The greatest misconception about cost management in procurement today is that price reductions equal cost savings. To help you make better informed sourcing decisions, this white paper reviews the danger of placing too much importance on unit costs and the benefits of working with a supplier who truly understands all the factors that influence the supply chain’s effectiveness and efficiency.
In this highly competitive marketplace, procurement has a natural tendency to select the cheapest suppliers, and does so with the best of intentions. After all, isn’t that the best way to save the company some money?
Not necessarily. The problem is that price reductions alone rarely equate to real cost savings, because they only apply to unit costs and have limited or no effect on the hidden costs associated with inventory management, rush shipments, product redesigns, product failures, or unscheduled downtime, to name only a few of the risks associated with the cheapest price.
On the other hand, any chief financial officer will tell you that real cost savings should be reflected in the company’s bottom line. So if we measure the bottom line and this is not the case, there are simply no true cost savings. Worse, some price reductions may actually have the opposite effect. That is indeed the case when the low-cost supplier delivers the parts too early or too late. Having items sitting idle on the shelf will undoubtedly increase the cost of inventory, and delivering the merchandise too late will likely result in some lost business or increased transportation costs for rush shipments, or worse, costly downtime with higher work-in-process (WIP) inventory as they wait for the late parts.
The question is: how can procurement avoid this type of situation? It all starts with a better understanding of how the effectiveness of the supply chain impacts the bottom line.
Supply Chain Management (SCM) is commonly defined as the process that spans all movement and storage of raw materials, WIP inventory, and finished goods from point of origin to point of consumption.[i]
So, in order to increase the effectiveness of the supply chain, procurement should take into consideration how sourcing decisions impact:
Let’s look at each of these hidden costs in more detail.
Impact on the quality and design of the product
Poor quality affects everything downstream: the rate of returns by unsatisfied customers, the cost of inventory (defective products don’t sell that well), profit margins (when the products need to be sold at a discount or be scrapped), your business’s reputation, etc. Naturally low-cost suppliers always promise products of equal or superior quality, so procurement may have to go through a period of trial and error, but over time procurement will realize that some suppliers stand out as offering consistently superior products. These are the relationships to nurture.[ii]
Also, the reality is that not all suppliers are created equal when it comes to solving design problems. While some suppliers may simply not have the capabilities—or the interest—to help your business address design flaws, others strive to improve a specific product’s design by suggesting a different material or by tweaking an existing design. Such modifications can significantly boost the performance of the end product or even lower the assembly and production costs. The cost savings associated with good design are often overlooked, probably because of the difficulty to quantify them, but they are nevertheless significant since by the time a product has been designed, the design has determined 80% of its cost.[iii]
Impact on the production schedule
Efficient organizations generally have an accurate production schedule for every machine, down to the minute. Consequently, when a supplier fails to deliver on time, the late delivery causes unscheduled production downtime, which is always very costly. This is more likely to happen if procurement has negotiated significant price reductions, because that supplier is now operating on very thin margins, so you are not exactly on his or her list of VIP customers.
Also, if the low-cost supplier operates on razor-thin margins, he or she runs a higher risk of going out of business, which again could significantly impact your production schedule, especially when dealing with custom parts. That is not a risk that every organization is willing to take.
Inversely, if the supplier is undercutting prices just to get the business, chances are the prices will go up over time. Unfortunately, you may be bound to that supplier for custom parts, at least until you go through the whole validation process again.
Impact on the product’s lead time
A product’s lead time is the amount of time it takes for a customer to receive a good (or service) once it’s been ordered. As indicated above, late deliveries can cause significant disruptions in the company’s production schedule. The options are then to either catch up on the delay, which may imply paying staff for overtime or paying extra for faster shipping, or to deliver the end product late. The first option decreases net profit margins and the second hurts customer satisfaction. Which one do you prefer?
Impact on inventory cost
Have a supplier deliver too early and the company will end up with excess inventory, which as everybody knows is extremely costly. Have a supplier deliver too late and the company may not be able to avoid stockouts, meaning that customers will simply look elsewhere to buy the product, a process the Internet has made easier than ever.[iv]
Procurement can avoid being caught between these two evils by negotiating Blanket Order/Kanban agreements with suppliers. Under this type of agreement, your supplier will maintain an agreed upon finished product inventory for you. These are products that are completely packaged and ready to ship. Similarly, your supplier may maintain semi-finished products ready to replenish the finished product inventory. Naturally, these types of services bear an additional cost, but they can by far offset the costs—and the risks—of excess inventory or stockouts.
Impact on shipping costs
When procurement selects a supplier who is either unreliable or unable to adapt rapidly to changes in demand forecasts, this inevitably translates into higher freight costs for either expedited orders or rush shipments to customers.
Also, if you are using low-cost country sourcing —selecting suppliers from China or another low-cost country—you would have to ensure that the potentially longer lead time would not negate the initial estimate of cost savings.
Impact on cash flow
Naturally, all the factors mentioned above also have a negative effect on cash flow, because they generally translate into unforeseen expenses or because of the opportunity cost of carrying excess inventory, meaning that the money tied up in inventory could have been invested elsewhere and yielded better returns. Not to mention that one dollar saved in total cost is equal to ten dollars of new sales.
It is easy to assume the lowest unit cost is the most economical choice, but the reality of the supply chain’s effectiveness is far more complex.
More often than not, the hidden costs associated with the risk of supply-chain disruption outweigh the money originally thought to be saved.
What also exacerbates the problem is that procurement compensation, in particular bonuses, is generally tied to savings in the cost of a unit. When that is the case, procurement and the finance/accounting departments are working with diametrically-opposed performance metrics, without realizing it. Thus the importance of agreeing on cost-savings reporting standards with management.
Fundamentally, procurement needs to view the supply chain as a whole and adopt a more collaborative approach with suppliers to determine the optimal mix of unit price, performance, reliability, and supplier responsiveness, as well as speed or time-to-market, because ultimately this is what drives company profitability.
[i] Wikipedia. Supply Chain Management http://en.wikipedia.org/wiki/Supply_chain_management (accessed October 26, 2011)
[ii] Ireton, Sara. 10 Factors to Consider When Sourcing Globally
http://www.joc.com/2010/10-factors-consider-when-sourcing-globally (accessed October 26, 2011)
[iii] Anderson, Dr. David. M. 2010 Design for Manufacturability http://www.design4manufacturability.com/DFM_article.htm (accessed September 22, 2011)
[iv] Demand Planning and Inventory Control http://www.web-books.com/eLibrary/NC/B0/B64/059MB64.html (accessed October 26, 2011)