On this blog, I will mainly write about should cost modeling, the concept is now introduced and I gave until now just one method how to perform a should cost model (by using industry averages). Other ways (including examples) will follow soon, but it is also important to know what you can do with a should cost price. Therefore my next post will be about ‘how to use the outcome of a should cost model’.
donderdag 13 januari 2011
Innovation Driven Procurement
As procurement is still often seen as a supporting function it is mainly only involved after a product is already developed which leaves the procurement with a limited supplier base in which they only can negotiate. The value that procurement may deliver is then fully neglected by the business. Involving procurement earlier in the process, or even in the development phase of the product, unties procurement and will give procurement the opportunity to add value. This is also called innovation driven procurement. On this blog: you will find more about this new interesting concept.
dinsdag 4 januari 2011
Should Cost Modeling based on Industry Averages powerpoint presentation
Based on the article about should cost modeling, I made a brief presentation.
Check it on my linkedin profile:
or ask a copy by mail!
Now also available on this blog! --> here
Check it on my linkedin profile:
or ask a copy by mail!
Now also available on this blog! --> here
donderdag 23 december 2010
Industry Averages Example
A lot of request for the example came in. Instead of sending the document each time, I've now uploaded the example. You can donwload it (FREE) with the following link:
But you do need a password to open the file. Mail me for the password, and you'll receive it by mail (for FREE of course).
dinsdag 7 december 2010
Should cost model based on industry averages
Should cost model based on industry averages
This method determines the costs based on the averages of the industry in which the supplier operates. Then these figures are compared to those of the supplier. As the supplier is dependent on its context in which it operates, this method will not be the most accurate one because it uses (industry) averages to estimate costs and does not take the context specific characteristics of the supplier into account. On the other hand, it has the advantage that it is one of the quickest methods.
vrijdag 3 december 2010
Methods to estimate the costs of your supplier
In previous articles I talked about the should cost model philosophy and about costs. This article continuous on those articles. With respect to the article on the should cost model philosophy, this article can be seen as part of the ‘methods’. It briefly introduces the methods which can be used to extract data to fill in the level of the cost-elements of a price.
Costs
As ‘costs’ are a central topic in my previous articles and may also be important in the coming articles, I thought it may be useful to explain some things about costs, how costs are composed and how costs are build up in the supply chain. Again, it won’t be rocket-science but it will elaborate on costs, just enough to understand what is meant with it in the my previous and future articles.
Zimmerman (2003) argues that the simple term 'cost' has multiple meanings. If a product costs €x,- it does not reveal what it measures. A lot of different type of costs exist like opportunity costs, average costs, fixed and variable costs to name a few. In the context of should cost modeling, 'costs' should be viewed throughout a supply chain. Costs in a supply chain are built up as is depicted in figure 1.1.
Figure 1.1: Cost route in the supply chain
A supplier produces a product and sells it to a customer. The price which the customer is paying for a product consist of the costs of goods sold (consisting of direct material, direct labour and manufacturing overhead), general, selling and administration costs and a certain percentage of profit. Table 1.1 provides some more information about the costs-components constructing the price.
Element | Definition | |
Direct material | Bill of material (BOM) | |
+ | Direct labour | Labour required to convert direct material into a finished product (production workers wages) |
+ | Manufacturing overhead | Indirect costs associated with the conversion process (depreciation, other plant costs, supervision, R&D, support, etc.) |
= | Cost of goods sold | Sub-total (DM + DL + MOH) |
+ | General, Selling and Administration cost (GSA) | Costs included to keep the organization in operation (R&D, Finance, Procurement, marketing) |
+ | Profit before tax | Profit before taxes are subtracted |
= | Price | Total of all cost elements |
Table 1.1: Price composition
The price the customer is paying for the product is (part of) the direct material in their own process[1]. The customer will on its turn then add value to it and is the supplier for its customer(s) when it sells their product further on along the supply chain. This process is repeated until it reaches the end-customer (see figure 1.1).
Direct material
The direct material costs are the costs which origin from the materials used in the product. Most of the time these direct material are for the largest part bought from other organizations (suppliers).
To obtain information concerning the costs of the materials used, several options are available. You can for example ask your supplier for that information, but you can also calculate it yourself if you know the type and amount of material used by your supplier. Another option is to appeal to your experts like an engineer or use the drawings of the product if you are in possession of them. In case you have identified the type and amount of material used in a product, you can calculate the material costs for the products as the prices of the materials are normally known to a certain extent (e.g. the copper price per kilogram).
To obtain information concerning the costs of the materials used, several options are available. You can for example ask your supplier for that information, but you can also calculate it yourself if you know the type and amount of material used by your supplier. Another option is to appeal to your experts like an engineer or use the drawings of the product if you are in possession of them. In case you have identified the type and amount of material used in a product, you can calculate the material costs for the products as the prices of the materials are normally known to a certain extent (e.g. the copper price per kilogram).
Direct labour costs
Direct labour costs are the costs for labour required to convert direct material into a finished product. The labour costs are dependent on the number of hours worked on the product and the height of the wages for the employees. If every step is known in the production process and the labour involved with those steps, these costs can be estimated with great precision. But completely knowing the production process of the supplier is actually a kind of utopia. To obtain an impression of the production process of your supplier, you should extract information of your supplier. But this can be a difficult job to do, because most suppliers will be hesitant to disclose their valuable and sensitive information. Having close relationships with your supplier will be more supporting to the information exchange, resulting in a greater and more precise estimation of the costs (in 2010 I conducted research to the information exchange between buying and supplying organizations, the results may follow in the coming year on this blog).
As will be the case in close relationships with your suppliers, but especially when your organization does not have close bonds with their supplier, you should take into account that information can be distorted or not completely disclosed because parties in the process do not want to show all their cards for free as they might lose their competitive advantage by doing so. So obtaining information for estimating the labour costs can be very tricky and time-consuming. Therefore other ways of estimating these costs can be used which are less time-consuming and which can approach accepting levels of precision and in some cases even come close to high levels of precision.
Manufacturing overhead
Manufacturing overhead (also referred to as factory overhead, factory burden, and manufacturing support costs) refers to indirect factory-related costs that are incurred while a product is manufactured. Manufacturing overhead includes aspects such as the electricity used for operating the factory equipment, depreciation on the factory equipment and buildings, factory supplies and factory personnel (other than direct labour). How manufacturing overhead is assigned to a product is of importance. The description and allocation of ‘categories’ in the manufacturing overhead differ per organization, this makes the estimation of the manufacturing overhead rather complex.
General, selling and administration costs
GSA is the sum of all direct and indirect selling expenses and all general and administrative expenses of an organization. Direct selling expenses are expenses that can be directly linked to the sale of a specific unit such as credit, warranty and advertising expenses. Indirect selling expenses are expenses which cannot be directly linked to the sale of a specific unit, but which are proportionally allocated to all units sold during a certain period, such as telephone, interest and postal charges. General and administrative expenses include salaries of non-sales personnel, rent, heat and lights. There is certain overlap between the costs in the manufacturing overhead and the GSA, this makes it more complex to distinguish the costs a supplier makes. When estimating those costs of your supplier’s product, it is important to make sure that you do not count certain expenses multiple times. Here again, as is the same with manufacturing overhead, the definition and allocation of GSA differ per organization, therefore it is difficult to determine these costs.
Profit
The remaining cost category is profit, which is making gain for certain business activities for the benefit of the owners of the business. The amount of profit must be reasonable. Reasonable means that the profit is not too high that you as purchasing party are swindled, but it should also not be too low because this would threat the continuation of the supplier, because a share of the profit should be reinvested in their business in order to stay competitive to their competitors.
[1] When purchasing services it is no direct materials but will it be one of the other categories (dependent wherefore the service is used: maintenance of a machine will be Manufacturing overhead, temporary labour will be direct labour).
vrijdag 26 november 2010
Should Cost Modeling Philosophy
Note: in this article SCM refers to Should Cost Modeling (and not to Supply Chain Management)
The subjects I write about on this blog will be about Supply Chain Management, Procurement and other related topics. In my previous article I wrote something about the cost-perspective on procurement. Part of the article was about Should Cost Modeling. In this article I will elaborate somewhat on Should Cost Modeling. It Is a broad and varied but sometimes unclear topic, therefore. I’m planning to right regularly on topics of Should Cost Modeling on this blog like the different methods which can be used, practical examples of Should Cost Modeling or how a Should Cost price can be used. These topics may not appear in a logical sequence, it just depends on how much time I have to write, and which topic I’d like to write about at that moment. Therefore I’ve decided to start with the topic about ‘my philosophy’ on should cost modeling, which can be used as an overview in which the expected detailed articles can be placed.
To go straight to the point, figure 1 represents schematically my SCM-philosophy. Further on each aspect of the schematic representations is briefly clarified.
The subjects I write about on this blog will be about Supply Chain Management, Procurement and other related topics. In my previous article I wrote something about the cost-perspective on procurement. Part of the article was about Should Cost Modeling. In this article I will elaborate somewhat on Should Cost Modeling. It Is a broad and varied but sometimes unclear topic, therefore. I’m planning to right regularly on topics of Should Cost Modeling on this blog like the different methods which can be used, practical examples of Should Cost Modeling or how a Should Cost price can be used. These topics may not appear in a logical sequence, it just depends on how much time I have to write, and which topic I’d like to write about at that moment. Therefore I’ve decided to start with the topic about ‘my philosophy’ on should cost modeling, which can be used as an overview in which the expected detailed articles can be placed.
To go straight to the point, figure 1 represents schematically my SCM-philosophy. Further on each aspect of the schematic representations is briefly clarified.
Figure 1: SCM-philosophy model
In figure 2 you see the first part of the model depicted in figure 1. It is called 'data sources'. It is the information/data-pool. The information required for the should cost model is gathered here. There are no restrictions in the types and amount of information you will use. Of course you should consider whether the benefits of certain information will outweigh the costs to extract that information.
Figure 2: Data sources
Next (figure 3) you see the second part of the model in which the methods are depicted. The methods are the 'tools' which can be used to extract information from the pool of information mentioned above. The links represented between the methods mean that several tools can be used at the same time, in combination, sequential and in a complementing way. The methods self will be discussed in a later article(s).
Figure 3: Methods
Is taking just one method (or using one tool) in figure 3 not useful or valuable? No…this is not the case, because sometimes triangulating, using multiple sources etcetera, is simply not an option and then you can only rely on one method.
It is dependent on many factors like:
- Which information is present?
- What is the cost of new information
- Which resources do I have available? (time, money, personnel)
- What is the end-purpose? Cooperation with supplier? Negotiating?
- Etc.
This article discusses just the superficial philosophy, but as will become clear in later articles, there are many considerations to make when applying a should cost model.
In figure 4 the supplier's quotation is depicted, this is the 'object of investigation’: What is the quotation of the product? How does the production process looks like? Where is value added? Which costs are present and why?
Figure 4: Supplier's quotation
In the last step, depicted in figure 5, you actually combine all information gathered in the left half of the figure and compare it with the information gathered in the right half of the figure 3. Are those costs reasonable? Why do other suppliers have higher/lower costs? Where are opportunities for reduction? Etc.
Figure 5: Should cost modeling
In figure 5 two two-sided arrow are depicted, because it is not a neat sequential process, it is a process of back and forth between the supplier and the ‘information pool’. It is finished when you think it’s finished, or better: when you are satisfied with the results.
woensdag 24 november 2010
Summary of article: 'Recapturing the Cost-Perspective in Purchasing'
Recapturing the Cost-Perspective in Purchasing
Integrating the Total Cost of Ownership and the Should Cost Model
Summary of Draft version 1
Date November, 2010
Introduction
The focus on value in procurement is increasing. In order to add value for the end customer, the procurement function needs to know what the customer desires are. But as value is indissoluble linked to costs, it is important not to get overenthusiastic and with that neglect cost. Cost always remain important as organizations have limited resources. Generally speaking, differentiation (increasing value) will increase costs. Conversely, reducing costs will lower value (decrease differentiation). Therefore solely focusing on value may increase costs too high for the (end)customer. This means that a trade-off must be made here, implying that costs and value must both be taken into account. Being enthusiast about the focus on value myself, I’m still convinced that costs remain very important as well, and therefore I propose in this article a perspective on costs with respect to purchasing, as a sort of counterweight to the upcoming focus on value.
In this perspective I divide cost into two categories, first cost incurred at your supplier, which is reflected in the price and secondly cost at your own organization.
The last category of costs, can be contemplated with the Total Cost of Ownership (TCO) perspective.
The TCO perspective is very useful to estimate the costs of purchasing a product or service of a certain supplier. It takes a ‘bigger picture perspective’ and extracts the cost-elements occurring when purchasing from a specific supplier over the lifetime of the product or service. The outcome of the TCO calculation can be used for supplier selection or serve as a base for cost reduction. The price is mostly one of the main cost elements appearing from the TCO. It is good to have the wider TCO perspective when selecting a supplier, but as the price of a product or service causes a great deal of the total costs, it remains very important. Therefore price is a cost element which should obtain a solid level of attention. It is important to look whether the price is fair/right. Is the supplier efficient enough? Does it have a fair margin on it? To go beyond the old fashioned negotiation game between buyer and supplier on the price of a product or service, it may be useful to make a cost break down of your supplier’s quotation. A ‘should cost model’ may be useful here. Dependent on the willingness of the supplier and the purpose of the buyer, the ‘should cost model’ can vary from a more cooperative to an adversarial variant. Besides price, the should cost model can also be used for contemplating all other cost elements revealed in the TCO calculation. Should cost modeling is the process of determining what a product/service should cost based upon its component raw material costs, manufacturing costs, production overheads, general, selling and administration and reasonable profit margins.
Figure 3: The sequential flow of TCO and SCM
Combining TCO and SCM
TCO is a useful tool which goes beyond purchasing based on the product/service price. It widens the scope and it provides insight in what the actual total costs of purchasing at a certain supplier are. Using TCO as a supplier selection tool is very useful, but you can also go a step further. When having revealed the cost elements of the TCO, SCM can be used to go into depth on those (main) cost elements. You try to extract what drives those costs? And are we (buyer and supplier) able to influence those costs?
Where TCO just widens the scope and SCM only goes into depth, the combinations of the two creates a holistic but detailed approach at the same time to purchasing. The combination of the two tools creates a sort of 3D-approach to purchasing (Figure 3).
Combining TCO and SCM
TCO is a useful tool which goes beyond purchasing based on the product/service price. It widens the scope and it provides insight in what the actual total costs of purchasing at a certain supplier are. Using TCO as a supplier selection tool is very useful, but you can also go a step further. When having revealed the cost elements of the TCO, SCM can be used to go into depth on those (main) cost elements. You try to extract what drives those costs? And are we (buyer and supplier) able to influence those costs?
Where TCO just widens the scope and SCM only goes into depth, the combinations of the two creates a holistic but detailed approach at the same time to purchasing. The combination of the two tools creates a sort of 3D-approach to purchasing (Figure 3).
Figure 4: Cost perspective on purchasing
A: Compare and select (alternative) products and services of (different) suppliers on their Total Cost of Ownership
B: Identify the main cost elements of the TCO’s determined in step A.
C: Apply Should Cost Modeling on the main cost elements identified in step B, to get a thorough understanding of the cost elements. What are the drivers of the cost elements? Can we (supplier and/or buyer) reduce those costs?
For a more detailed description, read the full article.
B: Identify the main cost elements of the TCO’s determined in step A.
C: Apply Should Cost Modeling on the main cost elements identified in step B, to get a thorough understanding of the cost elements. What are the drivers of the cost elements? Can we (supplier and/or buyer) reduce those costs?
For a more detailed description, read the full article.
maandag 22 november 2010
Recapturing the Cost-Perspective in Procurement
Recapturing the Cost-Perspective in Procurement
Integrating the Total Cost of Ownership and the Should Cost Model
Integrating the Total Cost of Ownership and the Should Cost Model
Author: Kevin Lemmens©
Date November, 2010
Draft version 1
Click here for a summary
1 Introduction
Costs have always been one of the main elements with respect to purchasing. Purchasing was seen as a support function, but last decennia the focus of purchasing is shifting from cost to value: purchasing is becoming a value adding activity. It is part of the core-processes of an organization which is indicated by the fact that purchasing functions are more and more reporting to the CEO (Capgemini Consulting, Global CPO Survey, 2010).
Among others, this shift has been a result of the focus on value. The service or product delivered by an organization is highly dependent on the input (material and services) which are purchased by the procurement function. This means that delivering value to your customers starts at purchasing the right input. In order to add value for the end customer, the procurement function needs to know what the customer desires are. It seems therefore a logical consequence that purchasing need to be incorporated in the core processes of the organization.
Undoubtedly, this focus on value has brought good things and it is expected to bring even more good or even better things. Nevertheless, it is important not to get overenthusiastic and with that neglect cost. Cost always remain important as organizations have limited resources; there always exists an ultimate price which a customer can or is prepared to pay for a product or service. Conversely, costs can also be seen as a type of value for a customer. Anyhow, costs and value are dissoluble linked; generally speaking differentiation (increasing value) will increase costs. Conversely, reducing costs will lower value (decrease differentiation). Porter (1989) argues that this does not have to be the case, but when differentiating also results in lowering costs, one or more of the following three issues are likely to be present:
Date November, 2010
Draft version 1
Click here for a summary
1 Introduction
Costs have always been one of the main elements with respect to purchasing. Purchasing was seen as a support function, but last decennia the focus of purchasing is shifting from cost to value: purchasing is becoming a value adding activity. It is part of the core-processes of an organization which is indicated by the fact that purchasing functions are more and more reporting to the CEO (Capgemini Consulting, Global CPO Survey, 2010).
Among others, this shift has been a result of the focus on value. The service or product delivered by an organization is highly dependent on the input (material and services) which are purchased by the procurement function. This means that delivering value to your customers starts at purchasing the right input. In order to add value for the end customer, the procurement function needs to know what the customer desires are. It seems therefore a logical consequence that purchasing need to be incorporated in the core processes of the organization.
Undoubtedly, this focus on value has brought good things and it is expected to bring even more good or even better things. Nevertheless, it is important not to get overenthusiastic and with that neglect cost. Cost always remain important as organizations have limited resources; there always exists an ultimate price which a customer can or is prepared to pay for a product or service. Conversely, costs can also be seen as a type of value for a customer. Anyhow, costs and value are dissoluble linked; generally speaking differentiation (increasing value) will increase costs. Conversely, reducing costs will lower value (decrease differentiation). Porter (1989) argues that this does not have to be the case, but when differentiating also results in lowering costs, one or more of the following three issues are likely to be present:
1) the organization has not exploited all possibilities for cost reduction before
2) being unique with respect to an activity was not desired before
3) an important innovation has occurred that competitors have not yet copied
Therefore solely focusing on value may increase costs too high for the end customer. This means that a trade-off must be made here, implying that costs and value must both be taken into account.
Being enthusiast about the focus on value myself, I’m convinced that costs remain very important as well, and therefore I propose in this article a perspective on costs with respect to purchasing.
In this perspective I divide cost into two categories, first cost incurred at your supplier, which is reflected in the price and secondly cost at your own organization.
The last category of costs, can be contemplated with the Total Cost of Ownership (TCO) perspective. This is not a new phenomenon anymore as we can see that supplier selection is bit by bit shifting from price-based towards TCO-based. But do managers exactly know what TCO is? And even more important, do they know how to use it? Although it is sometimes used as a fancy word by management, it sure isn’t just a hollow concept.
The TCO perspective is very useful to estimate the costs of purchasing a product or service of a certain supplier. It extracts the cost-elements occurring when purchasing from a specific supplier. The price is mostly one of the main cost elements appearing from the TCO. It is good to have the wider TCO perspective when selecting a supplier, but as the price of a product or service causes a great deal of the total costs, it remains very important. Therefore price is a cost element which should obtain a solid level of attention. It is important to look whether the price is fair/right. Is the supplier efficient enough? Does it have a fair margin on it? To go beyond the old fashioned negotiation game between buyer and supplier on the price of a product or service, it may be useful to make a cost break down of your supplier’s quotation. A ‘should cost model’ may be useful here. Dependent on the willingness of the supplier and the purpose of the buyer, the ‘should cost model’ can vary from a more cooperative to an adversarial variant. The should cost model can also be used for contemplating other cost elements than price. In the remainder of this article the basics of TCO and SCM are highlighted, followed by an integration of these models, offering a new cost-perspective on purchasing.
2 Total Cost of Ownership
The Total Cost of Ownership considers ‘all’ costs involved with purchasing a product or service from a particular supplier. TCO goes beyond just the price and takes a ‘bigger picture perspective’, considering all cost of purchasing from a specific supplier over the life time of the product or service. Examples of those cost are costs with respect to quality, ordering costs, inspection costs, warehousing costs and elimination costs.
A TCO model, is a tool with which these types of costs can be determined on a structured way. In figure 1 a TCO model is depicted, below is explained how to use it.
On the horizontal axis, you can find a chronically depiction of the stages of a life cycle of a product or service. In these categories you write down the cost elements of a particular product or service during those stages. Bear in mind that those stages may vary per product, organization, industry, etcetera.
Being enthusiast about the focus on value myself, I’m convinced that costs remain very important as well, and therefore I propose in this article a perspective on costs with respect to purchasing.
In this perspective I divide cost into two categories, first cost incurred at your supplier, which is reflected in the price and secondly cost at your own organization.
The last category of costs, can be contemplated with the Total Cost of Ownership (TCO) perspective. This is not a new phenomenon anymore as we can see that supplier selection is bit by bit shifting from price-based towards TCO-based. But do managers exactly know what TCO is? And even more important, do they know how to use it? Although it is sometimes used as a fancy word by management, it sure isn’t just a hollow concept.
The TCO perspective is very useful to estimate the costs of purchasing a product or service of a certain supplier. It extracts the cost-elements occurring when purchasing from a specific supplier. The price is mostly one of the main cost elements appearing from the TCO. It is good to have the wider TCO perspective when selecting a supplier, but as the price of a product or service causes a great deal of the total costs, it remains very important. Therefore price is a cost element which should obtain a solid level of attention. It is important to look whether the price is fair/right. Is the supplier efficient enough? Does it have a fair margin on it? To go beyond the old fashioned negotiation game between buyer and supplier on the price of a product or service, it may be useful to make a cost break down of your supplier’s quotation. A ‘should cost model’ may be useful here. Dependent on the willingness of the supplier and the purpose of the buyer, the ‘should cost model’ can vary from a more cooperative to an adversarial variant. The should cost model can also be used for contemplating other cost elements than price. In the remainder of this article the basics of TCO and SCM are highlighted, followed by an integration of these models, offering a new cost-perspective on purchasing.
2 Total Cost of Ownership
The Total Cost of Ownership considers ‘all’ costs involved with purchasing a product or service from a particular supplier. TCO goes beyond just the price and takes a ‘bigger picture perspective’, considering all cost of purchasing from a specific supplier over the life time of the product or service. Examples of those cost are costs with respect to quality, ordering costs, inspection costs, warehousing costs and elimination costs.
A TCO model, is a tool with which these types of costs can be determined on a structured way. In figure 1 a TCO model is depicted, below is explained how to use it.
On the horizontal axis, you can find a chronically depiction of the stages of a life cycle of a product or service. In these categories you write down the cost elements of a particular product or service during those stages. Bear in mind that those stages may vary per product, organization, industry, etcetera.
1) Initial acquisition: these costs relate to activities which take place prior to receiving the product from the supplier (e.g. price and costs for negotiation).
2) Reception: cost occurred when receiving the goods, processing invoices, performing inspection etcetera.
3) Possession: cost which occur after inspection but before utilization. Think of internal transportation and inventory holding costs.
4) Utilization: the costs for utilizing the product or service. Think of electricity costs, personnel training, waste material and maintenance costs.
5) Elimination: costs for throwing away products, eliminating used products or selling your used products.
These costs can occur at different levels: supplier, order and unit-level.
1) Supplier-level: these costs occur each time a supplier is used (e.g. cost of supplier audits and the salary of the buyer responsible for managing the relationship).
2) Order-level: costs occurring each time an order is placed with a supplier. (e.g. receiving, invoicing, external transportation).
3) Unit-level: these costs are incurred on a ‘per unit basis’, and often occur in the utilization and elimination stages. They might for example be caused by inventory costs or a production shutdown caused by a defect product of the supplier.
3) Unit-level: these costs are incurred on a ‘per unit basis’, and often occur in the utilization and elimination stages. They might for example be caused by inventory costs or a production shutdown caused by a defect product of the supplier.
For each level is distinguished between costs/savings realized in cash or costs/savings realized from occupying/freeing up capacity. In figure 1 you can find a template of a TCO model.
Figure 1: TCO-model template
Steps in TCO process
The template given in figure 1 is a useful tool for drawing up the TCO of a product or service. Below is described how to make use of the model in order to estimate the TCO.
The template given in figure 1 is a useful tool for drawing up the TCO of a product or service. Below is described how to make use of the model in order to estimate the TCO.
1) Map the process a product or service ‘follows’ through its lifetime.
2) Identify for each time-category (e.g. initial acquisition) the process steps which are the cost elements in the model
3) Determine whether it is supplier, order or unit-level cost.
4) Determine for each cost element the cost driver. What drives the costs of a cost element. Is it the number of hours in combination with the hourly rate? Amount of material? Amount of time? This is an important step!
5) Gather data about the (height of) the cost driver and quantify the costs. This data can be gathered on various ways like interviews, workshops, surveys, accounts payable systems or their databases. Be aware of the accurateness of the data, in the end the TCO calculation is as good as its data is.
Senior management approval or involvement in the TCO process may make data-gathering easier.
Data-gathering is a time-consuming process, therefore it can be useful to delineate some things in step 1 and 2. For example, by conducting interviews and facilitating workshops with content-experts you can determine what the expected main cost drivers of the product or service probably are. Then you can focus on these cost elements instead of wasting valuable time on gathering data and quantifying cost elements which have a minor and less important share in the TCO price.
Senior management approval or involvement in the TCO process may make data-gathering easier.
Data-gathering is a time-consuming process, therefore it can be useful to delineate some things in step 1 and 2. For example, by conducting interviews and facilitating workshops with content-experts you can determine what the expected main cost drivers of the product or service probably are. Then you can focus on these cost elements instead of wasting valuable time on gathering data and quantifying cost elements which have a minor and less important share in the TCO price.
6) After completion of step 4, put the costs in a time line. The time line for the length of the life cycle of the product or service. Sum all the costs per time period and calculate them to the present values (optional step).
How to use the TCO outcome
Having calculated the TCO of a product or service, it can be used for (at least) two things. First it can be used for supplier and product selection. Compare the TCO of a product of Supplier A with the TCO of a (comparable or alternative) product of Supplier A or another supplier B. Choose the best alternative (while taking contextual qualitative aspects like market situation and the importance of the product/service into account). For example ordering products in China may be cheaper, but the transport costs may increase. What about the quality of the products? And what about the costs of the decreased flexibility. Or is chosen for a larger inventory for keeping the lead-time and flexibility at the same level? These are just a few of the many things which can (or must) be taken into account.
Secondly, the TCO value can be used to search for improvements or cost reduction. Identify the main cost drivers and look whether you and/or your supplier is able to influence those costs. Ask yourself whether the time and effort required to realize the cost reduction are larger than the cost reduction itself.
Remarks
- Calculating the TCO for a product or service is a very time-consuming process, therefore make sure whether the process to calculate the TCO of the product or service fits the product or the size of the purchase order(s). Calculating the TCO for a punching machine or an airplane makes more sense than performing a TCO for a pencil. In between these extremes a lot of other products or services exist. Therefore it is important to make the tradeoff between the expected costs of making a TCO and the expected benefits.
- Reducing costs may be realized by making changes in any kind of process (like production processes and working processes), product characteristics, order and batch sizes, etcetera. Sometimes these changes must (partly) be performed at the supplier side or even a link further up in the chain (sub supplier). This can be a difficult job, depending on things like the kind of relation (is it a cooperative strategic alliance or an adversarial relationship), market situation, power etcetera.
- Although it is good for organizations to be as efficient as possible and drive down costs, the flipside of the medal is ‘value’. As costs and value are indissolubly linked to each other, it may be dangerous for the profit of an organization to focus on just one of the two. Generally speaking differentiation (increasing value) will increase costs. Conversely, reducing costs will lower value (decrease differentiation). Porter (1989) argues that this does not have to be the case, but when differentiating also results in lowering costs, one or more of the following three issues are likely to be present:
1) the organization has not exploited all possibilities for cost reduction before
2) being unique with respect to an activity was not desired before
3) an important innovation has occurred that competitors have not yet copied
- If is chosen for a TCO way of driving down organizational costs, it should be integrated throughout the complete organization. If this is not the case, it may be that the wrong performance measures are in place for the procurement department (e.g. if they are still measured on the level of purchase price).
Figure 3: The sequential flow of TCO and SCM
3 Should Cost ModelingSCM was originally designed for breaking down, understanding, comparing and validating a supplier’s quotation, therefore is first is looked to the original way a SCM can be used. The method for analyzing cost elements other than the price will not be very different.
External purchases of products and services account generally for more than 60% of the total costs of an organization. Reducing the purchase price of products drives down an organization’s expenses. Should cost modeling is a valuable tool for determining a supplier's costs, whether those cost are reasonable (for the supplier as well as for your organization) and the model provides insight where in the (production) process and value chain of your supplier cost reductions are possible. A reduction at your supplier may be beneficial for both the supplier and the purchasing organization.
Instead of taking a marketing based view on purchasing by focusing purely on the lowest price, a should cost model focuses on the structure of the price. Should cost modeling is the process of determining what a product should cost based upon its component raw material costs, manufacturing costs, production overheads, general, selling and administration and reasonable profit margins (see table 1).
External purchases of products and services account generally for more than 60% of the total costs of an organization. Reducing the purchase price of products drives down an organization’s expenses. Should cost modeling is a valuable tool for determining a supplier's costs, whether those cost are reasonable (for the supplier as well as for your organization) and the model provides insight where in the (production) process and value chain of your supplier cost reductions are possible. A reduction at your supplier may be beneficial for both the supplier and the purchasing organization.
Instead of taking a marketing based view on purchasing by focusing purely on the lowest price, a should cost model focuses on the structure of the price. Should cost modeling is the process of determining what a product should cost based upon its component raw material costs, manufacturing costs, production overheads, general, selling and administration and reasonable profit margins (see table 1).
Element | Definition | |
Direct material | Bill of material (BOM) | |
+ | Direct labour | Labour required to convert direct material into a finished product (production workers wages) |
+ | Manufacturing overhead | Indirect costs associated with the conversion process (depreciation, other plant costs, supervision, R&D, support, etc.) |
= | Cost of goods sold | Sub-total (DM + DL + MOH) |
+ | General, Selling and Administration cost (GSA) | Costs included to keep the organization in operation (R&D, Finance, Procurement, marketing) |
+ | Profit before tax | Profit before taxes are subtracted |
= | Price | Total of all cost elements |
Table 1: Costs
When properly used, a should cost model is a tool which is able to provide insight in the costs and the value adding activities of your supplier. It is the tool which can be used to open up the black box of the supplier. Knowing what the cost elements and their cost drivers are, is the first necessary step in reducing the costs, because if you do not know where the costs origin from, how could you ever been able to control them? And bear in mind that controlling your costs can be a source of competitive advantage!
When properly used, a should cost model is a tool which is able to provide insight in the costs and the value adding activities of your supplier. It is the tool which can be used to open up the black box of the supplier. Knowing what the cost elements and their cost drivers are, is the first necessary step in reducing the costs, because if you do not know where the costs origin from, how could you ever been able to control them? And bear in mind that controlling your costs can be a source of competitive advantage!
You need to know which cost elements are present and what the cost drivers of those cost elements are at the supplier’s processes and wherefore those costs are made and if they are necessary or just waste of resources. You have to think of aspects like:
· What value does your supplier add with its processes?
· Are those processes really required for adding value?
· What costs does it make for creating certain added value?
· Are those costs reasonable?
· How do you know whether the costs are reasonable or not?
· Can he (the supplier) or we reduce those costs?
Should cost modeling actually means: Opening the black box of the quotation!!The benefits of disclosing the black box may be obvious:
· Calculate a fair price for a product
· Compare a supplier’s quotations to industry averages
· Compare two or more supplier quotations with each other (benchmarking)
· Engage a supplier that has not provided any cost information in a discussion on cost (why his price is different than the calculated should cost price)
· Extract cost information from suppliers
· Identify key cost drivers for detailed analysis
· Estimate a target cost of a final product
By knowing the price composition of your supplier you can judge whether you want to do business with that supplier or not, whether you can expect price decreases, look together for cost reduction etcetera. In other words, organizations can use should cost modeling when their goal is to increase the value of a product (by means of reducing the costs or increasing revenues). A should cost model can be used in two ways:
1) as a negotiation tool, or in a
Because the product price is dependent on the type of product and the context it is in (like number of suppliers of the product and its alternative products), it becomes more difficult to construct one common type of should cost model for all products. This may be one of the reasons that should cost modeling is not (yet) widely accepted in the western business.
Although SCM was originally developed for contemplating the price of a product or service, the methods used for analysing the price, can also be used for other cost elements. The other cost elements exists of processes, products, services from internal or external suppliers and will also consists of (a selection of) direct material costs, manufacturing costs, production overheads, general, selling and administration and reasonable profit margins. It depends whether it is a product or service (services often don’t need direct material) and whether it is from internal or external suppliers (the profit margin may not be present with internal suppliers).
4 TCO and SCM
TCO is a useful tool which goes beyond purchasing based on the product/service price. It widens the scope and it provides insight in what the actual total costs of purchasing at a certain supplier are. Using TCO as a supplier selection tool is very useful, but you can also go a step further. When having revealed the cost elements of the TCO, SCM can be used to go into depth on those (main) cost elements. You try to extract what drives those costs? And are we (buyer and supplier) able to influence those costs?
Where TCO just widens the scope and SCM only goes into depth, the combinations of the two creates a holistic but detailed approach to purchasing. The combination of the two tools creates a sort of 3D-approach to purchasing (Figure 3).
Although SCM was originally developed for contemplating the price of a product or service, the methods used for analysing the price, can also be used for other cost elements. The other cost elements exists of processes, products, services from internal or external suppliers and will also consists of (a selection of) direct material costs, manufacturing costs, production overheads, general, selling and administration and reasonable profit margins. It depends whether it is a product or service (services often don’t need direct material) and whether it is from internal or external suppliers (the profit margin may not be present with internal suppliers).
4 TCO and SCM
TCO is a useful tool which goes beyond purchasing based on the product/service price. It widens the scope and it provides insight in what the actual total costs of purchasing at a certain supplier are. Using TCO as a supplier selection tool is very useful, but you can also go a step further. When having revealed the cost elements of the TCO, SCM can be used to go into depth on those (main) cost elements. You try to extract what drives those costs? And are we (buyer and supplier) able to influence those costs?
Where TCO just widens the scope and SCM only goes into depth, the combinations of the two creates a holistic but detailed approach to purchasing. The combination of the two tools creates a sort of 3D-approach to purchasing (Figure 3).
Figure 3: Cost perspective on purchasing
A: Compare and select (alternative) products and services of (different) suppliers on their Total Cost of Ownership
B: Identify the main cost elements of the TCO’s determined in step A.
C: Apply Should Cost Modeling on the main cost elements identified in step B, to get a thorough understanding of the cost elements. What are the drivers of the cost elements? Can we (supplier and/or buyer) reduce those costs?
Note that step A, B and C correspond with the steps A, B and C in figure 2.
B: Identify the main cost elements of the TCO’s determined in step A.
C: Apply Should Cost Modeling on the main cost elements identified in step B, to get a thorough understanding of the cost elements. What are the drivers of the cost elements? Can we (supplier and/or buyer) reduce those costs?
Note that step A, B and C correspond with the steps A, B and C in figure 2.
With TCO, an organization takes costs into account incurring in their own organizations, while using a SCM approach an organization is looking to costs at their supplier. The combination of the two approaches include both sources (buyer and supplier) for costs. It even provides opportunities for synergy, because knowing where the costs of both parties origin from and the processes of both organizations, actions can be taken to align processes and reduce costs with that.
Without taking notion of the other party in a Buyer-Supplier (B-S) dyad, cost reductions in one organization, may increase costs at the other organization. Conversely, when aligning processes, costs at one organization may increase, but the overall costs of the B-S dyad may reduce. If the buyer and supplier communicate in the last example, an organization may be prepared to increase their costs if it shares in the additional revenues at the other party (or in other words get compensated for their investments and efforts). Agreements about the division of the costs and revenues in order to reduce costs or increase revenues of a buyer-supplier dyad, is important, especially when looking to the future of the relationship.
5 What next?
Having made the first steps for recapturing the cost perspective, much work is still required in the area of procurement. With respect to this cost perspective, publications on my account are expected about Should Cost Modeling (the SCM-philosophy, practical examples, a manual, how to use a SCM outcome) and about Total Cost of Ownership. Compared to SCM more literature on TCO exists and therefore the focus will be more on SCM. Then the interaction among SCM and TCO is elaborated on, and a practical model is expected how to use this perspective in practice.
Without taking notion of the other party in a Buyer-Supplier (B-S) dyad, cost reductions in one organization, may increase costs at the other organization. Conversely, when aligning processes, costs at one organization may increase, but the overall costs of the B-S dyad may reduce. If the buyer and supplier communicate in the last example, an organization may be prepared to increase their costs if it shares in the additional revenues at the other party (or in other words get compensated for their investments and efforts). Agreements about the division of the costs and revenues in order to reduce costs or increase revenues of a buyer-supplier dyad, is important, especially when looking to the future of the relationship.
5 What next?
Having made the first steps for recapturing the cost perspective, much work is still required in the area of procurement. With respect to this cost perspective, publications on my account are expected about Should Cost Modeling (the SCM-philosophy, practical examples, a manual, how to use a SCM outcome) and about Total Cost of Ownership. Compared to SCM more literature on TCO exists and therefore the focus will be more on SCM. Then the interaction among SCM and TCO is elaborated on, and a practical model is expected how to use this perspective in practice.
Although the focus of this perspective on purchasing fully relies on costs, value is the other side of the coin cannot be neglected. Therefore the link between these two will be elaborated on in later publications.
Communication plays an important role when increasing the value of a buyer-supplier dyad (called inter-firm profitability), therefore this will be an important issue which will be elaborated on in a later publication.
6 ReferencesMonczka, R.M., Trent, R.J., & Handfield, R.B. (2005). Purchasing & Supply Chain Management. 3rd edition. Ohio , USA: Thomson-southwestern. Cousins, P., Lamming, R., Lawson, B., & Squire, B. (2008). Strategic supply management: Principles, theories and practice. Edinburgh Gate, England: Pearson Education Limited.
6 ReferencesMonczka, R.M., Trent, R.J., & Handfield, R.B. (2005). Purchasing & Supply Chain Management. 3rd edition. Ohio , USA: Thomson-southwestern. Cousins, P., Lamming, R., Lawson, B., & Squire, B. (2008). Strategic supply management: Principles, theories and practice. Edinburgh Gate, England: Pearson Education Limited.
Porter, M. (1989). : Concurrentievoordeel : de beste bedrijfsresultaten behalen en behouden. Utrecht: Veen.Capgemini Consulting. (2010). Global Chief Procurement Officer Survey 2010. Achieving sustained business value through procurement.
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