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Cost Innovation - The next development in cost management


Members of our Danish team, Søren Hjorth Lee and Christoffer Carstens, invited supply chain consultants from PA Consulting to explain how to build and sustain cost-effective practices. They helped over 70 supply chain and manufacturing operations leaders who attended the webinar to address cost management in product, software and process.

Cost innovation requires insight of the cost drivers at its lowest level of component granularity to optimise and re-engineer. We address three important elements:

  • component, process or software tear-down disaggregates the cost item into its lowest possible granularity to be able to arrive at a “should cost.”
  • The “should cost” serves as benchmark for supplier collaboration as well as the basis for re-engineering.
  • Cost-innovation happens when the product specification is re-engineered to reach the desired quality with the least-cost possible specification.

PA Consulting Group is a management consultancy that specialises in strategy, technology and innovation. Our thanks to René Overgaard, Barinder Lalria and Stephen May from PA Consulting for sharing their expertise.

Cost Management

The relationship between profit, price and cost is as follows:

PRICE – PROFIT = COST

This is different to COST + PROFIT = PRICE because price dictated by the marketplace. You therefore can only influence the cost.

Where does cost come from?

Cost primarily stems from the planning and design phase.

PRODUCT COST

Conventionally, most cost is conceived at the point of design. To assess the true cost of a supplier’s product, disassemble it to its component parts. Then investigate each component’s cost to manufacture. Add associated costs such as assembly and logistics to calculate the potential supplier’s cost.  Now you are able to negotiate with the supplier from a position of informed advantage.

You may also consider re-engineering the product with cheaper cost materials.

Costs can be addressed at all elements of an organisation.

The product cost is an important focus area.

The aim is to be able to calculate the “should cost.” Should cost methodology looks at the cost bottom-up and not at the top-down target pricing.

Further cost reduction can be achievable by re-designing and re-engineering components. PA Consulting worked with a client and identified potential cost savings of 42%. They followed the following stages:

1. Calculate the “should cost.”

2. Assess the technical perspective: what changes can be made?

3. Re-design for cost: what fundamental changes can be made to the machine whilst maintaining its quality and performance?

Addressing the product cost at the design phase is important because a large percentage of cost is determined in the planning and design phase. 

If cost is carried into production, it is hard to reduce or eliminate it after this stage. This is why cost needs addressing beforehand in design.

Do customers want this product’s current specification?

The question should be considered whether the current product’s quality and performance suits the needs of the customer. There may be components that are over-engineered or use materials that can be replaced with lower cost alternatives. It is also worth considering what can be learnt by analysing competitors’ alternatives. Exploring this with the customer will help define target costs for design.

PA Consulting addressed this with one client by disassembling a competitor’s van alongside its client’s vehicle to benchmark the competitor’s product.

SOFTWARE COST

Software prices are market led. The anticipated price for bespoke software is difficult to assess though and when requesting quotations, prices to build applications can frequently vary widely.

So, what should software cost and how can you break down its costs?

This starts by specifying the requirements of the software, reviewing existing contracts with software suppliers and then reverse engineering the software into its logical programmable components. Consider the platforms it will be deployed upon and the availability of developers to build it.

Following this process will provide a “should cost” that can be used for negotiating with the supplier.  Where the supplier disagrees with estimates, share your calculations if necessary and ask them where you went wrong. Their explanations will help to understand their motivations and methodology which will increase your knowledge.

Where cost disagreements exist, investigate these further.  For example, PA Consulting once asked a supplier to show them the source code and discovered that it was written very poorly, making it extremely difficult for other developers to amend and add to the code. The customer was being expected to pay for excessive development time caused by the suppliers’ problems.

Other cost saving areas may be as simple as reviewing contracts where one client identified that they were paying for 24 hour technical support despite the fact that the company only worked during standard office hours.

Customers’ decisions to authorised and embark on software development are usually taken before costs are known.  However, following the process outlined above can result in 20% - 60% cost improvements being achieved.

PROCESS COST

The initial approach to cost management is to use less and/or buy cheaper. Or if it relates to internal processes, to consider whether any aspects of these can be outsourced. Cost models for processes require understanding of 3 components:

  • The tasks in detail;
  • The cost drivers; and
  • The resource costs.

Deconstruct the process into its activities.

Understand the cost drivers is important because you need to identify what drives costs e.g. does the company run weekly or monthly period closes? You may also find that some individual cost drivers influence different aspects in the process.

Once completed, you can benchmark those costs to calculate the ideal cost of the process. This is usually lower than the current costs being incurred.

Example:  What should a third-party engineering process cost?

Try to understand the vendor’s process if their quotation is too high. PA Consulting took this approach in the example below. They then helped drive costs down by, for example, identifying that lower cost people could be applied to the process than those costed by the supplier.

SUMMARY

  • Deploy a fundamental understanding of your cost components.
  • Question everything
  • Re-innovate
  • Drive down all aspects of waste

And if your customer states the price they are willing to pay, remember that product cost is about delivering feature and functionality.  Attribute the “should cost” to each feature or function and work with customer to decide which features really are needed.

CAN WE HELP?

The team at Nigel Wright Group is always keen to help add value to people working within manufacturing operations and supply chains. If you would like us to introduce you to the team at PA Consulting, or would like to discuss other introductions we may be able to facilitate, please contact Christoffer below.

Christoffer Carstens

E: christoffer.carstens@nigelwright.com

M: +45 27 50 16 12

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