Materials Management BUS 3 – 141 Cost Management, Discounts, & Negotiation October 22, 2007

Page 2 2 Agenda –Cost Types –Total Cost of Ownership –Target Pricing –Learning Curve and Discounts –Negotiation

Page 3 3 Case 2: Sedgman Steel (p. 176) Due Oct 29, 2007 Approx. 20% of Total Effort / Grade Approx. 25% of Total Effort / Grade Approx. 35% of Total Effort / Grade

Page 4 4 Comparison of Fixed & Variable Costs with Volume Understanding Supplier Fixed and Variable costs is CRITICAL to any Negotiation

Cost Types

Page 6 6 Labor and Material Costs Labor: –Direct hours worked X Hourly Rates –Often charged based on Standard Hours per job Material: –Taken from Bill Of Material (if provided) –When purchasing manufactured items, some supplier material costs can be reasonably estimated Raw material cost is openly available Component cost can be obtained from catalogues and the internet There should be little – or no – Supplier Markup on material used to make the Purchased Item

Page 7 7 Examples of Overhead and General & Administrative Costs Overhead: –Indirect facilities and personnel costs incurred in: Manufacturing Research Engineering –Equipment depreciation –Other General & Administrative (G&A): –Selling –Promotion –Advertising –Executive Salaries –Legal –Other Overhead and G&A are a major factor in calculating Standard Cost at expected overall volumes, but less relevant for calculating the cost of incremental units for unexpected orders or additional volumes

Page 8 8 Labor, Material, and Overhead – Small Business Example Since you were traveling earlier while we spoke on the phone, and I was talking quickly, I thought it would be useful to list my concerns regarding the price of the booster pump and the fee for installation. Your charge of $ for the Letro Booster Pump is higher than is apparently available from many sources. A simple Google search yielded several suppliers selling the item for well under $ I also checked the Leslie's pool site and there was a Hayward Booster Pump on sale for $224.99, reduced from $ I would expect that as a contractor, you would have access to even better pricing, since you are likely paying wholesale, rather than the Retail prices I was able to find. I would also expect that since Pam and I have been solid customers for many years, you would charge little to no additional mark up on parts. I have two concerns regarding the Installation. One is based on the underlying hourly rate you charge. Please explain the Rate and Time that resulted in the $ charge. My second concern regarding the Installation fee is based on my assumption that there is some amount of "non-routine" service that is already included in your $ monthly charge. When you provide the standard weekly service, and you are in and out in minutes, I am pleased to pay you the $ I don't feel a need for you to "justify" your fee by spending a lot of time. In reality, I am paying you to worry about my pool for me. And if you can do that quickly and move on, it is good for both of us. However, if you have to do a little extra, I would assume that you have already accounted for some amount of that effort in your rates. What do you consider as included in the "standard" service, and what do you consider as incremental, and thus would require an additional charge? Based on these concerns, please adjust your charges for the Booster Pump and its installation. Either reply to this or call me at xxx-xxx-xxxx, so that we can agree on a revised total that is reasonable for both of us.

Page 9 9 Additional Cost Items –Understanding cost helps you negotiate Price –Previous estimates when analyzing make / buy decisions become a basis for understanding supplier cost –Co-workers who were previously employed at suppliers often understand supplier cost structure –Start-up costs and Setup costs are frequently separated from future unit costs Common in printing business Common in subcontract manufacturing –In New Product Development, it is recommended to separate research and start-up costs from production unit costs Nonrecurring Engineering as a separate line item Tooling as a separate line item Units produced as a separate line item

Total Cost of Ownership

Page Total Cost of Ownership Understanding total costs is a good early step in identifying Improvement opportunity ALL costs associated with the item: –Acquisition (purchase) –Administration –Follow-up –Expediting –Transportation –Inspection & Test –Rework –Storage –Scrap –Warranty –Service –Downtime –Customer Returns –Lost Sales

Page The Components of Total Cost of Ownership –Identifying need –Investigating sources –Qualifying sources –Adding supplier to internal systems –Educating: Supplier in firm’s operations Firm in supplier’s operations –Price –Order placement/preparation –Delivery/transportation –Tariffs/duties –Billing/payment –Inspection –Return of parts –Follow-up & correction –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 Pre-transaction Transaction Post-transaction Source: Lisa Ellram, “Total Cost of Ownership: Elements and Implementation,” International Journal of Purchasing and Materials Management, Winter * From Leenders, Johnson, Flynn, and Fearon, Purchasing and Supply Management, Thirteenth Edition, McGraw Hill Irwin

Target Pricing

Page Target Pricing Cost Profit Sales Price Traditional: + = Sales Price (Market) Profit Cost Target Pricing: - = Instead of adding profit and cost to establish a selling price, the organization starts with the market price and required profit to establish a target cost to achieve the necessary profit. The Supply function becomes responsible for working internally and with suppliers to achieve the target

Page Target Pricing drives cost reduction beyond Purchasing –Design-to-Cost on the part of Design Engineering –Manufacture-to-Cost on the part of Production –Purchase-to-Cost on the part of Supply The targets also drive cross-functional communication and shared problem-solving You get what you EXPECT and what you MEASURE

Page Target Pricing is key in Defining Product Specifications 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% % of Dollars SPENT on the Item over Time % of Dollars COMMITED to the Item * For illustration only; numbers are approximations The Initial Development & Design is the biggest factor in Life Cycle spend While volume buying takes place to support full scale production

Other Cost Items Learning Curve & Discounts

Page Learning Curve With practice and repetition, performance improves. Expected improvement can be calculated and incorporated into future cost projections The “Learning Curve” is a calculation that estimates the rate of improvement as output doubles. It implies that improvement NEVER stops. The relevance to Supply is lower price targets for future deliveries

Page Discounts Discounts are a LEGITIMATE and effective means of reducing prices. They may offered by Suppliers or negotiated by Buyers

Negotiation

Page How this Course supports Supply Chain Objective & Process The Right QUALITY The Right QUANTITY The Right TIME The Right PLACE The Right SUPPLIER The Right SERVICE The Right PRICE at the with the at the with the and paying

Page Background –Not the same as “haggling” Honest Professional Fact based Data driven –Different approaches for different situations One-time purchase with a non-partner supplier (buying a car) Recurring purchases with an ongoing partner supplier Initial purchase with a potential partner supplier –Different approaches for different Purchase Types Less leverage for most raw materials, standard, and low-value items More leverage in special items and Capital Goods ABC classification is key –Get EVERYTHING in WRITING

Page Relationship between ABC Classification and Negotiation –Highest dollar items need to also have the highest value –Cross-functional teams contribute input –Significant time commitment from many people –Significant fixed cost that should be recovered in better pricing Focus negotiating efforts on the BIGGEST PAYBACK for the time and cost invested

Page Different approaches for different Purchase Types Raw Materials Standard Production Items of Small Value Special Items Services Capital Goods Resale –Global sources of Supply –Potential for design and specification modifications Special Items –Very high dollar purchases –Many non-price items can be included Capital Goods –Can often be “A” items, especially with outsourcing relationships –Often very competitive market, with many alternative sources of supply Services Best Opportunity to Negotiate

Page Non-price Negotiation Quality Specification compliance Performance compliance Test criteria Rejection procedures Liability Reliability Design changes Support Technical assistance Product research, development, and/or design Warranty Spare parts Training Tooling Packaging Data sharing, including technical data Supply Lead times Delivery schedule Consignment stocks Expansion options Supplier inventories Cancellation options Transportation FOB terms Carrier Commodity classification Freight allowance/equalization Multiple delivery points * From Leenders, Johnson, Flynn, and Fearon, Purchasing and Supply Management, Thirteenth Edition, McGraw Hill Irwin

Negotiation Planning and Execution

Page The Basic Steps in Developing and Negotiation Strategy * From Leenders, Johnson, Flynn, and Fearon, Purchasing and Supply Management, Thirteenth Edition, McGraw Hill Irwin 1. Develop the specific objectives (outcomes) desired from the negotiation 2. Gather pertinent data 3. Determine the facts of the situation 4. Determine the issues 5. Analyze the positions of strength for both (or all) parties 6. Set the buyer’s position on each issue, and estimate the seller’s position on each issue based on your research 7. Plan the negotiation strategy 8. Brief all persons on the negotiation team 9.Conduct a dress rehearsal 10.Conduct the actual negotiations with an impersonal calmness

Page “Game plan” for Negotiation * From Leenders, Johnson, Flynn, and Fearon, Purchasing and Supply Management, Thirteenth Edition, McGraw Hill Irwin

Page The “Zone of Negotiation” The overlap between what the Buyer will pay and what the Seller will accept defines the Zone of Negotiation

Page The “Zone of Negotiation” There is a gap between what the Buyer will pay and what the Seller will accept. There is NO DEAL without Creativity or Compromise