Analyzing Managerial Decisions: Rich Manufacturing

Abstract

The production manager at Rich Manufacturing must analyze a cost increase announced by its supplier, Bhagat Incorporated. Cost-plus pricing is often used by suppliers to shift some of the risks of a contract to customers. This diminishes, in part, the supplier’s incentive to keep costs low and to maintain efficiency. In the long run, the customer might be able to choose lower-cost alternatives or to make production changes that limit its need for the supply. In the short run, if the customer is powerful enough within the industry or is proportionately significant to the total production of the supplier, some negotiating about the dollar value attributed to cost can influence the process. If the manufacturer utilizes the economy of scope and the relevant part does not affect the production costs of alternative products, then the manufacturer may choose to adjust production rates of each product accordingly as an accurate response to manufacturing. Additionally, while powerful unions might win increased wages in the short run, the long-term consequences of price increases could lead to their businesses being priced out of the marketplace.

Analyzing Managerial Decisions: Rich Manufacturing

The production manager at Rich Manufacturing must analyze a recent announcement made by Bhagat Incorporated, a supplier of machine parts. Recently union workers at Bhagat negotiated a steep salary hike, leading Bhagat to announce a $3 increase in price to offset the increased costs. Rich Manufacturing’s contract with Bhagat utilizes cost-plus pricing. It allows for an option to purchase 100,000 parts, with a minimum volume of 50,000. Prior to the announcement, parts cost $25 per part (with $10 for labor, $10 for other costs, and a $5 markup).

Supply Contracts

Many firms use cost-plus pricing for supply contracts because they are easy to calculate, keeping potential costs of contract oversight and management minimal. In some industries, suppliers will demand cost-plus pricing to shift part of the risk to the buyer. Industries affected by the unpredictable supply of natural resources or those that might acquire significant new costs because of political upheaval are especially likely to require cost-plus contract provisions.

Unions have a very strong foothold in some industries and negotiations can be intense and bitter. Firms might—in the end—need to accede to union requests, which can include very large wage increases. In order to plan for this eventuality, suppliers might shift some of the labor risks to the buyer by stipulating that increased costs will be passed on to them. Joskow details the necessary considerations of contracting parties in “Vertical Integration” (2010).

Problems with Cost-Plus Pricing

One of the problems with cost-plus pricing is that it removes some of the normal incentives for a supplier to contain its costs and run its operation management efficiently. For example, the negotiations between Bhagat and the union might have gone differently if the supplier knew it would lose an even greater amount on its profit margin. Because it can pass the cost increase on to its buyers, Bhagat can afford—at least in the short-term—to acquiesce more quickly to union demands. Of course, in the long term, a supplier must remain competitive to stay in business: to retain old customers and attract new customers. In order to remain competitive, it must keep its costs in line with the costs of other similar businesses.

Modern technology and global connectivity can reduce information asymmetry and create flexibility for purchasers in some markets. If purchasers can easily switch suppliers depending on price, there will be stiffer competition, keeping prices within those industries at a more predictable level (Araman, Kleinknecht, and Akella, 2002).

Price Increase Protest

Gina needs to consider many factors, including how Bhagat’s new pricing compares to other similar suppliers, the relative strength of the union in the industry and its ability to push similar wage increases through at other suppliers, and the union’s ability to retaliate against Rich Manufacturing if it begins to purchase supplies from companies that don’t utilize union labor. Additionally, Gina’s analysis must take into consideration the relative strength of Rich Manufacturing in its relationship with Bhagat. The size of Rich Manufacturing as part of Bhagat’s customer base will determine, in part, how much influence Gina will exert. The relative size of Bhagat as a percentage of Rich Manufacturing’s supplier base will also control the ability to influence.

If the potential 50,000 unit loss or the possibility of future lost sales is a big enough factor for Bhagat, Gina can pressure Bhagat to reevaluate the cost figure. She can negotiate in terms of additional units to be ordered by Rich Manufacturing, depending upon cost. Additionally, she can argue that Bhagat must work to reduce some of its overhead costs by using less labor, though there will likely be union retaliation if there is much of a reduction in labor hours.

Another possibility suggested by Quesada, Gazo, and Sanchez in a report titled “Critical factors affecting supply chain management,” would be a reconsideration of the supplier relationship dynamic (2012, p. 37). If she can fully understand supplier costs, she might be able to utilize network connections to assist Bhagat to curb costs unrelated to labor. By aligning needs or understanding potential methods for mutual benefit, Gina can create a less adversarial and more synergistic supplier-customer relationship. In fact, in “Performance Management Models and Purchasing,” Lardenoije, Raaij, and Weele suggest that suppliers are and should be considered stakeholders in a company’s performance (2012, p. 10). The fate of both the supplier and the purchaser might be more intertwined than either party fully considers when negotiating details of contracts.

Short-Term versus Long-Term Price Increase

The increase is more likely to be justified in the long run, partly because costs tend to increase because of inflation, but also partly because of union solidarity. If the union has a big enough foothold in the industry, competitor supply companies will match the wage increases, leading to cost increases across the board. If there is no reasonable alternative, Rich Manufacturing will be paying increased costs in the long run regardless of the supplier utilized. Sometimes, it is in the best interest of the buyer to eat the costs short term and maintain a strong relationship with a supplier for the sake of more favorable treatment at future contract negotiations.

Rich Manufacturing Production Decisions

The fact that there is a production analysis to be made perfectly exemplifies Crocker’s eloquent statement that contracts are merely a jumping-off point for renegotiation of companies’ interests and profits post ante (1991). While the companies generally cannot change actual terms of a contract, they often find ways to exploit weaknesses in the contract to achieve maximum gain for their party.

Keeping this in mind, a $3 increase in the cost of each part might influence Rich Manufacturing production decisions greatly. A simple analysis could lead Gina to order fewer parts for the machinery. In order to ensure fewer machine repairs, she might cut back on machine production hours. If only one type of product is affecting, Rich Manufacturing might decrease the production of the related product and begin to produce more of other products that do not require that machine and those parts. This will depend on the number of products Rich Manufacturing produces and whether or not there are cost-effective alternatives that use different machines that will not need the parts provided by Bhagat.

Rich Manufacturing could pass part or all of the additional cost on to customers. This may affect the demand for the product. Interestingly, in the end, the increased price might lead to less of a demand for the product. This could lead to Rich Manufacturing ordering even fewer parts from Bhagat in the future. If carried out to its logical conclusion, Bhagat could even go bankrupt if the new price ends up leading consumers to buy alternative products. As an example, American car companies kept increasing the costs of cars because of ever-increasing labor union wages. Eventually, the value and cost of Japanese cars made them more attractive to American consumers and the demand for American cars dropped. Detroit’s recent bankruptcy is evidence supporting this conclusion. A recent Bloomberg article on the American automotive industry discusses renegotiated labor contracts that bring labor costs close to those of Japanese car manufacturers (Green, 2012). Workers rehired at lesser wages now compare wage expectations to wages earned at alternative jobs during auto company bankruptcy and related closures.

Conclusion

In conclusion, supply chain contracts and decisions create complicated issues for manufacturing companies. Changes in pricing and cost at the beginning of the supply chain can cause a ripple effect throughout the industry. Sometimes seemingly small changes can cause unintended consequences.

References

Araman, V. F., Kleinknecht, J., Akella, R. (2002). Technical report: Coordination and risk-sharing in e-business. General Motors Research Center under Project No. PLMR 00327, American Axle & Manufacturing, Delphi Automotive, and a grant from AIM, Stanford University. Retrieved from http://people.stern.nyu.edu/varaman/Research/Procurement_LT_SM.pdf

Crocker, K., Masten, S. E. (1991). Pretia ex machina? Prices and process in long-term contracts. Journal of Law and Economics, 34(1), 69-99.

Green, J., Naughton, K. (2012 October 18). Autoworkers earning less in U.S. happy to compete again. Bloomberg. Retrieved from http://www.bloomberg.com/news/2012-10-18/mbdlhh0yhq0x.html

Joskow, P. L. (2010). Vertical integration. Antitrust Bulletin, VI, 1-49.

Lardenoije, E. J. H., Raaij, E.M. van, Weele, A.J. van (2005). Performance management models and purchasing: Relevance still lost. Researches in Purchasing and Supply Management. Proceedings from the 14th IPSERA Conference, (pp. 687-697). Archamps, France.

Quesada, H., Gazo, R., Sanchez S. (2012). Critical factors affecting supply chain management: A case study in the US pallet industry, pathways to excellence. Dr. Ales Grosnik (Ed.) ISBN: 978-953-51-0367-7, InTech, Retrieved from: http://www.intechopen.com/books/pathways-to-supply-chain-excellence/critical-success-factors-for-supply-chain-management-in-wood-industry