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Managing inflation internally

A company can rarely pass on supplier price increases in full to its customers. Managing inflation internally is a must. This is because the company’s existing customers will, in their own interest, try to buy cheaper from other suppliers, consume less, use other input materials or even withdraw their own offerings from the market, because they are no longer profitable due to price increases. Potential new customers will also compare offered prices and services and order where they feel they get the most for their money.

A bidding company must therefore maintain its own profitability despite inflation so that it can continue to invest in its own future. Professor Simon calls this profit defense (p. 56 in the book Beating Inflation). In terms of planning and control, profit “should be included in the calculation from the outset like a cost variable to be covered (ibid., p. 52).” This requires the continuous increase of effectiveness and efficiency of one’s own actions. (Definitions in the glossary)

Effectivity = doing the right things

Efficiency = doing the right things right.

Therefore, all cost centers must find, decide on and implement measures that are suitable for achieving profitability in line with the market (see “Profit in Line with the Market “).

Cost reduction measures for functional areas

The ROI-tree from the post “ROI and Inflation” helps to generate ideas to increase profits, to evaluate these ideas from a financial point of view and finally to measure their implementation success. Exemplary starting points are structured below according to functional areas:

Sales, prices, conditions:

- Announce and justify price increases quickly, even if customers temporarily switch to competitors (get ahead of the “cost wave” with price adjustments).
- Increase prices in several steps to discourage customers from switching.
- Do not give discounts at the time of ordering but pay refunds when a predetermined purchase volume is reached (sales model).
- Fix terms of payment without cash discounts and accelerate the dunning process in parallel (cash discounts directly reduce profits).
- Develop new pricing models, e.g. pay per use or pay per period (applies especially to products or services with low proportional manufacturing costs).
- If the product or service is superior to competing offers, customers will buy at even higher prices.

Marketing, sales, distribution:

- Care for existing customers according to ABC-analysis (A and B customers generate higher absolute contributions and should consequently be looked after more intensively).
- Continuous procurement of new leads (addresses of potential new customers) and prompt contacting.
- Largely digital customer engagement to reduce customer visits (less travel).
- Analysis of contribution margin development after trade shows and exhibitions.
- Fix advertising contributions to reselling customers as a share of your contribution margin and grant them only after the sales have been achieved.
- Free delivery of a part of the order quantity often reduces the customer contribution margin less than direct discount percentages from the sales price, because only the proportional costs reduce the contribution margin.
- Continuous monitoring of competitors’ prices, assortments and sales development to locate opportunities for new offers.
- Completely automated dunning system to reduce days sales outstanding.

Manufacturing processes / production planning and control:

- Larger production batches reduce proportional manufacturing costs per unit, as setup times are incurred only once per batch. It is worthwhile to regularly reconcile order intake with inventory levels and the size of production orders.
- Train employees to master several processes and thus have less idle time.
- Automate process steps. In times of inflation, it is often easier to obtain funds for investment, albeit at higher interest rates.
- Continuously check whether suppliers offer certain semi-finished products cheaper than you can produce them yourself (in- or outsourcing based on proportional manufacturing costs plus direct fixed costs of your own process).
- Introduce computer-controlled processing steps and thus reduce manpower requirements.
- Digitalization of planning and control of production orders as well as production data acquisition.
- Reduce scrap.

Purchasing and inventory:

- Consumption scheduling per purchased item based on planned consumption of production and sales in order to achieve more favorable framework-agreements with suppliers.
- Regular comparisons of purchase prices of potential suppliers. Have a substitute supplier ready for each procurement item.
- Immediate information of the sales department and other affected cost centers in case of imminent price changes of important articles or services to be procured.
- Report purchase price variances from budgeted purchase prices on a monthly basis to estimate the impact on product and services to be sold in subsequent stages.

Research and development:

- Find cheaper or more suitable input materials.
- Reduce process turnaround time for customer-specific developments as quick responses build customer confidence.
- Regular assessment of project progress with go/no go decision ends stagnant projects earlier and frees up research capacity.

Internal service areas:

- Continually re-evaluate out- or insourcing (what do we maintain and repair ourselves, what do we outsource?).
- Outsource maintenance and cleaning and reduce cadence if they are not a prerequisite for operational readiness (make fixed costs more controllable).
- Do not charge fixed costs to recipients in internal activity allocation. The service provider is responsible for its own fixed costs.

Controller:

- Fast execution of the planning process and prompt internal reporting are becoming increasingly important because inflation affects the procurement side quicker than the receipt of payments.
- At low value added, cost management is concentrated on the purchasing side because purchase prices change quickly and strongly. At high value added, the focus is primarily on personnel costs. Inflation tends to lead to job cuts.
- Introduce cost splitting into proportional and fixed costs both in planning and in target to actual comparisons.
- Enable computer simulation of cost and revenue developments so that changes in volumes, prices and costs can be estimated in advance.
- Apply dynamic investment calculations so that the effect of inflation on present values becomes apparent.

Management processes:

- Determine responsibilities of individual management positions so that adherence to qualities, quantities, deadlines, and results can be determined.
- Introduce company-wide Management by Objectives and regularly measure and assess the achievement of objectives by individual employees.
- Introduce shop floor data collection also in administrative areas to continuously reduce time consumption in these areas.

Fighting inflation internally is the task of managers at all levels of the hierarchy. If they do not manage to make the total value-added costs grow slower than net revenues, the company will lack the profits to invest in the future and will disappear from the market over time.

ROI and Inflation

The ratio Return On Investment ROI is defined as:

Profit before deduction of taxes and interest (EBIT) : invested assets.

EBIT (100) / Balance sheet total (1,000) = ROI (10%)

The financing structure, i.e. the shares of debt and equity on the balance sheet total, is therefore not taken into account. This enables the profitability comparison between different companies even if they have different financing structures.

If the revenue and cost sides of a company are broken down into their main components, it is possible to see which items affect ROI and to what extent. We call this representation the “ROI tree”.

In the example, 200,000 units were sold at a gross price of 50.- per unit. This corresponded to the gross revenue of 10.0 million. 10% discounts and other sales deductions were deducted from this, resulting in net revenue of 9.0 million (1a, 1b, 2).

The direct material and unit-related external service costs amounted to 8.50 per unit (3a, 3b, 4). Manufacturing consumed 24 minutes per piece, which at the rate of 40.00 per hour resulted in a proportional manufacturing cost of 16.00 per piece. Multiplied by the production quantity of 200,000 pieces, the proportional production costs were 4.9 million (5a,5b).

This resulted in a contribution margin I (CM I) of 4.1 million.

CM I was used to cover the fixed cost center costs of the functional areas (6, 7, 8), which resulted in a cash flow before deduction of interest and taxes of 0.9 million. After deducting imputed depreciation and amortization of 0.4 million, the profit before interest and taxes (EBIT) was 0.5 million.

Dividing the EBIT of 0.5 million by the assets invested in the period of 5.0 million (9, 10, 11) gives the ROI of 10% in the year under review.

Effects of inflation

- If the suppliers of materials and external services increase prices by 5%, this results in a cost increase of 0.085 million for the company. The graph shows that this amount has a direct impact on EBIT and thus also on ROI. See also the post “Purchase Price Variances are topical again”).
- In the same way, price increases for auxiliary materials and purchased services have an impact on the cost centers. This affects the production centers (5a, 5b) as well as the cost centers of the other functional areas (6, 7, 8).
- If machines, buildings, equipment and intangible goods become more expensive, the imputed depreciation increases as a consequence, which again lowers EBIT and thus ROI (12).
- Another consequence of inflation is that employees lose purchasing power. They will demand – somewhat delayed – higher wages (5b, 6, 7, 8).
- On the left side of the balance sheet, inflation also leads to higher invested assets.
- If inventory levels remain the same, the average value of the stock will rise (10).

Banks will raise interest rates on loans, which will reduce pre-tax profits. In the end, business owners (partners, shareholders) will also demand higher dividends because the purchasing power of their dividend income will also decrease.

Conclusion: Inflation is a vicious circle that must be broken by all means. In the private sphere, renunciation must be practiced in order to cope with disposable income and assets. In the corporate sector, attempts must be made to push through price increases. In doing so, there is always the risk that customers will jump to other suppliers, resulting in a drop in sales. Even more important is to strive to improve efficiency in all areas, i.e. to break the vicious circle through more cost-effective processes and structures.

Starting points for improving efficiency are the subject of the next post.

Beating Inflation

“Beating Inflation” is the title of the book by Prof. Dr. Hermann Simon, the “old master” in price management and profit control, published in 2022. This publication deals with the demands that the currently again rampant inflation places on corporate management. Many of his statements are also essential inputs for the design of a comprehensive management control system and thus for the sustainable success of a company. In this and in the next two posts of this blog, his insights will be combined with the design of the comprehensive planning and control system of a company.

After a period of about 40 years with hardly any significant inflation rates, Europe and the entire English-speaking world are affected by massive price increases as a result of the COVID pandemic and war-related events. Many managers are experiencing inflation intensely for the first time and need to understand how to plan and act in such a situation in order for their companies to survive successfully.

How price increases propagate

Generalizing, price increases are the result of bottleneck situations. Bottlenecks can arise in various areas when demand is greater than available supply. Insufficient supply capacity is often due to:

- Raw material availability in the required qualities too low
- Lack of transport capacity or transport containers
- Political/legal supply restrictions
- Inability to comply (yet) with regulations on manufacturing processes or guarantees of origin
- Insufficient personnel capacity for processing and handling
- Too little equipment available for manufacturing or insufficient manufacturing capacity
- Too much capital investment ris equired for manufacturing.

Such bottlenecks lead to cost increases for suppliers of material and services. They try to pass on the cost increases to their customers in the form of higher net selling prices. If this succeeds, the purchase prices for the (further) processing companies rise. These price increases must in turn be passed on to the next (production) level. If a company cannot successfully pass on its higher costs, it will sooner or later incur losses, become insolvent and go bankrupt.

At the end of this chain are the end customers, usually private individuals. If purchase prices rise for them, they consider which of the available products and services they will continue to buy, taking price increases into account. This is because they only have their disposable assets and regularly recurring income available for consumption. Customers usually opt for what they consider to be the best price/performance ratio.

Suppliers at all levels try to circumvent, delay and keep price increases as low as possible in purchasing by means of negotiations or changing suppliers. In sales, the aim is to pass on the price increases that have occurred. Whether this is fully successful depends on the preferences of customers on the one hand and on the behavior of competitors on the other.

In order to remain successful in inflationary times, one’s own company must succeed in interrupting the price increase spiral. Inflation is thus a challenge for all employees, because all functional areas are affected, and above all the entire management. Countless ideas for improvement have to be generated, evaluated and decided upon. Furthermore, the interruption of the inflation spiral has to happen quickly, because otherwise the financial result will suffer. Above all, the following must be adjusted:

- The assortment to be offered and the assortment width
- The pricing process from gross price to net revenue
- The marketing, customer acquisition and sales processes
- The distribution channels and the definition of target customers
- The product development and design
- The manufacturing processes and the input materials to be used
- The purchasing process and the choice of suppliers
- All administrative processes
- The data integration and the automation of administrative processes
- The investment planning as a result of the process changes.

Professor Simon estimates that most companies can only pass on about 50% of the inflationary cost increases on the procurement side to the customers; the entire cost side in the company must also make a contribution to the profit defense (p. 191).

The next post will go more into detail on which measures have how strong an impact on profits.

Localize Cost Reduction Potentials

When actual data is available to measure realized cost reductions, it is too late! In the meantime, the competition has already acted, which may have resulted in shifts in market share that give faster growing companies better opportunities for cost reductions than to one’s own company. Consequently, cost reduction potentials must be actively sought, planned and implemented.

Improving the cost position requires creative, innovative ideas. Realizing cost reductions means strenuous operational work.

Localize Cost Reduction Potentials

It is important to remember that effectiveness (scope and impact) comes before efficiency (less input for more output).

Giving regular feedback to one’s own employees on the performance and quality achieved increases effectiveness because the people being managed can thus control and improve their own efforts (see the post “Master Plan for Integrated Planning and Control”).

In order to be able to localize and realize cost reduction potentials, many methods and procedures have already been developed and recommended. The intention is to reduce costs or to let them grow slower than the realized net revenues, thus generating profits that can be used for the expansion of the organization.

Some proven successful methods and tools are listed below together with the improvements hoped for by their application.

1 Strategy and investment planning see the capital budgeting Excel-download

2 Lean management

3 Target costing: In simplified terms, target costing is intended to bring the expected future market into product development and production, thereby piloting a strong cost position as early as in the product design stage. A target cost calculation is used to determine the maximum costs that can be incurred for manufacturing the product, based on the net revenue that can be achieved on the market. The current percentages for the share of administrative and sales costs and for the target profit are deducted from the net revenue (estimation of a target contribution margin for these functions). The amount available for producing the planned quantities remains as the residual. For the quantification of the various items, dynamic investment appraisal must again be used, since target costing decisions usually require investments to be taken into account and implementation often takes several years.

4 Production data management

5 Measure input/output electronically

6 Plan and record internal tasks

7 Service Level Agreements (SLA) This is a service agreement between clients (internal divisions, functions and cost centers) and performing cost centers for the regulation of recurring services. An SLA is often also agreed with external service providers (e.g., IT outsourcing).

The purpose of such a service agreement is to describe the services to be provided by the service provider as completely as possible for the contractual partners. Care must be taken to ensure that the services are defined in such a way that they can be measured or at least verified.

In the SLA, the contractor is one or more cost centers; the customer is the community of cost centers receiving the services.

The supplier (cost center manager) is responsible for the service provision and for the target cost compliance. Therefore, he also has the obligation to say no if (in the plan or in the actual) more than what has been agreed is demanded. In return, the clients are responsible for approving the budget for the specified services. If they want more service or to pay less, the service providers can reject the proposed conditions. This agreement work must be fixed as part of the budgeting process. After all, once the authorizations are in place, the staff is hired and the money is spent.

Services provided by internal functions are often very diverse and can only be predicted imprecisely. This makes it difficult to agree on an SLA. Nevertheless, it is worthwhile for both contracting parties to describe the work to be performed as completely and comprehensibly as possible. After all, these minutes are an important element for budgeting and comparing planned/actual data. The following should be specified for each item

- Quantity: e.g., preparation of a monthly financial statement or ensuring 99% availability of applications.
- Quality: e.g., according to the principles of proper accounting or the response times of the systems to be maintained.
- Deadlines: e.g., on the 5th working day of the following month or response time until faults are resolved (service level).
- Costs / results: budget compliance.

The tasks to be performed in an SLA should be limited to what is necessary. As a result, the cost of SLA fulfillment should increase more slowly than the CM-volume of the company.

When an SLA is released, contractors may deploy their personnel and resources. The internal customers must periodically be given the opportunity to comment on the extent and quality of service delivery.

SLA costs are fixed costs. They are incurred for the using cost centers, not directly for the products. Due to the lack of a direct cause-effect relationship, they cannot be allocated to the products.

8 Functional diagram

Operational Excellence

Many brilliant strategic decisions have laid the foundation for exponential development of companies. Again, many of these companies have found their way into economic history as “success stories”. They are quoted in books and in seminars.

However, in the cases known to us, the fact that things got this far was always due to “operational excellence”. In our view, fine-tuning details, mastering processes, distinguishing between what is necessary and what is “good to have”, and continuously improving implementation are basic elements of successful corporate management, both in the area of sales and distribution and in the persistent improvement of the company’s own cost position.

Experience Curve for Your Company

How to develop the experience curve for the own company.

For the empirical proof of the experience curve, series of actual figures from various industries were used. These showed that the value-added costs per unit decreased by 20 – 30% for each doubling of the cumulative output quantity. This finding can also be used as a guideline for planning for one’s own company. Based on actual data (partly estimated), a company-specific experience curve can be drawn up. This can be used to analyze whether the medium-term planning figures will be suitable for implementing the experience curve in one’s own company.

Experience curve for Your company

The following initial data are required:

- Cumulative sales volume to date
- Value added costs of the most recent actual year
- Planned sales volumes for the planning horizon under consideration.

From this data, a “funnel”, i.e., a corridor for the development of the allowable value-added costs, can be calculated.

First, the annual context must be established (Compare with the table “calculation of cost reduction targets” below):

- In line 1, the actual sales volumes of year 1 and the planned sales volumes of the planning years 2-7 are entered.
- The sales volume of the assortment sold before year 1 is entered in line 2 (500,000 units). Since this is only a rough estimate, all product units are considered equal for simplicity. Also in line 2, the accumulated sales quantities until the end of the planning horizon are calculated.
- From this, the doublings per year can be calculated in line 3. The formula for this is:
  Formula to calculate annual doublings
  
  The fact that these values are continuously decreasing expresses that despite sales volume increases, an increasing number of years is needed to achieve another doubling.

- Line 4 shows the cumulative doublings of the planned years in relation to the initial situation. They form the basis for calculating the theoretical experience curve values.
- In line 5, the value added costs per unit of the actual year are calculated (1’800’000 : 200’000 sales volume = 9.00).
- Since a cumulative doubling of 0.4253 is to be achieved in planned sales in year 2 compared to actual year 1, the value-added costs of the previous year are exponentiated by the cumulative doubling factor (0.4253 in planned year 1). Depending on the selected experience curve target, this results in the value-added costs to be achieved in the respective plan year (e.g., 8.19 for the 20% experience curve for plan year 1, line 7).
- Purely arithmetically, the experience curves of 10%, 20% and 30% can be determined in lines 6-8 for the value-added costs per sales unit to be achieved.

Graphically, the “funnel” is created, in which the planned and effective value-added costs should move within the medium-term planning horizon shown (Plan1 to Plan 6).

Value-added cost targets for planned sales quantities

The next post will ask whether the medium-term cost center plans for the value-added cost areas will be able to meet these requirements. If not, ideas must be generated on how to reduce the planned costs of the affected cost centers. If this requirement cannot be met, the company will lose competitiveness due to excessively high value-added costs.

Importance of cumulative past sales volume

It is often difficult for companies to determine the cumulative sales volume to date, either because the data is missing or because estimates had to be made due to changes in the portfolio.

If, in the model presented above, the cumulative past sales volume is entered as 0 units, the value-added costs to be achieved per unit sold in plan year 1 and assuming an experience curve target of 20% will decrease from 8.19 to 6.49 per unit. In the opposite case, where the cumulative sales volume to date is 1,000,000 instead of 500,000 units, the allowable value-added costs increase to 8.49 per unit.

If these extreme variants are considered, it can be seen that an incorrectly estimated or calculated cumulative sales volume is significant, but the target values to be achieved change little. Overestimated cumulative past sales volumes lead to lower cost reduction targets for the planning years, while underestimated ones lead to higher ones. As these are planning targets, possible misestimates are justifiable.

Improve cost position

If you do not improve your cost position, your competition can overtake you.

Part of the consumer experience is that products, ignoring price changes due to inflation, are offered cheaper per unit over time, or that greater performance is offered for the same price.

Some examples:

In 1983, the Motorola Dyna Tac 8000x became the first commercially offered cell phone to hit the market at $3,995. Thirty years later, a cell phone with more features and no ties to a service provider can be purchased at a specialty retailer for about $20, or roughly 5‰.

The original IBM personal computer was introduced to the market in 1981 at a price of $1,565. Thirty years later, PCs were available for purchase for well under $100. These were also much more powerful than the original and offered more features. The HP LaserJet printer hit the market in 1984 at a price of $3,495. After about 30 years, laser printers were on sale around $100.

In https://winhistory.de, the development of the sales prices per megabyte of hard disk capacity from 1997 to 2011 is shown:

The fact that more output is offered for the same price over time can be observed in many areas of the economy. The main reasons for this are technological improvements, competition, and rising production volumes.

Improve cost position

A company must continuously strive to reduce its average total cost per unit of output. If it does not manage to do this, its existing or new competitors will do so, worsening its market position as well as the sales opportunities of the company.

A rapidly and continuously improved cost position is therefore a key prerequisite for achieving or maintaining a strong market position. Companies must be able to substantially reduce their average per unit costs of goods over time if they want to parry sales price reductions by competitors and maintain their profitability. Some of the companies that have managed this balancing act have become global corporations. Many others had to give up because they were not able to reduce the cost per manufactured unit to a sufficient extent.

These relationships have been known for a long time. As a result of his empirical investigations, B.D. Henderson presented the law of experience – also known as the experience curve or Boston effect – as early as 1974 (cf. B.D. Henderson, die Erfahrungskurve in der Unternehmensstrategie, Frankfurt/New York, 1974).

In the following posts, the determinants of the experience curve are first analyzed. It is then shown how the concept of the experience curve can be integrated into one’s own planning and control. The focus is on the alignment of internal objectives with external market developments.

Promises of the experience curve

In every company ways have to be found to implement the experience curve.

Bruce Henderson (cf. B.D. Henderson, The Experience Curve, Boston Consulting Group, Perspectives nr. 16, 1968 ) has proven with extensive empirical studies (ex post) for entire industries or for the product volumes offered in a market in various industries that:

The real (inflation-adjusted) full value-added costs decrease by 20 to 30% with each doubling of cumulative output volume.

Promises of the experience curve

The practical application of this finding in one’s own organization requires that the statement be viewed in a differentiated manner:

- The cost reduction applies to every doubling of the cumulative output quantity (since the market launch of an offering). How quickly a doubling takes place consequently depends on the market and on the company’s own growth. In fast-growing markets, a doubling of the cumulative output quantity (of all suppliers) can take place in a few months; in mature markets, it may take several years.
- Value-added costs comprise the costs of the services provided within the company itself. These are primarily the total (proportional and fixed) personnel costs and the externally purchased services consumed, as well as depreciation and amortization (fixed costs only). They are incurred so that the company’s own services can be delivered and profit can be generated. Direct product-related material and external service costs are not part of the value-added costs, as these are determined by the suppliers. Value-added costs are calculated by deducting from total expenses in the income statement the material and external service consumption directly caused by the products sold.

The value-added costs per unit sold must be reduced if competitiveness is to be increased. The graph shows the development of the value-added costs for each doubling of cumulative output quantity, assuming that the items sold remain the same.

Value added and cost of goods sold per unit must be reduced based on experience.

- The absolute company profit increases as long as the sales price can be maintained (in the example at 12.00) and the value-added costs as well as the costs for material and external services can be reduced according to the doublings.
- However, the experience curve also applies to competitors. If they manage the doublings faster, they also have the chance to reduce their value-added costs per unit faster. This increases their potential to lower their net selling prices and thus improve their market position.
- The graph does not contain a calendar reference. Therefore, it is not yet possible to derive which cost reductions can be realized in which years. The corresponding procedure will be explained in a further post.

There are four factors that determine the realization of experience curve progress: economies of scale, learning effect, improved processes, and product design.

- Economies of scale occur more or less automatically. If the sales volume and thus the production volume increase, the fixed cost block is distributed over more units, which reduces the average complete product cost.
- People and machines learn from experience. Through repetition, consistent processes can be completed in less time. Processes become more efficient, resulting in lower processing times per unit. Administrative processes can also be completed with less time and fewer errors. Integrated data processing makes information available across departments, and machine learning and artificial intelligence can automate many evaluation tasks.
- By using new and more powerful equipment, manufacturing can be done with less time and possibly improved quality. Often, such investments are combined with capacity expansions.
- New materials and new designs enable more cost-effective manufacturing. Changes in product design should at the same time allow for higher sales volumes and changed sales prices.

Application example:

Development of prices, costs and EBIT over 7 years

The table and the graphs show by way of example how the experience curve factors and the increase in sales volumes over seven years affect earnings before interest and taxes (EBIT):

- The increase in sales volumes over the years leads to sharply rising net revenues per unit, despite falling net revenues.
- Fixed costs fall per unit, although the absolute amounts for depreciation and fixed personnel and material costs rise (fixed cost degression).
- Due to learning effects and process improvements in production as well as possibly due to more favorable material purchases, the proportional manufacturing costs decrease from 10.00 to 8.00 per unit.

The form of presentation of the changes selected above presupposes that in management accounting a clear distinction is made between proportional and fixed costs and that a contribution margin calculation is prepared (cf., the corresponding posts on management accounting in this blog).

Note that only fixed cost degression is an automatic consequence of growing sales volumes. Realizing the promise of the experience curve in one’s own organization requires great effort in operational planning, implementation and control. Cost reduction opportunities must be sought everywhere in the company, not just in the products. Lower absolute personnel administration costs reduce the average costs per unit in the overall view just as much as a disproportionately low increase in IT costs in relation to sales growth over the same period.

In the next posts, methods and procedures will be shown which support the achievement of the improvements.

Experience curve and medium-term planning

The comparison of the current planning status with one’s own experience curve quantifies the cost gap that must be closed.

The experience curve adapted for the company itself forms the orientation framework for medium-term operational planning. Will it be possible to keep real costs within the empirically established “development corridor” of minus 20% to minus 30%?

The development of the income statements for the medium-term planning horizon, which is already known from previous posts, represents in condensed form the current processing status of medium-term planning. Lines 10 and 11 show that average value-added costs per unit are falling in absolute and percentage terms, although net revenue per unit is also declining. The planners expect that the competition will also reduce prices in the planning period.

Contribution margin and value-added cost

If the development planned to date is integrated into the company-related experience curve from the previous post, the following graphic results:

Experience curve and medium-term planning

It can be seen that the planned values to date are moving in the “funnel” but have not yet reached the 20% experience curve. The dotted trend line suggests an experience curve of about 15% for the planning horizon.

What is to be done?

Since it is not yet known in the planning phase whether the competition could grow faster through price reductions and thus achieve a better experience curve, the personnel and material costs as well as the imputed depreciation in the cost center plans must be revised again.

According to the budgeted income statements to date, personnel and non-personnel costs as well as imputed depreciation will rise sharply in plan year 2. In particular, fixed value-added costs will increase by 0.5 million. This explains the jump out of the “funnel” in plan year 2 and the resulting increase in the share of value-added costs from 42% to 46% of net revenues. In plan years 3 to 6, value added costs then rise again more slowly than net sales, which is reflected in the improvement in the company’s own experience curve and, of course, in higher EBITs.

Consequently, the plan revision must focus primarily on the plan values for personnel and material costs in the cost centers and look for ways to spread the useful live of the investments over more years, since they determine the amount of imputed depreciation.

The effort required to create your own experience curve is manageable. Comparing the curve with the company’s own medium-term plans makes it possible to see in which cost centers to look for cost-cutting opportunities first.

The comparison of the current planning status with one’s own experience curve quantifies the cost gap that must be closed in the coming years if the competitive cost position is to be maintained. The ability to compete is largely built up in the medium-term planning.