Is GM Smoking Something?

Industry News: GM To Offer Zero-Percent Financing, Raise Prices, Screen Hummer Buyers

It's very hard to figure out what GM is thinking these days. In the first link above, the Jalopnik blog highlights an inconsistency I also noticed... it's the old laws of supply and demand popping up again. It always amuses me, in a way, that this basic law of microeconomics is even considered a "Lean lesson" because Toyota leaders like Ohno wrote about it. The basic supply and demand laws dictate the prices for just about everything -- unless you are a monopoly provider or a (obscure econ word warning...) "monopsony" buyer (meaning you are the only buyer, or one of a few buyers for an item). There's no board game called Monopsony that I'm aware of.

GM likes to flout the laws of supply and demand, as evidenced in the Japopnik post. GM says they are raising 2009 prices for the typical excuse of "rising material costs" -- the last excuse of a scoundrel. Just because your raw materials and inputs cost more, that might mean NOTHING to your buyers and their valuation of your final product. Just because flour prices have gone up (and they have), that doesn't mean people are willing to pay more for bread and pizza. It's simple supply and demand economics.

So while GM announces they plan to raise prices in 2009 (a "price rise," as they call it here in England -- ah, the small differences), they were also offering ZERO PERCENT financing to buyers recently (basically a price cut). If you're having to cut prices to spur demand, why announce you're raising prices? Because you can? Good luck with that. I'm sure we'll be treated to yet another annual story about how GM no longer plans to rely on incentives and cheap financing to move metal. Let's see what they have to do to artificially prop up the June 2009 numbers (see "robbing Peter to pay Paul.") Pulling ahead sales from future months is such a laughably short-term strategy (and old habit) .... but again, typical GM.

So while GM is bitching about price increases, they're also (guess what) still attempting to squeeze those damn steel suppliers who are (guess what) trying to increase steel prices because of... wait for it... their rising material costs!!! Yes, we are living in bizarro land. The steel suppliers are now exerting THEIR market power for a change. And I bet GM doesn't like how that feels. From a WSJ article on this:

As emerging countries increase their need for steel to build infrastructure, commercial buildings and automobiles in their respective countries, the demand for steel has outstripped supply. That has caused prices to shoot up, most drastically in the past year.

That has left U.S. auto makers, which had long dominated steelmakers during negotiations, in a weak bargaining position. For decades, U.S. auto makers were the steelmakers' most lucrative customers and bullied them into selling them long-term contract steel at discount rates.

When you bully suppliers, they want to come back to bully you when they get the chance. Shouldn't be surprising... you reap what you sow?

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Using Lean and Cost Reduction to Counter Rising Materials Costs

E-Z-GO's Kevin Holleran 040608 - The Augusta Chronicle

On this blog, we often talk about the Lean concept that a company is not entitled to arbitrarily tack on a desired profit margin to their incurred costs (the equation of Price = Cost + Profit). Doing this violates rules of economics that say prices are set by the market (unless you have a monopoly or collusion, then prices CAN be set by the producer).

The Lean approach is to take market prices and then engineer or reduce your costs to the point where the targeted profit level is reached. The problem is that it's hard to find examples of companies doing this. It's far easier to find examples of companies whining and complaining about increased materials costs (such as for corn or fuel), trying to pass them along to customers (or complaining that the market isn't accepting those desired price increases). Ain't capitalism a bitch?

Well, anyway, here's the example we've been looking for: EZ-GO, a maker of golf carts. Incidentally, I drive past their facility in Hurst TX on my way to the train station (yes we have trains in Texas). Their President is Kevin Holleran, and he says:

"What we face as headwind from the commodities standpoint is really unprecedented in the market that we participate in," Mr. Holleran said. "You feel it at the pump; we feel it in the form of lead and copper.

"Like any organization, we have inefficiencies in everything we do -- how we design, build and promote. That makes it even more critical for us to understand how we can improve our own internal processes to identify cost savings."

OK, unfortunately that first paragraph is full of jargon. What he means is that lead and copper prices lead to higher commodity prices for their business. But the second paragraph nails it -- they can find way to reduce costs in other areas to make up for the rising commodity costs. If commodity costs go down, then look how far ahead they are now!

Not surprisingly, they are using Lean:

With more than 1,000 employees under his command, Mr. Holleran continues to promote the company's established Six Sigma and "lean manufacturing" principles, which are focused on making products faster and less expensively while still maintaining quality.

I'm glad they even managed to mention that Lean isn't just about speed and cost -- it's also about quality.

They've even illustrated how safety and Lean go hand in hand:

Workers use electric power tools that measure torque and angle for increased precision, and assembly lines are ergonomically friendly so the product can be adjusted to a worker's height. Parts are also scanned to eliminate product defects, and E-Z-GO has even increased its lighting from 30 to 120 foot-candles to assist workers' visibility.

Sounds pretty good, don't you think?

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Learning from Restaurants

Cutback Cuisine - WSJ.com:

If you're a regular reader, you know I like to try to draw from non-traditional sources and industries. This article from WSJ caught my eye and made me think of some Lean concepts.

As in many businesses, restaurants are caught in a double pinch right now. Raw material costs (food) are going up and the sluggish U.S. economy is dampening demand, especially for some moderately-high to high priced restaurants.

"Price increases are across the board; the commodities have just gone crazy," says Brett Reichler, a corporate executive chef of B.R. Guest Restaurants, owner of the Blue Water Grill. "Flour is up 30, 40%. Beef's on the rise, fish is on the rise. Nothing is inexpensive any more."

Some restaurants are going the route of many manufacturing companies -- trying to "pass along" the costs as if it's an entitlement. This is no more true for food than it is for automobiles. Just because the price of steel goes up, that doesn't mean you can automatically increase the price you charge for cars. The prices are all driven by supply and demand, as is true in any industry that's totally warped by regulation or monopoly power.

The WSJ article focuses, however, on the restaurants that are taking action instead of just complaining or trying to raise prices. Some restaurants are looking at what menu prices customers are willing to pay and they are "engineering" the food and ingredients to hit a profitable cost in comparison to that menu price.

This is reminiscent of the Toyota practice of "value engineering" where products are designed to hit a cost that allows profitability given a market-driven price. This is different than the old "cost plus" mentality where manufacturers try to "tack on" a profit margin on top of designed or incurred costs.

Some examples from the article (which make me drool because a weakness of mine is nice restaurants):

Restaurants have long engineered menus to allow the bigger profits from pastas and vegetable side orders to subsidize such loss leaders as rib-eye steaks. But rising prices have prompted a furious new round of behind-the-scenes shuffling. San Francisco's Slanted Door is known for its rack of lamb. On many days, chef and owner Charles Phan offers a more-profitable lamb sirloin stir-fry instead, shaving his food costs by a third. It is a temporary fix that draws some complaints. "Everyone wants that rack," he says.

At Le Cirque in New York, diners can choose from four pasta dishes, up from two a year ago. "Pasta's a great item for reducing food costs," says co-owner Mauro Maccioni. He estimates that he is paying 5% more for the food his restaurant prepares, including big increases for truffles and butter. He touts as good values his new pasta dishes, which include a chestnut-flour pappardelle with wild mushrooms and a veal ragu.

In the case of the Slanted Door, I guess you could argue that the chef is not meeting customer demand (for racks of lamb). He has to weigh the trade-offs of profitability and the risk of driving away a loyal customer who might be upset.

They talk about some menu items subsidizing others. We can also see this at fast food restaurants. Do you think the price of a burger and the soda are driven by true costs? Of course not, they charge what the market bears. Sandwiches are often cheaper (compared to their costs), but they make up for it by charging a relatively huge markup on a beverage.

Chefs are also getting more creative in making full use of their food and ingredient purchases, to reduce waste:

Some chefs, such as Raphael Lunetta of JiRaffe in Santa Monica, are yanking pricey entrees from the menu to promote as daily specials. He says a good pitch by waiters for the roasted rabbit with herb polenta gnocchi, for example, helps sell more of the dish and reduces leftovers.

Another strategy is to offer less of an expensive meat and add a cheaper cut. Diners who order "Roasted Pekin Duck" at the Powerhouse Restaurant and Bar in Chicago get a half-breast and a duck confit instead of a whole duck breast. The substitution cuts costs nearly in half by allowing the restaurant to buy entire birds instead of individual duck breasts. "You're not paying for processing," says managing partner Mitchell Schmieding.

Anyway, I hope you have access to the full article, it's definitely worth reading. As you do, think through the possible parallels to your business. Can you learn something from your local fast-food joint or a snooty French chef?

One chef sums it up:

Skilled chefs, says Mr. Chang, transform whatever comes their way. "If you need to make real food out of nothing, that's real cooking," he says. Echoing a culinary maxim, he adds: "It's easy to cook a sirloin. It's harder to cook with potato scraps."

Not much whining there -- just good business.

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United Adds $25 Fee for 2nd Bag

Yahoo News Story

By Mike R. Lopez:

I saw this story about United Airlines charging customers to check a SECOND bag. Not the fifth or sixth bag, but NUMBER TWO!

This reminded me of a training slide that we have in our Lean education program. There are three ways to cut costs. You can cut costs across the board by reducing all budgets a fixed percentage. This is the lazy path. You can cut costs by cutting services. This is the stupid path. Finally, you can cut waste. The smart path.

This extra fee strikes me as part of the stupid path because it cuts a core service and makes customers pay extra for something they get "free" from other airlines. According to the article, United expects it to generate $100 million in revenue and cost savings a year. Does this mean that United's tickets will be consistently cheaper than companies that do not charge a per bag tax? I highly doubt it as the article shares that this is but one small part of a larger plan to charge more for less, a clear violation of the Profit=Price-Cost rule:

Airlines want to charge more for not only checked baggage but assigned seats and other services. Investors have urged airlines to pass on the higher costs of fuel to passengers through ticket-price increases or similar surcharges.

If United is planning to save money by flying fewer people, they might be able to claim savings because I don't think their scheme will end up with them making any more revenue. We're likely to see United lose revenue to the benefit of airlines that are more responsive to real flying customers, not day traders.


********UPDATE 2/26/2008**********

It appears that US Air is going to charge $25 for a second bag.

**********************************

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Partly Correct on Rising Car Prices

GM Expects Car-Price Rise - WSJ.com

GM is raising prices:

"In December, GM raised its prices an average of 1.5%..."

This is great news if you're an employee, stockholder, or fan of General Motors. This means market demand is strong for products and overproduction has been curtailed (they're not dumping as much product on rental car fleets and they have some hot products).

The rest of the sentence I originally quoted read:

"In December, GM raised its prices an average of 1.5%, mainly because of higher raw-materials costs, especially nonferrous metals, steel and oil."

No, no, no. That is such a tired excuse, "our costs went up, so we have to pass it along." GM raised prices because they can, because the market will accept that (or they think it will). It's just so politically increase to say you're increasing prices because of increased demand, isn't it? They're not entitled to raise prices because of steel costs or elective costs, such as investments in new technologies...

"[CFO] Fritz Henderson said the industry has less manufacturing capacity than in the past and therefore less pressure to sell vehicles cheaply to move inventory."

It's all about supply and demand. I'm sure GM realizes that... they just can't say it, right?

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Once Again, Prices are Set by the Market, Not Your Costs

NPR: Airline Prices Depend on Airport

I haven't harped on this theme for a while, but I was reminded of it from this NPR story on airline prices. The report expressed such confusion (and almost outrage) that airline flight prices are set by the market instead of being based on what the flight costs.

Imagine that -- 2 different flights of 600 miles each might actually have different prices depending on where you're flying from/to. Of course, that's the free market (or what passes for it in aviation) at work. If you have a discount airline in your city, you're likely blessed with lower prices. If you're at a major hub city without a discount airline (say, Cincinnati), you'll have really high airfares (or you can drive to Dayton).

What the flight actually costs is pretty irrelevant, except for when the airline is calculating their profit/loss statement. It's irrelevant to the price offered to the customer.

It's the old mindset at work -- that I should be able to set my own price as "Price = Cost + Desired Profit Margin." That's just not how most of the world works. This idea that something "shouldn't" cost so much or that a company should be able to "pass along" increased costs to their customers isn't very helpful or realistic.

Prices are set by the market. That's the best lesson I learned in business school. A corollary to that is the Toyota lesson that you can't arbitrarily raise prices -- to reach a desired profit margin you have to reduce your costs (or, as my friend Jamie Flinchbaugh has pointed out, you can change the product so it is valued more by your customers. Arbitrary price increases, above what the market will bear, might eventually drive customers to competitors.

So, I can't believe I'm defending airlines (I rarely do)... but why do they charge $X for a certain flight? Because they can. Because people are willing to pay $X.

How do you see this concept relating to your business? Do you try to pass along increased supplier costs to your customers, instead of finding ways to reduce other costs to maintain your profit level? Has your company adopted more of the Toyota type mindset of Profit = Price - Cost instead of Price = Cost + Profit?

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P&G and Target Pricing

P&G's Global Target: Shelves of Tiny Stores - WSJ.com:

Interesting article in the WSJ about how Proctor & Gamble has had to adapt its approach in countries like Mexico, with different types of customers and different retail models:

"In marketing goods to low-income shoppers, P&G tries to keep in mind their budget constraints and even the coins they carry. Because they are often paid a daily wage, Mexican customers generally carry five- and 10-peso coins. 'If you want to sell to low-income consumers, you have to know what's in their pockets,' Mr. Riestra says. 'It doesn't make sense to have something cost 11 or 12 pesos.'

Now the article doesn't mention "Lean," but it takes us to the Lean notion of Profit = Price - Cost, where the Price is set by the market and your job, as producer, is to get your Costs low enough to be able to hit your Profit targets. Traditional business thinking (which pretty well ignores rules of economics) takes your production cost and what might be called your "entitlement profit" (such as "I need 10% profit on this") and determines the Price as Cost + Profit.

Toyota has taken the approach of saying "Here is what the market will give us for this car, so we have to engineer our costs accordingly." They call this Target Costing and Value Engineering. I think that's the approach P&G is using, even if they get the terminology a bit wrong:

To ensure satisfactory profit margins, P&G uses what it calls 'reverse engineering.' Rather than create an item, and then assign a price to it -- as in most developed markets -- the company first considers what consumers can afford. From there, it adjusts the features and manufacturing processes to meet various pricing targets. To hold down the cost of its Ace Natural detergent, used to hand-wash clothes, P&G reduced the amount of enzymes in the product. The result: a product that costs a peso less than regular Ace and is gentler on skin. P&G says that reverse engineering helps to keep the company's after-tax margins 'comparable' to those in wealthier, developed countries."

P&G also realizes quality is important, that you can't "trick consumers" by cheapening the product in a way where the product doesn't work anymore. That's good long-term thinking.

Updated: Matthew May also has a good take from this same article

Updated: Evolving Excellence also had a different angle on this same article

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Parker Hannifin and Market Driven Pricing

Seeking Perfect Prices, CEO Tears Up the Rules - WSJ.com

I haven't mentioned it in a while, was trying to give it a rest for a bit, but the front page of the WSJ highlighted this basic economic concept: prices are driven by the market.

The Toyota/lean approach has preached this, that prices are set by the market and the only influence you have over your profit is your costs: Profit = Price (set by the market) - Cost

Traditional manufacturers have viewed price as something that they can set, as they are entitled to a certain profit over and above their costs, the "cost plus" model, where Price = Cost + Profit (entitled).

Parker Hannifin, a company that has done a lot of work with lean, has woken up to this reality, through their CEO:

In early 2001, shortly after Donald Washkewicz took over as chief executive of Parker Hannifin Corp., he came to an unnerving conclusion. The big industrial-parts maker's pricing scheme was crazy.

For as long as anyone at the 89-year-old company could recall, Parker used the same simple formula to determine prices of its 800,000 parts -- from heat-resistant seals for jet engines to steel valves that hoist buckets on cherry pickers. Company managers would calculate how much it cost to make and deliver each product and add a flat percentage on top, usually aiming for about 35%. Many managers liked the method because it was straightforward and gave them broad authority to negotiate deals.

Their pricing policies were shooting themselves in the foot when they actually made improvements:

...if the company found a way to make a product less expensively, it ultimately cut the product's price as well.

Why? If you can produce something cheaper and the market is still willing to pay the same price.... take the extra profit! Keep it and invest it in the future development and strength of your company. Likewise, if your costs go up (through material costs or labor costs), you have find other ways (such as through lean methods) to get costs down to maintain the same profit. You're never entitled to price increases because your costs go up. Customers might put up with it in the short term, but they'll find other options eventually.

The CEO realized this same thing, who knows if the epiphany was divine intervention or if it was through some lean reading:

While touring the company's 225 facilities in 2001, Mr. Washkewicz had an epiphany: Parker had to stop thinking like a widget maker and start thinking like a retailer, determining prices by what a customer is willing to pay rather than what a product costs to make. Such "strategic" pricing schemes are used by many different industries. Airlines know they can get away charging more for a seat to Florida in January than in August. Sports teams raise ticket prices if they're playing a well-known opponent. Why shouldn't Parker do the same, Mr. Washkewicz reasoned.

This basic recognition of supply and demand (something any MBA should know) has really helped Parker:

Today, the company says its new pricing approach boosted operating income by $200 million since 2002. That helped Parker's net income soar to $673 million last year from $130 million in 2002. Now, the company's return on invested capital has risen from 7% in 2002 to 21% in 2006, putting it on the verge of moving into the top 25% of Mr. Washkewicz's list comparing Parker with "peer" industrial companies.

From the end of 2001 to present, Parker's shares have risen nearly 88% to about $86, compared to a 25% gain in the S&P 500.

The article talks about other companies, including Intel, who use "strategic pricing," but also points out:

...much of industrial America -- 60% of U.S. manufacturers, according to Thomas Nagle, a pricing consultant at the Monitor Group -- still relies on oldfangled, "cost-plus" types of pricing methods such as the one Parker used.

The article also points out complicated this change was and how much it was resisted by the internal inertia of the company and its leadership.

There was so much pushback the CEO eventually assembled a list of the 50 most commonly given reasons why the new pricing scheme would fail. If a manager came up with an argument not already on the list, then Mr. Washkewicz agreed to hear it ouht. Otherwise, he told them, get on board.

The article and CEO also blame computers:

To his surprise, Mr. Washkewicz discovered that computer programs for calculating prices, adopted in the 1990s, were part of the problem. "It became a cookbook approach," he says. Managers typed in myriad costs, and the computer spit out a recommended base price which was used as the starting point in negotiations.

How did customers react to the price increases? Not surprisingly, an auto parts supplier put the parts up for open bid... and couldn't find someone else to produce the part at that price. Parker only lost 3 out of 50 items that went out for open bid. At least in the short term... only time will tell if they have the right pricing for the long term.

Blame the Vendor or Hospital Purchasing??

I'm sure most of you are familiar with or have used the Akro blue bins for organizing parts, tools, or a kanban system. The bins are used all over factories and they are used quite often in hospitals (look in the background of episodes of House or Grey's Anatomy and you'll see them, though it normally doesn't look like a Lean kanban system).



A bin with dimensions 5.5"W x 10.875"L x 5"H costs $4.55 from the popular industrial supply house, Grainger. Click the photo on the right for a screenshot (and hit "Back" to return to this page).




That same bin, same dimensions, same manufacturer, same everything can be ordered from a different distributor company that specializes in equipment for laboratories. Guess the price?

$13

See the screenshot on the left. I've checked into this multiple times. These are the SAME bins (a lab I've previously worked with used to order through the healthcare vendor) and they are 2.5x more expensive. That hospital promptly started ordering through a new Grainger account that I recommended. New hospitals I work with always end up ordering through Grainger.

My point isn't that I saved the hospitals some money. The money DOES add up when you buy hundreds of bins for organizing supplies throughout a hospital. My point is that it's sad that vendors and distributors apparently see large dollar signs when they look at hospitals. I don't know what's worse, the fact that hospitals get charged these prices or that hospitals PAY these prices. Why does the vendor charge $13? Because they can.

A topic I often beat into the ground is that the market sets the price. To have a price, you need a seller and a buyer. I guess, ultimately, we have to say shame on hospital purchasing departments for not being more savvy. I've often recommended to lean manufacturing folks that they should move into healthcare and try to help fix things here. I guess I can extend that invitation to purchasing agents, purchasing managers, and purchasing directors. You don't even need "lean" experience to come in and drive big savings, I'd guess. Come into healthcare. Please.

GM Goes Big with Inventory

WSJ: At GM, Curbing Inventories Calls For Juggling Act

From the article:

At the end of December, GM had more than one million vehicles in stock in the U.S. That's equivalent to about 41,000 vehicles for every point of its 24.6% U.S. market share. By contrast, Toyota Motor Corp. of Japan, one of the world's most profitable auto makers, carried about 16,000 vehicles of inventory per point of its 15.4% market share.

GM says it is comfortable with its inventories...

More than 2x the dealer inventory... and GM is "comfortable" with it.

Maybe that's 1/2 the problem?

Really, they are damned either way, with their slowing sales and union contracts (see Jobs Bank):

GM still needs to generate huge sums each year to cover the more than a million people, mostly retirees and their dependents, who depend on the company for health benefits. That means that GM can't simply shrink its U.S. operations to meet reduced demand without risking making GM North America too small to finance its debts and obligations to workers.

"It's a very delicate balance," says Frederick "Fritz" Henderson, GM's chief financial officer.

Slowing production would stop the inventory buildup and prop up prices. But it would sacrifice revenue at a time when GM needs every dollar in sales it can bring in. If GM continues to run North American plants at the current pace, it may have to resort to rebates and discounts to spur sales, which would hurt profit margins and undermine prices.

And they're comfortable with this? I've written before about GM has to do more than try cut costs or complain about their cost gap. The price gap (Toyota being able to charge more for similar, or sometimes identical products -- Pontiac Vibe and Toyota Matrix) is larger than the price gap. GM's CFO is admitting as much, below. This comes back mainly to GM's quality reputation (an unfair reputation, GM would say, but it's their fault). People perceive a Toyota to be worth more because of quality and resale value (which isn't so much of a perception, really). The market sets the price of your product, and the market values Toyota higher than Pontiac.

Cost cutting alone isn't enough to put GM back on solid footing, says Mr. Henderson, the CFO. The company also has to improve what he and other GM insiders call "contribution margin," basically the profits left over after the costs of building the car are deducted from the revenue realized after discounts. The main way for GM to do that, he says, is to keep prices firm and avoid incentives and low-margin sales to rental fleets that artificially boost sales, damage the image of GM's brands and undermine resale values.

This is a dilly of a pickle that GM has been in. There's no easy, quick solution, but to be "comfortable" with the situation seems the opposite of Toyota Production System thinking. Toyota is much harder on themselves than GM ever is, and I guess we see the results of that.

Toyota: Today is the worst we will ever be

GM: We're comfortable with today

We'd be fine if you just Paid us More

Hospitals prescribe increased reimbursements from insurers to aid recovery of sickly health care system

Hospitals need to learn to reduce costs. You can't just ask for more money to cover your rising costs. It's a frequent topic on this blog, the Toyota Production System idea that:

1) The price is set by the market, not by you

Granted, healthcare is a really screwed up and complex market. But, the lesson still holds that SOMEBODY ELSE (someone external) sets the price for you and you have to live with it. That's true if it's manufacturing, consulting, or healthcare. You can't go by the old notion of "my costs are X, so I'm going to tack on my profit margin and that's my price."

2) The only way to ensure a given profit is to reduce costs

Profit Margin = Price - Cost

If price is given, you have to control costs. And I don't mean with traditional cost cutting (which would include getting rid of people, outsourcing, and closing operations). You have to use lean -- reducing quality AND improving care... which will lead to lower costs.

Hospitals whine too much about how little they are paid. They need to get their controllable costs under control.

13% of hospital costs are due to controllable waste.

Source: Zuckerman, Hadley, and Iezzoni, 1994

I bet that number has grown since 1994. I see so much waste in hospital processes, it's ridiculous. Different studies and experts estimate the percentage of non-value added time in healthcare processes and employee time at 40 to 50%. I believe it, based on my direct observations.

Let's work on controlling costs (by improving quality and care). We really have no other choice. Healthcare money won't grow on trees. We can't afford to have healthcare costs rising 9 or 10% a year.

See, GM raises prices because they can

GM raises price of some '07s | Chicago Tribune:

The other day, I complained about how GM was "forced" to raise prices due to materials cost increases and how wrong that concept is.

Yesterday's Chicago Tribune explained it better:

"'GM sales are doing a little better than they thought and so GM felt it was in a strong enough position to increase prices a bit to make a little money,' noted Jim Hossack, vice president of research and consulting firm AutoPacific."

There is nothing wrong with this. If GM thinks it is reading the market (and remember, the market sets prices), then GM is right to increase prices. Why? Because they can.

THAT is how the free market works. Not increasing prices because you "have to" because you're entitled to a given profit level. You raise prices because you can.

Why is an iPod $249? Because lots of people are willing to pay that. Why is a given car worth $24,999? Because people are willing to pay that. Why is a given house worth $249,000? Because one person is willing to pay that. It's all the marketplace talking, not the sellers "setting" prices.

GM Thinks Its Entitled to Price Increases - WRONG

Materials costs force GM to raise prices

Yet another example of a non-lean mindset company thinking they are entitled to price increases because costs went up.

General Motors Corp. has raised prices an average of 0.5 percent on about one-third of its models because of rising raw materials costs, a company official said Wednesday.

The increases were effective Monday and are driven largely by steel prices, which have gone up globally by 13 percent since January, McDonald said.

From a different article (Reuters):

General Motors Corp. said on Wednesday that it has raised prices on about one-third of its 2007 model-year vehicles in the United States to cover increased costs for steel and other commodities.

The price increases range from $60 to $425 per vehicle, GM spokesman John McDonald said, adding that the increase averages to about 0.5 percent per vehicle.

"What we are trying to do is to recover a portion of our increased costs -- things like steel, materials and other commodities that go into our products," he said.

This is such a dead horse topic on the blog, but again, the Lean/Toyota mindset says that prices are set by the MARKET. Prices have nothing to do with your costs: labor costs, commodity costs, etc. If GM is arbitrarily raising prices and the market doesn't value their cars accordingly, sales will drop, or GM will end up having to offer more incentives to get prices back down. But, if the market is really allowing GM to raise prices, why should GM have to use the "excuse" that raw material prices went up? Because that's "politically correct?"

In the mass production mindset, the equation was seen as:

Price = Cost + Profit

Where "Price" was set by the company based off of their Costs plus a desired Profit (10%, for example). If Cost went up, to maintain Profit, you had to increase Price. That only works if you have an monopoly.

With the Toyota/Lean mindset, the equation is more realistic:

Profit = Price - Cost

Where Price is set by the market and your Profit is based on how low you can get your Costs. Nobody is entitled to a given Profit or Price. If commodities or raw material costs go up, you have to find a way to get other costs down -- kaizen and continuous improvement are great tools for that. Here's an example.

GM still doesn't get it. But, neither does Boeing. More examples here. Either these companies don't get it, or again, it's somehow palatable to customers as an excuse... everybody does it.

Some Honesty in Pricing for Once

U.S. airlines raise fares by up to $10 each way

Here is some rare honesty in the discussion about how prices are set. Normally, an article or company would claim that "due to cost increases" (due to oil, etc.) that the company is "forced" to raise prices for their customers. Bull. Companies raise prices because they can, such as in the case of airlines with strong demand. Companies charge what the market will bear.

This is a central tenet of TPS, that Price is set by the market, so therefore Profit = Price - Cost. You only have direct control over costs, so reducing costs is the path to increased profits (yes, you can increase demand through good product design or marketing, which would increase the price the market will bear).

If your costs go up, you're not entitled to raise prices to keep profit the same. That's the old thinking of Price (set by you) = Cost + Desired Profit.

With this latest terror threat, if airline demand is down, they'll have to lower costs. That's how markets work. You charge that you can. Toyota's not the cheapest car out there... because people are willing to pay it, the market values the cars that way.

Some other Lean Blog posts on this same topic can be found here.

The "Because I Can" Surcharge

ContraCostaTimes.com | 05/05/2006 | Consumers feel the sting at pump and elsewhere

Post office wants to raise stamp prices - U.S. Life - MSNBC.com:

I'm ticked off reading about "fuel surcharges" that many companies are tacking on to their prices these days. Let me explain why.

One thing I find fascinating about lean is that it isn't just a factory improvement strategy. It really is a comprehensive business mindset. The one business idea that I am fond of writing about here is the difference in thinking about costs and the price your customer will pay.

Old Non-Lean Model:

PRICE = COST + PROFIT or...

PRICE (I set it) = COSTS (as incurred by me) PROFIT (that I am entitled to)

This model is wrong because it assumes 1) you can set the price of your product and 2) you are entitled to a given profit margin or profit percentage.

The Lean Model, as popularized by Toyota:

PROFIT = PRICE - COST or....

PROFIT (that I earn) = PRICE (as set by the market) - COST (as incurred by me)

Under the old model, you set a goal, say "I want (or Wall St. requires) a 10% margin or my stock price will go down or I will get fired or my wife will make me close up my business and get a regular job". If your costs go up $5 per item and you "need" to or "deserve" to maintain your profit goal, the logical response is to raise your price to your customers by $5.

The problem with this thinking is that it goes against basic microeconomics. You've probably heard of the idea of the supply and demand curve? The idea is simple.... for most products (let's ignore special cases like cigarettes or Microsoft Windows), when you raise prices, the amount you sell will decrease.

Another problem: look at airlines. Planes are always full these days. People want to travel. But, they are willing to travel at market-rate prices. The airlines, such as American, are losing money because their costs are too high (there are many reasons for this). If American was truly entitled to a profit (management, Wall St., employees all think they should make a profit), they would just raise prices so they were higher than their costs. But, travel would dry up. Companies would look at video conferencing, consumers would drive instead (oops, those high fuel prices) or stay home. The only price increase the airlines can get away with is a modest, you guessed it, fuel surcharge. Airlines need to focus on reducing costs, not just looking at ways to increase prices. One way to reduce costs is to get rid of their overpaid executives, but that's a different blog posting altogether.

So let's say you have 1000 customers for a lawn maintenance business (one type of company that is charging fuel surcharges) and each customer pays you $50 a month. You inevitably have some fixed cost to your business (trucks, mowers, your salary, etc.) and some variable cost that you incur each time you service a customer (truck fuel, mower fuel, wages to workers, etc.).

Your equation might have been:

• PROFIT = PRICE * CUSTOMERS - FIXED COST - VARIABLE COST * CUSTOMERS
• PROFIT = 50 * 1000 - 20000 - 20 * 1000 = 10000

Now gas prices have been rising and that's a significant part of your cost. Let's say your variable cost has now increased to $30 per customer. This would knock your profit down to ZERO. If you say "well, I must make a profit, I will just add a $10 fuel surcharge" and you send a letter to your customers saying you must raise your price to $60. You might even say you're really sorry and wish you didn't have to do this, but you all know, gas prices have gone up.

The problem with this approach is that some of your customers will go away. Let me repeat this. Some customers will leave. They might never come back, even if you reduce your "fuel surcharge" when, and if, gas prices fall.

I'll leave out the more technical economic terms.... but the question is "how many" customers will go away? If you sell something like cigarettes you have customers who are addicted and will continue buying, almost no matter what. But, with lawn service, if it gets too expensive, I might think it's now better for me to just quit being lazy and mow my own lawn.

If you lost 20% of the customers in this lawn business, you are still ahead with the "fuel surcharge" price increase.

• PROFIT = $60 * 800 - 20,000 - $30 * 800 = $4000

That's less profit than before the cost and price increase, but it's better than keeping your price at $50 and not making a profit with 1,000 customers.

But, if 350 of your customers (35%) go away, you're now losing money. Are you willing to take the chance, not knowing how many customers will go away with your fuel surcharge price increases?

Let's revisit the idea that prices are set by the market. I assume that, in setting your price of $50, you looked at what competitors were charging and what people are typically willing to pay. If you blindly set a price based on your internal costs, you're doomed to fail.

But, let's say we put a $10 gas surcharge on our lawn business and only lost 5% of our customers. In this case, we make almost as much money as we had before, $8500 a month (you can do the math.) So, if you were justified increasing your price because costs went up... why didn't you increase price because the market would bear it?

If your cost had stayed at $20 and you increased price to $60 "because you could" (you wouldn't tell customers this), your profit would have grown from $10,000 to $18,500. So, if you see a business say "we're increasing prices because costs went up" and they don't lose too many customers as a result, you should ask them (if you're an investor) "why didn't you raise prices earlier?????"

So what do I recommend? As a business owner, charge as much as you can, as much as the market and your customers will bear. But also, you need to focus on cost reduction.

When your costs go up, don't just "boo hoo" and watch profits drop. Work on reducing costs in other areas. Gas prices went up, you have no control over that. Fine, use lean methods to reduce waste and reduce costs in other parts of the business. Gas prices went up, so think about your driving patterns and think about ways to reduce the amount of gas you use.

That kind of thinking is much healthier for your business, and dare I say the economy, in the long run than is the idea of "passing along cost increases."

Another problem with "passing along cost increases" and surcharges.... where does the cycle end?

• Gas prices are up, increasing the cost of lawn maintenance
• Price of lawn maintenance is increased due to rising fuel costs
• Gas station owner has to pay more to have grass around station mowed
• Gas prices are increased due to cost of lawn maintenance
• Price of lawn maintenance is increased.....

You can see this is NOT a sustainable cycle. For one, gas prices are actually very competitive. Gas station owners can't just raise them willy-nilly. If the lawn maintenance company can raise them just "like that", they probably weren't charging enough before. Secondly, this "we all have to pass along our cost increases" would lead to inflation and would really hurt the economy.

Here is an article that was in the Wall St. Journal about a Wyoming gas station company that is focusing on cutting their costs so they can sell gas cheaper (which boosts their volumes immensely, and I assume their profits also).

There is money to be made in selling fuel cheaper," says Kristen Call.

Let's also look at stamps.... FedEx and others are adding surcharges, the Post Office has to try to raise prices (which is really basically the same thing).

“The Postal Service is not immune to the cost pressures affecting every household and business in America,” he said.

For example, each penny increase in the price of a gallon of gasoline costs the post office $8 million, and payroll, health expenses and other costs also have been rising.

And, unlike private delivery companies, the post office cannot simply add a fuel surcharge to its rates.

Maybe the USPS should look at reducing other costs and being more efficient rather than just passing their costs along to us?

What's next, companies adding "postage increase surcharges"? Stop the surcharges! Get lean. Get efficient. Get creative.

I'll tie this back to lean one last way. When Toyota charges a higher price for a model (Toyota Matrix) that is virtually identical to the GM model (Pontiac Vibe), is it because Toyota's costs are higher and Toyota is entitled to the profit? Of course not. Why does Toyota charge more? Because they can. The market has set the price for them.

Hey GM! Prices Are Set by the Market

Headline:
General Motors Cuts Prices on 80 Percent of Its U.S. Models

Remember the "new" Toyota Production System thinking:

Profit = Market-Set Price (minus) Your Costs

The "old" approach (still apparently endorsed by many companies) was:

Price = Desired Profit (minus) Your Costs

Under the old approach, a company would attempt to increase profits by increasing their price.

The TPS innovation was to accept that prices are set by the market and the only thing you can control is your costs. That's how you increase profit, by focusing on your costs.

Has GM finally realized that the market values their product less than what they had been charging? The good news for GM is that, from a supply/demand perspective, that lower prices should increase sales volume. Then again, if they're reducing base costs and cutting incentives, then the "real price" hasn't changed.

The question: Can GM embrace lean/TPS and reduce production costs enough to be profitable? Or will they continue to blame their "legacy costs?"

Toyota is able to charge more because the market values Toyota's quality and reliability. Some analysts say the "value gap" is much larger than the "cost gap" that GM is always blaming. In other words, if GM did as good of a job as Toyota, GM would be able to charge as much for their vehicles (the market would allow the higher pricing, really) and GM would be more profitable.

More on the Toyota Cost/Profit Model

Evolving Excellence: Its About Cost, Stupid!

Great post here by Bill Waddell about the Toyota "Profit/Cost" model of
Profit = Price - Cost. He elaborates on it as "Profit = (Price x Volume) - Cost and points out origins tracing back to Andrew Carnegie in the 1800's.

Most companies, even today, operate under the model of thinking Price = Cost + Desired Profit. Prices are not set by companies, for the most part, they are set by the market.

The only thing you have under control is costs. But, most American companies "cut costs" by closing plants and laying off people. As Bill points out, that also cuts volume, which could very well cut profit.

Here are links to earlier posts of mine on this topic:

• Boeing example
• Gas station example
• Toyota example
• "More whining" example
  

Local firms are squeezed by gas prices

SignOnSanDiego.com > News > Metro -- San Diego:

This story is from California, but I've also seen it in the local news. I've complained in the past about big companies complaining that they can't pass along the higher cost of oil (as a raw material to, say, nylon production), but you're hearing it from smaller companies regarding gasoline.

"The increased costs are coming largely out of Welk's pocket, pushing the company closer to posting losses even though some price increases have been passed along to customers.

'Fuel is huge right now,' Welk said. 'I will have to raise rates again because it won't cut it where it is right now.'"

We're all feeling the pain at the pump, but this is yet another example where the price should be set by the market, not by your raw material costs. I'm probably preaching to the choir here, but the Toyota model says:

Profit = Price (as set by the market) - Cost

This dictates that, if you want to maintain the same profit, that you have to find other ways to cut your internal costs, you can't just pass along higher costs to customers, necessarily, through higher prices.

If your customers readily accepted the higher price, maybe you weren't charging enough before?

But so many of us, as customers, are conditioned to the old notion of Price = Cost + Profit, that we accept "my costs are higher" as a reason to pay a higher price. We may accept that in the short-term or have no other choice. But, if we don't value the service, we might walk away in the long-term.

What do you think? Facing this challenge in your business, large or small? Facing it as a customer? Click "comments" to chime in.

More Whining About Not Being Able to Pass Along Costs

JS Online: Manufacturing outlook dips, but index is still strong:

When I saw this headline (also a WSJ article today), I expected to read something like this:

"'On profits, I think what you are seeing is pressure coming from higher energy and commodity prices,' Norman said. 'Many companies have difficulty passing these costs on to their customers in today's competitive environment.'"

In any environment, let alone "today's competitive environment", what entitles you to pass along costs to customers? The quote above demonstrates the "old" thinking of Price = Cost + Desired Profit.

In the lean mindset, price is driven by the market. In limited cases do you actually have control over prices (say if you have a unique patented product with no competitors). Remember, Profit = Market Price - Your Costs.

If you want to maintain profits, instead of thinking to raise prices (which will almost always drive volume down, it's basic economics), think of how to get lean and reduce costs by eliminating waste.

Keep an eye out for that "old" thinking. It's scary how often you see it and read about it, even in 2005.

Another Boeing Quote Saying Price = Cost + Profit??

Airbus, Boeing Eye Production Rate Boosts Across Product Lines - Fly Away Simulation, Flight Simulator #1:

I've written about Boeing's impressive cycle time reduction before. I've also pointed out quotes from Boeing folks who think and say "well, our costs have gone down, we can charge less."

"For its part, Boeing's chief salesman, Scott Carson, said the company's successes in lean manufacturing techniques over the past half-dozen years--it's halved production times on the 737 line--have allowed it to re-evaluate sales prices. 'Our costs are not as high as we thought,' he said."

No. In the lean model, prices are driven by the market. If customers still value the planes as much and will pay the same price and you cut costs -- congratulations, you've increased your profit! Why would you give that away to your customers? I can understand if they're in a price war with Airbus.... it's an argument that you're not "dumping" to say your production costs have dropped. That's the only reasonable explanation I can think of for why Boeing keeps talking like this. They are very defensive about how they're not taking unprofitable deals.