Download Purchase Negotiation - Texas A&M University

Chapter 13
Strategic Cost Management
IDIS 424
Spring 2004
1
Cost-related Concepts


A cost driver is any factor that affects costs. A
change in the cost driver will cause a change
in the total cost
Cost management are actions that managers
take to satisfy customers while continuously
reducing and controlling costs
2
Cost Behavior


Cost behavior refers to the way costs change
with respect to a change in an activity level or
cost driver
Typical cost behavior patterns include:





Fixed costs
Variable costs
Mixed costs
Semifixed costs
Semivariable costs
3
Cost Behavior Patterns



Fixed costs are costs that do not change with
changes of a cost driver
Variable costs are costs that increase directly
and proportionately with changes of a cost
driver
Mixed costs are costs that have both a fixed
and a variable component
4
Cost Behavior Patterns


Semifixed costs are costs that increase with
the level of activity, but by intermittent jumps,
rather than continuously
Semivariable costs are costs that increase
with increasing levels of activity, but not at a
constant rate. Can be separated into costs
that:


increase at an increasing rate
increase at a decreasing rate
5
Cost Behavior Patterns
Fixed Costs
Variable Costs
Semifixed Costs
Semivariable Costs
6
Total Cost


Total cost is the sum of all costs
Total costs increase as the volume of
production or service increases, while the
cost to produce each unit or provide each
service decreases
7
Total Cost

Total cost specifics:




Total fixed costs do not change with volume
increases or decreases
Unit fixed costs decrease as volume increases
Total variable costs increase with volume
Unit variable costs may or may not change
with volume changes
8
Cost-related Concepts

Direct costs are costs that are related to the
cost object and can be traced to it in an
economically feasible manner


Direct materials (e.g., raw materials,
purchased components, expendable
packaging associated with a given product)
Direct labor (e.g., all labor traceable to a given
product)
9
Cost-related Concepts


Indirect costs are costs related to the cost
object but cannot be traced to it in an
economically feasible way. Indirect costs are
allocated to the cost object using a cost
allocation method (e.g., overhead costs)
Indirect costs may have both a fixed and a
variable component
10
Overhead Cost Assignment

Three common overhead assignment
approaches include:



Overhead cost per direct labor hour
Overhead as a percent of direct labor cost
Overhead per machine hour
11
SG&A Expenses

SG&A expenses that are associated with
supporting the interface between buyer and
the supplier as well as those expenses that
are not directly related to the organization’s
primary operations but are required to
support these operations
12
SG&A Expenses

SG&A will typically include:





Sales salaries and commissions
Advertising
Administrative salaries
Research and development
SG&A is usually presented as a percentage
of annual net sales
13
Prices, Profit, and Revenue



Price is the amount that a buyer is willing
to pay for a given product or service
Profit is the difference between the total
cost to produce a product or service and
the selling price
Revenue (sales revenue) is the product
of price multiplied by the quantity sold
14
Cost-related Concepts


Sunk costs are those costs already
committed to a project or decision
An economic cost is the value of a
good when employed in an alternative
use. For example, specialized tooling
used for a discontinued project that has
no other alternative use or scrap value
has an economic cost of zero
15
Cost-related Concepts


Differential costs refer to cost differences
between two or more decision
alternatives
Controllable costs are those costs under
the direct control of a manager. A
manager should be accountable for only
those cost items that he or she has the
ability to control
16
Cost-related Concepts


Discretionary costs include any cost that can
be avoided in the short term
Continued cost avoidance, however, can
result in the deterioration of a firm’s
competitiveness or contribute to higher longrun costs
17
Cost-related Concepts


Relevant costs include only those costs having a
direct impact on a decision
Relevant costs have three necessary
characteristics:



They must be differential (costs associated with two
or more decision alternatives are different or unique)
Future oriented (costs will not occur until after the
decision is made concerning how to proceed)
Quantifiable
18
Price/Cost Management


Price analysis examines price proposals
without examining elements of cost and
profit
Cost analysis addresses actual or future
costs
19
Goals of Price/Cost Management




Develop accurate price/cost information
to enhance negotiating effectiveness
Drive continuous price/cost improvement
Effectively beat out the competition
Determine type of supplier relationship
20
Approaches
Price/Cost Management Approaches
Market Based Pricing
Cost Based Pricing
Non-collaborative
Collaborative
21
Approaches

Market-Based Pricing


Cost-Based Pricing


The price the buyer pays is not linked to the
supplier's cost structure
The price the buyer pays is directly linked to
the supplier's cost structure
Hybrid

Some elements of cost may be known by the
buyer
22
Market-based Pricing
Supply
PRICE
Dollars

Supplier's
Market
Buyer's
Market

Demand
VOLUME
Based on supply and
demand
Suppliers and buyers
determine the price
according to what either
suppliers are asking or
buyers will offer
23
Market-based Pricing Approaches

Market testing


Quantity discounts



Volume consideration linked to price
Longer term agreements linked to price
Price change control


Initial price determined by competitive bid, and
on-going negotiations thereafter
Ceilings established on future price changes
Reverse price analysis
24
Reverse Price Analysis
Hypothetical Price
Profit / SG&A Allowance (15%) Subtotal
Direct Material
Subtotal
Direct Labor
-
$20
$ 3
$ 17
4
$ 13
3
Manufacturing Burden
$ 10
X TOTAL VOLUME
= TOTAL FIXED COST
(Will vary as volume changes)
25
Cost-based Pricing - Non-collaborative



Market-testing - initial contact through bid
and on-going negotiations
Target pricing - established ceiling cost to
achieve a competitive position in the market
for the finished product
Supplier uses target price as a basis for
accepting the order
26
Cost-based Pricing - Collaborative





Cost identified - margin or ROI negotiations
Identification of cost drivers
Targeted goals
Establishment of value added / non-value
added costs
Continuous cost improvement
(collaborative)
27
Supplier Pricing Issues

Pricing objectives




Long-term versus short-term
Price leader versus follower
Establish entry barriers
Pricing Strategy


Cost based pricing (cost + fixed markup)
Market based pricing (penetration, skimming,
floor pricing)
28
Pricing Strategies

Demand (skimming) pricing




Introduction and growth of life cycle
“What the market will bear”
Works under conditions of no competition
Cost-plus (penetration) pricing



Maturation stage of life cycle
Minimum acceptable price
Appeals to a mass market with objective of
sales increase
29
Pricing Strategies

Survival pricing


Market share pricing


Forgoes sales and profits - puts society first
Rule-of-Thumb (myopic) pricing


Used to take market share from competitors
Social responsibility pricing


Price remaining capacity at marginal cost
DM + DL + 40%
Buy-in (foot in the door, low ball) pricing

Cover VC only
30
Pricing Variables

External




Nature of the product (life cycle)
Seller’s market characteristics
Buyer’s control variables
Internal



Seller’s internal characteristics
Management orientation
Accounting and costing methods
31
Measures of Price Management Effectiveness

Types of measures include:




Percent improvement of price paid over
inflation
Percent improvement of price paid vs. prior
year
Target prices achieved
Ratio of actual price change improvement to
comparable market index change
32
Problems with Traditional Cost Accounting






“Standard” product costs
No recognition of tradeoffs
Product cost structures
Allocation of overhead fixed
Budgeting and control
Labor efficiencies / machine utilization
33
Assigning Indirect Costs
Supervision
$1000
Cooling Fluids
$2000
Electricity
$1500
Direct labor-related
cost pool = $2500
($2500/500 hrs)=$5/hr
Direct material
Direct labor
Rags
$200
Material weight-related
cost pool = $2200
($2200/220 kg) = $10/kg
$15/kg
Products P1 and P2
Total Cost = $425
$10/hr
34
Cost Behaviors
Fixed Costs
Variable Costs
Semifixed Costs
Semivariable Costs
35
Which supplier would you rather do
business with?
High Fixed Costs
Low Fixed Costs
Revenues
Breakeven
VC
Revenues
Breakeven
VC
FC
FC
36
Relationship Between Sales and Costs

As a supplier’s sales increase. . .






Fixed costs __________
Average fixed costs _______
Average variable costs ________
Total variable costs __________
Total costs __________
Average total costs _________
37
Production Cost Schedules
Output Total Fixed Avg. Fixed Avg. Var
Cost
Cost
Cost
0
$500.00
--$0.00
10
$500.00
$50.00
$19.00
20
$500.00
$25.00
$17.00
30
$500.00
$16.67
$15.00
40
$500.00
$12.50
$13.00
50
$500.00
$10.00
$13.00
60
$500.00
$8.33
$13.00
70
$500.00
$7.14
$13.00
80
$500.00
$6.25
$15.00
90
$500.00
$5.56
$17.00
100
$500.00
$5.00
$19.00
Total Var
Cost
$0.00
$190.00
$340.00
$450.00
$520.00
$650.00
$780.00
$910.00
$1,200.00
$1,530.00
$1,900.00
Total Cost Average
Total Cost
$500.00
$690.00
$69.00
$840.00
$42.00
$950.00
$31.67
$1,020.00 $25.50
$1,150.00 $23.00
$1,280.00 $21.33
$1,410.00 $20.14
$1,700.00 $21.25
$2,030.00 $22.56
$2,400.00 $24.00
Price
$80.00
$80.00
$80.00
$80.00
$80.00
$80.00
$80.00
$80.00
$80.00
$80.00
$80.00
38
Average Cost Curve
80
Avg. Cost Per Unit
70
60
50
Avg. Fixed Cost
40
Avg. Var Cost
30
Average Total Cost
20
10
0
10 20 30 40 50 60 70 80 90 100
Volume
39
Total Cost Curve
3000
2000
Total Cost
1500
Total Var. Cost
1000
Total Fixed Cost
500
100
90
80
70
60
50
40
30
20
10
0
0
Costs ($)
2500
Volume (Units)
40
85
80
75
70
65
60
55
50
45
40
Price (Fixed)
0
10
90
80
70
60
50
40
30
20
10
Price -(5%/year)
0
Price ($)
Price Reductions
Output
41
What Happens to Profit?
6000
4000
Profit w/ Fixed Price
3000
Profit - 5% Price
Reduction
2000
1000
0
10
80
60
40
20
0
0
Total Profit ($)
5000
Output
42
Price/Cost Management



Price analysis examines price proposals
without examining elements of cost and profit
Cost analysis reviews actual or future costs
COST + PROFIT = PRICE
43
Goals of Price/Cost Management




Develop accurate price/cost information to
enhance negotiating effectiveness
Drive continuous price/cost improvement
Effectively beat out the competition
Determine type of supplier relationship
44
Approaches

Market-Based Pricing


Cost-Based Pricing


The price the buyer pays is not linked to the supplier's
cost structure
The price the buyer pays is directly linked to the
supplier's cost structure
Hybrid

Some elements of cost may be known by the buyer
45
Market-based Pricing
Supply
PRICE

Dollars
Supplier's
Market

Buyer's
Market
Demand
Based on supply and
demand
Suppliers and buyers
determine the price
according to what either
suppliers are asking or
buyers will offer
VOLUME
46
Framework for Cost Management
High
“Unique Products”
“Critical Products”
“Generics”
“Commodities”
Risk
Low
Low
High
Value (Cost, Service, Administration)
47
Generics


Low Value, Low Risk
Strategies


Critical Factors


Standardize / consolidate
Reduce cost of acquisition
Metrics:



Total Delivered Cost Reduction
Percent of CGS Improvement
Transportation cost reduction
48
Commodities


High Value, Low Risk
Strategies


Critical Factors


Leverage preferred suppliers
Reduce cost of materials
Metrics

Price change improvement to market
index
49
Unique Products


High Risk, Low Value
Strategies


Critical Factors:


Preferred suppliers
High costs when cost/quality problems occur
Metrics



Unit price cost reduction - Actual to actual prices for same
items
Target prices achieved, “Should cost” $
Total Delivered Cost Reduction
50
Critical Products

High Risk, High Value
Strategies


Critical Factors


Strategic supplier partnerships
High costs when cost/quality problems occur
Metrics



Target prices achieved
Unit price cost reduction - Actual to actual prices for same
items
Joint cost savings sharing
51