Lack of Trust

A significant lack of trust continues to exist in most supply chains and precludes the free exchange of cost information. Many managers believe their trading partners will act opportunistically if granted access to their cost information. Instead of focusing on jointly reducing costs with mutually beneficial results, they contend that their trading partners may use the cost information to increase profitability at the expense of other firms in the supply chain. As a result, exchanging cost information remains an extremely sensitive topic and senior managers are often currently unwilling to exchange any cost information.

Suppliers have major reservations regarding the sharing of cost and operational data with their trading partners. They contend that their customers will use the information to extract price concessions during future negotiations. As the customer acquires more knowledge about the supplier's processes, the customer has less difficulty in developing new sources or exchanging the information with competitive suppliers to obtain lower costs (prices). Some suppliers face the possibility that their customer may decide to vertically integrate to avoid paying the profit margin now earned by the supplier.

Downstream customers have similar concerns regarding the potential loss of competitive advantage. Customers may have devised unique ways to use a supplier's product to achieve lower costs or higher performance than their competitors. Managers in these firms believe that their suppliers may seek this information to obtain a competitive advantage for themselves. The supplier can use this information to show other customers how to better use the product or service. Any advantage the customer held evaporates as competitors adopt the same practices.

Trust appears to be a more significant hurdle to overcome in existing relationships than in new or potential relationships with other trading partners. These relationships are often marked by previous adversarial practices, and managers are very suspicious of any actions that could result in profit margin erosion or the release of competitive information. Large suppliers, and especially those that have successfully cultivated high profit margin business, simply refuse to disclose any cost data or collaborate with their trading partners in any way. Managers typically report that they can more easily obtain cost information from new, or potential, trading partners than from their existing trading relationships. The new trading partners have a “whatever it takes” attitude to establish a foothold or develop the relationship. This attitude often extends to being more willing to share cost information.

Limited Two‐Way Sharing of Cost Information

Due to management concerns about sharing cost information, few, if any, situations exist where all firms across an entire supply chain exchange their costs and management has complete cost visibility. In fact, few instances of bidirectional cost flow between firms have been identified and these exchanges are far from totally cost transparent. These firms exchange only information on the direct costs associated with a proposed process change and do not disclose any data on indirect costs or the costs of performing any other processes or activities.

Research shows that cost information flows primarily in one direction, from supplier to customer, and typically occurs during purchase negotiations. Large buyers require their suppliers to provide a detailed breakout of their costs. The breakout is used to determine whether the price is reasonable based on the supplier's labor, material, operating, and overhead costs. The information provided by the supplier rarely breaks out costs by process or activity. The fact that the information is “required” often increases the level of the supplier's mistrust.

The quality of information provided, even within the limited context of traditional labor, material, and overhead costs, varies by supplier. Some suppliers intentionally distort the cost information required by their customers because they fear it may be misused. Small suppliers often do not provide accurate cost information because they do not understand their costs. In some instances, customers report having a better understanding of their suppliers' costs than do the suppliers. Managers have cited instances where their suppliers bid well below the total cost the customer estimated was necessary to manufacture and deliver the product. The lack of cost knowledge within the supply chain remains one of the technical challenges of supply chain costing.

In many relationships, no cost information is exchanged. Some suppliers refuse to provide cost information even when required by the customer. Those that are in a strong market position due to their market dominance, specialized capabilities, or quality have no incentive to provide cost information that may only be used against them in price negotiations. Customers generally do not provide cost information when acquiring materials or services. They provide limited cost information only when the focus is on reducing their costs through a process improvement.

The lack of a two‐way flow of cost information presents an obstacle to supply chain costing. Ideas and suggestions largely flow in only one direction and suppliers lack the information needed to improve supply chain performance. Greater information visibility would provide more opportunities for the supplier to understand how their product or service is used and how changes in design or performance could create additional value downstream. When information is not shared, the supplier must rely entirely on the customer to identify these opportunities. This one‐way flow may result in missed opportunities and does not motivate the supplier to go beyond the minimum required to maintain the customer's business.

The current one‐way exchange of cost information is a major factor that fosters distrust in a supply chain. The supplier risks the customer's using the information to develop new sources or products—which customers frequently admit to doing. Upstream trading partners are reluctant to share cost information because they perceive that their customers will receive all the benefits while they incur all the burdens. The profitability of channel partners can be significantly affected by shifting functions from one trading partner to another in the supply chain. Changes in sales volume, product mix, or services offered can reduce revenues or increase costs at any point in the supply chain. Suppliers frequently experience the brunt of changes in the supply chain. They contend that their customers simply push inventory backwards in the supply chain and demand frequent and rapid replenishment without pursuing any initiatives to obtain offsetting cost reductions in other areas. As a result, the customer obtains the benefits of lower inventories and higher service levels while the supplier is left “holding the bag” with higher inventory levels, transportation costs, and greater risk.

Suppliers also contend that customers will use cost information to extract greater concessions. In some supply chains, customers require their suppliers to provide cost information to establish the prices they will pay. Customers expect the supplier to reduce costs (price) by a stated percentage each year. Suppliers generally receive little benefit in exchange for the additional burden imposed on them.

Inequitable Allocation of Resulting Benefits and Burdens

The perception of an inequitable allocation of benefits and burdens in the supply chain partially stems from the lack of a two‐way flow of cost information. Since the customer provides no visibility of downstream costs, the supplier assumes the worst—that the customer is hoarding any cost savings. The supplier cannot determine whether any cost savings have been passed downstream or whether future sales will increase due to the additional value created for the end user. The supplier's efforts to obtain additional cost reductions are stymied as well. The supplier cannot identify where offsetting cost reductions could be obtained in other processes or activities through collaboration with the customer.

Any alteration to a supply chain process will affect firms differently and may further contribute to perceptions of an inequitable allocation of benefits and burdens. For example, the adoption of a continual replenishment strategy generally provides greater benefits for downstream trading partners. Despite higher transaction costs due to more frequent ordering and receipts, they obtain even greater offsetting cost savings through higher inventory turns and fewer lost sales. Upstream trading partners achieve an overall cost reduction by trading off higher transportation and order fulfillment costs for lower inventory and production costs, made possible through more accurate demand information and forecasting. Although costs have decreased in both firms, the downstream trading partner generally obtains a greater benefit. Inventory, labor, and facility costs are higher downstream and the potential for savings can be much greater. These differences can create perceptions of inequity, especially when the level of investment or effort varies considerably between firms.

An equitable sharing of benefits and burdens does not necessarily imply an equal sharing. Suppliers have little motivation to exchange cost information if they are forced to reduce margins and incur additional costs and risk. Manufacturers tend to have higher margins than their suppliers or customers due to their large capital investment and the risks incurred. Their return on investment must cover product development and commercialization as well as the associated risk. Other trading partners may perceive an inequitable allocation when the manufacturer obtains higher margins. Complete cost transparency would reveal that the manufacturer incurred a substantial amount of the burdens to obtain a larger share of the benefits; however, few firms would be willing to provide this level of cost visibility or access in areas considered a core competency or source of competitive advantage.

Limited Cost Knowledge

Limited cost knowledge pervades most supply chains. Supply chain managers note that the majority of their trading partners do not have sufficient cost knowledge to integrate supply chain processes. These trading partners do not understand their key cost drivers, and the vast majority have little understanding of how their business practices drive costs elsewhere in the supply chain. There are numerous examples of suppliers quoting prices substantially below actual material and production costs.

Many managers report that their firm continues to rely on traditional costing approaches, and their cost systems provide little insight regarding the costs to support key processes or perform specific activities. As a result, these managers rely on surrogate nonfinancial measures to direct activities within their firms. Based on their experience and intuition, managers focus on a few indicators that they believe drive most of their costs and have the greatest effect on financial performance.

The lack of cost knowledge poses a significant challenge to implementing supply chain costing. Managers with limited cost knowledge refuse to exchange cost information to prevent exposing this potential weakness to their trading partners. If an exchange occurs, the information shared does not provide the insight or the accuracy necessary for supporting supply chain decision making. Differences in the level of cost knowledge across firms and functions make communication difficult and lead to adverse relationships in the supply chain. Limited cost knowledge prevents managers from understanding how process changes affect the firm's total costs. Managers frequently attempt to reduce costs within their firm at the expense of their trading partners—a situation leading to substantial suboptimization and higher costs and lower performance to the end user. If costs rise in their responsibility center, they are likely to refuse to participate in collaborative supply chain initiatives, despite lower overall total costs to their firm. When managers have limited cost knowledge, they are unable to determine how the firm is affected except in their individual areas.

Inadequate cost knowledge has serious implications for supply chain management. The end user incurs higher costs since the upstream channel members are unable to identify and exploit cost reduction opportunities. The channel members may become less competitive if alternative, lower‐cost channels emerge. Without sufficient cost knowledge, managers are unable to accurately measure and sell the benefits of supply chain management. They do not possess the cost information to demonstrate how process changes will affect costs, which firms will be impacted, and how to fairly allocate the resulting benefits and burdens. Within the firm, managers lack the capability to translate changes in nonfinancial performance into financial performance. Any improvements requiring investment or additional expenses are consequently difficult to sell to other trading partners.

Lack of Cost Estimation Capability

Customers frequently lack the capability to perform cost estimation or “should cost” analyses for their acquisitions. A cost estimation analysis requires the capability to reverse engineer the products and then determine the supplier's costs and how these products can be most efficiently purchased, manufactured, and distributed. Although the manufacturer may have designed the part, employees may not understand the manufacturing costs.

Several factors may contribute to the lack of cost estimation capability. The customer may lack the technical or engineering expertise associated with the product or service the supplier provides. The customer may not have sufficient manpower to perform this function in‐house. Cost estimation requires expertise regarding the cost structure of suppliers and may not have the costing expertise to understand how process changes affect costs. Lastly, management may not perceive the value of cost estimation analyses, especially when competitive bids mask opportunities for cost reduction and management assumes that a competitively obtained price represents the lowest cost to the firm.

The absence of an accurate cost estimation capability can seriously affect implementation of supply chain costing. Cost estimation provides the capability to develop process and activity costs for the entire supply chain, even when the trading partners do not exchange costs or possess sufficient cost knowledge. Without a cost estimation capability, supply chain managers have only isolated snapshots of their trading partners' costs. They are unable to determine what is driving their trading partners' costs and performance. The lack of cost estimation capability keeps managers from identifying potential cost reduction opportunities in their supply chains. Instead, their attention focuses primarily on high‐price items where competitive bidding has revealed a wide disparity in costs/margins or instances when the price obviously warrants attention.

An improved cost estimation capability would promote the exchange of interfirm cost information. Greater cost intelligence enables the customer to challenge supplier pricing more effectively. These price challenges can include a detailed analysis of what the product should cost. The customer can use this intelligence to suggest opportunities where the supplier can reduce costs. In instances where the supplier lacks sufficient expertise to effect the improvement, the customer can provide assistance, thereby promoting collaboration and the exchange of additional information. A key ingredient to the success of this approach will be how the customer agrees to share any benefits and how the supplier's margin will be affected.

Inconsistent Definition and Calculation of Cost across the Supply Chain

Cost can be defined in many different ways, and the lack of clear and consistent usage jeopardizes actions to implement supply chain costing. Management accountants across a supply chain may assign costs in different manners depending on the focus of their costing efforts. For example, a product‐oriented costing approach produces different results from a customer‐oriented costing approach. A firm using standard costs may assign only direct costs and use an arbitrary scheme for assigning indirect costs. Another firm in the supply chain may use an activity‐based costing (ABC) approach that more accurately calculates costs.

Inconsistent definitions in calculating costs also obstructs benchmarking within an organization, resulting in comparisons of apples to oranges rather than apples to apples for comparative analysis.

The lack of clear cost definitions makes communication and collaboration extremely challenging. For example, most managers believe that their financial systems can provide expenses at a very precise and detailed level. Further investigation reveals that although managers may have detailed cost information regarding their labor, material, and other expenses, they more often than not lack information regarding costs to perform specific activities or processes or their cost‐to‐serve different customers. Even firms with intricate standard cost systems have difficulty determining exactly what a product costs to make.

Senior managers find this situation frustrating but, in many instances, understandable. They frequently distrust the cost information in the accounting system due the lack of adequate cost drivers, different reporting mechanisms, or time lag. They tend to question the results of cost study teams due to the many assumptions made to derive costs and the inability to reconcile these special studies with the corporation's external financial reporting for government regulatory agencies. In some instances, they require that all cost studies be coordinated with the CFO to ensure some degree of consistency. As a result, managers find it difficult to communicate in cost‐based terms with their trading partners.

Cost Estimation

Some firms have developed sophisticated cost estimation tools that allow them to model and estimate the costs of other trading partners. This tool uses publicly available information and the firm's knowledge of their trading partner's processes, business strategies, and technology. Estimates can be developed independently, so collaborative relationships are not required to obtain costs. The experience gained in developing costs for immediate upstream or downstream trading partners enables firms using the most advanced applications of cost estimation tools to determine how process changes will affect costs throughout the supply chain.

These highly proprietary tools are used primarily for the firm's own benefit, but these tools can provide opportunities to leverage the value‐adding efforts of each trading partner. Some firms use cost estimation to identify where eliminating unnecessary steps and waste from the supply chain could lead to cost reductions and shorter lead times or create opportunities to develop more effective strategies based on all of the trading partners' costs and capabilities. Cost estimation tools can be used to demonstrate the cost and revenue implications of a new product or service. The analysis helps identify the process steps, required capability, and associated costs. Suppliers can more easily assess whether their current processes can accommodate a certain new product or service. The customer can provide additional information such as price, volume, and forecasts to assist the supplier in making the decision whether to produce this product or provide this service.

Cost estimation models can simulate the causal effect between end‐user demand and trading partners' costs and performance across the entire supply chain. The ability to simulate process changes is one of the most significant capabilities offered by supply chain costing and cost estimation. Managers can simulate whether changes in flexibility, cost, quality, and time produce a competitive advantage at the end‐user level. The simulation enables an assessment of the contribution of each trading partner and how they affect value creation in the supply chain. Based on the analysis, specific trading partners can be targeted for collaborative efforts or alternative providers. Instead of focusing on internal improvement, managers use cost and performance information to influence external behavior.

Leveraging Information‐Sharing Requirements

Many customers leverage their purchasing power to compel their suppliers to provide cost information. While this is a common strategy, if used inappropriately, it can simply exacerbate the trust issue. Some executives recognize this issue and have initiated efforts to work carefully with trading partners to pursue mutually beneficial improvements. Others have started by pursuing operational improvement opportunities or sharing expertise related to measuring and using supply chain cost data. They further foster trust by exchanging selected information with cooperating suppliers to collectively identify, simulate, and test the effects of proposed changes on overall supply chain costs.

The following examples show how firms can apply this strategy. Firms may require suppliers to submit their production‐related costs with their response to the customer's request for bids. The cost submissions follow a standardized reporting format that breaks out costs by labor, materials, other direct costs, equipment depreciation, and overhead. In a few firms, more sophisticated reporting requirements ask the supplier to map their process and identify their costs to perform each step with indirect cost allocations explained and justified. Buyers then circulate this information to internal technical experts and cost estimation analysts to validate the accuracy of the reported costs. A report with questionable data, either high or low, is discussed with the supplier.

Suppliers with long standing relationships or participating in a preferred‐supplier program may report their information through a more formal and ongoing process. Online reporting systems are used for suppliers to report their costs for components, services, or products provided to the customer. These costs are jointly reviewed by the trading partners to confirm their validity and to target areas where cost reductions or other improvements can most likely be obtained. In some instances, this reporting is tied to a cost reduction program. By participating, the supplier agrees to propose actions yielding a specified cost reduction each year. Cost reductions can occur within the supplier, customer, or in activities spanning the firms. These proposals must generate “hard savings,” producing quantifiable reductions in expenses or bottom‐line improvements. The standardized format associated with the supplier program provides a means for both trading partners to readily evaluate the initiative, check key assumptions, revise cost estimates, validate savings, and approve actions.

With their knowledge of supply costs, downstream trading partners have been able to assume a leadership role in improving the supply chain process. Joint supplier‐customer teams have used this information to conduct kaizen events to obtain cost savings by improving productivity, increasing quality, or eliminating waste and redundancies across the firms. Customers have identified where multiple tier one and two suppliers purchase the same commodities or components, and they use this knowledge to negotiate a single contract to leverage their combined purchasing power to obtain lower costs. Other analyses have demonstrated where customer investments in new supplier equipment can increase capacity, eliminate bottlenecks, or provide greater flexibility upstream to produce substantial cost reductions. By providing engineering and technical support, the customer can streamline and improve the productivity of the supplier's operations. The customer's marketing staff can assist the supplier in identifying noncompetitive markets for related products to generate additional contributions toward fixed costs and profit.

Suppliers can receive similar benefits through the resulting exchange of cost and process information. They obtain a better understanding of how their behavior and capabilities drive downstream costs. Suppliers can combine this understanding with their unique competencies to assist their customers in resolving a wide variety of issues ranging from manufacturing to product development. Customers frequently turn to their suppliers for assistance in reducing design complexity, such as combining several components to complete an assembly, or to perform a needed function. Suppliers may possess greater flexibility than their customers, and they can use this flexibility to efficiently produce in smaller lot sizes or to custom manufacture to end‐user specifications. They may possess a competency or technology their customers do not have, which can lead to new innovations within shorter time spans. Their increased knowledge and understanding of costs make them a more effective trading partner, capable of generating more value to their customers and the downstream supply chain.

This strategy initially makes the exchange of cost information an awkward and sometimes adversarial experience. The profit motive naturally causes each firm to concentrate on how any changes will affect them, and they will use the information to support incremental price and cost trade‐off analyses.¹ By taking a leading role in collecting and exchanging cost information, the customer can move supply chain costing forward. As the exchange of cost and process develops, this strategy can overcome the major challenges posed by attempting to manage costs across multiple trading partners. This strategy provides several benefits that are inherent to resolving existing supply chain costing issues.

The use of a standardized format helps ensure consistency in how costs are defined, assigned, and reported across firms. Accurate and consistently developed cost data is important for understanding what is driving costs today and for determining how to drive future profits and new strategies within the supply chain.

Managers use the reporting process to determine their trading partners' level of cost knowledge and to educate their upstream trading partners. Many suppliers do not have a thorough understanding of their costs and cost drivers. Managers can easily discern the level of cost knowledge by the information reported and the level of detail. By improving the suppliers' cost knowledge, the trading partners can enter into a more productive dialogue regarding how the demands placed on them by other trading partners drive their costs.

The subsequent cost exchange will encourage collaboration within the supply chain. One way to foster collaboration between trading partners is for them to understand how they affect each other's costs. Collaboration will grow in importance as the trading partners can credibly measure the cost impact that they create among themselves. Reliable cost and performance measures foster better communications, analysis, and understanding of how trading partners might collectively reduce costs.

In many instances, cost reporting identifies previously unknown competencies and knowledge resident in the upstream trading partners. This new knowledge enables the firm to seek opportunities to lower costs, increase customer service, obtain new services, achieve greater flexibility, and more quickly introduce new products and innovations. A cost reporting strategy increases cost visibility. Cost information is needed to see and understand the trading partners' cost structure both upstream and downstream. Without this information, managers within the supply chain will miss the opportunities for making effective cost trade‐offs. Cost visibility enables firms to eliminate excess costs all the way through to the end user. Lower costs and improved performance increase overall product demand and profitability for the entire supply chain.

Pilot Projects

Using pilot projects for overcoming the challenges associated with supply chain costing is a useful methodology. The initial sharing of a limited amount of cost information provides the catalyst for fostering collaboration and trust between trading partners. Successful pilot projects have led to a greater two‐way exchange of cost information as the trading partners attempt to broaden the scope of cost reduction opportunities. A limited test enables the participating firms to work out a method for ensuring the equitable allocation of the resulting burdens and benefits. Managers can use the pilot to increase their trading partners' level of cost knowledge while enhancing their cost estimation capabilities. During the pilot project, the trading partners can resolve any differences regarding cost definitions or allocations.

Revisit Chapter 10 and its section describing the rapid prototyping with iterative remodeling approach to implement activity‐based costing (ABC). This approach arrives at a permanent, repeatable, and reliable ABC production system in weeks, not in months. Its additional benefits are that it accelerates the learning and understanding of managers on how to calculate costs, gets buy‐in from those who are reluctant to use ABC, and stimulates the thinking of managers on how they will use the ABC information to make better decisions.

Managers should carefully pursue pilot projects for supply chain costing. Selection of an inappropriate pilot or partner may alienate rather than integrate the participating firms. Major factors that managers should consider when selecting a pilot study and partner are listed in Exhibit 13.1.

One example of a successful pilot project was the cooperative process used to reach a mutually beneficial delivery process change between a supplier and a major retailer (described in Chapter 2). Pilot projects such as this provide a quantitative understanding of the relationship. The use of costs enables managers to translate nonfinancial performance (such as dwell time and dock‐to‐stock time) into financial measures. To fully understand the cost trade‐offs being made, costs need to be made visible to management. When the trade‐offs occur across firms, management needs to have cost transparency regarding the complete process.

Pilot studies can provide several additional benefits that go beyond the sharing of cost information and obtaining process improvements. Managers can use the pilot as an opening to address a large number of disparate problems associated with restructuring supply chain processes.² These potential problems include the handling and ownership of any intellectual property resulting from the development of new services or products; information disclosure between the firms regarding demand forecasts, production levels, new product deployments, and sales promotions; and release of any information to other trading partners to obtain further improvements across the supply chain.

Despite the benefits, managers need to proceed with caution when pursuing supply chain costing initiatives. They need to ensure that their organization has developed a strong in‐house costing capability and tackled internal cost reduction initiatives before seeking external improvements. Otherwise, the firm will create a perception that the burden for improving supply chain performance is simply being shifted onto the shoulders of other trading partners. Any decision to expand the scope or span of the pilot project should be based on a careful assessment of the costs and resources consumed by processes and the benefits they will produce. The decision by multiple trading partners to integrate their supply chain processes requires these trading partners to weigh increased output performance against the costs of resources used in the process. Adding more processes to the integration initiative will increase the resources consumed and outputs produced and further complicate the task of supply chain costing.

New Trading Partners

Many firms initiate supply chain costing with new trading partners to increase their chances for success. New trading partners are more receptive to exchanging cost information. These firms focus on gaining market share and expanding the relationship more than on preserving margin. They are much more willing to exchange and use cost information as a way to create additional value and solidify the relationship. Established trading partners, on the other hand, are often reluctant to exchange cost information. They have built up their margins over time through internal efficiencies or by advancing along the learning curve. The exchange of cost information will reveal these higher margins. They fear future negotiations will erode these margins and the advantage they hold.

Initiating supply chain costing with a new trading partner provides a means to establish trust between firms. Trust develops from the working relationships established at multiple levels and on how the firms handle and safeguard the exchanged information. The ability to create value for both firms through the exchange of cost information and shift functions builds a solid foundation for a strong alliance and a trusting relationship. As trust develops, management can focus their collective efforts on other areas likely to yield high payoffs. The greater the degree of trust, the more the trading partners can exchange detailed information to better understand their costs and the factors driving these costs.

On the surface, this strategy may appear overly simplistic. However, the exchange of cost information occurs more frequently with new trading partners than in well‐established relationships. Managers should carefully consider how to best use these relationships to create mutually beneficial processes that can lead to creative approaches for value creation. A focus on attempting to collaborate with long standing trading partners may result in missing opportunities with new relationships.

The ability to exchange cost information with new trading partners provides a distinct advantage over other existing trading partner relationships. Management can more accurately determine how current processes between companies are performing, and improvements can be targeted where they will have the greatest effect. A free, cross‐boundary sharing of information fosters team problem solving, and management can engrain this culture and action within the new relationship from the very start.³ The exchange of cost and performance information supports the development of a common vision and strategy with the ability to accurately assess performance and profitability for each firm and the supply chain.

Value‐Based Strategy

A value‐based strategy provides a powerful tool for measuring and selling the value of supply chain costing to other trading partners. As managers make cost trade‐offs across the supply chain, costs will go up for some trading partners and go down for others. Focusing too narrowly on costs produces a “you win, I lose” scenario and means managers will miss opportunities for creating value for themselves, other trading partners, and the end user in the supply chain. By considering how these trade‐offs affect value creation, managers can more effectively demonstrate that sound business decisions targeted at improving process performance more often than not produce a win‐win for collaborating trading partners.

Tools such as EVA and the balanced scorecard (see Chapter 12) represent good examples of a value‐based approach that combines supply chain costing with other collaborative initiatives. Since many supply chain initiatives are focused on improving performance rather than on reducing costs, to obtain a competitive advantage, the ability to determine the effect on assets, costs, and revenue is extremely important to supply chain managers. Value‐based measures incorporate multiple views of financial and nonfinancial information.