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Cost Management: Intent Means Everything

Dec. 11, 2019
I wonder how an OEM would react if a potential end-use customer asked them to define their costs and profit margin prior to their buying decision?

The October 16 article Dullsville Just Got Interesting struck a nerve with me. It laid out the various approaches to Cost Management and how OEMs could apply related cost analysis in negotiations.  In case you are new to the concept, Cost Management is where OEM customers determine what the parts they are sending out for quote should cost. That’s all fine and good. 

Unfortunately, the underlying intent behind how OEMs apply Cost Management—at least in my experience—doesn’t always align with the price they should anticipate from their best suppliers. In fact, the intent of some OEMs—which will be laid out below—is to bastardize the whole Cost Management process to their own advantage.

Let’s be clear up front.  In theory, Cost Management provides OEMs a foundation for negotiating with a supplier upon receipt of their quote. Many times, however, some OEMs in fact wait to establish their should cost figures until after they’ve received the quotes from their suppliers. As a result of this, my experience is that should cost figures that these OEMs present to their potential sources aren’t real. By that I mean that they don’t account for realities of supplier costs.  In effect, they manipulate should cost figures to establish an artificial price that leverages suppliers to “buy” the business, negotiations or not.

You may not realize it, but many OEMs will not accept supplier proposals without the supplier providing the details of underlying costs related to their quoted price. In essence, suppliers are regularly asked to provide operational information such as wage rate; material cost; what they apply as overhead to their direct costs, etc.  In other words, their secret sauce.  Many times suppliers regard this as proprietary information but provide it anyway in an effort to get the job. Based on the supplier operational information they receive with the quote, it is relatively easy for an OEM customer to determine the amount of profit in their price. And they do, no kidding, so they can pressure suppliers to accept less than their business dictates they need to.

As stated above, a common approach some OEMs use in developing should cost numbers is based on the quote data received from multiple suppliers.  Instead of using that information to better understand supplier cost drivers and possibly recommend how to reduce them, they compile it to come up with the price they would receive from a world-class supplier.  For instance, assume supplier A has the lowest wage rate; supplier B has the lowest material cost; supplier C has the lowest overheads and Supplier D is willing to accept the lowest profit.  The OEM will then take A’s wage rate; B’s material cost; C’s overhead, and; D’s profit margin and meld them into the should cost they present to their suppliers.

Why have these OEMs departed from the theoretical intent of Cost Management?  Because their purchasing departments’ performance is measured almost solely on material variance; i.e. year-to-year pricing.  Consequently, they’ll use whatever approach they can to leverage lower prices, even if it means varying from the true basis of Cost Management.

Is this approach fair?  Let me answer that by putting the shoe on the other foot. I wonder how an OEM would react if a potential end-use customer asked them to define their costs and profit margin prior to their buying decision? They might argue that their products are differentiated by features and, because of that, customers should expect to make buying decisions based on factors other than price.  At the same time, they explain, what they buy from suppliers are commodities, which means price is king.  Note: Many OEMs view everything they purchase as commodities!  Really?  I don’t think so, at least in most cases.

Let’s use automobiles as an example.  In any product category—take SUVs, for instance –most competing models aren’t really very different, at least from my seat in the ballpark.  Really, it boils down to appearance and price. So is an SUV a commodity or not?

Let’s say that a potential customer demands manufacturer cost data and finds GM has the lowest material cost; Toyota has the lowest overheads; Subaru pays the lowest wages.  Parallel to how OEMs purchase parts and assemblies for their products, then, the end-use customer might then determine each company’s profit margin and then put together their own should cost based on the same type of cost cherry-picking some OEMs use in setting their own should costs.

Hmm.  First, I don’t think the OEMs would like this nor provide that kind of information to a potential customer.  Second, they would resent their products being treated as a commodity.  In short, in regarding price, OEMs prefer to have suppliers “do what I say, not what I do.”

This Cost Management approach will likely continue as long as C-Level corporate management regard purchasing as a tactical function that can only positively impact their company’s bottom line by getting lower piece-prices.  As I’ve written before, this is a short-term perspective. It precludes them from working with suppliers on improvements that will reduce the overall costs-of-goods-sold by reducing their own internal overheads and give them the ability to more quickly respond to market demand; i.e., reducing their need to rely on forecasts.

Creating a lean performance supply chain should be the goal of all purchasing organizations, and you-won’t-get-there-from-here by focusing primarily on piece-price.  If a focus on piece-price could deliver lean supply chain performance, most supply chains today would have this capability, since piece-price has been the focus of purchasing organizations for generations. Alas, as we all know, very few supply chains deliver lean performance.

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