Hello again cost management aficionados!
I would like to announce the first in my series of deep dive profiles on specific product cost management software solutions. You all may remember that I did a two-part series on the history and landscape of PCM and Spend Analytics solutions with our good friends over at SpendMatters.com in December. You can find those jumping off point analysis here and here.
As of late last week, we posted the first of our deep dives on one of the solutions, What’s the Price (WTP). Please check it out over at Spend Matters. One caveat: I have been the victim of my own success in that Spend Matters thinks the article such good content that you will see a teaser article and then need to pass through their paywall to see the full analysis.
WTP is really intriguing as a software solution, so I hope you enjoy the analysis!
Here’s a teaser of some of the insight that you’ll get:
Eric A. Hiller
As some of you may know, I joined McKinsey & Company a little over two years ago as an expert in their Product Development Design-to-Value practice. (Don’t tell anyone, but I do a lot of work for clients in the purchasing space, too!).
It’s been a whirlwind of a couple years, but I finally got some time to publish some new thought leadership. I just did this on McKinsey Ops Extranet, sadly not here. But, the good news is, you can join for FREE, so don’t be worried when you see you need to register.
Here’s the first. Enjoy! Oh, and may sure to 5-star my post if you read it and like it. Thanks.
(Welcome to the standard costing party! What’s this all about?)
Have you ever walked into a dining room with several pictures and seen that one picture that is not hanging parallel to the floor? If you’re a recovering engineer like me, you feel an overwhelming urge to correct the problem. You just can’t be comfortable until the frame is in alignment… unless you find your molding or floor/ceiling are not parallel. Then you have bigger problems!
Why does a slight misalignment (maybe just a couple degrees off bubble) set off instant and loud alarm bells in your brain? It’s because the human brain is very sensitive to two things:
- Discontinuity (especially non-monotonic functions)
I was having a lively discussion the other day with a director of pricing at a Fortune 500 distributor. We were talking about how this affects product pricing. For example, when you have a catalogue with millions of products, it can be very challenging to keep pricing consistent. Consider the figure to the right. The orange dots could be product offerings for electric motors, graphed by the price vs. a performance attribute, such as horsepower. We expect price to increase with performance. But what happens when you find the blue or green dots? The brain says “that’s not right!”
Now, there may be legitimate reasons for the negative or positive arbitrage. Maybe there is a sale? Maybe there is an economy of scale on selling that particular model? However, that brings us to the next challenge, pricing functions that are not monotonically increasing (i.e. they have a negative slope for at least one product model). This is a problem, because this is difficult for even economies of scale to overcome. And, the customer does not like it, because it makes the vendor look as if their pricing is capricious, which causes distrust.
Discontinuity in Product Costing
This happens in costing too. For example, although “sunk cost” is an important concept in capital investment, it can wreak havoc on product costing. If a certain machine is fully depreciated and now has a greatly reduced overhead rate assigned by the accounting department, this will likely confuse the purchasing or engineering folks using a Product Cost Management software. It will either cause them to distrust the costing software or your manual analysis or it will drive them to cost all the parts they can using that
This is yet another curse of the difference between the data relevance needs in order to perform good cost or pricing analysis versus the data reliability needs, over which accountants typically obsess. From an accounting point of view the depreciated resource is “free” (or highly discounted). However, from a costing viewpoint, the abilities of that machine will have to be replaced sooner or later. Worse, the distortion in the overhead rate will lead to underestimations of cost, and often, unpleasant surprises late in product development and sourcing.
What to do about non-linearity, discontinuity, and non-monotonic pricing/costing functions:
- Remove them – the first solution is to correct the false arbitrage by fixing the pricing or costing data. For example, in the case of the machine that is fully depreciated, change the overhead rate back to reflect the cost at which a new machine with the same capability would depreciate.
- Highlight them – if the pricing or costing curve has an unexpected kink in it for a legitimate reason, then you should make everyone aware of this and use it to your advantage. For example, in the catalogue motor example, advertise the sale and let people know this is not natural or permanent!
A lot of mistakes in pricing or costing are difficult to notice without close inspection, but remember anything that violates the brains desire for smooth regularity will stick out like a sore thumb… or a good deal.
Hiller Associates posted the following article at ENGINEERING.COM yesterday. You can read it there at this link, or just keep reading below!
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?
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.
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?
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:
- Continuous Design Cost Improvement – If your company consistently designs lower cost products because you have superior cost estimation information, you WILL beat your competitors.
- 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
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.
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.
As we posted on Monday, Hiller Associates has a new article in IndustryWeek titled:
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.
- 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.
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.
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.
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.
- 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).
- 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.”
In the last few weeks, there has been a hearty discussion on this blog about controlling costs before versus after a product launches. This got us thinking about this situation, we thought that it could be plumbed to greater depth.
Therefore, Hiller Associates is proud to announce its latest article in IndustryWeek, entitled:
If you would like to read the article, click the link above to go to IndustryWeek.com. Later in the week, we will post the article, in it’s entirety, on this blog.
Hello Internet and Product Cost Management industry! We’ve had strong interest in our latest article on the 2012 revenues of the Product Cost Management market. There have been several good questions that have made us want to clarify some of the assumptions in the analysis, so that people are clear on what is and is NOT included in the estimate.
The total addressable market is many times larger than the revenue of the included vendors that are estimated in 2012. In fact, we plan to write follow-up articles that discuss the total addressable market, as well as the growth rate of the current vendors in reaching that total addressable market Here’s some of the assumptions we made in the analysis:
- Only the Vendors noted are estimated – The uncertainties do not explicitly take into account other vendors. They reflect the fact that most of these are private companies whose numbers are not public and that vary from year to year. Obviously, it matters where one draws the line in the analysis.
- Focused on the estimation of manufactured products, not construction – there are many products in the market that focus on construction estimation, for example estimates for building an office building, an oil platform, a refinery, etc. We consider this a wholly different market. In our own experience we have rarely if ever see the companies that specialize in construction estimation also compete for the same customers for which the companies listed in this Monday’s article compete.
- Not focused on job shops – there is also a separate market for software used by small “job shops.” These are small, mostly family owned businesses, that typically manufacture one type of part, for example sheet metal, machined castings, etc. Some of the included vendors may sell to a few job shops, but there software is capable of being used by bigger enterprises.
- Generally Available Software – We only included vendors whose primary business involves selling a legitimate “generally available” software product (not a consulting business with internal tools)
Given these constraints, we believe this group represents over 90% of the revenue in the market today. If you know of other competitors who meet the criteria above and make over $2 million USD a year in revenue, let us know.
Keep the questions coming! We are glad there’s so much interest.