As some of you may know, I joined McKinsey & Company a little over two years ago as an expert in their Product Development Design-to-Value practice. (Don’t tell anyone, but I do a lot of work for clients in the purchasing space, too!).
It’s been a whirlwind of a couple years, but I finally got some time to publish some new thought leadership. I just did this on McKinsey Ops Extranet, sadly not here. But, the good news is, you can join for FREE, so don’t be worried when you see you need to register.
Here’s the first. Enjoy! Oh, and may sure to 5-star my post if you read it and like it. Thanks.
(Welcome to the standard costing party! What’s this all about?)
One of the most frustrating things for many engineers is understanding the quotes they receive from their suppliers. They want to know how these quotes compare to their own internal estimates. Unfortunately, most engineers are not skilled at getting the right answer.
Strangely, engineers are typically very good at this in their personal lives. Let’s say you’re going to buy a new stereo receiver. In a matter of minutes you have the following options laid out:
- Option 1 – Amazon ($300) + Shipping ($0) + Squarespace extended Warranty ($50)
- Option 2 – Amazon vendor ($270) + Shipping ($15) + Squarespace extended Warranty ($50)
- Option 3 – Stereo Shop ($320) + No Shipping ($0) + Included Extended Warranty ($0)
In your personal life, you not only outline how much costs are, but where they are. That is, in which cost bucket does each dollar reside? So why is this so hard when dealing with a part quote at work? The answer is: it shouldn’t be!
Don’t ask what, ask where
The first step to unraveling quotes is to put the numbers aside – what matters first is to decide into which cost buckets each dollar should go. To illustrate this, let’s consider buying a lightly machined casting.
First ask, what resources go into delivering this casting to your shipping dock? Take a look at the figure below. On the top line in orange blocks, we show the various cost buckets for the casting. These include the raw material that is melted, the various processes that are applied, the machining, any painting, and then margin and logistics.
Start with your estimate
We suggest that your starting point should be your own internal cost estimate from your cost expert, your spreadsheet, or from a third party Product Cost Management calculation tool.
It’s likely that the level of detail in your calculation method will be deeper than what you receive from suppliers. Even so, your tool or spreadsheet may not provide a number for each bucket of cost. In our casting example, our initial estimating method did not provide margin and logistics. Becaues these are real costs we will list them, noting that we don’t know what numbers to use for those costs at this point.
Lay out what you know from the Supplier Quotes
Now, it is time to match up your supplier quotes. We show three different quotes in the casting example. Your purchasing department may give you more quotes or less quotes. However, in our experience, three shall be the number of the quoting, and the number of the quoting shall be three. (If you don’t get that reference, please see the attached video).
The quotes you receive probably won’t line up exactly with your estimates. Suppliers, as in example Quote 3, rarely provide a detailed breakdown. Regardless, it’s important to know which costs are included in the $23.00. Are any costs included missing?
But what if I am missing a cost bucket?
It’s common to not have an estimate for every cost bucket from one single tool or spreadsheet. Thankfully, there are several methods to triangulate to a better estimate.
- Look at past part quotes for similar parts.
- Ask an expert. For example, your shipping department may know what it would cost to ship similar casting parts.
- Use a different estimation tool that does include the missing cost bucket.
- You can also surgically lift and triangulate cost buckets from the quotes themselves. For example, you could average the cost for logistics between Quote 1 and Quote 2, so your internal estimate of logistics cost becomes $1.50.
The benefits to you and your company
You may think that this exercise is just about whether you should be paying $23.00 for this casting or $20.00. That is an important question, but there are other big benefits to this method.
- Missing Buckets – One of the biggest advantages to accounting for cost buckets is to identify any misunderstandings between your company and the supplier. It is better to find out now that the supplier has not included the shipping costs than to find out later.
- Your time to shine in front of management – regardless of the final cost that you negotiate, if there is a question later from your management about why you paid what you paid for a part, you have a ready-made, easy-to-understand management slide prepared.
- Negotiation power – deep understanding of costs is very useful when talking to the supplier with whom you decide to negotiate. Of course, you cannot show them the numbers from other suppliers’ quotes, but there is nothing wrong with showing your internal should-cost estimates.
- Learning by doing – after you go through this exercise several times, you will start to develop an intuitive feel for what drives cost in a commodity class. In our example, you will start to understand the relative magnitude of machining vs. casting cost vs. raw material for lightly machined castings.
They say that “It’s not about the destination; it’s about the journey.” The good news is that with part quote evaluation, both the journey has value (as shown by the four points above) and the so does the destination (e.g. paying $20, rather than $23 for a casting). Enjoy both!
Hiller Associates has been invited to become an author on ENGINEERING.com. The Canadian company, headquartered in Ontario, has become one of the most influential voices in engineering worldwide. ENGINEERING.com reaches thousands of people, who work in the many disciplines of engineering, every day with the freshest and best content on a variety of subjects, including:
- Designer Edge
- Design Software
- 3D Printing
- Careers in engineering
Eric Hiller, managing partner of Hiller Associates said,
We are grateful to ENGINEERING.com for the opportunity to share our insights in Product Cost Management and other topics that sit at the nexus between finance and engineering with the readers of ENGINEERING.com. ENGINEERING.com has a great readership of influential people who are driving the next generation of products around the world and who range from individual contributors to engineering executives. We look forward to continuing to work with ENGINEERING.com.
Hiller Associates is writing for the ENGINEERING.com feature area called “Designer Edge,” which contains articles on techniques and tools for better design engineering. HA kicked off it’s authorship with an article focusing on the challenges that engineers face when presented with supplier quotes that the engineers have to understand versus their own internal should-cost estimates. CLICK on the the title of the article below to read the article at ENGINEERING.com.
John Hayes, President of ENGINEERING.com, said,
We welcome Eric ‘s authoritative and often humorous voice on the important, yet rarely discussed, topic of product costing.
Hiller Associates will republish the ENGINEERING.com article in its entirety on our own Product Profit and Risk blog later this week.
Anyone who has ever heard the famous NPR show the Prairie Home Companion will smile warmly, remembering warm and disarming voice of legendary storyteller Garrison Keilor talking about the fictitious Minnesotan town, Lake Wobegon. Garrison’s sign-off to the show has entered pop culture: “And that’s the news from Lake Wobegon, where all the women are strong, all the men are good looking, and all the children are above average.”
We know of another place called Lake Costbegone. It’s a magical land of companies tightly clustered around a lake of profit. Lake Costbegone is the vacation spot of Product Cost Management. Lake Costbegone (and maybe many other corporate disciplines besides Product Cost Management) are similar to Lake Wobegon.
That’s right. At Lake Costbegone ALL the companies are, at least, average.
The post that we put up a couple days ago (Is the View Worth the Climb in PCM?), showed the effect on a company’s product cost, based on whether a company is best in class, industry average, or a laggard at Product Cost Management. The splitting of the companies into these three categories is almost universal in Aberdeen research reports, and other analyst firms use a similar framework, too. However, we don’t think we had ever met a client or potential client to that thinks that they are in the laggard category.
Sure, there are people that are more realistic and honest within each firm, who will tell you “off the record” that their organization is doing very badly at Product Cost Management, or whatever corporate initiative we are talking about at the time. However, no one wants to proclaim in the sight of others that their organization is a “laggard.” Apparently, admitting that your organization is not, at least, average is the corporate equivalent of a stock analyst giving a sell signal. It’s just not done. Stock analysts typically give only three signals: Strong buy, Buy, and Hold. No one really knows what “Hold” means, but we are all pretty sure it means, “You might wanna think about dumping that stock.”
Being “industry average” might mean exactly that, the organization is industry average in whatever technique on which the firm is evaluating themselves. However, they could also be a laggard in need of great improvement, but just don’t want to admit it.
The funny thing about the post from a couple days ago is that the gap or potential between industry average and best-in-class companies is actually *bigger* than the gap between the laggards and the industry average (see figure to the left). Therefore, if you are in the industry average, you should be quite excited about getting to best-in-class, because there is a big carrot to do that.
Our opinion is that companies are better off when they mistakenly consider themselves laggards when they are really industry average than when they consider themselves industry average when they are really a laggard. The industry average designation is much more of an invitation to apathy in Product Cost Management. No one wants to be the laggard, and that’s a good thing! What’s the worst thing that can happen, after all? If you misclassify yourself as a laggard and you actually are the industry average, your effort to get out of laggard state will probably move into being best-in-class.
And that doesn’t seem like such a bad thing.
I worked with a colleague once that used the expression: “Is the view worth the climb?” That’s an interesting expression and a very visceral way of expressing the fear that we all have when undertaking a new project in our companies. New projects always require not only capital in the form of money, but also to human capital in the form of resources, emotion, and hard work. Careers can be made by a successful project… or destroyed by a major project gone awry. Is the view really worth the climb? Will the rewards be worth the effort?
For example, it’s easy to say that people should work on increasing their profit by reducing their product cost. We all understand that this intuitively seems like a good thing to do. Mathematically, who can argue? If you reduce your product cost, you create profit that drops the bottom line. The question is: how much profit will drop to the bottom line? Is the view worth the climb?
To answer this question, let’s take a look at a graph we made of data from a 2010 Aberdeen study on product cost. The graph shows the average effect on product cost over two year period for companies. The companies were broken into the standard three Aberdeen categories (Best-in-Class, Industry Average, and Laggards) based on other criteria of how they manage their Product Cost Management efforts.
The results were pretty impressive. In two years, best-in-class practitioners of Product Cost Management reduced the cost of their products on average by 7%, whereas companies that were average practitioners of Product Cost Management were only able to reduce cost by an average of 1% .
Let’s put this in perspective. The table below shows an example company with $10 billion in revenue, 80% product cost (as a percent of sales), and a 5% net margin. On an annualized basis, the difference between best-in-class and the industry average is the difference between $560 million and $80 million, respectively, of extra profit. Note also that the laggard’s product costs increased 3% per year equating to a $240 million profit loss.
These numbers represent the view (the results), but what about the climb (the investment)? The Aberdeen study does not investigate this. However, one should ask: how much money *should* the company be willing to invest to capture an incremental $480 million per year of profit? 100 million? 50 million? $25 million? What about $10 million? Would your company even invest $10 million?
It’s something to think about.
In the last few weeks, there has been a hearty discussion on this blog about controlling costs before versus after a product launches. This got us thinking about this situation, we thought that it could be plumbed to greater depth.
Therefore, Hiller Associates is proud to announce its latest article in IndustryWeek, entitled:
If you would like to read the article, click the link above to go to IndustryWeek.com. Later in the week, we will post the article, in it’s entirety, on this blog.
In last week’s post we talked about where Product Cost Management sits in the organization . We concluded that Product Cost Management lives in a weird no man’s land between purchasing, engineering, finance, and manufacturing. Because the area is a wilderness, we used the analogy the people seriously pursuing Product Cost Management in companies are similar JRR Tolkien’s legendary Rangers in the Lord of the Rings trilogy . The Rangers go about doing good and benefiting the general public, even when the public does not recognize the good they are doing. Sometimes, the general public even considers these solitary trackers and warriors as meddling, or even, sinister. We even compared the best product cost management folks to the most famous of all Rangers, Aragorn, son of Arathorn .
Several people wrote us about this article, very pleased with the analogy comparing product cost management people to Tolkien’s Rangers. They also validated our assertion that Product Cost Management in the organization, lives between other major functions. We must say that EVERYONE was on board with the post and feeling very good about it.
This week we’re going to burn through all that good will and make everybody angry!
We’ll do this by explaining why people from every one of the major functions in a manufacturing company are ill-equipped for Product Cost Management. Are we doing this for the schadenfreude* of internet lulz? No, we’re doing it because we believe these paradoxes are true. These are the unspoken but often thought, truths that need to come to the light of day.
*For a PG-13 musical definition of schadenfreude from Avenue Q, click here.
It’s unfortunate we have to say this, but we’re not embarrassed of it either. First, one disclaimer:
The statements below are obviously generalizations of the functions within the organization, as well as of the people of that make up those functions. Throughout our firm’s long experience in industry with Product Cost Management, we have met many individuals within each of these functions that do not fit the stereotypes below. However, the paradox below truths hold in general. Any resemblances to any person, living or dead, is purely coincidental.
Why each major function in a manufacturing company is so poor at Product Cost Management
The short answer is, that engineering really doesn’t care about product cost that much. Product cost is a distant second or third , or maybe a fourth priority, compared to other product attributes such as time-to-market, quality , or performance. We say this despite the fact that we have data of our own, as well as data from other analyst firms, that show that when asked about product cost, product development executives will prioritize it near the top (usually 1st or 2nd). However, our experience in practice is that when the rubber meets the road, product cost is not the first or second priority. On a personal level, the paradoxical thing is that engineering is actually better equipped than almost any other function to do a good job at Product Cost Management.
The reason for this is that a major challenge of Product Cost Management is linking the physical characteristics of a part (e.g geometry, features, mass , time to produce the part, etc.) to the financial (dollars and cents). Engineering lives and breathes the physical world. Engineers are trained to understand the physical world and to control it from the very first day they stepped foot into engineering school . They’re not afraid of the physical world . The problem is that product cost, despite the statements of most engineering executives, really is one of the last priorities to address when you’re in the middle of a product development program.
Finance relationship to PCM is the exact opposite of engineering . Finance DOES have the incentive to control product costs. In fact it, it’s their whole world. The problem is, most finance people are not from an engineering background, and are, quite frankly, terrified of the physical world of 3D CAD , features , and even if the manufacturing floor. To them, it is very uncomfortable to leave the safety of dollar numbers on an excel spreadsheet. They are also often hampered by the accounting classes they took in college. Specifically, Financial Accounting thinking has come to dominate the way they perceive Managerial Accounting in a way that is wholly inappropriate. Accounting , in reality, has a backwards looking allocation-of-cost viewpoint, rather than the forward looking predictive cost paradigm, which is needed for product cost management . The problems with the current accounting paradigm are certainly worth a future blog post, if not magazine articles or whole books !
Purchasing often suffers from the same malady as finance. They don’t understand the physical world very well. Many buyers also have a bit of a multiple-personality problem when dealing with product cost. On one hand, buyers are suspicious that the supplier is not telling them the truth and charging them too much. On the other hand, if a Product Cost Management person or another should-cost source provides the buyer with a product cost for a part that doesn’t match with the supplier gives them, the buyer often immediately concludes that the should-cost (not the quote) must necessarily be wrong . Riddle me that? They also have a a commodity worldview. It’s more beneficial for them to focus on large groups of parts within a commodity, as opposed to single parts within a product that is being developed. Finally, the incentive of RELATIVE cost reductions (i.e. “year over year” cost reductions) sets up a very bad dynamic with Product Cost Management. PCM is first focused on making sure the product comes to launch AT the right cost, rather than reducing cost year over year later. All these topics are worthy of extensive articles, in and of themselves, but that must wait.
In some ways, manufacturing is probably currently better equipped to deal with Product Cost Management than anyone else in the organization . Manufacturing people are usually comfortable with the physical attributes of the product, just as engineering people are (although they do not have the depth of knowledge in this respect that engineering typically does). Manufacturing does care about cost, just as finance does. They also have a practical nature like purchasing and are quite likely to be comfortable dealing with suppliers. However, there are PCM challenges and paradoxes for manufacturing, as well. First of all, due to rampant outsourcing in most organizations, the only manufacturing left in many companies is final assembly. Therefore, the manufacturing guys are often absent from the PCM ballgame. Their concern about how they’re going to assemble the parts together for the final product, not how to make the parts. Secondly, manufacturing is a very busy place, concerned with the here and now and fighting fires, rather than more strategic pursuits such as Product Cost Management.
What to do?
So, we’re all in a bit of a pickle functionally with Product Cost Management. The table to the right gives a summary of the paradoxes we face functionally. It also adds one global problem that we talked about last week, which is that PCM doesn’t really fit nicely within any of these functions.
Given these structural problems in the organization’s functional cultures, is it any surprise that most companies struggle with Product Cost Management?
What’s the solution? It’s probably too complex of a problem for one Silver bullet. However, hopefully in the next post we can propose at least one possible way to move beyond the organizational problems and paradoxes discussed today.
Good Morning PCM world,
Another reader sent in questions with respect to the article 2012 revenues of the Product Cost Management market. However, this question was a little more broad:
Is there any difference between Project cost management and Product cost management from your your point of view?
That’s a very simple but good question. We had not considered addressing it before the question came in. The short answer is “YES!,” there is a big difference. The big difference is as simple as the two words:
PRODUCT vs. PROJECT
We have defined Product Cost Management before here as:
Product Cost Management – An agreed, coherent, and publicized system of culture/goals, processes, people, and tools following the product lifecycle, that ensures the product meets its profit (or cost) target on the day that it launches to the customer.
The definition of “Project Cost Management” is more murky. The wiki entry on Project Cost Management is less than satisfying. Here is the main definition portion of the entry:
“Project cost management (PCM) is a method which uses technology to measure cost and productivity through the full life cycle of enterprise level projects. PCM encompasses several specific functions of project management that include estimating, job controls, field data collection, scheduling, accounting and design.”
Other resources for a definition are Ecosys EPC, the Project Smart blog, Hard Dollar Software, and TutorialsPoint. Based on the knowledge from these sources, we would define Project Cost Managemenet as:
Project Cost Management – Project cost management is a group of techniques, including budgeting, forecasting/estimating, change control, field data collection, scheduling, accounting and design, and reporting that are used together to ensure that a project is completed at its target cost and on schedule. It is most often associated with the construction industry. In construction projects, it would include tracking of both project costs and the costs of the materials for structure being built. In the world of manufacturing, it would only include the costs of the project such as R&D and SG&A.
Note that in the definition we make a distinction between two very different industries: Manufacturing vs. Construction. In construction, we are most often making one thing — some sort of structure WHILE we are in in the midst of the project itself. In manufacturing, we are undertaking the project in order that we make many copies of a product in the future (when production begins). In manufacturing, we call the project, “Product Development,” including sourcing, testing, design, manufacturing planning, etc. In manufacturing, which is our primary focus on this blog, there is a fundamental difference in Product vs. Project cost management that goes all the way to the income statement itself.
See the figure to above to understand the focus of Product vs. Project Cost Management on an example income statement for a manufacturing company. The question then probably arises in everyone’s minds: Do we need both and which one is more important? That’s beyond this article, but maybe we can talk about it further in the future, if there is interest. We’ve left you some clues to answer those questions yourself in the figure above.
In the meantime, somebody call the Project Cost Management guys and tell them they are infringing our acronym! Everyone knows that the *real* PCM stands for PRODUCT Cost Management!
People complain about the profitability of products, especially early in production, but how often do products actually miss their profitability at launch?
According to the latest research by Hiller Associates, most companies miss product cost targets. We asked almost forty people from a variety of corporate functions “How often do you meet or beat product cost targets at launch?” The results follow the familiar 80/20 rule of many business phenomena. On 17% of respondents said that their companies meet cost targets Often or Very Often.
That is not an impressive showing. We would not accept 17% as a pass completion percentage from a NFL quarterback. That’s not even a good batting average in baseball. So why do we put up with this in our companies? It’s also interesting that almost the same percentage of respondents (15%) don’t know enough about product profitability to even guess how well their companies are doing.
Companies are understandably careful with releasing actual product profit numbers. Still, it would be great to have a more in-depth academic study done, in which actual financials were analyzed to answer the same question.
How often does your company meet its product cost targets? Does anyone know in your company know? These are questions you cannot afford not to ask. Is your firm the 17%… or the 83%. If you are in the 83%, consider starting or improving your efforts in Product Cost Management.