Cost Optimization 103 | Zero Based Costing

In this article, we'll take it forward from previous articles discussing Procurement spend analysis (Article 101 ) and the basic hygiene of your contracts (Article 102 ). While in article 102, we understood if the contracted specs are being delivered or not, in this article we'll try to establish a relationship between the contract specs and the agreed cost. The method that I will be elaborating on is referred to as 'Zero Based Costing - ZBC'.

As a procurement professional, wherever you are in the world, early in your career you'll get to hear the term 'ZBC' - Zero Based costing. When I first heard about it, I searched for this on the internet, and, what I got is all sorts of analyses about a famous accounting methodology called "ZBB - Zero Based Budgeting". So there aren't many detailed write-ups available on the net about ZBC and hence this topic for the article.

Zero Based Costing is a bottom-up Cost Estimation method of a supplier-manufactured component and accounts for every big and small element that will be required to manufacture and sell this component at the industrial level. This tool calls for a good understanding of the manufacturing process, all the inputs required in the composition of the component, and the administrative elements required to run an organization that manufactures the component. Below is a very basic process flow for you to refer to the various elements of a manufacturing organization.

While the above flowchart depicts a broad flow chart, a Procurement Manager needs to have full details of each of these elements while developing the ZBC for their components. I am taking the following assumptions while explaining the ZBC construct. These are not sacrosanct but are the ones that will make your ZBC more effective for negotiation.

1. The Buyer's organization controls the composition & manufacturing process of the component
2. You are procuring a significant production percentage of the supplier capacity (10%+)
3. The supplier will take the risk of over-capacity of the plant and we'd assume that plant is operating at upwards of 85% of design capacity to apportion common costs.
4. The component or product is not a direct commodity (such as Cement, steel or any metal bar, sheets, ingots, etc., sand, stone, agri-produce, etc.)

Any component is manufactured by taking a few raw materials and processing them in a controlled environment using machines & other peripherals by a well-established organization run for profit. Hence, to derive the cost bottom-up through ZBC, we will consider the following components:

1. Material Cost
2. Processing Cost
3. Processing Overheads
4. Organizational Overheads
5. Profits

We'll understand how can we attribute a cost to each of these elements keeping in mind the actual manufacturing process.

1. Material Cost

The equation for material cost is very basic and simple.

Material Cost = ∑ (Raw material qty * Raw material rate) - ∑ (Recoverable Scrap qty. * Scrap sale Rate)

Raw material Quantity (qty.) is generally mentioned in your manufacturing drawings. One can always visit the supplier's shopfloor to estimate them as well. However, the Unit rate is something that has a higher range of variability. As a good procurement manager, it is always a great idea to know how much the raw material costs in the market. Each of the raw material will have its Unit Rates generally pegged to an available Index or these can be taken directly from respective sources of raw materials. In many cases, I have seen smart procurement managers save costs by a couple of percentage points just by connecting the manufacturer to the right and Cost-Effective Raw Material sources. The supplier may or may not use the source for actual purchase, but if your raw material source is cost-effective, you can always have a very good reference point for your negotiations.

Scrap qty. and scrap rates are tricky bits. One will have to be very enterprising and will have to do very good homework to establish the Scrap recovery value. The difference between the Raw Material qty & the Finished good qty (the qty part of the finished goods) will give us the 'Gross' Scrap qty. The reason I am mentioning it as 'Gross' is that not all the scrap can be recovered. Some qty can be attributed to process losses, e.g. in sheet metal components if produced through laser cutting process, a minor fraction of sheet metal cut out will be lost to oxidation, in the wood cutting process the material equal to the width of saw will be converted to dust, in the process of casting there are burning & slag losses, there are flashes in forging process, etc. So we should establish through sampling techniques the qty. of recoverable scrap (which will be greater or less than the Gross scrap qty.)

Discovering the unit rate of Scrap is something that calls for real enterprising skills. The basic method to evaluate the scrap cost is by understanding it from the supplier himself. In many cases, if the supplier shares it openly, you can use it. however, there are other ways in which the scrap can be used. As a smart procurement manager, you can trace the value change of this scrap across various industries and can maximize the recovery (You would have read a post on LinkedIn where a Dad asked his daughter to sell the old car, while the pawn shop offered $10,000, the antique collectors offered $100,000 for the same car. Scrap is the same story):

• The scarp is used back in the same process (the casting process uses the scrap in the molten metal mixture)
• The scrap goes as a raw material in the manufacturing process of another component. (sheet metal punchouts, rod ends, and wood ends are used to make smaller components, etc.)
• The re-use of packaging instead of considering complete waste
• The Scrap goes into the manufacturing of a completely different product. (metal chips and machining chips are taken as reinforcement additives, metal chips are also used for abrasive strips & tools, wood dust & chips, if collected properly, can be used for making compressed wood boards, etc.)

2. Processing Cost

To estimate this, we need to list down what all goes into processing the raw material into the finished goods. You would need machines, design-specific tools, Utilities (Electricity, Water, air, steam, etc.), Packaging material, consumables, and manpower to put them all to work. Each of these elements needs to be evaluated for its impact on the cost of the component.

The cost of the machine is apportioned to the components in two ways - The 'Depreciation Method' or the 'Lifetime Production Capacity Method (LPCM)'.

In the 'Depreciation Method', the cost of depreciation is well defined by the govt. regulations. The same cost needs to be apportioned into the machine's production capacity. However, When the machine gets outdated, there is an end-of-life sale that happens and some cost is recovered. You can negotiate to reduce the same in your calculations. In my opinion, this may not be the best method of defining the machine cost, as the Govt. depreciation guidelines are based on various (Tax related) other parameters which may not be the right representation of the actual loss of machine value.

The simpler method can be, apportioning the 'Net' cost of the machine on the 'Lifetime Production Capacity. We'll understand this using an example. Say, the cost of a new machine is $100,000. At the end of life, the machine can be scrapped at a recovery of $10,000. So the 'Net' Cost of the machine is $90,000. Now from the industry standards, you can identify what is the lifetime production capacity of this machine. Say, in this case, the machine can produce 45,000 pieces over its lifetime. So the cost of the machine will be $2 per component.

Next is estimating the cost of tools. The cost of the tool per component is calculated similarly to the LPCM of the machine. However, there are 2 cases - A. The tool is exclusively used by us, or B. The tool is common among other components produced by the supplier.

A. In case the tool is used exclusively for us then, we calculate the cost of the tool spread over a certain assumed production capacity of the tool, and if the tool continues to produce more components, then we withdraw the cost of the tool for all surplus production. Also, If it is only for our component production, it is advised to evaluate the TCO (Total Cost of Ownership) of buying the tool ourselves vs. if the supplier buys it.

B. In case the tool is common with other components produced by the supplier, we'll follow the LPCM method for the tool.

Manpower is required to run these tools & Machines. The cost of manpower can be well understood by closely monitoring the process on the shop floor. While there will always be Industry thumb rules, I would always recommend that one should always spend time on the shop floor and understand the way manpower is engaged. This process will call for a lot of good judgment. Standing on the shop floor, one will have to estimate the exact number of hours spent by various categories of manpower (Specialist, Skilled, Semiskilled, unskilled). One will have to use certain industry efficiency standards as the person on the machine will not be able to work continuously for 8 hours. They will have biological breaks, lunch breaks, production efficiency variabilities, etc. There will be machine breakdowns, run-time loss, and quality losses as well. Now depending on the automation level and the nature of the work the efficiency dip of 15-30% can be considered.

To explain it with an example, let us assume that there is a process that has the following use of manpower for each component produced.

Specialist ($35 per hour) - 2 persons - 2.0 Mins

Skilled ($30 per hour) - 2 persons - 1.5 Mins

Semiskilled ($25 per hour) - 1 persons - 2.0 Mins

Unskilled ($20 per hour) - 3 persons - 1.5 Mins

So by simple multiplication of the above costs will be adding up to $6.131 per component. However, assuming that the component is manufactured in a semi-automated environment and calls for heavy lifting exercise. In such a scenario, there can be a lost time of up to 20%. So the total cost will be $7.668 (6.131/0.8).

A Packaging cost is an important element and can attribute to up to 5% of the cost of the component or more. As for the tools, and a few other elements (explained ahead in the article), packaging will be a completely bought-out item. Unless it is a highly specialized packing, one can use competitive methods of sourcing (e-bidding, RFQ, Online commercial portals, etc.) to get the best value for the packaging. Co-sourcing is the best way to evaluating what is the cost of packaging rather than believing what the supplier claims. you can also explore clubbing sourcing for multiple suppliers and explore the volume discounts.

The Utilities used for the production can be elements like Electricity, Water, Air, Steam, etc. A walk to the shop floor and discussions with the Maintenance in charge will help us understand the consumption of these utilities very clearly. We need to establish the average consumption per hour of operations of the machine. Once we have those numbers, we can attribute them to the number of components produced per hour of the machine operations (accommodating for efficiency losses). The unit rate cost of electricity and water will be easily available as per the going rates, things like Air & Steam need to be estimated based on equipment cost, the power & water consumption rates. Assume that air & Steam are end products, and use the ZBC process to evaluate the cost of production of these utilities as well.

While processing the component, there will be a few Consumables that will be used. These will be typically off-the-shelf products (adhesives, lubricants, coolants, additives, Cleaning agents, safety gears, etc.) Again we need to evaluate the consumption of these items which will be collected by speaking to the machine operators and can be observed while the component is getting manufactured. In this case, as well, we need to search for the best and most cost-effective sources for these items (Co-sourcing using competitive bidding processes). The cost per component will be qty * unit rate.

Among all the 6 elements of Processing cost, in most cases, the time and energy are spent on identifying accurately Machine, Tool, packaging, and Manpower cost as they will contribute the highest to the processing cost. However, the Utility & Consumables are verified at a broad level. But if this element crosses 3% of the total cost contribution in some process, one needs to study it in full detail. In one of my projects, I could reduce 1% cost of a component by just reducing the electricity consumption values in the costing sheet.

3. Process Overheads

Process Overhead costs are the items that are being used during the manufacturing process, and may not be directly used while processing the components. These include elements like, Maintenance cost, Pollution control equipment, Rejections, and Inventory Carrying cost.

The maintenance cost of the machines is the AMC cost and the cost of the spare parts. It varies from industry to industry and from machine to machine, however, the annual cost of Maintenance will generally vary from 3% to 8% of the cost of the machine. This cost needs to be divided among the full-year production capacity of the machine.

Process rejections are the reality. No process is perfect and can operate with 100% perfect output. Our aim as sourcing managers should be to pick up manufacturers with the lowest process rejections (not only for quality purposes but for cost purposes as well). To calculate the cost of process rejections, we need to attribute the cost of rejected components to the good quality components produced. Now there are 3 key attributes of this calculation vis - a. % of rejection, b. % of material recoverable for reuse from the rejected lot, c. At what stage of production the rejection is happening?

To understand this method, let's take an example. Say there are 100 Components produced. Say for each component produced, the net cost of material is say $100, the cost of processing & processing overheads is $30, there is a rejection of 5%, in 3% of cases material can be reused for manufacturing fresh components, in 2% the material need to be scrapped and in all the cases the rejection happens when 70% of processing cost have been spent. So there will be 95 good quality components produced, 3 got rejected and the material is completely recovered and 2 are sold as scrap (recovery of sale is $40 each).

Cost of Rejection = 2nos *($100 - $40) + 5nos * $30 * 70% = $225

These $225 need to be apportioned among the 95 good components produced. So the cost of rejection per component will be $2.37.

In most of the contracts, we ask our suppliers to keep some inventory of Raw materials and finished goods. The supplier is going to block a lot of its working capital in keeping these stocks. We'll have to compensate for the finance cost of the capital that will be blocked in the process. Continuing with the example taken in the previous para (Raw Material - $100, Processing - $30, others $20), the total cost of the Finished good is $150. Now if the monthly purchases are 10,000 pieces, and we have contracted for 1 month of RM and 10 days of Finished goods inventory, then the total working capital blocked is $1.5mn. Assuming the annual cost of working capital as 12%, we'll have to provide $1.5 per component for Inventory carrying cost (1500000*12%/12/10000)

The next aspect of cost is more strategical than the basic requirement of production of your component. It is about the Cost of Maintaining Sustainable Practices. We can get a component from a supplier who does not re-cycle / re-use the water or releases the polluted gas into the atmosphere or who is socially insensitive. The cost of components from such suppliers may be a tad lower than the one that follows ESG Norms and follow sustainable practices. While there will be few countries where some sustainable practices are not an option, sourcing from the global markets one may not focus much on these practices. However, for a resilient and sustainable supply of components and as a responsible company, one should always pick the sources which follow ESG norms, even if there is a minor additional cost. The estimation of this cost will have 3 components - Equipment cost, Utilities, and consumables. These need to be individually established and apportioned at the component level.

4. Organizational Overheads

For running the organization, there are various costs your suppliers will incur. These can be Royalties, R&D, Quality Control, Sales & Marketing, Transportation, Financial, HR & Admin, Establishment Statutory, etc. These costs are difficult to build Zero-up. However, there are benchmarks in each of the industries on what percentage of the total cost can be attributed to Organizational Overhead. e.g. I have seen in Auto-ancillaries that this value ranges from 3% to 5%, in service organizations this value can be as high as 8-9%. You can refer to the P&L sheets of some of the publicly listed companies in the same industry and make a sense of what percentage goes into Overheads. Please note that in most of the P&Ls the overheads are not separated between Process & Organizational Overheads. So one needs to be mindful of the same and decide on the percentages accordingly.

A word of caution here is that, when you work for a product where the raw material is commodity-linked and the commodity prices are highly fluctuating,?it makes sense to take your calculations on a per unit basis - Per component, Per Kg, Per meter, etc. So if the Raw material cost goes up by 10%, the cost of organizational overheads (Management salaries, Govt Fees, Admin purchases, etc.) will not change by 10%.

In a few organizations, I have seen that the suppliers negotiate an additional payout for 'payment terms duration'. If the payment terms are for 30 days from the date of product delivery, the suppliers will add a cost of capital, say 1% per annum, for the cost of capital. Now whether to give this amount or not, is industry-dependent. At the same time, this has to be aligned with the Finance team of the Buyer organization as well. If the finance function wants to manage the Working capital of your organization by managing the payment terms, then adding such an element in the costing will negate their efforts.

5. Profits

As the supplier is taking the risk of investing their money, employing large manpower & machinery, and Managing the entire production for you, it must be compensated by an attractive profit for the supplier. Profit calculations are very much similar to the Organizational overhead. You need to benchmark the percentage as per industry standards and attribute it to the cost of the component. Again please make sure, that the impact of commodity price changes is not impacting the profits. It is true for both upwards and downwards trends in commodity prices.

In the profit calculations, there is another very interesting angle that I have not seen many times on the negotiation table. This is the concept of 'Return of Investment' instead of Profit percentage. Return on Investment is the net profits that any supplier earns over the investments s/he has done. Now, Consider that I am a specialized cable manufacturer. To produce cables I have invested $ 5mn in the fixed cost of Plant and machinery establishment. Over and above I have invested $2mn on the working capital over the variable costs of RM purchase, Utility payments, manpower salary, and all the expenditures we listed above. Now, you would have noticed that while calculating the cost of the component, we have tried to compensate for all these incurred costs (Fixed & Variable). Let's assume that the supplier bargains for 5% of the total cost as the profit. So if the sum of all the costs in the above 4 sections adds up to $150 per component, then by paying him 5% per component for the production of roughly 10-11K components per month, we are paying about $78-80k in profits per month. This means that at the end of the year the supplier's P&L will have an investment of $7mn and a profit of $950k which is 13.5% of the investment. So when I mentioned that the Profit percentages are benchmarked with the listed firms' financial statements, one needs to derive a comparison between this calculation and compare it with the observations from the financials (P&L, BS).

Conclusion

The ZBC will give a Procurement manager a very good idea of the approximate cost of the component. There are various other factors as demand-supply, product complexity, geographical constraints, Geo-political constraints, Taxations, etc. which will define the final cost of the component. Hence, it is to be understood that ZBC is a 'Tool', it is not an end. Just like having a weapon in hand does not guarantee you a win in a battle, having a ZBC alone does not necessarily mean you'll get the cost reduced. But, do you think that you can go to a battle without a weapon? So, you need to have it and know how to use it. Later in the series, I am going to elaborate on the various power equations and where to use various tools in different power equations.

VERY IMPORTANT TIP: In any negotiation, one should not share the ZBC working right at the beginning of the negotiation. One should get a cost break-up of the supplier's quote in a format so that you can compare it with your ZBC working.