Surely you, as a purchasing (or supply chain) professional, have heard of cost breakdown or cost breakdown. But after all, why is this concept so important (in fact, exercises related to this are often used as an elimination criterion in job interviews)?
The opening of costs not only allows an understanding of the cost composition of a given material or service, but also guides the authorization of price adjustments when these are requested.
Let's look at an example to make it easier to understand: Let's say that you, the buyer, are responsible for the glass packaging category in your company. Therefore, the first step to good category management is to know the material you buy. You can do your own research, talk to the Packaging Engineering department (if your company has one) or simply go straight to the source, that is, your supplier. It is always important to remember that no matter how much we should be, or are experts in a subject, our supplier is always (or should be) "more" expert than us. In this case, selling glass packaging is the supplier's main activity and therefore, he or she needs to be able to explain the glass manufacturing process to you in detail.
Well, in a world where pandemics do not exist, one of the best ways to obtain information is through visits to the supplier (this experience is extremely rich and provides us with countless pieces of information about the supplier, which are not always revealed with questions or questionnaires – we will discuss this in a future text).
When you are visiting a supplier, a good tip is to ask the supplier to take you through the “production process”, that is, to show you everything that happens, from receiving the raw material, through production, to inspection, packaging and shipping to the customer. This way, you will be able to understand the flow of raw materials and processes that culminate in your final product.
In the case of glass packaging, for example, the main raw materials are silica, sodium carbonate and limestone. The supplier must show you the receipt, inspection and storage of all raw materials. At this point, you should ask what the share of these raw materials is in the composition of the glass. In this case, you should get something around 70% silica, 15% sodium carbonate (commonly called “soda ash”) and 10% limestone. Keep this information in mind, it is invaluable for your cost breakdown.
Moving on to the processing part of our visit to the supplier, you should look for signs of everything that could add cost, for example: Material stopped waiting for machine set-up time, manual inspection of received raw material, rejected batches of received raw material, lack of space for raw material storage, among others. Again, a golden rule here is to think that each person (or department) that in some way “touches” the raw material or the final product, incurs a cost. And it is up to you, the buyer, to ask questions: What is the cost of inspecting the raw material? What fuel is used in your furnaces? (the furnaces for transforming raw materials into glass need to reach a temperature of approximately 1500 degrees Celsius – think that water boils at a temperature of 100 degrees Celsius, therefore a lot of energy (heat) is needed to melt the raw materials and transform them into glass, thus making the “energy” item important for your cost breakdown).
Now, let's pay attention during our visit or ask the supplier about the labor force. How many people did you see working in the supplier's production plant? Are the operations mostly automated or manual? Again, you should ask the supplier what the impact of labor is on the final cost of the product.
The next part of the cost breakdown that you should be aware of is called “SG&A” (Selling, General and Administrative Expenses) or operating costs. These are basically the costs of maintaining the business and include rent, marketing costs, equipment, employee benefits, and more.
And finally, the last (and most important) part of cost disclosure is understanding the supplier’s profit margin. This information is often treated as confidential and requires a huge partnership with the supplier (and confidentiality agreements) to disclose. It is important to note that profit margins can vary depending on the product and the customer.
Right! You must be wondering what to do with all this information now. Ideally, you should create a simple spreadsheet table with the items that make up your cost in one column and their respective percentages in the column next to it. It is worth remembering that the sum of the percentages of the items must be 100% – since the sum of all the items must be the total amount you pay for the material or service. This tool is something that is worth spending a little time on initially in research, conversations, investigations and visits to the supplier, because once developed, it does not tend to change in a short space of time – unless there is a change in the supplier's production, such as the acquisition of a robot that automates one of the manufacturing steps.
With this spreadsheet, you should enter the current price paid in another column, next to the total sum of the percentages of your cost breakdown and “break down” your total price according to the percentages of each item. For example, if the total amount paid for a glass container is R$1,00 (100% of the cost breakdown) and you know that Silica’s share of the cost is 20%, R$0,20 of your total cost is “caused” by Silica, and so on.
Whenever a supplier requests a price adjustment, you should understand what led to the request. For example, let's say that something happened and the price of silica had a 10% increase. You should never apply the 10% increase to your total cost. In our example above, if you apply the 10% increase to your total cost, the packaging will cost R$1,10. Since you, the buyer, have already done your homework and developed your cost breakdown spreadsheet, you know that you should apply the 10% increase only to the 20% of silica that makes up your final cost. If the only reason for the increase requested by the supplier was the increase in silica, your new total adjusted price will be R$1,02 (and not R$1,10, if you simply apply a 10% increase to the total value). Furthermore, suppliers (especially Brazilian ones) usually request adjustments to cover inflation. Yes, it's fair. But it is not fair that the supplier's profit is also adjusted. The cost can be adjusted to cover inflation, but there is no reason to increase the supplier's profit and again the cost opening spreadsheet should be used, applying the adjustment to the "SG&A" line. Raw materials are generally adjusted according to their own indexes, while SG&A can be adjusted using, for example, the IGPM index.
In a future text we will also address the “should cost model”, another tool that is based on cost disclosure.
In any case, remember that knowledge is a very valuable bargaining chip for purchasing professionals and knowledge of your cost structure can bring a competitive advantage to your company, as well as results (savings) for you and your area.
Written by Flavia Paiva | 1/03/2021
