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Pricing strategy metamorphosis

R. Srinivasan discusses, through a case study, the importance of market-related product pricing

FOR DECADES, in a protected business environment such as India, pricing of products never posed any serious problems to the manufacturers as they could sell all that they could produce at whatever it cost them to produce plus the usual p rofit margin. However, with the gradual dismantling of all tariffs and other trade barriers and with India getting integrated with the global economy, `cost-plus' pricing has lost its relevance.

With increased competition, both from domestic producers and from overseas companies, the price of a product is not based on what it costs a company to produce but on what it costs its competitors to produce it. If Indian companies are to survive in such an environment, the selling price of the product, even at its design stage, will determine the cost that could be incurred in manufacturing it. This case study looks at how a company, operating in a high-technology industry where the rate of obsolescenc e is very high, seeks to maintain a good bottomline growth with a market-related pricing policy.

Alpha Technologies Ltd was formed in the late 1980s by a group of technocrats with the initial funding provided by the promoters and their friends and relatives. Initially, the company was involved only in the development of standard as well as customise d software for providing business solutions. With high levels of quality and expertise set as its goals and consistently meeting these goals as a reliable supplier, the company had established indisputable credentials with its customers. A number of Fort une 500 companies were using the company's software products, especially in the critical areas of production, inventory control and distribution management.

The growth rates achieved by the company in turnover and profits were commendable and, over a period, it had built a sizeable volume of retained earnings as it had consistently followed a conservative policy of dividend distribution. As the company's tur nover consisted predominantly of exports to the US and, to a much lesser extent, to the UK, it was able to maintain such a high growth in profits year after year benefiting significantly from tax concessions on export earnings.

However, in 1992, the company realised that the real future in business computing and information technology lay in the US and that it would have to establish a physical presence there to be able to benefit fully from the tremendous potential for busines s-growth in that country. It made its first public issue of shares in India that year and its share commanded a high premium because of its high book value coupled with its record of maintaining a high rate of growth in turnover and profits. The company' s shares were listed in the major stock exchanges in

India and had consistently traded at high premiums ever since. It set up an office in the Silicon valley and chose, as its strategy for future growth, diversification into the manufacture of semiconductors and chips for a variety of end-uses. The company decided that the acquisition-route for a foray into this area would be far more advantageous than green-field projects, beset with long gestation periods.

With funds generated from the public issue in India and, also, overseas through an ADR issue and, having its shares listed on the New York Stock Exchange, the company acquired two semiconductor manufacturers based in the US which were already operating a t high levels of efficiency with their own niche customers. Alpha Technologies also had some of its strategic US customers subscribe for its own shares of up to 20 per cent of its share capital.

In addition, with a view to taking advantage of the lower production costs in India, the company also set up a facility for manufacturing semiconductors and chips in Bangalore, close to its existing location for software development business. Simultaneou sly, the company acquired a 40 per cent stake from some of the promoters of a wafer-fabricating foundry located on the outskirts of Bangalore. All these arrangements and the restructuring of its activities were to prove the growth engines for the future.

The chips are intermediate products which constitute a critical element in the architectural design of electronic sub-systems and systems and the chips, in turn, are integrated circuit boards built from wafers fabricated in foundries. There are many comp anies operating in the semiconductor industry and these are largely made up of US, South Korean and Japanese companies. The average annual rate of growth for the industry is around 20 per cent, but success depends on the speed and the ability of the com panies to meet the stiff deadlines of customers who need the chips to suit their architectural styles during the design of new systems. Newer applications and newer systems and, in turn, changes in their architectures are emerging almost daily and unless time and cost schedules are stringently met, by the time a new system is launched in the market, it could already be too late.

The case study

Excel Ltd, one of the major customers of Alpha Technologies, based in the US, has made a strategic decision to adopt the Bluetooth technology, a major breakthrough in the design of computing and telecommunication products of the future. This technology d ispenses with the use of wires for linking of electronic devices and uses a new, wireless technology. This new technology uses simple shortwave radio links to allow devices such as laptop computers, cell phones, personal digital diaries, cameras and prin ters, to communicate with one another over short distances enabling individuals to form their own personal network and even accessing the Internet without plugging in.

This technology helps signals change frequency 1600 times a second and is capable of moving data at about 723 kilobits per second, more than 10 times the speed of the fastest telephone modem currently in use. Almost all the industry majors are considerin g seriously the adoption of the Bluetooth technology and the potential demand for chips based on this technology could, therefore, be far in excess of the current capacities with semiconductor companies.

Excel had offered Alpha Technologies an initial contract for the design and manufacture of 10,000 chips using the Bluetooth technology for use in many of its current range of devices. This order was being offered with a view to:

* taking advantage of Alpha's superior product quality and Excel's long relationship with it as a trusted supplier;

* place Alpha as a favoured supplier in view of the latter's existing infrastructure for manufacture -- right from the wafers to the chips for custom circuits;

* dispel Alpha's misgivings about assurance of steady, sizeable volumes of business by offering to pay for the non-engineering costs;

* Alpha was free to design any type of chip, whether single or multiple silicon, bearing in mind considerations of cost and product-efficiency; and

* Alpha's price for the chip to be offered to Excel should be maintained irrespective of volume considerations and should at least match the quotes Excel had received from a couple of South Korean semiconductor companies.

Alpha Technologies worked out an estimated cost of producing the 10,000 chips ordered by Excel and, based on its present policy of a margin of 20 per cent of the selling price, had arrived at the following figures:

Estimated cost of manufacturing 10,000 chips for Excel Ltd:

Materials (wafers, and so on) -- Rs. 5,850,000 ($130,000)

Labour (entirely for the supervision of machine set-ups, all the manufacturing processes being fully automatic) -- Rs. 4,50,000 ($10,000)

Overheads (spread over the entire range of products on the basis of machine hour rates) -- Rs. 9,00,000 ($20,000)

Total cost -- Rs. 7,200,000 ($1,60,000)

Margin @ 20 per cent on selling price -- Rs. 1,800,000 ($40,000)

Sales revenues -- Rs. 9,000,000 ($200,000)

Selling price per chip -- $20

Cost of manufacturing, per chip -- $16

Rupee-dollar conversion ratio assumed at Rs. 45 = $1

In working out the estimated cost and, on that basis, the price-quote submitted to Excel, Alpha had assumed that the new chips could be manufactured with the existing plant and equipment at all its manufacturing facilities and that no additional capital expenditure would be necessary except for minimal, inconsequential balancing equipment. The selling price of $20 per unit offered by Alpha did not find favour with Excel who had lower quotes from their South Korean suppliers. Alpha's marketing division a dvised the top management that only a price of $16 or lower would be acceptable to Excel as that was the price offered by competition.

As a result of Excel's lukewarm reaction to its quote, Alpha Technologies decided to review the cost structure through the system of target costing, adopting, as the basis, the competitor's price of $16 and subtracting $1 for a possible further reduction by competitors. The target cost derived from this target price led to the following details:

Target price per unit -- $15

Less: Target profit @ 20 per cent of target price -- $3

Target cost per unit -- $12

This target cost cannot be allowed to be exceeded if the selling price is to be maintained at $15 after allowing for a margin of 20 per cent on the selling price as per company policy. The original cost estimate of $16 becomes, therefore, the drifting c ost which must now be subjected to a review for possible reductions in the various elements of cost and bring it in line with the target cost.

The company will now have to decide whether it is worth its while accepting Excel's offer to pay for non-engineering costs. Such a condition, Alpha argued, would take away its freedom and flexibility in widening its customer-base for the proposed chip de sign. Alpha was, however, able to bring the estimated cost down significantly, after considering the following factors:

i) While the estimates were based on multiple silicon chips, Alpha decided to offer a single silicon chip to Excel, reducing the material cost by $2.50 per unit to $10.50.

ii) The volume-based, arbitrary allocation of overheads to products based on machine hours had the effect of charging products for resources and activities they may not have consumed. Alpha decided therefore, as a matter of policy, to switch to activity- based costing which allocates overheads to products based on resources actually consumed by them. All products of the company were brought under this system of overhead allocation and it was, indeed, then discovered that the new chips being designed woul d be charged with overhead costs from two activities which they will not attract.

Firstly, Alpha's wafer-suppliers had offered to compensate the company for all wafers damaged during Alpha's production process, with an assurance that their quality control measures would be stringent before shipment of supplies to Alpha. This dispensed with the need for an inspection of the wafers at the time of their receipt into Alpha's central reception and, before being taken into stores, thus cutting down inspection costs to nil.

Inspection was recognised as one of the activities the costs in respect of which being chargeable to products on the number of inspections performed.

Secondly, as the length of the production process was now much less because of the designing of single silicon chips, there would be a significant reduction in plant set-up operations. It was estimated that the curtailment of these two activities would r esult in a reduction in the overheads cost per unit of $0.75.

iii) The wafer-manufacturers had offered to make shipments of supplies of wafers on the basis of `just-in-time', making shipments to Alpha only on confirmation of its actual requirements from time to time, obviating the need for Alpha maintaining invento ries, thus locking up working capital. There would, therefore, be a saving in interest costs of $0.25 per unit on this account.

Total reduction in overheads cost per unit thus amounted to $1.

iv) Consequent upon the reduction in the number of set-ups envisaged, the labour cost per unit would also drop to $0.50.

Based on these measures such as a) target costing by adopting a price based on what the market is offering, b) activity-based costing by adopting a more realistic basis for overhead allocation and, also, c) by undertaking a review of the chip-design itse lf, Alpha was able to bring down its drifting cost of $16 per unit to the target cost of $12 per unit and was, therefore, able to accept the order from Excel. In accepting the order, Alpha had also borne in mind other non-monetary considerations such as:

* the long-term benefits from increased demand for Alpha's chip from Excel as well as all the industry majors since the company is now ideally positioned to bid for substantial orders because of the capacities at its disposal;

* the possible further reduction in all elements of cost arising from increased demand for the product and resultant volume growth;

* the potential for growth in turnover and profits because of the radical shift in systems-design brought about by the new technology;

* the diversification into semiconductor and chip manufacture as a strategy for business growth insulates the company from possible stagnation as there are too many companies involved in software development because of low entry barriers; and

* the infrastructure it has created for sourcing raw materials from its own facilities for captive use insulates Alpha from problems of material stock-outs leading to disruptions in production.