Targeting Purchasing for Product Profitability
John Matthews, Associate Director, ADR International Purchasing Consultants, Bracknell, Berkshire RG12 1RP, +44 01344/303078.
Robin Jackson, Chairman, ADR International Purchasing Consultants, Bracknell, Berkshire RG12 1RP, +44 01344/303078.
82nd Annual International Conference Proceedings - 1997
Introduction. In response to serious cost down pressure now being experienced in many business sectors, ADR introduced delegates to POPP: Purchasing Opportunity Performance Program, the model of price / cost development and its implication on the purchasing function and the way in which the business manages purchasing activity at last year's NAPM conference. ADR's conclusion was that the future for purchasing will be an evolution from its traditional functional focus to a business process and that the emphasis must be on cost, not price.
Our main focus last year was on the development of price and cost through the phases of:
- Price Drift
- Price Down
- Cost Down
- Cost Out
and the ways in which the business could manage this evolution internally in the business and externally with suppliers.
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This year we want to extend the thinking beyond the cost out approach, using value engineering / analysis to manage and forecast future profitability by product, which ultimately will determine the total company profitability - in other words - "target costing".
Definition. There is some confusion in the use of the term "target cost". It is often used to describe a value analysis / value engineering approach to new product development (i.e., the cost down phase of the price / cost model) or it is seen as a purely tactical device in the negotiation process. Target costing is neither of these. It is a methodology which leads to the alignment of final customer perception of product value and functionality with the design, manufacture, logistics and cost requirements of the business.
As a basic premise, it is apparent that target costing goes beyond a business driven process. It is a process driven by the needs of the end customer with the business, aligning it's internal processes to meet these needs. In fact, target costing is an extension of the concept of value delivery developed by M. Porter. (Graphic not available in text-only version.)
Value Delivery states that customers select a product because they believe it has a superior value (defined as "benefits minus price"). If this is the case, then the heart of running a business is delivering superior value to enough customers at a low enough cost to generate profit. This will require the gearing of all the functions in a business to profitably deliver customer value.
Process Driver. In a true target costing regime, the principal internal driver of the target cost process will be the Marketing function. Marketing will have two main roles.
First, it is Marketing who will determine the product strategy and its key constituents, namely:
- product profile
- customer value delivery requirements (benefits minus price)
- customer profile
- selling price (price point)
- required market share / volume
- marketing support programs (type and cost of communicating value)
- product margin contribution
- timing to market
Second, marketing will require input from the business to determine the maximum level of costs that will be incurred in the manufacture and provision of the product, that is:
- manufacturing costs
- marketing costs
- logistic costs
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This process will not only determine the value delivered to customers at a given price and internal costs in the product launch phase, but it will look at all the requirements at each stage of the product lifecycle. The objective is to ensure at each phase of the product lifecycle that:
- the appropriate product value is delivered to the customer,
- that the required volumes are maintained, and
- that the margin contribution is not eroded.
Thus, the process will not only establish the level of profit that the product will generate, but, equally, and as important, it will determine the total cost of the product provisionally at each stage of the product lifecycle.
From their analysis, Marketing will have determined:
- the product profile (i.e., product price and value required to meet the needs of the chosen customers),
- the maximum total product cost
- the timing to market, and
- by deduction, the profitability of the product.
In other words, Profit = Selling Price - Cost. In this case, however, both selling price and costs are predetermined at the product design and development stage.
Business Impact. The requirement of the target costing approach will create a number of new challenges for the business:
a) Product Design and Development. The rigor of the target cost approach will put new requirements on product design and development. New products will be required to meet new and stringent requirements:
- Customer needs (value)
- Corporate needs (volume / margin / market position)
- In house Target Cost of manufacture, marketing and logistics
- External Target Cost of purchased materials / components (purchasing).
b) Purchasing. The role of purchasing in the target cost process will significantly change from its more traditional functional role. Purchasing will no longer determine the price of each purchased material or component through market testing, but will be tasked to work with suppliers and R&D to achieve the overall target cost for each item of external spend. In addition, where this is not easily achievable, it will be required to support both supplier value engineering / analysis activity and to support supplier manufacturing capability improvements in an effort to reduce costs and the gap between the necessary target price and the required price of the supplier.
The emphasis will be on "Team Purchasing". Teams will be built around individual components / suppliers and will include representatives from manufacturing, quality, design and purchasing from both the business and supplier. Purchasing will have a key responsibility in bringing together the needs of the business and those of the supplier through discussion and task setting. Purchasing's key activities will be:
- communicating the target price to suppliers
- measuring the gap between the required target price and the supplier's required price
- supporting the supplier in offering technical changes to the business to remove the gap and achieve the target
- supporting the supplier in efforts to improve manufacturing capability - again, to reduce costs, remove the gap and achieve target
- liaising between the internal functions of the business and the supplier.
The Challenge. As you have gathered, the concept of target costing is one that is complex and challenging. It requires a fundamental change in business processes and, more specifically, purchasing processes. It introduces the concept of "Team Purchasing" with purchasing being involved in coordinating technical and manufacturing development in suppliers to assist in meeting the target price. It will lead to fundamentally different relationships with suppliers. Relationships will become longer term and will result in a much greater understanding of the supplier's costs. Suppliers will become integrated with the purchaser's business, and will have a greater reliance placed on their own product development capability.