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The Top Ten Approaches to Cost Reduction

Author(s):

Robert E. May, Jr., C.P.M.
Robert E. May, Jr., C.P.M., Sr. Consultant, Harris Consulting, Inc., Lexington, MA 02173, 781/674-0041, Harriscon@aol.com.

83rd Annual International Conference Proceedings - 1998 

Abstract. America's most successful, as well as most internationally competitive companies, are using proven methods to reduce cycle times, improve quality, enhance customer satisfaction levels, and most importantly, reduce total costs of goods purchased. Some of these methods have used for many years, while others are relatively new tools that reflect the current supply management thinking associated with close, long-term customer-supplier relationships.

This paper discusses the ten most effective approaches to cost reduction being used by Fortune 200 companies today. As different companies are having varying levels of success with them, these tools and methods are not presented in any particular order. How many are you familiar with?

1. Value Engineering.

2. Value Analysis. Both Value Engineering (VE) and Value Analysis (VA) are tools companies are using to reduce costs by identifying unnecessary processes or costs, or improvement opportunities, in order to increase the ultimate value of the final product to the customer.

Although these terms are often used interchangeably, VE and VA differ in two important aspects. VE strictly addresses the functionality of a part, exploring other methods of meeting the need that the function performs. Put another way, VE tries to find other ways to do the same thing. Because of this, a VE approach to a product typically occurs in the conceptual phase of a new product or service. Value Analysis, on the other hand, is usually undertaken on a part or assembly when its design is firm (and usually being produced by suppliers in large quantities).

Both approaches try to increase value by either increasing the functionality or performance of the part being considered, or reduce its cost. This statement can be represented by the following simple equation:

Value = performance,functionality/$

Value Engineering focuses on the numerator of this equation, looking for alternate solutions to customer needs at the stage when possibilities are first being formulated. At this conceptual stage, no drawings exist and no designs have been drafted.

A VA approach, on the other hand, focuses on the denominator of the equation, looking for unnecessary costs or methods that can be taken out of existing products without affecting the function that it performs when integrated with other parts into a finished good. Products that are usually the most appropriate for a value analysis program are those which are being produced in fairly large quantities, since even small cost reductions can be leveraged.

3. Negotiation. Negotiation is when a buyer and supplier use facilitative and problem solving skills in order to arrive at an agreement that enables each to proceed to a further objective. Companies should only expect to realize savings of 3 - 5% when using this method strictly as a price reduction or cost avoidance tool. Negotiation skills are leveraged when used to support another cost reduction strategies.

4. Target Costing. Target Costing is a cost management process for reducing total costs at the product planning and design stages.

To begin a discussion of target costing, it is necessary to first describe the traditional process that manufacturing companies use to determine the selling price for new products. Typically, an opportunity for a competitive new product is identified by the marketing department, who outlines the customer needs and desires for the new product in general terms.

Next, design engineers translate these needs and desires into the functional aspects of the new product, and often spec in state-of-the-art technology and features for it. At this point, production planning would analyze the manufacturing requirements for the sub-systems that, when assembled, comprise the final product. Here, make/buy decisions would determine which of the sub-assemblies will be made in-house, and which will be purchased from suppliers.

After collecting all the cost data from manufacturing for producing the 'made' components and from purchasing as a result of gathering supplier quotations in response to all the RFQ's sent out for the 'buy' parts, the total cost of producing the new product is found. A targeted profit margin is added to this figure to arrive at a price that the new product will be sold to customers. Will this final price be competitive in the marketplace in which we are competing? Maybe some analysis has been done in this area, maybe not. Typically, rollout of the new product proceeds according to the defined plan for introduction, promotions, etc.

Target Costing eliminates the uncertainty of the competitiveness of the selling price of the new product. When taking a target costing approach for new products, it is necessary to first determine what a competitive selling price will be for the new product, before any sub-assembly or components are designed or developed. The next step would be to obtain what targeted profit is required to continue operation of the company profitably. Subtracting the target profit margin from this competitive price leaves the target cost:

Sell Price - Target Profit Margin = Target Cost

Breaking down the final product to its major sub-components and assigning percentages of cost, enables buyers and suppliers to understand and work together to design supplied parts at "appropriate" cost levels.

To illustrate, an example follows. OTIS Elevator, a United Technologies Company, is the world market leader in the elevator and escalator market. OTIS takes a target costing approach for their new elevator models:
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Using this chart, OTIS can calculate the target cost for the "button component" of the elevator, and work with its partnered supplier to obtain a solution that will be purchased at a unit price of (.25)(.35)(.30)(X), or .025X, with "X" being the target cost for the complete elevator system.

5. Early Supplier Involvement. Early Supplier Involvement (ESI) is having partnered suppliers participate in cross-functional teams to develop new products.

The optimal use of suppliers' special skills and processes is experienced when suppliers are provided with a set of performance specifications Performance specifications are an "envelope" of conditions that the suppliers' part or sub-assembly must operate within. Performance specifications are in contrast to design specifications, where the component or part to be purchased is defined in a blueprint or other drawing that defines its material, dimensions, surface finish, production method, etc.

A good example of ESI is from Kawasaki motorcycle, a Japanese manufacturer. Kawasaki has its supplier of motorcycle seats participate in its integrated (i.e., cross-functional) product development team (IPDT) for new motorcycle models. Before designs are drafted or finalized, Kawasaki engineers provide general requirements for weight, environmental conditions, and frame interface specifications (how the seat will attach to the frame). This information, together with the developed target cost (see above) for the seat, is taken back to the supplier plant where these performance specs are developed into a customer solution.

6. Leveraging Purchases. With the de-centralization of management in the U.S. in the last few years, coupled with the initiative of many companies that compete globally to establish or evaluate their local overseas operations, came the realization that their procurement functions have evolved into fragmented, unstandardized processes. With each location "doing its own thing" with respect to supply management, there was no recognition over time of opportunities for consolidation of volumes as the organization expanded and satellite offices increased their volume of purchased products. In this scenario, orders for large volumes of parts and services are divided to a patchwork of suppliers rather than to one or two large suppliers. Some companies with many subsidiaries purchase the same commodities from the same suppliers without each others knowledge.

By identifying the parts and services used across departments, groups, and divisions, organizations are realizing significant savings for both production parts and MRO materials.

7. Consortium Purchasing. Consortium (or co-operative or group purchasing) is a number of buying organizations coming together for the purpose of consolidating their purchasing volumes for leveraging purposes.

Traditionally, the strategy has been implemented by non- and not-for-profit organizations in similar businesses such as educational institutions and hospitals. Commercial, for-profit companies, perhaps wary of anti-trust legislation like the Clayton and Robinson-Patman Acts, have not aggressively pursued the opportunities that consortiums provide. When the numbers are analyzed, however, it is revealed that it would be rare even for large commercial buying groups to breach the 20/35 rule that legal experts say would prompt the FTC to investigate the consortium.

The focus on consortium purchasing has indirectly given rise to a new class of service business - third-party purchasing, where an independent party, using only purchasing leverage, makes purchases for its "customer" for a small fee. With a minimal customer service staff and low overhead, a third-party purchaser is to a traditional distribution channel what Charles Schwab( is to the brokerage industry. Tenneco, a natural gas provider located in Texas, recognized that its purchasing volume for MRO materials like office and janitorial supplies could not be matched by the smaller, local companies in the area. What began as a small, profitable side business has evolved into a stand alone enterprise for Tenneco.

8. Cost and Price Analysis. For the professional buyer, it is of utmost importance to "know what you buy", and this directive is generally understood and accepted in our profession. However, when the typical buyer is asked to describe the commodity he is responsible for, or what products they purchase from suppliers, answers usually address such issues such as the technology incorporated into the purchased products and how they interface with the buyer's final product, who the major suppliers are for that component family, and supply/demand factors, to name a few. Surely, these are all very important and relevant aspects.

Unfortunately, unless the buyer knows and thoroughly understands the cost breakdown for the products and services purchased, he or she does not fully "know what is being purchased", and could be missing an opportunity to reduce costs significantly.

In response to Requests for Quotations, suppliers quote prices, not costs. In its most basic form, a quoted price is made up of the following components:

  • Material
  • + Labor
  • + Overhead
  • + Selling, General and Administrative
  • + Profit =
  • Price

By analyzing and understanding these cost elements, a buyer can make an informed judgment as to whether or not the price being paid for the purchased good is "fair and reasonable" (another fundamental responsibility of the purchasing professional).

9. Design for Purchase. Design for Purchase, or DFP, ensures that designs for purchased parts or sub-assemblies are in a form that is recognizable to suppliers, and use standard terminology and industry standards. It recognizes the 'disconnect' that typically occurs in a manufacturing company after a decision is made to purchase some part or assembly rather than produce it in-house.

Many manufacturing companies have developed sophisticated programs to ensure that all internal production efficiencies are realized after the decision has been made to produce a component in house. Among them are Design for Manufacture (DFX), Design for Assembly (DFA), or Design for Installation (DFI). All require ongoing industrial engineering support during and after design to maximize the utilization of the company's production equipment, tooling capabilities, scheduling, etc. Typically, however, this technical support evaporates after the decision is made to purchase the needed part from a supplier.

10. Standardization. The widely recognized approach to standardization, [reducing the number of custom-made parts, or reducing the number of components, etc.], is just one facet of a thorough standardization program. Companies are finding that by working closely with suppliers, and understanding their production processes, other benefits can result. This approach does not strictly focus on finished goods, but relates to taking work-in-process up to a point where any further production would define its ultimate state.
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Recognizing opportunities such as these has the added benefit of reducing supplier cycle time as well, since forecasts for parts A, B, and C can be consolidated to production Step 3. This has the effect of "diversifying" forecasting errors, thus reducing supplier risk associated with holding WIP inventory. It also allows for greater flexibility with respect to short-term quantity requirements, changes, and implementation of engineering change orders.

What Approach(es) Should I Pursue? Companies are experiencing varying levels of success with these tools, anywhere from 4% to 45% and more. Typically, a successful, formal cost reduction program would entail the use of two or more of these techniques for maximum effect. However, the approach to take depends chiefly on four factors: the type of product (or service) being purchased, the stage of the product in its life cycle, the number of suppliers providing the product or service, and the annual spend. Cost and price analysis, although not captured in either of the below charts, should be used for all procurements, regardless.
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