Chapter 11 Strategic Cost Management
Learning Objectives
After completing this chapter, you should be able to
• Understand the impact of cost management on the supply chain
• Understand the fundamental approaches to price management
• Understand approaches for reducing supplier costs of production and delivery
• Understand the concept of total cost of ownership
• Identify collaborative approaches to cost management
Honda of America’s Emphasis on Strategic Cost Management Permeates Every Part of Its Business
Honda was built upon a cost management culture from the time the company began. The com- pany founder sought to move into the automotive industry from a motorcycle base, despite gov- ernment blockades, and found that the automotive supply base in Japan was unwilling to support his business. As such, he developed his motorcycle component suppliers into automotive component suppliers through supplier development, financial support, and most importantly, re- lationships and trust. This loyalty to suppliers, under any circumstances, still exists today. Honda will not “fire” a supplier unless the supplier requests them to do so. They will support and invest in suppliers who are going through difficult periods, but expect the same leeway when economic times become difficult in the automotive industry. This long-term view towards co-destiny has paid off. Moreover, like a strict but loving parent, Honda demands a lot from their suppliers, in- cluding multiple visits to their site to drive improvement with a refusal to take “no” as an answer. This concept of supplier development, integration, and ongoing socialization and trust is a core and integral component of the Honda business model.
Honda’s business model has always been focused around a six-year plan, which is highly depen- dent on a small group of committed suppliers who are involved upfront for the entire six years. The second component of their model is 100 percent understanding of all components of product cost, with a high level of precision. The third component of their model concerns lean supplier development engineering, with a large population of field engineers working closely with key sup- pliers on every aspect of their production process. The fourth component is based on flawless new product launch. Honda is a firm believer in extreme attention to detail in every aspect of component, subsystem, and system development. The “Same Part, Same Place, Same Process” mentality emphasizes that multiple visits and meetings take place with a supplier during prototype development and ramp-up, to ensure that products coming off of a supplier’s line are of “first product” quality and ready to go to market when production conditions occur. Finally, one of the most important components of Honda’s business model is communications. The quality, frequency, and content of every communication that takes place between Honda and its dealers, suppliers, and stakeholders is reviewed, and is systematically controlled for in every aspect of their business model. Communications are the foundation for inter-organizational relationships.
Measurement systems support all cost management decisions. Initial metrics in the design in- clude the price that the final product could be introduced at in the market. The price/value rela- tionship for Honda’s customer is a focal point of debate and discussion. What price level at the retail level can provide the required profit at the manufacturing level? A production cost is es- tablished at a high level as a target, and then R&D, manufacturing, and supply chain work on how to achieve it, separating manufacturing and supply cost to make that unit. They then break it down component by component, on how to build up to the target price. Certain types of quality characteristics are set in stone (five-star crash ratings, eight airbags, and so forth). There is then an ongoing effort by suppliers and supply management to share ideas and innovation with R&D teams early on to discover how to reduce expense, while adding more value and features. Price is the first differentiator, followed by quality. Target cost elements are based on Activity Based Costing procedures, derived from historical analysis conducted by key R&D groups who are capable of estimating realistic manufacturing and supplier expenses. These are broken down into budgets developed by category teams. Tradeoffs are always a point of discussion at category team meetings. This is a stressful and rigorous process, as multiple teams each work on their own target costs, all seeking to meet the market price.
Cost engineers (procurement) at Honda are aligned by the specific types of suppliers they work with, and are dedicated to this role with the objective of becoming global experts. For example, a cost engineer can visit any given supplier of stampings, and produce a lengthy report docu- menting the level of capability associated with that supplier, based on one visit. There is a high level of capability and knowledge regarding what to look for, which is designed into the culture.
On a regular basis, all of the procurement groups meet at a quarterly meeting to discuss inte- grated global supply management strategy. At this meeting, the discussion focuses on opportu- nities for commonality and standardization, coordination with marketing’s export strategy, new product planning, cost management, and technology transfer issues within the supply base.
An important part of this strategy meeting also focuses on development of a truly “global” sup- ply base. All divisions and business units come together on a regular basis to discuss and share global platform development, common supply strategies, and ongoing cost management objec- tives. Opportunities for learning and identification of lessons learned are a major part of this ef- fort. Honda continues to measure cost against attributes such as customer value, ensuring that its new vehicle costs do not rise even though global material costs are rising, and also to add features that ensure customers have a safe, innovative, and fulfilling driving experience.
Source: Handfield, R., and Edwards, S. (2009, July), “Cost Leadership Best Practices,” White Paper, Supply Chain Resource Cooperative, NC State University.
In today’s economy, the driving force behind global competition can be summarized in a single equation:
Value = ðQuality + Technology + Service + Cycle TimeÞ=Price
Although supply management has a major impact on all of the variables in the numerator in this equation, this chapter focuses on the denominator: price, and its primary driver, cost. A major responsibility of supply management is to ensure that the price paid for an item is fair and reasonable. The price paid for purchased products and services will have a direct impact on the end customer’s perception of value provided by the organization, thereby leading to a competitive advantage in the marketplace. By delivering value through continued progress in reducing costs, and thereby improving profit margins and return on assets for enterprises, supply management is truly becoming a force of its own within the executive boardroom.
Evaluation of a supplier’s actual cost to provide the product or service, versus the actual purchase price paid, is an ongoing challenge within all industries. In many situations, the need to control costs requires a focus on the costs associated with producing an item or service, versus simply analyzing final price. In these cases, innovative pricing approaches involve cost identification as a process leading to agreement on a final price. In other cases, however, supply management may not need to spend much effort understanding costs, and will focus instead on whether the price is fair given competitive market conditions.
Supply management and supply chain specialists must understand the principles of price and cost analysis. Price analysis refers to the process of comparing supplier prices against external price benchmarks, without direct knowledge of the supplier’s costs. Price analysis focuses simply on a seller’s price with little or no consideration given to the actual cost of production. In contrast, cost analysis is the process of analyzing each individual cost element (i.e., material, labor hours and rates, overhead, general and administrative costs, and profit) that together add up to the final price. Ideally, this analysis identifies the actual cost to produce an item so the parties to a contract can determine a fair and reasonable price and develop plans to achieve future cost reductions. Finally, total cost analysis applies the price/cost equation across multiple processes that span two or more organizations across a supply chain. For example, the total cost of shipping a good manufactured from China into the United States may include shipping, tariffs, inventory, quality, and other costs that are over and above the actual price paid to the Chinese manufacturer. Total cost decisions may also extend to the cost of poor quality, or environmental risk. For example, consider the total cost of the decision to use a less expensive drilling pipe on the deepwater rig Horizon, versus the total cleanup cost resulting from the oil spill (see Sourcing Snapshot on p. 425).
This chapter presents a traditional discussion of price and cost fundamentals along with a number of innovative price and cost management tools that can be applied using available information on the Internet and simple spreadsheet analysis. Some of these tools are price analysis, reverse price analysis, and total cost analysis. By applying such tools, purchasers can evolve toward a system of strategic cost management that seeks to reduce costs across the entire supply chain. Although not all of these tools are appropriate for every situation, supply managers must learn to recognize when and how such tools can be applied.