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How to Use Cost Modeling to Help Offset Inflation

Inflation is at high levels and is expected to be at high levels for the medium term. You can reduce the impact of inflation requests from your suppliers if you implement visibility into cost drivers.

Most parts and assemblies that are purchased by companies, are sourced and managed with a single price. Not having visibility into the cost drivers of components and assemblies makes it near impossible to identify waste and continuous improvement opportunities.

Even if you do have some cost breakdowns, most supply chain management organizations lack implementable cost standards that are recognized by suppliers. Credibility and leverage is key to success with implementation of cost models with suppliers.

Cost Modeling will accomplish 3 important strategic deliverables:1. Set Cost Standards on what commodity and parts should cost
2. Bring Visibility into Waste, Savings and Continuous Improvements
3. Transition to Effective Data Driven Negotiations

Cost modeling is a very effective way to bring visibility into cost drivers and waste reduction opportunities. These waste reduction opportunities can be used to offset inflation cost increases. Without cost modeling, you only have a price and are in the dark.

Only having a price hides the valuable cost driver data and prevents the customer’s ability to identify waste. Most suppliers want their customers to be ignorant with no cost data information. It is up to the customer to transition to cost modeling and cost data management and negotiations.Common waste reduction opportunities that cost modeling will uncover includes the following.
Cycle time improvements
Lot run size optimization
Use of automation to reduce direct labor and # of operators
Use of workspace layout improvements to reduce direct labor and # of operators
Raw material blank optimization
Raw material scrap credit

Let’s look at a real world example.

The current price before inflation is $14.00
The price increase request is $15.03 or $1.03/part increase. The price increase request is due to 2 factors:

1. Steel cost per pound increase from $.80/lbs. to $.92/lbs.
2. Direct Labor increase from $37/hr. to $44/hr.

But after applying cost modeling and determining what the part should cost, there are 4 waste reduction opportunities that have become visible after a cost modeling analysis was completed.

The continuous improvement opportunities include the following:

RAW MATERIALS

1. Blank size reduction from 225 lbs. to 218 lbs., yet still getting 45 parts out of the blank.

a. (225lbs./45 parts = 5 lbs./part) vs. (218 lbs. / 45 parts = 4.85 lbs./part)

b. = $.14 /part improvement

2. Scrap Credit

a. (4.85 lbs. for the blank) – (3.23 lbs. for the net weight) = 1.62 lbs.

b. The 1.62 pounds is sold at $.20/lbs. = $.324/part improvement

PROCESSING

3. Cycle Time Improvement

a. The cycle time to make 1 part has improved from 73 seconds to 63 seconds = 10 seconds / part improvement = 10/3600 = .002777 hr. improvement

b. The 10 seconds improvement can now be multiplied by the labor rates ($44/hr. x .0027 x 3 operators) = $.36/part direct labor cost improvement

c. This cycle time improvement can also be applied to the machine burden rate = $175/hr. x .00277 = $.48/part

4. # of Operators Improvement from 3 to 2 operators

a. The workplace layout was improved and the result was a reduction from 3 operators to 2 operators to operate the production equipment.

b. The cost current cost = 63 seconds / 3600 = .0175 x 3 x $44/hr. = $2.31/part

c. The new cost = 63 seconds / 3600 = .0175 x 2 x $44/hr. = $1.54/part

d. The cost improvement = $2.31 – $1.54 = $.77/part

The new target price after 100% of all improvement opportunities are recognized it $12.93/part.

This target price with all of the waste reduction would offset the entire inflation and provide for a price reduction if 100% of the offset was recognized.

But as with many negotiations, there is a compromise and both the customer and supplier will likely meet somewhere in the middle.

Savings money is a 2 step process. Step 1 is to find the savings. Step 2 is to implement the savings, many times through negotiations. In this example we have strong success in Step 1, identifying savings.