A Better Pricing Model Leads to Increased Profitability

A $25 MM component manufacturing company

How to optimally price a mix of work that ranges from very easy to produce to very difficult. Complex jobs involve many more setups on the manufacturing line, slowing down production. Simpler jobs have fewer setups, so the line runs more continuously, increasing total throughput. The standard way to price work in this industry was to use higher percentage markups for more complex, slower-to-produce jobs and a lower one for jobs that were faster to produce.

This is rational, but not optimal as some jobs were so slow to produce that it was clear the percentage markups used were not high enough, and the markup structure created a step function in pricing when jobs went from one complexity level to another. The issue was further clouded by the fact that some jobs were simple to manufacture but were made of expensive high-strength materials. In cases like this, the percentage markup would yield a very high price relative to the complexity of the work. It seemed like there must clearly be a better way to assign value to the manufacturing complexity of the work, separate from the cost of the materials.

Sharpen took a “Moneyball” approach to solving this problem. We figured there must be a better way to measure and put a price on the resource consumption of jobs of varying difficulty.

We noted that the plant was operating at or near capacity 100% of the time, so there was a fixed number of hours of manufacturing equipment and labor resources available each day. Using basic arithmetic, we derived a pricing equation that directly linked the consumption of production capacity to the amount of markup added to the material cost.

In the first year of implementing this model, the company realized a 50% increase in EBITDA on revenue that was about 10% higher than the previous year. The throughput of the plant was optimized for the maximum value of markup that could flow through the manufacturing process as opposed to a series of jobs marked up by percentages that were not directly linked to their complexity.