Supply chains have become more and more dis-integrated, with value added in multiple steps along a supply chain that is divided by arms-length transactions. Traditional cost accounting, which attempts to allocate labor and overhead, is of less value in understanding product cost drivers when costs for many companies are now dominated by things they buy rather than value they add. Most of the information about product cost drivers is baked into a price from the supplier. The result: those price drivers are not visible to the people charged with managing product cost. With a dis-integrated supply chain, we have, in essence, let the market pricing mechanism determine the cost allocations. That can lead to situations that dont tell the truth about product cost.

Here are several key pitfalls to avoid when managing product cost in an outsourced supply chain

The Price Versus Cost Myth

Any good salesperson will tell you that the price quoted to the customer is related to, but rarely defined by, the underlying cost of the product. Price is what the market will bear, and pricing schemes are used to maximize the total profit for the seller, not to give an accurate picture of true cost. In supplier relationships with a lot of complexity in the pricing, such as outsourced manufacturing, there is abundant use of prices with wildly different margins. Why? The supplier needs to appear competitive on aspects of price that are easily benchmarked, and yet wants to make as much money as possible on prices that are not.

There are many examples: A supplier may charge a fixed markup across a family of products, even though higher volume products probably cost less to make. A supplier may set a price well above market on certain low dollar items within a larger set of parts because the customer is less likely to notice those variances. To achieve steady quarter over quarter cost reductions, a supplier can start prices high so there is room to go down until the next product is introduced. To win a competitive bid, a supplier may price below cost, but once the business is awarded, the supplier will find ways to make up the difference on other products and services. Suppliers will find a way to maintain total profitability on the business by putting margin where the customer does not squeeze.

Prices negotiated in this fashion distort the information going to the buyer about the real cost of products, and the buyer may make poor choices about where to focus cost reduction efforts, or which products to promote more heavily. The key is to understand the distinction between price negotiation and actual manufacturing cost reduction. Both are important, but in the long run, understanding the true cost drivers and taking real cost out of the supply chain is the way to achieve lasting cost reduction.

Non-Recurring Expenses That Recur Every Period

In pricing outsourced manufacturing, one of the tactics that most distorts information about cost is the use of non-recurring charges. The quoted price for a product typically assumes a steady run rate at a certain volume and yield. Any time there is a deviation from the quoted assumptions, the manufacturing service provider will invoice for the one-time costs of the change. These charges take many forms: engineering changes; re-work; over-time for orders in excess of forecast; excess materials and under-utilization charges when orders are less than forecast, and more.

While these charges are often referred to as non-recurring or one-off, the truth is that there will be some level of these expenses every quarter. These types of charges typically sum up to a few percent of the total product cost, but they can be greater than 15%. In many procurement organizations, however, there is a near total focus on the product price, while these types of charges can often be dumped into an operational expenses account. The buyer has strong incentives to show stability or decline in the PO price, while using the one-off charges to satisfy the service provider. The service provider gets trained that it is easier to submit one time invoices than to try to change the product price.

When this pricing game is abused, customers lose sight of the true product cost, and a meaningful portion of manufacturing cost remains mis- or un-allocated.

The Cost Accounting Ghost in the ERP Machine

There are many companies who manufactured their own products in the past, but have moved some or all of their manufacturing to an outsourced model. Often such companies still maintain full cost accounting detail on their product in their ERP: Indented BOMs with standard costs at the subassembly level, work centers, standard hours, allocations, etc. This requires significant overhead to maintain, but when the data no longer match the reality of the process, it fails the most important mission of managerial accounting ­- provide useful information that can be acted on to make improvements. Beware of going through the motions of product costing just because of an antiquated systematic requirement for it. Many companies do have useful cost models of their outsourced products, but they are rarely part of the transactional accounting system.

Everything Else is SG&A

This problem is the opposite of the one above. This issue is more common at the companies that have no history of manufacturing and little understanding of manufacturing cost. Because most of their cost of goods is the purchased price from a subcontractor, they simply call the PO price the product standard cost and fail to allocate almost everything else.

But all product companies even those with fully outsourced manufacturing have internal costs related to production: Planning, supplier management, quality, etc. Thats in addition to the non-recurring charges described previously. These Other Costs of Goods Sold (everything additional to the direct purchase price) often remain largely unexamined because the quoted product price from the supplier is the primary metric. It is common for a product companys OCOGs to exceed the manufacturing overhead charged by their manufacturing service provider, and yet more effort will be spent squeezing the service provider than reducing internal overhead.

Working Capital isnt Free

Every manufacturing operation requires a certain level of working capital in the form of inventory, and net payables and receivables. Manufacturing service providers will necessarily include a sufficient margin in the product price to provide a rate of return on that capital which is at least equal to their weighted average cost of capital (WACC). Setting a product margin based on return on capital effectively allocates a cost of capital at a product level. Return on working capital is the largest driver of quoted profit in many outsourced manufacturing prices.

As a customer, be aware of the terms that drive more working capital and therefore a higher price:

  • Increasing payment terms from the supplier (either contractually or by habitually paying late)
  • Requiring the supplier to buy from sub-tier suppliers on very short payment terms
  • Requiring buffer stocks
  • Frequent schedule changes that drive excess on-hand materials

When you understand the ways that product cost is obscured in an outsourced supply chain, you can manage that cost more effectively. Best of luck managing your product cost in an outsourced world.

Jeff Wallingford is vice president, Supply Chain Strategy for Riverwood Solutions .

See also:

When Companies Shouldn't Outsource Manufacturing

Six Steps to Align Supply Chain with Corporate Strategy