Isqa 439 539 fall 2004
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ISQA 439/539 Fall 2004. Week 3 Dr. Alan Raedels, C.P.M. COST ANALYSIS: Understanding The Cost Structure. Types of Cost Direct Versus Indirect Costs Fixed Versus Variable Costs Common and Joint Costs. Activity-Based Costing ABC is relevant to purchasing for a number of reasons.

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ISQA 439/539 Fall 2004

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ISQA 439/539Fall 2004

Week 3

Dr. Alan Raedels, C.P.M.

COST ANALYSIS:Understanding The Cost Structure

  • Types of Cost

    • Direct Versus Indirect Costs

    • Fixed Versus Variable Costs

    • Common and Joint Costs

Activity-Based Costing

ABC is relevant to purchasing for a number of reasons.

As a tool for analyzing supplier prices

To support the analysis of the cost of doing business with a particular supplier

To identify problem suppliers.

To improve purchasing systems and processes

There are four basic components of an ABC system:


Cost driver

Cost object

Bill of activities

COST ANALYSIS: Understanding The Cost Structure

Breakeven Analysis

Learning Curves

Life Cycle Costing

Total Cost of Ownership

Approaches for Determining TCO

Standard Versus Unique TCO Models

Barriers to TCO Implementation


Marketing Perspectives On Pricing

  • Market Structure

    • Monopoly

    • Monopolistic competition

    • Oligopolistic

    • Perfect competition

    • Oligopsonistic

    • Monopsony.

Marketing Perspectives On Pricing

  • Cost-Based Pricing

    • Straight Markup

    • Rate of Return

    • Variable Pricing

Perceived substitutes

Unique value

Switching cost

Difficulty of comparison


Expenditure size

End benefit

Shared cost



Location or Time

Supplier=s reputation, service, and relationship

Value-Based Pricing

Competitive Proposals

Comparison with Published Prices

Historical Comparisons

Internal Cost Estimates


Comparison with Similar Products/Services

Detailed analysis


Quantity Discounts

Trade Discounts

Cash Discounts

Seasonal Discounts



Life-cycle Costing

  • Costs considered include the following:

    • Maintenance costs;

    • Training costs;

    • Repair part costs;

    • Energy use;

    • Cost of scrap and by-products;

    • Operating costs (labor and materials); and

    • Installation costs (including layout changes).

  • Steps to perform a life-cycle cost analysis

    1.Determine operating cycle, types of operation, routine maintenance, overhaul, and actions (costs incurred) required.

    2.Identify and quantify factors that affect costs (e.g., power consumption, labor requirements, material usage, maintenance costs, failure rates, and downtime costs).

    3.Project costs through the life of the equipment, including salvage value.

    4.Discount costs to obtain present values and sum to obtain total life cycle cost.

Life-Cycle Costing Example

  • Machine A

  • 5-year life and 4% downtime

  • Cost Amount for Years:

    0 1 2 3 4 5

  • Purchase80,000

  • Engineering10,000

  • Installation10,000

  • Training4,500

  • Labor40,00042,00044,10046,30548,620

  • Energy50,00055,00060,50066,55073,205

  • Downtime12,00012,96013,99715,11716,326

  • Total Costs104,500102,000109,960118,597127,972138,151

  • * 12% PV Factor1.0000.8930.797 0.712 0.636 0.567

  • = Present value104,50091,08687,63884,44181,39078,332

  • Present value of costs totals 527,387

Life-Cycle Costing Example

Machine B

5-year life and 2% downtime

Cost Amount for Years:

0 1 2 3 4 5








Total Costs125,00095,000101,900109,357117,420126,141

* 12% PV Factor1.0000.8930.7970.7120.6360.567

= Present value125,00084,83581,21477,86274,67971,522

Present value of costs totals 515,112

Cost/Price Analysis Grid

Reasons For Using Total Cost of Ownership

  • Support supplier selection, RFQ, RFP, or RFB

  • Give supplier awards for excellent performance

  • Drive supplier improvements, identify priorities

  • Plan future supplier performance

  • Provide data for negotiations

  • Forecast new item performance based on historical data

  • Concentrate resources on the “important few” purchases

  • Compare supplier performance against others, self over time

  • Support strategic alliance efforts

  • Supply base reduction/volume allocation decisions

Primary Reasons for TCO Adoption

  • Supplier selection decisions

  • Measure ongoing supplier performance

  • Drive major process changes

Benefits of Total Cost of Ownership

  • Performance measurement

    • Good framework to evaluate suppliers

    • Concrete way to measure results of quality improvement efforts

    • Excellent tool for benchmarking

  • Decision making

    • Forces purchasing to quantify tradeoffs

    • Good basis for making supplier selection decisions

    • More informed decision making

    • Creates a structured problem solving environment

  • Communication

    • Excellent communication vehicle between firm and suppliers

    • Way to get other functions involved in purchasing decisions

Benefits of Total Cost of Ownership

  • Insight/Understanding

    • Provides excellent data for trend analysis on costs

    • Provides excellent data for comparing supplier performance

    • Provides excellent data for negotiations

    • Provides critical data for target pricing

    • Requires purchasing to develop an awareness of the most significant nonprice factors that contribute to TCO

    • Long-term orientation by focusing on the “big picture”

  • Supports continuous improvement

    • Identifies where suppliers should focus improvement efforts

    • Helps identify cost savings opportunities

    • Forces firm to look at internal issues, how their own requirements/specifications may actually increase costs

    • Encourages professional growth in purchasing personnel by broadening their perspective

Approaches for Determining TCO

  • Dollar-based Approach

    • Direct cost

    • Formula

  • Value-based Approaches

Dollar-based - direct cost

Supplier selection

Supply base reduction

Make vs. buy/Outsourcing

Process improvement

Dollar-based - formula

Supplier volume allocation

Supply base reduction

Ongoing supplier evaluation

Process improvement


Supplier selection

Make vs. buy/Outsourcing

Process improvement

Primary Uses of Different Types of TCO Models

Relative Advantages of Types of TCO Systems

  • Dollar-based, Direct cost

    • Advantages

      • Tailor factors considered to decision

      • Very flexible

      • Alter level of complexity to fit decision

      • Helps identify critical issues

    • Disadvantages

      • Time-consuming

      • Doesn’t make sense for repetitive decisions

      • Not cost-beneficial for low-dollar buys

Relative Advantages of Types of TCO Systems

  • Dollar-based, Formula

    • Advantages

      • Easy to use once system is in place

      • Excellent for repetitive decisions in which costs for key factors can be determined

    • Disadvantages

      • Time-consuming to establish system

      • Formulas need to be periodically reviewed and updated

      • Inflexible to different types of decisions

      • Considers a limited set of factors

Relative Advantages of Types of TCO Systems

  • Value-based

    • Advantages

      • Can incorporate issues where costs cannot be determined

      • Considers the importance of factors using weighting

      • Easy to use for repetitive decisions

    • Disadvantages

      • Time-consuming to develop; only good for important and/or repetitive decisions

      • Much judgment in establishing weightings

Standard versus Unique TCO Models

  • When to use unique models

    • Buys to be considered vary greatly

    • No one set of factors captures critical issues across buys

    • Desire for flexibility in cost modeling

      • adapting to user needs

      • adapting to various buys

      • adapting to changes in internal focus

  • When to use standard models

    • Issues of concern are the same across buys

    • Desire for user-friendly model

    • Desire to computerize the system

    • Desire to analyze repetitive purchases

Most Frequently Mentioned Costs Included in TCO Analysis

  • Price

  • Delivery

  • Service

  • Supplier’s EDI capabilities

  • Acquisition costs

  • Quality

    • Inspection

    • Cost of nonconformance

    • Quality programs

Example of Standard TCO Model for Capital Purchases

  • Standard Assumptions

    • Fully burdened labor rates

      • Exempt:: Manager$36.00

      • Exempt: Engineer, etc.$36.00

      • Programmer$24.00

      • SNE: Technician$40.00

      • Hourly: Operator$12.00

      • SNE: Administrative$15.00

    • Facilities Standards

      • Space valuation per foot$2,650

      • # of weeks operating/year52

    • Financial Standards

      • Useful life4

      • Cost of funds12.8%

      • Tax rate38.0%

Example of Standard TCO Model for Capital Purchases

  • Equipment Costs

    Capitalized costs

    Supplier ASupplier B

    Purchase price$657,059$746,785

    Options & upgrades 2,915 479

    Service contract 14,815 14,815

    Installation 229,630 229,630

    Freight/duty 70,000 70,000

    Packing 14,815 14,815


    Amortization period4 yrs4 yrs

    Capitalized costs/yr$247,309$269,131

Example of Standard TCO Model for Capital Purchases

  • Expended Costs - First Year

    Supplier ASupplier B

    Engineering expense

    Spares cost$ 8,400$48,000

    Buy-off costs$39,000$39,000




    Equipment Expense

    First year$67,400$107,000

Example of Unique TCO Model for Car Rental Service Contract

Dollar-based TCO Example

Value-based TCO Example

Barriers to TCO Implementation

  • Data availability

    • Difficult to obtain information needed

    • Determine what data is needed for calculating TCO

  • Complexity

    • Large initial time investment

    • Wanted to develop a system that was easy to use

    • Factors that drive costs are constantly changing

    • Some models have been complex

    • Teaching people not to get too detailed

    • Lack of common terminology

    • Lack of user expertise

Barriers to TCO Implementation

  • Resistance/Fear by users

    • Resistance to using standard format

    • Team may take away control of individuals

    • Fear too theoretical

    • User resistance

    • Lack of user confidence

  • Organizational culture

    • Get away from “price” mentality

    • Buyers need new skills to be successful

    • Concern in selling it

    • Communicate with rest of organization

    • People: need change agents, talent, process leaders

  • Scope of TCO in the Organization

    • Get away from idea that TCO is only a purchasing program

    • Determine to which procurements to apply TCO

    • Viewed as a purchasing program

Overcoming Barriers to TCO Development, Implementation, & Use

  • Create understanding

    • Training classes

    • Provide centralized expertise and support

  • Develop the right model

    • Improve systems over time

    • Adapt TCO to the situation

    • User friendly model

    • Develop the right approach before taking the idea public

  • Get support from the right people

    • Integrate TCO into the culture

    • Have teams build TCO models

    • Hire people with the right skills

    • Sell the idea

    • Top-management support

    • Move resistant people into other positions

Impact of TCO on Purchasing’s Decision Making Involvement

  • Plays a different role; facilitator, communicator, trouble shooter

  • Sourcing has more visibility

  • Now a strategic part of the business

  • Purchasing is now part of a team

  • Frees up purchasing from routine decisions

  • Purchasing has more credibility, value added

How TCO Supports the Organization Overall

  • Fits into overall total quality focus

  • Helps support the purchasing organization’s efforts to improve purchasing processes

  • Helps support the organization’s overall reengineering process

  • Encourages the purchase of “best value” items, reducing cost and increasing competitiveness

  • Provide access to supplier TCO information to all of those who work with suppliers

  • Free up purchasing to support the organization’s more strategic objectives

Implementing TCO Analysis

1. Determine desired benefits of TCO.

2. Determine the type(s) of purchases to analyze.

3. Choose standard model, unique model, or mix of both.

When to Use Standard or Unique Models

Implementing TCO Analysis

4. Choose between a cost-based and value-based approach.

  • Data availability

  • Ability to capture critical performance issues

  • Desire for accuracy vs. magnitude of cost

  • Desire to TCO analysis data for reporting

  • Corporate culture

    5. Form a team to work on TCO project.

    6. Test the TCO benefits and modeling approach.

  • Identify relevant costs

  • Select critical costs

  • Develop and document supporting cost data

  • Pilot test

Implementing TCO Analysis

7. Fine tune the TCO analysis approach.

  • Timetable

  • Types of purchases included and why

  • Any computerized linkages and how they will be established

  • Plans for educating the organization

  • Who will be responsible: overall & day-to-day

  • Benefits

  • Types of decisions TCO will support

    8. Present recommendations to top management and implement.

Benefits of a TCO Pilot Study

  • Gain understanding of data sources/ unavailability

  • Experiment with alternative TCO models

  • Educate others in the organization regarding TCO

  • Improve cooperation within the organization by enlisting participation of those outside purchasing

  • Convince people in the organization of the benefits of TCO by demonstration

  • Become familiar with the TCO model and possible pitfalls

Characteristics of an Item for Pilot TCO Project

  • The organization spends a relatively large amount of money on that item.

  • The organization purchases the item with some degree of regularity.

  • Purchasing believes the item has significant transaction costs associated with it that are not currently recognized.

  • Purchasing believes that one or more of the currently unrecognized transaction costs is individually significant.

  • Purchasing has the opportunity to have an impact on transaction costs, via negotiation, changing suppliers, or improving internal operations.

  • Those purchasing or using the item will cooperate in data gathering to learn more about the item’s cost structure.

Implementing TCO Analysis

9. Continuous improvement.

10. Expand TCO concepts to supply chain.

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