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.
It’s been a couple of weeks, since we discussed the Voices series, so if this post is interesting to you, you may want to go back and read the first two:
- Do you hear the voices? (Voices Series, Part 1)
- The Voices of Discord in Product Cost Management (Voices Series, Part 2)
In these first two articles we introduced several of the voices that are always present in the Product Cost Management conversation, including:
- The Voice of Hopefulness – the Pollyanna voice that assumes product cost will just work itself out in the end. It is a voice of justification to ignore Product Cost Management, because the team is just too busy at XYZ point in the development process to seriously consider product cost. Hope is NOT a strategy.
- The Voice of Resignation – the nihilist voice that assumes that you have to accept high prices because the three suppliers that purchasing quoted gave you pricing far higher than what seems reasonable
- The Voice of Bullying – the seemingly unreasonable scream of the customer telling you what your product should cost — not based on reality, but based on the customer’s own financial targets.
However, there is another voice in the conversation that can bring some reason to the cacophony. It is a voices of reason — the Voice of Should-cost.
Buck-up Cowboy. The Voice of Should-cost Can Help
Should-cost is just what it sounds like, using one or more techniques to provide an independent estimate of what the cost of a part or product “should” be. The question is, what does “should” really mean? For many, the definition depends on the type of cost being calculated, as well as personal should-cost calculation preferences. I will provide my own definition here, mostly targeted at providing a should-cost for a discretely manufactured part.
Should-Cost – The process of providing an independent estimate of cost for a part, assembly, component, etc. The should-cost is based on a specific design, that is made with a specific manufacturing process, and at a supplier with a specific financial structure. Or, the should-cost is calculated assuming a fictitious supplier in a given region of the world that uses the best manufacturing technology, efficiency operating at maximum sustainable capacity.
I realize that this is a broad definition, but as I said, it depends what you want to estimate. For instance, do you know the supplier’s exact manufacturing routing, overhead and labor rates, machine types, etc.? In this case, do you want to estimate what it “should” cost to manufacture the part under these conditions? OR… do you want to know what the cost “should” be for a new supplier who is well-suited to manufacture your design and has a healthy but not overheated order book? Although you could make many other assumptions, the point is: KNOW YOUR ASSUMPTIONS. You will note that I said nothing about margin. Some people call this a “Should-Price,” while others call it a “Should-Cost” referring to what they will pay vs. what the part costs the supplier to make. The only difference is that you will also make an assumption for a “reasonable” margin for a Should-Price.
The important point is that the team relying on the should-cost information must define the scenario for which they want a should-cost estimate. There is nothing wrong with wanting an answer for all these scenarios. In fact, it’s preferable. Run the calculation / estimate more than once.
Should-cost, Should Be a Choir, not a Solo Act
Manufacturing cost is a very tricky thing to calculate. I often say that the true cost of the economic resources to make a part or product is a number known but to God. Put statistically, you can’t know the true meaning or standard deviation of a population, you can only estimate it from the samples that you take. People take two common approaches to should-cost.
The Pop Star Solo Act
The popular solution that too many people pursue is the solution pictured at the right.
They want the easy button — the single source of truth. They want the plasticized overproduced solo pop star version of should cost, i.e. the easy button tool. There’s nothing wrong with this and there are some really good should-cost solutions available, but none of them are infallible. In addition, it is not appropriate to put the same should-cost effort into each part or assembly in a problem. One should focus where the money is. However, too many people, especially cost management experts, become sycophants of one particular tool to the exclusion of others.
Looking at the diagram to the left, you can see what the landscape looks like when you make your comparisons to one point in cost space. It is an uncertain, scary world when you only have one point of reference. In this case, all one can do is try to force a supplier to match the should-cost output of your favorite tool.
The Andrews Sisters, Competitive Trio Quoting
The other very popular approach comes from the purchasing department: three competitive quotes. If the auto-tuned single pop star should-cost is too uncertain, purchasing will listen to a trio instead. Why three quotes?
No one seems to know, but in EVERY purchasing department with which I have ever worked, three shall be the number of the quoting, and the number of the quoting shall be three. [If you are an engineer, you know my allusion. If not, watch the video to the left!] The trio of quotes in the diagram to the right do help clarify the picture a little better, but there is still too much uncertainty and what I call “commercial noise” to really believe that the quotes alone bound what the should-cost plus a reasonable margin is in reality.
An Ensemble of Should-Cost Estimates
Returning to our statistics example, one of the first things you learn in statistics is that it takes about 33 samples to characterize a bell curve distribution. At 33 samples, you can start to approximate the true mean and standard deviation of the actual population. I am not saying that one needs 33 estimates of should-cost to triangulate on the true cost, but you should get as many as you can within a reasonable time frame. Have a look at the diagram at the right to see this illustrated. Instead of the single pop star approach or the Andrews Sisters trio of quotes, hopefully what you get is a well-tuned small chorus of voices who start to drown out the Voices of Resignation, Hope, and Bullying. The chorus of should-cost estimates start to bound the “true” should-cost of the part or product and can give the team a lot more confidence.Sometimes the team does not have time to assemble all the voices of should-cost. Not all parts or products are worth assembling the full choir. More often than not, the organization is either unaware of the should-cost voices at its disposal, or are just too lazy to assemble them.
Don’t let your organization be lazy or sloppy with respect to should-cost, and remember that the best music is made when groups of instruments and voices work together, not when one person sings in isolation.
p.s. Bonus PCM points if you can guess what a cappella group is pictured in the thumb nail to the post
One thing that is interesting about Product Cost Management is that people have different thoughts as to what is included in the product cost. Is the product cost the raw material, labor, and direct labor? What about the capital tooling? What about logistics and shipping? Oh, and what about warranty cost or end of life disposal fees for which your firm is responsible?
The short answer is E. All of the above.
In a product and manufacturing firm, everything on the income statement is included in the product cost. However, the income statement does not easily present a direct association between a particular cost with a certain product. Hence, accounting came up the concept of “indirect,” “period,” or “burden” costs. This is accounting speak for, “We’re not really sure how to reliably split this bucket of cost and assign it to an individual product.” Later, academics and consultants made a lot of money, and caused great pain and suffering, with Activity Based Costing. This method was invented to try to reasonably amortize indirect costs in a logical way, so that people could call them direct costs. ABC was a good idea, but in most companies, it was badly implemented in an impractical way that made everyone lose interest in it.
So, what IS in Product Cost? That’s a tricky question that we may be talking about for a long time. However, I would like to address one particular cost that is a perennial burr in my bell bottoms.
Grand Theft Auto — Yes Virginia, Capital is a Real Cost
Imagine you were selling your car and put a “For Sale” sign on it in the parking lot of your company. Over lunch one day, one of the engineers in your firm walks up to your desk and says he’d like to buy your car. You might say, “Great! I’ll make you a deal. It’s $5,000.” But the engineer looks at you in a confused manner and said, “Oh no, you see, I’m only responsible for the ‘variable’ costs of the car such as gas, insurance, those little pine tree air fresheners, etc. The capital cost of the car is not my problem. It comes out of ‘another budget,’ for which I am not responsible. Can I have the keys now?” You would not give him your car and might actually ask his supervisor to have the guy checked out for behaving in such an irrational way.
That’s a bizarre story, and no engineer that I know would say something like that… unless they are talking about Product Cost. I wish I had a dollar for every time an engineer or his manager told me that capital tooling “didn’t matter because that comes out of a different budget.” Capital Investment and Capital Tooling are real things that cost real money. However, most organizations treat them as if they are totally different than the variable product costs (e.g. raw material, labor, direct overhead, etc.). No, capital is not different, in the sense that the design team’s decisions will determine how much capital is needed, just as their decisions affect variable costs. However, at best, engineering teams will only consider capital as completely separate from the “Piece Part Price.” Many engineering departments do not consider capital in any serious manner at all.
This leads to perverse decision making. Why? Typically, investment in capital will reduce the variable cost of a part, and there are often multiple ways to make a part. For example, let’s say that you are Joey Bag O’Donuts design engineer, who has been given challenging cost targets for Piece Part Cost. You design a part and your purchasing guy comes back with quotes from 3 suppliers:
|Supplier||Piece Part Cost||Capital Tooling Cost|
|Louie’s Laser Library||$15.10||$1,000|
|Pete’s Press Emporium||$12.50||$15,000|
|Chuck’s Casting Shack||$10.50*||$13,000|
* Redesign will be required to use Chuck as a supplier
Of course, capital is “considered” by Joey’s engineering team, but it’s hard to comprehend because it is considered separately from variable costs. Joey would likely choose Pete as a supplier because Pete is cheaper on Piece Part Cost. Joey won’t have to redesign as he would if Chuck was Joey’s supplier. Joey’s Cost Target is based on Piece Part Cost. Sure, his supervisor tells him to “watch the capital,” but the capital budget is this big amorphous pot of money that everyone shares, so Joey is not personally penalized for using it.
However, using a bit of eighth-grade math, we can graph the real cost to the company, including the capital amortized over the life the tool. We see that the right decision for maximum product profit depends on the volume of products we will sell before more capital needs to be spent to refurbish or replace the tool.
Capital is Different… It’s MORE Important Than Piece Part Cost
The attitue of most product development teams towards capital shows that they implicitly believe capital is LESS important than the Piece Part Cost. However, I would argue that the opposite is true for at least 3 reasons:
- Time Value of Money — You have to buy capital up front, spending the dollars earlier. Using sophomore math and a proper cost of capital for the organization, you can calculate how much more expensive capital is than variable costs.
- Risk of Change — Capital Tooling is often called “hard tooling” because it is made for a specific part. Often out of hardened steels that are expensive to manufacture and machine. But, the tooling is ‘hard’ in another way: it’s hard to change. Let’s say that Joey’s part failed in the field and needed to be modified. It’s likely that the tooling will need to be to be modified, and tooling modifications are expensive. So, how do we account for the risk of changes in calculations of tooling cost? I will have to look into that, or perhaps, one of our readers can suggest a method. One method would be to ask the following questions: What percentage of parts are modified after tooling is created and what is the average cost of tool modification as a percentage of the original tooling cost? Using these two numbers, we could create a reasonable risk multiplier for capital.
- Return on Assets — Since the 1980’s, Wall Street has been obsessed with “asset light” companies. Some of this is just Wall Street codifying reasons 1 & 2 in the stock price. However, a lot of this has to do with leveraged buyouts and other financial “engineering” voodoo. Regardless of whether assets light strategy really adds or subtracts value from the firm, Wall Street thinks it does.
These are just three reasons why capital is an expensive cost that should be considered as part of product cost and considered together with piece part cost. There may be others, too, but at the end of the day remember:
Cars are not free and neither is the capital tooling for your product.
This advice may help keep you out of jail and/or the world of unprofitable products.
I happened to stumble upon an article on SpendMatters from a few weeks ago by Sheena Moore:
The article about the manufacturing cost versus the price of a new bracelet at Tiffany. If you don’t know what Tiffany is, you’re probably unmarried and have not been dating. Some say you can’t put a price on love; Tiffany disagrees and will help you do it! The first great thing about the article is Sheena’s calling out of Tiffany’s deceiving marketing. Apparently, they told her the bracelet is made of a golden “metal” called “Rubedo.” No ladies it’s not gold; it’s something better; it’s Rubedo. (Rubedo is actually just an alloy that helps Tiffany water down the gold to make more $$$. Sheena and I had a good laugh about this on the phone).
Sheena’s article caught my eye for two reasons. First, I’m just really cheap, and the idea of a $7,500 bracelet made of 55% Copper and 31% Gold flabbergasted me. However, more interesting than my miserly instincts was that Sheena does a nice little product cost analysis of the bracelet. In doing so, she highlights another form of fool’s gold: Material Cost Multipliers.
The Material Cost Multiplier
Material Cost Multipliers are a simple idea. They postulate that one can first calculate the cost of a product’s raw material and multiply it by a number to get the overall “Piece Part” cost. But wait, you may object: how can this be valid? Why would someone vastly oversimplify the product cost calculation like that? That’s simple: calculating actual cycle times and tooling costs for each machine needed in the product’s manufacture is HARD, and it requires a lot of manufacturing knowledge.
Material Cost Multipliers just sweep all that nastiness under the rug… or into the multiplier, in this case. They have the following assumptions:
- Assumption 1: Parts is Parts. Remember the old Wendy’s commercial making fun of the contents of Chicken McNuggets? No? Well I do, and you can too, by watching the video below.
The Material Cost Multiplier inherently assumes that all parts that you are manufacturing require the same processes and have the same complexity of design. For example, assume that our Tiffany bracelet and this Gucci Earring had the same mass:
Would you guess that both of these items take the same effort to make? If you said ‘no,’ you are right.
- Assumption 2: The Biggest Loser – The Material Cost Multiplier also assumes that the part mass is very highly correlated to the part’s processing costs. Therefore, the more mass you lose, the more your processing cost goes down in DIRECT correlation. There is no doubt that many manufacturing costs do have a correlation to the mass of the part, but many do not. For example, the polishing or burnishing of the Tiffany bracelet is much more dependent on the surface area burnished, the complexity of the surface, and the hardness (composition) of the material than the mass of the item.
The Cost of the Tiffany Bracelet
Sheena received notice from a colleague that material is only about 25% of the cost of an item. So, Sheena first did a nice material cost analysis of the bracelet. She says that the cost of material is $1,500. Although, she does not account for scrap or loss, this is a pretty good assumption, given that this type of material which can be re-melted. Also, the manufacturing process is likely a net form process, where there is virtually no loss in specific design). I would, however, question the assumption that:
- Material Cost = 25% * Piece Part Cost.
- Or, Materal Cost * 4 = Piece Part Cost. Basically, 4 is her Material Cost Multiplier.
First of all, that seems backwards in the world of simple metal part manufacturing which, in my experience would be more likely to have:
- Material Cost = 75% * Piece Part Cost
- Materal Cost * 1.33 = Piece Part Cost).
In fact, I think the processing costs are even lower than my general assumption. Just looking at the picture of the bracelet, my guess is that this is made by a routing such as:
Extrusion is very efficient and cheap, especially for a straight cylinder. I would shoot from the hip and say the processing is definitely under $20 (probably under $10). Let’s say we have the $1500 raw mat’l cost + $20 processing/logistics + $100 for marketing (which might be outrageously high). That’s a $1,600 Fully Burdened Cost for the high class Wonder Woman wrist bracer (you’ll need 2 for Halloween). At a price of $7,500, just one bracelet is generates $5,900 PROFIT (370+% margin)! I did a product cost analysis in one of the commercial Product Cost Estimation tools for a very similar looking part to the Wonder Woman Tiffany Bracer, and I got a result of $5.25 (Extrusion = $2.20, Flaring = $0.7, Marking = $0.50, Polishing = $1.30, Packaging – $0.55). My former co-founder’s wife owns a florist and gift shop and once told me told me once that typical mark-up for jewelry is ~50%, so the bracelet should be priced (at max) at $3,200, not $7,500.
So are Material Cost Multipliers bad?
No, they are not necessarily bad or inaccurate… but they often can be because they are misapplied. It’s important to know:
- What processes will be used to make a product? Each major process probably needs its own multiplier for accuracy.
- What physical part attribute most strongly drives cost in each process?
- Make sure if someone gives you a multiplier that it is based on these considerations?
Consider the differences:
- Sheena’s general manufacturing Material Cost Multiplier = 4x –>Processing Cost = $6,000!
- Eric’s general simple part metal manufacturing Material Cost Multiplier = 1.33x –> Processing Cost = $1,900!
- Eric’s manufacturing “judgment” from experience and given the the routing Eric assumed Processing Cost = $20 –> Material Cost Multiplier = 0.013x!!!
- The Product Cost Estimation Tool’s estimate of Processing Cost = $5.25 –> Material Cost Multiplier = 0.003x!!!
There is no doubt in my judgment that the Product Cost Estimation tool is the closest to reality. Regardless, a fast back-of-the-envelope calculation is far better than nothing. I am a big fan of common sense and back-of-the-envelope reality checks. I applaud Sheena’s effort, which, honestly, is more than many design engineers or purchasing engineers would do in considering the profit impact of their decisions.
- Material Cost Multipliers are useful, but can be dangerous. They should be applied by experts or with expert guidance.
- My analysis shows that Sheena is even MORE correct in that the bracelet is not worth it.
- Kudos to Tiffany for Jedi Mind Tricking girls into believing a $1,600 bracelet is worth 3x as much.
- Ladies, your boyfriend’s/fiancee’s/husband’s willingness to buy you the Tiffany Rubedo bracelet may mean he’s filthy rich, desperate, or not too smart… but it may not necessarily mean he loves you. Admittedly, that’s just my guess… but then again, I’m a product cost guy, not the love Dr.)
p.s. Guys, perhaps you would be interested in buying the woman of your dreams the Hiller Associates RubedA bracelet. It’s just like the Tiffany RubedO bracelet, but MINE is 35% gold, not 31% like Tiffany. The only difference is my bracelet will say “H&CO” where Tiffany’s says “T&CO”, and likewise mine says Hiller’s, instead of “Tiffany’s”. It’s a bargain at $4,999, versus Tiffany’s $7,500. H&CO: “Don’t just show her your love; show her your intelligence.”