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 / First Quarter 1997 / Issue 6(originally published by Booz & Company)


Setting Supplier Cost Targets: Getting Beyond the Basics

The second approach, cost-based targeting, has evolved substantially over the last few decades. In its least effective application, "cost-plus contracts" have been used by the Government to insure that contractors achieve an acceptable but not exorbitant profit margin. Unfortunately, the result has often been to limit the motivation of suppliers to lower the total cost. A modern version of the "cost-plus" mind-set is now being employed by many large companies. These companies now demand "open books" of their suppliers to pierce the veil of price quotes.

For example, the automotive industry aggressively employs cost-based targeting. The large vehicle manufacturers have the buying clout to force their suppliers to share detailed cost information. Unfortunately, suppliers complain that many of the Western vehicle manufacturers misuse the information to squeeze margins -- which often leads to an extra set of "books" that hides the profits. The Japanese vehicle manufacturers demand the same cost information, but use it differently. They use open books and a detailed understanding of "cost drivers" for joint improvement efforts to eliminate waste -- not simply to squeeze margins.

The third approach, value-based targeting, is the least understood technique and the most difficult to apply. From our observations, only a handful of companies do it well. This method of costing compares consumer "wants" with a willingness to pay. When done well, the desired "functionality" is mapped back to the subsystems that contribute to the functionality to drive the design process. Such a technique improves product development by insuring that new designs are not simply innovative -- but, more important, provide the right value proposition.

Swatch is an excellent example of value-based targeting. Major cost reductions were achieved by appropriately valuing the "subsystems" to reach a different level of functionality. For example, the Swatch design employs a plastic casing since the end product is priced cheaply enough to be discarded when the battery dies. Accordingly, the timepiece also has less severe reliability/durability requirements, which allow for less expensive mechanisms. The band is also significantly cheaper. Swatch uses integrated plastic moldings rather than expensive, sewn-leather bands that must be replaced over the longer life of a traditional watch. As a result, Swatch created a fundamentally new value proposition in the marketplace: a low-cost fashion accessory that also keeps time.

All three techniques have a place in insuring competitiveness in supplier pricing. But each is more effective in a given circumstance than the others.

For example, price-based targeting is quite effective in dealing with commodity products and services. Pricing of true "commodities" generally reflects supply-and-demand curves rather than bottoms-up cost. Likewise, pricing of a commodity like memory chips for personal computers does not vary due to changes in "consumer value" but rather due to changes in competitive dynamics.

Cost-based targeting -- supported by an understanding of cost drivers -- is effective at fostering improvement in supplier operations. Cost-driver understanding and comparative benchmarks can reduce quality costs, improve equipment up-time and lower manning levels. This technique is often applied effectively with suppliers of "modules," as described in the previous article in this series.

For its part, value-based targeting is unmatched for driving the kind of major innovation that is expected from a supplier serving in the role of "solutions provider." A solutions provider has the skills to take overall "black box" responsibility for specification, planning, execution and performance of an entire system and accordingly needs greater freedom. Appropriate value-based targets provide the freedom but within a firm envelope of what the customer will pay for a given functionality. The supplier must then creatively apply its expertise to develop a detailed design that meets the needs at the target cost.

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