Procurement » Hiller Associates Product Cost Management

Comparing Quote Apples with Estimate Oranges

Product Cost in Industry, Purchasing / Sourcing 5 Responses »

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.

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.

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.

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!

Your Should-cost Number is Wrong, But It Doesn’t Matter

PCM Technique / Cost Models, Product Cost Culture, Purchasing / Sourcing 12 Responses »

Oct 292012

Last week Hiller Associates published an article on Should-cost in one of the leading online magazines for manufacturing companies, IndustryWeek.com. Below is a synopsis of the article. However, you may want to just read the article here:

Your Should-cost Number is Wrong, But It Doesn’t Matter

Should cost is not perfect, but it does not matter, because its purpose is to be a leverage tool to improve negotiated cost, regardless of the should-cost number’s absolute accuracy.

What is should cost?
Methods of should cost?
Uses of should cost, specifically to reduce the price of products one buys
No one expected Peter Lynch to achieve his absolute return predications for a stock
How to use should cost as pricing pressure

The Voice of Should-Cost (Voices Series, Part 3)

PCM Technique / Cost Models, Product Cost Culture, Purchasing / Sourcing, Uncategorized 4 Responses »

Jul 092012

It’s been a couple of weeks, since we discussed the Voices series, so if this post is interesting to you, you may want to go back and read the first two:

In these first two articles we introduced several of the voices that are always present in the Product Cost Management conversation, including:

The Voice of Hopefulness – the Pollyanna voice that assumes product cost will just work itself out in the end. It is a voice of justification to ignore Product Cost Management, because the team is just too busy at XYZ point in the development process to seriously consider product cost. Hope is NOT a strategy.
The Voice of Resignation – the nihilist voice that assumes that you have to accept high prices because the three suppliers that purchasing quoted gave you pricing far higher than what seems reasonable
The Voice of Bullying – the seemingly unreasonable scream of the customer telling you what your product should cost — not based on reality, but based on the customer’s own financial targets.

However, there is another voice in the conversation that can bring some reason to the cacophony. It is a voices of reason — the Voice of Should-cost.

Buck-up Cowboy. The Voice of Should-cost Can Help

Should-cost is just what it sounds like, using one or more techniques to provide an independent estimate of what the cost of a part or product “should” be. The question is, what does “should” really mean? For many, the definition depends on the type of cost being calculated, as well as personal should-cost calculation preferences. I will provide my own definition here, mostly targeted at providing a should-cost for a discretely manufactured part.

Should-Cost – The process of providing an independent estimate of cost for a part, assembly, component, etc. The should-cost is based on a specific design, that is made with a specific manufacturing process, and at a supplier with a specific financial structure. Or, the should-cost is calculated assuming a fictitious supplier in a given region of the world that uses the best manufacturing technology, efficiency operating at maximum sustainable capacity.

I realize that this is a broad definition, but as I said, it depends what you want to estimate. For instance, do you know the supplier’s exact manufacturing routing, overhead and labor rates, machine types, etc.? In this case, do you want to estimate what it “should” cost to manufacture the part under these conditions? OR… do you want to know what the cost “should” be for a new supplier who is well-suited to manufacture your design and has a healthy but not overheated order book? Although you could make many other assumptions, the point is: KNOW YOUR ASSUMPTIONS. You will note that I said nothing about margin. Some people call this a “Should-Price,” while others call it a “Should-Cost” referring to what they will pay vs. what the part costs the supplier to make. The only difference is that you will also make an assumption for a “reasonable” margin for a Should-Price.

The important point is that the team relying on the should-cost information must define the scenario for which they want a should-cost estimate. There is nothing wrong with wanting an answer for all these scenarios. In fact, it’s preferable. Run the calculation / estimate more than once.

Should-cost, Should Be a Choir, not a Solo Act

Manufacturing cost is a very tricky thing to calculate. I often say that the true cost of the economic resources to make a part or product is a number known but to God. Put statistically, you can’t know the true meaning or standard deviation of a population, you can only estimate it from the samples that you take. People take two common approaches to should-cost.

The Pop Star Solo Act

The popular solution that too many people pursue is the solution pictured at the right.

There’s no easy button to should-cost

They want the easy button — the single source of truth. They want the plasticized overproduced solo pop star version of should cost, i.e. the easy button tool. There’s nothing wrong with this and there are some really good should-cost solutions available, but none of them are infallible. In addition, it is not appropriate to put the same should-cost effort into each part or assembly in a problem. One should focus where the money is. However, too many people, especially cost management experts, become sycophants of one particular tool to the exclusion of others.

Single estimates in Product Cost Hiller Associates

The Lonely World of a Solo Should-cost Voice

Looking at the diagram to the left, you can see what the landscape looks like when you make your comparisons to one point in cost space. It is an uncertain, scary world when you only have one point of reference. In this case, all one can do is try to force a supplier to match the should-cost output of your favorite tool.

The Andrews Sisters, Competitive Trio Quoting

The other very popular approach comes from the purchasing department: three competitive quotes. If the auto-tuned single pop star should-cost is too uncertain, purchasing will listen to a trio instead. Why three quotes?

Supplier quotes in Product Cost Hiller Associates

The Trio of Should-cost Quoting

No one seems to know, but in EVERY purchasing department with which I have ever worked, three shall be the number of the quoting, and the number of the quoting shall be three. [If you are an engineer, you know my allusion. If not, watch the video to the left!] The trio of quotes in the diagram to the right do help clarify the picture a little better, but there is still too much uncertainty and what I call “commercial noise” to really believe that the quotes alone bound what the should-cost plus a reasonable margin is in reality.

An Ensemble of Should-Cost Estimates

Returning to our statistics example, one of the first things you learn in statistics is that it takes about 33 samples to characterize a bell curve distribution. At 33 samples, you can start to approximate the true mean and standard deviation of the actual population. I am not saying that one needs 33 estimates of should-cost to triangulate on the true cost, but you should get as many as you can within a reasonable time frame. Have a look at the diagram at the right to see this illustrated. Instead of the single pop star approach or the Andrews Sisters trio of quotes, hopefully what you get is a well-tuned small chorus of voices who start to drown out the Voices of Resignation, Hope, and Bullying. The chorus of should-cost estimates start to bound the “true” should-cost of the part or product and can give the team a lot more confidence.

Triangulating on Product Cost Hiller Associates

Chorus of Should Cost [CLICK TO ENLARGE!]

Sometimes the team does not have time to assemble all the voices of should-cost. Not all parts or products are worth assembling the full choir. More often than not, the organization is either unaware of the should-cost voices at its disposal, or are just too lazy to assemble them.

Don’t let your organization be lazy or sloppy with respect to should-cost, and remember that the best music is made when groups of instruments and voices work together, not when one person sings in isolation.

p.s. Bonus PCM points if you can guess what a cappella group is pictured in the thumb nail to the post

Don’t Pave the Cowpath; Plan the Autobahn (Part 3 of Pete Schmitz at Harley-Davidson)

Product Cost Culture, Product Cost in Industry, Product Cost Management, Purchasing / Sourcing No Responses »

Jun 252012

Today we have the third in our series of insights from the article “Putting it All Together at Harley-Davidson.”

At the end of the article, Pete Schmitz strikes a chord in my heart when talking about supplier selection:

[Schmitz] Don’t pave a cowpath! We believe in never automating a bad process – first, fix the process, do a solid supplier selection, then automate it. The tools are only so good – at the core it is the philosophy.

I believe this is a brilliant observation. Too often, companies that want to get involved in Product Cost Management kick start their PCM efforts after a particularly painful event where they missed a profit or product cost target on a specific product. Often, their first impulse is, “What tool can help me solve this problem?” That is just human nature, especially in our modern technological society, to look for an instant, easy, off-the-shelf solution to all the things that bring us woe. Isn’t there an app for that? For most complex problems in life, there is not an app for it, and if there is, that app does not work in isolation. To make a tool work well, we have to assume that three other elements are considered:

Culture
Process
Roles

We talked about these three elements and the fourth (Tools) in our discussion on the PCM World Map before. I would argue that you need to start with Process. Depending on the maturity of your Product Cost Management culture, you may be able to handle a more or less complicated set of PCM processes. However, Pete Schmitz at least takes the focus from Tools up to the Process, which is major progress.

His analogy is interesting. If you have a traffic problem, and the road connecting two places in a winding narrow cowpath, the solution is not to pave the winding road. Cars move faster than cows and are wider. Cows make cowpaths seeking the path of least resistance and not being able to remove inherent natural roadblocks and bottlenecks. But, if you need to move thousands of cars per hour, you would look at the two places and see where the straightest path would be. Within reason and technical ability, you will invest in removing the natural roadblocks first and then lay down a solid foundation, before paving a wide road.

Think of Product Cost Management like this too. Buying the software tools to supercharge your process is the last step in your journey. Consider the diagram to the right.

Fix the process in Product Cost Management Hiller Associates

Don’t Pave the Cowpath –> Simply and Supercharge!

Most people want to buy tools to speed up an existing PCM process. However, there are usually many inherent problems, including:

There is NO Product Cost Management process to begin with
The old PCM process assumes a certain level of tools and roles/team attention
The old PCM process developed in an emergent way, i.e. no one ever design it; it just happened.
The old PCM process assumes a much lower priority on profit and product cost and the company wants in the future.

Assuming your firm is already clear on your PCM goals, the firm first should lay out the PCM process that will accomplish those goals, which are specific to its corporate culture.

As shown on the diagram, when you focus exclusively on the new tool, the firm will simply move from the existing process on the left to the the upper right diagram. Here, the firm keeps the old byzantine cowpath process that was constructed with more primitive (or no) PCM tools in mind. At best, the firm is just slightly speeding up the wrong process with new tools. However, often the firm will realize no benefit from the new PCM tools, and they may even slow the process down further!

Compare this to the diagram at the bottom right. Here, the process has been re-designed and value streamed with the the availability of newer tools in mind. The firm has removed old process steps that are no longer value added. In the bottom right process, the same PCM tools can much better supercharge a clean straight process.

Don’t pave the cowpath; plan the Product Cost Management autobahn.

Eric

Note: there is no PCM Tool today that can handle all of the many varied use cases most firms have for Product Cost Management. You may likely need more than one of them and some of your own internal tools. This is no reason for despair, though. By realizing this and picking the PCM toolset that seamlessly threads into your PCM process, this is your opportunity to out distance your competition.

What are you trying to boil? (Part 2 of Pete Schmitz at Harley-Davidson)

Product Cost Culture, Product Cost in Industry, Purchasing / Sourcing No Responses »

Jun 182012

To continue my thoughts from last week’s blog regarding the article “Putting it All Together at Harley-Davidson“, I’ve put together some additional insights below.

Keep Your Product Cost Management Promises and Don’t Force Others into Promises They Can’t Keep

I am reminded of a story about, Saint Augustine of Hippo, a brilliant theologian, who meets a young boy along the Mediterranean sea sea shore one day. As the story goes, Augustine had gone for a walk to clear his prodigious brain, trying to fathom the Christian mystery of the Trinity. He sees a little boy running back and forth between the sea and a hole that the boy dug on the beach. The boy uses a little bucket to transfer water from the sea to the hole. Augustine asks the little boy what he is doing, and the boy replies that he is draining the ocean. Augustine laughs at him and tells him that his goal is ludicrous, and he’ll never do it. At this, the little boy replies to the great Doctor of the Church, “I’ll accomplish MY goal before you get to yours!”

Spiritual implications aside, the secular point is that there are goals that cannot be achieved. In the article, Schmitz talks about his time at Honda:

“Plus, at Honda we learned to never miss a target, to never make a commitment that we couldn’t keep.”

That is a subtle, but important point. I don’t believe the bigger problem is people not keeping realistic commitments, but forcing the team for sign up to unrealistic commitments. The culture of US business has morphed to a state where everyone must accept “stretch” goals, some of which are ridiculous. In addition, eager managers make assumptions about the execution of projects. Getting a project authorized is the equivalent to assuming that that the Boston Red Sox will hit 3 home runs per inning for a whole game. Managers who accept such ludicrous targets are “inspiring leaders with a ‘can-do’ attitude;” while those who cry foul on silly expectations are “negative” and “not team players.” The article on Harley seems to say that Honda has at least partially overcome this problem and is a bit more realistic in goal setting and acceptance.

Reality Cannot Be Fooled Repeatedly for Very Long

There are “stretch” goals, and then there are miracles. For example, consider the picture below. This leads us to ask, how do you know if your goal is too aggressive in Product Cost Management? I don’t have an exact answer, but I would suggest that people think of goal setting like tolerance stack up. Managers should remember back to the days when they were engineers. If a design is so delicate that all parts must have extremely tight tolerances and must be heated/cooled to assemble, would you say this is a design that will ever work in the real world of production? No. Alright, so when you are setting your product cost targets, reduction targets, or any other target, consider what intermediate goals must be reached to accomplish the overall target. It is a lot easier to assess the chance of accomplishing the more narrow intermediate goals than the big longer term goal. If you need flawless execution on each intermediate goal to achieve the overall goal, you may want to consider whether or not you are boiling the ocean.

Part 3 in this series is coming soon.

Where’s Finance and Accounting in Product Cost Management? (Part 1 of Pete Schmitz at Harley-Davidson)

Product Cost Culture, Product Cost in Industry, Product Cost Management, Purchasing / Sourcing 8 Responses »

Jun 112012

I just read the article “Putting it All Together at Harley-Davidson” in the July 2012 [July??] Blue Heron Journal. The article is a profile on Pete Schmitz, a Honda veteran in Product Cost Management, who now works at Harley-Davidson. According to the article,:

“[Schmitz] combines procurement, design, manufacturing and cost expertise in a unique job function. Reporting up ultimately to Harley’s CFO, Schmitz describes his ten year Finance Product Cost Manager position as ‘the cat bird’s seat…we are the neutral third party in product development – getting the whole organization to work together.”

That perked up my ears right away. As many of our readers may know, Harley Davidson is a classic case study in the positive effects of successful Product Cost Management. It was an exciting article to me for several reasons. I would like to explore them in the next few days in some shorter posts. The first insight that I gained from the article is the following:

Finance Must be Involved with Purchasing and Engineering

According to the article, Harley is at the mature stage of Product Cost Management making their efforts truly cross-functional. Specifically, the finance (maybe accounting too?) people are involved directly with the engineering and purchasing groups. That is impressive. If you are familiar with Product Cost Management efforts, you know how difficult it can be just to get engineering and purchasing to work together. However, getting finance and accounting meaningfully involved is even harder in my experience. That is unfortunate, because often finance and accounting have so much of the existing data that the cost management team needs to make valid cost models, do spend analytics, etc.

I am not sure why finance and accounting often shy away from participating in PCM efforts. My own experience is that the finance and accounting people are uncomfortable with the very physical world that includes the Bill of Material (BOM) and purchasing commodities. Moreover, the PCM team often needs to recalculate overhead and other financial rates to be RELEVANT for cost management analyses. This recalculation is is very different from the RELIABILITY focused, acceptable financial accounting viewpoint with which the accounting team is comfortable. That is just a general guess from my experience over the years, but maybe a reader can provide more insight. Regardless, I would urge more finance and accounting folks to step out of their comfort zone in the financial world to participate in the physical world with engineering, purchasing, and manufacturing.

Translating from the Physical World to the Financial

At the end of the day, isn’t translating the physical into the financial what Product Cost Management is about? I actually wrote one of my first blog posts in 2007 about this concept for Jason Busch at SpendMatters. The article is called What’s The Language of Your Business? It’s very helpful to ensuring a good translation when experts in all languages are present during the translation work. Ergo, both the people that speak physical (features, functions, BOM, machines, and supplier) and people who speak financial (dollars, overhead rates, internal rate of return, net present value) need to be around the table to make sure nothing is lost in translation.

See you again soon with part 2.

The Voices of Discord in Product Cost Management (Voices Series, Part 2)

Product Cost Culture, Product Cost in Industry, Product Cost Management 1 Response »

May 212012

In last week’s post “Do you hear the voices? (Voices Series, Part 1) ” we talked about the different voices that speak throughout the product life cycle and how they relate to Product Cost Management. This week, we’ll talk about some voices give bad advice and expectations. As the diagram to the left shows (click to enlarge), there are at least two typical conversations happening in the product life cycle. The conversation at the top shows the voices that are beneficial to Product Cost Management and help lead to a profitable product. The conversation at the bottom has some of the same voices, but also replaces some of the voices with new, discordant voices, who more often than not, lead to an unprofitable product.

Voices in Product Cost Management Hiller Associates

CLICK TO ENLARGE Good and Bad Product Cost Conversations

Hope is Not a Strategy

Organizations have a variety of excuses for why they don’t let the Voice of Reason limit the finance team’s desires for product cost or profit. The same is true for not listening to the Voice of Intent (seriously evaluating alternatives in concept design and costing them), and for having no Voice of Engineering (not doing product cost management in engineering or being lax on cost roll-ups). These voices are replaced by a new voice: the Voice of Hope!

“Hope” — that sounds pretty positive, doesn’t it? However, as Rick Page taught us in his book, if hope is not a strategy for sales, why would a company think it is a good strategy for its Product Cost Management? The difference between a conversation on product cost with the Voices of Reason / Intent / Engineering vs. a conversation with only the Voice of Hope is the difference between a profitable and unprofitable product.

The Voice of Resignation (…or Eeyore)

Eeyore Voices in Product Cost Management Hiller Associates

Voice of Resignation

This brings us to the Voice of Partners and the Market, i.e. your suppliers and factory who have to actually deliver your new product. The supplier or plant will determine the price at which they are willing to sell to you.

People often add pernicious voices to the conversation that are manic depressive opposites. The first is the Voice of Resignation. If you have kids, or if you ever were a kid, you may know this as the Voice of Eeyore. Eeyore is the lovable, but chronically dejected donkey in Winnie the Pooh. This voice says, “I don’t care what your ‘should-cost’ says. This is what the market will sell for, so I guess that I have to buy at that price.”

The Voice of the Bullying (…800 lbs and growing)

The manic brother of the Voice of Resignation is the Voice of Bullying. However, instead of Tigger as the opposite of Eeyore, we have another mascot for this voice — the 800 pound gorilla. After all, Tigger is more of an annoyance than a bully. The Voice of Bullying

Gorillas in Product Cost Management Hiller Associates

The 800 Lbs Customer Purchaser

says: “We’re the 800 pound gorilla customer, and we’ll use our weight to force some cost reductions with the supplier.” Is the price requested reasonable? The 800 pound gorilla doesn’t care, because he needs the price to be what he wants it to be for one of several reasons that are beyond explanation in this post. I plan to discuss the reasons more fully in a subsequent post, but for now we’ll just list them as the following:

Cost was never targeted properly in the first place (a.k.a. the Voice of Hope was listened to over the Voice of Reason)
Engineering let things get out of control (a.k.a. the Voice of Sound Cost Engineering was replaced with the Voice of Hope… or apathy)
The Voice of the Ghost-of-Product-Costs-Past haunts purchasing (a.k.a. the demand for post-launch cost reductions)

So, how do we silence, or better yet, learn from the Voice of Resignation and the Voice of Bullying, while keeping them in control? I’ll leave that for next time.

Do you hear the voices? (Voices Series, Part 1)

Product Cost Culture, Product Cost in Industry, Product Cost Management 4 Responses »

May 142012

Lately, it’s become popular to talk about “voices” in business, e.g. the “Voice of the Customer.” With all the voices, it is difficult not to wonder if one is listening in on a business meeting, or a group of choral composers arguing over the score’s balance, psychologists trying to diagnose a patient, or a kitschy show with karaoke singers trying to go pro. I believe that the “voice” nomenclature is the new new way to say “stakeholders,” a term that was the new way to describe the groups of people and forces of the universe that prioritize your product decisions and limit its possibilities.

All frivolity aside, the Voices framework is not a bad one. Instead of arguing over what we call the rose, I’d like to focus on WHO and WHAT those voices are with respect to Product Cost Management. Click on the diagram to the right. In this graphic, I show three categories across the product development cycle:

Click to Enlarge! Voices in Product Cost Management

What are the ‘Voices’ in the discussion of product cost and profit
What are the target costs or cost statuses that the voices dictate or influence
What are the ways that people can estimate the cost target or cost

The First Voices in the Discussion Had Better Be Balanced

The first two voices are the Voice of the Customer and the Voice of the Business. The Voice of the Customer is supposed to tell you what consumers will pay for a certain bucket of product features and attributes based on perceived customer value. Understanding the weird customer dialects isn’t so easy because customers won’t give you an exact number for the price they expect, such as $44.85. If customers do give you an exact number, the number should still be considered fuzzy because customers have a hard time conceiving the value of your intended offer. It is traditionally marketing’s job to read these tea leaves in order to decipher the Voice of the Customer.

The second voice, the Voice of the Business, gives us the Product Target Price and Product (System) Level Cost Target. To illustrate, the CEO or Group VP comes in and says, “We need X total revenue and Y market share,” and the VP of Finance comes in and says “We need to have Z profit margin on the product.” Great! Right? Well, yes, but this is a TOP-DOWN cost target, or as the EE‘s in the room would say, an “open loop” control. Normal people refer to this as an “estimate” or a “guess” (a.k.a. a hope).

Trade-offs in Product Cost Management Hiller Associates

Click to Enlarge! Product Fiscal Planning Triangle

The hopeful nature of the top-down product cost target is why the next voice in the discussion is so important: the Voice of Reason. What modern businesses don’t like to think about (or have been taught not to by consultants) is that there is a fairly rigid triangle (see the figure to the left) linking the price you must charge (or the customer will pay), the feature set (value) you will deliver in the product, and the product’s cost (margin). If you set two of the corners of the triangle, the third will move to compensate. I am not saying that people cannot do better on their product cost, but there are limits.

The key is to ALSO estimate what is theoretically possible for product cost in a BOTTOMS UP way — given REASONABLE assumptions.

The bottoms-up estimate moves you from an open loop control to a closed loop control (with feedback for adjustment), as the EE’s would say. If the top-down and the bottoms-up costs are too far apart, somebody needs to throw a flag. The first figure above shows the methods one can use to get an early bottoms-up product cost estimate. Another voice that is often not heard is the Voice of Intent. People often just assume a design alternative and immediately launch into full scale engineering. But the old DARPA study told us that 80% of cost is decided in the first 20% of decision making. So, the solution is pretty obvious.

Spend significant effort and time in the concept design stage seriously generating, considering, and costing a series of alternatives with your cross-functional team of design, manufacturing, purchasing, etc.

Spend the money needed on comparative teardowns of carryover systems you plan to cost reduce and systems with new features you plan to design versus similar systems of your competitors’ products. Spend time together in a workshop evaluating your design alternatives and estimating your costs (raw material, manufacturing, shipping, etc.). You do not need triple point precision — you only need a good enough estimate to allow you to compare one alternative to another. Then you should give a REVISED Product Cost Target to management and marketing. Very little cost has been spent up to this point, so if a program needs to be stopped or modified, now is the time!

Keep the Conversation Going

The next voice that should be in the product cost discussion is the Voice of Engineering. Often, the discussion on product cost just stops for months or years until suppliers send in the first quotes at the end of the detailed design phase. However, the conversation should continue. Where is the engineering team in their cost roll-ups? Have they discovered problems and barriers that will force costly changes, or have they found clever ways to beat the cost target?

Shrink the Triangle with Should-Cost and Spend Analytics

The Voice of Partners and the Market refers to the price your suppliers (or your internal plant) will charge you to produce your design. If you want to get the best prices, it is important to understand another triangle: the Purchased Cost Triangle (to the right). The corners of this triangle are the price the supplier or plant quotes, the final cost you negotiate with the supplier/plant, and your should-cost calculations. Here’s the secret: this triangle is much more flexible and stretchy than the product fiscal planning triangle above. Powered by the number and quality of your should-cost and spend analytics estimates, you want to drive all three vertexes together and converge. Product cost is a difficult and fuzzy world; it’s even fuzzier when you have no facts (or even well-reasoned estimates) to rely upon.

Triangulating in Product Cost Management Hiller Associates

Click to Enlarge! Purchased Cost Triangle

If you want your Negotiated Costs to reflect the actual costs of manufacturing plus a reasonable supplier margin, invest heavily in good Should Cost and Spend Analytics.

If that’s too hard or too expensive… well, it’s only your product’s profit anyway, right?

Time to Pay the Piper

For the most part, the final voices settle things. The Voice of Realization happens when you actually start to make the product and do the formal accounting to see what the product actually costs. Sadly, this is where most companies spend the lion share of their product cost management effort. This is not to say that there are not opportunities to reduce costs after launch. However, this is not where companies should be spending a lot of Product Cost Management effort. Cost is pretty much set at this point, and companies should be working on the NEXT product.

The last voice is the Voice of Regulation / Responsibility. In general, the Voice of Regulation should be known up front, in regards to disposal fees or other government penalties and taxes for which the company is responsible. On the other hand, the Voice of Responsibility is trickier. The company should take its warranty predictions very seriously. Most products, though, tend to have surprises, and they are typically not positive surprises. Sometimes, the Voice of Responsibility speaks with legal authority (e.g. contractual warranty), but it should also speak to the corporate conscience to do the right thing for the customer, even when the company is not legally bound.

Next week….

This week we talked about how things SHOULD work. However, the framework and solutions presented are not how many companies DO work. Next week, we’ll talk the ad hoc and emergent system by which most companies operate, and what problems this causes.