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Chapter 10. Strategic Cost Management. Definition. Strategic Cost Management: Supply chain partners working together to identify design changes, efficiencies, and process improvements to reduce costs. Understanding terms. Price = Cost + Profit

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Chapter 10

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Chapter 10 l.jpg

Chapter 10

Strategic Cost Management


Definition l.jpg

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 Hours

    Direct Labor Rates

    Material costs

    Tooling

    Overhead

    G&A

    Profit

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

Perfect Competition Monopoly

Supplier’s ability to set price:

None Some Much


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Price Analysis and market structure

Perfect Competition Monopoly

Supplier’s ability to set price:

None Some Much

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

Variable Labor$1000

Variable Material$2000

Fixed Costs$1100

Total Cost$4100

Example:

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


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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 Labor

  • 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


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Learning Curve

Labor hours/unit

T1

Units of output


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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.

  • Direct material

    -Raw materials

    -Components

    -Subassemblies


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Elements of a cost analysis, cont.

  • 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.

  • Tooling

  • 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”?


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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

Total Revenue

Total Costs

Fixed Costs

1

2

Quantity


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Two Approaches to Collaborative Cost Management

  • Target Pricing

    • Traditional approachCost = f(design)

    • Target pricingDesign = 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:

  • Supplier shares all information on the cost to produce an item

  • 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

  • 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.

  • The issue of Allowable Costs


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Let’s move on


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