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SUBJECT: Deriving Target Product Cost Elements

ALPHANUMERIC IDENTIFIER:

BRIEF DESCRIPTION: Direct material cost currently represent 30% to 70% of most manufacturers COGS. Therefore, the role of the Purchasing function is increasingly gaining corporate management's attention and is now seen as a major contributor to a corporation’s success in the areas of profits, product quality, reduced cycle time, and the early introduction of new products. Chris Ingraham, past Vice President of Polaroid Corporation, made the following statement recognizing the contribution of the purchasing function: "Today, there is no single group in the corporation with more direct influence on the bottom line than the purchasing organization"¹. The purpose of this section is to describe the use of strategic cost management to derive target product cost elements for key purchased components.

KEYWORDS: should cost, target cost, product cost, all-in costs, allowable cost

OVERVIEW:

The importance of strategic cost management can perhaps be best illustrated by the following "rule of thumb":

• Material Cost % (MC%) = Material Costs / Revenue

• Net Income % (NI%) = Net Income / Revenue

The ratio of MC% divided by NI% provides an estimate of the impact of procurement savings relative to sales increase to a company’s bottom line. For example, if the MC% is 60% and the NI% is 8% (ratio = 60%/8% = 7.5%), then a 1% reduction in material cost has the same impact to net income as a 7.5% increase in sales. Therefore, a solid understanding of a supplier’s cost structure is paramount to strategic cost management.

Strategic Cost Analysis to Determine Target Costs

Need for cost analysis: The need for cost data in strategic supplier relations is underscored by the following reasons: prevents disagreement on facts, fosters a "common starting point" for contract management, and forces buyer to identify and understand major cost elements which facilitates the development of a cost management strategy¹. Cost data can be obtained through strategic alliances with suppliers, industry cost models, and from supplier responses to request for proposal requirements. Many industry experts advocate this last method as the most effective way to engage in an "open book" relationship with suppliers from the beginning of a relationship.

Cost Model: The cost model described in this section is the "percentage of sales" method. Prior to delving into the details of this method, some key cost definitions will be provided.

• Net Sales: Gross sales – returns & discounts

• COGS: Material + Direct Labor + Factory OH

• Gross Profit: Net Sales – COGS

• Operating Exp.: General, Selling & Administrative, R & D, Depreciation

• Other Exp.: Miscellaneous, Interest, and other non-operating expenses

• Profit before: Gross Profit – Operating Expenses – Other Exp.

• Taxes

Example: The best way to describe this method is by providing description of the steps to be conducted with a sample product.

0. The buyer should obtain the latest copy of the following information sources:

• Annual Survey of Manufacturers (ASM): Statistics for Industry Groups and Studies, Table 2 Statistics for industry groups and industries (see Exhibit 1)
• Robert Morris Associates (RMA) Annual Statement Studies (see Exhibit 2)

• Both of these publications are available in the Kresge Library.

2. The first step is to obtain the SIC code representing the manufacturing classification of a particular supplier.

• For this example use SIC code 2522 (Office Furniture, except wood)

3. Next, the buyer should obtain an estimate of the supplier’s annual sales generated by the plant or plants producing the part to be purchased.

• Assume that the supplier’s plant generates $50 M in sales

4. Buyer should obtain relevant Income Statement Data from RMA.

• On the "Current Data Sorted by Sales" section we obtain the following for SIC code 2522 (see Exhibit 2)

Income Data:      Net Sales 100%

Gross Profit 27.1%

Operating Expenses 20.2%

Other Expenses 2.4%

Profit Before Taxes 4.5%

5. Calculate COGS as a percentage of sales

• COGS = Net Sales – Gross Profit = 100% - 27.1% = 72.9%

6. Calculate Direct Materials as a percentage of Sales by using the ASM Table 2 for SIC code 2522 (see Exhibit 1)

• Direct Materials % = ASM "Cost of Materials" ($ M) {Column G} = 2656

ASM "Value of Industry Shipments ($ M) {Column H} 6320

42%

7. Calculate Direct Labor as a percentage of Sales by using the ASM Table 2 for SIC code 2522

• Direct Labor % =ASM "Wages" ($M) {Column E} = 873

ASM "Value of Industry Shipments ($ M) {Column H} 6320

14%

8. Calculate Factory Overhead

• Factory Overhead = COGS – Direct Materials % - Direct Labor %

= 72.9% - 42% - 14% = 16.9%

9. You are now ready to decompose a suppliers quote into its key elements

• Suppose the supplier has quoted a price of $400 for an office chair. You are going to purchase hundreds of them and would like to get a good understanding of the supplier’s cost structure.
• Cost Structure

Armed with the information captured in the example above, the buyer is in an excellent position to engage in cost management negotiations with a particular supplier. The buyer should then engage in an iterative process to continuously fine tune the cost elements illustrated above. For example, if the supplier is operating in a geographic region where wages exceed the national average, then the direct labor element should be adjusted accordingly. A plant tour may reveal other areas where a supplier's cost structure deviates from industry averages. For example, a visit may reveal that a supplier's plant contains a high degree of automation and therefore the overhead element should be adjusted. The buyer is also encouraged to consult with engineers to develop a more accurate estimate of the direct material cost element. Usually this is the easiest element to estimate since many times the buyer has specific material requirements.

The method outlined above is a best practice in the area of purchasing management. It provides purchasing agents with an excellent starting point to pursue strategic cost management initiatives. Unfortunately, current practice indicates that the use of these strategic cost management tools is not prevalent in the purchasing departments of most US manufacturing companies. Although some positive trends are starting to emerge, major improvements are needed to fully benefit from these methods. If well implemented, they set the stage for the establishment of lean manufacturing principles with a company's key supply base.

REFERENCES:

• Anklesaria, J., Norquist, W., Burt, D., Zero Base Pricing^TM: Achieving World Class Competitiveness Through Reduced All-in-costs, Chicago, Illinois: Probus Publishing Company, 1990
• Bhote, K, Strategic Supply Management, New York: AMACOM, 1989
• Dobler, D.; Burt, D.; Lee, L..; Purchasing and Materials Management Text and Cases, New York: McGraw-Hill, Inc., 1990
• Schronberger, R, World Class Manufacturing, New York: The Free Press, 1986
• 1993 Annual Survey of Manufacturers: Statistics for Industry Groups and Industries, Bureau of the Census, U.S. Department of Commerce, Superintendant of Documents, U.S. Govt. Printing Office, Washington, DC 20402, Telephone: (202) 275-3054.
• 1996 Robert Morris Associates Annual Statement Studies, Morris Associates, One Liberty Place, 1650 Market Street, 23^rd Floor, Philadelphia, PA 19103-9734, Telephone: (215) 851-0585

ACKNOWLEDGEMENT: This is a March 29, 1999 revision by Gene Goodson of an assignment for OM742 contributed by TM.