Better Business Decisions Using Cost Modeling The Supply and Operations

SOWER • SOWER
For Procurement, Operations, and Supply Chain Professionals Management Collection
Victor E. Sower and Christopher H. Sower Steven Nahmias, Editor
Information is power in supply chain operations, negotiations, continuous improve-
ment programs, process improvement, and indeed in all aspects of managing an op-
eration. Accurate and timely information can result in better decisions that translate
into the improvement of the company’s bottom line. The development and effective
use of cost modeling as a method to understand the cost of products, services, and
processes can help drive improvements in the quality and timeliness of decision
Better Business
making.
This outstanding book will provide you with a concise guide to the creation and ef- Decisions Using
Cost Modeling
fective use of both internal and external cost models. The authors detail internal cost

Better Business Decisions Using Cost Modeling

models and include illustrations showing how these cost models can be deployed to
assist in new product development, pricing decisions, make-or-buy decisions, and
the identification of opportunities for internal process improvement projects.
You will also gain real insight into how cost models can drive collaborative im-
provement efforts among supply chain partners, better prepare for price negotia- For Procurement,
Operations, and Supply
tions, and keep negotiations focused on facts rather than emotions—all while al-
lowing for future discussions with preferred suppliers to focus on more strategic
and operational improvement initiatives and less on pricing. A number of detailed
examples are provided to illustrate how cost models are constructed and to demon-
strate how they have been effectively deployed.
Chain Professionals
Victor (Vic) Sower is a distinguished professor emeritus of operations manage-
ment at Sam Houston State University (SHSU). Before entering the academic arena
at SHSU, Vic worked for 18 years in a variety of manufacturing positions, including
process engineer and process development engineering manager for Ampex Corp.
At SHSU he taught courses in operations management, supply chain management,
quality management, and technology and innovation management and established

Victor E. Sower
the Sower Business Technology Laboratory in the College of Business. During his aca-
demic career he earned numerous awards for his teaching and research, including
being named a Piper Professor in 2005 by the Minnie Stevens Piper Foundation of
Texas. Vic has a BS in chemistry from Virginia Tech, an MBA from Auburn University,
and a PhD in operations management from the University of North Texas.
Christopher H. Sower
Christopher (Chris) Sower is director of strategic sourcing for ConocoPhillips in
Houston, Texas. Prior to his employment at ConocoPhillips, Chris worked 11 years in
a variety of supply chain, procurement, and management information systems (MIS)
positions, including business systems analyst for Texaco, strategic sourcing analyst
for ChevronTexaco, strategic sourcing specialist for ChevronTexaco, category manag-
er for Limited Brands, and director of strategic procurement for Charming Shoppes.
Chris has a BS in psychology and an MBA from Sam Houston State University.

The Supply and Operations Management Collection

Steven Nahmias, Editor

ISBN: 978-1-60649-266-6
90000

www.businessexpertpress.com 9 781606 492666

www.businessexpertpress.com
 Contents

List of Illustrations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi

Acknowledgments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xv

Abbreviations and Acronyms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xvii

Chapter 1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Chapter 2 Constructing Cost Models . . . . . . . . . . . . . . . . . . . . . . 11
Chapter 3 Internal Cost Models . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Chapter 4 Other Internal Cost Models . . . . . . . . . . . . . . . . . . . . . 43
Chapter 5 External Cost Models for Procured Materials . . . . . . . . 65
Chapter 6 External Cost Models for Procured Services . . . . . . . . . 87
Chapter 7 Total Cost of Ownership Models . . . . . . . . . . . . . . . . 107

Appendix: Data Sources for Cost Modeling . . . . . . . . . . . . . . . . . . . . 127

Notes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
 Illustrations
Tables

2.1 Income Statement Components and Definitions . . . . . . . . . . . 12

2.2 Prevalently Referenced External Data Sources . . . . . . . . . . . . . 26

3.1 Estimated Material Costs for Accessory Kit P/N 007-040 . . . . 31

3.2 MTM Table for Accessory Kit P/N 007-040 . . . . . . . . . . . . . . 32

3.3 Ninety-Five Percent Learning Rate Example . . . . . . . . . . . . . . 34

3.4 Sixty-Minute Type II Audio Cassette Tape (per 1,000 Units) . . . 40

3.5 Non-value-Added Components in Standard Cost . . . . . . . . . . 41

Figures

1.1 General cost model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

3.1 General cost model applied to internal cost models . . . . . . . . . 28

3.2 Examples of learning curves . . . . . . . . . . . . . . . . . . . . . . . . . . 34

3.3 Truncated learning curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

4.1 Graphical representation of the simple breakeven model . . . . . 45

4.2 Graphical representation of the stepped breakeven model . . . . 47

5.1 Steps in creating a procured material cost model . . . . . . . . . . . 68

5.2 NAICS 322211-corrugated and solid fiber box

manufacturing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

5.3 PPI data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

5.4 Extrapolated material costs . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

xii ILLUSTRATIONS

5.5 Escalated material costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

5.6 BLS wage data by industry . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

5.7 Validated wage data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

5.8 Wage comparison and fluctuation calculation . . . . . . . . . . . . . 80

5.9 Updated cost model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82

6.1 Procured service cost model process. . . . . . . . . . . . . . . . . . . . . 88

6.2 Income statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

6.3 Cost components directly modeled . . . . . . . . . . . . . . . . . . . . . 91

6.4 Amortization schedule. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

6.5 COS components of cost model in Excel . . . . . . . . . . . . . . . . 97

6.6 Cost components modeled and not modeled. . . . . . . . . . . . . . 98

6.7 Finalized procured services cost model dashboard in Excel . . . 99

7.1 Total cost of ownership (TCO) value pyramid iceberg. . . . . . 110

7.2 Time value of money. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

Examples

1.1 External Projected Cost Models in Price Negotiations . . . . . . . . 2

2.1 XYZ Apparel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

2.2 Framework Session Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

2.3 Influence Diagram . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

2.4 Component Details . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

2.5 Dashboard/User Interface Tab . . . . . . . . . . . . . . . . . . . . . . . . . 21

2.6 About the Model Tab . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

2.7 Cost Model Dashboard Update . . . . . . . . . . . . . . . . . . . . . . . . 24

3.1 New Product Internal-Projected Cost Model . . . . . . . . . . . . . . 31

3.2 Internal Cost Modeling for Cost Reduction

and Efficiency Improvement . . . . . . . . . . . . . . . . . . . . . . . . . . 39
 ILLUSTRATIONS xiii

4.1a Use of the Breakeven Point Cost Model . . . . . . . . . . . . . . . . . 46

4.1b Use of the Breakeven Point Cost Model . . . . . . . . . . . . . . . . . 46

4.1c Use of the Breakeven Point Cost Model . . . . . . . . . . . . . . . . . 47

4.2 Use of the Stepped Breakeven Point Model . . . . . . . . . . . . . . . 48

4.3 Stepped Breakeven Point Cost Model

With Revised VC/Unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

4.4 Make-or-Buy Cost Modeling: Trendy Specialty

Products Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

4.5 Using the Crossover Chart Cost Model . . . . . . . . . . . . . . . . . . 52

4.6 Operating Division P&L Statement . . . . . . . . . . . . . . . . . . . . 56

4.7 Assignment of P&L Entries to COQ Categories . . . . . . . . . . . 59

4.8 COQ Distribution Over Time . . . . . . . . . . . . . . . . . . . . . . . . 63

5.1 Corrugate Price Increase. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

5.2 The Backbone Cost Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

5.3 Extrapolate Material Pricing to Present-day . . . . . . . . . . . . . . . 76

5.4 Using the Model to Derive Value . . . . . . . . . . . . . . . . . . . . . . 83

6.1 LMN Energy Trucking Costs . . . . . . . . . . . . . . . . . . . . . . . . . 88

6.2 Collecting Cost Model Data . . . . . . . . . . . . . . . . . . . . . . . . . . 92

6.3 The Value Proposition / Savings Results . . . . . . . . . . . . . . . . 100

7.1 TCO Analysis Case Study . . . . . . . . . . . . . . . . . . . . . . . . . . . 107

7.2 Lighting TCO Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

7.3 Normalizing Lamp Life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

7.4 Installation Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114

7.5 Operating Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

7.6 Maintenance Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118

7.7 Opportunity Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

7.8 Total Cost Analysis Results . . . . . . . . . . . . . . . . . . . . . . . . . . 121

 Acknowledgments
The authors would like to acknowledge the peer reviewers for this book
for their careful review and helpful comments:
Dr. Ross Lovell, Professor Emeritus of Operations Management, Sam
Houston State University
Mr. Peter Birkholz, Management Consultant—Birkholz Manage-
ment Co., LLC
Mr. David Maley, Vice President Procurement.
Mr. Rick Monical, Chief Procurement Officer, BP Azerbaijan
Dr. Jaideep Motwani, Professor and Chair, Department of Manage-
ment, Grand Valley State University
We would like to thank Mr. Scott Isenberg, principal and consultant,
CounselPub Publishing Services, who provided us the opportunity to
undertake the writing of this book, and the editorial staff at Business
Expert Press for their excellent work in expertly taking our work from
manuscript to finished product.
Lastly we would like to acknowledge and thank our wives Judy and
Emilie for their support and encouragement.
Abbreviations and Acronyms
ABC activity-based costing
BEP breakeven point
BLS Bureau of Labor Statistics
BOL bill of labor
BOM bill of material
COGS cost of goods sold
COQ cost of quality
COS cost of service
CPI Consumer Price Index
ERP enterprise resource planning
FC fixed cost
FDC factory direct cost
FMCSA Federal Motor Carrier Safety Administration
FOB free on board
FOIA Freedom of Information Act
GM gross margin
GPU gross profit per unit
HR human resource
IRS Internal Revenue Service
JIT just-in-time
MRB materials review board
MRO maintenance, repair, and operating
MTM methods time measurement
NAICS North American Industry Classification System
NPV net present value
PAF prevention, appraisal, failure quality cost model
P&L profit and loss statement
PPI Producer Price Index
PV production volume
QA quality assurance
R&D research and development
RFI request for information
RFP request for proposal
xviii ABBREVIATIONS AND ACRONYMS

RISI Resource Information Systems, Inc.

RMA Risk Management Association
SG&A sales, general, and administrative expense
OCC standard occupational code
SOP standing operating procedure
SPC statistical process control
SOW statement of work
tmu time measurement unit
TCO total cost of ownership
TR total revenue
VC variable cost
 CHAPTER 1

Introduction
Watch the costs and the profits will take care of themselves.
—Andrew Carnegie

In God we trust; all others must bring data.

—W. Edwards Deming

Efficiency and effectiveness in procurement, supply chain operations,

and internal operations are important to the success of all organizations.
This book discusses a variety of external and internal cost models that,
when used properly, can help an organization dramatically reduce costs
of both purchased and internally produced goods and services. There are
numerous examples in the chapters that follow—most from the authors’
experience—of how organizations saved substantial amounts through
the use of cost modeling. One organization saved more than $1 million
annually on a single purchasing contract negotiation through the use of
external cost modeling. Another reduced its cost of production by more
than 6% in less than 6 months through the use of internal cost modeling.
What might your organization save by using cost modeling?
The benefits of cost modeling extend beyond the purchase price to
long-term costs of ownership, safety, risk management, and to overall
viability of product lines and businesses. But use of the models alone
has no effect on costs. It is the improved management decisions that are
based on the information provided by cost models that reduce costs. So
in addition to discussing how to create cost models, this book illustrates
ways the results of the fact-based information output of the cost models
can be presented and used to enhance decision quality.
We have all heard the expression “Information is power.” Power, as
used here, does not refer to coercive power, although the results of cost
modeling can be used in a coercive way. But coercion is not the only form
of power, nor is it the best. The use of coercive power might result in a

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 2 BETTER BUSINESS DECISIONS USING COST MODELING

one-time “win,” but it will not result in a long-term change in behavior.

Power based on factual information is more likely to result in short- and
long-term benefits to all parties. Power in the form of actionable infor-
mation is necessary in order to get things done and thus has a place in
collaborative supply chain relationships as well as in operations internal
to the organization. Indeed, a number of studies1 have shown the positive
influences of power on procurement and supply chain performance.
Cost issues can be better addressed with external parties using infor-
mation rather than coercion. In procurement, the knowledge provided
by an external cost model increases the purchaser’s relative power in price
negotiations and can help assure that the final price paid is fair to both
supplier and purchaser. Additionally, the information provided by an
external cost model can be shared with supply chain partners to serve as
the basis for discussions directed toward collaborative efforts to reduce
costs throughout the supply chain. This transparency can benefit all sup-
ply chain members.

Example 1.1. External Projected Cost

Models in Price Negotiations
Supplier A’s representative is meeting with her client’s purchasing
manager about the renewal of the contract for purchase of materials
from Supplier A. “As you know, transportation and energy costs have
risen dramatically since our last negotiation. In addition, we have seen
increases in many other cost categories as well. As a result we must ask
for a price increase of 15% for the new contract period.” We have all
been there. The question is, will the price negotiations progress much
like those with a vendor in a flea market, or will they be fact based and
focused on achieving a deal that is fair to both parties?
In a flea market, the vendors have all the information. They know
their costs and they know what prices shoppers at last Saturday’s mar-
ket were willing to pay. The vendor starts with a price he believes is
higher than you are willing to pay, and you counter with a price lower
than you believe the vendor will accept. After several rounds of discus-
sion, if you have not agreed on a price somewhere in the middle, you

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 INTRODUCTION 3

begin to walk away. Now the real negotiations begin. No matter what
price you pay, you feel as if you have been taken advantage of. This is
no way to negotiate prices in the current business environment.
How would the negotiations with Supplier A’s representative differ
if you had an accurate estimate of the supplier’s product cost and a
feeling for what a fair profit should be? Instead of countering the sup-
plier’s offer with a lowball offer of your own, hoping to meet in the
middle, you might counter by saying, “This is what we believe your
cost for this product to be. Adding a profit margin based on the indus-
try average, we believe the increase in price should be just 8% instead
of 15%.” The supplier may well respond that your cost estimates are
incorrect. Your response is, “Show me where I am wrong.” We are now
engaged in fact-based negotiations and are much more likely to arrive
at a price that is fair to both parties.
Where do we obtain the information about supplier cost? We
construct an external cost model. Information is power, and cost mod-
eling can empower you.
Similarly, discussions about ways to improve internal operations
always proceed more smoothly and with a greater probability of suc-
cess when based on objective information rather than on opinion
and speculation. The knowledge provided by an internal cost model
increases the ability of an organization to identify areas where improve-
ment efforts can be best focused to increase the price competitiveness
of products and services produced by the organization. Internal cost
models are also of value in new product and process development to
evaluate feasibility and aid in pricing decisions.

Human/Political Issues
Human issues can be especially important, particularly when using
internal cost models with internal customers (the people within our
organization who receive our work or services) and external cost models
with supply chain partners. Simply presenting the results of a model in a
meeting and expecting everyone to see the logic of your recommendation
rarely works. More frequently this out-of-the-blue style of presentation
will result in some sort of push back or defensive reaction. When the

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 4 BETTER BUSINESS DECISIONS USING COST MODELING

buy-in of external constituents or internal customers is required to build

on the results of a cost model, it is important to involve those constitu-
ents from the beginning of the modeling project. When those involved
feel that they are part of a cooperative effort that involves cost modeling,
the probability of buy-in is greatly increased. On the other hand, when
people feel that others are encroaching on their turf, they often will resist
acting on the most objective evidence supporting that action.
Working with an internal customer to fully understand both the
quantitative and nonquantitative aspects of a cost-saving opportunity
will help assure the quality of the model and the acceptance of the results.
For example, working with store management to understand the aesthet-
ics of lighting as well as the costs associated with that lighting will help
assure that the lower-cost lighting alternatives being modeled will satisfy
the aesthetic requirements. Involving store management from the begin-
ning makes it “our” cost modeling project and enhances the probability
that everyone will accept the recommendations resulting from the model.

The General Cost Model: What Should the

Cost of a Specific Product or Service Be?
In this book we discuss two general categories of cost model: external
cost models and internal cost models. Cost modeling may generally be
defined as the analysis of resource data including direct labor, direct
material, indirect cost, sales, general and administrative (SG&A) costs,
research and development (R&D) cost, and profit to understand the pro-
jected or true cost of products and services produced or purchased by
the organization. It is a critical procurement tool that can provide “the
foundation for virtually everything that a purchasing organization does,
from setting strategy, to simplifying designs, to improving supplier opera-
tions and negotiating piece prices.”2 The general cost model is depicted
in Figure 1.1.
External cost modeling’s main purpose is the evaluation of the reason-
ableness of a price or quotation for a product or service; however, often
other cost drivers relating to how the company’s operations inadvertently
add to supplier costs and thus the end price may be identified from the
modeling process. Identification of these customer-based cost drivers can

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 INTRODUCTION 5

Type of material
Amount of material
Price: Delivered cost of material
Normal conversion loss
Direct material
Amount of labor
Wage rate
COGS Direct labor

Direct labor benefits

Indirect cost General overhead
Material usage variance
Labor efficiency variance
SG&A
Usually Applied as % of Sales
Returns
R&D
Allowances
Advertising
Pretax profit Headquarters expense

Usually Applied as % of Sales

Usually Calculated as % of Sales

Figure 1.1. General cost model.

More detailed external company-specific and internal models may
explicitly include other costs such as material scrap, labor efficiency,
and rework that may otherwise be buried in the indirect cost category
as well as transportation costs and income tax. Often internal cost
models will focus on cost of goods sold (COGS) and not include
SG&A, R&D, or profit.

facilitate a joint supplier-customer project to address these cost drivers

and share the cost reduction that derives from these efforts.
Internal cost modeling’s purpose is price feasibility analysis for new
products and services, and it provides input to operations decisions
such as process improvement, cost reduction, process selection, capac-
ity planning, make-or-buy, quality management, process optimization,
risk management, and inventory management. The same type of model
used for basic external cost modeling is often employed for the analy-
sis of costs of products and services produced within an organization.
However when doing this kind of internal cost modeling, the analysis
is usually done at the gross profit level rather than the net profit level, as
is done with the external cost model (Figure 1.1). The general internal

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 6 BETTER BUSINESS DECISIONS USING COST MODELING

cost model is useful in projecting costs for products and services under
development and for analyzing the cost structure for existing products
and services to determine fruitful areas for cost improvement activities. It
is generally true that improvement activities are more likely to be success-
ful when the parameters of interest (in this case cost parameters) are well
defined and measureable.
The development of cost models alone will not produce a more effec-
tive and efficient organization. The results obtained are dependent on
an organization and its management adopting a culture that integrates
them into the decision-making process. That culture shift combined with
appropriate development and use of cost models will result in better man-
agement decisions that will positively affect effectiveness and efficiency.
Interestingly, it is neither as difficult to construct an external cost
model nor as easy to construct an internal cost model as one might expect.
There are many sources of information available to support external cost
modeling. Many of these sources are readily searchable online. Exam-
ples include government census data and information available through
industry associations. While most if not all the information required to
construct an internal cost model already exists within the organization,
rarely is it sufficiently accurate, at the necessary level of detail, or in the
appropriate form to be used directly. Frequently the model builder must
drill down through several layers to find the information required and
then must validate that information to assure its accuracy before using
it to construct the model. We discuss the process of creating cost models
and data sources for those models in chapter 2.

Categories and Uses of Cost Models

In this book we discuss two general categories of cost models: external
and internal. Within each general category, there are multiple specific
types of cost models as will be shown in the following list. In chapter
3 we discuss internal-projected cost models. An internal-projected cost
model is used to understand the cost structure of products and services
produced within your organization to aid in decision making. Among the
uses for internal-projected cost models is cost feasibility analysis for new
product/service development by providing a snapshot of the projected
costs to produce a specific product or service. The learning curve cost

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 INTRODUCTION 7

model is discussed as a way to adjust the basic model for increased labor
efficiency expected to be derived over time. These models are useful as
inputs to pricing decisions for new products and services. Another use of
internal cost models is to identify opportunities for reducing costs and
increasing efficiency. One example in chapter 3 works through the cost
model a manufacturing company used to help reduce the factory direct
cost of one class of products by more than 6% over a 6-month period.

Internal and External Cost Models

• Internal cost models

◦ Internal-projected cost model
◦ Basic breakeven cost model
◦ Stepped breakeven cost model
◦ Make-or-buy cost models
◦ Crossover chart model
◦ Cost-of-quality model
• External cost models
◦ Industry-specific projected cost models
• Product
• Service
◦ Total cost of ownership model

Other types of internal cost models are discussed in chapter 4. Each

type is designed for a particular purpose. Often several types of internal
cost models are used during the life of a project to guide different types
of decisions. Breakeven cost models can be used to determine the rela-
tionship between sales volume, expressed as total revenue; fixed costs of
production; and variable costs of production. Breakeven models are use-
ful in new product/service development for determining the sales volume
necessary to reach breakeven and thus provide a lower bound on proj-
ect feasibility. The basic breakeven model is suitable for a limited range
of production. The stepped breakeven model allows for analysis over an
unlimited range of production. Next we discuss an internal cost model
that compares the variable cost of internal production to quotations for
outside production by a supplier that is useful to support make-or-buy
decision making. The crossover chart is a type of internal cost model that

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 8 BETTER BUSINESS DECISIONS USING COST MODELING

is related to the breakeven model. It is useful in process selection and

make-or-buy decisions by identifying the range of total cost over which
specific options are preferred.
The cost-of-quality model is an internal cost model that is very useful
in quality management. This model achieves a level of granularity not
found in most standard cost systems. The increased granularity facilitates
the identification of specific areas where costs are incurred due to poor
quality. In most standard cost systems, much of this information is bur-
ied within variance and overhead accounts. The typical reaction for an
organization using cost-of-quality modeling is incredulity, because with-
out the model they had significantly underestimated their costs due to
poor quality.
Certain internal cost models are most useful in the early stages of the
product or service life cycle where the focus is on feasibility and pricing.
Other models are most useful during the middle stages of the product
or service life cycle where the emphasis is on increasing output and effi-
ciency and lowering cost. However, all types of internal cost models can
be used effectively to support decision making in all phases of the prod-
uct or service life cycle.
In chapters 5 and 6, we discuss external cost models. Specifically, we
discuss industry-specific cost models for both products (chapter 5) and
services (chapter 6). The primary example used in chapter 5 demon-
strates how a retailer saved more than $1 million per year on corrugated
boxes using cost modeling. The primary example used in chapter 6 shows
how another firm used cost modeling to save more than $12 million over
the 3-year life of a transportation services contract.
In chapter 7 we discuss a particular type of cost model referred to as
the total cost of ownership (TCO) model. TCO models are critical com-
ponents of strategic sourcing activities because they help the purchaser
look beyond the initial price when making the purchase decision. When
the total costs associated with a purchasing decision over the life of the
product or service purchased are explicitly examined using TCO model-
ing, the purchasing decision often will be different than the decision that
results from an analysis that focuses exclusively on the initial price.
Cost models provide a snapshot of a particular cost component for a
particular point in time usually to support a specific decision. However,
if it is desirable to track that cost component over time, this may be done

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 INTRODUCTION 9

simply by updating the model. While specialized cost modeling software

is available, a properly constructed cost model using a spreadsheet can
facilitate the updating of the model. Periodically updating the model is
particularly useful when the original use of the model involves setting
cost improvement goals by providing a series of snapshots that enable the
tracking of progress toward the goal.
Cost models are tools that can provide additional power to enable
managers to increase organizational efficiency through lower costs and
increase organizational effectiveness through better quality decisions. The
models are useful in negotiations with suppliers by helping to keep the
discussions focused on facts rather than on opinion and political maneu-
vers. The appropriate use of cost modeling can increase supply chain
effectiveness and efficiency by facilitating collaborative efforts among
supply chain partners to decrease costs and improve performance. Cost
modeling should be part of every supply chain, procurement, and opera-
tions professional’s toolbox.

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