OSCM Ch 11, and 12

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Strategic Cost Management

Chapter 11

OSCM 3660:002 Strategic Sourcing

Spring 2016

Sandeep Jagani

PURCHASING & SUPPLY CHAIN MANAGEMENT, 5e

Chapter Overview

Structured approach to cost reduction

Price analysis

Cost analysis techniques

Total cost of ownership

Collaborative approaches to cost management

Purchasing & Supply Chain Management, 5e

The Honda Business Model for Suppliers

Six-year plan

100% understanding of all components of product cost

Lean supplier development concurrent engineering

Flawless new product launch

Communications

Purchasing & Supply Chain Management, 5e

The Value Equation

Purchasing & Supply Chain Management, 5e

Quality + Technology + Service + Cycle Time

Price

Value =

Definitions

Price analysis

Process of comparing supplier prices against external price benchmarks

Cost analysis

Process of analyzing each individual cost element that makes up final price

Total cost analysis

Applies value equation across multiple processes

Purchasing & Supply Chain Management, 5e

Cost Management Approaches

Tier 2 Supplier

Tier 1 Supplier

Enterprise

Customer

Consumer

Purchasing & Supply Chain Management, 5e

Single Company Focused Cost-Reduction Initiatives

Strategic Cost Management –

Finished Product/Service Focus throughout the

Supply Chain

Customer Needs

Historical Cost Reduction Approaches

Value analysis/value engineering

Process improvements

Standardization

Improvements in efficiency using technology

Purchasing & Supply Chain Management, 5e

Strategic Cost Management Processes

Purchasing & Supply Chain Management, 5e

Most focus is on a single company

Need to migrate to a supply chain focus

Supply Chain Strategic Cost Management

Supply Chain Cross-Enterprise Focus (Joint Efforts)

Value Engineering / Value Analysis

On-Site Supplier Development

Cross-Enterprise Cost Improvement

Joint Brainstorming for Cost Improvement

Supplier Suggestion Programs

Supply Chain Compression

Strategic Cost Management Processes

Value analysis/Value engineering

Team-based

Cross-enterprise

On-site supplier development

Process to accomplish supplier continuous improvement

Purchasing & Supply Chain Management, 5e

Strategic Cost Management Processes

Cross-enterprise cost improvement

Joint effort

Costs identified

Cost drivers determined

Strategies to improve execution

Results review

Joint brainstorming

Establish list of value-add projects and execute

Purchasing & Supply Chain Management, 5e

Strategic Cost Management Processes

Supplier suggestion programs

Motivate

Act on

Reward

Overall process

Supply chain compression

Reducing number of levels

Supplier consortiums

Purchasing & Supply Chain Management, 5e

Managing Life Cycle Costs

Purchasing & Supply Chain Management, 5e

Initial Cost Target  Final Cost Target  Contract Baseline  Cost/Price Continuous Improvement

Quality function deployment Feasible cost Risk assessment Technology road map/information shared Supplier concept competition/request for proposal Finalize statement of work

Value engineering Design for manufacturing, purchasing, assembly, environment, etc. Supplier integrated into new product development Target costing standardization

Competitive bidding Value analysis Aggressive negotiations Volume leveraging Inventory consignment Managed service contracts Forecast/adjust for inflation Engineering change control Longer-term agreements

Remanufacture Recycle Refurbish

Idea/Concept Generation

Design and Development

Prototype, Pilot, Launch

Ongoing Production

Product End-of-Life

Strategic Cost Framework

Critical Products Strategies: Cost analysis Collaborative cost-reduction efforts focused on total costs	Commodities Strategies: Leverage preferred suppliers Price analysis using market forces
Unique Products Strategies: Cost analysis – reverse pricing Standardize requirements	Generics Strategies: Total delivered cost Automate to reduce purchasing involvement

Purchasing & Supply Chain Management, 5e

VALUE

NUMBER OF AVAILABLE SUPPLIERS

High

Low

Strategic Cost Framework

Generics

Competitive market with many potential suppliers

Emphasize total delivered price

No need for detailed cost analysis

Users order direct through supplier catalogs, p-cards, or e-procurement

Purchasing & Supply Chain Management, 5e

Strategic Cost Framework

Commodities

High-value products or services

Competitive market situation

Traditional bidding approaches

Identify competitive pricing through price analysis

Standardized products

Purchasing & Supply Chain Management, 5e

Strategic Cost Framework

Unique products

Few available suppliers

Relatively low value

Utilize reverse price analysis to determine whether price is “too high”

Try to move to generics quadrant over time

Purchasing & Supply Chain Management, 5e

Strategic Cost Framework

Critical products

Requires majority of buyer’s focus

Relatively few suppliers

Higher-value items

Explore opportunities for:

VA/VE

Cost savings sharing

Collaborative efforts to identify cost drivers

Supplier integration early in product development cycle

Purchasing & Supply Chain Management, 5e

Price vs. Cost vs. Total Cost Analyses

Price analysis

Commodities and generics quadrants

Cost analysis

Unique and critical products quadrants

Total cost analysis

All quadrants

Purchasing & Supply Chain Management, 5e

Market-Based Pricing

Purchasing & Supply Chain Management, 5e

Supplier’s

Market

Buyer’s

Market

PRICE

VOLUME

Supply

Demand

Market Structure Analysis

Number of competitors in industry

Relative similarity (or lack thereof) of competitive products

Any existing barriers to entry for new competitors

Purchasing & Supply Chain Management, 5e

Market Structure Types

Monopoly

Single supplier market

Unique product with no substitutes

Large barriers to entry

Oligopoly

A few large suppliers

Pricing strategies of one supplier influence others in industry

Purchasing & Supply Chain Management, 5e

Market Structure Types

Perfect competition

Many small suppliers

Price is solely function of supply and demand

Minimal barriers to entry

Purchasing & Supply Chain Management, 5e

Economic Conditions

Conditions favorable to supplier

High level of capacity utilization

Tight supply

Strong demand

Conditions favorable to buyer

Low level of capacity utilization

High level of supply

Weak demand

Purchasing & Supply Chain Management, 5e

Analyzing Supplier Pricing

Does supplier have long-term or short-term pricing strategy?

Is supplier price leader or price follower?

Is supplier attempting to establish entry barriers?

Is supplier using cost-based or market-based approach?

Purchasing & Supply Chain Management, 5e

Elements of Price and Cost Drivers

Profit Margin

Selling and Administrative Cost

Production Overhead

Direct Labor Cost

Direct Materials Cost

Purchasing & Supply Chain Management, 5e

Price Charged

Skimming

Rate of return

Margin pricing

Supplier’s Total Cost

Market forces

Market strategy

Competition

Direct Costs

Labor force

Raw materials

Economic conditions

Market-Driven Pricing Models

Price volume model

Market-share model

Market skimming model

Revenue pricing model

Promotional pricing model

Competition pricing model

Cash discounts

Purchasing & Supply Chain Management, 5e

Price Volume Model

Maximizing profit

Lowering price results in more units sold

Greater volume will spread indirect cost over more units

Quantity price breaks

Leveraging volume across units can yield savings in tooling, setup, and operating efficiencies

Purchasing & Supply Chain Management, 5e

Market-Share Model

Long run profitability depends on level of market share obtained

Also known as penetration pricing

Lower margins initially to increase market share

Eventually spreads out indirect costs over greater volume

Purchasing & Supply Chain Management, 5e

Attributes of Different Hedging Tools

Purchasing & Supply Chain Management, 5e

Call Options

Specific, up-front cost (like buying insurance)

Ceiling price established

Collars

Often, no up-front costs

Downside is price is set (floor)

Unlimited downside price participation

Upside cost is capped (ceiling)

Fixed Price Swaps

No up-front costs

Single, fixed price

Full protection from higher prices

No ability to participate in price decreases

Customer Pays Difference

Customer Receives Difference

Customer Buys a Fixed-Price Swap

Purchasing & Supply Chain Management, 5e

Swap Price

Net Price

Underlying Market Price

Hedged

Unhedged

Customer Receives Difference

Customer Buys a Call Option

Purchasing & Supply Chain Management, 5e

Strike Price

Net Price

Underlying Market Price

Hedged

Unhedged

Premium Paid

Customer Pays Difference

Customer Receives Difference

Customer Buys Zero-Cost Collar

Purchasing & Supply Chain Management, 5e

Call Strike

Net Price

Underlying Market Price

Hedged

Unhedged

Put Strike

Market Skimming Model

Prices set for high profit margins on each unit

May be used through “back door” selling

Need to carefully analyze price to ensure validity through greater benefits of product

Purchasing & Supply Chain Management, 5e

Revenue Pricing Model

Obtain sufficient current revenue in market downturns

Supplier concerned with generating revenue to cover out-of-pocket costs

Capacity utilization issues

Covering fixed costs

Retaining skilled personnel

Be aware of quality and service degradation

Purchasing & Supply Chain Management, 5e

Promotional Pricing Model

Prices set to enhance overall product line profitability, not individual products within line

Need to utilize total cost of ownership (TCO) analysis

Purchasing & Supply Chain Management, 5e

Competition Pricing Model

Focuses on reacting to actual or anticipated competitor pricing

What is highest price the supplier can charge and be just below its competition?

Example

Reverse auctions

Purchasing & Supply Chain Management, 5e

Cash Discounts

Incentives to buyer who pay invoices promptly

Example: 2/10, net 30

Usually worthwhile to take advantage of cash discounts

Relatively high return

Purchasing & Supply Chain Management, 5e

Producer Price Index (PPI)

Appropriate for market-based products where price is largely function of supply and demand

Published by U.S. Bureau of Labor Statistics (BLS)

PPI tracks material price movements on quarter-to-quarter basis

Purchasing & Supply Chain Management, 5e

PPI Example

Purchasing & Supply Chain Management, 5e

Company Advantage

QUARTER

#REF! 100 100 103 105 Company 100 98 102 103 Market 1

INDEX

Market Pricing Questions

How did supply management situation affect price fairness and reasonableness at the time?

How have conditions changed?

What is effect on price from quantity changes?

Sole source or competitive situation?

Are index comparisons driving sourcing strategy?

Purchasing & Supply Chain Management, 5e

Cost Analysis Techniques

Cost-based pricing models

Product specifications

Estimating supplier costs using reverse price analysis

Break-even analysis

Purchasing & Supply Chain Management, 5e

Cost-Based Pricing Models

Cost markup pricing model

Estimate costs and add markup %

Margin pricing model

Establish profit margin that is predetermined % of quoted price

Rate-of-return pricing model

Desired profit on financial investment is added to estimated costs

Purchasing & Supply Chain Management, 5e

Cost Markup Pricing Example

Assume supplier desires 20% markup over its $50 total cost

$50 + (20% x $50) = $60

Purchasing & Supply Chain Management, 5e

Margin Pricing Example

Assume supplier would like 20% profit margin on sales price

Assume $50 total cost

Cost ÷ (1 – margin rate) = unit selling price

$50 ÷ (1 – 20%) = $62.50

Purchasing & Supply Chain Management, 5e

Rate-of-Return Pricing Example

Assume supplier wants a 20% return on its investment of $300,000 to produce 4,000 units

Assume $50 total cost per unit

$50 + ((20% x $300,000) ÷ 4,000) = $65

Purchasing & Supply Chain Management, 5e

Product Specifications

Custom design and tooling increases product costs

Determine if added differentiation gives competitive advantage in marketplace

Standardized components helps reduce product costs

Purchasing & Supply Chain Management, 5e

Cost Analysis

Direct function of quality and availability of information

Techniques

Require detailed production cost breakdown

Joint sharing of cost information

Early supplier design involvement

Purchasing & Supply Chain Management, 5e

Reverse Price Analysis

Also known as “should cost” analysis

Can be used when supplier is reluctant to share its proprietary cost data

Break down cost into basic components

Techniques

Internal engineering estimates

Historical experience and judgment

Review of public financial documents

Purchasing & Supply Chain Management, 5e

Reverse Price Analysis Example

Hypothetical price	$20
Profit/SG&A allowance (15%)	- 3
Subtotal	$17
Direct material	- 4
Subtotal	$13
Direct labor	- 3
Manufacturing burden (overhead)	$10

Purchasing & Supply Chain Management, 5e

Opportunities for Cost Reduction

Plant utilization

Process capability

Learning curve effect

Supplier’s workforce

Management capability

Supply management efficiency

Purchasing & Supply Chain Management, 5e

Insights from Break-Even Analysis

Identify if target purchase price provides reasonable profit given supplier’s cost structure

Analyze supplier’s cost structure

Perform sensitivity (“what if”) analysis on impact of varying mixes of purchase volumes and prices

Prepare for negotiation

Purchasing & Supply Chain Management, 5e

Assumptions of Break-Even Analysis

Fixed costs remain constant over period and volumes considered

Variable costs fluctuate in linear fashion

Revenues vary directly with volume

Fixed and variable costs include semivariable costs

Purchasing & Supply Chain Management, 5e

Assumptions of Break-Even Analysis

Considers total cost rather than average costs

There are minimal joint costs

Considers only quantitative factors

Purchasing & Supply Chain Management, 5e

Break-Even Analysis

Where:

P = average purchase price

X = units produced

VC = variable cost/unit of production

FC = fixed cost of production

Net income = $0 @ break-even point

Purchasing & Supply Chain Management, 5e

Net income (or loss) = P(X) - VC(X) - FC

Break-Even Analysis Example

Total Costs

Fixed Costs

Break-Even Point

$30,000

$75,000

Revenue / Cost ($)

Volume

7,500

9,000

Profit

Target price - $10/unit

Fixed costs - $30,000

Variable costs - $6/unit

Forecast purchase volume - 9,000 units

Purchasing & Supply Chain Management, 5e

Total Revenues

Break-Even Example

Purchasing & Supply Chain Management, 5e

Net income (or loss) = P(X) - VC(X) - FC

$6,000 = $10(9,000) - $6(9,000) - $30,000

$0 = $10(7,500) - $6(7,500) - $30,000

Forecasted Volume:

Break-Even Volume:

Break-Even: Expected Supplier Loss

Is target purchase price too optimistic given supplier’s cost structure?

Are supplier’s production costs reasonable compared with others?

Are cost and volume estimates accurate?

Is this right supplier for item?

Will direct assistance help reduce costs?

Purchasing & Supply Chain Management, 5e

Total Cost of Ownership (TCO)

Purchase price

Invoice amount paid to supplier

Acquisition costs

Costs of bringing product to buyer

Usage costs

Conversion and support costs

End-of-life costs

Net of amounts received/spent at salvage

Purchasing & Supply Chain Management, 5e

Building a TCO Model

Map the process and develop TCO categories

Determine cost elements for each category

Determine how each cost element is to be measured (metrics)

Gather data and quantify costs

Develop a cost timeline

Bring costs to present value

Purchasing & Supply Chain Management, 5e

Opportunity Costs

Defined

Cost of next best alternative

Examples:

Lost sales

Lost productivity

Downtime

Purchasing & Supply Chain Management, 5e

Factors to be Considered in TCO

Use for evaluating larger purchases

Obtain senior management buy-in

Work in a team

Focus on big costs first

Obtain realistic estimate of life cycle

Consider all relevant costs in global sourcing throughout supply chain

Purchasing & Supply Chain Management, 5e

TCO Model Example

Cost Elements	Cost Measures for 1,000 PCs
Purchase price: Hardware Software licenses A, B, and C	$1,200/PC – supplier quote $450/PC – supplier quotes (3)
Acquisition costs: Sourcing Administration	2 FTE employees @ $85K and $170K for 2 months 1 P.O. @ $150, 12 invoices @ $40 each
Usage costs: Installation Equipment support Network support Warranty Opportunity cost – lost productivity	$700/PC $120/month/PC – supplier quote $100/month – supplier quote $120/PC for 3-year warranty Downtime: 15 hours/PC/year @ $30/hour
End-of-life costs Salvage value	$36/PC

Purchasing & Supply Chain Management, 5e

TCO Model Example

Purchasing & Supply Chain Management, 5e

Cost Elements	Present	Year 1	Year 2	Year 3
Purchase Price:
Hardware	$ 1,200,000
Software licenses A, B, and C	$ 450,000
Acquisition Costs:
Sourcing	$ 42,500
Administration	$ 150	$ 480	$ 480	$ 480
Usage Costs:
Opportunity cost – productivity		$ 450,000	$ 450,000	$ 450,000
Installation	$ 700,000
Equipment support		$ 1,440,000	$ 1,440,000	$ 1,440,000
Network support		$ 1,200,000	$ 1,200,000	$ 1,200,000
Warranty	$ 120,000
End-of-Life Costs:
Salvage value				$ (36,000)
Total	$ 2,512,650	$ 3,090,480	$ 3,090,480	$ 3,054,480
Present Values @ 12%	$ 2,512,650	$ 2,759,799	$ 2,463,113	$ 2,174,790

Collaborative Cost Management

Target pricing

Used in new product development

Sales Price – Profit = Allowable Cost

Gap in cost becomes cost reduction goal

Cost savings sharing

Sharing of continuous improvement benefits

Financial incentives to supplier to pursue cost reduction

Purchasing & Supply Chain Management, 5e

Target and Cost-Based Pricing

Agreement on supplier’s full costs

Built upon high degree of …

Trust

Information sharing

Joint problem solving

Need to manage risks associated with target pricing

Especially volume variability

Purchasing & Supply Chain Management, 5e

Target and Cost-Based Pricing

Identify and agree on:

Product volumes

Target product costs at different points in time

Quantifiable productivity and quality improvement projections

Asset base and rate of return requirements

When cost sharing savings starts and how calculated

Purchasing & Supply Chain Management, 5e

When to Use Collaborative Cost Management Approaches

Not appropriate for all sourced items

Supplier contributes high levels of value-added

Complex, customized items

For products requiring conversion from raw materials through supplier’s design

Purchasing & Supply Chain Management, 5e

Cost-Based Pricing Example

First-year target price = $61.00
Negotiated/Analyzed Cost Structure	Material Labor rate Burden rate Scrap rate SG&A expense rate Effective volume range Projected product life ROI agreement	$20/unit $8.50/unit 200% of direct labor 10% 10% of mfg cost 125,000 units/year ± 10% 2 years 30%
Supplier Investment Total Supplier Investment	Year 1 $3,000,000 $5,000,000	Year 2 $2,000,000
Cost Savings Sharing (50/50)	Direct labor Scrap rate	10% annual reduction 50% annual reduction

Purchasing & Supply Chain Management, 5e

Cost-Based Pricing Example

	Year 1	Year 2	Rationale
Materials	$20.00	$19.24	Materials reduction of $1.50 plus an overall materials increase of 4% or ($20.00 - $1.50) x 1.04
Direct labor	8.50	7.88	Reduction of 10% - Contractual target improvement - plus 3% increase
Burden (200% of D.L.)	17.00	15.76
Total Materials, Labor, & Burden	$45.50	$42.88
Scrap @ 10%	4.55	2.14	Scrap reduced from 10% to 5%
Manufacturing Cost	$50.05	$45.02
Selling and administrative expenses @ 10%	5.00	4.50
Total Cost	$55.05	$49.52
Profit **	6.00	6.75	Includes $0.75 share for joint material reduction or $6.00 + ($1.50 / 2)
Selling price	$61.05	$56.27	New selling price after Year 1 improvements
** Profit based on 30% return on investment negotiated in agreement
($5 million over 2-year investment x 0.3) / 250,000 total units = $6.00 profit/unit

Purchasing & Supply Chain Management, 5e