Case Total Cost of Ownership at 3M

Prof. Dr. Filip Roodhooft Vlerick Business School CC Accounting & Finance Email: Filip.Roodhooft@vlerick.be & An-Katrien de Vlieger Vlerick Business School CC Accounting & Finance Email: An-Katrien.deVlieger@vlerick.be

Reep 1, 9000 Ghent, Belgium Vlamingenstraat 83, 3000 Leuven, Belgium

This case was prepared by Prof. Dr. Filip Roodhooft and Ms. An-Katrien de Vlieger as the basis for class discussion rather than to illustrate either effective or ineffective handling of a business situation. Copyright 2006 Vlerick Business School.

Total Cost of Ownership at 3M

Prof. Dr. Filip Roodhooft An-Katrien de Vlieger

Background 3M (Minnesota Mining and Manufacturing Co.) was founded in 1902 at Two Harbors (Minnesota) by five entrepreneurial businessmen. The original focus of the company was digging up minerals, to produce abrasives for the automobile industry. Later on, they also started to produce tapes and the famous Post-it Notes. Today, 3M is an international company, operating in more than 60 countries and global sales of more than $20.000 billion. With 70.000 employees worldwide, the company produces 50.000 different products for the industrial, the consumer, the medical and the pharmaceutical sector.

New offer In 2005, external purchases represented 50% of 3Ms total cost. At its Specialty Materials site in Belgium (Antwerp), 3M purchases different packaging items (drums and pails) from several suppliers. November 2005, a company called VATMAN made an offer to 3M to become its single distributor for a range of 17 packaging items. The purchasing manager of 3M, identified this offer as an The aim of the opportunity to evaluate the Total Cost of Ownership (TCO) of these purchases, as it required evaluating additional services from this distributor against higher unit costs. purchasing manager was to evaluate the offer made by the distributor (the VATMAN scenario), by comparing its cost with the TCO of the current purchasing strategy (Business as Usual or the BAU scenario).

Activities BAU scenario In order to set up the Total Cost of Ownership model, the purchasing manager decided to start by defining the activities related to the external purchasing. He organized the activities into a matrix. The horizontal axis laid out the different steps in the procurement value chain, from initial acquisition, through reception and possession, all the way to utilization. He did not take into account elimination or recycling, as this step was the same for both scenarios. The vertical axis represented the 3 main levels, at which the costs were aggregated (supplier, order and unit level). In addition, the purchasing manager thought it useful to introduce a new level of activities: the product level. The costs at this level were no longer related to the number of product units, orders or suppliers, but were dependent on the number of products under consideration.

Currently, 3M is purchasing packaging items from several suppliers. Managing these suppliers in order to acquire the necessary products involves a number of activities for audit, follow-up and evaluation purposes. Procurement managers periodically meet with suppliers to exchange The cost of resources needed for both the information and negotiate purchasing agreements.

planning and follow-up of orders are proportional to frequency or order placements. The reception of the ordered goods, is also made up of several activities. First, the security guard receives the truck driver for site permission and checks the delivery documents from the driver. In the warehouse, the receiving clerk will match the delivery documents to the order placed via the order number. If these correspond, he will assign 2 warehouse operators to unload the truck using a forklift. The items are transported on pallets to an outside storage area. Once the goods have been unloaded, warehouse operators perform a visual check of quality and quantity of all items, input the delivery information into the manufacturing computer system, and sign the delivery slip. Before the truck leaves the 3M site, the security guard performs a final check on the delivery documents. The accounting department receives and handles the invoices of each order. Taking into account the minimum order quantities as required by the suppliers and the use of economic order quantity calculations, 3M has established an optimal inventory level. The average inventory levels represent an opportunity cost due to the investment of capital in physical stock. To keep track of the actual inventory level on-site, a regular review is needed. A cycle count of all items on-site is performed on a monthly basis and the values in the manufacturing computer system (MCS) are adjusted accordingly. between the MCS and real values. same for each item. Incomplete reporting of used drums causes differences The amount of time needed for a cycle count is roughly the

Because the drums are stored outside, no warehouse costs are made, but due

to weather conditions, there is an estimated loss of 5% of the average items in stock. When the production department requests the needed drums, a warehouse operator delivers the items on pallets from the storage area to the production buildings and reports the used quantity in the MCS.

Activities VATMAN scenario In the VATMAN scenario, 3M accepts VATMANs offer and procures the 17 packaging items from this distributor. Because VATMAN is the preferred supplier for packaging items, 3M would no longer need to manage multiple manufacturers, which would result in considerable savings in supplier level costs. One yearly blanket order is negotiated with VATMAN based on the usage forecasts per item generated by the planning department. During the contract period, VATMAN is able to supply all items from stock and delivers three times a week, following the Just-in-time principle. The reception process will also be subject to some important adaptations. There will no longer be a need for a receiving clerk and the truck driver will do the unloading. The VATMAN truck driver also checks on the available items and evaluates the existing stock in order to define the next shipment.

The involvement of the truck driver is possible since the number of different truck drivers involved (2 or 3) will be limited. The accounting department receives an invoice from VATMAN every two weeks. Also, each month, the invoiced quantities are compared to the used quantities. As a result of the Just-in-time delivery policy, the average amount of items in stock is very limited. Furthermore, because the truck driver delivers the items directly to the production site, there are no extra pallet movements or loss of damaged items due to outside storage. As in the BAU scenario, the consumption of items is reported by the operator in the MCS.

Cost of activities After identifying the activities in the purchasing process, the purchasing manager determined the cost of each activity by measuring its resource usage. According to the purchasing manager, the rows in the new TCO matrix of 3M, referring to the cost hierarchy, provide a useful framework for doing so. Supplier level: The average total time purchasing managers spend in managing suppliers and negotiating contracts multiplied by the cost of a manager was estimated at 1.850 per year. In the BAU scenario, 3M used 10 suppliers. For the VATMAN scenario, it can be assumed that the cost for managing this single supplier is the same. The cost of a single blanket order1 is 50. Product level: 3M currently spends one hour per month to count the actual amount of each item in stock. The standard hourly labor rate for all 3M employees, including managers and staff, amounts to 50 per hour. In the VATMAN scenario, 3M spends one hour on forecasting the monthly demand for each product. The time needed for the monthly review of invoiced versus used products is also estimated at one hour for each product. Order level: To calculate the costs to plan, place, and follow-up on orders in the BAU scenario, based on minimum stock quantities, supplier lead times, and minimum order quantities, the average time spent on a single order was estimated for the different products. Exhibit 1 shows the calculations, taking into account the hourly cost of a purchasing manager and the average numbers of orders per year. The reception costs for the BAU scenario are estimated in exhibit 2. In the VATMAN scenario however, the security guard check and the invoicing process are the only activities related to the deliveries performed by 3M. There are 156 deliveries per year in the VATMAN scenario and the cost to perform a check by the security guard is 5 per delivery. Every two weeks, an invoice is received for six deliveries. Since the invoices have to be compared to the

Blanket order: A contract under which a vendor agrees to provide goods or services on a purchase-on-demand basis. The contract generally establishes prices, terms, conditions and the period covered (no quantities are specified); shipments are to be made as required by the purchaser.

delivery documents, the cost of the invoice per delivery is estimated to be the same as in the BAU scenario. Unit level: The most important cost at the unit level is the price. The prices are illustrated in exhibit 3. In terms of the cost related to the possession of the purchased products, the inventory holding costs per item can be calculated as follows: Inventory holding costs = average-items-in-stock*price-per-item*cost-of-capital The cost of capital is 25%. Since 5% of the items in stock are damaged and can be written off due to weather conditions, the associated damage costs per item can be calculated as follows: Cost damage = 5%*average-items-in-stock*price-per-item Since VATMAN offers a Just-in-time delivery policy, the holding costs can be neglected in this scenario and no outside storage is necessary; hence, no items are damaged due to weather conditions. For the same reason, internal transportation of pallets from the storage area to the However, the current cost of one Finally, the cost of reporting the consumption of the production buildings is unnecessary in the VATMAN scenario. pallet movement is estimated at 30.

purchased items in the manufacturing computer system is 0,01 per item

Exhibit 1: Order level costing - Acquisition Supplier Item A sABCD B C D sEF sG sHI sJK sLM sN sO sP sQ E F G H I J K L M N O P Q Orders/year 1,3 11,3 1,5 25,3 7,6 0,4 1,7 2 7,7 7 1,1 0,4 70,7 3,7 2,9 1,7 8,3 Hours/order 1,3 0,1 1,1 0,1 0,3 5 0,2 2,5 0,8 0,4 2,4 2,5 0,02 0,7 1 5 1

Exhibit 2: Order level costing - Reception Activity Check by security guard Document matching and assignment of two warehouse operators Unloading of truck and visual quality inspection Quantity inspection and delivery slip is signed Check by security guard before leaving site Handling of invoice Total Hours/order 0,1h 0,2h 2*2h 0,1h 0,1h 0,2h 4,7h

Exhibit 3: Unit level costing Quantity/yr (2002) 384 3359 452 7500 1910 100 2410 200 615 Avg inventory (BAU) 200 350 200 400 350 300 700 100 500 Items per pallet 8 8 8 8 8 8 30 15 8 Price () (BAU) 21,01 21,92 25,55 24,24 13,36 10,29 2,53 7,26 8,23 Price () (VATMAN) 23,73 24,64 28,27 26,96 16,12 13,05 2,718 7,354 8,418 Price increase 13% 12% 11% 11% 21% 27% 7% 1% 2%

Supplier

Item A B C D E F G H I

sABCD

sEF sG sHI

sJK sLM sN sO sP sQ

J K L M N O P Q

1400 210 200 21000 730 500 100 500

200 60 250 400 350 400 60 120

8 10 10 8 32 8 1 1

25,79 12,87 6,89 21,94 9,47 29,33 108,2 124,8

28,55 15,63 9,65 24,7 9,845 29,68 120,2 136,7

11% 21% 40% 13% 4% 1% 11% 10%