10.5 Tool: Cost Breakdown Analysis
To gain insight into the individual cost elements that make up a product, you need to perform a cost breakdown analysis. Cost breakdown analysis involves "breaking down" a supplier's cost summary (i.e., price) into its individual pieces. You can then examine each cost component, looking for cost savings. You may even use insight gained to work with the supplier to reduce costs. Table 10.4 shows a simplistic example of a cost breakdown based on typical accounting procedures. Let's work through an example.
Scenario: You get a call from your hardware supplier (i.e., knobs and pulls) for a line of bedroom furniture that has been selling extremely well over the past 12 months. You spend approximately $2 million dollars per year with this supplier. The supply manager called to warn you that labor negotiations on a union contract were going poorly. She warned that labor costs could go up by 25% and that she will have to raise prices by 25% to make up for the higher labor costs. You respond, "Thanks for the heads up. Let me run some numbers and I'll get back with you later this afternoon." After you perform a cost breakdown analysis, how will you respond?
Step 1: Get the Data
You go to your friends in the accounting department and ask for the most recent cost-breakdown from the hardware supplier. You also download the price history from your supplier database. With this information, you build Table 10.5.
Step 2: Calculate Relevant Costs
You next calculate the supplier's anticipated higher price; that is, you multiply the current price by the 25% price increase: $5.04 X 1.25 = $6.30. Looking at your cost breakdown, you feel this is too high. You use your spreadsheet to run the new numbers based on higher labor costs (see Table 10.6). You note that higher labor costs should affect four items: labor, overhead, SGA Expense Allocation, and Markup. Material costs and tooling should remain unchanged. Your analysis shows a new price of only $5.97.
Step 3: Prepare for Your Supplier Conversation
Now that you've identified a discrepancy between the price your supplier is requesting ($6.30) and what the supplier should actually request ($5.97), you ask, "How significant is the discrepancy?" You calculate the percentage difference as follows: (($6.30-5.97)/5.97)) = .552. The supplier is asking for approximately 5.5% more than is necessary based on a 25% increase in labor costs. Simply put, given the supplier's cost structure, a 25% increase in labor costs should lead to only an 18.5% increase in price—i.e., (($5.97-5.04)/5.04) = .185.
To avoid paying more than the $5.97, you will need to share your analysis with the supplier. However, as you performed your analysis, you noted that the overhead allocation is 150%, which is pretty high. Maybe it is time to discuss this allocation with the supplier and look for some opportunities to minimize or even avoid the price increase.
Reverse engineering is a similar concept. Reverse engineering involves buying a product and then taking it apart to see how it is made. Automakers, for example, have always bought rivals' cars and disassembled them to look for hints to improve their own designs, technologies, and assembly processes. They also check out which suppliers are making key parts. More recently, financial analysts have adopted these costing techniques to look for hints to estimate future stock valuations. For example, every time Apple releases a new product, analysts "take it apart" to identify component suppliers and estimate both costs and profits. IHS Technology estimated that the Apple Watch Sport costs about $83.70 to source and assemble—only 24% of the watch's $349 retail price.1 Of note, the The “ingredients” and quantities required to make a product or service. for the Watch Sport is $81.20, leaving only $2.50 for manufacturing cost.
The bottom line: When you know what a product costs to make, you can change the nature of your supplier conversations, including the dynamics of your negotiations. You will be better positioned to save your company money. One final thought: You may encounter cost breakdown analysis before you start your dream job. Many companies now include quantitative reasoning exercises as part of the interview process. If you can do a cost breakdown, you will be well prepared for such an exercise.
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