Cost Breakdown Analysis
The Final Frontier in Cost Cutting
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Cost Breakdown Analysis
Rising input costs, coupled with increasing
global competition, often adversely impact
profits. Intense global competition leaves little
or no room to raise prices of goods and services
at par with the rise in input costs. The only way
forward to achieve a better top and bottom
line is to reduce or control costs. A prerequisite
for implementing high-impact Cost Reduction
Program is to develop a consistent and end-toend visibility of all input costs.
Input cost visibility can be obtained using a
technique called Cost Breakdown Analysis. It is
the process to build up and understand the
elements that compose the cost of a product or
service procured. For an organization's senior
management, Cost Breakdown Analysis is an
effective technique that helps evaluate
competitiveness of current prices and the
economic impact of executive decisions.
Definition: Cost breakdown analysis is the process to build and understand the elements that compose the
cost of a product or service. This technique is also referred to as Clean Sheet Costing, Open Book Costing,
“Should-be” Cost Analysis, Teardown Analysis, Price Breakdown Analysis or Supplier Cost Analysis.
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Cost Breakdown Analysis
The Approach to Cost Breakdown Analysis (CBA):
Though many supplier relations are moving
toward strategic supply alliances, traditional
arm's length relationships still exist. In such a
situation, the purchaser must discover the
main drivers of the supplier's costs to
demand competitive pricing. Even within a
strategic supply alliance, in which both
companies jointly study costs and cost drivers
to reduce material costs, it is necessary for the
purchaser to be aware of supplier's costs.
Cost Breakdown Analysis is a Four-step Approach.
GEP Approach
1. Data Collection
Collect Data
using either one
or all of the
following sources:
• ERP
• Spend Analysis
• Invoices
2. Systematic Expansion
of the six key cost
components to include
all relevant costs
Identify and Expand all
relevant costs which
were incurred among
the following areas in
providing the product
or service:
• Materials
• Labor
• Conversion Costs
• Overheads
• Logistics
1. Data Collection:
The product or service data to be analyzed under
the CBA framework is identified by obtaining
information through the following data sources:
 Enterprise Resource Platform (ERP)
 Procurement Systems
3. Determine
To determine the cost drivers
and units for a product or
service use the following
sources:
• Experts
• Open Data Sources
• Internal Databases
• External Third party
databases
4. Develop Insights
Summarize the Cost
Breakdown
Approach to analyze
and benchmark the
data to develop
insights which will
help improve value
for the client
business.
2. Systematic Expansion of the Key Six
Cost Components:
Once the service or product procured to be
analyzed is identified, it is important to expand all
components that comprise the following six key
cost elements.
 Supplier Invoices
 Spend Analysis Summaries
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Cost Breakdown Analysis
Product/Service Procured Costs
Materials
The price of the materials can be obtained
through the use of sources such as:

Labor
Conversion Costs

Overheads
Logistics
Profit


Market situations and price trends for
product in consideration
Prevailing and historic commodity
markets prices
Estimation for the product/raw materials
in question
Internal benchmarks
b) Labor:
3. Determine Drivers of Cost/Unit:
The drivers can be determined by identifying
all cost/process factors, in addition to the
derived costs to manufacture the product or
provide the service:
To estimate the cost of labor, you need to
know the number of workersl used in the
manufacturing process, the hours worked on
the process and the average wage rate.
To determine the above factors, it is
important to identify the following labor
specific characteristics:
a) Materials:
The bills of materials or design and production
specification documents providea list (and
quantity) of materials consumed in the
product. The relevant information can be
obtained through:





ERP/MRP systems
Research of open market sources
Internal consultant databases
Interviews with experts / primary research
Professional associations
If you cannot obtain these documents you may
have to reverse engineer the product. This
means that you disassemble the product to
determine all the cost of materials in it. In case
of liquid products, you can use gas
chromatography to separate all chemicals used
in the final mix.


Technology employed by the
manufacturing process level of process
automation
Skill requirement and eligibility for the
personnel to produce a product such as
education, expertise, training, etc
To obtain accurate estimates of the total
annual labor, costs can be multiplied with
adjustment factors such as vacation and
supervision. All information required to
accurately compute the cost of labor can be
obtained from the following sources:





Independent primary research
Professional associations
Experts
Secondary research
Supplier visits
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Cost Breakdown Analysis
c) Conversion Costs:
Conversion costs include all the activities
associated with the physical process of
conversion of raw materials into finished
goods. The costs include manufacturing
process and cycle time costs, utilities,
depreciation, maintenance and all other
ancillary activities related to manufacturing
the product.
Manufacturing process costs refer to costs of
activities like machining (e.g., turning,
drilling), finishing (e.g., honing, milling),
preparation (e.g., heating, mixing) and
processing (e.g., printing, cutting).
It is important to identify the appropriate
drivers and units that form the key
components of the conversion process. For
example, using $/M Sq.Ft or $/M pieces as
unit for cost drivers could lead to very
different results while performing price
sensitivity analysis.
To effectively analyze conversion costs, it is
important to develop detailed process maps of
all activities involved in manufacturing a
product. It is also important to develop an
understanding of all additional costs incurred
during the manufacturing process, such as
time taken to complete a process, throughput,
cost of machinery, set-up costs, machine
maintenance costs and associated depreciation
rate. Understanding all the above can be
confirmed by soliciting expert opinion in
consultation with the supplier.
d) Overheads:
Typical overheads include all non-operating
expenses incurred in the manufacture of a
product. It can include expenses such as:


Plant overheads
Selling expense




Executive compensation
Design and development expenses
Administrative expenses
Rent, leases , etc.
Plant overheads include all the indirect costs
associated with the production of a product or
service. This term encompasses many different
elements, depending on the company and the
industrial sector. Generally items include:



General plant burden
Overtime
Plant administration
As there exists no formal method of allocating
such expenses, overheads can be estimated as a
percentage of the labor costs incurred to
manufacture a product.
It is difficult to attribute the exact overhead
expenditure incurred for manufacturing a
product. A common approach is to estimate the
expected expenditure as a percentage of
revenues. If the supplier's financial statements
are available, it is reasonable to assume that
overhead expenditure on the products sold is in
the same proportion as that of the overall
corporate entity. If financial statements are not
available, then a reasonable estimate can be
made by assuming that incurred expenditure is
similar to industry average.
e) Logistics:
Logistics comprise the following costs:




Custom clearance
Transportation
Warehousing
Distribution
Each of the aforementioned cost elements can
be influenced by specific factors. For example,
custom clearance as costs is dependent on the
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Cost Breakdown Analysis
importing country's prescribed rules
and regulations.
Transportation and distribution costs incurred
are dependent on:




The distance travelled in moving goods
from the production centre to the
consumption centre.
The mode of transportation, such as
inland water transportation, ocean water
transportation, air, train or road.
Warehousing cost is dependent on
volume of goods stored, type of goods
stored and the length of time for which
the goods were stored.
Finally, all of the above are also affected
by the nature of goods procured and the
frequency of procurement.
f) Supplier Margins:
The last cost-driver is supplier margins, as even
suppliers must earn profit that is
commensurate with the market conditions and
industry structure. Any adjustment to supplier
margins in relation to observed industry
averages can be made by taking the existing
relationship into account, willingness to do
business, and product / service differentiation.
4. Strategic Benefits from the Approach:
The over arching aim of the analysis is to answer
the following questions: Are we buying the right
products and services?
How do we proactively control costs and
derive competitive advantage through our
procurement practices?
Since the CBA exercise is done largely based on
industry level averages and estimates, the results
can be used to measure competitiveness of our
procurement costs with respect to industry peers.
Comparative analysis across suppliers, SKUs and
geographies helps us craft informed negotiation
strategies to lower purchase prices and minimize
overall procurement costs. The increased visibility
that the technique provides assists in controlling
costs on an ongoing basis.
Are we buying the right products and services?
Many organizations understand very little about
what they buy. The impact that this has on the
organization's product quality and cost
competitiveness can be immense, depending on
the criticality of the product/service being
procured. Cost breakdown analysis is a good way
to increase the understanding of what is being
procured, and its impact on the business. The
process gives a greater insight into the
manufacturing process, and an understanding of
all inputs needed to convert raw materials into
the final procured product.
This can help review current specifications and
service levels, and reduce the excesses and
inefficiencies.
How does our supplier alliance impact
competitiveness?
In this age of integrated supply chain and colocated vendors, suppliers and customers are
extremely inter- dependant. Procurement is not
just about reducing costs. It is also about aligning
your supplier to become your partner in success.
Cost Breakdown Analysis is very useful in the
supplier development process. The knowledge
obtained through the CBA exercise helps
organizations understand strengths and
weaknesses of their suppliers. It also helps to
evaluate existing and potential suppliers on the
basis of their operational capabilities (technology,
level of automation, etc.) and their fit with the
organization's requirements. Additionally, Cost
Breakdown Analysis helps to develop a
long-term supplier strategy for the category
(e.g., competitive sourcing vs. collaborative
vendor development).
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Cost Breakdown Analysis
CASE STUDY: 1
During a performance benchmarking exercise for a leading international food processing company,
consultants used the cost breakdown analytical methodology to systematically reverse-engineer all costs
incurred in the procurement of flour (intermediate product), in addition to batter (final product).
Part1: Cost Breakdown Analysis of Flour
(Ingredients for batter)
$540
Current Flour Cost
$527
Est. Flour Cost
$27
Profit
Taxes and Duties
$12
Admin Charges
$60
Logistic
$8
Amortization of Equipment
$11
Maintenance
&Repairs
$5
$14
Energy Charges
Milling Costs
$22
Labor
Cleaning Costs
Wheat
$51
$19
$300
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Cost Breakdown Analysis
$1,080
Current Batter Cost
$1,054
Est. Flour Cost
$105
Profit
$38
Taxes and Duties
$76
Admin Charges
$36
Logistic
Amortization of
Equipment
$21
Maintenance &
Repairs
$9
Other Ingredients
$21
RESULT
Additives Costs
$76
Energy Charges
$79
Labor
Flour
Based on the analysis, we were able to
realize 6 per cent reduction in batter prices,
using the following approaches:
o Standardize some batter recipes to
increase economies in conversion
$67
$527
o Negotiate more effectively with the
supplier to bring down costs in
specific areas
o Conduct negotiations on behalf of batter
manufacturer to reduce procurement
costs of the purchase of flour
INSIGHTS
The analysis revealed the following:
o Current batter prices were at least 5 per
cent higher than estimated costs
o A savings opportunity existed with flour,
as well as batter conversion costs
o There was no visibility into wheat costs
and the cost of additives as the recipes
were confidential and shared by end
customers directly with the batter supplier
o Work with end customers to implement a
variable cost model that would compute
wheat and additive costs based on hidden
recipe formulas, hence increasing visibility
of costs without breaching confidentiality
o Index the prices of wheat to the market
o Introduce a price list mechanism for
additives, reviewed quarterly
o Work with the supplier to separate
packaging transportation and storage
from conversion cost
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Cost Breakdown Analysis
CASE STUDY: 2
While executing a spend analysis project for a leading beverage manufacturer, consultants at GEP
noticed a high spend across three high-value SKU categories. Using the cost breakdown analytical
framework, we observed the following cost structures:
Cost Breakdown Analysis of three SKUs
INSIGHT:
100%
90%
The cost breakdown variance between
different SKUs indicated that the design
specifications had a significant impact on the
end product price, hence the need to
increase visibility of price at an SKU level.
Also, comparative analysis of each of the
suppliers across the three SKU categories
identified significant opportunities to
improve processes and to reduce margins
through systematic negotiations.
80%
70%
60%
50%
40%
30%
20%
10%
RESULT:
0%
SKU 1
Cost component
Substrate Cost
Total Ink Cost
Total Coating Cost
Additional Ink Cost
Machine Set Up Costs
Raw MaterialConversion Costs
Cutting Costs
Packaging Costs
Inspection Costs
Other Overhead
Transportation
Profit Margin
Supernormal Profit
Quoted Price
SKU 2
SKU 3
SKU 1
33%
0%
8%
1%
8%
31%
SKU 2
41%
3%
10%
3%
3%
17%
SKU 3
41%
4%
10%
4%
3%
17%
1%
4%
2%
4%
1%
5%
0%
100%
1%
3%
3%
6%
1%
5%
2%
100%
1%
3%
3%
5%
1%
5%
2%
100%
To determine an appropriate pricing for the
SKUs, a Request for Pricing with a variable
price model was developed to capture each
detailed cost component. Using the
information collected, the most competitive
prices across suppliers were applied to each
component to develop best case price. The
process not only provided more visibility into
the individual cost components, but also
developed an informed negotiation
strategy to realize 13 per cent savings in
procured costs.
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