Have you ever walked into a dining room with several pictures and seen that one picture that is not hanging parallel to the floor? If you’re a recovering engineer like me, you feel an overwhelming urge to correct the problem. You just can’t be comfortable until the frame is in alignment… unless you find your molding or floor/ceiling are not parallel. Then you have bigger problems!
Why does a slight misalignment (maybe just a couple degrees off bubble) set off instant and loud alarm bells in your brain? It’s because the human brain is very sensitive to two things:
- Discontinuity (especially non-monotonic functions)
I was having a lively discussion the other day with a director of pricing at a Fortune 500 distributor. We were talking about how this affects product pricing. For example, when you have a catalogue with millions of products, it can be very challenging to keep pricing consistent. Consider the figure to the right. The orange dots could be product offerings for electric motors, graphed by the price vs. a performance attribute, such as horsepower. We expect price to increase with performance. But what happens when you find the blue or green dots? The brain says “that’s not right!”
Now, there may be legitimate reasons for the negative or positive arbitrage. Maybe there is a sale? Maybe there is an economy of scale on selling that particular model? However, that brings us to the next challenge, pricing functions that are not monotonically increasing (i.e. they have a negative slope for at least one product model). This is a problem, because this is difficult for even economies of scale to overcome. And, the customer does not like it, because it makes the vendor look as if their pricing is capricious, which causes distrust.
Discontinuity in Product Costing
This happens in costing too. For example, although “sunk cost” is an important concept in capital investment, it can wreak havoc on product costing. If a certain machine is fully depreciated and now has a greatly reduced overhead rate assigned by the accounting department, this will likely confuse the purchasing or engineering folks using a Product Cost Management software. It will either cause them to distrust the costing software or your manual analysis or it will drive them to cost all the parts they can using that
This is yet another curse of the difference between the data relevance needs in order to perform good cost or pricing analysis versus the data reliability needs, over which accountants typically obsess. From an accounting point of view the depreciated resource is “free” (or highly discounted). However, from a costing viewpoint, the abilities of that machine will have to be replaced sooner or later. Worse, the distortion in the overhead rate will lead to underestimations of cost, and often, unpleasant surprises late in product development and sourcing.
What to do about non-linearity, discontinuity, and non-monotonic pricing/costing functions:
- Remove them – the first solution is to correct the false arbitrage by fixing the pricing or costing data. For example, in the case of the machine that is fully depreciated, change the overhead rate back to reflect the cost at which a new machine with the same capability would depreciate.
- Highlight them – if the pricing or costing curve has an unexpected kink in it for a legitimate reason, then you should make everyone aware of this and use it to your advantage. For example, in the catalogue motor example, advertise the sale and let people know this is not natural or permanent!
A lot of mistakes in pricing or costing are difficult to notice without close inspection, but remember anything that violates the brains desire for smooth regularity will stick out like a sore thumb… or a good deal.
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.
If you are a Product Cost Management person with an inner nerd like us, then you probably love and the Lord of the Rings trilogy by JRR Tolkien. One of the iconic characters in the book is the king in exile, wondering the wilds as a Robin Hoodesque type of character, a man named Aragorn. One of the things that makes this character so compelling is the fact that he, and his brothers-in-arms, the Dunedain Rangers, secretly wander the wilds protecting those who are blissfully unaware of the evil all around them.
Why do we love Aragorn, who goes by the nom de guerre “Strider” so much? It’s because Aragorn is unpretentious, self-sufficient, self-sacrificing, and yet dangerous and mysterious at the same time. Aragorn gets things done, even when those around him don’t realize it. And when those around him do get to know him, they are astounded at just how powerful, efficient, and clever he is.
Yes, Strider is a misunderstood man, as Mr. Butterbur, the bartender at the Prancing Pony, the inn at Bree says,
He’s one of them rangers. Dangerous folk they are — wandering the wilds. What his right name is I’ve never heard, but around here, he’s known as Strider.
Strider and the rest of the Rangers don’t really have a home, and so it is also with Product Cost Management in most organizations. It’s very rare to find Product Cost Management a department that is not a part of a larger organization. And, it is always seems to be the red-headed stepchild of that organization. No one really knows exactly who these guys are or what they do, except that “I think they know a lot about cost and manufacturing stuff.” Product Cost Management never seems to fit in with the organization in which it has been placed, and everyone is always wondering if it really belongs in another organization.
So where does product cost management belong in the organization? That’s a difficult question because Product Cost Management relies so heavily on information from four different organizations. In order to do their work of profit maximization, expert in PCM deep domain knowledge of the following:
- What is the geometry a part, a subsystem, a product, and how does the geometric features, tolerance, and materials of these physical items relate to their costs?
- What is the costing structure of the organization, what are its overhead rates, what are its labor rates?
- What suppliers does the organization have and what are the cost structures of these organizations? What are their manufacturing capabilities?
- What is the organization’s internal manufacturing capabilities?
These are very broad pieces of information that are flung across the organization. If we look at the figure above, we see that these pieces of information are hidden in the four main functions of a manufacturing company: engineering, finance, purchasing, and manufacturing. Product cost management, like the Rangers in JRR Tolkien’s trilogy, seems to live in the no man’s land or wilderness between these organizations, where few people from any of the four organizations are comfortable operating.
Why are most people so uncomfortable operating in this nexus? Well, that’s a subject for our next post.