Should Cost Analysis: A Valuable Addition to Your Sourcing Strategy

Strategic sourcing has been an integral part of most supply chain models for decades. The essence of
strategic sourcing is to create an environment where multiple vendors competing for a companys
spend drive down prices and drive up performance and services. But what about products and services
where there are only a few providers, or where the product itself is so unique or highly specified that
only a few suppliers can make it? Perhaps the item in question is custom built, complex to manufacture
and purchased in low volumes making it difficult to get comparable competing bids. In many
businesses, these categories of spend can be a significant portion of the total. What do these
companies do?
One solution to this problem is a technique known as should cost analysis, which allows a company to
simulate the manufacturing process and cost structure of its suppliers providing valuable information for
supplier price negotiation. In order to understand how and where to apply should cost, it is important to
understand the limitations of traditional strategic sourcing.

Background

Strategic sourcing generally consists of aggregating, categorizing and analyzing a companys spend.
The results are then used as leverage in price negotiations. Advancements in technology have
repeatedly breathed new life into strategic sourcing by, for example enhancing the ability to gather
information through data warehouses / reporting or improving negotiating ability through on-line
auctions.

This model has worked extraordinarily well for a long time. The latest wave of sourcing has fueled a
drive into low cost countries where labor rate arbitrage, government policies and other factors have
combined to drive further spend reductions.

The reliance on supplier competition to drive down prices works best when the subject products are
very comparable. This is one reason why strategic sourcing is frequently applied to indirect spend.
Even when the pricing is complex, for example telecom, shipping or information technology, the actual
product or service is fairly comparable so it is relatively straightforward to compare opposing proposals.

Strategic sourcing gets more complicated when applying it to direct materials. Of course many direct
spend items are relatively common and have many alternate suppliers so it is possible to do direct price
comparisons. But what about an item designed and engineered with characteristics specific to your
product. Examples of these items are everywhere from your car to the appliances in your home to the
airplane that you fly on. Many of these items are also consumed in relatively low volumes, further
complicating attempts to reduce purchased price. This is where should cost analysis enters the picture
and provides a valuable additional tool to manage category spend.

Should Cost Analysis

 Should cost analysis was developed by the U.S. Department of Defense to improve the governments
ability to monitor pricing and drive cost reductions. Initially, Should cost analysis was a highly analytical
and labor intensive approach that required a team from DoD to spend weeks or months at a supplier
analyzing their processes and production metrics:

The team would identify inefficiencies (e.g. long setups, poor flow, low yields)
Product cost would be recalculated based on the elimination of these inefficiencies
The team would provide their observations and recommended improvements to the supplier

This type of approach works for the DoD where they are the dominant and possibly the only customer,
however it is too lengthy, expensive and labor intensive for most companies especially if done as part of
a procurement process where multiple suppliers might need to be analyzed.

Initiating should cost analysis requires that the company have a good understanding of the
manufacturing processes used to produce the item that they are buying. Because should cost analysis
is typically applied to specialized and unique parts, this is a reasonable assumption. When a company
designs a part or assembly for a car or airplane they typically specify much of the manufacturing
process or at the very least they specify the characteristics of the part that define the process. Based
on those specifications, engineers can determine the manufacturing process steps what a reasonable
amount of accuracy.

What the engineers likely will not know are the capacities and cost structure of the supplier. For
example, the parts specifications may require heat-treating at a certain temperature and duration. How
much it costs the supplier to run the furnace and how many parts can fit in the furnace are often not
known by the buyer. This is where should cost analysis comes in.

At the core of should cost analysis are statistical models and a database of manufacturing processes
that can be used to define the manufacturing processes of various parts. Frequently, the databases
contain information for a wide range of manufacturing processes including typical standards and cost
information. For the heat-treating example above, the database might contain information that allows a
company to translate the parts specifications into typical time and cost standards based on the type of
heat-treating, the metal composition, dimensions and weight of the part. These databases are often
populated with information gathered from the software companys user base, thus providing a large
number of data points and increasing the reliability of the information.

Various statistical modeling tools are then used to analyze and model the cost behavior of a part. By
analyzing a combination of the manufacturing processes (machining, drilling, heat treat, etc.) and key
characteristics of a number of parts (dimensions, composition, tolerances, weight, etc.) along with
supplier cost information and the cost database described above, a model can be developed that will
predict what a part should cost. A key output of this analysis is the determination of which variables
(characteristics and processes) correlate most closely with the parts cost behavior. The figure below
provides a simple example of the output from this analysis. The resulting parametric model can be
used to infer the suppliers cost structure through various what-if analyses, for example by varying labor
or overhead rates.

Notional Example of a Should Cost Model

Typically a company will build several of these models corresponding to different combinations of
characteristics and processes that define different cost behaviours. Once developed the models can
predict with a reasonable accuracy what a part should cost.

Application to sourcing

Should cost models provide insight and direction that can be invaluable when negotiating prices with a
supplier. They help purchasing professionals understand what is driving an items cost and allows them
to explore a variety of scenarios such as how changes in labor and overhead rates or improvements in
process efficiency might impact an items price. By comparing the models output to a quoted price,
purchasing can infer profit margins, production efficiency, overhead costs, and other key negotiating
elements.

The chart below shows how should cost analysis best fits into a procurement strategy based on part
characteristics such as volume, cost, supply base and level of engineering.

Should Cost Modeling in Overall Sourcing Strategy

Should cost analysis is not appropriate for every item. In many cases, traditional strategic sourcing
techniques work well. But in those cases where strategic sourcing cannot be applied, should cost
analysis provides a valuable tool that can drive cost reductions and supplier continuous improvement
efforts. It should be in the procurement toolkit of every manufacturer that buys highly engineered and
costly items from a range of suppliers.

Should Cost Modeling: Take the Guesswork Out of What a Project Should Cost

The advantages of outsourcing a project can be substantial

allowing your organization to free up internal resources, gain
access to world-class capabilities, and increase revenue
potential. Of course, there can also be significant cost savings.

However, to utilize these advantages, you must have a clear

understanding of what you should be paying for an outsourced
project. Without knowing the should cost, there is a strong
likelihood that you will either be paying too much or requiring
more hands-on attention than you originally anticipated.

A should cost analysis provides a solution that can give you the
knowledge, data, and framework to empower you with the
 information you need to determine fair market pricing when
negotiating with outsourced vendors. With the SEER project
management tools from Galorath, you can create an accurate
should cost model that enables you to effectively negotiate with
suppliers while maximizing profitability through the optimization
of a variety of critical parameters.

SEERs should cost models provide the credible and

defendable estimates necessary to effectively negotiate and
give the insight to compare outsourcing options with in-house
capabilities.

For nearly three decades, Galorath Incorporated has been

dedicated to the mathematical science of parametrics in the
application of cost estimation technology, developing solutions
that assist project estimation, planning and management. SEER
by Galorath solutions combine an intuitive interface, extensive
project-applicable knowledge bases, sophisticated should-cost
and project-modeling technologies and rich reporting features
to accurately forecast real-world outcomes by combining
advanced modeling technology with a database of industry and
user-defined metrics.
SEER for Manufacturing
Estimating Manufacturing Projects

Core Capabilities

PLAN, MANAGE, AND CONTROL MANUFACTURING PROJECTS

AND PROCESSES

Datasheet

View SEER for Manufacturing Demo

The best design in the world is destined to fail if it cant be

efficiently and reliably manufactured. Where SEER for
Hardware evaluates and analyzes product options, SEER for
Manufacturing (SEER-MFG) focuses on manufacturing project
and process options, and can be used to model virtually any
manufacturing operation.

Project Estimation Software - A key component of a

complete Design for Manufacturability. Enables organizations to
optimize both functional design and costs for production,
providing a realistic and manageable view of production costs,
labor, materials, tooling, set-up and rework.

Cost Management Software - A key component of a Design

to Cost solution, SEER-MFG is widely used by manufacturing
outsourcers to develop should-cost guidelines, and by
manufacturing subcontractors who need to reduce bid
preparation time and error rates, and to quickly determine
when not bidding at all is the best option.

A broad set of manufacturing processes is supported, including

company-defined processes:
All SEER project management software solutions are built on
the same design principles, incorporating the following
application elements:

INTERFACE:

An intuitive interface for defining and describing projects. Users

can generate a new project from an existing project template
or by adding and defining individual work elements. A series of
pop-up windows and annotations guide users through the
process of defining project scope, complexity, and technologies.
SIMULATION/MODELING ENGINE:

Sophisticated sector-specific mathematical models derived from

extensive project histories, behavioural models, and metrics.

KNOWLEDGE BASES:

SEER Knowledge Bases serve as a virtual in-house expert,

providing default project definitions, values, ranges, and
calibrations based on time and motion studies. Enables users to
develop first-look estimates when very little information is
known, and to refine those estimates as details become
available.

OUTPUT:

A variety of charts, graphs, and reports for quickly summarizing

and presenting project outcomes and alternatives as well as
work-in-progress.

Open architecture and APIs ensure that SEER applications can

be easily integrated with departmental productivity solutions
and enterprise applications.
SEER MFG (formerly SEER-DFM) was designed to enable both
intermittent and advanced users in management, finance,
engineering, industrial design, and manufacturing to evaluate
process options and tradeoffs impacting such factors as ease of
fabrication and assembly, number and availability of parts,
materials selection, and failure and repair rates. As with all
SEER project estimating software solutions users can optimize
their process strategy by performing extensive trade-off
analyses varying assumptions and options to determine what
manufacturing strategy is likely to produce the best outcome.
The results of these analyses can be documented and shared
using SEERs rich reporting capabilities, as well as exported to
numerous 3rd-party applications.

Enabling organizations to model a broad range of

manufacturing processes, SEER for Manufacturing provides a
strong adjunct to traditional project estimating software, cost
estimating software, and workflow software solutions.
 For information about the extended SEER for
Manufacturing product line, go to:
SEER for Manufacturing
Estimating Manufacturing Projects

The SEER for Manufacturing (SEER-MFG) product line consists

of the SEER Core and extended capabilities which can be
licensed individually or bundled within a choice of delivery
editions.

The SEER-MFG (formerly SEER-DFM) product line consists of

the specialized SEER Core and extended capabilities which can
be licensed as product options.

Labor and Facilities Calculator is designed to quickly and

accurately generate labor and machine cost rates for use in the
estimating process and in determining facilities costs on a
global basis. It contains a regularly updated, comprehensive
database which includes worldwide labor cost data, default
technology costs, costs for many regions (including low-cost
centers), default year and labor costs, and regional currencies.

Aerostructures Pro provides additional trade and design

analysis options involving all types of composites: part shape;
build-ups and cores; materials and resins; material cutting and
bagging processes; consumable materials; hot-ply forming,
curing, and trimming; and other aerostructure-specific
 fabrication and assembly processes. Aerostructures Pro was
developed in conjunction with the U.S. aerospace industry's
leading companies, with sponsorship and participation of the
U.S. Air Force and Navy. At the CAI Final Technical Review, held
in April 2006, Aerostructures Pro was recognized as one of the
three most significant technology transitions since the inception
of the program in 1996.

Cost to Point of Use (CPOU)

A Supply Chain Decision Framework

The recent and ongoing events in Japan are creating unprecedented challenges for global supply
chains. When including global geopolitical and financial concerns it becomes clear that many
businesses have been underestimating the risks associated with supply chain globalization.
Unfortunately, risk is not the only factor that has been missing from many supply chain decision models.

Having consulted with companies across industries on supply chain topics like sourcing, cost reduction
and globalization I am often surprised at the lack of sophistication of their decision models. One clients
model was basically that if they can achieve more than a 1/3 reduction in purchase cost then they were
confident that they would save money regardless of what additional costs might be incurred. Another
company told me about significant unexpected inventory increases as a direct result of their longer low
cost country supply chain. Others have told me about quality problems that they were unaware of until
they unpacked the product when it arrived at their distribution center.

The hard lesson here is that there are numerous incremental and often unexpected costs that come
along with the savings associated with a low cost country supply chain. Facilitating comparison of
sourcing alternatives requires a baseline, which many companies have difficulty measuring. The most
straightforward approach to this base lining is what I call cost to point of use (CPOU). CPOU basically
means the farthest point in the supply chain where the purchased item and any associated services
cease to be the responsibility of any supplier regardless of the suppliers physical location, capabilities
or other factors. For example, a local supplier might manage inventories and deliver a part to the plant
floor location where it is consumed on an as-needed basis. If this is the highest level of service and/or
cost, it becomes the baseline CPOU. By contrast, a low cost country supplier may deliver the part in
bulk only as far as the plant loading dock (or a port of entry), requiring the manufacturer to perform the
remaining services: inventorying, unpacking, stocking and shop floor delivery, and also resulting in
higher inventory levels. To adequately compare these 2 suppliers, you have to go beyond the items
purchase cost and determine all of differentiated costs associated with getting the part to the point
where is consumed in the production process.

CPOU can mean different things to different companies. For example, at an automobile manufacturer it
likely means the point where the purchased part is installed into the car. For a retailer, it may mean
when the product is delivered to the warehouse or perhaps when it is put on the store shelf, depending
upon the farthest point of control offered by a supplier. What many companies overlook or find difficult
to quantify are the services and cost implications that different suppliers have on the CPOU.

Systems and process costs can also add to the CPOU. Using the factory example above, switching to a
distant supplier may mean that the manufacturer has to have the systems and internal capabilities to
manage the supplier, handle customs, track inbound freight, manage inventories and process quality
returns some of which are either not required or are vastly simplified when using a local supplier.
Managing and performing these functions adds cost that can offset savings. The graphic below shows
some of the elements that can be included in a CPOU calculation.

Cost-to-Point-of-Use Conceptual Model

The model above breaks CPOU into 10 segments focusing on production/execution costs, logistics,
supply chain, SG&A/overhead, and infrastructure. While these categories and their associated
elements may not be all encompassing, the model provides a useful framework for thinking about the
comparative value and relative costs of alternate supply chain / sourcing strategies.

It is important to consider that the CPOU model can be very different for different businesses and can
change substantially over time. As an example, consider a business where all elements of the supply
chain can be found in a 100-mile radius of the factory. Lead times are very short, it is easy to visit and
track supplier performance and the suppliers might provide a variety of value add services. The
decision to extend the supply chain to an offshore manufacturer for one item will carry a
disproportionate amount of incremental cost as new processes are needed and value added services
will likely be lost. The second outsourced part will have less of an impact as the new processes have
already been defined, perhaps a new job will have been created, systems will have already been
changed, and so forth.

The models purpose is not to try to define a universal point where an offshore sourcing strategy
reaches scale and there is no longer a meaningful incremental cost to adding parts and suppliers.
Instead it is to provide a framework for companies to consider a more holistic approach to evaluating
supply chain strategies and to recognize the importance of reaching geographic scale.

In summary, every business with a supply chain that includes a variety of different suppliers should
consider adopting the CPOU approach by building their own model and identifying / quantifying as
many costs as possible. The resulting model can be used in both making supply chain strategy
decisions and as a framework for supplier negotiations by facilitating fact-based analysis of alternatives.

Sales & Operations Planning

Sales & Operations Planning (S&OP) may be the fastest and least expensive way to dramatically
improve supply chain operations. It may also be among the hardest to get right.
At its core, S&OP consists of a set of well-defined processes, information and analytics that balance a
companys competing constraints. While the concepts and goals of S&OP are well understood, many
companies struggle to get the promised results. In order to put these challenges in context, it is
important to first establish a high-level baseline description of the S&OP process.
Overview
Every manufacturing company must balance competing constraints. Sales wants a mix of products that
are inconsistent with what production would optimally like to build. Meeting customer delivery
expectations requires a higher investment in inventory than finance would like. The timing of new
product introductions adds complexity to the supply chain and creates difficulties for some suppliers.
Forecasts continually change putting the business and its supply chain into a reactive mode that is
difficult to break out of.
For a business to function in this complex and competing environment, its various parts need to be
working together on an agreed upon plan that typically reflects a set of compromises among different
interests and allows each party to execute and deliver their responsibilities. For example, while the
agreed upon inventory investment may be higher than finance would want and lower than Sales might
like, each can proceed accordingly. Finance can arrange to fund the working capital needs and Sales
can commit to realistic delivery dates. In many ways, the S&OP process can be viewed as the
orchestra conductor that keeps all of the musicians in sync regardless of what music they are playing.

In a typical planning framework, S&OP falls into an intermediate space between long range strategy
and tactical day-to-day plans. It typically covers a 12 18 month timeframe beginning one month out.
Tactical daily/weekly plans cover the immediate timeframe and define what each business group needs
to do today, this week and this month. Strategic planning typically looks much farther out usually in the
3-5 year timeframe and among other things defines the long range expectations for the business, what
markets will it serve, how big those markets will be, what businesses might be acquired, plants that may
be built, etc.
Figure 1: S&OP Context in Typical Planning Framework

By covering the intermediate timeframe, S&OP allows the business to anticipate capability gaps and
develop plans to manage or avoid problems that might occur. Examples of actions that may be taken
include: qualifying new suppliers, growing / reducing workforce, changing timing of new product
introductions, managing customer demand, and other approaches that take some time to implement
and proactively address the challenges of daily/ weekly / monthly plans and actions.
The S&OP process itself is composed of a defined and repeatable series of planning events. The
diagram below depicts this as a waterfall type process because the output of each event serves as
 input for a downstream event. While the sequence is not critical, it is important that each major
constituency have the opportunity to understand the plans and identify their specific constraints.
Figure 2: Typical Sequence of Monthly S&OP Events

The culmination of these individual planning events is the monthly S&OP Review followed by the
Executive Review:
The Monthly S&OP Review is where each party (Sales, Production, Supply Chain, Finance,
etc.) gets together to review the plans and resolve outstanding issues and constraints. Ideally, each
party brings appropriate data and analysis and is prepared to address the implications of alternatives.
For example, what happens to the supply chain if sales 3 months out are 10% lower than current
forecasts indicate? The objective of this review is to arrive at a consensus plan that includes actions,
contingencies and trigger points for potential future events.
Ideally, the Executive Review, is to present the consensus plan to business leadership to ensure
that potential future events have been considered and to gain their support. Realistically, it seldom
works that way. Impasses occur at the S&OP Review that requires executive level decisions. A
decision to fund additional finished goods inventory in anticipation of growing customer demand is
generally a decision that must be made at the executive level. When properly framed during the S&OP
Review, the executives have the information needed to understand the implications of a decision to
fund or defer the additional inventory and make the right decision.
This all seems relatively simple and straightforward. Why then do so few companies get it right and is
the journey so long and winding?
S&OP Challenges
While every business has its unique challenges and culture which impact the success of S&OP, there
are 5 challenges that seem to occur in company after company. Addressing these and getting beyond
them can be the keys to getting the performance promised by S&OP.
1. Planning Framework Confusion: Figure 1 lays out the mid-range context of the S&OP process.
Often, companies do not draw a hard-line between S&OP and the short-term planning and control
process. This happens because day-to-day firefighting takes immediacy over planning and avoidance,
and surfaces during the Monthly Review (see Figure 2). Instead of focusing on preventing future
problems, the Monthly Review is hijacked by immediate problems like part shortages, quality issues
and order fulfillment concerns. Avoiding this trap requires a combination of a formal non-S&OP process
for addressing these types of issues and a strong leader of the Monthly Review to keep the meeting on
track.
2. Multiple Versions of Truth: Data is like oxygen to S&OP. Without data, it dies. It falls victim to
opinions and agendas. As bad as a lack of data may be, a more vexing problem is multiple versions of
the same data. This often happens because of multiple systems and /or informal systems. Examples
abound:
o Sales has a system for customer orders that differs from the one production uses for
planning.
o Production keeps inventory information on spreadsheets because the ERP system is
either unreliable, takes too long or is inconvenient.
Regardless of the rationale, these multiple versions poison S&OP. It causes needless debate about
what is really happening, defers decisions until someone validates the information and results the
events wrong decisions in the Monthly Meeting.
3. Insufficient Leadership: S&OP is one of the only processes that requires cooperation,
collaboration and decision-making across a broad range of business constituencies and
interests. Balancing these often competing and sometimes conflicting interests requires the
active leadership of an unbiased senior executive. Having the right person leading the
Executive Review also creates a powerful incentive for issues to be resolved during the Monthly
Review. Occasionally, companies give this role to the VP of Marketing or Operations. This
often fails because whether real or perceived, these executives have a bias toward their
segment of the business that complicates reaching a balanced consensus. The best solution
to the leadership challenge is for the business unit President to own the process and lead the
Executive review. The next best alternative is the CFO, who is usually the next least biased
executive.
3. Mis-aligned Incentives: It is not uncommon for leaders of different parts of a business to get paid based
on their functions performance. Operations may be rewarded in part for keeping inventories low, while
Sales is rewarded on sales volume. To the extent that Sales believes product availability drives
business there are conflicting incentives between these two groups. Because incentives are designed
to drive behavior, it becomes difficult to arrive at a best for the business solution when leaders are
motivated to achieve a local optimum.
3. Unrealistic Expectations: For these and other reasons, getting S&OP right is difficult and requires a fair
amount of soak time. The first Monthly Meeting is likely to devolve into a discussion of near term
tactical issues that are hampered by missing and inaccurate data. It takes several cycles before a
business can understand what data is really needed and for the participants to understand what is
expected. Often companies expect amazing results immediately. Occasionally, companies become so
enthused about the S&OP process that they decide if a monthly cadence is good than a weekly
cadence is better. Both of these expectations fail to recognize the difficulties inherent in S&OP and can
create an atmosphere that leads to failure.
Conclusion
S&OP is the critical link tying together a companys planning and execution processes by proactively
addressing obstacles and constraints. It is one of the few processes that is truly cross-functional, which
makes it difficult to implement.
There are well-defined approaches to S&OP which have been described above. Companies are well
advised to follow these approaches especially in the areas of S&OP scope and cadence and to be
mindful of the role of S&OP which is summarized in the chart below.

Figure 3: Scope and Role of S&OP

S&OP is difficult and takes time for each participant to find the right role and figure out what data and
analysis is needed. It is not unreasonable to expect that 3 to 12 months of S&OP cycles will be needed
before the process finds its way and delivers on expectations. But the rewards are great, and
companies that successfully implement it have a major and measurable advantage over their
competitors.