Understanding the Complex Nature of RL Job Cost Modeling

by L. B. Underwood & Thomas Welsh

Reverse Logistics Magazine, Nov/Dec 2007

How can so many smart people come up with different numbers when deciding what the same service should cost? We've all seen it before; multiple vendors get the same description of the work to be done and they come back with numbers that can vary by up to 40% and none of them match the target price set by the client.

Of course, none of the numbers are wrong, per se – they're just different. Some participants like to use the bids as marketing efforts and don't intend to have those numbers end up in a contract. This activity is not conducive to a relationship founded on trust and honesty and, sometimes, it causes problems more often than resolving them. Some participants are using flawed methods for costing and don't know whether the price they're submitting will produce a normal margin or would mark the beginning of a new, difficult relationship.

That said, job costing is the initial gate that all vendors must pass through before other considerations are discussed and it turns into the heart of how customers and vendors learn to collaborate. It is just that urgency that brings out the "worst" in some people and allows them to choose to veil their true costs to get through the first gate with a potential client and then causes them to persist in this behavior beyond its usefulness.

These challenges extend outward and include not just the 3PSPs but also greatly affect most all areas of RL service offerings and the very clients we are all trying to serve. Let me illustrate this with an all too common scenario.

A client decides the internal repair depot's costs are too high and targets outsourcing to solve the financial pain points. Internal estimates of unit repair costs are based on the operation's status as an internal cost-center within a branded OEM. These costs then become the basis for building a 20% savings benchmark for outsource providers to achieve.

As the RFQ process proceeds, a vendor is selected as the leading candidate. The vendor used a ‘shop rate' as the basis of the proposal response. As the negotiations continue the client lobbies to further reduce the pricing because the vendor's current operations are profitable and this would be incremental business. The pricing is adjusted and the business is awarded. However, the size of this business compared to the current operation is significant. Also the terms required by the client are net 60 and parts purchased for repair cannot be returned for stock balancing.

While the terms in the situation described above are obviously skewed in the client's favor, they are not an unusual starting point for most negotiations.

By now you have guessed the results. The client underestimated the true benchmarked cost. The status as a cost center hid some shared services and fixed costs that were not counted. The vendor was severely exposed to huge cash flow risk. With the net 60 terms, the vendor's business was acting more like a bank than an RL Service Provider. In an effort to salvage profitability, the vendor's performance did not meet the service level requirements. End users became dissatisfied and a potential partnership that could have been mutually beneficial is now exposed to outright failure and termination. The result is a client that may decide that outsourcing does not work and a vendor that may decide that the shop rate ‘they have always used' needs another 15% added onto it to make sure this never happens again. Clearly not a good outcome for anyone involved.

Is there a way this could have been avoided? At several points in the process it is obvious that there was ample opportunity to get things corrected. However, what almost always happens is that the desire to please the client and make the "WIN" takes over and begins to drive the whole process forward.

Two ways to avoid these traps are listed below. A basic understanding of two important accounting concepts will help.

Activity Based Job Costing
Understanding ROIC and the affects of terms and ramp costs on net margin

In this issue we will outline ABC (Activity Based Costing) with some key considerations and elements to include. In the next issue we will give some helpful tips on the use of ROIC (Return On Invested Capital) management & controls. Experience tends to show less than half of the RL companies that respond to RFQs use ABC. Of those that do use ABC, many use a pricing model that overlooks critical cost elements. The remaining vendors typically use some type of ‘shop rate' as the basis of the pricing part of the response. Take a look at the questions and answers below that help to outline the ABC benefits and critical process points.

WHAT IS ABC?

In its most simple form it is a detailed documentation of all of the direct, variable costs needed to perform work. These costs are summed and expressed in per unit terms. All remaining expenses are summed and divided into budgeted units. This activity is called allocating fixed costs. These costs are often referred to as SG&A (Sales, General & Administrative) costs but may include other costs depending on corporate structure. At the site level, allocations are commonly made on units, revenue or space.

WHY IS IT NOT MORE WIDELY USED?

Complexity. There is no getting around the fact that ABC is much more complex than other costing methods. For most companies there are layers of staff that must approve pricing prior to release to a Client of RFQ response. Not all of the stake-holders in the chain of approval may have the same level of understanding regarding pricing methods. The process of communicating the details as to why a certain proposal price is justified quickly can turn your brain to mush as you are locked in conference call hell. However, by using ABC models that are standardized and better understanding of the process, through staff training these barriers can be overcome.

WHAT ARE THE ISSUES AGAINST USING "SHOP-RATE" PRICING METHODS?

For repair service, the cost of test equipment alone can vary greatly depending on support for CDMA vs. GSM vs. Wideband. Add onto that the labor cost variance for refurbish skills, BGA solder skills or repair diagnostics and you can get a glimpse as to how out of line shop rate pricing can take you. Then there are problems with definitions. A guy I know recently quoted business for level three repair of a PDA for an OEM. Due to time constraints he used a shop-rate based on another PDA quote that was produced using ABC methods. The OEM was impressed with the pricing but did not understand how they could "offer a price that was that low." During the consultative meetings the reasons for the variance became obvious. The OEM expected that the product would not just be repaired but that detailed diagnostics and root cause analysis would be performed on each defective component. This was a cost effective step because it was needed so that the OEM could recover the component warranty from their part vendors. If not for the OEM making time for a follow up meeting the information would not have been discovered until it was too late to avoid a poor outcome and poisoned relationship.

WHAT ABOUT ABC MAKES IT THE PREFFERED COSTING PROCESS?

Greater participation across process owners. The range of knowledge will usually require an IE (Industrial Engineer) from the Operations Group and a Cost Accountant work together in completing the pricing. Having two professionals working together gives better oversight and a better opportunity of a correct outcome. Another benefit is accuracy and with improved accuracy there comes a tremendous freedom. A vendor with a solid ABC cost model can feel very comfortable with exposing all of the drivers and comprehended elements with the vendor. This openness has several benefits:

By seeing the vendor's details the Client has the opportunity to second-guess themselves for the right solutions before the contract is awarded based on error-filled assumptions.
The greater visibility can better manage risk for Client and Vendor.
Comparisons between vendors becomes much more meaningful.
Reasons for price quotes that are out of line can be verified.
Trust is built from the beginning, helping to move the sales process along.

For most RL Service Businesses with high labor VA (Value Add), the operations are costed using what are essentially two P&L (Profit & Loss) Statements. One P&L tracks costs for materials while the other one controls the VA targets. By using ABC methods each P&L and the total cost presented to the client will be much more in-line with the service level desired.

WHAT ARE THE MOST COMMON MISTAKES IN PROPER USE OF ABC COSTING?

Not keeping the Client in the process
Not using a team approach with talent from an Industrial Engineer and a Cost Accountant working together.
Not comprehending all of the costs. Examples include:
- PF&D (Personal, Fatigue & Delay) Comprehending the time used for rest rooms, training, smoking breaks, trips to the HR department, waiting for work, etc...
- SLA (Service Level Adjustments) Increased costs for meeting specific service level targets. Most often these are:
  - Batch Size: Work that can we worked as same unit flow can have lower SLA costs than work that must be worked in specified lots of a certain quality as they are received.
  - Inbound Delta: Estimates of inbound volume are usually made based on a steady average inbound rate. The problem is that work almost never arrives at X number of units each day. What will happen is that during a standard week the volume will vary between X and Y. As the TAT (Turn-Around-Time) requirements become shorter this becomes much more of an issue with costing.
- Training Costs: The ramp of a new business may have formal training in addition to some level of production inefficiencies as the newly trained staff become proficient.
- Materials Spoilage: No matter what you do-there will be spoiled materials. At the beginning this will result from training. On a day-to-day basis this will happen from units that loop through the process as quality failures.
- Others:
  - Vacation Time
  - Overtime for business ramp
  - Variance of staffing agency markup vs. direct hire benefits costs

OK I'M CONVINCED, HOW CAN I GET STARTED USING ABC?

The overall project plan to kick off an ABC initiative would focus on;

Setting the objectives to be achieved
Selecting the team of SMEs (Subject Matter Experts) at the very least this will be an IE and a Cost Accountant
The team conducting modeling and assessment of your current operations
Adjusting/tuning the model until the cost outcomes predicted from the model matches what your finance team is recording on the LOB's (Line of Business) P&L Statement.

In closing, much of RL business is based on outsource relationships and superior vendor performance. The promotion and growth of these relationships only results as we develop and standardized best practice for essential touch points for measuring performance needs and costs components. Having a well developed and proven ABC cost model is a chief requirement for the successful and sustaining award of RL business.