Purchasing learns cost modeling, accounting
Buyers are working with engineers, finance and suppliers to identify cost drivers in product development and eliminate them.
By Paul Teague -- Purchasing, 10/15/2009 2:00:00 AM
Purchasing staff at Benton Harbor, Mich-based Whirlpool recently joined with colleagues in the company's marketing, sales, engineering, global design, production and quality control departments in a pilot project to find a way to close the gap between the target cost for an aesthetics module on one product and the designed cost. The gap was 30%. The team put together a cost model, identified the cost drivers of the subassemblies causing the gap and agreed on an alternative design that would get them to the target cost. Result: a better chance of hitting the profit target.
Welcome to the world of target costing, the process of tweaking designs at the earliest stages of product development so that the final development cost will be low enough to allow manufacturers to hit their profit goals while charging a price that the market will bear. Purchasing has a critical role in the efforts, as do suppliers.
It's not a new concept at all. It's an outgrowth of the Toyota manufacturing process, and it's related to such concepts as simultaneous or concurrent engineering, where purchasing and other departments within a company work with suppliers as a team for product development; and value engineering, where the emphasis is on maintaining value while reducing costs.
Some even call target costing procurement engineering. But whatever label it carries, it's getting more attention these days as companies, including Boeing, Olympus, Komatsu and others look for ways to maximize their supply chain operations so they can cost effectively enable them to develop profitable products that customers are willing to pay for.
"As revenue and sales go down, the next big area that influences yield is cost, and target costing helps you control that area," says Bob Lemyre, who heads purchasing at Whirlpool.
"It's about value optimization," says Jason Lynn, who does cost modeling at Whirlpool and who has written about the subject for Appliance Design magazine. "But for it to work, you need supplier involvement."
You also need a Lean environment, says Robin Cooper, president of Strategic Cost Systems Consulting as well as a business professor at Emory University and a well-known speaker on the subject. "Target costing equals Lean product design," he says.
Cooper says chief engineers need to take responsibility for target costing and insist that product-development teams design products for a specific cost with specific features. But, he says purchasing is critical to the effort, especially at the component target-costing level. "They have to bring the parts in at the right cost," he says.
Some companies employing the concept start it within their procurement departments. The reason for purchasing's involvement, says Keith Hallin, director of cost knowledge and targeting at Whirlpool, is the high percentage of a product's cost that's related to the supply base. He says target costing requires an objective view of a design. "The mantra," he says, "is that we who do target costing must be hated by all functions equally."
Purchasing can't act as an island when it comes to target costing, any more than it can with any other of its scope of responsibilities. In fact, target costing may be the ultimate example of collaboration in action. Typical target-costing projects involve representatives from engineering, marketing, purchasing and the supply base working in sync to identify the must-haves in a product and the cost drivers for those features.
And it may be the one area where finance departments will give purchasing credit for cost-avoidance efforts. The result of target costing ideally is the removal of costs before you actually incur them.
"Target costing gives purchasing the opportunity to look at every piece in a product, identify its costs and decide whether the component gives the end customer an advantage it really wants," says Ed Blocher, a business professor at the University of North Carolina (UNC) at Chapel Hill. "It enables the manufacturer to get the cost of the product down to the point where they can include features important to the market and still make a profit."
Target-costing efforts aren't just aimed at component costs. Lynn writes that cost models give a breakdown of costs so buyers can understand the competitiveness of the supply base.
Jay Mortensen, who has run target-costing programs for two companies and now does the same for a third company, has written that effective target costing also requires purchasing to take a hard look at its own company's product-development processes, including its own engineering and manufacturing operations, to see if there are inefficiencies that they can cut out to lower their costs.
"It's too easy to just go to suppliers and tell them to cut their costs," he has said. "It's important to know if there are things you're doing that are driving up your suppliers' costs."
In a conversation four years ago after a Boothroyd-Dewhurst engineering conference , Mortensen recalled a time when he worked at a different company and got complaints from a supplier that the company's practice of ordering in lots of 10,000 was costing the supplier money. "He said it was better for him in terms of his own set up and other costs if we ordered in lots of 8,000," Mortensen recalled. "When we looked into it we found that the smaller lot size worked better for us too, so we changed our minimums and everyone saved."
So what is a target cost anyway? Mortensen answered that question in a paper he wrote in 2005 in which he analyzed an automaker's approach. It's the cost that returns the required profit at the price the market will bear, he wrote. Cooper says you arrive at the target cost by working out the selling price of a product and backing out the required profit. The target cost is what's left.
The best way to get to that cost is in the product-planning stage rather than the traditional route of cutting costs after a product is in production. The benefits, he says, are decreased product-development time, lower costs, elimination of waste in products, potential competitive advantage and, ultimately, attainment of the financial return required by a company's investors for each product.
Critical to getting to the target cost is cost modeling. Lynn, of Whirlpool, writes in his article that there are at three types of cost models: parametric, industry-based and supply chain. "Parametric is the easiest," he says. "You take your current spend and look at the parameters that are driving your costs, including your processes."
Once you get those parameters, you analyze industry costs, he says.
Finally, you engage with suppliers and look at their books and try to find out their materials, manufacturing and process costs, he says. Mortensen has suggested tracking suppliers' costs back to the commodity level. For example, for an injection-molded part you should ask what the resin cost is.
Tom Linton, chief procurement officer at South Korea-based LG Electronics, says they do target costing up front in product development, in the research and development phase. "'Should cost' is an exercise our commodity teams perform to calculate what a material costs from raw material through finished assembly."
In any case, Lynn writes that it's important in target costing to prioritize your efforts. He suggests that manufacturers concentrate on the costs of product components that are unique to them and to the market they serve. In other words, don't concentrate on components where you can't influence the price.
By concentrating on cost drivers for components or features that are important to the market, the Toyota Camry team was able to overtake the Ford Taurus several years ago, says UNC's Blocher, who co-authored the book "Cost Management." The Taurus and Camry were neck and neck for best selling car in the 1980s, with Taurus edging out its Japanese rival. But, says Blocher, "Ford did a redesign of the car and added features. Toyota, instead, focused on pulling costs out, and it eventually pulled ahead in sales." Blocher says that proved that manufacturers need the right bundle of features at the right cost that customers will pay for.
For purchasing professionals to determine that right cost, they have to learn to speak the language of some of the other functions within their companies' product-development operations. At conferences on design for manufacturing, Mortensen has said purchasing must acquire engineering skills and financial-analysis skills.
"You don't have to have deep engineering knowledge," he has written, "but you have to know the engineering technology that goes into the product features, and understand the cost flow." And you have to know what costs to leave alone. In other words, if marketing tells you that a feature will let you sell many more units, you don't want to remove the feature because if you do you will affect a revenue driver for the product and customers could walk away.
Cooper adds that purchasing needs detailed knowledge also of the design and manufacturing processes at their key supplier companies. Olympus did that, he says, and then sent procurement engineers to suppliers to help them find ways to reduce their costs.
But it's not all about suppliers. "Buyers also have to understand the design process at their own companies and how process costs work," Cooper says.
One important tool that engineering will use in its target-costing efforts is design for manufacturing and assembly processes and software, such as those from Boothroyd Dewhurst. That company holds meetings every year where engineers present examples of projects where they have taken costs out of products.
But not so many costs that suppliers get squeezed or customers walk away for lack of product features. Hallin of Whirlpool says target costing must result in a win/win/win. "Shareholders, customers and suppliers must all win," he says. "You can't drive your suppliers out of business."
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