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Perspective: Buying vs Selling

I recently had an incredibly good discussion on LinkedIn which started out with the topic of Machine Rates.  This discussion first started with a post which discussed a highspeed stamping press and how if it was charged out at $50 per hour it would equate to less than a penny a part.   This math is simple as all it entails is dividing the $50 by the pieces per hour to get a piece price contribution.  Simple enough.  Where I took the discussion was the $50 per hour rate.

I started with the question, what is a machine rate and what is in it?  We cannot have a reasonable discussion about Machine Rates or any rate unless we define exactly what is include within that rate.  It became obvious the perspective of the engineer is just as important.  A Cost Engineer of the sales side (Estimator) will look at the calculation differently than a Purchasing Engineer (Should Cost).

The Cost Estimator’s job is to cover all the company’s expenses, potentially including inefficiencies.  His job is assisting the organization to get the best sales price he can and still win the business.  Conversely, the Should Cost Engineer’s responsibility is the help his organization procure products at the best price possible, ensuring they get the product they requested, usually utilizing benchmark data.

During my career I had the opportunity to sit on both sides of the table.  I conducted estimates as well as should cost models.  I played both roles at the negotiating table.  This experience gives me what I think is a unique perspective.  I would like to share some of my insights as a SHOULD COST ENGINEER.

As a Should Cost Engineer I want to discover how this $50 per hour was developed.  For example, for every $100,000 invested spread over 10 years, this would equate to $10,000 a year.  Standard available hours per year is approximately 2000 per shift.  A benchmark facility would work 3 shifts a day so this would lead to $1.66 per hour MACHINE DEPRECIATION rate.  So, what makes up the remained of the $50 per hour?

Let us assume the machine is actually $1 Million.  That would be 10X our $1.66 or $16 per hour.  That still leaves $33.44 per hour.  By the Society of Cost Engineers definition, we would still need to add in some items such as floorspace, interest, insurance, and variable costs (depending on the process these may or may not be significant)

Machine Hourly Rate

The running cost per hour of any equipment or machine. According to the SOCE, it is composed of the sum of Fixed and Variable Machine Rates

  • Fixed Machine Rate: Are those costs that are incurred regardless of the number of parts produced. For example: building rental, equipment amortization, shop floor heating/cooling, Interest, Insurance, Floorspace
  • Variable Machine Rate: Are those costs that are directly proportional to the numbers of parts produced. If we produce 0 parts, the Direct Costs spent should have been 0. Electricity consumption, Gas or other elements consumptions, Maintenance

 

This discussion and nearly all discussion at the negotiating table quickly diverts to the “rest” that make up the original number, $50.  The seller or Estimating Engineer usually lumps in indirect cost, SG&A and Profit.  Sometimes it even included labor.  As a Procurement Engineer, we like these separated out from the Machine Rate.  These are different categories of costs to us.  We like to drill down to understand each of these sub-buckets.

Inevitably, one of the first discussions is about the depreciation schedule as this can be one of the largest contributors to the “Machine Rate”.  As a Should Cost Engineer we strive to use benchmark data.  Benchmark data would suggest following Generally Acceptable Accounting Principles for the length of time (depending on the equipment, usually 7-10 years).  Another benchmark would be the number of shifts or hours per day.  This benchmark would be 3 shifts (discounting for some inefficiencies).  The idea would be that the customer pays for the time they use of the machine, with the machine being run at correct cycle times, and not at the TAKT time.  This last point may leave the machine with extra capacity.

Some suppliers argue that the customer needs to pay for 100% of the machine if it is not utilized.  I have even seen suppliers run equipment as slow as needed vs as fast as possible.  They do this to improve their manufacturing metric like utilization and uptime.  If they ran it as fast as possible, the machine may sit unused or a period of time.  Unfortunately, this drives up the actual cost of the product.  Using the $50/h as an example:  If the machine can make 50 parts in an hour (cycle time) but you only need one part an hour (TAKT time), you would pay $1 per part using the cycle time vs $50 a part using TAKT time.  I have actually seen this in practice.

The argument from the Should Cost Engineer is that the supplier is responsible to fill unused capacity, after all, is that not why they have a sales force (by the way, part of the SG&A costs)?  (* of course, there might be exceptions, please see the blog https://societyofcostengineers.com/amortization-of-production-equipment-impact-in-part-cost/).

The supplier may then come back with the argument that the real reasons you are purchasing from them is they expertise, abilities, and knowledge.  From a should cost and decision point of view, this has little or no accountability, it may be used however in case of similar quotes between different suppliers.

Let us look at this as a business case.  Let us agree there are 5 main buckets of costs: Material, Labor, Manufacturing, SG&A and Profit.  It is expected that a supplier makes an acceptable profit on all these categories.  If the estimator expects the customer to pay for 100% of the equipment and inefficiencies and those get marked up for overheads and profits, what incentive do they have?  Why would they not vertically integrate?    Let us not forget that one of the reasons a customer becomes a customer is because the supplier can produce the product more cost efficiently than if the customer brought it in house, because of their expertise, and their broader sales perspective to that type of part that helps them filling up available capacity and then equipment after equipment.  If not, the customer may be able to match your material, labor and SG&A costs especially considering it gets marked up by the supplier for overheads and profit.  This leaves manufacturing as hopefully the strongest selling point.

Cost Category Cost to Customer
From Supplier Internal
Material $+ Overheads and Profit $
Labor $+ Overheads and Profit $
Manufacturing $+ Overheads and Profit $
SG&A $+ Overheads and Profit $

 

A similar agreement can be made for all indirect costs.  If the claim is that the customer needs to pay for 100% of the costs and they do not get thinned and they get marked up, then what incentive is there from them to be your customer.

So what is the correct answer?  That depends on your perspective.  A Cost Engineer on the sales side is much different than a Cost Engineer on the purchasing side.  Which side are your on?

 

Jerry Collins

Owner and Founder

Society of Cost Engineers

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