ISQA 439/539 Fall 2004

1. ISQA 439/539Fall 2004 Week 3 Dr. Alan Raedels, C.P.M.

2. COST ANALYSIS:Understanding The Cost Structure • Types of Cost • Direct Versus Indirect Costs • Fixed Versus Variable Costs • Common and Joint Costs

3. Activity-Based Costing ABC is relevant to purchasing for a number of reasons. As a tool for analyzing supplier prices To support the analysis of the cost of doing business with a particular supplier To identify problem suppliers. To improve purchasing systems and processes There are four basic components of an ABC system: Activity Cost driver Cost object Bill of activities COST ANALYSIS: Understanding The Cost Structure

4. Breakeven Analysis Learning Curves Life Cycle Costing Total Cost of Ownership Approaches for Determining TCO Standard Versus Unique TCO Models Barriers to TCO Implementation EVALUATING COSTS

5. Marketing Perspectives On Pricing • Market Structure • Monopoly • Monopolistic competition • Oligopolistic • Perfect competition • Oligopsonistic • Monopsony.

6. Marketing Perspectives On Pricing • Cost-Based Pricing • Straight Markup • Rate of Return • Variable Pricing

7. Perceived substitutes Unique value Switching cost Difficulty of comparison Price-quality Expenditure size End benefit Shared cost Fairness Inventory Location or Time Supplier=s reputation, service, and relationship Value-Based Pricing

8. Competitive Proposals Comparison with Published Prices Historical Comparisons Internal Cost Estimates Roundtables Comparison with Similar Products/Services Detailed analysis Discounts Quantity Discounts Trade Discounts Cash Discounts Seasonal Discounts PRICE ANALYSIS TECHNIQUES

9. SELECTING A COST/PRICE ANALYSIS TECHNIQUE

10. Life-cycle Costing • Costs considered include the following: • Maintenance costs; • Training costs; • Repair part costs; • Energy use; • Cost of scrap and by-products; • Operating costs (labor and materials); and • Installation costs (including layout changes). • Steps to perform a life-cycle cost analysis 1. Determine operating cycle, types of operation, routine maintenance, overhaul, and actions (costs incurred) required. 2. Identify and quantify factors that affect costs (e.g., power consumption, labor requirements, material usage, maintenance costs, failure rates, and downtime costs). 3. Project costs through the life of the equipment, including salvage value. 4. Discount costs to obtain present values and sum to obtain total life cycle cost.

11. Life-Cycle Costing Example • Machine A • 5-year life and 4% downtime • Cost Amount for Years: 0 1 2 3 4 5 • Purchase 80,000 • Engineering 10,000 • Installation 10,000 • Training 4,500 • Labor 40,000 42,000 44,100 46,305 48,620 • Energy 50,000 55,000 60,500 66,550 73,205 • Downtime 12,000 12,960 13,997 15,117 16,326 • Total Costs 104,500 102,000 109,960 118,597 127,972 138,151 • * 12% PV Factor 1.000 0.893 0.797 0.712 0.636 0.567 • = Present value 104,500 91,086 87,638 84,441 81,390 78,332 • Present value of costs totals 527,387

12. Life-Cycle Costing Example Machine B 5-year life and 2% downtime Cost Amount for Years: 0 1 2 3 4 5 Purchase 100,000 Engineering 10,000 Installation 10,000 Training 5,000 Labor 50,000 52,500 55,125 57,881 60,775 Energy 40,000 44,000 48,400 53,240 58,564 Downtime 5,000 5,400 5,832 6,299 6,802 Total Costs 125,000 95,000 101,900 109,357 117,420 126,141 * 12% PV Factor 1.000 0.893 0.797 0.712 0.636 0.567 = Present value 125,000 84,835 81,214 77,862 74,679 71,522 Present value of costs totals 515,112

13. Cost/Price Analysis Grid

14. Reasons For Using Total Cost of Ownership • Support supplier selection, RFQ, RFP, or RFB • Give supplier awards for excellent performance • Drive supplier improvements, identify priorities • Plan future supplier performance • Provide data for negotiations • Forecast new item performance based on historical data • Concentrate resources on the “important few” purchases • Compare supplier performance against others, self over time • Support strategic alliance efforts • Supply base reduction/volume allocation decisions

15. Primary Reasons for TCO Adoption • Supplier selection decisions • Measure ongoing supplier performance • Drive major process changes

16. Benefits of Total Cost of Ownership • Performance measurement • Good framework to evaluate suppliers • Concrete way to measure results of quality improvement efforts • Excellent tool for benchmarking • Decision making • Forces purchasing to quantify tradeoffs • Good basis for making supplier selection decisions • More informed decision making • Creates a structured problem solving environment • Communication • Excellent communication vehicle between firm and suppliers • Way to get other functions involved in purchasing decisions

17. Benefits of Total Cost of Ownership • Insight/Understanding • Provides excellent data for trend analysis on costs • Provides excellent data for comparing supplier performance • Provides excellent data for negotiations • Provides critical data for target pricing • Requires purchasing to develop an awareness of the most significant nonprice factors that contribute to TCO • Long-term orientation by focusing on the “big picture” • Supports continuous improvement • Identifies where suppliers should focus improvement efforts • Helps identify cost savings opportunities • Forces firm to look at internal issues, how their own requirements/specifications may actually increase costs • Encourages professional growth in purchasing personnel by broadening their perspective

18. Approaches for Determining TCO • Dollar-based Approach • Direct cost • Formula • Value-based Approaches

19. Dollar-based - direct cost Supplier selection Supply base reduction Make vs. buy/Outsourcing Process improvement Dollar-based - formula Supplier volume allocation Supply base reduction Ongoing supplier evaluation Process improvement Value-based Supplier selection Make vs. buy/Outsourcing Process improvement Primary Uses of Different Types of TCO Models

20. Relative Advantages of Types of TCO Systems • Dollar-based, Direct cost • Advantages • Tailor factors considered to decision • Very flexible • Alter level of complexity to fit decision • Helps identify critical issues • Disadvantages • Time-consuming • Doesn’t make sense for repetitive decisions • Not cost-beneficial for low-dollar buys

21. Relative Advantages of Types of TCO Systems • Dollar-based, Formula • Advantages • Easy to use once system is in place • Excellent for repetitive decisions in which costs for key factors can be determined • Disadvantages • Time-consuming to establish system • Formulas need to be periodically reviewed and updated • Inflexible to different types of decisions • Considers a limited set of factors

22. Relative Advantages of Types of TCO Systems • Value-based • Advantages • Can incorporate issues where costs cannot be determined • Considers the importance of factors using weighting • Easy to use for repetitive decisions • Disadvantages • Time-consuming to develop; only good for important and/or repetitive decisions • Much judgment in establishing weightings

23. Standard versus Unique TCO Models • When to use unique models • Buys to be considered vary greatly • No one set of factors captures critical issues across buys • Desire for flexibility in cost modeling • adapting to user needs • adapting to various buys • adapting to changes in internal focus • When to use standard models • Issues of concern are the same across buys • Desire for user-friendly model • Desire to computerize the system • Desire to analyze repetitive purchases

24. Most Frequently Mentioned Costs Included in TCO Analysis • Price • Delivery • Service • Supplier’s EDI capabilities • Acquisition costs • Quality • Inspection • Cost of nonconformance • Quality programs

25. Example of Standard TCO Model for Capital Purchases • Standard Assumptions • Fully burdened labor rates • Exempt:: Manager $36.00 • Exempt: Engineer, etc. $36.00 • Programmer $24.00 • SNE: Technician $40.00 • Hourly: Operator $12.00 • SNE: Administrative $15.00 • Facilities Standards • Space valuation per foot $2,650 • # of weeks operating/year 52 • Financial Standards • Useful life 4 • Cost of funds 12.8% • Tax rate 38.0%

26. Example of Standard TCO Model for Capital Purchases • Equipment Costs Capitalized costs Supplier A Supplier B Purchase price $657,059 $746,785 Options & upgrades 2,915 479 Service contract 14,815 14,815 Installation 229,630 229,630 Freight/duty 70,000 70,000 Packing 14,815 14,815 Other Amortization period 4 yrs 4 yrs Capitalized costs/yr $247,309 $269,131

27. Example of Standard TCO Model for Capital Purchases • Expended Costs - First Year Supplier A Supplier B Engineering expense Spares cost $ 8,400 $48,000 Buy-off costs $39,000 $39,000 Training Travel $20,000 $20,000 Other Equipment Expense First year $67,400 $107,000

28. Example of Unique TCO Model for Car Rental Service Contract

29. Dollar-based TCO Example

30. Value-based TCO Example

31. Barriers to TCO Implementation • Data availability • Difficult to obtain information needed • Determine what data is needed for calculating TCO • Complexity • Large initial time investment • Wanted to develop a system that was easy to use • Factors that drive costs are constantly changing • Some models have been complex • Teaching people not to get too detailed • Lack of common terminology • Lack of user expertise

32. Barriers to TCO Implementation • Resistance/Fear by users • Resistance to using standard format • Team may take away control of individuals • Fear too theoretical • User resistance • Lack of user confidence • Organizational culture • Get away from “price” mentality • Buyers need new skills to be successful • Concern in selling it • Communicate with rest of organization • People: need change agents, talent, process leaders • Scope of TCO in the Organization • Get away from idea that TCO is only a purchasing program • Determine to which procurements to apply TCO • Viewed as a purchasing program

33. Overcoming Barriers to TCO Development, Implementation, & Use • Create understanding • Training classes • Provide centralized expertise and support • Develop the right model • Improve systems over time • Adapt TCO to the situation • User friendly model • Develop the right approach before taking the idea public • Get support from the right people • Integrate TCO into the culture • Have teams build TCO models • Hire people with the right skills • Sell the idea • Top-management support • Move resistant people into other positions

34. Impact of TCO on Purchasing’s Decision Making Involvement • Plays a different role; facilitator, communicator, trouble shooter • Sourcing has more visibility • Now a strategic part of the business • Purchasing is now part of a team • Frees up purchasing from routine decisions • Purchasing has more credibility, value added

35. How TCO Supports the Organization Overall • Fits into overall total quality focus • Helps support the purchasing organization’s efforts to improve purchasing processes • Helps support the organization’s overall reengineering process • Encourages the purchase of “best value” items, reducing cost and increasing competitiveness • Provide access to supplier TCO information to all of those who work with suppliers • Free up purchasing to support the organization’s more strategic objectives

36. Implementing TCO Analysis 1. Determine desired benefits of TCO. 2. Determine the type(s) of purchases to analyze. 3. Choose standard model, unique model, or mix of both.

37. When to Use Standard or Unique Models

38. Implementing TCO Analysis 4. Choose between a cost-based and value-based approach. • Data availability • Ability to capture critical performance issues • Desire for accuracy vs. magnitude of cost • Desire to TCO analysis data for reporting • Corporate culture 5. Form a team to work on TCO project. 6. Test the TCO benefits and modeling approach. • Identify relevant costs • Select critical costs • Develop and document supporting cost data • Pilot test

39. Implementing TCO Analysis 7. Fine tune the TCO analysis approach. • Timetable • Types of purchases included and why • Any computerized linkages and how they will be established • Plans for educating the organization • Who will be responsible: overall & day-to-day • Benefits • Types of decisions TCO will support 8. Present recommendations to top management and implement.

40. Benefits of a TCO Pilot Study • Gain understanding of data sources/ unavailability • Experiment with alternative TCO models • Educate others in the organization regarding TCO • Improve cooperation within the organization by enlisting participation of those outside purchasing • Convince people in the organization of the benefits of TCO by demonstration • Become familiar with the TCO model and possible pitfalls

41. Characteristics of an Item for Pilot TCO Project • The organization spends a relatively large amount of money on that item. • The organization purchases the item with some degree of regularity. • Purchasing believes the item has significant transaction costs associated with it that are not currently recognized. • Purchasing believes that one or more of the currently unrecognized transaction costs is individually significant. • Purchasing has the opportunity to have an impact on transaction costs, via negotiation, changing suppliers, or improving internal operations. • Those purchasing or using the item will cooperate in data gathering to learn more about the item’s cost structure.

42. Implementing TCO Analysis 9. Continuous improvement. 10. Expand TCO concepts to supply chain.