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Cost Reduction Strategies:Focus and Techniques


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This is a highly concentrated presentation that addresses the differences among price, cost, and TCO; what cost reduction strategies to focus on; and an overview of various techniques, as well as when and where to use them. Faced with excruciating competitive pressures, many senior C-Level executives require maximum effort from every part of their organization to survive. Today, purchasing, acquisition, procurement, contracting, and supply management professionals must be the most progressive cost reduction oriented group in the company.

For many organizations, senior C-Level executives set forth annual purchasing, acquisition, procurement, contracting, and supply management goals that mandate cost reductions. Regardless of the cost savings, avoidances, or containments achieved previously, you are faced with new cost reduction initiatives and objectives.

To make the goal of cost reduction a reality, we cannot focus solely on the price. We must examine the total cost of ownership to your organization, which means moving beyond the organizational environs to include suppliers, internal customers, other allied business functional entities, and external customers. By working both internally and externally with these stakeholders, cost reduction opportunities will become visible.

A typical purchasing, acquisition, procurement, contracting, or supply management professional will help reduce supplier prices and avoid incremental costs. A good purchasing, acquisition, procurement, contracting, or supply management professional will reduce costs by lowering both costs of acquisition and risks of supply. A great purchasing, acquisition, procurement, contracting, or supply management professional will reduce total costs across the board, increase service levels to the internal customer, make a significant contribution to the bottom line, seek value-added opportunities, and help to delight the organization’s customer. This type of professional also balances supply related costs and cycle time for the lowest overall cost, at the best value, while seeking risk optimization rather than risk minimization strategies.

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Cost Reduction Strategies:Focus and Techniques

  1. 1. Cost Reduction Strategies: Focus and Techniques for NAPM-Wichita presented by Thomas L. Tanel, C.P.M., CTL, CCA President and CEO CATTAN Services Group, Inc. College Station, TX © 2009 CATTAN Services Group, Inc.
  2. 2. Agenda Topics          Cost Reduction Strategies and Ideas Price and Cost Analysis--Applied Total Cost of Ownership and Total System Cost Use of “Should” Cost Models Innovative Thought and Ideas Solicitation Value Analysis and Engineering Target Cost Analysis and Target Pricing Low (Best) Cost Country Sourcing Summary
  3. 3. Cost Reduction Strategies  Cost Savings  Cost Containment  Cost Avoidance  Value Enhancement
  4. 4. Cost Reduction Terminology Product cost savings  Defined as obtaining and realizing a lower unit price on the same item than the unit price was in the last contract period.  A cost saving is valid for as long as the comparative that generated the saving is; but it is not to exceed the end of the contract period in which the saving was produced. On the first day of the next contract period the old price becomes the baseline against which any future cost savings are measured.
  5. 5. Cost Reduction Terminology Revenue generation  New financial sources that can be used to leverage or increase monies/resources available to an activity.  Revenue generation is a quantifiable monetary benefit. Non-monetary benefit  A benefit that cannot be measured in terms of finances or resources, such as better quality of services; improved health, safety or quality of life; enhanced security; enterprise-wide consistency; or contribution to achieving supplier diversity goals. Return on investment  Monetary benefit from an investment as a ratio or percentage of the amount invested.
  6. 6. Cost Savings Cost Savings—definition  A cost reduction that can be specifically identified and will be made to a budget or program, resulting from implementing a specific alternative in lieu of continuing the present system.  The result of a planned or deliberate action taken by Purchasing  Savings are a quantifiable monetary benefit  There must be a direct activity reduction for a savings to occur; thus, benefits are considered as savings only if the estimate identifies benefits that start accruing during the budget/activity’s fiscal year.
  7. 7. Cost Avoidance Cost avoidance—definition  Financial or economic benefits that result from an initiative but do not permit a monetary reduction to a funded activity or budget.  Is a quantifiable monetary benefit  Usually addresses the reduction or elimination of a future cost  Does not lower the cost of materials purchased when measured against historical results, but it does minimize or avoid entirely the negative impact on net income that a price increase would have.
  8. 8. Cost Containment Cost containment—definition  The process of maintaining organizational costs within a specified budget; restraining expenditures to meet organizational or project financial targets.  Measures taken to reduce expenditure or the rate of growth of expenditure, or the unit cost of goods/materials/supplies/services.  When an organization keeps costs low, or within a limit that has been planned.
  9. 9. Value Enhancement Value enhancement—definition  Value which affects the whole-life costs or whole-life income and its required functionality. Value  For any service or offering to have financial value, the organization must have been willing to pay for it out of pocket or must have already been paying for it in a way that can be measured on the organization’s income statement. This definition is a requirement for any discussion of legitimate cost avoidances.  For example, in practicing sustainable environmental management, we may reduce the environmental impact; while at the same time achieve cost reduction and create environmental friendly conservation added value.
  10. 10. The Difference between Price and Cost  “Price” . . . is a sales and purchasing concept.  “Cost” . . . is an accounting concept.
  11. 11. The Difference between Price and Cost Price =Cost of Material + Labor + Overhead Price =Cost of Material + Labor + Overhead + General & Administrative Expenses + General & Administrative Expenses + Selling Expense + Profit + Selling Expense + Profit Cost =Cost of Material + Labor + Overhead Cost =Cost of Material + Labor + Overhead + General & Administrative Expenses + General & Administrative Expenses + Sales Expense + Sales Expense
  12. 12. Comparability Factors for Prices Comparative price analysis involves the comparison of the current proposed price with quotes or prices for the same or similar items.
  13. 13. Total Cost of Ownership (TCO) TCO = Purchase Cost + Logistics •Inland Freight •Ocean/Air Freight •Transfer charges + Taxes •VAT •Incentives + Customs Duties & Fees + TCO – the sum of all costs associated with any given supply stream Source: The Executive Guide to Supply Chain Management, David Riggs/Sharon Robbins Other Costs •Quality •Safety Stock •Supplier Development •Currency
  14. 14. Cost Reduction and Negotiation ACQUISITION COST Typical Negotiation Focus TRAINING COSTS MAINTENANCE COSTS WAREHOUSING COSTS ENVIRONMENTAL COSTS SALVAGE VALUE Cost Reduction Opportunities Traditional Supplier Cost and Price Structure Traditional Supplier Cost and Price Structure OPERATING COSTS
  15. 15. Total System Cost (TSC) Total System Cost (TSC) – the sum of the buyer’s costs, supplier’s costs and interaction cost between the two
  16. 16. Total System Cost Buyer Costs TSC Savings Buyer Costs Interaction Costs Profit Price Savings Interaction Costs Profit Supplier Costs Traditional Focus Supplier Costs Strategic
  17. 17. Elements of Cost Selling Price and Margin Profit General and Administrative Selling Expense Overhead Labor Materials Cost of Goods Sold
  18. 18. Drive Out Costs Creatively  Considering alternative products, designs, concepts, and services, or looking at different or alternative solutions to existing services, processes or applications, requires a multi-disciplined approach, making use of internal customers or subject matter experts as well as first-tier suppliers or prime contractors.  Remember to create an arena that is friendly and open to suggestion, change, and innovation.  When defining the elements of cost, focus on cost reduction opportunities.
  19. 19. The Creativity Formula Remember: Most of the opportunities to reduce costs occur during the design, SOW, or conceptual stage for products and services—not after.
  20. 20. Should Cost Technique  “Should Cost” as a price challenge technique:  Provides cost analysis to buyers to be used for negotiations and determining price reasonableness  Provides cost analysis in responding to price challenges and pricing issues from your internal customers and management  Should costs are independent analytical estimates to determine the cost for manufacturing an item.
  21. 21. Building a Total Cost Model Total Price of Contract Total Cost of Contract Costs to Meet Contract Requirements Product Costs Direct Costs Indirect Costs Direct Labor Plus Direct Material (Allocation of Overhead to Labor and Material) Other Direct Costs (Other Allocable Costs Plus Overhead) G&A Expenses Profit /Fee
  22. 22. Should Cost—Supplier Cost Decomposition  What is in a typical “Should Cost” report:      A detailed description of the item. A list of references used in the analysis. A break down of cost and labor burden rates. Estimated unit prices for specified quantities. A break down of the material and associated cost and minimum economic buys.
  23. 23. Material—Terms & Definitions Term Definition • Raw materials Materials in a form or state requiring further processing before they can be used • Parts Items that, when joined with other items, are not subject to disassembly without destruction or impairment of use • Subassemblies Self-contained units of an assembly that can be removed, replaced, and repaired separately • Components Relatively simple hardware items which are listed in the specifications for an assembly, subassembly, or end item • Manufacturing Items that are required by or in support of the manufacturing process supplies • Inbound Freight, express, cartage, insurance, and postage for goods purchased, in process, or delivered, which transportation and can be added to the cost of an item or as an Other in-transit insurance Direct Cost (ODC)
  24. 24. Direct Labor—Terms & Definitions Term Definition • Direct Labor Work performed by individuals which is directly related to a specific cost objective. This work is readily identifiable with a particular product or service. • Indirect Labor Work performed by individuals which is not identifiable with a single final cost objective but is identified with two or more final cost objectives or an intermediate cost objective. One example of indirect labor is the work expended by the Controller of a company. The Controller’s work is not directly identifiable in the production of a specific product or service, since his or her work includes several projects or tasks. • • Labor Hour The unit of time by which direct labor activity is measured. Labor Rate The dollar amount paid to an individual per a given amount of time in consideration of work accomplished. • Labor Cost The product (i.e., result) of multiplying labor hours by appropriate labor rates. • Labor Category A grouping of workers with similar skills or expertise or trade classification. • Labor Mix The combination of functional skills and levels of worker experience required to accomplish a given task. • Basis of Estimate (BOE) A statement of the rationale used by a supplier/contractor to generate a cost estimate for a specific task or item to be produced.
  25. 25. Indirect Costs—Terms & Definitions Term Definition • Indirect Costs Any cost that cannot be directly identified with a single final cost objective but can be identified with two or more final cost objectives or an intermediate cost objective • Overhead Indirect costs related to specific operations, such as general product lines, organizational groups, and groups of contracts. Overhead is a type of indirect cost pool that is related to the specific operations of the firm. The three major types of overhead are material, labor, and fringe benefit (if not included in labor overhead). The three overheads differ in regard to which costs they include and how they are allocated. • General & Administrative Any management, financial, and/or other expense incurred by or allocated to a business unit for the general management and administration of the business unit as a whole • Business Unit Any segment of an organization, or an entire business not further divided into segments • Home Office Expense The expenses of an office responsible for directing or managing two or more, but not necessarily all, segments of an organization • Indirect Cost Pool A logical grouping of incurred costs identified with two or more objectives but not specifically with any final cost objective • Cost Objective A function, organizational subdivision, contract, or other work unit for which cost data are desired and for which provision is made to accumulate and measure the cost of processes, products, jobs, capitalized projects, etc.
  26. 26. Profit—Terms & Definitions Term Definition • Profit Represents the performance contracts • Fee Represents a flat charge paid as compensation for services or supplies provided and is associated with cost reimbursement contracts • Risk The level of uncertainty associated with specific factors regarding contract performance excess of revenue over applicable costs of and is associated with fixed-price type
  28. 28. SUPPLIER PART COST BREAKDOWN WORKSHEET—Part B LABOR AND OVERHEAD Labor Details # Operations Process Descriptions (6) Labor Rate (7) Std Hrs (8) Labor Cost (9) Machine Data Op. (10) Mach. Size (11) Mach. Type (12) Overhead Detail Var. Cost (13) Fixed Cost (14) 1 2 3 4 Total Labor Cost Total Overhead Cost Total Manufacturing Cost (material + labor + burden) (16) Selling, General and Administration Expenses (17) Selling Price FROM TOOLING COST BREAKDOWN—TOTAL TOOLING COST QUOTED Total Cost (15)
  29. 29. Meeting the Competitive Demands of Supply Management through Supplier Ideas Solicitation
  30. 30. Meeting the Cost Reduction Mandate through Innovative Thought and Supplier Ideas Solicitation  EPI and Concurrent      Change procurement engineering method/instrument  Volume and forecasts VMI/SMI/SOMI/ISM  Inbound freight and Cycle or lead time reduction packaging Addition or elimination  Relaxed specification, of value-added material substitution, services or service level improvements Standardization
  31. 31. Competitive Bidding— Use Ceteris Paribus  Buyers normally look at the price (total cost) as stated on each bid to determine which supplier should be awarded the PO or contract.  If there are any differences, for a fair evaluation, then allowances must be made for the differences in performance and pricing.  When comparing performance or prices the buyer should use Ceteris Paribus assumptions (everything else held constant) so you compare “an apple to an apple, not an apple to an orange.”
  32. 32. Value
  33. 33. What Is Value?—Four Distinct Kinds  Exchange Value  Cost Value  Esteem Value  Use Value
  34. 34. Value Analysis and Engineering (VA/VE) 1. An organized creative approach to cost reduction 2. Emphasis on function or use 3. Identifies areas of excessive or unnecessary costs 4. Eliminates non-value added activities
  35. 35. VA/VE Job Plan—Philips Example
  36. 36. Value Equation Quality/Worth Value = Cost
  37. 37. How To Get Started in VA/VE  Identify what is it and what     does it do? Obtain and review all available cost information Try to anticipate roadblocks Promote cooperation with VA/VE effort Seek guidance from those in management that assigned study
  38. 38. VA Is the Way—Ten Ways to Reduce Co$t 1. Use it to reduce cost in design, concept, or SOW 2. Use cross-functional teams to approve product or service offering changes 3. Consolidate supplier base using full service partners 4. Reduce paperwork with supply base by using more EDI/E-Com 5. Bundle any engineering changes or project scope changes quarterly 6. Move towards common, simple methods and standard items or services used at multiple sites or facilities 7. Use returnable dunnage or containers instead of nonreturnable 8. Identify and eliminate unnecessary testing, measuring and diagnostics 9. Reduce the number of prototypes or models 10.Consolidate “A” type purchases with suppliers’ if possible
  39. 39. Process of Determining Target Costs Cost Costs not subject to subject to Target = + cost cost Costs reduction reduction activities activities
  40. 40. Target Costing Process
  41. 41. Target Cost Breakdown and Impact
  42. 42. Target Cost Breakdown and Impact
  43. 43. Target Pricing A reduction in the direct costs of a supplier’s cost profile has more impact on your bottom line than a major percentage discount in the supplier’s price. Negotiation based on cost allows you to challenge the logic of each element of the price.
  44. 44. Vendor Preferred Supplier Marketing, Purchase Orders, Proposals, Variations in Quality Partner/Alliance Redundant Capabilities in Systems, Activities that Add No Value, Approval Processes, Contracts, Excessive Communications and Controls, etc. Cost to Serve Cost to Serve Cost to Serve Profit Profit Profit Competitive Bidding Based upon Variable Profit Redefined (Streamlined) Process Reduces Cost and Yields Acceptable Profit Reengineered Process through Close Relationship; Maintains Profit and Greater Cost Reduction
  45. 45. Target Pricing Perspective— An Example For a service contract, the total quoted price was $260,565. A 1% reduction on the price is one thing, but reducing each of the cost elements by 1% yields an actual price reduction of more than 2.5%. Individual cost elements are more vulnerable to argument than the price as a whole
  46. 46. Elements of Cost-Services Profit and Margin COSP Other Services/Overhead Service Labor Materials and Supplies Occupancy Equipment and Technology
  47. 47. Opportunity Knocks The ultimate objective is to maximize the value of each purchase spend dollar. Sometimes the buyer has a chance to gain the upper hand. This occurs when the supplying industry’s margins are healthy because selling prices rose faster than their costs escalated.
  48. 48. Low (Best) Cost Country Sourcing (LCCS) Near Sourcing Domestically Outsourcing Overseas Indigenous Localization Transfer business to provide materials or services by swapping out overseas suppliers for closer proximity to home country Transfer internal dept,activity or process to more capable suppliers or contractors to lower cost of ownership Find and develop local indigenous sources to support country markets for low cost country plants and distribution facilities Adapted in part from Ariba’s Executive Overview on this subject
  49. 49. LCCS and Supply Chain Risk Although significant cost savings opportunities exist , the risk may be greater when dealing with unfamiliar suppliers, different business protocols, language barriers and new cultures.
  50. 50. Landed Cost LC = TSC ÷ SU Note: Total Selling Cost (TSC) and Selling Unit (SU)
  51. 51. SUMMARY and THANKS © 2009 CATTAN Services Group, Inc.