CPSM Blog

Indirect costs and Target costs in cost analysis

As pointed out in the earlier post this is a large section of 20 pages with 8 questions and therefore well worth the effort of studying in detail because (a) it’s the largest number of questions in the 1-B part (Cost and Finance) part of the CPSM exam (b) this speaks to the central purpose of the traditional purchasing/supply manager's role in organizations. Ultimately top management does ask the supply leader about costs and therefore it’s essential to be really clear about the topics of this section given its perceived importance and alignment with the supply manager’s role. There are several topics in this section and this post specifically discusses the only Indirect costs and Target costs. So here goes:

• Indirect costs are those costs that are not directly related to the supplied item in question. Thus if you buy packaging material you have to keep in mind that you have already invested in a particular packaging equipment. The interest and depreciation of the equipment is fixed cost and you cannot do much about them. The electricity and labor used on the packaging machine varies with how much the packaging line is utilized. This provided your labor is paid by the hour. If labor is on a salary that cost is pretty much fixed. Why should you care about indirect costs of equipment if your job is to buy packaging material? Because frequently you find that your supplier choice becomes limited when your equipment can do only some things. As you get into understanding the packaging material market, you become more knowledgeable about newer types of equipment that perhaps is more able to deal with thinner or more environmental friendly materials so when it comes time to decide to replace packaging lines you can weigh in with your expertise.
• Target Costs is the fascinating concept of arriving at a target cost for raw materials, components particularly for new products. Let us say that your organization has figured out that a new product can be sold at $1 a pack given consumer feedback, competitive offerings and projected sales volumes. Working backwards let us say that 20 cents are marketing costs, 20 cents are ingredient costs, 20 cents is overhead costs including fixed and variable costs ( a total of 60 cents). The remaining 40 cents cover packaging costs and profit margin. Today’s packaging costs are say 20 cents and margin is only 20 cents. A typical target cost could be to reduce packaging cost from 20 cents to 15 cents. The traditional way is to try and simply negotiate with the suppliers but the target cost approach could be to work with your suppliers and your internal manufacturing, design and marketing folks. It is possible that you bring down the thickness of the packaging material and use a newer packaging material that has more strength at lower thicknesses. You could find that marketing colleagues are thinking about a multi-pack and you might be able to have outer packaging that is able to take some off the load from the individual packs. You might also find from manufacturing that certain changes in the way the packaging material is supplied (larger rolls) might actually reduce waste in the packaging line, adjusting packaging roll size might reduce transport costs and pallet capacity. Considering all these angles might help you find a solution to reaching the target cost of 15 cents from 20 cents without squeezing supplier margins and not sacrificing quality/performance of the package in the market. In other words, target costing is not about trying to beat the supplier down but instead is about studying what would delight your final customers ( the 1$ pack) while maintaining quality and profits for members of the supply chain. Note : Target cost is a Bridge topic as well.

Cost management program strategies for purchasing

The cost management program strategy for purchasing section is at the core of the supply management leader's role. To find a seat at the Chief Officer table the Supply Leader must be able to understand not only the costs in terms of dollar terms but be able to hold her/his own in discussions with the CFO (Chief Financial Officer). For earlier posts on this Section 1-B-2 scroll down. It has 9 sub-sections some of which you are very likely to have dealt with in your jobs.

It is very likely that you have dealt with the question of "total cost of ownership" which includes the purchasing cost, installation cost, service cost and disposal cost. If your organization is strong on sustainability the disposal cost, mode and impact on environment can be an important consideration. Thus if two vendors provide comparable total cost solutions but one has a better sustainability element - you might decide to go for the more sustainable solution.

Included in this section are the concepts of value analysis and value engineering that are sometimes used interchangeably. However, value analysis is about studying existing processes and products relevant to what you are purchasing. For example, value analysis for the purchase of a low value bottle-neck item might reveal that the processes of purchasing sometimes can hold up production. Here, it might be better to just have approved vendors and allow shop floor managers to buy items using a fixed value P-Card.

On the other hand value engineering is connected with the development stage of the new product and innovation process. Here when you are turning a concept into prototype, value engineering can be useful. Thus the development team for a machine might consider a design that allows for easy access inside a machine for servicing and save service costs down the line when the machine is installed at a customer. Such value engineering at the design stage can greatly help in cost management. 

What's the connection of the supply management department budget to the company's strategic plan?

What's the connection of the supply (purchasing/procurement) management department budget to the company's strategic plan? is the starting topic in this section (1-B-1) that catapults the CPSM exam to the C-Suite of the company. For all the other sections are from the CPM exam viz. steps in budgeting, purposes for a budget and  types of budget.Not to say that you should not know the mechanics of budgeting - but it's really important to understand how and why  the supply management department budget is connected to the company's strategic and operational goals.  In fact, the company strategic goals should guide and dictate the supply management department's budget plan because it is in the budget that you put the money where your mouth is and the rubber hits the road!

As I explained in the context of qualitative goals in the product innovation charter, every strategy document,intent and implementation should consciously try to align to the organizational mission... if the overall organization is to move forward. So too with the Supply Management department budget. If say, your company's  mission includes  continually educating and developing it's employees with leading edge knowledge then what does it tell you to include in your budget? It tells you that you should budget for funds for supply department employee training and education. Also, you need to think carefully how many hours of time off for training you will provide. Doing so will explicitly mean that there is a bunch of money budgeted to allow for the training and education of supply management personnel that includes the time off.

In other words, if you read this section and look at your department budget and your company's mission you will find that there are several mismatched items. You are budgeting stuff just because it was included last year although it has a poor mission fit - or you are eliminating mission critical budget items just because of a slow economy.All this  because you never really sat down and thought carefully about the following questions:

• Is this activity of the supply department contributing to the company mission?
• Are the funding and expected results appropriate?
• Are gaps between funding and expected results clear and well articulated?

The budget is a huge mechanism to keep track of spending and earning (like sales, sale of assets etc.). More importantly budgets are the easiest way of reviewing progress towards the goals of the organization and its units including the supply department. Thus if you have a monthly review meeting, and had budgeted for 40 total hours of employee training a month,  and find that you have arranged only 10 hours- you have a problem. Upon review though, this can be fixed for the next month where you consciously arrange for 40+ 30 (the previous month shortfall) training hours. 

To conclude, try to find the higher "purpose" of the supply department budget , i.e. achieve the company goals. On an exam note do read the more tactical stuff around the other standard topics viz. steps in budgeting, purposes for a budget and types of budget in the study guide.

Defining and measuring supply management department performance

In this section, the methodology of measuring supply management performance is discussed. The section starts with a discussion of expectations from supply management from top management. Ideally, the top management should have a measurement of supply management expectation consistent with the company's mission. For example. historically Southwest airlines had the mission of "THE low cost airline" and you'd expect that supply management would have a similar aim.However, the website has the following mission :"The mission of Southwest Airlines is dedication to the highest quality of Customer Service delivered with a sense of warmth, friendliness, individual pride, and Company Spirit". So if you lead the Southwest airline supply management you need to have a sense of the history and what is expected going forward. So along with "low cost" you are supposed to deliver "warmth, friendliness, individual pride, and Company Spirit. " You need to therefore make sure that you are able to measure the department's performance from the point of view of passengers, suppliers, individual department members- against the explicit website mission statement and the implied,historical low cost idea.

Once you articulate specific metrics of goals for the department,individuals users you need to measure how well you did. For example, if you want a 90% reliability of supply delivery date according to the delivery date in your  purchase order terms, you must have data that are able to show what the actual reliability number is. It's fine if you are at 85% in the first year and its great if you have 87% in the next year. In other words, the idea is to keep track of how well you are doing as per standard. So long as you are working towards the goal (85% moves to 87% in the second year against the target of 90%). it's fine. If you are short then you need to have a remedial action in place like giving suppliers more lead time that in turn must be supported by early requisition by the users. You don't need to beat every target , but you need to have an explicit plan and progress data as you keep trying to improve the metrics.

Risk-value matrix - a modified Kraljic model?

Several considerations go into financing and leveraging strategies for purchasing. These include considering your cash flow because you have to pay for what you order,interest rates, setting payment terms,understanding commodity markets, currency markets for international purchases,tax laws  etc.

An understanding of market conditions is of strategic importance for the purchaser. For example depending on the product life cycle of the product in the buyer's organization the buyer must adjust her strategy. In the growth stage scalability with suppliers is important whereas exit and scale down in the decline stage is more important in the decline stage. The right time for focusing on lower cos and lean initiatives is when the buyer's organization's product is at the maturity stage.This was a rather cool  way of putting it - I thought!

Another interesting discussion, though very brief,  was the Risk/value matrix. This matrix seems to be a development of the Kraljic Model.

Diagram and more on the Risk Value Matrix and Kraljic Model.

Understanding costs and analyzing suppliers finances and the buy vs. lease

This section though large (20 pages) is broadly concerned with understanding what the total costs are and understanding the financial position of the supplier and the kind of contract one is getting into.

Thus it is not price alone that is important but the TCO (Total cost of ownership) these goes beyond the IT concept of TCO  and cover unit total cost,life-cycle cost, landed cost and total cost of performance for services.

Understanding the financial stability of the supplier is critical and therefore reading the supplier's balance sheet can give asense of the stability of the supplier and supply. Finally it's important to understand the lease vs buy considerations particularly for equipment as is the clarity on legal accounting issues like Uniform Commercial Code 2A, FASB 13 and SOX though is examined in more detail in a later section.

Why spend analysis is a challenge

This entire section is rather brief but very interesting. Before ERP systems became common it was hard to find data on spend in organizations. This data could be sitting in accounts payable, material requisitions, purchase orders or anywhere! Unless you have all the data by category - you cannot analyze it and you cannot advise or decide where you must focus attention with appropriate value analysis and negotiation.

Data mining modules in ERP systems like SAP and Oracle make it possible to retrieve and analyze  spend data. In addition other supply management softwares like Ariba,i2 also facilitate tracking your spend. In fact major consultants like AT Kearney and Deloitte offer services for analyzing spend.

How do you set up cost management program strategies?

Cost savings is either reducing historic costs or avoiding additional cost increases through the use of strategies that are clear, sit well with realities of the organizations market, economic environment etc.
Value analysis and engineering is part of these considerations. For example what exactly adds value (to the onward activity of the buyers organization) needs to be understood by the supply manager. For example, the seller might be emphasizing how great their service is because their sales/service executive makes a plane trip every 3 weeks to see your production folks. This routine trip - may or may not to adding value to your colleagues in production but you can be sure that the travel costs are added to the suppliers price! Solution: make a trip every two months - just call or email otherwise.

Cost modeling is another interesting idea of this section.  Modeling involves creating a formula - a regression  or just a spread sheet that allows you to plug in changing variables and see what the impact is on your purchased product. Thus, if  you buy a product or service that depends on oil prices - and if you have modeled what the per barrel price does to the costing of your buy (say freight) then you know that today you'd need to plug in $100/barrel and see exactly what it does to your freight .....

Budget and relationship with strategy and operations plans

The Cost and Finance section moves to considerations of budgeting including steps,purposes and types of budgets. I liked the way the strategic plan of the organization is connected to the operations and then supply management budget at the implementation level.

For example, if the Board and CEO decide to increase profits by  say 10% in a particular segment, Sales and Marketing have to find ways to do that and then Finance has to find the money but finally this has to be implemented at the department or lower level. Here extra people (HR is involved) might need more desks, manufacturing would need more materials and all of these have to be put in as costs with the inputs of supply management. In fact, the connection of the supply manger's work with the aim of the organization (its strategic plan) is something that is critical to understand. You get to know the broader purpose of your daily work...