Identifying critical costs in the supply chain

On October 21, 1993, the Wall Street Journal published an article by the don of business management, the late Dr. Peter F. Drucker, titled "The Five Deadly Business Sins." One of the deadly sins Dr. Drucker mentions is "cost-driven pricing." According to him, "the only thing that works is price-driven costing. Most American and practically all European companies arrive at their prices by adding up costs and then putting a profit margin on top." He then adds: "If Toyota and Nissan succeed in pushing the German luxury automakers out of the U.S. market, it will be the result of their using price-led costing. To be sure, to start out with price and then whittle down costs is more work initially. But in the end, it is much less work than to start out wrong and then spend loss-making years bringing costs into line—let alone far cheaper than losing a market." Amen! I couldn't agree with you more, Dr. Drucker.

As global competition becomes a hot priority for top management in many companies, there is going to be a scramble to lower prices at any cost. And that is precisely what we want to avoid. The AIM & DRIVE process1 is designed to help develop a strategy of managing costs through the supply chain—a strategy that is driven by both customers and suppliers alike. It is a strategy that has one clear objective: to bring products with world-class quality and leading technology to the ultimate customer, on time, every time, at the lowest market price. This is the customer who is the only one who puts money into the value chain. The rules of economics are crystal-clear: If total revenue is less than total cost, the firm will lose money. If this continues over a period of time, it is highly likely that the firm will cease to exist as a business entity.

Article Figures

[Figure 1] Supply chain cost flowEnlarge this image

[Figure 2] The process mapEnlarge this image

[Figure 3] Cost activity worksheet for Anything Inc.Enlarge this image

[Figure 4] "Should cost" model phasesEnlarge this image

[Figure 5] Cost elements in total cost of ownership (TCO)Enlarge this image

[Figure 6] Estimated cost of customer service (for goods under warranty)Enlarge this image

[Figure 7] Completed worksheet (for identifying critical costs of customer service for goods under warranty)Enlarge this image

[Figure 8] Master worksheet (for identifying critical costs of customer service for goods under warranty)Enlarge this image

[Figure 9] Completed worksheet (for identifying critical costs of printed manuals)Enlarge this image

[Figure 10] Completed worksheet (for identifying critical costs of printed manuals)Enlarge this image

[Checklist for Step 2: Identifying critical costs in the supply chain]Enlarge this image

Figure 1 takes a look at the cost flow through the supply chain. It is the entire supply chain that ends with the ultimate consumer of the goods and services provided by the chain. How unfortunate it is that the traditional role of customer and supplier pits one against the other on the issue of price. I am convinced that if we all started with the common understanding that costs have to be reduced rather than just the price, the relationship will start on a much better footing. And it will continue to build as the benefits of true cost management are shared through the supply chain.

In Figure 1, assume that your company is the final assembler of a consumer item that is sold to the end customer. The supply base represents your suppliers, and their suppliers, and so on. Let's pick up the action when a customer buys your product. To the customer, the amount paid for the item is the "acquisition price." To you, this represents revenue. The sum of all the "acquisition prices" paid by your customer base is your total revenue. Agreed? Now, what is the basic economic formula for total revenue? It is:

TOTAL REVENUE = TOTAL COST ± PROFIT/LOSS

I believe we need to modify the basic formula for total cost and include profit as a cost element. The reason is that profit should be given the respect it deserves. As a company budgets for advertising, research and development, training, and management, so should it budget for a return on investment in the form of profit. This is a symbolic gesture, but it is worth making in order to show a supplier that, as a customer, you do not expect it to run a charity.

Let's say a company has a total revenue of "$X." What is the breakdown of this total revenue? It's the sum of the acquisition price paid by the company to all its suppliers (we'll call that "A"), plus the conversion costs incurred by that company (call it "B"), and the administrative, marketing, and distribution costs needed to bring the product to its customer, plus or minus a profit or loss ("C"). Now, what if you had to further break down the acquisition price (A)? Can you see something emerging from this model? Not surprisingly, it is the total revenue (total cost) of the next-level supplier in a particular supply chain.

At this stage there appears to be a conflict of interest. If, for example, a team at the fictional example company, Anything Inc., wanted to reduce its cost of customer service, one possible solution would be to find a way to negotiate the hourly rate of the technical service engineers and other billable personnel at Fixit, the repair service it uses. Other things being equal, that action would reduce the acquisition price paid by Anything Inc. to Fixit. However, Fixit would see this as a drop in revenue from the Anything Inc. account.

In situations like these, a customer wants to reduce its acquisition price (A) in order to increase its profit margin or to sustain a fall in the market price of its product without compromising on profit margin. On the other hand, the supplier would prefer to increase its revenue (A) by increasing the price charged to the customer. Unless the drop in price is offset by a change in volume, you are going to have a very disappointed source of supply—a firm that will compromise in some way on quality, delivery, or service, or one that will eventually walk away from your business. It's a tough call when you get down to face-to-face negotiations with a supplier. Should you go after the price at any cost? Isn't that what management is going to measure the team on, after all? Or will the team stand tall and take a strategic view?

Here's an example of an opening remark by Ms. Cheep of Anything Inc. to the account manager of one of Anything's major material suppliers: "Look Joe, this is the position. I'm under tremendous pressure from my management to lower the cost of direct material. It now accounts for nearly 50 percent of our product's selling price. With our customer becoming more informed and demanding, we have no alternative but to meet, and beat, the competition on price. For that reason we need to set a target of reducing the price we pay for your product or service by 15 percent per year for the next three years. Now, I could threaten you with moving the business or use other bullying tactics to extract price concessions. But I'm not going to stoop to that level. I'd like to work with you to identify costs at your end. That means we need to understand your acquisition price (A1), your conversion costs (A2), and your administrative, marketing, and distribution costs (A3). Then we can see what action we can take to reduce or eliminate some of those costs. You will be able to reduce your price without compromising your margins by much. In fact, with your experience, you may be able to help me identify costs in my conversion process that I could reduce. Of course, you may consider this to be proprietary, against your company policy or whatever. In that case, I will still pursue my goal of price reduction and leave it to you to manage your costs as you see fit. The choice is yours."

Firm but fair, isn't it? The question is, how long can a company continue to slash costs as a reaction to competitive price pressure? Isn't it time for someone to lead the way? There has to be a more strategic focus to cost management. Look at Figure 1 again. If a team wants to tackle the costs of incoming material (the acquisition price), it needs to follow the same process as it did with its customer. That is, for the acquisition price to drop, the total cost of the supply base has to decrease. Therefore, we'll need to identify costs regardless of who incurs them. That means we have to sit down with a cross-functional team, including key suppliers or customers where necessary, agree on the need to manage costs, and begin Step 2 of the AIM & DRIVE process: identifying critical costs in the supply chain.

Map the process
Once a cost management strategy team has been assembled, it is important that all members view the process before, during, and after their respective activities are performed. Process mapping for the purpose of writing a cost management strategy doesn't have to be very sophisticated. All you are trying to accomplish is to view costs and activities from different perspectives. It also helps the participants understand the elements of costs for each activity. A rule of thumb would be to keep the initial process map to around 10 to 15 activity "boxes." If needed, one or two key boxes could be expanded into separate process-flow diagrams.

Before breaking down the cost of customer service, the team at Anything Inc. developed a process map, which is illustrated in Figure 2. Having done that, they talked in general terms about the type of cost elements that would describe the activities in each activity box. This does not have to follow any ledgeraccount heads or, for that matter, generally accepted accounting principles.

The terminology is not important at this stage. I call it the "Windows" system. Just choose a name for the activity, as if you were naming a file. Then, look at the list of names; determine whether some of them could be "filed" under the same "folder" or "subfolder." For example, the predominant cost incurred in activity box No. 1 is labor charges for the customer-service center operator, a cost that is fairly administrative in nature. In activity box No. 2, it is again a labor cost, but this time of a technical service-center person who is a more highly skilled individual. Next, in activity box No. 3, you have a field service technician's labor cost but also the cost of travel to get to the customer's site, and perhaps some parts to perform the repair, if necessary. Thus, for these three activity boxes you could have about five cost elements that stand out.

A team may decide to look at all of them separately or take the three labor categories and put them under a general category (a file folder like in Windows) called "Labor Cost." Following the trail of cost categories, the primary cost would be the cost of customer service; a secondary, or second-level, cost would be direct labor; and a tertiary, or third-level, cost would be technical service center (TSC) labor.

At this stage, depending on the level of cost knowledge or cost cooperation by a supplier, the team may take a stab at estimating the cost of each of the major activity boxes. Alternatively, if it is the acquisition price that is being discussed, the team could break that cost into the typical five key cost elements or "subfolders," namely:

1. Direct material
2. Direct labor
3. Manufacturing or service overhead
4. General, selling, administration, and distribution
5. Profit

It is up to the team to determine how deeply they would like to drill down into the subcost elements (the various cost elements in each subfolder). Sometimes you may break a certain cost into subcost elements, and then decide that doing so does not add any value. There is no hard-and-fast rule as to how deep you have to go.

Select critical costs to be managed
Once the team has identified the topic, established its goals from different perspectives, completed the Goal Specification Worksheet, mapped the process, and understood the general cost elements associated with each cost activity, it is time to begin the process of identifying critical costs in the supply chain.

Remember, so far, no numbers have been attributed to the cost elements identified in the process map. Now it's time to take a stab at that. A good guide is the Cost Activity Worksheet (Figure 3), which was developed by Steve Frels and his Strategic Supply Management Services team at Deere and Company. The purpose is not to fill in every single item on the worksheet but to start from the left and move toward the right only if the team recognizes the cost to be significant in monetary terms as a percentage of the total, or if it happens to have a major variance from the budget. Also, it is not so important to be exact with your numbers. I've always maintained, "It's better to be approximately correct than to be exactly wrong."

Compare Figures 1 and 3. Do you see the similarity? In Figure 3, if you are looking at it from a customer's perspective, the bottom line is the sales price/revenue. This is the same as X in Figure 1. The "direct material" box represents A in Figure 1. Direct labor, manufacturing, and engineering overhead are the equivalent of conversion costs (B) in Figure 1. And "general selling and administration" (GS&A) and "profit and others" in Figure 3 correspond to C in Figure 1. If you were to go further, then you could do a similar Cost Activity Worksheet for the supply base, in which direct material becomes the bottom line for the supplier (we'll use A instead of X). The rest is the same, except that A1 replaces A, A2 replaces B, and A3 replaces C.

Obtaining cost data
As a team begins filling in the Cost Activity Worksheet for a product or service, the first signs of trouble emerge. While it may be possible to estimate some of the costs, there are times when the customer has no clue whatsoever about the supplier's cost structure. I am often asked: "Will the supplier share such sensitive data?" My first response is another question: "Have you asked for it?" You will be amazed at the amount of data you can gather by simply asking the right question of the right supplier with the right objective in mind. Here are three ways that will help extract vital cost information about a product or service:

1. Supplier-provided data. In order to obtain cost information from a supplier, you should take the time to prepare a well-thought-out request for quotation (RFQ) that includes, among other information, a detailed breakdown of the supplier's quoted price. The objective should be clearly communicated. You, the customer, are trying to understand the supplier's quotation better and are not attempting to be an auditor. Many times, one or two suppliers will not provide data, but others will. As long as the prices are within a reasonable range, you can create an average price profile from the cooperative suppliers to estimate the cost structure of the uncooperative ones. Here, it must be made clear that under no circumstances should you share the specific numbers of one supplier with another. To do so would be unethical, and while it may give you some short-term benefit, the long-term consequences would be disastrous.

What if a supplier does not provide a cost breakdown in response to an RFQ? You must be persistent. Of course, the first reaction of a supplier to such a request is bound to be, "Why do they want this information?" Or, "It is against our policy to share such information with a customer."

I remember a story about just such a situation, narrated to me by Bob, the director of electronics marketing at a major U.S. company. One of his account managers approached him with an RFQ from a Japanese auto company that had just established a plant in the United States and wanted to source a small electronic device locally. The RFQ required a fairly detailed cost breakdown of the supplier. Bob's initial reaction was, "We do not give out such data. Just enter the price at the bottom and send it back to them."

A couple of days later, the account representative came into Bob's office with a FedEx package containing the same RFQ with a little note attached to it. It was from the automaker's category manager for electronic parts, who wrote: "Thanks for your very interesting quote. However, it appears you forgot to include the breakdown of the quote on the worksheet attached to the RFQ. Please fill this in and send it back to us at your earliest convenience so that we can process your quotation." Bob scribbled a note on a Post-It pad and sent it back to the customer. The note simply said: "We do not share this type of data with anyone." Two days later, the documents came back by FedEx with another short note, also on a Post-It pad, with the words: "We are sorry that you think of us as anyone. We would like to work with valued partner suppliers who think of us as someone special." The package included information about the customer's supplier relationship management program and its vision of being one of the largest manufacturers of automobiles in the United States within the next 10 years.

Bob and his team met to discuss what could be a future strategic account, and they decided to make an exception. Not only was the quotation successful but the customer also used the cost data to help Bob's company find ways to further reduce its costs. This resulted in a 25-percent reduction in the part price within a year. Ten years later, the Japanese automaker was indeed one of the largest manufacturers in the United States, and Bob's company was one of its largest suppliers of electronic parts. Persistence certainly paid off in this case.

2. Development of "should cost" models. Despite all the persistence in the world, there are times when suppliers are still not willing to share cost data. At such times it is immensely useful to break the ice by developing a "should cost" model for the product or service being purchased. The level of detail can vary from an industry cost profile to a detailed, processbased model.

Before developing a detailed model, a team should think about its objective. Is it necessary to establish what the product should cost, or is the team satisfied with the price but wants to better understand the breakdown of that price into its various cost elements? Information about the concept and process of shouldcost modeling can be found in the book Zero Base Pricing: Achieving World Class Competitiveness Through Reduced All-in-Costs, by Burt, Norquist, and Anklesaria (Probus Publishing, 1990). Figure 4 shows the progression in the level of detail obtained from the various cost models.

3. Availability of internal data. In some cases, your company may have had experience in producing a particular product or service and has now decided to outsource it. In such cases, it helps to dig out the cost data from your internal records and use that as a base for estimating the cost breakdown of the supplier's quote. While the numbers may not match exactly, it is useful to assume that the percentages are fairly similar.

The purpose of developing a cost breakdown for use in the AIM & DRIVE process is to understand the cost structure underlying a supplier's price and be able to identify critical costs in the supply chain. Notice the words "supply chain." I have often observed that when teams consisting of two or more levels of the supply chain engage in an AIM & DRIVE exercise, the first thing the customer wants to do is tear down the supplier's price. That may be fine, provided the team has determined that the acquisition price is one of the critical costs in the supply chain.

In order to do this, it is necessary to lay out all costs associated with the target product or service. That can be a nightmare. The total cost of ownership (TCO) is the present value of all costs incurred during the life of a product or service. In the AIM & DRIVE process, unlike the process for a make-versus-buy analysis, it is not necessary to estimate the present value of each cost element. However, it is important to at least identify the in-house costs that you (the customer) incur in addition to the cost of acquisition of the product or service.

Figure 5 illustrates the type of cost elements in each of the TCO categories. The team needs to prepare a list of costs in each category, estimate the values of those costs, and identify which of those costs are critical in the supply chain. Most often, a customer has poor or nonexistent data on the cost of receiving, inspection, storage, handling, scrap, warranties, field service, lost productivity or lost sales, outbound logistics, customer returns, and end-of-life costs. When that is the case, it is easier, of course, to focus on the supplier's price. But that is a big mistake. It's not that the supplier's price is unimportant; it's just that there also are so many opportunities for reducing your own costs.

It is hard to calculate some of the costs in the total cost of ownership model. For example, the cost of lost sales or lost productivity may be difficult to estimate. If the team determines that such factors are critical costs to consider, you must make an effort to put a number on that type of cost.

Getting back to our example, the team at Anything Inc. that is working on customer service looked at the process map and determined that they would break down the primary cost into the following second-tier (L2) costs:

• Direct labor
• Direct materials (spare parts and finished units)
• Logistics
• Administration charges

These costs are summarized in a worksheet, shown in Figure 6.

At this stage, the team may decide that one or more of the secondary costs could be broken down even further. This would create a third-level, or tertiary, cost (L3). For example, direct labor may be broken down into technical labor, field-service labor, and repair-shop labor. Likewise, logistics could be broken down into freight, inventory, and handling costs. It is not mandatory that all costs be broken down into smaller elements. This depends on the team and the project chosen.

As noted earlier, the purpose of a cost breakdown is to identify critical costs in the supply chain, not to audit the price structure of a supplier. The definition of the term "critical" is left to the members of the team. In some cases, the choice would be made based purely on the numbers. If so, then you can take the top two or three most costly items and break them down further. In other cases, teams have chosen costs that they believe could be leveraged across other projects or across the entire enterprise, even though they are not of significant value in the current project. An example in the case of the Anything Inc. team is the choice of logistics as a cost worth breaking down further.

Figure 7 illustrates the discussion above. Having broken down direct labor and logistics costs, the next decision is which of these costs are critical enough to carry forward to the next step in the AIM & DRIVE process. The decision to further break down a certain cost is based on a "yes" answer to each of the following two questions:

1. Is the cost a future cash flow?
2. Is this a cost that a team can affect?

In regard to the first question, the objective is to write a strategy for costs that are likely to be incurred in the future. If the cost is a nonrecurring (one-time) cost, then it may still make sense to write a strategy, provided that the one-time expense has not yet been incurred (because it is to be incurred in the future).

Nonrecurring expenses, for example, include purchase of capital equipment, tooling, development, and buildings. If a piece of equipment or tooling is to be purchased in the near future, you may be interested in writing a strategy before spending the money.

However, the team is most clearly interested in recurring future costs. Examples of recurring costs include material, labor, freight, and administration. Having selected certain cost elements that represent recurring future cash flows, the next question is whether or not the team will be able to affect those costs. This is not always possible. Sometimes costs (property taxes, license fees, and environmental cleanup fees, for example) are mandated by a government body, and therefore the team will have little or no control over them. This type of cost element should be dropped from further discussion. In other cases, it may be possible to affect a cost, but this particular team is not in a position to do so. In such situations, the team would pass on its suggestion to another team that is in a position to develop a strategy for this cost element.

In Figure 7, the Customer Service team at Anything Inc. argues that with the exception of administrative costs, all other costs were future cash flows that it could affect. Administrative costs were shared with other functions of the company and were allocated by the corporate office, and thus were beyond the team's control. So they set aside administrative costs for now; entered direct labor, direct materials, and freight in column "I" of their Master Worksheet (Figure 8), and proceeded to the next step of the AIM & DRIVE process: measuring secondary and tertiary costs.

The two other teams in our Anything Inc. example—the Printed Manual team and the Corrugated Boxes team—used the same process to select their critical costs to carry over to the next step of the cost management process. The Printed Manual team spent about US $9.8 million on the set of manuals that accompanied each Zigmo (the product whose costs they were analyzing). There were three manuals for each Zigmo: a "quick start guide" of 70 pages, an operating guide of 194 pages, and a "personal information guide" of 223 pages. They decided to break down the primary cost of printed manuals into second-tier costs of design, paper, printing, and translation. This breakdown and the cost elements chosen by that team to be carried forward to the next step are illustrated in Figure 9.

The Corrugated Boxes team took a different approach and broke the cost per box into two major subcategories: manufacturing and distribution. They then went all the way down to level five for manufacturing and level four for distribution costs. This is illustrated in Figure 10.

Now that you have seen three totally different cost breakdowns, I hope it is clear that it is up to each team to determine how it wants to break down the primary cost and whether to use a per-unit cost or the total cost.

Editor's Note: Excerpted from Supply Chain Cost Management: The AIM & DRIVE Process for Achieving Extraordinary Results, copyright 2008 by Jimmy Anklesaria. All rights reserved. Published by AMACOM Books, a division of the American Management Association. The book is available for purchase at www.amacombooks.org.