How to Deal with a Price Reduction from a Major Customer

    Daniel M. Cushard

    When business is already hurting, a mandatory price reduction from a major customer can close a struggling company. Management’s natural instinct is to panic and look for instant cost savings. This type of “firefighting” often leads to poorly thought out decisions that cause more harm than good. The difference between strategic(long-term) and a tactical (short-term) approaches toward material and supplier management will change everything.

    Case Study
    LMN Corp faced this dilemma. (Editor’s Note: LMN Corp is a fictional entity based on three Michigan firms and used for the purposes of this case study.). In response, the management team met in the conference room and came up with these ideas:
    -¢ Call their own suppliers demanding price cuts
    -¢ Find a lower cost supplier
    -¢ Shut off every other light
    -¢ Negotiate with their customer for a smaller price reduction
    -¢ Reduce staffing levels via layoffs

    Demanding a price reduction from their suppliers is an option, but how will this affect their relationship? The same problems arise for layoffs: moral and output fall. Shutting off lights and other energy reductions are important and need to be done, but will not meet the necessary cost reduction. How about searching for a new low cost supplier? It’s a good idea to understand market prices and ensure suppliers are competitive, but LMN had done this recently.

    These are all tactical responses only solving today’s problem; a more strategic approach is necessary for long-term success. Before cutting jobs, reducing utilities or taking short-term action, business leaders must understand where the “waste” is in their product components. This is an important strategic objective that will guide them toward smart cost cutting.

    The first step in finding waste is understanding what gives your product value. Value is defined by your customers; why do your customers want your product and you as their supplier? Do you provide fast delivery? Solve a problem? Or do you make their product work better? The best way to find out this information is to talk to your customers -¦for once, put them to work for you. Now take the information and put it to work.

    Focus on the top 20 percent of your customers; they create 80 percent of your sales. Send out a survey to them. Ask questions about how and how often they use your product. If the response is poor, offer a discount to complete the survey, or take clients out to lunch and pick their brain. Most customers want to work with you to get a better product.

    The key performers for eliminating waste in product components are sales professionals, purchasing agents and upper management. Sales people are the pipeline for determining customer expectations. Purchasing agents have a broad list of suppliers offering economical options that meet expectations. Management’s role should be to coordinate the department activities and inform everyone of the common strategic plans.

    Turn lemons into lemonade, and use this opportunity to form a stronger relationship with customers. Find out why your products are valuable to them, or how the product can be improved. This information may provide insights to the real value of your product.

    Once you understand the value of your product, you can review its parts and look for areas to cut costs. A 20cents pen only needs to write well for a month; adding a gold tip is obvious waste. From customer surveys you can break down the components of your product into value-added and non-value-added parts. Value-added are components that the customer expects and determine why your product is bought; this is not a place to cut costs. Instead, focus on the non-value-added category. Break these components into “critical to the function” of the product and “non-critical” parts. A critical component of a pen is the ink; non-critical can be a cushy grip. The non-critical parts should be eliminated immediately. The process is shown in Figure 1.

    Now determine what the minimum requirements are for the critical pieces, and find lower cost options that will still meet your customer’s expectations. These can be cheaper materials, smaller pieces, or fewer features. If your suppliers do not offer better options, search for different providers that meet the necessary standards.

    After eliminating the non-critical components and reducing the cost of your critical components, you still may not reach your cost target. At this point, focus on the internal processes; this is an area where massive leaps can be made in labor and materials, usually by 40-60 percent

    A mandatory price reduction from a major customer, as LMN experienced, can make any leader panic. Their initial reaction to this problem was layoffs, passing the buck to suppliers, or non-effective operating cost cuts. By taking a more strategic approach toward material cost management, large amounts of waste are removed and costs are lowered without reducing value in the customer’s perception. The end result is better supplier relations and an understanding of your customer needs. Also, the product has a higher profit margin for all of your customers.

    Daniel M. Cushard earned a bachelor degree in Chemical Engineering from Michigan Technological University. He has implemented continuous improvement and lean manufacturing principles at several companies.

    Jeremy D. Dunaj has a bachelor’s and master’s Degree in Mechanical Engineering from Lawrence Technological University. He worked for a major automotive OEM, and is now employed as a Design Engineer for Molex Incorporated, a global manufacturer of electrical components. Daniel and Jeremy can be reached at [email protected] and [email protected].