materials management bus 3 – 141 cost management, discounts, & negotiation october 22, 2007

Materials Management

BUS 3 – 141

Cost Management, Discounts, & Negotiation

October 22, 2007

2

Agenda

– Cost Types

– Total Cost of Ownership

– Target Pricing

– Learning Curve and Discounts

– Negotiation

3

Case 2: Sedgman Steel (p. 176) Due Oct 29, 2007Please include the following:

1. FACTS OF THE CASE Quantitative data (Revenue, Inventory, Costs, Employees, Divisions, etc….)

2. BUSINESS ISSUES IDENTIFIED Customers, Suppliers, Internal Measurement Systems, Organization, Competitors, Supply Shortages, Price Increases, Cash Flow, etc…)

3. CONCLUSIONS What has been going well? What needs improvement?

4. RECOMMENDATIONS What improvements should be made? What (if any?) activities should be stopped? How can the improvements be implemented?

Be concise. Use a format equivalent to what you would use in writing a persuasive email to your boss. Try to limit your report to no more than one page, single-spaced. Longer will be accepted, but is not required.

Approx. 20% of Total Effort / Grade




4

Comparison of Fixed & Variable Costs with Volume

Unit Cost

1,000 2,000 5,000

Direct materials $5.50 Direct Variable 5,500.00 11,000.00 27,500.00

+ Direct labor $2.00 Direct Variable 2,000.00 4,000.00 10,000.00

+ Factory Overhead Indirect Fixed* 2,500.00 2,500.00 2,500.00

= Manufacturing Cost $7.50 $10,000.00 $17,500.00 $40,000.00

= Unit Mfg. Cost $10.00 $8.75 $8.00

+General, administrative, and Selling cost

Indirect Fixed* 1,500.00 1,500.00 1,500.00

= Total Cost $11,500.00 $19,000.00 $41,500.00

Average Unit Cost $11.50 $9.50 $8.30

Selling Price $12.42 $12.42 $12.42

Profit 920.00 5,840.00 20,600.00

Profit Percentage 8% 31% 50%

Cost Behavior

Units Sold

Understanding Supplier Fixed and Variable costs is CRITICAL to any Negotiation

Cost Types

6

Labor and Material Costs

Labor:

– Direct hours worked X Hourly Rates

– Often charged based on Standard Hours per job

Material:

– Taken from Bill Of Material (if provided)

– When purchasing manufactured items, some supplier material costs can be reasonably estimated

• Raw material cost is openly available• Component cost can be obtained from catalogues and

the internet

There should be little – or no – Supplier Markupon material used to make the Purchased Item

7

Examples of Overhead and General & Administrative Costs

Overhead:

– Indirect facilities and personnel costs incurred in:

• Manufacturing• Research• Engineering

– Equipment depreciation

– Other

General & Administrative (G&A):

– Selling

– Promotion

– Advertising

– Executive Salaries

– Legal

– Other

Overhead and G&A are a major factor in calculating Standard Cost atexpected overall volumes, but less relevant for calculating the costof incremental units for unexpected orders or additional volumes

8

Labor, Material, and Overhead – Small Business Example

Since you were traveling earlier while we spoke on the phone, and I was talking quickly, I thought it would be useful to list my concerns regarding the price of the booster pump and the fee for installation.

Your charge of $305.00 for the Letro Booster Pump is higher than is apparently available from many sources. A simple Google search yielded several suppliers selling the item for well under $200.00. I also checked the Leslie's pool site and there was a Hayward Booster Pump on sale for $224.99, reduced from $259.99. I would expect that as a contractor, you would have access to even better pricing, since you are likely paying wholesale, rather than the Retail prices I was able to find. I would also expect that since Pam and I have been solid customers for many years, you would charge little to no additional mark up on parts.

I have two concerns regarding the Installation. One is based on the underlying hourly rate you charge. Please explain the Rate and Time that resulted in the $125.00 charge.

My second concern regarding the Installation fee is based on my assumption that there is some amount of "non-routine" service that is already included in your $100.00 monthly charge. When you provide the standard weekly service, and you are in and out in minutes, I am pleased to pay you the $100.00. I don't feel a need for you to "justify" your fee by spending a lot of time. In reality, I am paying you to worry about my pool for me. And if you can do that quickly and move on, it is good for both of us. However, if you have to do a little extra, I would assume that you have already accounted for some amount of that effort in your rates. What do you consider as included in the "standard" service, and what do you consider as incremental, and thus would require an additional charge?

Based on these concerns, please adjust your charges for the Booster Pump and its installation. Either reply to this email or call me at xxx-xxx-xxxx, so that we can agree on a revised total that is reasonable for both of us.

9

Additional Cost Items

– Understanding cost helps you negotiate Price

– Previous estimates when analyzing make / buy decisions become a basis for understanding supplier cost

– Co-workers who were previously employed at suppliers often understand supplier cost structure

– Start-up costs and Setup costs are frequently separated from future unit costs

• Common in printing business• Common in subcontract manufacturing

– In New Product Development, it is recommended to separate research and start-up costs from production unit costs

• Nonrecurring Engineering as a separate line item• Tooling as a separate line item• Units produced as a separate line item

Total Cost of Ownership

11

Total Cost of Ownership

Understanding total costs is a good early step inidentifying Improvement opportunity

ALL costs associated with the item:

– Acquisition (purchase)

– Administration

– Follow-up

– Expediting

– Transportation

– Inspection & Test

– Rework

– Storage

– Scrap

– Warranty

– Service

– Downtime

– Customer Returns

– Lost Sales

12

The Components of Total Cost of Ownership

– Identifying need

– Investigating sources

– Qualifying sources

– Adding supplier to internal systems

– Educating:

• Supplier in firm’s operations

• Firm in supplier’s operations

– Price– Order

placement/preparation– Delivery/transportation– Tariffs/duties– Billing/payment– Inspection– Return of parts– Follow-up & correction

– Line fallout– Defective finished goods

rejected before sale– Field failures– Repair/replacement in

field– Customer goodwill /

reputation of firm– Cost of repair parts– Cost of maintenance and

repairs

Pre-transaction Transaction Post-transaction

Source: Lisa Ellram, “Total Cost of Ownership: Elements and Implementation,” International Journal of Purchasingand Materials Management, Winter 1993.

* From Leenders, Johnson, Flynn, and Fearon, Purchasing and Supply Management, Thirteenth Edition, McGraw Hill Irwin

Target Pricing

14

Target Pricing

Cost ProfitSalesPrice

Traditional:

+ =

SalesPrice

(Market)Profit Cost

Target Pricing:

- =

Instead of adding profit and cost to establish a selling price, the organizationstarts with the market price and required profit to establish a target cost toachieve the necessary profit. The Supply function becomes responsible forworking internally and with suppliers to achieve the target

15

Target Pricing drives cost reduction beyond Purchasing

– Design-to-Cost on the part of Design Engineering

– Manufacture-to-Cost on the part of Production

– Purchase-to-Cost on the part of Supply

The targets also drive cross-functionalcommunication and shared problem-solving

You get what you EXPECT and what you MEASURE

16

Target Pricing is key in Defining Product Specifications

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0 1 2 3 4 5 6 7 8% of Dollars SPENT on the Item over Time

% o

f D

olla

rs C

OM

MIT

ED

to

the

Ite

m

* For illustration only; numbers are approximations

The Initial Development & Design is the biggest factor in Life Cycle spend

While volume buying takes place to support full scale production

Other Cost ItemsLearning Curve & Discounts

18

Learning Curve

With practice and repetition, performance improves.Expected improvement can be calculated and

incorporated into future cost projections

The “Learning Curve” is a calculation that estimates the rate of improvement as output doubles. It implies that improvement NEVER stops. The relevance to Supply is lower price targets for future deliveries

Units 95% 90% 85% 80% 75% 70%1 10.0 11.0 12.0 13.0 14.0 15.02 9.5 9.9 10.2 10.4 10.5 10.54 9.0 8.9 8.7 8.3 7.9 7.48 8.6 8.0 7.4 6.7 5.9 5.1

16 8.1 7.2 6.3 5.3 4.4 3.632 7.7 6.5 5.3 4.3 3.3 2.564 7.4 5.8 4.5 3.4 2.5 1.8128 7.0 5.3 3.8 2.7 1.9 1.2256 6.6 4.7 3.3 2.2 1.4 0.9512 6.3 4.3 2.8 1.7 1.1 0.6

1,024 6.0 3.8 2.4 1.4 0.8 0.42,048 5.7 3.5 2.0 1.1 0.6 0.34,096 5.4 3.1 1.7 0.9 0.4 0.28,192 5.1 2.8 1.5 0.7 0.3 0.1

16,384 4.9 2.5 1.2 0.6 0.2 0.1

Exp

ecte

d H

ou

rs p

er U

nit

19

Discounts

Discounts are a LEGITIMATE and effective means of reducing prices.They may offered by Suppliers or negotiated by Buyers

Cash DiscountsIncentive to pay early. Usually 2% if payment is made within 10 Days

Trade DiscountsPaid to distributors in exchange for providing administrative and selling services

Quantity DiscountsA function of amortizing fixed costs over many units

Cumulative / Volume Discounts

Accumulates the individual volumes of multiple items. If total volume thresholds are passed, the discount is applied to all

Negotiation

21

How this Course supports Supply Chain Objective & Process

The RightQUALITY

The RightQUANTITY

The Right TIME

The Right PLACE

The Right SUPPLIER

The Right SERVICE

The Right PRICE

at the

with the

at the

with the

and

paying

22

Background

– Not the same as “haggling”

• Honest• Professional• Fact based• Data driven

– Different approaches for different situations

• One-time purchase with a non-partner supplier (buying a car)• Recurring purchases with an ongoing partner supplier• Initial purchase with a potential partner supplier

– Different approaches for different Purchase Types

• Less leverage for most raw materials, standard, and low-value items

• More leverage in special items and Capital Goods• ABC classification is key

– Get EVERYTHING in WRITING

23

Relationship between ABC Classification and Negotiation

– Highest dollar items need to also have the highest value

– Cross-functional teams contribute input

– Significant time commitment from many people

– Significant fixed cost that should be recovered in better pricing

Focus negotiating efforts on the BIGGEST PAYBACKfor the time and cost invested

24

Different approaches for different Purchase Types

RawMaterials

StandardProduction

Items ofSmallValue

SpecialItems

ServicesCapitalGoods

Resale

– Global sources of Supply

– Potential for design and specification modifications

Special Items

– Very high dollar purchases

– Many non-price items can be included

Capital Goods

– Can often be “A” items, especially with outsourcing relationships

– Often very competitive market, with many alternative sources of supply

Services

Best Opportunity to Negotiate

25

Non-price Negotiation

Quality

• Specification compliance

• Performance compliance

• Test criteria

• Rejection procedures

• Liability

• Reliability

• Design changes

Support

• Technical assistance

• Product research, development, and/or design

• Warranty

• Spare parts

• Training

• Tooling

• Packaging

• Data sharing, including technical data

Supply

• Lead times

• Delivery schedule

• Consignment stocks

• Expansion options

• Supplier inventories

• Cancellation options

Transportation

• FOB terms

• Carrier

• Commodity classification

• Freight allowance/equalization

• Multiple delivery points


NegotiationPlanning and Execution

27

The Basic Steps in Developing and Negotiation Strategy


1. Develop the specific objectives (outcomes) desired from the negotiation

2. Gather pertinent data

3. Determine the facts of the situation

4. Determine the issues

5. Analyze the positions of strength for both (or all) parties

6. Set the buyer’s position on each issue, and estimate the seller’s position on each issue based on your research

7. Plan the negotiation strategy

8. Brief all persons on the negotiation team

9. Conduct a dress rehearsal

10. Conduct the actual negotiations with an impersonal calmness

28

“Game plan” for Negotiation


29

The “Zone of Negotiation”

The overlap between what theBuyer will pay and what theSeller will accept defines the

Zone of Negotiation

$220,000 $230,000 $240,000 $250,000 $260,000 $270,000 $280,000 $290,000 $300,000Buyer's Range

Seller's Range

30

The “Zone of Negotiation”

There is a gap between what theBuyer will pay and what the Seller

will accept. There is NO DEALwithout Creativity or Compromise

$220,000 $230,000 $240,000 $250,000 $260,000 $270,000 $280,000 $290,000 $300,000Buyer's Range

Seller's Range

materials management bus 3 – 141 cost management, discounts, & negotiation october 22, 2007

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