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Chapter 11Cost Management

Key Questions Addressed in Chapter 11

• How can cost management and negotiation tools help identify opportunities and assure value?

• How can we determine – the supplier’s costs? – deliverer’s cost? – our own use costs? – disposal costs?

Strategic Cost Management

• An externally focused process of analyzing costs in terms of the overall value chain– A continuous improvement process– Measure and improve specific cost elements– Tools and techniques to sustain cost savings year over year– Strategic partnering to achieve competitive advantage– An opportunity for strong supply leadership to develop a cost

culture rather than a price culture with multiple internal stakeholders and suppliers

ABC or Pareto Analysisand Cost Management

• Assign items to A (high-dollar), B (medium-dollar), or C (low-dollar) category

• A items = greatest percent of annual spend • Cost management approach for A items:

– More time and managerial attention– Understand supplier’s cost structure – Identify opportunities for supplier or joint buyer-

supplier initiative to eliminate, reduce, or avoid costs in any cost elements (materials, services, labor, and overhead)

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Portfolio Analysis

non-criticalitems

bottleneckitems

strategicitems

leverageitems

Value

Ris

k

Low

High

High

Low

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Major Categories for the Components of Total Cost of Ownership

Pretransaction Components• Identifying need• Investigating sources• Qualifying sources• Adding supplier to internal

systems• Educating:

–Supplier ins firm’s operations

–Firm in supplier’s operations

Transaction Components● Price● Order

placement/preparation● Delivery/transportation● Tariffs/duties● Billing/payment● Inspection● Return of parts● Follow-up and correction

Posttransaction Components● Line fallout● Defective finished goods

rejected before sale● Field failures● Repair/replacement in field● Customer

goodwill/reputation of firm● Cost of repair parts● Cost of maintenance and

repairs

Total Cost of Ownership

Source: Lisa Ellram, “Total Cost of Ownership: Elements and Implementation,” International Journal of Purchasingand Materials Management, Winter 1993.

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Target Costing Example

Future Market Price – Desired Profit = Target Cost

Current Price

Par

t/S

yste

m P

rice

Verified By Cost Standards

Target Cost

Desired Profit

CurrentCost

ComponentTarget Costs

A

B

CPurchased Component Part Level Costs

Internal Costs

>

Current Profit

Model-to-

ModelChange

Adjust for Spec. Differences

Value Expression

• Value can be expressed as:

VALUE = Function Cost

– Function = a noun-verb combination (e.g., holds liquid)

Activity Based Costing

• Tries to turn indirect costs into direct costs by tracking the cost drivers behind indirect costs

• Manufacturing overhead is divided into:– costs that change in response to unit-level activities– batch-level activities– product-level activities– the remainder are true fixed costs and are allocated

according to traditional cost accounting

Negotiation

• The most sophisticated and most expensive means of price determination

• A difficult art requiring judgment and tact• An attempt to find an agreement that allows

both parties to realize their objectives• Requires the buyer and supplier, through

discussion, to arrive at a common understanding on the essentials of an issue