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How Capacity Utilization Can & Should Drive Pricing Decisions

Posted by INSIGHT2PROFIT

ThinkstockPhotos-484726544Whether you’re a manufacturer, distributor, or service provider, you likely face some form of capacity constraint.

For manufacturers, it might be machinery throughput. For distributors, it might be truck capacity; for service providers, staffing.

It’s critical that you understand how these constraints impact your profitability.

Typically, businesses focus on optimizing cost structures to maximize margin per unit. But we repeatedly find that margin per constraint is a more accurate profitability metric. We call this capacity utilization, and optimizing capacity utilization should drive your overall pricing strategy.

Capacity Utilization in Manufacturing Companies

We recently worked with a manufacturer with machinery capable of producing multiple sizes of products.

The larger products had a slightly higher profit margin per unit, but the machinery could produce more of the smaller products per hour. The pricing team wanted to know: How can we optimize product mix to maximize profitability?

Since the machinery was limited by the number of units it could produce in any given day, we knew this key capacity constraint needed to be factored into the analysis. Sure enough, when we calculated margin per machine hour, we saw a very different view of the company’s profitability than when we looked solely at margin per unit.

Even though the margin per unit for the smaller products was slightly lower, because the throughput was so much higher, increasing the number of smaller products in the overall mix had a much stronger impact on profitability than the manufacturer expected.

Armed with this insight, the manufacturer was able to make pricing decisions that generated growth in these smaller products, which led to dramatic overall profit improvements.

Capacity Utilization in Distribution Businesses

In distribution businesses, often the biggest constraint is the quantity of products that can be placed on a truck, regardless of whether the truck is owned by the company or a third party.

By analyzing profitability per delivery, you gain a more realistic view of the business than profitability per unit. The goal here is to optimize profitability simply by improving delivery patterns—without having to sell more units of products.

Capacity Utilization in Service Businesses

It’s critical, therefore, to understand the financial impact of the partners’ valuable time spent, so you can optimize how those partners spend their time in order to drive the most profit dollars.

Often, there are opportunities to better leverage other people in the firm who bill at lower hourly rates. We frequently find that by relying on the partners less and support staff more, we can set more accurate pricing targets for everyone within the firm—and as a result, improve the firm’s overall profitability.

Conclusion

Across the board, capacity utilization is a critical pricing factor that too few businesses leverage. Fortunately, the analysis doesn’t need to be overly complicated or detailed. Simply recognizing the broad impact is often enough.

By taking capacity utilization into account in your pricing decisions, you can confidently drive the right product mix in your business and set a course for maximum profitability.

How One Manufacturer Earned $2M In Profit

Topics: For Pricing Managers , Pricing Strategy , Manufacturing