Cost-Driven Pricing: An Innovative Approach for Managing Supply Chain Costs

Transcription

1 Cost-Driven Pricing: An Innovative Approach for Managing Supply Chain Costs Robert J. Trent, Ph.D. Supply Chain Management Program Director and Eugene Mercy Associate Professor of Management, Lehigh University Robert M. Monczka, Ph.D. Distinguished Professor of Supply Chain Management, Arizona State University Director of Sourcing and Supply Chain Research Center for Advanced Purchasing Studies (CAPS) Research Competing successfully on a worldwide basis demands new and innovative ways to identify and reduce supply chain costs. Buyers and sellers who view each other as strategically important must consider non-traditional pricing practices in their pursuit of competitive market advantages. This discussion presents cost-driven pricing as an innovative approach for managing the costs of selected items over the life of a purchase contract. Without creative cost management approaches and techniques, supply-chain members risk losing ground to those companies that truly understand how to cooperate to succeed. This article discusses when to apply cost versus price analytic techniques, develops the concept of cost-driven-pricing and contracting, presents a best-practice example that illustrates the cost-driven pricing concept, and identifies the potential risks that must be managed within cost-driven agreements. Across virtually every industry firms are experiencing unrelenting pressure to improve at dramatic levels. This includes customer and competitive pressure to improve in quality, service, cycle time, innovation, and responsiveness to customer needs. Perhaps more than any other area, however, is the need to satisfy cost reduction pressures. 1 An analysis of how to improve costs must include a discussion of how firms create and manage cross-organizational relationships. An important part of improved cost competitiveness may very well center on a firm s ability to develop and manage inter-firm relationships that lead to the creation of new value within the supply chain. An earlier study by the Harvard Business School confirmed that a primary reason for the competitiveness of many non-u.s. firms resulted from a greater commitment in intangible investments such as supplier relationships. 2 Executive managers must begin to endorse a non-traditional perspective toward those suppliers that affect a firm s competitive position. While progressive firms are able to capture the value offered by their critical suppliers, others are failing to respond. Competing successfully on a worldwide basis requires the development of approaches that help identify and reduce supply chain costs. This article presents cost-driven pricing as an innovative way to manage important items over the life of a purchase contract. To better understand this concept we discuss when to apply cost versus price analytic techniques, develop the concept of cost-driven pricing and contracting, and present a best-practice case that illustrates the successful use of a cost-driven approach. We conclude by identifying the potential risks that must be managed within a cost-driven framework. Applying Price versus Cost Analytic Techniques A major responsibility of a buying company is to ensure that the prices it pays for externally acquired goods and services are fair and reasonable. In many situations the need to control costs Supply Chain Forum An International Journal Vol. 4 - N

2 requires a focus on the cost elements associated with producing an item or service versus simply analyzing a quoted price. In other cases, however, it is not necessary to commit much effort or time to understanding costs. A comparison of whether a price is fair given competitive market conditions is all that may be required. Throughout this discussion it is important to recognize that fundamental differences exist between price and cost analysis. Price analysis refers to the process of comparing one price against another price, comparing against external price benchmarks, or comparing against other available information without in-depth knowledge about underlying costs. Examples of price analytic techniques include competitive bid comparisons, comparisons against published catalog prices, price behavior relative to an external benchmark such as government price indices, and comparisons against historical price behavior. Cost analytic techniques focus primarily on the costs that are aggregated to create a purchase price. By better managing and reducing the elements of cost, a buyer should see the result of these efforts in a lower purchase price compared with prices where cost management did not occur. Cost-driven approaches require the identification and management of costs and cost drivers, which are the factors that directly affect cost levels. A change in a cost driver will cause a change in the total cost (and usually the price) of a related product or service. A primary difference between price and cost analysis is that cost analysis requires a more technical and detailed understanding of costs. Cost analysis also requires greater cooperation with a seller to quantify costs, identify cost drivers, and develop strategies to improve performance. Increasingly, supply chain managers must become skilled at managing supply chain costs. The issue of when to apply cost versus price analytic approaches within a supply chain is an important one. Exhibit 1 presents a matrix that helps conceptualize when to apply price versus cost-analytic approaches. In fact, a progressive supply chain practice involves segmenting supply requirements according to the characteristics of those requirements. 3 This matrix helps identify when to apply cost analytic approaches, such as cost-driven pricing, versus traditional price analytic approaches, such as bid comparisons or comparisons against market price indices. Exhibit 1 segments purchase requirements across two dimensions the number of active suppliers in a marketplace and the Competing on a worldwide basis requires the development of approaches that help identify and reduce supply chain costs. value of the good or service to the buying organization. The goods and services in the lower left quadrant, or the transaction quadrant, have a lower total value with a limited supply market. Unfortunately, most organizations commit a disproportionate amount of time and resources obtaining and managing transaction items, also referred to as nuisance items by some supply chain managers. 4 Reducing the transactions cost of the purchase is the primary way to create value in this quadrant (such as through the use of e-procurement systems). Even when an item has many potential suppliers, the cost of searching for and comparing supply chain sources usually outweighs the value resulting from the search. Any price analysis that occurs is cursory due to the low value of the good or service. Routine office supplies, one-time purchases, magazine subscriptions to trade journals, and emergency tools needed at remote locations are examples of transaction purchases. The lower right quadrant, or the market quadrant, includes standard items that have an active supply market. Commodity chemicals, fasteners, corrugated packaging, and other basic raw materials are logically part of this quadrant. The common trait shared by these products and services is they have a lower to medium total value, many suppliers that can provide substitutable products and services, and lower supplier switching costs. Price rather than cost analytic techniques usually work best when obtaining these items. Competitive bid or price comparisons, shorter-term contracting, reverse Internet auctions, and blanket purchase orders are often used techniques when obtaining market items. The upper right quadrant, or the leverage quadrant, includes those items where consolidating volumes and reducing the size of the supply base can lead to economic benefit. Supply chain managers leverage their requirements not only to obtain favorable pricing, but also to gain advantages in other non-price areas. For example, leveraging volumes through longer-term contracts may lead to discussions with a supplier about quality, delivery, packaging, and service (all factors that can affect cost). Depending on the leveraged item, a cost rather than price focus should begin to emerge in this quadrant. The upper left quadrant, or the critical quadrant, includes goods and services that are essential to the purchaser s operation. This means the good or service consumes a large amount of purchase dollars, the item or service affects a product s function, Supply Chain Forum An International Journal Vol. 4 - N

3 Exhibit 1 Purchasing and Supply Segmentation Matrix High Value to Buyer Low Critical Items Collaborative relationships through alliances or partnerships Transaction Items Low dollar purchase systems, such as procurement cards Few and/or the item or service differentiates the product in the eyes of the end customer. By definition this quadrant includes fewer suppliers that can satisfy a purchaser s requirements, which often involve customized rather than standardized items. Although these items represent a small portion of total transactions, opportunities exist to create value through collaborative supply chain efforts. This involves, but of course is not limited to, a strong focus on cost and cost drivers. Supply chain managers must recognize that the items residing in the lower half of the matrix will benefit most from the application of price analytic techniques. At times an item may have such a low value or be part of a highly competitive market that any analysis beyond price comparisons yields minimal return. At other times, supply chain managers must apply innovative cost management techniques to manage and control costs and cost drivers for items that are more important or higher in value. It would be unproductive to apply cost analytic techniques when a situation requires basic price analysis. Conversely, applying price analytic techniques to situations that would benefit from cost analysis could leave a degree of value or improvement opportunity unrealized. One of the more innovative cost-focused approaches, something we have termed cost-driven pricing, is one way to manage those items and services that are vital to an organization s competitiveness and even survival. Leverage Items Longer-term purchase agreements Market Items Competitive bidding Reverse Internet auctions Many Number of Qualified Suppliers in Marketplace Understanding Cost-Driven Pricing Cost Focus Price Focus Cost-driven pricing is a collaborative approach for managing the cost, and therefore the price, of critical items. This approach, which offers an opportunity to promote cooperative behavior between a buyer and seller, has as its primary objective accelerated supplier improvement with continuous cost reductions achieved over the life of a contract. Cost-driven pricing enables buying and selling firms to achieve real cost reductions over time while simultaneously reducing the conflict typically associated with pricing approaches that promote short-term profit maximization. Exhibit 2 summarizes the key features of cost-driven pricing. As will be explained, this approach should intuitively appeal Exhibit 2 Cost-Driven Pricing Key Features to suppliers because a buyer commits to a fair return on a supplier s investment while agreeing to share any savings that accrue throughout a contract. Exhibit 3 shows the interrelated factors that must be present when pursuing a cost-driven approach with critical suppliers. A cost-driven approach to contracting promotes cooperative behavior between buying and selling firms. Joint buyer/seller evaluation and analysis of product cost structures lead to agreed upon return-on-investment requirements, target price setting, and cost-saving sharing goals that drive subsequent or future purchase/selling prices. Once a buyer establishes price and profit targets for an item (often through a broader target costing approach), the buyer and seller must manage costs through effective product, component, or subassembly design along with the management of variable and fixed cost drivers. Cost-driven pricing contracts differ radically from costplus contracting. With cost-plus contracting, profits often increase or decrease based on actual costs incurred. Cost-plus contracting results in conflicting goals because increasing costs eventually benefit the supplier at the buyer s expense. A cost-driven pricing approach is most applicable when the seller adds higher levels of value through direct and indirect labor or design A buyer and seller's joint agreement on the target price, profit, and full cost to produce an item is the foundation of a cost-driven price A supplier's asset investment and return requirements provide the basis for establishing the profit for each item produced Profit is a result of an agreed to percentage return on assets employed directly by the seller to satisfy the buyer s contract Joint assumptions and agreement on product cost, production volumes, quality, targeted costs, quantifiable productivity improvements, risk sharing, and contractual sharing of supplier initiated savings are essential elements of cost-driven pricing Pricing improvement results from a better understanding of requirements and costs, information sharing between firms, and the continuous reduction of a supplier's product cost structure Supply Chain Forum An International Journal Vol. 4 - N

4 Exhibit 3 Cost-Driven Pricing Interrelated Factors Relationship-Specific Investment and Accurate Volume Estimates Cost-driven pricing is also not market-driven pricing. In a market-driven approach, the buyer or seller maintain an advantage depending on supply and demand, the level of product differentiation, or the number of firms involved within a market. Suppliers focus on achieving the highest allowable price while buyers strive for prices that are often unrealistic. Pursuing advantages at the expense of the other party, unstable pricing, and conflicting goals do not promote cooperative behavior across the supply chain. Furthermore, market-driven pricing typically ignores the cost drivers behind a purchase price. It becomes necessary to discuss several concepts further to understand cost-driven pricing. First, a buyer and seller's joint agreement on the target price, profit, and full cost to produce an item becomes the foundation of a cost-driven price. This requires agreement not only about target prices and allowable profit, but also agreement about standard material, labor, and other direct and indirect costs associated with producing an item. The parties must also agree on any variances due to start up and normal aberrations beyond standard efficiencies. Reasonable administrative, selling, and other general expenses are also recognized as a fundamental part of the supplier's full cost base. Perhaps the most important element of a cost-driven pricing Targeted Rate of Return on Investment INTERRELATED For Cost-Driven Princing Benefits and Sharing Continuous Individual and Joint Improvement Strategies Variable Cost, Productivity, and Performance Improvement Targets contract is that a supplier's asset investment and return requirements provide the basis for establishing the profit for each item produced. Profit is the result of an agreed to return on assets employed directly by the seller to satisfy the buyer s contract. This differs from traditional pricing approaches that establish profit as a percentage of the selling price or manufacturing cost. Thus, once a buyer and seller agree upon an appropriate asset base, fluctuations in manufacturing costs (labor, material, etc.) do not affect a supplier s return. Establishing profit based on asset and return requirements should encourage the supplier to commit resources specifically to the buyer-seller relationship. In cost-driven pricing, the buyer explicitly acknowledges the need to satisfy a supplier s financial return requirements. Joint assumptions and agreement on product cost, production volumes, quality, targeted costs, quantifiable productivity improvements, specific cost content definition, and contractual sharing of supplier-initiated savings are also essential to a cost-driven approach. Agreeing on these issues requires higher levels of trust, information sharing, negotiation, and joint problem solving. The complexity of cost-driven pricing ensures it will only be applied as a strategic cost management technique in selected relationships that feature mutual trust and a willingness to share information. Cost-driven pricing contracts require the establishment of joint improvement targets in areas such as cost, quality, scrap, and delivery. These agreed-upon improvement targets help drive continuous cost reduction over time. Furthermore, shared cost-saving takes effect only after the supplier achieves initially targeted price/cost improvements. For example, if the buyer and seller target a material content cost reduction of 10 percent per year, shared cost-saving would take effect on any savings beyond the 10 percent level. Productivity improvement targets must be aggressive and mutually established with both parties developing an action plan to attain the targeted goals. Shared costsavings provide the incentive to accelerate price/cost improvements beyond those agreed to in the purchase contract. Joint agreement on productivity targets, cost reductions driven by cost-saving sharing arrangements, and risk-sharing further enhances the potential for cooperative efforts when creating cost-driven agreements. Within this type of agreement a buyer benefits from lower priced goods while the seller enhances its competitive position by improving its total cost structure and the possible transfer of acquired learning and improvement to other products and customers. As previously discussed, not all products or items are candidates for cost-driven pricing. A costdriven approach is most applicable when the seller adds significant value through direct and indirect labor or design capabilities. It is also applicable when sophisticated technologies provide opportunities for product design and process alternatives. Raw materials or other commodity items, even those with high value, are least likely to benefit from cost-driven pricing. Market forces encourage the buyer and seller to take advantage of "market opportunities" and "play the market." Cost-driven pricing requires a complete evaluation of suppliers Supply Chain Forum An International Journal Vol. 4 - N

5 and their capabilities. The supplier selection process and decision, however, are usually separate from the mechanics of cost-driven pricing. Supplier selection usually occurs before the parties have formally discussed a cost-driven agreement. A willingness to enter a relationship that features approaches such as cost-driven pricing, however, may influence the final choice of a supplier. In our experience, the parties within a cost-driven pricing contract almost always have a lengthy history of interaction before entering into a relationship that requires higher levels of trust and information sharing. Cost-Driven Pricing Case Example Without question, this discussion of cost-driven pricing appears conceptual. This creates a need to further refine this topic by demonstrating how two supply chain members managed and improved cost to the point where the producer began to realize competitive market advantages through its cost and pricing strategies. This section presents a case example based on the experiences of a producer of industrial pumps. 5 The buyer, a large U.S. producer with annual sales of several billion dollars, approached a supplier with whom it had a close working relationship and initiated a discussion about taking a different approach to supply contracting. The level of familiarity between the buyer and supplier was critical to the initial discussion and eventual success of applying a cost-driven pricing approach. This case highlights the mechanics of costdriven pricing by presenting a three-year contract developed through collaborative cost analysis and negotiation. This example relates to a mechanized subsystem used in a newly designed industrial pump. Both parties have agreed to negotiate and analyze the supplier's cost structure for the subassembly, which requires a high degree of trust and confidentiality. An important assumption is that the most efficient manufacturing processes to produce an item form the basis of the supplier's cost structure. A cost-driven pricing contract should not reward supplier inefficiency. Supply chain cost analysts become an integral part of this process when developing cost-driven agreements. Investment requirements for this product were established jointly at $12,000,000 over the contract's expected three-year life. This includes $6 million in working capital requirements and $6 million in net capital assets over the projected product life. In addition, the supplier committed to annual productivity improvements of 10 percent and 50 percent for direct labor and scrap reduction, respectively. (See the sidebar to see how learning improvements integrate with a cost-driven pricing approach). The agreement also included a 50/50 cost saving sharing agreement covering any cost reductions due to design modifications initiated by either party. Finally, both parties shared volume fluctuation risk equally if volume increased or decreased by more than 20 percent in a year compared to the plan (the +/-20 percent band is a negotiated item Exhibit 4 Negotiated or Agreed Upon Contractual Issues Product : Initial Expected Price : Negotiated/Analyzed Cost Structure : Direct Labor Rate Overhead Rate Scrap Rate Selling, General, and Administrative Expense Effective Volume Range Projected Product Life Return on Investment Agreed to Contract Length Volume Fluctuation Risk Contract Specific Investment : Working Capital Net Capital Assets Total Investment over Three Years Supplier Productivity Commitment : Direct Labor Content Scrap Rate Joint Effort Design Revision/Cost Reductions: Subassembly for industrial pump $98.50 per unit $13.50 per hour 175% of direct labor 10% of total material, direct labor, and overhead 10% of total manufacturing cost 100,000 units per year +/- 20% 3 years 20% Life of product with annual pricing recalculation Shared equally if volume fluctuates more than +/- 20% in a year Year 1 Year 2 Year 3 $2 million $2 million $2 million $3 million $2 million $1 million $12,000,000 10% reduction from previous year level 50% reduction from previous year level Savings shared jointly on a 50/50 basis Supply Chain Forum An International Journal Vol. 4 - N

6 Exhibit 5 Year One Agreement and Events Dollars Material Costs $ % increase $2 per unit joint design saving Direct Labor Costs $ % increase 10% annual improvement Overhead (Direct Labor x 175%) $25.99 Economics Productivity Commitment and Changes Total $76.84 Scrap ($76.84 x 10%) $ % annual reduction Manufacturing Cost $84.52 SG&A (Mfg. Cost x 10%) $8.45 Total Cost $92.97 Profit Per Unit $8.00 Selling Price $ Year One Notes : Cost and procurement engineers determined each unit requires 1.1 hours of direct labor ($13.50 x 1.1 = $14.85 year one direct labor) and material costs are $36 per unit Total profit = ($12,000,000 supplier investment x 20% agreed upon ROI)/3 year life of contract = $800,000 expected profit per year. $800,000/100,000 units per year = $8 profit per unit Year Two Agreement and Events Dollars Material Costs $35.02 Direct Labor Costs $13.63 Overhead (Direct Labor x 175%) $23.85 Total $72.50 Economics Productivity Commitment and Changes 5% increase 4% increase 10% annual improvement Scrap ($72.5 x 5%) $ % annual reduction Manufacturing Cost $76.13 SG&A (Mfg. Cost x 10%) $7.61 Total Cost $83.74 Profit Per Unit $9.00 Selling Price $92.74 Year Two Notes : Material costs = $34 ($2 material design saving from $36) x 1.03 (3% supplier material cost increase from Year One events) = $ Direct labor costs = $14.85 x.9 (reflects 10% agreed upon productivity commitment from Year One level) = $ $13.36 x 1.02 (2% increase in supplier labor costs in Year One) = $13.63 $9 per unit profit includes supplier share of material design saving ($1.00) plus the original $8 per unit profit Year Three Agreement and Events Dollars Material Costs $36.77 Direct Labor Costs $12.76 Overhead (Direct Labor x 175%) $22.33 Total $71.86 Economics Productivity Commitment and Changes Scrap ($71.86 x 2.5%) $ % annual reduction Manufacturing Cost $73.66 SG&A (Mfg. Cost x 10%) $7.37 Total Cost $81.03 Profit Per Unit $9.00 Selling Price $90.03 Year Three Notes : Material = $35.02 x 1.05 (5% material cost increase from Year Two events) = $36.77 Direct labor costs = $13.63 x.9 (reflects 10% agreed upon productivity commitment from Year Two level) = $ $12.27 x 1.04 (4% increase in supplier labor costs in Year One) = $12.76 Supply Chain Forum An International Journal Vol. 4 - N

7 that can vary from contract to contract). They also agreed on ways to limit price adjustments that may result from severe volume increases or decreases. Exhibit 4 highlights the details of the cost-driven pricing contract as it appeared at the start of Year One. Exhibit 5 shows what transpired over the three-year contract. Working jointly, the buyer and seller have agreed on an initial target price of almost $101 (see Exhibit 5). This price is based on the buying firm's cost expectations for this item as well as a fair return that allows the supplier to achieve return-on-investment targets. The buyer could also establish a target price as part of a broader target costing approach that allocates finished product costs across subsystems and individual components. The buyer and seller would have to agree how to reduce cost if the agreed upon first-year price of $ was not close enough to the buyer s initial expected price (which was $98.50 as indicated in Exhibit 4). Reevaluating return-oninvestment requirements could also affect the supplier s profit and selling price. If target costing is applied, which is often the case during new product development, then cost-driven pricing is interdependent with rather than independent of target costing. The two parties in this case agreed to reevaluate product pricing at the end of years one and two, which will reflect the changes that have occurred over years one and two. Major year one occurrences include economic increases for material and direct labor of 3 and 2 percent, respectively. Furthermore, a joint study team developed and approved a substitute material that reduced the material cost by $2 per unit, resulting in a 50/50 sharing of savings during year two. At the beginning of the second year, material cost decreased from $36 to $ This resulted from the $2 material reduction (from $36 to $34) from the material substitution along with a 3 percent increase in the supplier s material costs ($34 x 1.03 = $35.02). The buyer and seller shared the material cost reduction equally. The buying company received its share in the form of a $2 direct material reduction, with $1.00 given back to the supplier in higher per unit profit from $8 to $9 per unit. See Exhibit 5 for profit calculation using ROI requirements. A further downward movement in cost reflects agreed upon labor and scrap reduction commitments. The selling price at the beginning of Year Two ($92.73) reflects the modifications to cost and profit. The year two selling price is over 8 percent lower than year one, even though material and labor costs increased during the year. During the second year of the contract, economic increases for material and labor were 5 percent and 4 percent, respectively. Adjustments to labor productivity and scrap reduction lessened the subassembly s price at the start of Year Three to $ The reduced selling price, now almost 11 percent lower than year one, is important given that material and direct labor costs increased 8 percent and 6 percent respectively from years one to three. Productivity goals, which the buyer and seller agreed to at the onset of the contract, offset the negative economic changes. Supplier profit increased by $1.00 per unit in year two and three (from $8 per unit to $9 per unit) due to the cost-saving sharing provision within the agreement. Although the supplier s internal costs are rising throughout this agreement, a negotiated price with contractual performance improvement goals resulted in a lower purchase price to the buyer while still providing a profit that satisfies the seller s return requirements. The parties in this case might have realized even greater cost reductions if they had focused their attention more closely in several areas. First, the analysis presented here assumed that overhead was strictly a function of direct labor costs. Today, firms should use progressive cost management techniques such as activity based costing to better understand, allocate, and manage overhead costs. No such efforts occurred in this case. Second, the responsibility for direct labor improvements rested solely with the supplier. The buyer assumed the supplier would benefit from the effects of learning and investments in process improvement. A more collaborative approach would feature the buyer working directly with the supplier to accelerate the supplier s productivity gains, perhaps through supplier development activities. Even with room for improvement, this case highlighted a win-win relationship between the buyer and seller. By working jointly, the parties have expanded the value they each received from the contract. The supplier received a long-term contract while the buyer realized price reductions that were not available through a traditional market contract. Presumably, a lower cost on an important subsystem will make the entire product more competitive, which should lead to a stronger product position within the marketplace. As the final product becomes more competitive, the seller realizes a steady stream of orders that protect financial return requirements. Cost-Driven Pricing Risk Considerations Buyers and sellers must agree on the risks associated with a cost-driven approach before agreeing to a final contract, making risk management a joint rather than individual challenge. The parties should also agree on a plan, often presented in the form of contract clauses, to reduce the effect of these risks if they were to materialize. Examples of risk include unforeseen volume changes, forecast unreliability, Supply Chain Forum An International Journal Vol. 4 - N

8 Exhibit 6 Volume Risk Sharing Calculation Volume (units) Volume outside the 20% band (units) Expected profit (Volume x $8 per unit) Profit shortfall Profit shortfall outside the 20% band 50/50 sharing remitted to supplier liabilities associated with program cancellation, establishing an inaccurate asset or capital base that distorts return and profit requirements, and a supplier s inability to achieve promised labor and scrap reductions. A large labor turnover, for example, could prohibit the supplier from capturing the benefits of the learning and experience curve. Maintaining cost confidentiality is often a concern or risk to buyers and sellers, particularly since costdriven pricing applies to critical rather than standard items. In fact, the buying firm's view regarding confidentiality is consistently a highly rated factor limiting interaction, early supplier design involvement, and information sharing across the supply chain. 6 Supply chain members must take great care ensuring the protection of proprietary information. Perhaps one of the biggest unknowns in any contract involves forecast reliability, particularly for new products. Unanticipated volume increases usually result in a reduction of the average cost to produce a product as fixed costs and overhead are allocated across a larger number of units. In this situation the buyer will expect even greater price reductions than what was planned during negotiation. Year One Expected 80, ,000 0 $800,000 (100,000 units x $8) $0 $0 $0 Year One Actual 75,000 5,000 $600,000 (75,000 units x $8) $200,000 ($800,000 - $600,000) $40,000 ($80,000 - $75,000) x $8 $20,000 ($40,000/2) Unanticipated volume decreases usually increase per unit costs due to research and development and fixed costs being allocated over fewer units. Buyer and seller must agree either to price adjustments if volumes change or agree that pricing will not be volume sensitive. If lower than expected volumes result, the buyer might request that the supplier obtain additional business to compensate for the decrease (i.e., the supplier assumes volume fluctuation risk). The agreement should address the specific volumes at which prices will change, the maximum financial exposure each firm is willing to accept, and the opportunity for additional business from the buyer in the event of a volume shortfall. Since forecasts are inherently inaccurate, the need to address forecast risk is vital to cost-driven contracts. To illustrate volume fluctuation risk using the case illustrated here, recall that projected volumes are 300,000 total units at 100,000 units per year. Included in the contractual agreement is a risk sharing plan that takes effect when actual volume varies from the forecast by +/- 20 percent annually. The buyer and seller have agreed that a +/-20 percent fluctuation represents normal risk that each party is willing to assume. Risk sharing takes effect only when actual demand moves outside the +/- 20 percent band. If actual demand fell below 80,000 units the buyer would calculate a reimbursement to compensate the seller for lower than anticipated volume. This reimbursement occurs only for the volume that is outside the 20 percent band. If, on the other hand, demand increases 20 percent or more than the forecast, the buyer would expect additional price reductions beyond those agreed to in the contract. This assumes that the volume increase did not place costly capacity constraints on the seller. The +/- 20 percent band is similar to international purchasing agreements that allow currencies to fluctuate within some range before reviewing or reopening a contract. Exhibit 6 illustrates how the buyer and seller operationalized the 50/50 risk sharing agreement in the case presented here. Although actual volumes did not fluctuate outside the agreed upon bands over the three year agreement, assume that year one volume was actually 75,000 units instead of the expected 100,000 units. The 50/50 sharing takes effect only for the shortfall (5,000 units) that was outside the range that the buyer and seller considered normal risk. This is certainly not the only way to manage risk sharing. This exhibit simply illustrates one way to proactively address this issue within a contract. Risk adjustment calculations are usually an annual exercise conducted by the relationship owners or managers from the buyer and seller. Cost-driven pricing agreements require appreciably more time and effort to develop than typical purchase agreements, which itself presents a risk compared with traditional contracts. However, once firms gain experience with an initial cost-driven agreement, we would expect subsequent agreements to require less intensive effort to develop. The experience curve applies to contracting as well as production. Supply Chain Forum An International Journal Vol. 4 - N

9 Concluding Remarks Firms that must confront relentless pressure to improve need to become more innovative in their use of leading-edge supply-chain approaches, including cost-driven pricing. As an example, General Motors recently entered a ten-year agreement with Alcan, a major supplier of aluminum. In this agreement, the two parties have agreed to apply pricing mechanisms to maintain price stability, something that is difficult to achieve in the volatile aluminum market. The agreement also guarantees Alcan a specific return on its investment similar to the ideas presented in this article. Finally, the two sides established a joint research program with engineers from the two companies working together to identify ways to increase the use of aluminum in cars, to make automotive aluminum more recyclable, and to reduce total costs. 7 Buyers and sellers who view each other as strategically important must consider non-traditional supply chain practices in their pursuit of competitive market advantages. Cost-driven pricing is an innovative approach that promotes the development of supply chain relationships and continuous price/cost improvements. Each party to a cost-driven agreement sees its future success linked to the success of the other. The parties capitalize on opportunities to modify product designs, specifications, and manufacturing processes to achieve mutual benefits. Without the use of cost management approaches and techniques like the one presented here, supplychain members risk falling behind those companies that truly understand how to cooperate to succeed. End notes 1. Monczka, Robert M. and Robert J. Trent, Global Sourcing Benefits, Barriers, and Critical Success Factors study, a researched study conducted through the Global Electronic Benchmarking Network, Michigan State University, East Lansing Michigan, This study found that competitive and customer pressure to achieve price/cost improvement was the most intense of ten potential improvement areas 2. Porter, Michael, Competitive Advantage of Nations, Free Press: New York, 1990, pages Monczka, Robert M., from the Global Electronic and Benchmarking Network study of supply chain strategy development, Michigan State University, East Lansing Michigan, Trent, Robert J. and Michael G. Kolchin, Reducing the Effort and Transactions Costs of Obtaining Low Value Goods and Services, Center for Advanced Purchasing Studies, Both the supplier and buyer have requested that company names not be disclosed. Furthermore, some data have been disguised at their request. 6. Monczka, Robert M. and Robert J. Trent, citing data collected at the Executive Purchasing and Materials Management Seminar, Michigan State University, East Lansing, Michigan Simison, Robert L., GM Commits To Aluminum in Alcan Pact, The Wall Street Journal, November 11, 1998, page A3. Applying Learning Improvements to Cost-Driven Pricing Contracts One reason the buyer in this case is confident that the supplier will realize the agreed upon productivity improvements is due to the effects of learning. Learning curves establish the rate of direct labor improvement that results as production volumes increase. When referring to learning improvement, the learning rate represents the improvement (reduction) in direct labor requirements as production doubles from a previous level. For example, with an 85% learning rate, the average direct labor required to produce a unit declines by 15% each time production doubles. The fundamental principle underlying learning curve is that as production doubles, direct labor requirements decline by an observed and predictable rate. The rate of improvement varies from situation to situation. Not all processes or items benefit from or exhibit improvement from learning. In fact, when used incorrectly this approach can result in a significant underestimation of true production costs. Applying a learning curve is appropriate when a supplier uses a new production process, produces an item for the first time, or produces a technically complex item where the design is still evolving. Learning curve application requires accurate collection of cost and labor data, particularly during the early stages of production. A buyer and seller must be confident that learning occurs at a uniform rate and that any improvement results from employee learning rather than process redesign or other continuous improvement activity. The term experience curve refers to the longer-term factors of production that systematically reduce production costs. These factors include the shorter-term labor component along with longer-term product and process modifications. Unfortunately, many buyers agree to contracts that ignore cost improvements due to learning. If learning occurs and the buyer neglects to address this issue, the supplier captures the benefits in the form of more productive direct labor. A costdriven pricing approach recognizes the need to achieve continuous cost reductions, which learning curve supports. Supply Chain Forum An International Journal Vol. 4 - N