Jun 052014
 

IW_LogoNEW ARTICLE in Industryweek.com by Hiller Associates

Synapsis:  No matter how badly you think you are pinned down in a pricing negotiation, there are always tools for leverage that can help you improve your position. Relative should costing is one of these powerful tools.

To read the article at Industryweek.com, click here.

Or, you can read the full article below

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Relative Cost Power – How to not know the cost of your products and win negotiations, anyway

With product cost accounting for 70 to 90% of every revenue dollar on the income statement, it’s not hard to understand why cost is such a big deal to many companies. In the last decade, there has been a renewed focus on the world of Product Cost Management, including techniques like Design for Manufacturing (DFM), Should-Costing, Spend Analytics, etc. Many of these techniques are used (or are intended to be used) *before* the sourcing phase of the Product Life Cycle. While procurement professionals should be involved up front in product design, a lot of the responsibility for success with these techniques will rest on the design engineering staff.

Regardless of whether your company is best-in-class in Design-To-Cost, or whether you have the most cost-oblivious design staff in the world, your designs must be eventually made or bought. With the dominance of outsourcing, it’s more difficult than ever to know what the should-cost of a product is? Purchasing agents are told that they should know the should-cost of products before they walk into a negotiation with a supplier. However, that is not easy, and the fact is:

Your supplier will typically know more about their costs than you do.

So, how do you precede in a negotiation where your supplier has more and better information? Are you completely at their mercy? And, what if your supplier holds oligopoly, or even monopoly, supplier power? Are you just a price taker?

ANSWER: No, you don’t have to be a price taker, at least in the case of buying multiple variants of a similar spend item.  Recently, I wrote a blog post about how the human brain does not like non-linearity, discontinuity, or non-monotonic functions. This is a fancy way of saying that people are very good at detecting pricing inconsistencies within multiple similar products.

This inconsistency is the key to being able to better control a negotiation, in which you really don’t know what the absolute cost of a product should be, or where you know the should-cost, but have little buyer power. Let’s explain this with an example:

Case Study in Relative Should-cost: Pick-up Truck Driveshafts

Hiller_Associates_Relative_Should_DriveshaftsIn the late nineties, I had the privilege of being the product development owner for the drivelines (axles and drive shafts) used in the full-size pick-up that was best-selling vehicle in the world for over 30 years. This truck made over 100% of the profit for my employer (making up for losses on other vehicle lines). I was very young and inexperienced at the time, so it was a great experience, but a big challenge.

Within the first few weeks in the assignment, I was told that it was time to negotiate the contract for the driveline commodity (over $450 million annually) for the upcoming 2004 vehicle. I was told that this was a very complex process, but that the purchasing group would lead it. However, my first meeting with our purchasing team lasted about 10 minutes… long enough for the purchasing team to say: “Oh, your supplier is *that* supplier? We don’t get involved with them. Have a nice day.” And, they walked out of the room.

After the shell shock of the experience wore off, my manager explained that our supplier was the former components division of our employer (the OEM) and that our CEO had desperately wanted to spin-off the component divisions from the OEM. To do this, our CEO had negotiated a deal with the powerful automotive union, agreeing that the union members would technically work for us (the OEM), but be leased to the newly spun-off supplier. If the OEM did not give enough business to the components supplier to keep the union members employed, the OEM was responsible for paying them a large portion of their wages, while they waited to be deployed somewhere else.

Effectively, this removed almost all negotiation power from us, the OEM. Therefore, our purchasing team had made a decision at the executive level to not participate in negotiations with this particular supplier. Instead, these negotiations were dumped into the laps of the product development team, with some support from finance.

Suppliers with Complete Supplier Power

The product development team had its own problems already. The marketing team were demanding much better performance and quality out of our parts. But, the finance team demanded that those parts be cheaper than the previous generation of parts! And now, we had an AWOL purchasing team. In terms of the old Porter’s Five Forces framework, our supplier had tremendous supplier power! What to do?

I certainly was not an expert in drivelines yet, but I had just completed a master’s thesis focused on product cost. So, I first reached out to the cost estimation team within the OEM. They helped us understand what the absolute cost might be for a driveshaft. We were also able to negotiate with the purchasing to do an “unofficial” price study with other driveline suppliers.

Our first negotiation with our supplier (the OEM’s former component divisions) was pleasant, but utterly futile. I excitedly explained what we thought the absolute part cost of these driveshaft parts should be, and hinted that we had quotes from other suppliers to prove it. Our supplier, being quite shrewd, politely explained why their product was, obviously, so much more valuable, combined with a tangible undercurrent of, “Well that’s nice that you have should-costs and quotes from other suppliers, but we really don’t care, because you have to use as a supplier regardless.”

Relative Should-Cost to the Rescue

Now what were we going to do? These lines of argumentation (absolute should-cost and competitive quoting) were not prevailing on the supplier. So I tried something different: Relative Should-Costing.

Hiller_Associates_Relative_Should_CostA driveshaft is complex in many ways, but in reality, it is a modular part design. It’s constructed mostly of the end yokes coupled with an extruded or seam-welded tube between those yolks. If we had a longer truck we simply extended a tube. (For technical safety reasons, we had three variants: a 1-piece steel driveshaft, 1-piece aluminum, and a 2-piece steel.)   In total, we had over 70 part numbers of these three designs, and we knew the price quote for each variant.

Using a spreadsheet, I simply estimated a reasonable cost for one driveshaft tube for each of the 3 variants. With this estimate, it was easy to calculate a per-inch cost of that tube. By subtracting, I knew what all the other parts in the driveshaft (e.g. end yokes) approximately cost. That was all I needed. I didn’t need to know what the absolute cost of each driveshaft should be.

I just needed to know what each similar part should cost RELATIVE to another part.

In the second negotiation, we politely questioned the supplier on their confidence in their pricing ability. They professed with great certainty that they knew how to price and stood by those prices. Then we coyly pulled out the part numbers for the three drive shafts for which I had estimated the absolute, and asked if they stood by those prices. They eagerly declared they stood by those prices. Gotcha!

At that point, we started asking how Part B that was 5 inches longer of extruded tube than Part A could cost $10.00 more than Part A, when the tube extension was only worth $0.30. The supplier was not sure and asked for time to investigate. We had several more meetings on the topic, but in the end, the supplier could not give any logical reason why their pricing for similar drive shafts varied in bizarrely non-linear ways.

The supplier reduced the cost of the entire driveshaft commodity by about 8%, resulting in about $35 million a year, straight to the bottom line of my employer, the OEM.

Should the discount have been bigger? Yes. Did my calculations show that the supplier should have given us more money? Yes. But, did we get a significant concession from a supplier who held every card in this negotiation? Yes we did!

In reality, the supplier still could have refused to reduce their costs. However, the point of these Relative Should-Cost negotiation techniques is to bring logic and facts to bear to increase leverage in a situation where you seemingly have no leverage.

The win occurred when the supplier just couldn’t answer why their own pricing was internally inconsistent with itself.

This is a good lesson for suppliers to learn, as well. When quoting a basket of similar parts, it’s wise to make sure that you understand your own pricing and reflect the underlying costs in a logical and linear way to your customer. This greatly reduces the risk of your customer casting doubts and driving your pricing down, perhaps unfairly.

Diagnostic vs. Leverage Tools and Absolute vs. Relative Should-Cost

The case study above is an example of the difference between using a Relative Should-Costing technique, versus an Absolute Dollar Should-Costing technique. If this sounds interesting to your company, you may want to read more in my previous article in Industryweek.com, Your Should-cost Number is Wrong, But It Doesn’t Matter. In this article, we talk further about using should-costing, not only as a diagnostic gage to tell you what the cost is, but as a tool for leverage to move the cost down.

Remember, no matter how badly you think you are pinned down in a pricing negotiation, there are always tools for leverage that can help you improve your position. Relative-Should costing is one of these powerful tools that should be in your tool box.

May 142014
 

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:

  1. Linearity/symmetry
  2. 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!”Hiller_Associates_Costing_Linearity

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:

Hiller_Associates_Fix_it_or_feature_itYou have a couple of choices on how to resolve the geometric costing/pricing problems in the minds of your customers or colleagues:

  1. 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.
  2. 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.

 

 

Mar 202014
 

Hiller Associates posted the following article at ENGINEERING.COM yesterday.  You can read it there at this link, or just keep reading below!

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Another solid piton in the cliff of making product cost mainstream in CAD / PLM Products?

CATIA users can now get a faster and more effective way to design and source composites products with the highest profit by bringing the estimation ability closer to the designer’s native environment. Galorath Incorporated debuted its newest integration of SEER® for Manufacturing with the Dassault Systems 3DEXPERIENCE® Platform in CATIA at the JEC Composites conference in Paris. The new product is called the SEER Ply Cost Estimator.

Who is involved?

Hiller_Associates_Seer_Catia

Galorath Incorporated grew out of a consulting practice focused on product cost estimation, control, and reduction that began in the late 1970

s. Over the last 30 years, Galorath built their costing knowledge into the SEER suite of software products. SEER is one of the independent product cost estimating software companies.

Dassualt Systems is one of the “big 3” Product Lifecycle Management (PLM) companies in the world.

Hiller Associates spoke with Galorath CEO Dan Galorath, Vice President of Sales & Marketing Brian Glauser, and SEER for Manufacturing product lead Dr. Chris Rush and got a full product demo.

What does this integration do?

The integration allows users of CATIA to use SEER’s costing software for composite materials within the CATIA environment. In CATIA, the engineer designs a lay-up for a composite part, generating a Ply Table (a critical design artifact for composite parts that specifies material, geometry, and some manufacturing info). That activates the integrated SEER Ply Cost Estimator so that the designer (or the cost engineer or purchasing person aiding him) can set up more part-specific costing choices and preferences within the CATIA environment.

When ready, the user pushes the cost analysis button. The information is processed by SEER Ply Cost Estimator which sends the ply table data and other information to the interfacing SEER-MFG software to compute cost. The cost data is returned and presented to the user, once again within a native CATIA screen.

How broad is the capability?

Click to ENLARGE!

Click to ENLARGE!

Currently, the integration of SEER is applicable for parts made of composite materials. It’s a strong starting point for the integration partnership because SEER has a long experience in the field of costing composites, working with companies in the defense and aerospace verticals. Composites are also becoming more mainstream in other industries, such as automotive and consumer products. Galorath has been a major player in the US Government’s Composites Affordability Initiative (CAI), a 50/50 government/industry funded consortium including Boeing, Lockheed and Northrop Grumman that was formed to drive down the costs of composites. Galorath has also worked with Airbus in the area of composites parts costing.

Galorath’s Brian Glauser says that the SEER Ply Cost Estimator has hundreds of man-years invested, much from previous work with CAI and with aerospace companies that resulted in several of the modules already in the SEER-MFG standalone product.

The first version of the SEER Ply Cost Estimator handles many composites manufacturing processes, materials, concepts of complexity, and both variable and tooling costs. However, it does not yet directly cost the assembly of one part to another.

The initial integration will be to CATIA v5, but SEER and CATIA have signed a v6 agreement as well. That integration will follow later.

Galorath (and likely Dassault) are hoping that the SEER Ply Cost Estimator will be well received by customers and help drive many product cost benefits. If this happens, there may be demand from Dassualt’s end customers not only to improve the SEER Ply Cost Estimator, but to expand the SEER/CATIA integration to other manufacturing processes covered in SEER’s stand-alone software products such as machining, plastics, sheet metal and assembly processes.

What does it mean for Functional Level Groups?

Philippe Laufer, the CEO of CATIA was quoted saying :

“Using Galorath’s SEER for Manufacturing in CATIA…will help companies perform early trade-off analysis on the use of various materials and composites processes before manufacturing even takes place.”

Well, that has been one of the goals in Product Cost Management for a long time. If your company uses composites, the tool has the following possibilities:

  • Engineering – identify which design choices are driving cost and by how much
  • Purchasing/Manufacturing – get an early warning of what to expect from suppliers before asking for quotes or estimates (should-cost)
  • Cost Engineering –focal point for the cross-functional discussion about cost to drive participation, especially from engineering

It’s important to realize that this integration will have its limitations, as with any costing product. First, the current integration applies only to composites. While expensive, composites are only one type of part on the Bill of Material (BOM). You will have to go beyond the current integration of SEER/CATIA to cost the full BOM, perhaps to SEER’s standalone costing product or to those of its competitors.

Second, remember that cost is far harder to “accurately” estimate than many physical performance characteristics. While meeting an absolute cost target is important, even more important are the following:

  1. Continuous Design Cost Improvement – If your company consistently designs lower cost products because you have superior cost estimation information, you WILL beat your competitors.
  2. Correct Cost and Margin Negotiation – If your company is better at negotiating quotes because it can give suppliers a better understanding of what it will cost them to make your part and you can negotiate a margin that is not too high, but adequate to keep your suppliers healthy, you WILL beat your competitors1.

What does it mean for the C-Level?

Philippe Laufer of CATIA also says:

“This [the SEER Composites integration] leads to finding out the most efficient way of manufacturing a product while meeting cost, performance, functionality, and appearance requirements.”

The C-suite doesn’t really care about composites or ply tables in and of themselves, but it does care about revenue and profit. Of course every well-marketed product will claim to improve these metrics. Regarding product cost, the good news is that Galorath and Dassault are aiming at a big target. Companies that use a lot of composites can have very high costs. For example, Boeing and Airbus have Cost of Goods Sold of 84.6% and 85.5% and Earnings before Tax of 7.2 and 3.6%, respectively2. Those COGS figures are big targets on top of a highly leveraged COGS/Profit ratio.

What does it mean for Product Cost Management becoming mainstream in the enterprise software stack?

We asked Dan Galorath how long it would be before Product Cost Management was as much of the PLM ecosystem as finite element, manufacturing simulation, or environmental compliance. He replied:

“Cost estimation software will never be on every designer’s workstation, but I don’t believe that is what it means for Product Cost Management to be considered ‘mainstream.’ It’s not fully mainstream yet, but a greater need is being driven by outsourcing and the tight business environment. The procurement folks can’t only rely on internal manufacturing knowledge like they used to. They need tools like SEER to fill the gap and move the cost knowledge base forward.”

We agree with Mr. Galorath. This is another step, another piton to secure Product Cost Management onto the PLM cliff, as PCM continues to climb this steep hill.

This is the first integration point between independent Product Cost Management software companies and the PLM/ERP world since September 2012, when Siemens PLM purchased Tsetinis Perfect Costing3. PTC has built some level of cost tracking ability into Windchill, and Solidworks (owned by Dassault) has developed the first couple versions of a costing calculation module for their product.

There is still a lot of ground to cover. There are quite a few independent product cost management software tools that have costing intellectual property that can accelerate the process, especially if the big PLM companies acquire them or partner with them. When that will happen is anybody’s guess, but for now it looks like CATIA users, at least, have a viable solution for composites costing… and maybe more in the future.

1 For more information, see the Hiller Associates Industry Week Article: Your Should-cost Number is Wrong, But It Doesn’t Matter

2 Per www.morningstar.com, trailing 12 months COGS, 3/13/2014

3 Siemens buys Perfect Costing Solutions (Tsetinis), Hiller Associates, September 2012

Jul 122013
 

Today we are reposting the article we wrote this week for ENGINEERING.com.  The original article is here and our announcement of our partnership with ENGINEERING.com is here.  Enjoy!

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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.

CastingFirst 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.

Hiller Associates Matching Estimates and Quotes

CLICK TO ENLARGE

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.

  1. 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.
  2. 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.
  3. 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.
  4. 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!

Jul 102013
 

 

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
  • Electronics
  • 3D Printing
  • Education
  • 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.

engineering.com_logo_new_tagline

 

 

 

Comparing Quote Apples with Estimate Oranges

 

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.

 

 

Jun 272013
 

Anyone who has ever heard the famous NPR show the Prairie Home Companion will smile warmly, remembering warm and disarming voice of legendary storyteller Garrison Keilor talking about the fictitious Minnesotan town, Lake Wobegon. Garrison’s sign-off to the show has entered pop culture: “And that’s the news from Lake Wobegon, where all the women are strong, all the men are good looking, and all the children are above average.”

We know of another place called Lake Costbegone.  It’s a magical land of companies tightly clustered around a lake of profit.  Lake Costbegone is the vacation spot of Product Cost Management. Lake Costbegone (and maybe many other corporate disciplines besides Product Cost Management) are similar to Lake Wobegon.

That’s right.  At Lake Costbegone ALL the companies are, at least, average.

The post that we put up a couple days ago (Is the View Worth the Climb in PCM?), showed the effect on a company’s product cost, based on whether a company is best in class, industry average, or a laggard at Product Cost Management. The splitting of the companies into these three categories is almost universal in Aberdeen research reports, and other analyst firms use a similar framework, too.   However, we don’t think we had ever met a client or potential client to that thinks that they are in the laggard category.

Sure, there are people that are more realistic and honest within each firm, who will tell you “off the record” that their organization is doing very badly at Product Cost Management, or whatever corporate initiative we are talking about at the time. However, no one wants to proclaim in the sight of others that their organization is a “laggard.”  Apparently, admitting that your organization is not, at least, average is the corporate equivalent of a stock analyst giving a sell signal. It’s just not done. Stock analysts typically give only three signals: Strong buy, Buy, and Hold. No one really knows what “Hold” means, but we are all pretty sure it means, “You might wanna think about dumping that stock.”

Being “industry average” might mean exactly that, the organization is industry average in whatever technique on which the firm is evaluating themselves. However, they could also be a laggard in need of great improvement, but just don’t want to admit it.

Hiller Associates effect of Product Cost Management

CLICK TO ENLARGE!

The funny thing about the post from a couple days ago is that the gap or potential between industry average and best-in-class companies is actually *bigger* than the gap between the laggards and the industry average (see figure to the left).  Therefore, if you are in the industry average, you should be quite excited about getting to best-in-class, because there is a big carrot to do that.

Our opinion is that companies are better off when they mistakenly consider themselves laggards when they are really industry average than when they consider themselves industry average when they are really a laggard. The industry average designation is much more of an invitation to apathy in Product Cost Management. No one wants to be the laggard, and that’s a good thing! What’s the worst thing that can happen, after all? If you misclassify yourself as a laggard and you actually are the industry average, your effort to get out of laggard state will probably move into being best-in-class.

And that doesn’t seem like such a bad thing.

 

Jun 242013
 

 

I worked with a colleague once that used the expression: “Is the view worth the climb?”   That’s an interesting expression and a very visceral way of expressing the fear that we all have when undertaking a new project in our companies. New projects always require not only capital in the form of money, but also to human capital in the form of resources, emotion, and hard work. Careers can be made by a successful project… or destroyed by a major project gone awry.  Is the view really worth the climb? Will the rewards be worth the effort?

For example, it’s easy to say that people should work on increasing their profit by reducing their product cost. We all understand that this intuitively seems like a good thing to do. Mathematically, who can argue? If you reduce your product cost, you create profit that drops the bottom line. The question is: how much profit will drop to the bottom line? Is the view worth the climb?

Hiller Associates effect of Product Cost Management

CLICK TO ENLARGE!

To answer this question, let’s take a look at a graph we made of data from a 2010 Aberdeen study on product cost. The graph shows the average effect on product cost over two year period for companies. The companies were broken into the standard three Aberdeen categories (Best-in-Class, Industry Average, and Laggards) based on other criteria of how they manage their Product Cost Management efforts.

The results were pretty impressive. In two years, best-in-class practitioners of Product Cost Management reduced the cost of their products on average by 7%, whereas companies that were average practitioners of Product Cost Management were only able to reduce cost by an average of 1% .

Let’s put this in perspective. The table below shows an example company with $10 billion in revenue, 80% product cost (as a percent of sales), and a 5% net margin. On an annualized basis, the difference between best-in-class and the industry average is the difference between $560 million and $80 million, respectively, of extra profit. Note also that the laggard’s product costs increased 3% per year equating to a $240 million profit loss.

Hiller_Associates_profit_from_Product_Cost_Management

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These numbers represent the view (the results), but what about the climb (the investment)?   The Aberdeen study does not investigate this. However, one should ask:  how much money *should* the company be willing to invest to capture an incremental $480 million per year of profit? 100 million? 50 million? $25 million? What about $10 million? Would your company even invest $10 million?

It’s something to think about.

 

 

 

 

Jun 172013
 

 

We spend a lot of time thinking about how organizations can improve Product Cost Management. After all, it’s our job at Hiller Associates, but we’re also very passionate about it. We’ve often wondered, why is it that there are so many people in Product Cost Management who are very intelligent and hardworking individuals, and yet the field, in most organizations, does not advance.

Why is this?

 

  • We don’t think it’s due to lack of effort.
  • We don’t think it’s due to lack of intelligence.
  • It may be due, in part, because the tools in the area are not that great, at least until recently. However, we don’t think that’s the cause either.

We have concluded that one of the biggest problems is that most Product Cost Management Experts are independent acoustic live performers.

Sing me a song!

What do we mean by that ? Well, if you go into the average product company and meet the Product Cost Management organization, it usually consists of a very small group of experts. They typically are sequestered in some back office.  They appear to be a covert operation of some large organization, such as purchasing. When you meet them, they are almost always hardworking people , who looked frazzled, but still have their noses to the grindstone.  They are busily trying to avoid product cost before launch and wringing cost out after the start of operations.

Traditional PCM experts are like solo classical musicians. They improvise solo (excel spreadsheets) or play an expensive instrument (an expert tool). They play for command performances before the nobles. In this case, the noble is whatever manager is in the most desperate trouble at the time. The PCM guys are always overworked, but their solution to this is to work harder. Just like a classical live musician, they can only be at one place at one time. Their performances are beautiful to listen to, but there is no recording, nor is there a broadcast, so that others in the world can hear the wonderful music they make. They really are a solo act.

We show this on the diagram below by showing the simple sine wave representing the music they sing. Pound for pound, person for person, no one can save more cost than these soloists, singing their song live and alone. However, as with any organizations that relies on people to scale, it can all only scale so large, and it can only scale so fast . That is why professional services companies are typically very small. The growth of the company is limited by the expert resources they can find. Think of this versus a product company, where once the product is designed, it can be replicated very quickly through the magic of manufacturing.

Product Cost Management Rock Star Hiller Associates

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Time to Crossover to Being a Rock Star

It’s time for product cost management groups to stop being solo live classical musicians  and crossover, as they say in the music biz, to be rock stars. On the diagram to the right, look at the traditional path vs. a maximum performance path. It’s time for PCM experts to spend less time playing alone and move to being Rock Stars (and maybe the director of the band). In this arrangement, the musician continues to do a lot of what he does today. He composes and produces the music. The music itself is the technical expertise needed for product cost management, but the expert should be sharing it with the entire organization, not just a few people in solo performances. This requires that he have a *vision* for Product Cost Management. This is not a vision for how to cost model the next part or assembly, but where the organization is today and where he wants it to get to in the future.

This Amp Goes to 11

The key to success is to amplify the music made by the Product Cost Management expert. To do this, you need to find the right management champion. Management is an amplifier, because their job is to receive the good ideas that their people bring them and then boost the signal on the idea to the rest of the organization. Management also parses the signal to the right speakers in the organization that can most beautifully and powerfully and produce that signal. Think about a modern 5.1 or 7.1 home theater system, where the amp or receiver parses the signal and sends the right frequencies to the right speakers.

And, if you’re going to be a Product Cost Management rock star, you want the biggest and highest quality amp you can get. You would be pitching your vision at the VP or C-level. Remember the movie Spinal Tap? You want the amp that goes to 11!

The Recording Industry

Every rock star is going to both tour and record. The management amplifier lets you to play to stadiums full of people. But you also need to record it, so that your fans can hear it over and over. To generate maximum profit for the organization, the fans (engineering, purchasing, manufacturing, etc.) needs to be able to execute on your PCM vision. Many times that music will need to play when you can’t be there. You record by (1) changing the culture and (2) designing a PCM process that the organization can follow.

Money for Nothing and Your Savings for Free

The rewards to the organization when the PCM team moves from live classical performers to rock stars are very enticing. Although the results of the individual product cost manager experts will certainly be smaller, the rest of the organization now is producing results as well. Together, they will produce many more cost savings and far more the cost avoidance than the Product Cost Management expert could do alone.

The Path to Stardom

We realize that moving to the rock star model will initially be uncomfortable for some people who are experts. It’s hard for experts to let go of control, especially on a complex set of activities like Product Cost Management. There will be mistakes by the organization. There will need to be teaching. The system may be chaotic at first. That’s OK. This is the only way to get to a better state. It also means that the individual product cost expert will have to spend LESS time actually producing results on his own. His time needs to be used developing vision, casting vision, teaching, strategizing, and leading the organization. He doesn’t have to compose that vision and record it alone. His executive sponsor can help get him some great song writers and producers, both internal to the organization and through external consulting partners. And the executive champion will also fund these resources.

Therefore, it is critical to find the right management sponsor who understands the benefits of moving from a solo live performance model to the recorded rock star model. The management sponsor needs to have the authority to reduce the individual PCM demands on the expert. The expert must produce less individually so the organization can produce more as a whole.

Product Cost Management – Behind the Music…

Sadly, looking back at my time as a CEO and then the Chief Product Officer at a company that made Product Cost Management software , and in my current roll as a strategic consultant, I have never seen this rock star transition be driven by the musician (the Product Cost Management expert). Every time I’ve seen organization move the needle on Product Cost Management, the impetus for that change was an executive sponsor who had a vision for a better world. The executive sponsor (typically in engineering, purchasing, or a product owner) was poking his nose into the world of product cost, sometimes knowing very little about it. Paradoxically and sadly, often the existing Product Cost Management organization, instead of being grateful for the help and wanting to get made into a rock star, was resistant or even resentful of the help. That’s too bad, because rock stars make a lot more money than classical musicians, and often have far better job security. (People are going to pay to see Aerosmith until they die.)

So, my advice to you is that if you want to become critical to your management, be noticed in the organization, see your organization produce far better results, and get rewarded for doing it, it’s time to stop playing acoustic solos live.

It’s time for you to become a rock star.

 

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%.

Product Cost Management Ignorance is Bliss

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.

 

 

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.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

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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.

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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.”

 

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