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.