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One of the most frustrating things for many engineers is understanding the quotes they receive from their suppliers. They want to know how these quotes compare to their own internal estimates. Unfortunately, most engineers are not skilled at getting the right answer.
Strangely, engineers are typically very good at this in their personal lives. Let’s say you’re going to buy a new stereo receiver. In a matter of minutes you have the following options laid out:
- Option 1 – Amazon ($300) + Shipping ($0) + Squarespace extended Warranty ($50)
- Option 2 – Amazon vendor ($270) + Shipping ($15) + Squarespace extended Warranty ($50)
- Option 3 – Stereo Shop ($320) + No Shipping ($0) + Included Extended Warranty ($0)
In your personal life, you not only outline how much costs are, but where they are. That is, in which cost bucket does each dollar reside? So why is this so hard when dealing with a part quote at work? The answer is: it shouldn’t be!
Don’t ask what, ask where
The first step to unraveling quotes is to put the numbers aside – what matters first is to decide into which cost buckets each dollar should go. To illustrate this, let’s consider buying a lightly machined casting.
First ask, what resources go into delivering this casting to your shipping dock? Take a look at the figure below. On the top line in orange blocks, we show the various cost buckets for the casting. These include the raw material that is melted, the various processes that are applied, the machining, any painting, and then margin and logistics.
Start with your estimate
We suggest that your starting point should be your own internal cost estimate from your cost expert, your spreadsheet, or from a third party Product Cost Management calculation tool.
It’s likely that the level of detail in your calculation method will be deeper than what you receive from suppliers. Even so, your tool or spreadsheet may not provide a number for each bucket of cost. In our casting example, our initial estimating method did not provide margin and logistics. Becaues these are real costs we will list them, noting that we don’t know what numbers to use for those costs at this point.
Lay out what you know from the Supplier Quotes
Now, it is time to match up your supplier quotes. We show three different quotes in the casting example. Your purchasing department may give you more quotes or less quotes. However, in our experience, three shall be the number of the quoting, and the number of the quoting shall be three. (If you don’t get that reference, please see the attached video).
The quotes you receive probably won’t line up exactly with your estimates. Suppliers, as in example Quote 3, rarely provide a detailed breakdown. Regardless, it’s important to know which costs are included in the $23.00. Are any costs included missing?
But what if I am missing a cost bucket?
It’s common to not have an estimate for every cost bucket from one single tool or spreadsheet. Thankfully, there are several methods to triangulate to a better estimate.
- Look at past part quotes for similar parts.
- Ask an expert. For example, your shipping department may know what it would cost to ship similar casting parts.
- Use a different estimation tool that does include the missing cost bucket.
- You can also surgically lift and triangulate cost buckets from the quotes themselves. For example, you could average the cost for logistics between Quote 1 and Quote 2, so your internal estimate of logistics cost becomes $1.50.
The benefits to you and your company
You may think that this exercise is just about whether you should be paying $23.00 for this casting or $20.00. That is an important question, but there are other big benefits to this method.
- Missing Buckets – One of the biggest advantages to accounting for cost buckets is to identify any misunderstandings between your company and the supplier. It is better to find out now that the supplier has not included the shipping costs than to find out later.
- Your time to shine in front of management – regardless of the final cost that you negotiate, if there is a question later from your management about why you paid what you paid for a part, you have a ready-made, easy-to-understand management slide prepared.
- Negotiation power – deep understanding of costs is very useful when talking to the supplier with whom you decide to negotiate. Of course, you cannot show them the numbers from other suppliers’ quotes, but there is nothing wrong with showing your internal should-cost estimates.
- Learning by doing – after you go through this exercise several times, you will start to develop an intuitive feel for what drives cost in a commodity class. In our example, you will start to understand the relative magnitude of machining vs. casting cost vs. raw material for lightly machined castings.
They say that “It’s not about the destination; it’s about the journey.” The good news is that with part quote evaluation, both the journey has value (as shown by the four points above) and the so does the destination (e.g. paying $20, rather than $23 for a casting). Enjoy both!
Hiller Associates has been invited to become an author on ENGINEERING.com. The Canadian company, headquartered in Ontario, has become one of the most influential voices in engineering worldwide. ENGINEERING.com reaches thousands of people, who work in the many disciplines of engineering, every day with the freshest and best content on a variety of subjects, including:
- Designer Edge
- Design Software
- 3D Printing
- Careers in engineering
Eric Hiller, managing partner of Hiller Associates said,
We are grateful to ENGINEERING.com for the opportunity to share our insights in Product Cost Management and other topics that sit at the nexus between finance and engineering with the readers of ENGINEERING.com. ENGINEERING.com has a great readership of influential people who are driving the next generation of products around the world and who range from individual contributors to engineering executives. We look forward to continuing to work with ENGINEERING.com.
Hiller Associates is writing for the ENGINEERING.com feature area called “Designer Edge,” which contains articles on techniques and tools for better design engineering. HA kicked off it’s authorship with an article focusing on the challenges that engineers face when presented with supplier quotes that the engineers have to understand versus their own internal should-cost estimates. CLICK on the the title of the article below to read the article at ENGINEERING.com.
John Hayes, President of ENGINEERING.com, said,
We welcome Eric ‘s authoritative and often humorous voice on the important, yet rarely discussed, topic of product costing.
Hiller Associates will republish the ENGINEERING.com article in its entirety on our own Product Profit and Risk blog later this week.
Welcome to the Product Profit and Risk blog!
First things first: what is the purpose of the blog? Well, hopefully, the title is fairly descriptive (although, maybe not catchy?). Maybe we’ll have a renaming contest later if the name is not compelling…
At the end of the day, we believe most ventures in life, including business, have the goal of generating the most reward with the least risk. In the case of product & manufacturing companies, we are going to define “reward” from the standpoint of the business as Profit. (for now we are not going to worry about the canonical definition of profit as EBIT, EBITDA, Net Profit… or even Free Cash Flow). On the other hand, there is risk in undertaking any venture for profit. That’s even harder to define. Is it the dollars you could lose, the hair you could lose, the family you could lose, and/or the reputation that you could lose (or the life you could lose, like the guy in the picture above)?
For product companies, anywhere from 50-90% of their Revenue goes to COGS (cost of goods sold). COGS (~=Product Cost) is the largest expense on these companies’ income statements, and we believe the single most powerful driver of Profit… and reducing the risk of poor financial performance.
We plan to talk about those things that directly affect Product Cost (ergo product profit), such as:
- Raw Material Cost
- Labor & Direct Overheads
- Capital Part Tooling
- Sourcing & Supply Chain
If these are the problems, what are the solutions? We’ll talk about that tomorrow. Welcome, and thanks for joining us on the ride.
Your friendly moderator,
Eric Arno Hiller
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