Purchasing At All Costs? Understanding Your Supplier's Cost Structure
Patrick S. Woods, C.P.M., A.P.P., CPIM
Patrick S. Woods, C.P.M., A.P.P., CPIM, Commodity Manager, Emerson Electric/Fisher Controls, Sherman, TX 75091, 972-491-1394
84th Annual International Conference Proceedings - 1999
Overview. Are you paying too much for a product or service? Simply eliciting three or more supplier proposals may allow you to pick the lowest price and give you an "artificial feeling of security." I am paying the lowest price since the other sources are obviously more expensive! However, what if the lowest quote was $5.00 per unit, but you should have paid no more than $2.50? How would you know that? The answer lies in analyzing your supplier's actual or anticipated cost structure.
This presentation will explain the importance of understanding this cost structure including a detail of the elements that make up a supplier's costs and will provide practical examples of how understanding your supplier's costs can benefit and strengthen your company's future in the competitive marketplace. Purchasing at all costs? No way!
Cost Analysis Defined. Purchasing And Supply Chain Management (South-Western College Publishing, 1998) defines cost analysis as "the process of analyzing each individual cost element (i.e., material, labor hours and rates, overhead, general and administrative costs, and profit) that together add up to the final price." A slightly different perspective is provided by NAPM's Glossary Of Key Purchasing Terms (Second Edition) in defining cost analysis as "an evaluation of actual or anticipated cost data (material, labor, overhead, general and administrative). This analysis involves applying experience, knowledge, and judgement to data in an attempt to project reasonable estimated contract costs. Estimated costs serve as the basis for buyer-seller negotiation to arrive at mutually agreeable contract prices."
Fundamentals Of Cost Analysis. Here's a question that your suppliers' may initially find more painful than gum surgery: Would you be willing to provide me with a cost breakdown of your proposal? Detailed and accurate cost breakdown(s), or as the Japanese popularized in the 1980s: "You show me your books and I'll show you mine," is the foundation for performing an effective and accurate cost analysis.
This could be an area where you may have to test your Reverse Marketing skills. Reverse Marketing is the process whereby the purchaser reverses roles with the supplier and sells him or her on an idea, program, or concept that at first may be perceived as unpopular or painfully expensive. Here is the bottom line: you must convince your supplier that your intent in obtaining costing information is not to reduce their Profit. This word is highlighted in that we are moving from 1960s mentality to 21st century thinking. In the past, it was standard practice to "beat the supplier down," so to speak, such that their profit was reduced, or even worse, eliminated, causing them to take shortcuts on service and quality and eventually go out of business.
Today, purchasing and supply professionals need to emphasize to their supply base that their desire is for them to maintain the same or even greater level of profit while at the same time, explore ways to reduce costs. Thus, not only does the supplier reach its financial goals, but they are also able to maintain market competitiveness due to a lower or maintained price level.
Elements That Make Up A Supplier's Cost. Let's assume that your supplier supports the strategy listed above and subsequently provides you with a complete cost breakdown; then what? As shown in Table 1, the three elements that make up a supplier's cost are direct materials, direct labor, and indirect manufacturing costs. In cost accounting terminology, the combination of direct materials and direct labor form what is referred to as prime cost; direct labor and indirect manufacturing costs (including general, administrative, and sales expenses) make up what is referred to as conversion cost.
Table 1 - Key Supplier Cost Elements
- Direct Materials: All materials that are physically observable as being identified with the finished good and that may be traced to the finished good in an economically feasible manner. Examples are sheet steel and subassemblies for an automobile company. Direct material costs do not include minor items such as glue or nails, because the costs of tracing insignificant items do not seem worth the possible benefits of having more accurate product costs. Such items are considered supplies or indirect materials.
- Direct Labor: All labor that is physically traceable to the finished good in an economically feasible manner. Examples are the labor of machine operators and assemblers. For goods and services that have a large content of high-skilled labor, such as consulting or information technology, you may be dealing with significant direct labor increases. If there is scarcity in the market, especially in your geographic location, you may want to use local data to judge appropriate pricing. Keep in mind that purchases involving highly skilled labor will have to be addressed on a case-by-case basis. Much labor, such as that of material handlers, janitors, and plant guards, is considered direct labor because of the impossibility of economic unfeasibility of tracing such activity to specific products via physical observation.
- Indirect Manufacturing Cost: All costs other than direct materials and direct labor that that are associated with the manufacturing process. Other terms describing this category include factory overhead, factory burden, manufacturing overhead, and manufacturing expenses. Within this category exist three types of overhead:
- Variable factory overhead. Examples are power, supplies, and most direct labor. Whether the cost of a specific subcategory of indirect labor is variable or fixed depends on its behavior pattern in a given company.
- Fixed factory overhead. Examples are rent, insurance, property taxes, depreciation, and supervisory salaries.
- Miscellaneous overhead. Examples are advertising, marketing, sales, and central overhead.
A Practical Example. As shown in the following example, a supplier's cost breakdown can be analyzed to determine whether a price increase is warranted.
Jane Smith purchases approximately $500,00 per year of service from the ABC Company. She receives notice that ABC's local utility, Juice Plus, has just increased its utility costs by 10 percent. Does this mean that ABC can give Smith a 10 percent price increase? The first request should be a cost breakdown from ABC. The breakdown, detailed as follows, shows the change in utility costs from 1997 to 1998.
|ABC Product Cost -1997|
- plant building
|Total Factory Overhead||50,000|
* Calculated by ABC in taking the difference between sales and costs.
|ABC Product Cost - 1998|
- plant building
|Total Factory Overhead||51,000|
A quick review of the two breakdowns reveals that in order for ABC to maintain its profit level of $50,000, they will need to raise their price by only .2 percent, yielding total sales of $501,000 as opposed to raising the price by the full 10 percent. By recognizing these three types of costs, direct material, direct labor and indirect manufacturing, we can isolate the true cost increase driver. Although we understand where the proposed price increase is coming from, by analyzing the cost breakdown as shown above, we may encourage the supplier to reduce costs in other areas to offset the increase in their utilities.
For example, since direct material purchases account for 60 percent of the total cost and utilities approximately 2 percent, a .35 percent reduction in direct material purchases can more than offset the 10 increase in utilities with money to spare.
Break-Even Analysis. A slightly different way to describe a supplier's cost is variable, fixed, and semi-variable (mixed) as illustrated in Table 2 below.
Table 2 - Types Of Supplier Costs
- Variable Costs: Costs that are uniform per unit but fluctuate in total in direct proportion to changes in the related total activity or volume. Note that variable costs can be both direct costs (examples: labor, material) or indirect costs (examples: power, supplies, indirect labor that can vary with output, such as additional utilities required to run an operation three shifts, 24 hours per day).
- Fixed Costs: Costs that remain unchanged in total for a given time period despite wide fluctuations in activity or output (examples: salary, building rent).
- Semi-Variable (Mixed) Costs: Costs that have both variable and fixed elements. The cost changes within a relevant range, but not in direct proportion (example: purchaser's salary plus bonus for sales year in excess of $1 million - the salary is the fixed cost; the bonus is the variable cost).
By reviewing cost in this perspective, the tool called break-even analysis can help you analyze your supplier's true profitability picture. In a nutshell, break-even analysis allows you to vary the purchased volume to affect your supplier's cost and hopefully, corresponding unit price.
Break-even analysis, as implied in the term, is the point at which your supplier's total revenues equal their total costs. Additionally, you can determine the point at which the number of units produced and sold will exceed the break-even volume, and at which point your supplier will enjoy a profit. Inversely, you can also figure out the point where the number of units produced and sold is less than the break-even volume, resulting in a loss for your supplier. Of course, once the break-even point is determined, then you can estimate the amount of profit or corresponding loss through the volume purchased.
Example: Supplier XYZ provides your company with a product used only by your firm. The setup time for a machine to run each order (one piece or 500 pieces) is $200. The cost to produce each unit is $.50 and XYZ's sales price to your company for each unit is $.90. How many units does XYZ have to sell to break even?
We previously defined break-even costs as the point where total sales/revenues equals total costs. The total sales equation can be stated as follows:
Total Sales = Sales Price Per Unit X Number Of Units Sold
Total Costs = Fixed Costs + Variable Cost Per Unit X Number Of Units Sold
Since the number of units sold to achieve the break-even quantity is unknown, assign it a value of "X" and then solve for "X"
We know the following:
|Sales Price Per Unit:||$0.90|
|Fixed Costs Per Run:||$200.00|
|Variable Cost Per Unit:||$0.50|
The equation to determine the quantity at which total sales equals to total costs is:
|Total Sales||=||Fixed Costs + Variable Cost|
|$0.90X||=||$200.00 + 0.50X|
- Isolate "X" from both sides: $0.40X = $200.00
- Divide both sides by $0.40 = 500 units
Therefore, XYZ must sell 500 units in order to cover its total costs. If you plug the quantity of 500 back into the equation in place of "X", total sales will equal to total costs:
|$0.90(500)||=||$200.00 + $0.50(500)|
In the above example, you would need to commit volume in excess of 500 units to allow your supplier to make a profit.
Three Additional Cost Concepts. Lastly in this discussion, three additional concepts that merit attention are Relevant/Irrelevant, Opportunity, and Total Cost Of Ownership (Life Cycle) costs as defined in Table 3 below.
Table 3 - Additional Costs To Consider
- Relevant/Irrelevant Costs: Relevant costs are costs that change as a result of a specific decision and irrelevant costs obviously are ones that do not change as a result of such a decision. For example, if a distributor decides to close a branch location, the salary and other operational costs that would be eliminated as a result of this decision would be relevant costs. The salary and operational costs of the remaining locations, which would be incurred regardless of the closing, would be irrelevant costs.
- Opportunity Costs: Opportunity costs are better stated as "missed opportunity costs" and relate to the cost of the missed opportunity in making one decision over another. For example: In the case of a firm that makes a decision to invest $100,000 currently wrapped up in a Certificate of Deposit (CD), in a piece of machinery, the return on the CD is the opportunity or missed opportunity cost of selecting the machinery purchase over the CD. Obviously, the profits realized from the additional machine would eventually offset the missed opportunity of the investment.
- Total Cost of Ownership (Life Cycle) Costs: Total cost of ownership (life-cycle costing) is a total cost method used to determine the total cost of ownership over the useful life of an asset. To perform life- cycle cost analysis, the purchaser must first identify the operating cycle for the equipment and qualify all factors that affect costs.
The relevant/irrelevant cost principle can be applied primarily when awarding a supplier increased business. If this is the case, have you thought of negotiating a one-time rebate based on the incremental or additional business awarded to the supplier? How could this be a plausible point with the supplier and put money back into your own pocket? Assuming that the increased business will be absorbed by the supplier's existing capacity, then the supplier's fixed costs will have been amortized into the initial/original business volume. In pricing the additional business volume, the only costs that should be incurred by the supplier should be direct labor and materials. Fixed costs, therefore, should be irrelevant. However, if the increased business volume requires the supplier to purchase new equipment, expand facilities, and/or incur additional fixed costs, then the additional portion would be relevant and the expected rebate should be reduced or not pursued.
Opportunity cost theory could be applied if you are requesting that the supplier make additional capital investments to their facility to accommodate first time or repeat business. The supplier may initially hesitate to tie up that money into capital when the alternative opportunity leads to a return on investment. You may be required to contractually commit a certain level of business or develop a letter of intent to earmark future capacity (reverse marketing).
Total cost of ownership theory is best applied to capital procurements (i.e. fleet vehicles, copy machines, production equipment) where maintenance and warranty are issues. In reviewing the supplier's proposal, determine what other factors are included in addition to the purchased item. You may discover that total cost of ownership is less expensive through Supplier A than Supplier B, even though Supplier A's original equipment price is more expensive than Supplier B.
Parting Thoughts. Your supplier may be initially hesitant to accept the factors discussed above, so you may have to help them appreciate that as your supplier-partner, cost analysis is to their benefit as well. Remember, as emphasized above, you and your company's goal is not to diminish their profits but to reduce their costs to the mutual benefit of both parties. It is recommended that all cost analysis plans be communicated to your supplier in writing - either in a policy statement prior to the start of the business relationship or stated in a contract or long-term agreement. Once agreed to by your supplier and your company up front, the expectations should be routine.
Although it's a gradual change, more and more firms are realizing the positive impact that purchasing can provide to the bottom line by either avoiding a price increase or reducing current price. Understanding and applying cost analysis to supplier pricing will give the purchaser an edge in the business arena and will contribute to his/her firm's global competitiveness. Purchasing at all costs should be replaced by Purchasing at best costs!
Woods, Patrick S. Adding It Up: Performing Effective Supplier Price And Cost Analysis, NAPM INFOEDGE, June 1998
Monczka, R. Trent, R., and Handfield, R. Purchasing and Supplier Chain Management, South-West College Publishing, 1998
Horngren, C.T. Cost Accounting: A Managerial Emphasis, Prentice-Hall, 1982