Increasing Profits

First, I would like to understand the cost structure of the jet to see what we should look at first. Next, I would like to look at major factors driving the costs we are targeting. Finally, I would like to explore potential ideas to reduce cost.

That sounds like a very logical approach. Let's proceed.

Because the time for the interview is limited, I think we should try to identify those areas most responsible for the cost of the jet.

Time is limited on real projects as well, so I think that would be a good idea! You have the following cost information for the jet. How would you interpret it?

The major cost driver for the jet appears to be purchased materials. Within manufacturing, direct labor is a fairly large component of cost, as are program management and corporate overhead within overhead. I think we would want to concentrate most on materials, however, since that's where most of the costs can be found.

That sounds like a good place to start. Where would you look within materials?

I see that materials are broken down into purchased subassemblies, components, and raw materials. I understand what raw materials would be, but what would be the difference between components and subassemblies?

A subassembly functions on its own. An example is the pilot night vision system. A component is a smaller part, such as a part of the engine.

I know that governmental agencies often have very strict guidelines about purchasing that could affect the cost of materials.

For the sake of this case, you can assume that the British Ministry of Defense, MOD, allows "commercial off-the-shelf" purchases, which means that the client is free to purchase from whomever it wants, as long as it can ensure that the parts meet MOD quality guidelines.

I see that purchased subassemblies comprise more than 70 percent of materials. How many suppliers are there for these subassemblies?

There are seven suppliers of major subassemblies that go into the fighter jet.

That seems like a relatively small number. Are there more suppliers that are qualified to do this type of work?

The manufacture of these parts requires a substantial investment in R&D, engineering, and infrastructure. It would be very costly for new suppliers to make the required investment, particularly if the client is trying to reduce the price it pays to the subassembly manufacturers.

Since there are only a few subassembly suppliers, and the investment hurdle would preclude bringing in competing manufacturers, it would be difficult to reduce the price paid. Perhaps we should look elsewhere for savings.

But remember, if your client loses the contract, it will lose its customer unless it is teamed with the competing bidder. Even then, if the competitor is underbidding your client, there will be even less room for it to profit.

Perhaps it would have an incentive to reduce its costs in order to maintain the contract. Are the majority of its costs in materials as well?

How could you find that out?

I would want to interview the purchasing and engineering personnel of the different subcontractors in order to understand their cost structures. If we had a better understanding of their economics, our client might be able to reduce cost across the board, allowing it to compete more effectively for the contract without killing everyone's margins.

Let's say that purchased materials average approximately 70 percent of the price paid to most of the manufacturers.

If the cost of subassemblies represents 40 percent of the jet cost and 70 percent of that is purchased materials, total purchased materials would be approximately 28 percent of the jet cost subassemblies. Purchases of raw materials and components represent another 15 percent, for a total of around 43 percent of the cost of the jet. If our client could reduce the cost of raw materials by 20 percent, it could reduce the cost of the jet by more than 8 percent, more than enough to offset the 5 percent reduction it would need to win the contract.

That sounds reasonable, but 20 percent is a very lofty goal. How would you go about doing that?

First, I would look at the number of suppliers. Are there a large number of suppliers to the subassembly manufacturers?

The client estimates that there are approximately 125 suppliers of raw materials and components among the manufacturers of the subassemblies and itself.

Well, that sounds like a large number of suppliers. Of course, they could be providing very specialized materials to the subassembly manufacturers. Are these suppliers providing customized or more commodity products?

About 80 percent of these products are commodities, such as sheet metal and wire harnesses. Even some of the electronics, such as printed wire boards and circuitry, are fairly generic.

That sounds promising, but I would need to know whether these commodities are interchangeable, so that our client could concentrate spending with fewer suppliers. Are there many commonalities among the parts used by the different subassembly manufacturers? We could talk to their engineers and look at the designs and bills of material to determine how much overlap there is.

Let's say that you did this and discovered that approximately 30 percent of the cost of raw materials is from similar materials used across the subassembly manufacturers.

It seems safe to assume that the client would need more commonality to be successful in concentrating its purchasing and reducing costs. Do the engineers believe that the percentage of overlap could be increased if the designs were modified?

They believe they could increase that percentage substantially, particularly with basic materials such as screws and sheet metal, but also in other more customized areas.

That's great news, but we would still need to know whether the subcontractors are using the same suppliers. We could analyze the number of suppliers for each of the areas of overlap.

Good suggestion. Although there are some common suppliers, the analysis indicates that the subassembly manufacturers tend to use different suppliers.

Our client needs to reduce costs by 5 percent. The largest area of opportunity appears to be in purchased materials, the majority of which comprise subassemblies manufactured by seven subcontractors. By looking at its purchases in total, the client can target approximately 40 percent of costs. To achieve the 5 percent cost reduction, it would need to reduce costs by 15 to 20 percent. It could try to do that by increasing commonality in the design of the subassemblies and components and by shifting volume to a smaller number of suppliers.

Considering that the majority of the raw materials and components are purchased commodities, do you think the 15-20 percent cost reduction is achievable?

Well, I know that raw materials and components typically have lower margins than more customized products. I suspect it may be challenging to hit the client's savings target by focusing only on these purchases. But since raw materials and components represent about 40 percent of costs and there is an opportunity to concentrate purchasing, I think we should start here.

Where else could you look for savings?

If I look back at the cost data on the jet, direct labor is another large cost component. As a contingency, we could look into that area as well. I've read that other companies use outsourcing to lower their manufacturing costs�perhaps our client could do the same.

For example, it might want to increase its use of purchased subassemblies and reduce the amount of direct manufacturing it does. Of course this would work only if it could drive direct labor costs below the offsetting cost of these subassemblies. The client will be working closely with the subassembly suppliers to implement its purchasing initiative. This may give it an opportunity to explore the suppliers' capabilities at the same time.

That's an interesting suggestion. How would you recommend the company pursue both of the initiatives you have discussed?

I would look first to combine purchases across the subassembly suppliers with our client's purchases. I suspect that the client and the subassembly suppliers will need to share a great deal of information, including engineering drawings and specifications, with potential suppliers of the raw materials and components.

The Internet could prove to be a very effective medium for forming a single "virtual" purchasing department to consolidate both the flow of information and purchase orders across the companies. Our client might also want to use a bidding system for those materials that are true commodities.

Next, I would turn to the engineering departments and form cross-company teams to look for areas to increase commonality of design. At the same time, those teams could explore opportunities to use more purchased subassemblies and decrease the client's direct labor costs.

That sounds great, and is very similar to a project we did. I would caution you, however, to examine the upfront costs involved in your recommendations, both for the redesign and for the implementation of the purchasing system, before going ahead.