Why is the profit pool so low in the transformers business?

When looking at the market for power transformers from a helicopter perspective, we see that the global volumes the past five years, measured in MVA or number of units, are quite good compared to the average volumes we have seen the past three decades. Despite of this, the profit pool in the business is very low and many companies are lossmaking. Why is it like this?

This text uses the transformers business as example, but we have seen that the same situation is common also in other related industries as well as in contracting business.

There are of course many reasons at play here, but many are caused by the manufacturers themselves. First, after having some good years during the period 2004-2008, most of them invested too much in additional capacity, way beyond what the true demand has ever been. Some tripled or even quadrupled their manufacturing capacity, without having any idea where they would sell this volume. The capacity to design power transformers was not expanded as much as the manufacturing capacity was. This, in itself, created additional price pressure, when companies tried to fill the added capacity in new markets, too often at low prices, but there are also other factors at play, where the manufacturers do a lot to harm themselves.

The first place when companies do damages to themselves is in the budgeting phase. During this phase of the business year, several key assumptions are made, that will later guide the pricing process:

• Assumptions regarding capacity utilization are in most cases overly optimistic. This leads to a situation where the true hourly costs for the factory are understated in cost calculations as overheads are distributed over a too big volume. Variation in the product mix are hard to budget and do influence the output of a factory a lot. While studying this matter, we have seen factories that have been almost empty at the same time as the design departments have been working overtime. This will immediately cause under-absorbed costs.

• Another assumption that is made, is regarding the failure-rate in tests. A typical approach is to take the average failure rate the past two-three years and assume that the situation will get better the coming year. History shows that this is rarely the case. Especially if volumes from new markets or higher voltages are budgeted, the true failure rate often goes up instead. We have seen examples of factories where more than 10% of the available working hours during a year have been spent correcting failures, while less than 2% has been assumed in the cost calculation.

• The timing of key orders is very difficult to predict, leading to a situation where not yet received orders are used to fill in known holes in the production. This can give a too good picture short term, further distorting the true situation.

• Every company has productivity improvement plans. When preparing the budget, the planned savings are too often taken into account before they are achieved. This means that cost calculations risk being based on a cost level not yet achieved and that the prices are set too aggressively.

There are of course numerous other reasons leading to companies offering lower prices than they should and causing a situation where their whole business gets considerably less profitable than it should be. The real question is how to break this pattern:

• We all know that it is much easier to lower a price than it is to increase one, but this is where it must start. Successful companies have a clear pricing philosophy, where prices are managed in a consistent way and where unprofitable orders are rejected.

• Such companies use full-cost models and avoid contribution calculations. They regard it better to accept a gap in the production than lowering the prices. They also clearly demonstrate in the market that they do not bid low prices and make sure to act in a predictable way

• Successful companies do not treat their products as a commodity. Successful companies do a lot to differentiate their offering from competition and avoid ‘apple-to-apple’ comparisons.

• Low prices are contagious. If you lower the margin to get an order from a new customer, it is a very high risk that your existing customers find out and ask for the same discounted price level.

It takes time to rectify a too low price-level as customer, competitors and even the own sales force get used to it. In our group, we have identified this area as a key to success for companies in the electrotechnical business and have helped develop strategies to turn the situation.