"Should Cost"—From Spreadsheets To Science

Knowing what you should be paying when you go into a negotiation gives you a lot of strength. Also, any understanding you have of how to optimize and reduce costs goes right to the bottom line. It's pure profit.
John Kagan
Lenovo

Solving the simpler problems in supply management pays enormous benefits. For example, in the 1990s Thomas T. Stallkamp, a pioneer of modern supply management, was "flabbergasted" when he discovered that the use of two part numbers for the same fastener in a Chrysler data system had created $40,000 in administrative costs.¹ Efforts toward parts standardization and sophisticated spend-analysis systems have resulted in massive savings for many companies. The next step is tougher—analysis of the attributes of products in the system to determine what they really should cost.

Article Figures

[Figure 1] "Should costing" and on demandEnlarge this image

[Figure 2] Product candidates for costing modelsEnlarge this image

[Figure 3] Lessons LearnedEnlarge this image

"Should costing" (also called "reverse price analysis" by Monczka, Trent, and Hanfield in Purchasing and Supply Chain Management, a well-known supply management textbook²) is a huge potential weapon in the supply management arsenal. Often many big suppliers will not provide cost data because the data is proprietary. Many small manufacturers do not understand their cost structures. They make sales to utilize machine time and hope that all of the numbers "add up" at the end of the fiscal year. It is small wonder that 35 of the largest 100 injection molders in the United States went out of business from 2000 to 2005. The mad rush to electronic reverse auctions that started in 1999 accelerated this crisis.

In reverse price analysis, very rough cuts of supplier costs are made based on publicly available data, such as average profit and selling, general, and administrative (SGA) expense by industry group; labor costs as a percentage of a product's cost (from the U.S. Department of Commerce); or producer prices (from the U.S. Department of Labor's Bureau of Labor Statistics). When using publicly available data, proceed with great caution. U.S. government-generated statistics range from okay to extremely poor. Broadbrush industry estimates from various sources are also perilous. Using these types of data may appear to give a supplier a much larger profit margin than he had ever hoped for. For example, profit margins for American injection molders, a significant part of the manufacturing supply base, are close to 1 percent or 2 percent, even for above-average performers.

Cost-accounting systems
Sophisticated costing departments are not unusual in very large manufacturing companies. Large manufacturing companies typically use spreadsheets or some other type of database to allocate costs based on traditional cost accounting or activity-based costing (ABC) principles.

Traditional accounting systems—The challenges
In traditional cost accounting, overhead costs are arbitrarily allocated to product costs. In ABC, each overhead expense category is traced for each product; for example, how much engineering time is consumed? How long does the setup take? How much of what type of machining takes place?

Commercial systems that use ABC principles include Starn Job Shop Manager (Starn Technical Services Inc.), Acorn Systems Profit & Cost Analyzer (Acorn Systems Inc.), Goldenseal Business Software (Turtle Creek Software), and Lead Software Activity Analyzer (Lead Software Inc.). Capturing cost information is a time-consuming process, particularly if senior management wants a quick review of how well a major project is conforming to target costs.

Commercial systems are also often not particularly accurate. For example, a major manufacturing company that launched a $1 billion product quickly realized that costs were far beyond target levels, which resulted in losses on the product line. Engineering and purchasing subsequently launched a major cost-reduction effort. After three years, this effort resulted in $17 million in cost reductions. Total losses on the product in that time period were $31 million.³

Important: The point of new should-costing efforts and approaches is to do it right the first time.

Another major failure of most efforts at cost estimating has been a general failure to leverage those systems as supply management tools. Most supply management departments "wing it" (that is, act based on guesswork) without access to costing-system professionals and without the tools that allow them to analyze the true cost basis of many of the manufactured products they buy. Best-in-breed supply management departments try to develop meaningful costs through detailed supplier questionnaires and spreadsheets. Purchasing guru R. David Nelson has famously pursued this path during stints with Honda, John Deere, and Delphi Automotive. In the best-case scenario, buying companies can then help suppliers develop more cost-effective designs or manufacturing processes with support from supplier development engineers.

In an on-demand, technology-driven world, old paradigms fail (Figure 1). A scientific and rapid system is needed for determining product cost. The system should be a "sword that cuts two ways"—one that is inward looking and one that is outward looking. A company's supply chain management must ensure that product development teams are meeting target costs and that suppliers are providing the most efficient costs.

Additionally, in an on-demand world, there is an even loftier goal—one that is truly rare in today's world. Important: No longer should it be a company's goal to seek the best deal with no concern for the impact on suppliers' profit and loss (P&L) statements, particularly if suppliers are—or could be—technology partners. On-demand relationships require having a new, much higher level of partnership with suppliers that in effect necessitates a full understanding of costs. Both companies then share the risks and reach optimum performance levels.

Software solutions
Technology solutions have stepped into this breech. Should-cost software dates back to the 1980s. Two engineers in Rhode Island, Peter Dewhurst and Geoffrey Boothroyd, developed a system in 1980 that predicted manufacturing costs during the productdesign stage with a software analytic system they called design for manufacture and assembly (DFMA). A library in the software allows product developers to investigate alternative materials and processes for producing parts and helps them select the most cost-efficient design. In the first four years of using the tool, Ford Motor Company stated that it had saved $1 billion. Increasingly, the Boothroyd-Dewhurst tool is being used for supply chain analysis, particularly for determining whether to source a product in the United States or in China.

In another development, Thomas Charkiewicz, a former machinist and manufacturing manager who had studied computer-aided manufacturing at the University of Massachusetts, launched MTI Systems Inc. in 1982. His software, known as Costimator, models manufacturing costs. Many other companies have subsequently entered the cost-estimating business, and many later failed.

More recently, should-cost software development has taken a more scientific, and parametric, turn. Caterpillar developed an internal, engineering-driven system that estimated part costs and optimization opportunities for castings, forgings, and other manufactured products and spun out the technology into Akoya (Peoria, Illinois), a venture-capital-backed firm.

Meanwhile an "incubator" of technology solutions for cost estimating at the University of Illinois, headed by Michael Philpott, was approached by John Deere, which was in search of a better approach to target costing. Philpott and graduate student Eric Hiller, among others, worked with professional managers to launch another venture-capital-backed entry, aPriori (Concord, Massachusetts). The aPriori model is unique in its efforts to model costs of specific suppliers into a library used with this tool.

Contemporary software tools allow sourcing professionals to receive alternate price quotes almost immediately through "what if" scenarios. What if we made a specific component from polypropylene instead of high-density polyethylene? What if we machined a core pin using high-speed or high-feed techniques versus electric-discharge machining? What if we changed a draft angle by 1 percent? What if we replaced four fasteners with a snap-fit? What if we replaced a 21-part front module with a one-piece metal molding?

Understanding costs
Cost analysis is the investigation of what something should cost based on a construction of its cost elements or the use of a features-based analytics tool, or both. An understanding of actual costs is most important when dealing with subcontractors. Underlying cost factors include material costs, labor costs, equipment, overhead, and margin.

Even if an organization has no interest or need to become an on-demand organization, there are many powerful reasons why an understanding of cost is required.

Supplier pricing verification
The first and most obvious reason for understanding cost is to ensure that suppliers' pricing is in line with reasonable economic and performance requirements. (Note: For this discussion, we are differentiating between price and cost analysis.) Probably more than 99 percent of all procurement investigation is done strictly by using price analysis. Price analysis primarily involves a comparison with the previous price paid. Some organizations may also compare the price with a previously developed in-house estimate or use a comparison with third-party sources of pricing information. Some procurement managers use carefully constructed requests for information to investigate the pricing structure of suppliers. During the economic recession of 2002?2003, some buyers used electronic reverse auctions on an almost weekly basis to "plumb the depths" (search for the cheapest) of prices for electronic and other components.

An inward view
Another good reason to understand costs involves looking inward. When developing a new product in discrete manufacturing industries, the new analytical tools are powerful ways to ensure operations are within cost targets. At least 70 percent of costs typically are built in through product design (Figure 2).

New-product design analysis reveals features that are particularly expensive. Are they really needed? Designers can also determine whether alternate designs could make products more easily manufactured. Such issues are particularly important when designing tooling. Few product-design engineers understand well how certain features, or a lack of features, can significantly increase tooling cost. Complicated tooling (usually with several internal movements) incurs significant capital expense, but there are hidden costs as well, for example, maintenance or lack of full tool functionality when several cavities fail to function or make repeatable parts. The inward-looking process, of course, is not new. Since at least the 1960s, it has been widely practiced as value analysis or value engineering (VA/VE). (Comment: The authors sense that VA/VE was a more highly valued process in the 1970s and 1980s than it is today. VA/VE should move back to the forefront.)

Cost modeling
In process industries, cost modeling takes a different form but is equally important. When Bethlehem Steel was preparing for negotiations with industrial gas suppliers, co-author Rudzki would engage a senior member of the company's research department to build a process economics model, based on that individual's intimate knowledge of the air liquefaction process. That model was then "field tested" on individual suppliers in a carefully planned manner, which permitted buyers to obtain the verification needed to have confidence in the economic curve. That curve played a critical role in negotiations planning and execution. Comment: This approach is best suited for large spends, due to the lengthy professional time required.

Some research firms have developed commercially available models of chemical processes for supply management departments that cannot afford to undertake a process-modeling project. Data Resources Inc. (DRI) famously developed a model of the entire U.S. economy in the 1970s under economist Otto Eckstein (a veteran of the administration of President Lyndon Baines Johnson) and then hired industry experts to build cost models of specific processes, such as sulfur production, to model and predict costs. In 2002 DRI merged with Wharton Economic Forecasting Associates (WEFA) to create Global Insight, a major player in this area. Global Insight offers a "purchasing and pricing" service that combines models of manufacturing costs of a wide variety of industrial products, which are tied into its database of materials prices, micro forecasts, and macro forecasts. Global Insight's service is widely used by the U.S. Department of Defense to monitor contractor costs and by purchasing executives of many Fortune 1000 companies. According to Franz Price, managing director of Industry Practice at Global Insight (Philadelphia, Pennsylvania), "We provide forecasts of prices of products they buy as well as forecasts of the cost structures of those products so purchasing managers can see what is really driving the prices of those products." This type of modeling was particularly effective in coping with the "roller coaster" steel and plastics prices in 2003 and 2004.

Comment: However costs are modeled, business process is at the heart of a recommended approach. First of all, you must decide you want to do it. And then you must move forward using a cross-functional team approach—design engineering, manufacturing engineering, procurement, and finance, at the least.

Using Should-Cost Systems
Lenovo, a Chinese company that is one of the world's three largest manufacturers of personal computers (including the ThinkPad developed by IBM), is an advanced user of should-cost systems. When Lenovo bought IBM's PC business in 2005, it also acquired one of the most sophisticated should-cost operations in the world.

In the 1970s and 1980s, industrial engineers had studied costs associated with IBM's operations for manufacturing monitors, terminals, keyboards, typewriters, and mainframe computers. Processes studied included captive injection molding, die casting, cable and card assembly, and some tool manufacturing. IBM software engineers developed a tool called Pisces, which became the repository for all of the standard time, labor rates, machine time, and other data. Data was recorded based on geography, and Pisces became a tool that could be used to study manufacturing economics in different parts of the world.

John Kagan, the former manager of PC Cost Management at IBM and Lenovo, said the system had two uses—to estimate internal manufacturing costs and to compare internal costs to suppliers' costs for potential outsourcing—which set the stage for a massive move to outsourced manufacturing by IBM in the late 1980s and early 1990s. IBM and other high-tech electronics manufacturers jettisoned much of their own manufacturing capacity in favor of contract manufacturers such as Celestica. This was not an arbitrary move; it was based on a very scientific calculation of costs. Third-party manufacturers that specialized in certain manufacturing operations achieved enormous economies of scale and allowed optimal equipment investment and process optimization.

The role of should costing at IBM continued to evolve, first into a process for improving internal designs and then to a comparison of competitors' designs with IBM's internal designs. Kagan said, "We started looking at our competitors' designs, tearing them down and estimating what their costs were. We then compared them to our own designs. We began to develop a "lessons learned" approach, which could then be applied to our next generation of designs."⁴ IBM also applied rigorous cost estimating to various design iterations, using the tool to determine the best possible approaches.

Costimator—The IBM experience
About 2000, IBM decided its Pisces tool should move to a higher level. Kagan commented, "It took a lot of time to train on and it wasn't very user-friendly." IBM considered development of its own software and also studied commercial offerings. In 2002 IBM bought Costimator OEM from MTI Systems Inc. (West Springfield, Massachusetts), the firm started by Tom Charkiewicz. Many of the similar products on the market focused on machine-shop operations. Costimator had its roots in the machining industry, but had branched out to several other manufacturing processes.

Kagan continued, "The main purpose is to understand what your costs are and what they should be. Once you understand that, you are in a good position to achieve those costs. Knowing what you should be paying when you go into a negotiation gives you a lot of strength. Also, your understanding of how to optimize your designs produces savings that go right to the bottom line."

Kagan was manager of PC cost management when Lenovo acquired the personal computer business from IBM in 2005 and is now manager of global desktop manufacturing engineering at Lenovo. He estimates that in 2003 and 2004, IBM saved more than $10 million by using Costimator.

Costimator also includes a function known as IQ Builder with which customers can model almost any manufacturing process, using their own historical data. The manufacturing data that resides within Costimator was derived from the company's 900-plus customers in addition to various independent industry sources. Labor costs come from the U.S. Bureau of Labor Statistics (data that was collected from W-2 forms).

Charkiewicz of MTI Systems estimates that use of Costimator can save 10 to 30 percent as a should-cost tool.⁵ If companies use Costimator as a "could cost" tool, savings potentially rocket to 70 percent. Charkiewicz explains: "Could cost is where purchasing has done a better-than-average job fitting the part to the right-sized shop. Generally a purchasing person will request a quote from a supplier he or she trusts and is comfortable with. That supplier may use a 90-horsepower machine to make that part when only a 5-horsepower machine is required."

Charkiewicz also said that buyers who use couldcost analysis should also "wise up" to the fact that suppliers use operators to run more than one machine and group jobs for various customers at a single work table. For example, a machine shop may charge a customer $X for a part made on a given machine, which is actually making parts for four customers on a given cycle. The supplier pockets four times $X for the cycle of the machine.

Another area for improvement using costing strategy is how a company pays for setup time on a machine. According to Charkiewicz, "One customer was paying $65 for a part that should have cost only $3.50 at the most. The first time a buyer ordered the part, he only ordered six, and that price went in the books. The next buyer was a recent college graduate who looked up the price and ordered 10,000 for $65 a piece. The supplier laughed all the way to the bank."

The Costimator system is based on a detailed, stepby-step analysis of the costs to manufacture a part or assembly. The data includes optimal times for each step and the amount of labor input required. At Lenovo, internal data for materials costs based on negotiated contracts are then plugged in. IBM had also conducted significant research on manufacturing costs in various geographies around the world— costs can be estimated for China versus Mexico, for example.

The Lenovo tool operates on a stand-alone basis— that is, it has not been tied into the company's spenddata warehouse or product lifecycle management tools. Charkiewicz says that is generally the case because of the high costs involved in integration. Interestingly, the cost management team at IBM was part of the finance department, not purchasing or supply chain. At Lenovo, the cost management group moved into the procurement department.

Cost estimating—the challenges of functional isolation
According to executives at aPriori Technologies, one of the failings of cost estimating in general is that it is generally a highly specialized function that is not well integrated into the rest of the company. Frank Azzolino, President and CEO of aPriori commented, "If a company has 40,000 employees, 4,000 design engineers, and 1,000 people in purchasing, there may be 21 people in the cost-estimating department. Most cost-estimating tools focus on those 21 people. There are many different communities of people engaged in determining cost. They are not integrated well into the process. The people who know the most about cost often have the least ability to impact it in a significant way."⁶

The functional groups with the greatest ability to affect costs are design engineers, manufacturing engineers, and procurement professionals. That is why companies with sophisticated cost-estimating departments can experience significant problems in achieving cost targets, as in the example cited earlier of the $1-billion product that lost $31 million over three years. This is a niche that aPriori wants to mine with its Cost Management Platform, which in early 2006 was being used by six customers.

At the heart of the system architecture is a cost model engine. As a design engineer creates a geometric engine with his computer-aided design (CAD) software, the cost model engine automatically derives geometric cost drivers and interrogates the cost management database to obtain information about the planned manufacturing facility, either internally or externally; nongeometric cost drivers; and process cost scripts. The cost model engine automatically returns a manufacturing cost estimate to the user. As the product is designed, other functions (such as, procurement, manufacturing, and cost management) can view the process through a Web client. aPriori cofounder Eric Hiller explains that cost structures of planned manufacturing facilities are developed through a question-and-answer process by individuals who run those plants. Although other systems would use a "best case" model, the aPriori engine is based on actual costs at a potentially very wide variety of manufacturing sites, possibly around the world. The process cost scripts calculate manufacturing process time and convert that time to cost.

Important: The most important objective would be integration of the "cost record" into other enterprise software, such as the "product record" created by the product lifecycle management or product data management systems; the "production record" maintained by the manufacturing resource planning (MRP) system; the "supplier record" managed by supply chain management (SCM) systems, or the financial "accounting record" of the enterprise resource planning (ERP) system.

According to Azzolini, aPriori's Cost Management Platform became Netweaver-compliant in 2006, which is an important first step for integration with the SAP ERP system.

CAD—the Akoya experience
Another new CAD approach is being undertaken by Akoya, whose core technology was developed at Caterpillar Inc. CAD serves as the foundation for its primary product, known as CostPoint, an on-demand, Web-based, cost-estimating tool for highly engineered products. Users put CAD files and purchasing data into the CostPoint system and receive should-cost analyses of the parts. Besides providing costing benchmarks, the system is also useful for showing cost impacts of proposed engineering changes or the cost impact of material substitutions. Careful study of the data can allow 10 percent to 15 percent cost reduction through design optimization. The initial focus was on castings, and forgings and stampings were added in 2006. There are also plans to introduce a module for injection-molded parts.

Akoya is targeting the technology at purchasing and engineering professionals. According to Brett Holland, chief operating officer at Akoya, and Nelson Jones, the technology expert at Caterpillar who developed the software, "If a cooperative product-modeling effort were to take place early in the process, accompanied by knowledgeable input of material and supply costs, there could be proactive collaboration to create the same products but at a lower cost."

Holland also said that Akoya's tool can also be used to perform cost analyses of suppliers' parts. According to Holland, "The limitation on supplier-generated designs would be access to them. However, we anticipate engagements in which we would start working with original equipment manufacturers (OEMs) and then push the tool upstream. Suppliers could use the models for quoting and to determine their relative competitiveness."⁷

As of early 2006, Caterpillar and Textron Inc. were using Akoya's service. Each company has unlimited usage because Akoya is not based on a per-seat license fee model. Instead, subscribers pay a fee based on the size of their spend. Implementation costs as well as hosting and data updates are priced based on time and material expenses. New versions feature plug-in integration with other electronic systems.

BDI software—current vs. new design analysis
Boothroyd and Dewhurst Inc. (BDI) software allows users to analyze current and new designs to quickly determine how to simplify the design for significant cost savings. Various manufacturing processes and materials can be studied while a concurrent costing module instantly shows the cost ramifications of alternate designs. BDI played a role in the turnaround of Harley-Davidson, the iconic American motorcycle manufacturer, through redesign of various bike components. Product cost is now a bedrock approach at Harley-Davidson. BDI also helped Dell redesign the chassis for its desktop computers. (Note: Peter Dewhurst has turned over active management of the consulting company to Nick, his son, and co-owner John Gilligan.)

Nick Dewhurst commented, "If you have a project already in production and you do what we do—apply design for manufacturability and assembly (DFMA) techniques and take parts out and look at different materials and processes—you get about a 50-percent reduction in product cost. That same thing is achievable if you do these things early."⁸

If many OEMs paid better attention to costs, they would probably send less manufacturing business to China. In a paper, Nick Dewhurst and David G. Meeker state, "Outsourcing overseas is often being done with little or no understanding of what the true costs really are." At least 24 percent must be added to an Asian price quote to account for shipping and logistics expenses, supplier-selection costs, quality issues, and travel and communications, among other factors in the total cost equation. BDI says savings on a DFMA cost study yield on average 50-percent savings. If companies do a thorough cost analysis of the product and add in the extra costs of Asian manufacturing, then a 60- to 70-percent savings would be required to justify the outsourcing. Dewhurst said, "Interestingly enough, I've run into two companies in the last two months that have products in China that they are redesigning and bringing back to the United States for a percentage cost savings."⁹

Closing thoughts about should cost
Some final points about should cost include:

• Focus where payoff is greatest. According to Monczka, Trent, and Handfeld (2001), 20 percent of purchased items typically account for 80 percent of total costs.¹⁰ Within that 20 percent, certain items are highly engineered and are particularly outstanding candidates for should-cost tools—castings, forgings, injection-molded parts, and complex assemblies.
• Get involved early—very early. At least 70 percent of a product's cost is committed during the first part of the design phase.
• Keep your eye squarely on the big prize: total cost of ownership. Suppliers' sales officials love to say that purchasing people pay no attention to total cost of ownership. Translation: Purchasing people will not buy the suppliers' products because doing so is too expensive. In the narrower sense, total cost means how long the product will last, maintenance costs, and the impact of the quality of the part on everything around it. In a broader sense, total cost of ownership includes inventory-carrying costs, deliveryrelated issues, lifecycle costs (end-of-life recycling opportunities or disposal costs), packaging issues, administrative costs, etc. Figuring out how important each issue is in the total scheme of things, including a company's financial goals (such as cost of capital), is the really tough part.
• Ensure that the company's approach is totally cross-functional, with plenty of visibility from key supplier partners.

Endnotes
1. Robert A. Rudzki, Douglas A. Smock, Michael Katzorke, and Shelley Stewart Jr., Straight to the Bottom Line, J. Ross Publishing, 2005, p. 88.
2. Robert Monczka, Robert Trent, and Robert Handfeld, Purchasing and Supply Chain Management, Thomson Learning/South-Western, 2001, p. 429.
3. "The Challenge in Manufacturing Industries," Corporate Backgrounder, www.apriori.com
4. Personal interview, January, 2006.
5. Personal interview, January, 2006.
6. Personal interview, January, 2006.
7. Personal interview, January, 2006.
8. Personal interview, January, 2006.
9. Personal interview, January, 2006.
10. Monczka et al., p. 429.

Editor's Note:On-Demand Supply Management: World-Class Strategies, Practices, and Technology can be purchased from J. Ross Publishing at www.jrosspub.com for $44.95.

Excerpted from On-Demand Supply Management: World-Class Strategies, Practices, and Technology, J. Ross Publishing, 2007. Reprinted by permission of the publisher.