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Product Cost Management Precision… Ignorance is Bliss

Jun 032013

Numbers. They have such a comforting certainty to them, don’t they?

Words can be interpreted. But, numbers, they have that beautiful mathematical ring of truth. I was thinking about this the other day, when I got a number from a friend. I was helping him review a model he had made, and I asked him what the median result was from the model. He told me 16.42%. I ask him, “Do you believe it’s 16.42%?” He responded, “Yes, 16.42%.” This was a very smart guy, with multiple advanced degrees in engineering from a great school. However, the data set from which he was calculating this percentage came from a group of people who are giving him estimates of the money they had spent on certain activities, as well as data from an accounting system. And yet, he was quite positive that the result was 16.42%. I.e., he thought that the result he calculated from the inputs had enough precision to generate FOUR significant figures.

Now, I’m sure that he would have realized, if he had sat down and thought about it for a second, that expecting this kind of precision when the inputs had virtually no precision of all, at least not the precision of four significant figures, was ludicrous. However, that’s the great thing about computers, especially when using spreadsheets like Microsoft Excel. They will give you as much precision as you want. In fact, to what does Excel default… two significant digits behind the decimal point.

What I find really funny about this is that most engineers have learned the hard way, over time, that there is this thing called “tolerance stack-up.” In other words, no matter what you specify on a CAD model or drawing, a machine only has so much physical capability to hold that dimension. Therefore, engineers become very proficient at specifying tolerances. In recent years, they have even become much better at understanding the stack up of these tolerances on the final dimensions of a part. In fact, there are very sophisticated software packages dedicated to helping engineers do this.

In more general usage, Monte Carlo modeling became all the rage 10 to 20 years ago. Monte Carlo was an attempt to recognize the inherent noise in numbers that we measure, and how that uncertainty affects the models that we make, especially financial models. However, the funny thing is that when it comes to calculating product costs, people ignore the precision question, and just assume they have the precision they wish they had.

Take a look at the figure below . Let’s go through a simple product costing in concept. For the part we are looking at, we first need to know the physical quantities that are used in making it. For example, we need to know the mass of the part, but that’s a tricky thing, because we have scrap and varying amounts of mass could be used up in certain processes. So, we might be +/-1-3% in our estimate of how much was used. Similarly, we need to know how much time is actually spent on each machine. However, this varies batch to batch, and measurements aren’t always so accurate. There may be many processes that make up the part, including extra inspections and re-work. Let’s say our measurement of the time it takes has a range of 5 to 15%.

Until this point in the analysis, at least we’ve been dealing with physical quantities, not financial quantities. But, if we move to financial qualities, the problem gets much worse. Even material rates are not such a certain thing. They move around over time with various surcharges for this and that from the different material providers. And, the number depends on what material is sent t0 what lines, etc. Labor rates and overhead rates are far more black magic. Accountants with green eye shades spend endless hours calculating these rates from monstrous ERP systems, using Byzantine Activity Based Costing allocation schemes. We hope that the allocated rates are accurate to the real truth on the floor, but I don’t think we can really expect them to be more than +/- 10-20% from what’s really going on.

Never fear though! At the end of the calculation, we have calculated that this particular part cost is $93.45. Why $93.45? Well, that’s what our spreadsheet model or our product cost management software told us. And, of course, a cost NEEDS to be within 10% of what we think the real cost is.

If the product cost management user actually calculated the tolerance stack-up of the uncertainties of the inputs that went into that cost, they would probably find that the costs are more than +/-10% from the true cost. If they seriously considered the possible precision, would they say the part cost $93.40-93.50? I doubt it. Would they say it costs $92.00-93.00? Nope . They probably would say that the part could cost between $88-$97. But, a range like that is not very comforting . It’s much more fun to hit that little “$” format button on Excel or cut & paste the number from the product cost management software .

It’s $93.45. That’s what it is. Because ignorance is truly bliss in the world of Product Cost Management.

If Your Company Does Product Cost Reductions, It’s Already Too Late

Product Cost Management, Uncategorized 28 Responses »

May 222013

As we posted on Monday, Hiller Associates has a new article in IndustryWeek titled:

If Your Company Does Product Cost Reductions, It’s Already Too Late

Here’s the full re-print of the article:

————————————————————————————————————————————————

Refocusing product cost management efforts from cost reduction to cost avoidance is less comfortable but far more profitable.

Executive Summary

Product cost is the largest expense for manufacturing and the key to profit.
Companies today focus on reducing cost after start of production, rather than meeting their product cost targets initially at launch.
A pure cost avoidance strategy is far more profitable than a pure cost reduction strategy.
Product cost management teaches us that the most profitable strategy is a combined strategy of both avoidance and reduction, with the majority of resources focused on avoidance.
The combined strategy requires culture change and process design, before hiring people or buying software. It is challenging, but the added profit gains are worth the effort

Product cost, which is roughly equivalent to cost of goods sold on the income statement, is the biggest expense for manufacturing companies, typically 70% to 90% of revenue. You can see COGS as a percent of sales for a random sample of companies in the table below.

Given the magnitude of product cost, one would think that manufacturing companies would have the process of controlling product cost down to a fine art. Sadly, this is not true, and meeting cost targets at start of production in most companies is black art with the predictability of the stock market.

In this article, we will talk about two different strategies that companies use to control product cost. Let’s call them “cost reduction” and “cost avoidance.”

Cost Reduction vs. Cost Avoidance

Figure 1 shows a graph of product cost over time in the product life cycle. In the cost reduction strategy, the company goes through product development putting little or no effort into controlling product cost. Cost increases as parts are designed and added to the bill of material. The product is almost assured to exceed its product cost targets at the start of production. After start of production, the cost reduction efforts begin in earnest through a variety of techniques, such as lean, value analysis/value engineering, purchasing demanding year over year cost reductions, etc.

Hiller Associates Cost_Avoidance vs Reduction

CLICK TO ENLARGE!

A cost avoidance strategy is exactly the opposite of cost reduction. In cost avoidance, a large amount of effort is spent as early as possible in product development to meet the product’s cost target at launch. However, post launch, little effort is spent on year-over-year savings.

On the graph, we have shown the extremes of the cost reduction vs. cost avoidance strategies. Most companies are doing something in between. However, on which strategy do you think most companies focus? It’s pretty obvious from the graph, correct? Most companies obviously are going to focus on cost avoidance, correct? Right?

Why people reduce cost instead of avoiding it

The sad truth is that most companies focus the majority of the resources they use for product cost control after launch, not before. Why is this? Many who have worked in product development have heard management and others disparage cost avoidance as “not real.” Cost reductions can easily be measured; cost avoidance cannot. For example, I was paying $10 and now I am paying $8. That’s tangible and real. But, if I say, I am paying $7 now, but had I not been careful in my design, sourcing, and manufacturing decisions, I likely would have paid $10, management considers that ephemeral.

This attitude of most management is detrimental to the company’s profit. Can you imagine living your personal lives like this? Let’s say you need to get cable TV service. Would you search around carefully and find the TV channel package you wanted for $60/month? Or, would you do the following: First, do minimal shopping around and take a package for $100/month. Then, a year later, you investigate to find the “low hanging fruit” of a new deal for $90/month. Another year later, you beat on your cable supplier to reduce the price to $80/month. Next year, the “easy wins” are gone, so you really work hard to find a deal for $70/month.

We don’t shop this way in our personal lives, but most companies manage cost in this way. They do it because accountants can measure reductions. Reductions are real. People get rewarded and promoted for reductions.

Why focusing solely on cost reductions doesn’t work

Looking at Figure 2, we can split the difference between the cost reduction line and the cost avoidance line into two parts. The first is the triangular region. Even if, after years of cost reduction efforts, we were able reduce cost to the point at which the cost avoidance line starts at launch, we have still failed. In has taken years to reduce cost, and that triangular region has a name: lost profit.

Cost Avoidance Maximum Profit vs. Cost Reduction Hiller Associates.

CLICK TO ENLARGE!

It is actually worse than this in reality. We will NEVER get down to the same price as the cost avoidance line. We know from the legendary DARPA study from the 1960s that the vast majority of product cost is “locked in” very early in product development. Products are systems, and it’s very hard to extract cost fully without changing the whole system. Furthermore, the cost of making the change is much higher, post launch. Per a 2010 Aberdeen’s study[i], engineering changes made after release to manufacturing cost 75% more than those made before release. These trapped costs that we cannot get out are shown in the rectangular region on Figure 2.

What’s the solution? Do both and flip the focus

So far in the article, we have been talking about a 100% cost reduction strategy vs. a 100% cost avoidance strategy. The field of product cost management would teach us to focus on what practically works and generates maximum profit. In this case, the solution is to do the following two things.

Do BOTH cost avoidance and cost reduction– As shown by the orange line on the graph, the most profit can be made if you meet or come close to your product cost target at start of production and then focus some effort on reduction after launch. Realize that this means that management needs to expect LESS reduction each year in production (e.g. 1% to 2% a year, not 3% to 5% a year).
Flip the focus of the majority of product cost management resources before production begins– Today 70% to 90% of product cost management resources are focused on reduction. Management needs to flip the focus so the majority of effort is on avoidance.

These improvements require cultural changes in how people are incentivized and motivated. Management needs to cast the vision, educate, and walk the walk. This also requires that companies have a solid process for product cost management. Most do not. A common pit that most companies fall into when attempting this transition is to focus first on hiring more resources or buying software tools, rather than first designing a process and starting cultural change. The right people are critical, and tools can greatly enable the process. However, if the cultural and process elements are not in place FIRST, the company will waste a lot of time and money in failed attempts at product cost management and re-starts to the effort.

These are not easy changes to make, but they are worth the effort.

Consider the table at the beginning of the article again. If your company has 80% cost of goods sold and 5% net margin, then reducing COGS to 79% means a 20% increase to profit! What do you think, managers and executives? Is 20% increase in profit worth the effort? We can ponder that question in another article.

In the meantime, the next time someone disparages cost “avoidance,” show them this article and tell them, “You call it ‘cost avoidance’; I call it maximizing profit.”

A Product Cost Management Post to Upset Everyone!

Product Cost Culture, Product Cost in Industry, Product Cost Management 44 Responses »

May 062013

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

Engineering

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.

Product Cost Abilities by Functional Group

CLICK TO ENLARGE

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

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

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.

Manufacturing

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.

Project Cost Management vs. Product Cost Management

PCM Technique / Cost Models, Product Cost in Industry, Product Cost Management 13 Responses »

Apr 222013

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.[citation needed] 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.

Income Statement and Product Cost Hiller Associates

CLICK TO ENLARGE!

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!

2012 Product Cost Management Revenue Assumptions

Product Cost Management, Software Tools (for PCM, ERP, PLM, etc.) No Responses »

Apr 172013

Hello Internet and Product Cost Management industry! We’ve had strong interest in our latest article on the 2012 revenues of the Product Cost Management market. There have been several good questions that have made us want to clarify some of the assumptions in the analysis, so that people are clear on what is and is NOT included in the estimate.

Most importantly, this is an estimate of the REVENUE of the group of included vendors today in 2012. This does NOT represent the Total Addressable Market for Product Cost Management software.

The total addressable market is many times larger than the revenue of the included vendors that are estimated in 2012. In fact, we plan to write follow-up articles that discuss the total addressable market, as well as the growth rate of the current vendors in reaching that total addressable market Here’s some of the assumptions we made in the analysis:

Only the Vendors noted are estimated – The uncertainties do not explicitly take into account other vendors. They reflect the fact that most of these are private companies whose numbers are not public and that vary from year to year. Obviously, it matters where one draws the line in the analysis.
Focused on the estimation of manufactured products, not construction – there are many products in the market that focus on construction estimation, for example estimates for building an office building, an oil platform, a refinery, etc. We consider this a wholly different market. In our own experience we have rarely if ever see the companies that specialize in construction estimation also compete for the same customers for which the companies listed in this Monday’s article compete.
Not focused on job shops – there is also a separate market for software used by small “job shops.” These are small, mostly family owned businesses, that typically manufacture one type of part, for example sheet metal, machined castings, etc. Some of the included vendors may sell to a few job shops, but there software is capable of being used by bigger enterprises.
Generally Available Software – We only included vendors whose primary business involves selling a legitimate “generally available” software product (not a consulting business with internal tools)

Given these constraints, we believe this group represents over 90% of the revenue in the market today. If you know of other competitors who meet the criteria above and make over $2 million USD a year in revenue, let us know.

Keep the questions coming! We are glad there’s so much interest.

2012 Revenues in the Product Cost Management Software Market

Product Cost Management, Software Tools (for PCM, ERP, PLM, etc.) 8 Responses »

Apr 152013

Hiller Associates received a question this week from a business school asking us what the revenue of the product cost management market is. That was a very interesting question, and one that we have thought about before. However, we’ve never actually sat down to think about the question formally. So rather than answer the person privately, we thought it might be helpful to everyone to discuss this in a public forum.

Product Cost Management Software Companies Hiller Associates

Companies included in the Revenue Aggregate

There’s good news and there is bad news with respect to the estimation of the size of the Product Cost Management market. The good news is that the market is fairly self contained, i.e. there are only a certain limited number of players in that software market. However, that’s where the good news ends. There are several challenges to estimating the market size:

Private companies -80% of the players in the product cost management software market are privately held companies, either venture funded, or privately held by a small group of founding owners and managers. Therefore, their revenue numbers are closely guarded information that is not publicly available. This includes the PCM company that our managing partner, Eric Hiller, founded and at which he was the CEO and then the Chief Product Officer for many years (aPriori).
Bundling – the second challenge comes with the fact that some of the larger players bundle product cost functionality into the price of another larger product. For example, Solidworks Cost is a bundled-free option that is included whenever someone buys their professional or premium level Solidworks CAD product.

There is is one other good piece of news, which is that Hiller Associates knows most of the players in the market and speaks with them regularly. For some of them, we do know the revenue, and for others, we have a good idea. Obviously, we cannot share revenue numbers of an individual company, but this inside information will help us move the estimate from a wild guess to an educated guess.

Taking a look at the figure on the left, you will see the companies that we have included in the estimate. These are all the main players that we know of in the market. If there are others that we’ve missed, we’re very happy to learn about them and consider if we should add them to the market sizing.

2012 Revenues in the Product Cost Management Software Market

Those of you who follow this blog or have worked with Hiller Associates know that our philosophy is that point estimates are very dangerous and, often, not even that useful. Knowing the uncertainty around a cost number is just as important as having a point estimate of what that number is. We feel this holds true with any financial quantity. Therefore, we will provide a range of the size of this market. Please see the figure on the right, which shows are estimate of the total revenue of the company’s above for 2012. When given the uncertainty factors that we have discussed above, we feel the total market has a large range. Total revenue could be as low as $60 million or as high as, perhaps, $115 million.

Current market revenue of Product Cost Management Hiller Associates

Click to Enlarge!

Other questions that people should ask are how much of this revenue comes from services and how much of this revenue comes from actual licensing of product. Some of the companies included are primarily product companies, and most of the services that they offer are tightly bound around the product. Such services would include training on the software, implementation, and customization. However, there are others in the group that also maintain general consulting businesses. For example, several of these companies offer classes about product cost or subsets of product cost management, such as design for manufacturing & assembly (DFM/DFA). These are general classes which only relate peripherally to their products.

Estimate Methodology

To do our estimate, our methodology was to estimate the revenue of each of the included companies individually. We also did an estimate of the service percentage of their revenue on an individual company basis. Then we added up the aggregate numbers. You will notice from the estimate figure to the right that when all the numbers for service and product revenue or aggregated, there is approximately a 60/40% split between product and service respectively. This ratio of product vs. service revenue seems approximately correct, per our experience in the market.

It’s important to understand, that this estimate is four the actual revenue of these companies in 2012. It does not reflect the total addressable market for product cost management software, which we believe is woefully on realize that this moment. This is the first our discussions about revenue in the product cost management software market.

NEXT TIME: Growth Rate in the Product Cost Management Software Market

You want to be within 10% of the cost? (Internal Variance in Product Costing)

Product Cost Management, Purchasing / Sourcing 2 Responses »

Mar 182013

There are universalities that seem to cross people and cultures, such as, it’s polite to say “please” and “thank you.” These universalities also occur numerically. For example, designs that follow the Golden Ratiopop up all over the world. Many other aspects of one group versus another may vary, but there are these universal touchstones that pervade the world. The same is true with companies. Granted, one might argue that one company simply is imitating another company and that is why they share a simple practice or the important of a certain number. We believe that this is, indeed, true in most cases. Still, there are a couple of numbers in companies that seem to arise independently in all companies. We are going to talk about some of those universal and independent numbers today with respect to Product Cost Management.

The great universal number in PCM is “10%.” I have met hundreds of companies over the years, both in consulting and when I was the Founder, CEO, and then Chief Product Officer of one of the product cost management software companies. Invariably, a meeting with a company will occur, in which one of the customers will utter the “a” word: accuracy. The dialogue proceeds similar to the following:

CUSTOMER: So, how accurate is your software?

PCM TOOL COMPANY: What do you mean by “accurate?”

CUSTOMER: Uhh, um, well, ya know. How ‘good’ is the number from your software?

PCM TOOL COMPANY: Do you mean do we have miscalculations?

CUSTOMER: No, no, I mean how accurate is your software to the ‘real’ cost?

PCM TOOL COMPANY: What do you consider the real cost?

CUSTOMER: Uhh, um, well, I guess the quotes that I get from my purchasing department from our suppliers.

PCM TOOL COMPANY: Oh, I don’t know, because it depends on how close the quote is to the true cost of manufacturing the part plus reasonable margin. Are you confident your quotes are correct proxies for the true cost of manufacturing.

CUSTOMER: Hhmmmmmmm… yeah, I think think so

PCM TOOL COMPANY: OK, how close do you expect the costs from our PCM software to be to your quote [or internal factory cost or whatever source the customer believes is truth]?

CUSTOMER: Oh, you know, I think as long as you are +/-10% of the quote, that would be alright.

Ding! Ding! Ding! – no more calls, we have a winner! The customer has uttered the universal expectation for all costs produced by a product cost management tool, with respect to the “source of true cost”: +/-10%

The universal expectation of customers of Product Cost Management software is that the PCM tool is accurate to within +/-10% of whatever forecast the customer considers the “true cost.”

This expectation is so common that you would think that every customer in the world had gone to the same university and had been taught the same expectation. Of course, that is not the case, but it is a ubiquitous expectation. How did this universal convergence of expectations come to be? We will probably never know; it’s one of the great mysteries of universe, such as, why do drivers is Boston slow down to 4 mph at the lightest sign of snow or rain?

The more important question is: Is the expectation that the cost from a PCM tool should be +/-10% of a quote realistic? To answer this question, we first have to ask: How truthful is “the truth?” The truth in this case is supposedly the quote from the purchasing department. The reader may already be objecting (or should be), because there is not just one quote, but multiple quotes. How many quotes does a company get? Well, that depends, but we all know how many quotes a typical company gets: THREE!

The universal number of quotes that purchasing gets is 3, and they believe the “true cost” is within +/-10% of whichever of these 3 quotes they select as truth.

Three shall be the number of the quoting and the number of the quoting shall be three. Four that shalt not quote; neither shalt they quote two, excepting thou proceedest to three.

Variance Within Supplier Quotes

Do all the quotes have the same price for the quoted part or assembly? No, of course not. If they were the same, purchasing would only get one quote. So what is the range among these quotes? That is a fascinating question, one that I am currently investigating. So far, my research indicated that the typical range among a set of three quotes is 20-40%. That seems about right from my personal experience.

But, is the “true” price (cost + reasonable margin) contained within the range of the 3 quotes? Not necessarily. If we assume that quotes are normally distributed (another assumption that I am researching), the range would be much bigger in reality. For example, if we had three quotes evenly distributed with the middle being $100 and these quotes had a 30% range, the high quote would be $115 (+15%) and the low, $85 (-15%). This gives us a standard deviation that, conveniently, is $15. At two standard deviations (~95% confidence or “engineering” confidence), we predict that the “true cost” of the part is between a predicted high quote of $130 and a low of $70. This is a range of 60% (+/-30%). You can see this on Figure 1.

OK, but what about if we just source a single supplier. Well, there will be variance in this supplier, as well. This variance breaks down into two types: physical noise and commercial noise.

Physical noise — the difference in cost that could occur due to physical reasons, such as choosing a different machine (i.e. different overheads) a different routing (sequence of the machines), or even simple human variation from part to part or day to day.
Commercial noise – differences in pricing driven by the market, emotions, and transient conditions.

Variance in the Cost Forecast from Quotes Hiller Associates

Figure 1 – Variance in the Cost Forecast from Quotes (click to enlarge)

Physical noise can easily account for a range of 20% (+/-10%) in the quote that a supplier might provide to an OEM. However, physical noise can be quantified and discovered. A supplier can share what routing or machine they are using. The problem is that Commercial noise is very difficult to quantify. How do you quantify when the supplier believes you hurt him in the last negotiation and now he is going to repay you for it, or that he needs your company as a new strategic customer and will underbid to get initial business? Worse yet, Commercial Noise is often LARGER than Physical Noise in the quote! How big is Commercial noise? That is difficult to say, because we can’t measure it very well, but from our discussions with purchasing groups, at minimum, Commercial Noise adds at least another +/-10% .

Physical Noise	Commercial Noise
Comes from selection of different machines, routings.	Comes from market conditions, emotions, and transient conditions
Quantifiable in general by understanding the selections.	Very difficult quantifiable
+/-10% of the “factory average”	+/-20%+ on top of Physical Noise

Supplier quotes are just one forecast of true cost. There are other forecasts the organization has.

Cost Estimation Experts

What about those people in the organization with the most manufacturing and product cost knowledge? What is the noise in their estimates compared to a source of alleged truth, such as a quote. We are not sure, but we have asked another question about variance to these experts. When asked the question, “How close are you as a cost estimator to the estimates of other cost estimators in your company, people most often reply, “Probably +/-10-20% depending on the complexity of the part cost estimate or assembly.” So, we might say that the cost estimators have at least a 30% range of quotes themselves.

Historical Costs in ERP

What about the historical costs in ERP? How “accurate” are they? There’s actually at least two problems with data in corporate databases. First, sometimes it is just plain wrong from the beginning of its life in the database. However, even if it is correct initially, it gets out of date very quickly. Material cost, labor rates, efficiency, etc. change. Go ask you purchasing buyer how close a re-quote of a current part that has been in the database for three or four years will be to the original quote. To give you an idea of the magnitude of this problem, consider these findings:

The Accuracy (i.e. variance to quote) of a Product Cost Management Software

Variance in Different Forecasts for Product Cost (click to enlarge)

So, after all of the discussion of the variance within other cost forecasts, how “accurate” are the forecasts from a product cost management software? Well, if the internal variance among expert cost estimators independently estimating is 30%, the BEST the PCM tool could do would be +/-15%… IF it is controlled by experts. What happens when non-experts use this software? How much does the range increase? Who knows? Obviously, the more automatic and intelligent the PCM Tool, the less the added variance would theoretically be. But, is this added variance +/-5%, +/-10%, +/-20%? That is hard to say.

The Reality of Accuracy and Variance in Product Cost Forecasts

Regardless of the answer to the above question, the bigger questions are:

What is your EXPECTATION of how “accurate” your PCM Tool’s cost forecast is to the quote forecast?
Is your expectation reasonable and realistic?

We know the answer to question 1: Be +/-10% of a my selected quote.

To answer the second question, let’s quickly review what we know:

Source of the Cost Forecast	Common Variance Inherent in the Forecast
Range among 3 quotes	+/-15%
95% confident interval (engineering confidence in quotes)	+/- (15%+15%)
Physical noise within one single supplier	+/-10%
Physical noise plus Commercial noise within one single supplier	+/- (10%+20%)
Internal range among cost experts	+/-30%
Best Case PCM Tool used by experts	+/-30%
Non-cost expert using PCM tool	+/- (30%+ 5%?)

Common [Universal] expectation of PCM Tool Cost Forecast	+/-10%

Hhhmmmmmmm… Houston, I think we have a problem.

It just doesn’t seem that +/-10% is a reasonable expectation.

Bringing Sanity Back to Product Cost Management Expectations

What can you do in your company to help reset these unrealistic expectations? There are three things.

First make your colleagues (engineering, purchasing, etc.) aware of the reality of the cost forecasting world. Don’t let them develop uninformed and unrealistic expectations.
Don’t focus exclusively on the end cost, but on the physical and immutable concepts that cost is supposed to quantify: mass, time, tooling.
Start to quantify the internal variance in your own firm’s cost forecasts. Your firm’s internal cost ranges in quotes, internal estimates, etc. may be lower or higher than the numbers presented here. However, you won’t know until you start to investigate this.

Is this a painful realization? Perhaps, but you are already living with the situation today. It is not a new problem in the organization. If you don’t acknowledge the potential problem, you run the risk of misleading yourself. If you acknowledge the potential problem, you may be able to solve it, or at least make it better.

It’s not the club… it’s YOU! (Lean = Vertical Integration = Better Product Cost Management Part 2)

Product Cost Management, Software Tools (for PCM, ERP, PLM, etc.), Uncategorized 2 Responses »

Feb 212013

Last week we talked about the struggle in corporate strategy between Core Competency structures and Lean manufacturing. Whereas Core Competency thinking naturally leads to more outsourcing and extended supply chains, Lean manufacturing would advocate for a geographically tight supply chain, often with more vertical integration.

So, what does this have to do with Product Cost Management. The answer is “knowledge.”

The Lack of Manufacturing Knowledge In Design

One of the biggest complaints that I get from my clients is that their teams have lost or are rapidly losing product cost knowledge in the last 10 years. This is especially acute with design engineering teams, but also effects other parts of the organization, such as purchasing. Years ago, the engineering curriculum at universities became so overloaded that manufacturing began to be pushed to the side in the education of most engineers (excepting the specific “manufacturing” engineering major). In fact, at most top engineering schools today, there is only one high level survey course in manufacturing that is part of the required curriculum.

However, manufacturing and its evangelistic design missives (design-to-cost, design-for-manufacturability, design-for-assembly, etc.) were still learnable skills that the young engineers and others could pick up on the job, over time. This is because most product companies were not only in the business of final assembly, but also in the business of sub-assembly, as well as manufacturing components from raw materials. These companies employed large amounts of manufacturing engineers who were resources for the design and purchasing teams. Even for parts and subassemblies that were purchased, the suppliers were likely close by the design centers and had long standing relationships with the OEMs.

Designers and purchasing people could literally walk down to a manufacturing floor in an internal plant or drive a few minutes to a supplier. Conversely the manufacturing engineer would walk upstairs to question engineering about a design. This is nearly impossible when suppliers are often in different countries and the firm that designs does little manufacturing themselves

The Effect of Lack of Manufacturing Knowledge on PCM Tools

One of the ways that industry has tried to remedy this situation is with sophisticated Product Cost Management software. This software codifies a lot of the tribal knowledge that resided in the manufacturing engineers head. However, these tools assume that the tool users have (1) the will and (2) the skill set to properly use a PCM Software.

There is no doubt that the PCM and DFM/DFA tools today are far more advanced than they were, even ten years ago. However, the value one derives from a tool is not a function of the tool’s capability alone. There is a bottleneck problem of using a tool to its full potential. We could say that the value the PCM tool actually gives to the organization equals:

Value of PCM Tool = (Will to use tool) * (Ability to use tool) * (Potential of the tool)

People often forget about the ability component, but this is true with any tool. People buy expensive tools, e.g. golf clubs, hoping to improve their performance. However, 90% of the time, they cannot even use the set clubs they have to their full potential. Worse yet, often more expensive or sophisticated tools are more powerful and have the potential to give more value, but they are often less forgiving of errors. If you don’t know how to use them, they will HURT your performance.

In the past, with a Lean (vertically integrated and geographically close) supply chain, people used primitive PCM tools (often only spreadsheets). On a scale of 1 (worst) to 10 (best), on average what I hear from industry is that there capability to use the tool was higher, but the tool was limited and cumbersome. The users, including design engineers, knew what decisions to make in the tool, but the tool was cumbersome. Currently, we have more of the opposite problem. The PCM tools are better and much easier to use, but most design engineers are somewhat baffled on how to make what seems like the simplest of manufacturing input decisions in the tools. The “Will to use the Tool” is another problem altogether that is beyond our discussion today. However, my experience, in general, would be represented by the following table:

These results will vary company to company, and even, from design team to design team within the company. Regardless, I wonder if we are at a breakeven state from where we were in the past today in the value we get from PCM tools… or maybe, we have even lost ground. The sad thing is that the PCM tools today ARE more user friendly and requires less of an expert to use. However, is the loss of manufacturing knowledge in design engineering is so bad that it has overwhelmed the PCM tooling ease-of-use-improvements?

What Can You Do to Help the Situation in Your Company?

Obviously, nothing is as good as the osmosis of manufacturing learning that occurs from a tightly coupled, geographically close, and vertically integrated supply chain. However, the state of your firm’s supply chain is likely out of your control personally. There is some positive movement with the re-shoring and re-integration trends in industry, in general. However, there are steps you can take to improve the value your firm derives from PCM tools.

Send Engineers Back-to-School – do you offer (or better yet, mandate) classes in Product Cost Management, DFM/DFA, Target Costing, etc. for your design team? This should be part of the continuing education of the design engineer. I am not talking about training on the PCM tools themselves (although that is needed, too), but general classes on how different parts are made, the different buckets of cost, the design cost drivers for each manufacturing process, etc.
Design Cost Reviews – This is a very low tech way to create big wins. Design reviews in which design engineers review each other’s work and offer cost saving ideas should be a regular facet of your PCM process. Even better: include the engineer’s purchasing counterpart, company manufacturing experts, and a cost engineer to lead the review
Embed Experts – Does the design team have at least one advanced manufacturing engineer or cost engineering expert for no more than 20 design engineers? If not, you should consider funding such a resource. Their salary will easily be paid for by (a) the cost reductions they they help your team identify for products already in production, (b) the costs that help the team avoid in designs before production, and (c) the speed their efforts will add to time-to-market by helping the team avoid late changes and delays due to cost overruns.

In the past, vertical integrated, geographically close supply chains helped Product Cost Management in a passive way. The pendulum may be swinging back to that structure. However, even if it does, don’t rely on the “passive” Product Cost Management to help. Take the active measures described above and get more value out of your PCM Software investment.

Only 17% Percent of Companies Meet Product Cost Target

Product Cost in Industry, Product Cost Management 32 Responses »

Feb 042013

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.

Product Cost Results goals at launch Hiller Associates

CLICK TO ENLARGE

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.

Buying the shake weight as the solution to your bad product cost eating habits

Product Cost Culture, Product Cost Management, Software Tools (for PCM, ERP, PLM, etc.) No Responses »

Jan 292013

Hiller Associates recently was the keynote speaker at aPriori’s first customer conference. It was a great opportunity to both teach and learn from experts that came from a wide range of industries and geographies.

Hiller Associates’ President, Eric Hiller, discussed several topics, of which we’ll mention two here. The entire presentation can downloaded for FREE. Just click on the slide below and get the presentation: Best_Practices_for_Starting Your Procuct Cost Management Journey or Improvement.

Variance in Cost Numbers

One of the main themes discussed was the possibility of getting an “accurate” cost, meaning how possible is it to get a cost that is within a certain percentage of a fixed point of reference, such as a supplier quote. There are several ways to look at this problem that we may discuss in subsequent weeks on this blog.

Eric Hiller at aPriori STARS 1 2012 product cost Hiller Associates

Eric Hiller presenting the keynote speech at the aPriori Customer Conference

However, in summary, the presentation asked the question: what cost variance is inherent in your system already? For example, if your 3 quotes from supplier have a range of 30% from highest to lowest, then is it realistic to expect the cost that you calculate in a product cost management software to be closer than 30% away from a random quote?

It was refreshing to see how open the audience was to these concepts. The reactions to the variance concept went from wide-eyed amazement from people who were new to the cost management field, to thoughtful reflection from the veterans. In fact, the veterans reacted like men who had been reminded of a truth that they knew all along. Often, such common truths are forgotten due to immersion in the day-to-day challenges of keeping a company profitable. We call this concept having a “blinding flash of the obvious” – a BFO. Everyone in the room had that BFO, and no one wanted to argue about it. Instead, there were many comments throughout the conference that further explored this concept.

Culture is the biggest loser

Another theme of the presentation was driven by the latest research in Product Cost Management done by Hiller Associates. Those who follow us regularly know that we segment problems in our consulting work into four root causes: Culture, Process, Roles/People, and Tools.

Our latest research shows that cultural problems are the clear bottleneck in most firms’ Product Cost Management journeys. The respondents overwhelmingly agreed. When Eric ask the attendees which area was their firm’s biggest PCM bottleneck, the conference participants voted as follows, based on a rough estimate of hands in the air:

Best Practices for Product Cost Management Hiller Associates

CLICK TO GET FULL PRESENTATION

Culture 60-70%
Process 20-30%
People/Roles 0-5%
Tools 5-10%

That’s fairly shocking at a conference whose organizers are a Product Cost Management TOOL vendor. [Next time HA will have to set our honorarium higher for taking the pressure off of any problems with the vendor’s product!] Joking aside, culture is obviously the biggest problem and it is not an easy thing to change. In fact, companies often buy a PCM software tool hoping that it will somehow magically fix their bigger cultural problems.

It reminds one of obesity problems. Many companies have a culture of binging on product cost during design. In purchasing & manufacturing they continue with cost obesity denial — not know what the cost calorie count is until the parts arrive at the door with an invoice. However, instead of changing their cost eating and exercising habits, they look for a magical cure in the form of a software tool. Let’s call this “the shake-weight approach” to product cost management.

We’re not disparaging the shake-weight, or any other home exercise equipment. Certainly, all home exercise equipment can help you lose weight, just as we are sure that all of the PCM Tools can help one reduce cost. But, you have to use these tools regularly and properly. PCM software tools are too much like home exercise equipment. People buy them thinking that the tool will magically solve cost obesity. They use the tool twice and then it sits in the corner unloved, unused, and unmaintained… and, yet, people wonder why they are still product cost obese! It’s not the tool that the problem, it’s your culture. Much like changing your eating lifestyle, changing the PCM culture is really hard and tricky to do. That’s why cultural issues are often at the forefront of most of the engagements that we do with clients at Hiller Associates.

However, it was refreshing to see that the attendees at aPriori’s conference did seem to understand this problem, or at least were very open to the idea. So, maybe we are making progress on this point. Or, maybe HA needs a TV show “The Biggest Cost Loser” in which Hiller Associates works with companies to increase product profit with weekly product cost “weigh-ins.” What TV viewer wouldn’t watch that kind of riveting drama…

Now, get out there and do some product cost push-ups!

If you would like to see the entire presentation from the conference, just click on the slide image above and get the presentation: “Best Practices for Starting Your Product Cost Management Journey or Improvement.”

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