Strategic Cost Management

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Strategic Cost Management
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Objectives

• Understand relationship between sales and product
  costs
• Identify processes for assessing supplier pricing
  strategies
• Present tools for analyzing suppliers costs
• Provide overview of contract management strategies

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Problems with Traditional Cost Accounting

• Standard product costs
• No recognition of tradeoffs
• Product cost structures
• Allocation of overhead fixed
• Budgeting and control
• Labor efficiencies / machine utilization

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Assigning Indirect Costs
Supervision 1000
Cooling Fluids 2000
Rags 200
Electricity 1500
Direct labor-related cost pool 2500 (2500/500
hrs)5/hr
Material weight-related cost pool
2200 (2200/220 kg) 10/kg
15/kg
Direct material
Products P1 and P2 Total Cost 425
Direct labor
10/hr
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Cost Behaviors

• Fixed Costs
• Variable Costs
• Semifixed Costs
• Semivariable Costs

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Which supplier would you rather do business with?

• High Fixed Costs Low Fixed Costs

Revenues
Revenues
Breakeven
Breakeven
VC
VC
FC
FC
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Relationship Between Sales and Costs

• As a suppliers sales increase. . .
• Fixed costs __________
• Average fixed costs _______
• Average variable costs ________
• Total variable costs __________
• Total costs __________
• Average total costs _________

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Production Cost Schedules
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Average Cost Curve
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Total Cost Curve
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Price Reductions
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What Happens to Profit?
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Price/Cost Management

• Price analysis examines price proposals without
  examining elements of cost and profit
• Cost analysis reviews actual or future costs
• COST PROFIT PRICE

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Goals of Price/Cost Management

• Develop accurate price/cost information to
  enhance negotiating effectiveness
• Drive continuous price/cost improvement
• Effectively beat out the competition
• Determine type of supplier relationship

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Approaches
Price/Cost Management Approaches
Market Based Pricing
Cost Based Pricing
Non-collaborative
Collaborative
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Approaches

• Market-Based Pricing
• The price the buyer pays is not linked to the
  supplier's cost structure
• Cost-Based Pricing
• The price the buyer pays is directly linked to
  the supplier's cost structure
• Hybrid
• Some elements of cost may be known by the buyer

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Market-based Pricing

• Based on supply and demand
• Suppliers and buyers determine the price
  according to what either suppliers are asking or
  buyers will offer

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Types of Market-based Pricing

• 1) Market testing
• Initial price determined by competitive bid, and
  on-going negotiations thereafter
• 2) Quantity discounts
• Volume consideration linked to price
• 3) Longer term agreements linked to price
• 4) Price change control
• Ceilings established on future price changes
• 5) Price give-backs - with and without
  assistance
• Prices linked to commodity prices, or linked to
  future increases/decreases due to process
  improvement

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Cost-based Pricing Non-collaborative

• Market-testing - Initial contact through bid and
  on-going negotiations
• Target pricing - established ceiling cost to
  achieve a competitive position in the market for
  the finished product
• Supplier uses target price as a basis for
  accepting the order

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Cost-based Pricing Non-collaborative

• Volume consolidation - linked to number of
  suppliers in pool, and change in average fixed
  costs and variable costs
• Design changes - linked to resulting incremental
  costs only
• Long term agreements with
• Productivity improvement goals
• Percentage of economics
• Cost saving sharing

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Cost-based Pricing Collaborative

• Cost identified - Margin or ROI negotiations
• Identification of cost drivers
• Targeted goals
• Establishment of Value added / Non-value added
  costs
• Continuous cost improvement (collaborative)

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Supplier Pricing Program

• Pricing Objectives
• Long-term versus Short-term
• Price Leader versus Follower
• Establish Entry Barriers
• Pricing Strategy
• Cost based pricing (cost fixed markup)
• Market based pricing (penetration, skimming,
  floor pricing)

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Pricing Strategies

• Demand (Skimming) Pricing
• Intoduction and growth of life cycle
• What the market will bear
• Works under conditions of no competition
• Cost-plus (Penetration) Pricing
• Maturation stage of life cycle
• Minimum acceptable price
• Appeals to a mass market with objective of sales
  increase

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Pricing Strategies

• Survival Pricing
• Price remaining capacity at marginal cost
• Market share Pricing
• Used to take market share from competitors
• Social Responsibility Pricing
• Forgoes sales and profits - puts society first
• Rule-of-Thumb (Myopic) Pricing
• Formula - DM DL 40
• Buy-in (Foot in the door) Pricing
• Cover VC only

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Pricing Variables

• External
• Nature of the product (Life cycle)
• Sellers market characteristics
• Buyers control variables
• Internal
• Sellers internal characteristics
• Management orientation
• Accounting and costing methods

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Measures of Price Management Effectiveness

• Types of measures include
• Percent improvement of price paid over inflation
• Percent improvement of price paid vs. prior year
• Target prices achieved
• Ratio of actual price change improvement to
  comparable market index change
• Purchase cost improvement as of cost of goods
  sold
• Total delivered cost reduction
• Inventory cost reduction
• Transportation cost reduction

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Ratio of Price Change to Market Index Change

• Most appropriate for market-based products where
  pricing is function of supply and demand
• Price change measure for a purchase family which
  compares difference in an index and compares to
  price paid for a purchase family
• Useful to ensure an external benchmarking
  perspective for product / service family category
• Critical issue target for how much better
  than market in increasing and decreasing market

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Illustration of Market Index Measure

• Market based index March 31, 1996 125
• Market based index June 30, 1996 137.5
• Index change rate (137.5 - 125) / 125 10
• Company price index
• March 31 1996 150
• Company price index
• June 30, 1996 160
• Company index rate (60-150) / 150 6.67
• This indicates better than market performance
  by 3.33 for the quarter

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World Class Excellence - Case

• Manufacturer measures price performance against
  predetermined agreement, versus a PPI or other
  index, or simply increases/decreases by
  percentage
• Problems Difficult to group suppliers when
  industries, markets and our expectations vary.
  Some data are still too subjective.
• Performance Avg. performance of .5 to 3
  better than inflation over a 15 year rolling
  average. Actual average performance is
  approximately .75 better than inflation annually
  for 15 years (15 Million to over 50 Million in
  competitive pricing advantage.

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World Class Excellence - Process

• Set standard costs at item, commodity buyer and
  supplier level at each unit.
• Track prices paid at each business unit against
  the relevant PPI. Units have specific cost
  management stipulations with key suppliers.
• Material variances against standard costs are
  tracked monthly at each unit and comparisons
  against PPI data are calculated at corporate on a
  quarterly basis.
• Detailed cost analysis studies are completed on
  key strategic purchases in order to identify the
  primary cost drivers.

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Issues to Consider - Price Index

• How did the procurement situation affect the
  price fairness and reasonableness at the time?
• How have conditions changed? (e.g. delivery
  requirements)
• What is the effect on price of changes in the
  quantity of a material or service purchased?
• Was the procurement situation a sole source or
  competitive?
• Historic prices might involve onetime
  engineering, tooling, and start-up costs.

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Issues to Consider - Price Index

• Does not consider total cost performance
• May not be appropriate for critical items with
  high value-added by supplier
• Need to track history of a particular index and
  also check validity periodically
• Does not benchmark competitors pricing
  agreements
• How are index comparisons driving procurement
  strategies?
• Forecasts/indices MUST be from impartial third
  party

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Reverse Price Analysis
Hypothetical Price 20 Profit / SGA Allowance
(15) - 3 Subtotal 17 Direct
Material - 4 Subtotal 13 Direct
Labor - 3 Manufacturing Burden
10 X TOTAL VOLUME TOTAL FIXED
COST (Will vary as volume changes)
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Price/Cost Structure
Profit Margin Selling Administrative
Cost Factory Overhead Direct Labor
Cost Direct Materials Cost
Long-term Market Cost
Total Cost
Mfg Cost
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Data Sources

• Labor Annual Survey of Manufacturers total
  direct labor and material for SIC codes
• Overhead
• 150 for labor intensive
• As high as 600 for capital intensive
• Materials and Profit Robert Morris Associates
  data broken out by SICs, including
• Breakout of income sources
• Gross profit margins
• Percentages for operating expenses
• Percentages for all other expenses)
• Before tax profit percentagesL

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Other Sources of Data

• Wards Industrial Directory
• Census of Manufacturers
• Yahoo! Financial section (biz.yahoo.com)
• Morningstar (morningstar.net)
• Marketwatch (marketwatch.com)
• 411Stocks (411stocks.com)
• The Street (thestreet.com)
• Buying Strategy Forecast (206.128.186.135)
• Thinking Cap Solutions (ice-alert.com)

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Framework for Cost Management
High Risk Low
Unique Products
Critical Products
Generics
Commodities
Low High Value (Cost, Service, Administration)
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Generics

• Low Value, Low Risk
• Strategies
• Standardize / consolidate
• Critical Factors
• Reduce cost of acquisition
• Metrics
• Total Delivered Cost Reduction
• Percent of CGS Improvement
• Transportation cost reduction

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Commodities

• High Value, Low Risk
• Strategies
• Leverage preferred suppliers
• Critical Factors
• Reduce cost of materials
• Metrics
• Price change improvement to market index

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Unique Products

• High Risk, Low Value
• Strategies
• Preferred suppliers
• Critical Factors
• High costs when cost/quality problems occur
• Metrics
• Unit price cost reduction - Actual to actual
  prices for same items
• Target prices achieved, Should cost
• Total Delivered Cost Reduction

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Critical Products

• High Risk, High ValueStrategies
• Strategic supplier partnerships
• Critical Factors
• High costs when cost/quality problems occur
• Metrics
• Target prices achieved
• Unit price cost reduction - Actual to actual
  prices for same items
• Joint cost savings sharing

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Analyzing Total Supply Chain Costs

• Buy Price
• Supplier Performance Cost (Delivery, Quality)
• Cost of Acquisition
• Out of Synch Planning
• (Delays Between Schedule Changes)
• - Speculation Returns
• Speculation Costs
• (Buffer Cost -Inventory, Capacity)
• Manufacturing Cost
• Selling Cost
• Distribution Cost
• Profit

SELLING PRICE
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Exercise - Plastic Shield Price Analysis

• Determine if any discrepancies in pricing exist
• What type of approach should be used to reduce
  costs?
• What types of metrics are appropriate to use to
  monitor costs over time?

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Summary

• A first step to cost management is understanding
  the total volume of sales and relationship to
  suppliers costs
• Suppliers use different pricing strategies which
  may not have any relationship to actual costs
• A price index is a good way to understand pricing
  trends
• Different approaches to reducing costs are
  possible