Chapter 4 1

Chapter 10

Strategic Cost Management

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Definition

Strategic Cost Management:

Supply chain partners working together to identify design changes, efficiencies, and process improvements to reduce costs.

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Understanding terms

Price = Cost + Profit

Price Analysis Cost Analysis Direct Labor HoursDirect Labor RatesMaterial costsToolingOverheadG&AProfit

Relates to materials

This chapter considers both Price Analysis and Cost Analysis

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Understanding terms, continued

Acquisition Price = Price + Transportation costs Total Cost of Ownership:

TCO = Acquisition Price + Present Value of Usage costs (conversion costs, scrap, re-work, warranty costs, operating and maintenance costs)

Marketing price = Buyer firm’s selling price

Relates to materials

Relates to materials

Relates to finished product

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Strategic Cost Management

The driving force behind global competition can be summarized in the following equation:

Value = (Quality + Technology + Service + Cycle Time)

Marketing Price

This chapter focuses on the denominator: price, and its primary driver, cost.

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I. Price Analysis

Definition: Look at the supplier’s price (or bid) and compare to reasonable benchmarks without looking at the separate elements of cost and profit.

Some form of price analysis is done with every purchase

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Price Analysis

Price Analysis focuses on Comparisons Consideration of reasonableness Market structure and economic

conditions Pricing strategies of the seller

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Price Analysis

Goals of Price Analysis: Fair and Reasonable Price Market influenced Don’t pay more than your

competitors

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Price Analysis and market structure

None Some Much

Perfect Competition Monopoly

Supplier’s ability to set price:

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Price Analysis and market structure

None Some Much

Perfect Competition Monopoly

Supplier’s ability to set price:

With market power, firms will have a pricing strategy

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Pricing Strategies Cost-and-profit based pricing or market-

conditions based strategy Price – Volume Strategy Trade discounts Cash discounts Buy-ins Revenue pricing

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Trade Discounts

•Trade (also called Series) Discounts

Example: 10-10-10

$100 – 10%(100) – 10%(90) – 10%(81) = $72.90

$100 $90 $81 $72.90

(a 27.1% discount)

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Cash Discounts

•Cash Discounts; e.g. 2/10/net 30

What is the opportunity cost, at an annual rate, of not taking advantage of the seller’s discount terms?

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Revenue Pricing

Here a seller is focused on seeking revenues to cover some overhead

Example:

Variable Labor $1000

Variable Material$2000

Fixed Costs $1100

Total Cost $4100

Under what circumstances would a supplier agree to a price of $3001?

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Tools of Price Analysis

Analysis of Competitive Proposals Comparison with published or

market prices Comparison with historical prices Use of PPI (by commodity type) Use of Web-hosted information

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Tools of Price Analysis

Using the Producer Price Index (PPI) www.bls.gov/ppi By Standard Industrial Code (SIC) Base year is 1988 Expressed as

100Period Base Price Average

PeriodCurrent Price AverageX

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Common Price Clauses

Price Protection Clause Most-Favored Customer Clause Escalator Clause

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II. Cost Analysis Independent Cost Estimate (ICE)

Based upon Internal engineering and operations estimates Historical experience and cost estimating relationships

(CERs) Learning curves

Part of proposal analysis Prepare for negotiation

Reverse Price Analysis (Guestimating—to—Should Cost)

Target Costing (Design-to-Cost) Breakeven Analysis Profit analysis

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Elements of a formal cost analysis process

Direct labor Material Overhead Tooling Profit

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Direct LaborLabor hours x labor rates

Application of the Learning CurveRequires: (1) Labor-intensive process (2) Repetitive tasks (3) Operations not machine-paced (4) New product or new production process

Direct Labor

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Learning Curve

T1 Units of output

Labor hours/unit

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Learning Curve Rates Common learning rates are 70% - 90% % applies to doubled units Example: an 80% curve and a T1 of 100

hours:T1 = 100 hours

T2 = 80 hours

T4 = 64 hours

T8 = 51.2 hours

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The Learning Curve in practice

The Boeing Tables Hand-out exercise

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The Learning Curve is used for:

Cost estimating Production rate and schedule:

Progress Payments

Output per month

Month of production

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Elements of a cost analysis, cont.

2. Direct material-Raw materials-Components-Subassemblies

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Elements of a cost analysis, cont.

3. Overhead (in manufacturing, engineering, and materials)

Pool dollars/labor hours = allocated overhead per labor hour

Example: Assume copy machine rental, secretary salaries, office supplies, travel, etc. is $20,000 per month. Assume 500 direct labor hours in this area per month.

Allocated Overhead Per Hour: $20,000/500 hours = $40

If labor rate is $30 per hour, overhead rate is 40/30 X 100 = 133%

We say: A direct labor rate is $30; a loaded labor rate is $70

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Elements of a cost analysis, cont.

4. Tooling5. Profit

Purposes of profit:

(1) Motivate the supplier to take the business

(2) Provide a return on investment(3) A reward for efficiency(4) A reward for risk and innovationWhat is a “fair “ profit”?

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What ought to be the basis for profit amounts?

Cost Risk Invested Capital Efficiency and responsiveness

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What ought to be the basis for profit amounts?

Cost Risk Invested Capital Efficiency and responsiveness

X

A profit is “fair and appropriate” if it motivates a supplier toward efficiency and responsiveness, and appropriately rewards him for risks taken and capital invested.

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Breakeven Analysis as a preparatory tool for negotiation

Context: I have a target price and a required procurement volume for a material.

With insights on supplier fixed and variable costs, will this target price and volume provide adequate profit to the supplier?

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Breakeven Analysis as a preparatory tool for negotiation

Revenues and Cost

Quantity1 2

Fixed Costs

Total Costs

Total Revenue

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Two Approaches to Collaborative Cost Management

Target Pricing Traditional approach

Cost = f(design) Target pricing

Design = f(cost target)• Requires collaborative effort and the tools of ESI,

value engineering, manufacturing process changes, standardization

• The difference between the supplier’s quote and the target cost becomes a strategic cost-reduction objective

•Cardinal Rule: Target cost can never be violated

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Two Approaches to Collaborative Cost Management

“Cost Savings” Initiatives (by supplier) Based upon a formula for sharing

savings

Two critical requirements for this to work:

1. Supplier shares all information on the cost to produce an item

2. Profits are incentivized

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Three final thoughts relating to Strategic Cost Management

• Geographic area• Labor productivity• Plant conditions and utilization level• Process technology• Capabilities of management• Supply management practices

1. Costs vary among suppliers

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Three final thoughts relating to Strategic Cost Management

2. The techniques of cost analysis are sophisticated and time consuming. Accordingly, they are only used on items of high value or strategic importance, or in procurements with uncertain costs.

3.The issue of Allowable Costs

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Let’s move on