Cost Engineering in Procurement: Three Methods That Increase Business Value
The primary goal of procurement is to efficiently realize external business value creation, thereby generating added value for the company. to obtain detailed insight into product cost structures and manufacturing processes within the scope of a purchased part price analysis.
Cost engineering methods are used to perform the purchased part price analysis, such as target costing or activity-based costing.
Method 1: Target costing as an essential part of supplier request
Target costing is used to determine an appropriate price for the product components and helps businesses understand what the product is allowed to cost – not what the product will cost. The planned product costs are first broken down into the individual product components using a “top-down” analysis. The product costs are calculated using an analytical, bottom-up process and compared with the target values. A standardized costing scheme with the supplier (cost break-down) provides the basis for cost transparency and an understanding of cost origination.
In the event of deviations between target and actual values, it is possible to control costs as early as the product development process by means of cost analyses and evaluations for different product and production variants. This is a decisive factor for procurement success. Defining cost levers facilitates targeted, value-oriented development and creates a balance between functions and costs.
Method 2: More cost transparency by combining activity-based costing and target costing.
Target costing is not the end of the path to full cost transparency. Cross-sectional areas of the business and the associated costs to the analyzed manufacturing steps cannot be uniquely assigned, meaning that a significant amount of the product costs remain unclear even after target costing. Activity-based costing is designed to counteract this deficit. Processes that run in the individual divisions and the human and material resources needed to carry out these processes are entered. Then the corresponding cost rates are determined to settle them based on the principle of cost object unit calculation.
By combining activity-based costing and target costing, the in-depth detail and transparency of this overall cost assessment makes it easier to understand all the cost parameters (manufacturing and overhead costs). Companies create the ideal prerequisites for open book accounting or supplier workshops.
The requirements for cost analysis and evaluation can be met with target costing and activity-based costing methods. However, a comprehensive cost overview requires an overview of the entire production period along with the costs associated with acquiring the product.
Method 3: Complete overall cost assessment by total cost of ownership and supplier lifetime value
The overall cost assessment is the third key component in the purchased part price analysis. A low product price does not necessarily translate into the lowest overall cost level for the entire project duration.
The total cost of ownership (TCO) approach enables businesses to keep track of product costs along the entire product life cycle. In addition to incorporating monetary factors, the main idea behind procurement management based on the TCO approach also offers a further complementary option: Qualitative characteristics can be incorporated into the assessment, making it possible to assess the supplier’s overall performance capability. Qualitative characteristics are quantified and weighted here and can be added to the calculation as multipliers or output as ratios. This method, when joined with the breakdown of all the costs incurred across the entire lifetime of the product, offers a cohesive overview of the product costs – and not just for manufacturers, but also for users. However, since this approach varies from company to company and is not an integral part of the costing process, it is beyond the scope of this document.
Supplier lifetime value (SLV) is another meaningful supplement to TCO. The term SLV is closely interlinked with Supplier relationship management (SRM) in the context of strategic supplier/procurement management because it considers the supplier’s contribution to a company’s own product over the entire manufacturing period. SRM encompasses all a company’s supplier relationships. The aim is to use the close collaboration with the supplier to develop, procure and manufacture products in a more efficient way. This meets the growing need to transfer supplier innovations to one’s own company and impact and control costs early on to gain further competitive advantages. Moreover, this method of viewing results takes both cash-in and cash-out transactions in the customer/supplier relationship into account so that the supplier is viewed as an investment item. This approach simplifies entrepreneurial decisions while acknowledging the strategic significance of procurement.
Every costing method is viable in its own right, but a multistep concept should be considered to achieve optimum results.
Strengthen cost knowledge in Procurement
New products, unknown manufacturing processes and increasing production relocations demand know-how in the production process from procurement teams. Cost engineering is an important method and role for analyzing production and costing processes more quickly, deriving optimization opportunities and implementing efficient change management. As part of operational product costing, cost engineering leads to greater cost transparency and supports purchasing teams in the cost-analytical assessment of prices and the analysis of further negotiation options in supplier management. The combination of technical and business methods under the aspect of Enterprise Product Costing guarantees more business value in procurement.
Author: Rüdiger Stern
President for North America, FACTON
Advisory Board, Society of Cost Engineers