Inter Organizational Cost Management

(IOCM)
Nilendra Singh Pawar
 What is IOCM
• “Structured approach to coordinate activities of firms in a supplier network, so that total costs in the network are
reduced”

• Examples:
– During Product Development: Determining costs of a new purchased part
– During manufacturing: Determining the buying prices of purchased parts
– Improving Buyer Supplier Interface: Reducing costs through better interfacing

• Why is it crucial ?

• How is it different from “within the organization” cost management ?

 Structure of the session/s
• Environmental Factors influencing IOCM

• IOCM during product design:

– Target costing, Chained Target Costing
– FPQ, ICI, Concurrent Cost Management

• IOCM during manufacturing - Kaizen Costing

• Reducing Interface Costs

• CASE on IOCM
 Environmental factors influencing IOCM

The environment factors influencing IOCM include

1. Number of suppliers

2. The Level of Buyer Supplier Relationships

3. Trust and interdependence in Buyer Supplier Relationships

4. Type of Buyer Supplier networks

 1. Number of suppliers
• Larger no. of suppliers may help in negotiations
– Basic form of IOCM – negotiation/bidding, applicable in few situations
• Lean Supply management: Fewer Suppliers, closer working between buyers and
suppliers
– Evolved IOCM practices

• Reduce # of suppliers through:

– Fewer vendors per part or per part family

– Outsourcing fewer parts – Buying subassembly, intermediates..

• Outsourcing intermediates leads to tiered structure

– Automobile manufacturing OR manufacturing of paints
 Implications of tiered structure
Total no. of suppliers at
each stage, e.g. • Outsourcing intermediate parts leads to tiered supply structure
(40) (400) (1600)
Tier 3
• Mature industries, in general, have higher tiering
Tier 2 Tier 3
Tier 1
Tier 2 Tier 3
Tier 2
Firm Tier 1 • Reduces risks, increases specialization
Tier 2
Tier 2 • Crucial for buyer-supplier interdependence and stability. Why ?
Tier 1
Tier 2

• Implications for IOCM – evolved methods of working together

for cost management
 2. Type of Buyer Supplier Relationships
Compare the examples listed below. How are the following Buyer-Supplier relationships different? What are the
buyer’s expectations from supplier?

1. Buying sheet metal (Mild Steel) for making furniture

2. Buying plastic molded casings for plastic watches

3. Buying fragrance additive for a soap, from a fragrance manufacturing company

4. Buying engine for a sports car, from a automobile engine supplier

 Four Types of Buyer Supplier Relationships
Increasing closeness, IOCM sophistication
Common Suppliers
• Supply widely available,
industry standard or
replaceable parts
• Established market prices
available
• Supplier seen as easily
replaceable, cost is a key
determinant for selection
• Little or no IOCM related
to product design.
• Cost management largely
through negotiations
(Source: Robin Cooper)
Subcontractors Major Suppliers Family Members
• Supply products designed • Design and manufacture • Define functionality,
by the buyer part to meet part’s design and manufacture
functionality requirements the part as required in the
• Ensure mfg to provided by the buyer buyer’s finished product
specifications
• Low R&D on component • Buyer provides functional • Get involved at the
functionality. Limited requirements for the product concept
inputs on design changes component development stage
• Unsophisticated IOCM –
limited to basic engg • Have high level of
support from buyer, • Richer IOCM: Strong R&D autonomy, part of product
simpler design ability. Close interaction of development team
improvements engineers from Supplier & • Work independently to
• Limits of IOCM for many Buyer provide competitive
organizations advantage
• Long term relationships –
blurring of organizational
boundaries
 3. Trust and Interdependence in Buyer Supplier
Relationships
“Firm ABC buys components for their electrical appliances manufacturing plant.
The firm is constantly exploring new suppliers to get lower prices. They have a policy of shifting business to the
lowest bidder.
Many new suppliers start business by quoting low prices, however, they are unable to sustain the business. Soon, the
firm moves on to a lower priced / different supplier. “

• How will the firm’s policy affect IOCM with its suppliers..
 The nature of Buyer Supplier relationships
Trust and Interdependence
INTERDEPENDENCE TRUST

Keeps firms together Determines how they interact

• Interdependence is largely structural

• Building trust through actions: • Highest level of trust

– High information sharing Drivers
– Stability of business, leading to
• Aligned goals – Dedicated investments for
• Willingness to invest or incur a loss
• Higher efficiency of interactions due to familiarity
– R&D sharing IOCM
• Risk of Complacency. – Employee sharing
– Manage through Limited competition, Disruption by hierarchy or
other departments

– Pursuing Cooperation & mutual benefits

• Long term view while placing demands
• Supportive behavior
• Policy based vs. Opportunistic behavior
 4. Understanding supplier Networks
• Supplier network: Aggregate of Buyer – Supplier linkages in an industry/Geography/Sector…
– Typically found in a limited geography, with several interdependent firms catering to an industry. Examples..
– Key determinant of Supplier network is the number of firms that dominate the network

Types of Supplier networks:

• Kingdoms:
– Built around one large firm. Largest firm drives IOCM pressures and discipline. Well structured practices to manage
interorganizational costs
• Barony
– Dominated by 3-4 large firms. The competition between the large firms and their cost pressures. Reasonably structured IOCM
practices.
• Republic
– Has many firms with no dominant player. IOCM driven by market pressures. Unstructured.

(Source: Kathleen Gumbleton)

 Structure of the session/s
• Environmental Factors influencing IOCM

• IOCM during product design:

– Target costing, Chained Target Costing
– FPQ, ICI, Concurrent Cost Management

• IOCM during manufacturing - Kaizen Costing

• Reducing Interface Costs

• CASE on IOCM
 Inter organizational cost management (IOCM)
• During product design

• During product manufacturing

• Improving buyer-supplier interface

 Mechanisms in IOCM
Two types of mechanisms

• Disciplining Mechanisms: Placing Demands on suppliers

• Enabling Mechanisms: Providing support to meet the demands

Exercise: Identify disciplining & enabling mechanisms…

• Target Costing
• VE/VA
• Kaizen Costing
• Interorganizational Cost Investigation (ICI)
• FPQ trade offs (Functionality, Price, Quality)
• Delivery & Service protocol
• Joint product development
• Transaction cost reduction
• Collaborative forecasting
IOCM during new product development
Example: Developing a low cost
manual washing machine

Consumer appliances company

decides to launch low cost washing
machine to cater to the masses.

The engineering team needs to

develop the parts with the supplier
base.
 Arriving at target Cost
Costing technique:
Target Costing
• Target Selling Price: 6000,
• Target Margins: 2500,

• Target Ex Factory Cost: 3500

• Allocate the ex-factory costs to
– Internal mfg/assy Operations - 500
– Bought out sub assy and components - 3000

• How to allocate total component costs across components.. ?

 Breakdown of target cost for new product
Existing Target cost breakdown on the basis of:
Product
Sub Assy Costing Target Cost
Body 900 700 • Functional analysis: Setting costs for major
Inner & outer tub assy 1050 800 functions, based on historical data and
Motor assy 600 500 product positioning
Transmission assy 400 300
• Early Supplier quotes
Agitator assy 400 300
Controls & Power assy 300 200 • Cost break up of similar existing product
Hoses & chord 250 150 • Supplier cost information and cost
Packaging 100 50 reduction capabilities
TOTAL 4000 3000

• Cost break down requires strong understanding of supply side commercials, as well as market positioning of the
product. Done by the Chief product engineer, in consultation with various dept.

• Protect key functionalities while setting target costs

• Crucial to set achievable but stretch targets

Next steps after break down of target costs.. ?

 Outsource the parts
• Various forms of outsourcing
COMPONENT LEVEL PART SPECIFICATION LEVEL FUNCTIONALITY LEVEL
Buyer decides Buyer decides functionality, Buyer specifies functionality.
functionality, designs part, specifies part. Supplier specifies and
specifies components Supplier designs part, designs part, specifies
specifies components components

How can you outsource the washing machine parts

at these levels

• Body Assy

• Motor assy

• Agitator assy.

Buyer provides desired part/functionality and

target cost to the supplier
 Next Steps..
Existing
Product
Sub Assy Costing Target Cost • You meet the first supplier, Metal fabrication firm: Supplies
Body
v 900 700 products to many industries as well as competition firms.
Inner & outer tub assy 1050 800
– The drawings of the washing machine body / tub assy / transmission assy
Motor assy 600 500
and their specifications are provided to supplier
Transmissionv assy 400 300
Agitator assy 400 300 – You also specify target costs: Body (INR 900 -> 700), Tub assy (INR 1050 -
Controls & Power assy 300 200 > 800), Transmission assy (INR 400 ->300)
Hoses & chord 250 150
Packaging 100 50
TOTAL 4000 3000 • Likely response… ?
 Applying target costing
• Enforcing vs. Negotiation
– Costs get enforced whenever the buyer position OR supplier position is very strong
– Costs also get enforced in cases of industry standard products, commodities, large number of sellers/buyers
– Intermediate positions provide scope for negotiation

• Individual part target costs vs. Bundled target costs

– Bundled target costs: Provide more flexibility to vendors, however, supplier may take more reduction on one part
– Individual part target costs: Enables buyer to squeeze costs as per their estimate of buffer, however, may leave out some scope
of reduction in a part

• Closely Monitored vs. Independent part development

– Depends on the capability of the vendor and the supplier

You communicate the target costs to the suppliers. Next…

 What will the suppliers do with target costs..
• Suppliers perform target costing at their end..

• Target price of Metal body – INR 700. Target margin INR 50. Target cost INR 650
– Target Cost of Internal Operations – INR 50
– Target Cost of Sheet metal purchase – INR 350
– Target Cost of Powder coating – INR 200
– Target Cost of Other parts – INR 50

• Target price of Motor assy – INR 500. Target margin INR 75. Target cost INR 425
– Target cost of Internal operations – INR 50
– Target cost of Stator assy – INR 100
– Target cost of Rotor assy – INR 125
– …………………………………………………..
 Chained Target costing
Customers with little power
• Mechanism to drive cost pressures across the supplier
network.
Top firm
• Target Costing chain – Continuous chain of firms
through which target cost pressures are transmitted
Tier 1 supplier
• Target costing of a product propagates multiple target
costing chains
Tier 2 supplier
• Top firm: Individual buyers do not dictate price.

• Bottom firm: Under maximum pressure – buying from

Tier 3 supplier
suppliers immune to target costing

• Crucial to understand where does your vendor lie in

the chain, to apply cost reductions judiciously
Suppliers immune to target
costing
Enabling vendors to meet target costs…
• Washing machine body maker

• Detailed part drawing and a target cost of INR 700

was provided to the supplier. Supplier reverted
with a quote of INR 850.

• In addition, Supplier also provided option of using

cheaper steel source, and local galvanization
vendor, that can save another INR 125. This will
reduce mechanical strength & corrosion resistance
of the body

• Supplier also provided an option of using a

cheaper powder coating. The cost reduction
expected was INR 100. However, the aesthetics
(shade consistency & gloss) and wear resistance
will not remain top class

• Path forward.. ?
 FPQ (Functionality, Price, Quality) Tradeoffs
• Negotiations on achieving target costs through compromise
on functionality or quality Conceptuali-
sation

Time
• FPQ tradeoffs do not alter the basic functionality of the final
product
Design
– FPQ tradeoffs happen at each level in the value chain Conceptua
FPQ li-sation
tradeoffs
• FPQ Trade offs may offer quick solutions to cost reduction Design
• Limitations of FPQ tradeoffs
– Win lose conversation
Buyer Tier 1
– Limited scope as product design is frozen
vendor
– Buyer’s Design may not consider supplier’s processes

– Supplier’s design may have redundancies

– There may be an altogether different method to meet buyer

requirements
 FPQ leads to a stalemate
• Reducing Corrosion resistance is unacceptable to the
company, hence lowering of quality of steel or galvanization
is ruled out.
• Aesthetics is not a problem, however, reduced wear
resistance of cheaper powder coating is also unacceptable.
• Vendor is unable to come up with other ideas of reducing
costs
• Path forward.. ?
Joint investigation
• Joint team of engineers from supplier and buyer.
• Get full visibility in to each other’s processes
• Review each element of product design, mfg processes and equipment at supplier & buyer locations

Questions asked:
• Can the design be altered to use different guage of steel, or different material
• Can the design be altered to make sheet metal working more efficient at the vendor
• Is there any overdesign in the fasteners and other joints
• Can the last stage of assembly be shifted to the buyer’s premises
• Can you use a different grade of paint on non-visible surfaces
• Can the product me made or assembled on different equipment or with different processes.
Interorganizational Cost Investigation (ICI)
• Detailed review and redesign of the part in question & the product. Done jointly by
the engineers from Buyer and Supplier
• Questions asked
– Can the functionality be provided with a lower cost design
– Is the design well suited to the supplier’s mfg processes
– Are there any feature redundancies in the product
– Can we eliminate some processes at supplier or buyer’s end
– Can we relocate some processes to save costs

• Trigger: Usually due to failure to reach target costs

• Leads to more more significant design changes as compared to FPQ

• Preconditions:
– Stable, cooperative, mutually beneficial relationships
– Significant information sharing between buyer and supplier
– Power balance: Power imbalance breeds fear of being squeezed out, when internal
information is shared.
 FPQ vs. ICI
Conceptuali- Conceptuali- ICI
sation sation investigat
ion
Design
Time

Time
Conceptua Conceptua
FPQ li-sation Design li-sation
tradeoffs
Design Design

Buyer Tier 1 Buyer Tier 1

vendor vendor
• ICI leads to extension of product design phase
• Getting into ICI can result in project delays
More complications..
• Motor Vendor: Closely located firm, almost a
dedicated supplier

• The motor vendor was asked to reduce the cost

from INR 600 to INR 500.

• As per the vendor, their currently supplied

motor is the most basic design for the
particular toque & power output.

• They can undertake an ICI to redesign the

motor to a lower torque / power output.

• However, the motor design determines

transmission design and the design of agitator.
Changing motor specifications may impact
mechanical stability / cleaning action of the
washing machine.
 Concurrent Cost Management (CCM)
• ICI is usually too late to alter design radically. It may lead to significant rework.
• Late involvement of key suppliers may cause cost infeasibility
• Involving key suppliers at concept development and design stage avoids rework

CCM
• Applicable for major suppliers or
family members CCM
• Buyer asks supplier to deliver a key
Time
Conceptuali- Conceptuali-
functionality (typically a group sation
component) sation
• Usually done only with Tier 1
vendors Design Design

Buyer Tier 1
vendor
 Types of CCM
• Parallel Engineering
– Buyer provide high level of functionality requirement
– Supplier team works independently and reverts with design possibilities
• Simultaneous Engineering
– Buyer and supplier teams work jointly on part design and part specification leading to product design.

• Parallel vs. Simultaneous engg

– Does working together add value
– Inter-depedence of the part in question with rest of the product
– Confidentiality concerns

• Benefits of CCM: Saves time. Most effective in meeting FPQ targets

• Disadvantages of CCM: Technology may get shared with competition (Anyway possible with teardown in some
products?)
 Low cost manual washing machine
• Target Selling Price – 6000, Target Margins – 2000, Target Ex Factory Cost – 3500
– Internal operations - 500, bought out parts -3000

Existing
Product
Sub Assy Costing Target Cost
Body 900 700
Inner & outer tub assy 1050 800
Motor assy 600 500
Transmission assy 400 300
Agitator assy 400 300
Controls & Power assy 300 200
Hoses & chord 250 150
Packaging 100 50
TOTAL 4000 3000

• How would you have applied CCM in this

product development project ?
 Structure of the session/s
• Environmental Factors influencing target costing

• IOCM during product design:

– Target costing, Chained Target Costing
– FPQ, ICI, Concurrent Cost Management

• IOCM during manufacturing - Kaizen Costing

• Reducing Interface Costs

• CASE on IOCM
 IOCM during manufacturing
• Continuous cost reduction: Kaizen Costing: Maintain competitive edge through profitability
– Period specific
• Cost reduction target for a period & overall spend (e.g. annual)
• Top down + bottom up approach for target setting
• Modest targets (~3% YOY). Add up to significant savings over time
• Usually flat targets applied over a product category
• Part of vendor evaluation
– Item specific
• Focus on maintaining or achieving target cost for a specific product. Given separately from period specific targets.
• Involve closer interaction between buyer & supplier
– Overhead specific
• Target specific overhead costs involved the manufacturing of the part e.g. changeover costs, supervision costs, inspection
costs
 Kaizen costing
• Buyer Led
– Educating suppliers

– Setting targets

• Supplier led initiatives

– Design change

– Process change
 Linked Kaizen costing
• Similar to chained target costing
Top firm • However the part is already under manufacturing and vendor may
supply the components to many buyers.

• Vendor will receive different Kaizen Costing targets from different

Tier 1 supplier
buyers, and will work out an overall target for itself.

Tier 2 supplier • Kaizen targets may not get not passed on directly.

Tier 3 supplier

Suppliers immune to Kaizen

costing
Improving efficiency of Buyer Supplier Interface

Collaborative
forecasting
Reduce Lower inventories,
uncertainty Better servicing
Cycle time
reduction

Increase interface
efficiency Eliminate
redundancies

Increase Standardize Reduced

transaction transactions:
efficiency EDI/Ecomm transaction costs

Simplify
transactions
 Recap…
• Confrontation Strategy…

• IOCM is crucial due to higher outsourcing

• Types of Suppliers – Common /Sub-Contractors / Major / Family members

• Target Costing / Chained Target Costing

• IOCM through
– FPQ tradeoffs
– ICI – Inter company investigations, Joint investigation
– CCM – Concurrent Cost management (Parallel or Simultaneous)

• Kaizen Costing (Period specific, Product specific, Overhead reduction)

• Improving interface efficiency

 Case assignment on IOCM

• How was the target costing process and chained target costing applied in the case ? How would you do it differently?

• How would you characterize the supplier relationships for ACME ? How were the key suppliers selected for this project ?

• How was FPQ / ICI / CCM practiced in the case ?

• What are your overall comments on the IOCM practice in the case ? How would you do it differently.

Each group to answer the above questions. Maximum 8 slides.

Quiz on the case, followed by case discussion in next class.