Chapter 41 Chapter 10 Strategic Cost Management

2 Definition Strategic Cost Management: Supply chain partners working together to identify design changes, efficiencies, and process improvements to reduce costs.

3 Understanding terms Price = Cost + Profit Price Analysis Cost Analysis Direct Labor Hours Direct Labor Rates Material costs Tooling Overhead G&A Profit Relates to materials This chapter considers both Price Analysis and Cost Analysis

4 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 finished product

5 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.

6 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

7 Price Analysis Price Analysis focuses on Comparisons Consideration of reasonableness Market structure and economic conditions Pricing strategies of the seller

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

9 Price Analysis and market structure None Some Much Perfect Competition Monopoly Supplier’s ability to set price:

10 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

11 Pricing Strategies Cost-and-profit based pricing or market- conditions based strategy Price – Volume Strategy Trade discounts Cash discounts Buy-ins Revenue pricing

12 Trade Discounts Trade (also called Series) Discounts Example: $100 – 10%(100) – 10%(90) – 10%(81) = $72.90 $100 $90 $81 $72.90 (a 27.1% discount)

13 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?

14 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?

15 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

16 Tools of Price Analysis Using the Producer Price Index (PPI) By Standard Industrial Code (SIC) Base year is 1988 Expressed as

17 Common Price Clauses Price Protection Clause Most-Favored Customer Clause Escalator Clause

18 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

19 Elements of a formal cost analysis process Direct labor Material Overhead Tooling Profit

20 Direct Labor Labor hours x labor rates Application of the Learning Curve Requires: (1) Labor-intensive process (2) Repetitive tasks (3) Operations not machine-paced (4) New product or new production process Direct Labor

21 Learning Curve T1T1 Units of output Labor hours/unit

22 Learning Curve Rates Common learning rates are 70% - 90% % applies to doubled units Example: an 80% curve and a T 1 of 100 hours: T 1 =100 hours T 2 = 80 hours T 4 = 64 hours T 8 = 51.2 hours

23 The Learning Curve in practice The Boeing Tables Hand-out exercise

24 The Learning Curve is used for: Cost estimating Production rate and schedule: Progress Payments Output per month Month of production

25 Elements of a cost analysis, cont. 2. Direct material -Raw materials -Components -Subassemblies

26 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

27 Elements of a cost analysis, cont. 4. Tooling 5. 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 innovation What is a “fair “ profit”?

28 What ought to be the basis for profit amounts? Cost Risk Invested Capital Efficiency and responsiveness

29 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.

30 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?

31 Breakeven Analysis as a preparatory tool for negotiation Revenues and Cost Quantity 12 Fixed Costs Total Costs Total Revenue

32 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

33 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

34 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

35 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

36 Let’s move on