May 222013
 
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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:

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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.Cost of Goods Sold Hiller Associates

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.

  1. 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).
  2. 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.”

 

  28 Responses to “If Your Company Does Product Cost Reductions, It’s Already Too Late”

  1. Moderator re-posting comment from linked-in group.

    http://www.linkedin.com/groupItem?view=&gid=49280&type=member&item=242396153&commentID=139608435&report%2Esuccess=8ULbKyXO6NDvmoK7o030UNOYGZKrvdhBhypZ_w8EpQrrQI-BBjkmxwkEOwBjLE28YyDIxcyEO7_TA_giuRN#commentID_139608435

    Roman Siemens SAYS

    It’s actually not that much about cost reduction or cost avoidance then about proper product development. It’s true, the mistake in the product design are the most expensive mistakes.
    That’s why it so important during development phases to have close cooperation between sales department, actually design office and production. Sales people know best what the potential customers need. Production can tell about what design is best for cost efficient manufacturing. The designer finally brings all that together

  2. Moderator re-posting comment from linked-in group.

    http://www.linkedin.com/groupItem?view=&gid=1075247&type=member&item=242396160&report%2Esuccess=62WUlrnddR6bgwSqXhj6sMCTLzs-Mtpi3fLJWbNsWtuooxKwgTL8r5xsvgkbozKwEkXBakadko

    John T Bushling SAYS:

    Eric,
    Enjoyed the article. I have been a proponent of cost avoidance and capturing the stats for years. Accounting has typically been the drawback because cost avoidance ‘is not real’. Last paragraph was key.

    Similar to the argument that inventory is an asset (no matter what it cost to build) vs. a costly liability.

    Thanks for the article.

  3. Moderator re-posting comment from linked-in group.

    http://www.linkedin.com/groupAnswers?viewQuestionAndAnswers=&discussionID=242879209&gid=1841351&commentID=139239521&trk=view_disc&ut=0DeUkgrbfOf5M1

    George Spiller SAYS:

    John Lyons fixes die deficiencies without sacificing die life the same as I do. In most cases we are unable to obtain the same result that would have been possible if we had a better starting point. This is a good observation on the same topic

  4. Moderator re-posting comment from linked-in group.

    http://www.linkedin.com/groupAnswers?viewQuestionAndAnswers=&discussionID=242879209&gid=1841351&commentID=139239521&trk=view_disc&ut=0DeUkgrbfOf5M1

    John Coughtrie SAYS:

    Great article! I have been preaching this to casting buyers for years, some agree but many don’t. As you say Eric, cost avoidance is not such a measurable metric UNLESS the management makes it one.
    Perkins Caterpillar is a good example (in the past anyway) of a company who does/did measure cost avoidance.

  5. Moderator re-posting comment from linked-in group.

    http://www.linkedin.com/groupAnswers?viewQuestionAndAnswers=&discussionID=242396155&gid=106516&commentID=139262155&trk=view_disc&ut=0mFAvycfjUf5M1

    Alice Bunt SAYS

    A lot of Value in this presentation! Thank you Eric for this insight.

    My company has been providing Cost Engineering Services to Aerospace OEMs for several years and we have noticed a shift in thinking from Cost Reduction to Cost Engineering. In fact our revenues will shift from 60% Cost reduction / 40% Cost Avoidance to 40% Cost Reduction / 60% Cost Avoidance by the end of this year. I expect successive years to continue the trend.

    We are now contacted more by Engineering Managers than Supply Chain Managers. It seems that Supply Chain has their hands full to get the Quality and Delivery requirements from the suppliers. Those are ongoing issues no matter what the negotiated price.

    We have worked in teams with OEM Design Engineering, OEM Finance, OEM Purchasing, Supplier Sales, and Supplier Manufacturing Engineering to bring projects to production at or near the target cost. Fro there, the daily issues of Quality and Delivery have no distraction, the focus is on those.

    Especially valuable was your comment of getting the process and culture right before spending a lot on manpower and software. I’ve seen the aftermath of poor preparation and it set the OEM back about 10 years in Product Cost Management.

  6. Moderator re-posting comment from linked-in group.

    http://www.linkedin.com/groupItem?view=&gid=49280&type=member&item=242396153&commentID=139869110&report%2Esuccess=8ULbKyXO6NDvmoK7o030UNOYGZKrvdhBhypZ_w8EpQrrQI-BBjkmxwkEOwBjLE28YyDIxcyEO7_TA_giuRN#commentID_139869110

    Janson Kok See Chen SAYS:

    Don’t worried for my Company having the cost problem ! Actually, my Company is the best “low cost” company to provide the best quality for all customers in world ! In fact one company can provided any “low cost” and “good quality” same as my company, behind must have a good, super and cheaper engineer support it. I’m one of this support engineer who’s working in my Comapny with more 15 years with hardy.

    Do you believe my saying ?

  7. Moderator re-posting comment from linked-in group.

    http://www.linkedin.com/groupAnswers?viewQuestionAndAnswers=&discussionID=242879209&gid=1841351&commentID=139926356&trk=view_disc&ut=23kL-CuxFxmlM1

    Jon Rush SAYS

    Excellent article! Cost avoidance is part of what I term very simply as “impact”. Surprisingly, not many companies that I’ve had the opportunity to interact with have a great handle on this factor. It’s a shame, as so many of the “acceptable” metrics today do not necessarily affect the bottom line and let’s face it folks – we can focus on EBITDA, etc all day long, but it’s that bottom line that is the pulse of our business health. Sure, we’ll have some up’s and downs, but the bottom line can’t as easily be affected by shell games as the individual sums of that metric can.

    Hat’s off to the organizations that address the “soft costs”, such as cost avoidance. Your margins will thank you!

    • Jon,

      Thank you for your interest. To be honest, I take umbrage at calling Cost Avoidance “soft costs.” That is the PROBLEM! Managers call cost avoidance “soft” cost, when it is actually a “harder” cost than cost reductions.

      • Eric,
        You and I are on the exact same page. I’m simply using industry jargon to be easily understood. Bottom line is that until “impact” is embraced and effectively measured, companies will continue to struggle.
        By Jon Rush

        • Moderator re-posting comment from linked-in group.

          http://www.linkedin.com/groupAnswers?viewQuestionAndAnswers=&discussionID=242879209&gid=1841351&commentID=139926356&trk=view_disc&ut=23kL-CuxFxmlM1

          John Coughtrie SAYS

          It’s interesting to see healthy banter on this topic, why aren’t more people participating?

          @Jon – in your role as a buyer of commodities, do you have a “Cost Avoidance” team supporting you? I ask this because so many suppliers are so frustrated, that they often don’t bother to suggest cost avoidance these days.
          Why are the suppliers frustrated? In my experience it’s because their customers, often (not always) present an almost finished product design for tender or quotation. The supplier can make representation regarding cost avoidance but, the designers have shut the window of opportunity.

          • Jon Rush SAYS

            Mr. Coughtrie – In response to your request, unfortunately I have not been in an organization that has an official entity focused on cost avoidance. The product is sourced much in the same vein as described in your comment, however I must come to the defense of my current company as ability for a supplier partner to have influence in the product was the primary reason for my coming here. As a supplier before I was an employee, I was thoroughly impressed with the collaborative environment between both supplier and customer Engineering groups to affect positive change in the product.

            Not exactly what I think you’re looking for, but at a quasi-functional piont at least.

            How has such a cost avoidance function been implemented in your history? I’m very interested in the structure of such a function.

            Thank you!

  8. Moderator re-posting comment from linked-in group.
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    Bart Grosemans SAYS:

    Hi guys, i have spent my career in thebigger companies, where cost driven designing is part of the culture.
    To achieve this, you need some decent overhead to set up procedures, instructions, gather info to set up or determine new processes. Smaller companies often cannot afford such overhead.

    Now even th ebigger companies seem to suffer from this overhead drainage, cost pressure is so intense that the necessairy engineering support , to work ahead of the bunch, become too expensive. So whilst the market would benefit from cost designing , that same market also asks for cheap prodcuts now, cheaper than cheap, by doing this creating a new cost problem in the near future.

  9. @ Bart

    That is an interesting observation about the cost to do Product Cost Management. However, I see that as either an excuse or a sign that people are practicing Product Cost Management incorrectly. Much like the failure of Activity Based Costing (ABC), a large part of the failure people have with PCM is their obsession of having “accuracy” beyond the inherent noise level of the system.

    It is possible to set up a model for the cost of factory and material resources that is reasonable accurate for design decision making purposes (evaluating design idea A vs. idea B vs. idea C), and for identifying the bottlenecks in factories.

    We want high relevance, not high reliability for good Product Cost Management.

    Eric

    • John Coughtrie SAYS

      @Jon, your explanation is clear.

      My experience of formal “Cost avoidance” teams has always been driven by the purchasing function of the customer. This has been initiated sometimes by the customer and sometimes by ourselves as the supplier.

      The fundamental task is in the early supplier selection. The supplier or “supply partner” selection must be during the early product design stage!

      Sometimes this can even mean a complete change in manufacturing process required for the product. A pressing can become a casting, an Iron casting can become an Aluminum casting, an aluminum casting can become a forging. Rarely does the customer “design team” have enough wide ranging manufacturing experience to select the absolutely correct process. Also, rarely do potential suppliers offer alternatives which may preclude them from the bidding process.

      That puts you back to needing a “cost avoidance” team who are open to all possibilities but, crucially, are able to give logical analysis which can be quantified as a Metric.

      Good “cost avoidance” teams can be made up of staff from the buyers company and a cross section of their best “supply partners”. That way you can get quick unbiased recommendations with cost estimate comparisons validating the cost avoidance.

  10. Moderator reposting comment from Linked in group.

    http://www.linkedin.com/groupAnswers?viewQuestionAndAnswers=&discussionID=242396153&gid=49280&commentID=140716738&trk=view_disc&ut=0ZJunPA-_onRM1

    Juan León Sánchez SAYS

    The key factor is, when a company need to reduce the cost is an indicator of a bad cost controlling, a good planner has to be always looking for new ways to reduce the costs. In my opinion, cost controlling and cost reduction have the same level of importance and they have to ‘work’ together. The highest cost in my experience are the workforce and the inventory costs. A lot of mid size and large companies have a bad inventory management. It occupate an space in the warehouse (equal to money every month) and generate a lower level of quality.

    The correct worker managing the inventory combined with the automatization of the processes can be a way to reduce the cost with an impact of the final price of our products. Other way to reduce the costs in our company is look for the gap in our production line, I mean, which products can use common parts to obtain the same result? If we can find it we will reduce the cost of our product (better prices from the supplier), an easier operations management.

    I think the example below is addecuate to our conversation. Do you think the decision had a direct impact in the customer satisfaction?

    http://www.nbcnews.com/id/3073562/ns/business-us_business/t/how-cure-airlines-ills/#.UaYm5tLVDDs

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