Cost Reduction Strategies:

Focus and Techniques

for

NAPM-Wichita
presented by

Thomas L. Tanel, C.P.M., CTL, CCA

President and CEO
CATTAN Services Group, Inc.
College Station, TX

© 2009 CATTAN Services Group, Inc.

 Agenda Topics
 Cost Reduction Strategies and Ideas
 Price and Cost Analysis--Applied
 Total Cost of Ownership and Total System Cost
 Use of “Should” Cost Models
 Innovative Thought and Ideas Solicitation
 Value Analysis and Engineering
 Target Cost Analysis and Target Pricing
 Low (Best) Cost Country Sourcing
 Summary
 Cost Reduction Strategies
 Cost Savings  Cost Containment

 Cost Avoidance  Value Enhancement

 Cost Reduction Terminology
Product cost savings
 Defined as obtaining and realizing a lower unit
price on the same item than the unit price was in
the last contract period.
 A cost saving is valid for as long as the
comparative that generated the saving is; but
it is not to exceed the end of the contract period
in which the saving was produced. On the first
day of the next contract period the old price
becomes the baseline against which any future
cost savings are measured.
 Cost Reduction Terminology
Revenue generation
 New financial sources that can be used to leverage or
increase monies/resources available to an activity.
 Revenue generation is a quantifiable monetary
benefit.

Non-monetary benefit
 A benefit that cannot be measured in terms of finances
or resources, such as better quality of services;
improved health, safety or quality of life; enhanced
security; enterprise-wide consistency; or contribution to
achieving supplier diversity goals.

Return on investment
 Monetary benefit from an investment as a ratio or
percentage of the amount invested.
 Cost Savings
Cost Savings—definition
 A cost reduction that can be specifically identified
and will be made to a budget or program,
resulting from implementing a specific alternative
in lieu of continuing the present system.
 The result of a planned or deliberate action
taken by Purchasing
 Savings are a quantifiable monetary benefit
 There must be a direct activity reduction for a
savings to occur; thus, benefits are considered as
savings only if the estimate identifies benefits that
start accruing during the budget/activity’s fiscal
year.
 Cost Avoidance
Cost avoidance—definition
 Financial or economic benefits that result from
an initiative but do not permit a monetary
reduction to a funded activity or budget.
 Is a quantifiable monetary benefit
 Usually addresses the reduction or elimination
of a future cost
 Does not lower the cost of materials purchased
when measured against historical results, but it
does minimize or avoid entirely the negative
impact on net income that a price increase
would have.
 Cost Containment
Cost containment—definition
 The process of maintaining organizational
costs within a specified budget; restraining
expenditures to meet organizational or
project financial targets.
 Measures taken to reduce expenditure or
the rate of growth of expenditure, or the unit
cost of goods/materials/supplies/services.
 When an organization keeps costs low, or
within a limit that has been planned.
 Value Enhancement
Value enhancement—definition
 Value which affects the whole-life costs or whole-life
income and its required functionality.
Value
 For any service or offering to have financial value, the
organization must have been willing to pay for it out of
pocket or must have already been paying for it in a way
that can be measured on the organization’s income
statement. This definition is a requirement for any
discussion of legitimate cost avoidances.
 For example, in practicing sustainable environmental
management, we may reduce the environmental impact;
while at the same time achieve cost reduction and create
environmental friendly conservation added value.
 The Difference between

Price and Cost

 “Price” . . .
is a sales and purchasing concept.
 “Cost” . . .
is an accounting concept.
The Difference between
Price and Cost
Price
Price=Cost
=Costof
ofMaterial
Material++Labor
Labor++Overhead
Overhead
++General
General&&Administrative
AdministrativeExpenses
Expenses
++Selling
SellingExpense
Expense++Profit
Profit

Cost
Cost =Cost
=Costof
ofMaterial
Material++Labor
Labor++Overhead
Overhead
++General
General&&Administrative
AdministrativeExpenses
Expenses
++Sales
SalesExpense
Expense
Comparability Factors for Prices

Comparative price analysis involves the comparison of the current

proposed price with quotes or prices for the same or similar items.
 Total Cost of Ownership
(TCO)
Other Costs
Logistics •Quality
Purchase •Inland Freight Taxes Customs •Safety Stock
TCO = + •Ocean/Air Freight + •VAT + Duties & + •Supplier
Cost
•Transfer charges •Incentives Fees Development
•Currency

TCO – the sum of all costs

associated with any given
supply stream
Source: The Executive Guide to Supply Chain Management, David Riggs/Sharon Robbins
Cost Reduction and Negotiation
ACQUISITION COST Typical Negotiation Focus

Traditional Supplier Cost and Price Structure

OPERATING COSTS

TRAINING COSTS

MAINTENANCE
COSTS

WAREHOUSING
Cost Reduction
COSTS
Opportunities

ENVIRONMENTAL
COSTS

SALVAGE VALUE
 Total System Cost (TSC)

Total System Cost (TSC) –

the sum of the buyer’s costs,
supplier’s costs and
interaction cost between the two
Total System Cost
TSC Savings
Buyer
Costs

Interaction Buyer
Costs Costs

Profit Price Interaction Costs

Savings
Profit

Supplier Focus
Costs Supplier
Costs

Traditional Strategic
 Elements of Cost

Selling Profit
Price
and
Margin General and
Administrative

Selling Expense

Overhead Cost
of
Labor
Goods
Sold

Materials
 Drive Out Costs Creatively
 Considering alternative products, designs, concepts,
and services, or looking at different or alternative
solutions to existing services, processes or applications,
requires a multi-disciplined approach, making use of
internal customers or subject matter experts as well as
first-tier suppliers or prime contractors.
 Remember to create an arena that is friendly and open
to suggestion, change, and innovation.
 When defining the elements of cost, focus on cost
reduction opportunities.
 The Creativity Formula

Remember: Most of the opportunities to reduce costs occur during the

design, SOW, or conceptual stage for products and services—not after.
 Should Cost Technique

 “Should Cost” as a price challenge

technique:
 Provides cost analysis to buyers to be used
for negotiations and determining price
reasonableness
 Provides cost analysis in responding to price
challenges and pricing issues from your
internal customers and management
 Should costs are independent analytical
estimates to determine the cost for
manufacturing an item.
 Building a Total Cost Model
Total Price of Contract

Total Cost of Contract

Costs to Meet Contract Requirements

Other
Product Costs Direct
Costs Profit
Direct Indirect G&A /Fee
Costs Costs Expenses
(Other
(Allocation Allocable
Direct
of Costs Plus
Labor
Overhead Overhead)
Plus
to Labor
Direct
and
Material
Material)
Should Cost—Supplier Cost
Decomposition
 What is in a typical “Should Cost” report:
 A detailed description of the item.
 A list of references used in the analysis.
 A break down of cost and labor burden rates.
 Estimated unit prices for specified quantities.
 A break down of the material and associated
cost and minimum economic buys.
 Material—Terms & Definitions
Term Definition
• Raw materials Materials in a form or state requiring further processing
before they can be used

• Parts Items that, when joined with other items, are not subject
to disassembly without destruction or impairment of
use

• Subassemblies Self-contained units of an assembly that can be

removed, replaced, and repaired separately

• Components Relatively simple hardware items which are listed in the

specifications for an assembly, subassembly, or end
item

• Manufacturing Items that are required by or in support of the

supplies manufacturing process

• Inbound Freight, express, cartage, insurance, and postage for

transportation and goods purchased, in process, or delivered, which
in-transit insurance can be added to the cost of an item or as an Other
Direct Cost (ODC)
 Direct Labor—Terms & Definitions
Term Definition
• Direct Labor Work performed by individuals which is directly related to a specific
cost objective. This work is readily identifiable with a particular
product or service.

• Indirect Labor
Work performed by individuals which is not identifiable with a single
final cost objective but is identified with two or more final cost
objectives or an intermediate cost objective. One example of
indirect labor is the work expended by the Controller of a
company. The Controller’s work is not directly identifiable in the
production of a specific product or service, since his or her work
includes several projects or tasks.

• Labor Hour The unit of time by which direct labor activity is measured.

• Labor Rate The dollar amount paid to an individual per a given amount of time
in consideration of work accomplished.

• Labor Cost The product (i.e., result) of multiplying labor hours by appropriate
labor rates.

• Labor Category A grouping of workers with similar skills or expertise or trade

classification.
• Labor Mix The combination of functional skills and levels of worker experience
required to accomplish a given task.

• Basis of Estimate (BOE) A statement of the rationale used by a supplier/contractor to

generate a cost estimate for a specific task or item to be
produced.
 Indirect Costs—Terms & Definitions
Term Definition
• Indirect Costs Any cost that cannot be directly identified with a single final cost objective
but can be identified with two or more final cost objectives or an
intermediate cost objective

• Overhead Indirect costs related to specific operations, such as general product

lines, organizational groups, and groups of contracts. Overhead is a
type of indirect cost pool that is related to the specific operations of
the firm. The three major types of overhead are material, labor, and
fringe benefit (if not included in labor overhead). The three
overheads differ in regard to which costs they include and how they
are allocated.

• General & Any management, financial, and/or other expense incurred by or

allocated to a business unit for the general management and
Administrative administration of the business unit as a whole

• Business Unit Any segment of an organization, or an entire business not further divided
into segments

• Home Office Expense The expenses of an office responsible for directing or managing two or
more, but not necessarily all, segments of an organization

• Indirect Cost Pool A logical grouping of incurred costs identified with two or more objectives
but not specifically with any final cost objective

• Cost Objective A function, organizational subdivision, contract, or other work unit for
which cost data are desired and for which provision is made to
accumulate and measure the cost of processes, products, jobs,
capitalized projects, etc.
 Profit—Terms & Definitions

Term Definition

• Profit Represents the excess of revenue over applicable costs of

performance and is associated with fixed-price type
contracts

• Fee Represents a flat charge paid as compensation for services or

supplies provided and is associated with cost
reimbursement contracts

• Risk The level of uncertainty associated with specific factors

regarding contract performance
 SUPPLIER PART COST BREAKDOWN WORKSHEET—Part A
SUPPLIER NAME: CONTACT: E-MAIL:

PART NUMBER: VOLUME QUOTED: QUOTE NO:

DESCRIPTION: EST. TOOL LIFE: DATE:

DRAWING ISSUE: TOOLING CAPACITY EXCHANGE RATE:

@ Hrs/day:
@ Days/Week:

RAW MATERIALS & PURCHASED COMPONENTS CURRENCY:

# Item Descriptions (1) Item ID (2) Unit of Measure (3) Unit Cost (4) Total Cost (5)

Total Material Cost

 SUPPLIER PART COST BREAKDOWN WORKSHEET—Part B
LABOR AND OVERHEAD

Labor Details Machine Data Overhead Detail

Labor Std
Labor Op. Mach. Mach. Type Var. Cost Fixed Cost
# Operations Process Descriptions (6) Rate Hrs Total Cost (15)
Cost (9) (10) Size (11) (12) (13) (14)
(7) (8)

Total Labor
Total Overhead Cost
Cost

Total Manufacturing Cost (material + labor + burden) (16)

Selling, General and Administration Expenses (17)

Selling Price

FROM TOOLING COST BREAKDOWN—TOTAL TOOLING COST QUOTED

Meeting the Competitive Demands of
Supply Management through
Supplier Ideas Solicitation
 Meeting the Cost Reduction Mandate
through Innovative Thought and
Supplier Ideas Solicitation
 EPI and Concurrent  Change procurement
engineering method/instrument
 VMI/SMI/SOMI/ISM  Volume and forecasts
 Cycle or lead time  Inbound freight and
reduction packaging
 Addition or elimination  Relaxed specification,
of value-added material substitution,
services or service level
 Standardization improvements
 Competitive Bidding—
Use Ceteris Paribus
 Buyers normally look at the price (total cost) as stated
on each bid to determine which supplier should be
awarded the PO or contract.
 If there are any differences, for a fair evaluation, then
allowances must be made for the differences in
performance and pricing.
 When comparing performance
or prices the buyer should use
Ceteris Paribus assumptions
(everything else held constant)
so you compare “an apple to an
apple, not an apple to an orange.”
Value
What Is Value?—Four Distinct Kinds

 Exchange Value

 Cost Value

 Esteem Value

 Use Value
 Value Analysis and
Engineering (VA/VE)
1. An organized creative
approach to cost reduction
2. Emphasis on function or use
3. Identifies areas of excessive
or unnecessary costs
4. Eliminates non-value added
activities
VA/VE Job Plan—Philips Example
 Value Equation

Quality/Worth
Value =
Cost
How To Get Started in VA/VE
 Identify what is it and what
does it do?
 Obtain and review all available
cost information
 Try to anticipate roadblocks
 Promote cooperation with
VA/VE effort
 Seek guidance from those in
management that assigned
study
 VA Is the Way—Ten Ways to
Reduce Co$t
1. Use it to reduce cost in
design, concept, or SOW
2. Use cross-functional teams to
approve product or service
offering changes
3. Consolidate supplier base
using full service partners
4. Reduce paperwork with
supply base by using more
EDI/E-Com
5. Bundle any engineering
changes or project scope
changes quarterly
6. Move towards common, simple
methods and standard items or
services used at multiple sites
or facilities
7. Use returnable dunnage or
containers instead of non-
returnable
8. Identify and eliminate
unnecessary testing, measuring
and diagnostics
9. Reduce the number of
prototypes or models
10.Consolidate “A” type purchases
with suppliers’ if possible
Process of Determining
Target Costs

Cost Costs not

subject to subject to
Target = +
cost cost
Costs reduction reduction
activities activities
Target Costing Process
Target Cost Breakdown
and Impact
Target Cost Breakdown
and Impact
 Target Pricing

A reduction in the direct

costs of a supplier’s cost
profile has more impact on
your bottom line than a
major percentage discount
in the supplier’s price.
Negotiation based on cost
allows you to challenge the
logic of each element of the
price.
 Vendor Preferred Supplier

Marketing, Purchase Orders,

Proposals, Variations in Quality
Partner/Alliance
Redundant Capabilities in Systems,
Activities that Add No Value,
Approval Processes, Contracts,
Excessive Communications and
Controls, etc.

Cost to Serve Cost to Serve Cost to Serve

Profit Profit Profit

Competitive Bidding Redefined (Streamlined) Process Reengineered Process through
Based upon Variable Profit Reduces Cost and Yields Close Relationship; Maintains
Acceptable Profit Profit and Greater Cost
Reduction
 Target Pricing Perspective—
An Example
For a service contract, the
total quoted price was
$260,565.

A 1% reduction on the price is

one thing, but reducing each
of the cost elements by 1%
yields an actual price
reduction of more than 2.5%.

Individual cost elements are more vulnerable to argument than the price as a whole
Elements of Cost-Services
Profit and Margin

COSP
Other Services/Overhead

Service Labor

Materials and Supplies

Occupancy

Equipment and Technology

 Opportunity Knocks
The ultimate objective is to maximize
the value of each purchase spend
dollar.

Sometimes the buyer has a chance to gain the upper hand.

This occurs when the supplying industry’s margins are healthy
because selling prices rose faster than their costs escalated.
Low (Best) Cost Country Sourcing
(LCCS)

Near Sourcing Outsourcing Indigenous

Domestically Overseas Localization

Transfer business Transfer internal Find and develop

to provide materials dept,activity or local indigenous
or services by process to more sources to support
swapping out capable suppliers or country markets for
overseas suppliers contractors to lower low cost country
for closer proximity cost of ownership plants and
to home country distribution facilities
Adapted in part from Ariba’s Executive Overview on this subject
LCCS and Supply Chain Risk

Although significant cost savings

opportunities exist , the risk may
be greater when dealing with unfamiliar
suppliers, different business protocols,
language barriers and new cultures.
 Landed Cost

LC = TSC ÷ SU
Note: Total Selling Cost (TSC)
and Selling Unit (SU)
SUMMARY and THANKS

© 2009 CATTAN Services Group, Inc.