tel. 330) 665-2931, or [email protected]