SOURCING DECISIONS’ IMPACT ON THE BOTTOM LINE

HOW SELECTING THE RIGHT SUPPLIER CAN HELP YOU STAY AHEAD OF THE COMPETITION
As worldwide competition intensifies and more and more manufacturers try to compete on price, this white paper reviews the impact sourcing decisions can have on a company’s bottom line and explores the benefits of working with value-added suppliers.

THE DIFFERENCE BETWEEN COST SAVINGS AND PRICE REDUCTIONS
In this highly competitive marketplace, your company’s purchasing department is probably driven to select the lowest bidders, 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.

As you know, 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.

Let’s look at some of these hidden costs in more detail to gain insight into how the purchasing department’s decisions impact the company’s bottom line.

THE RIPPLING EFFECTS OF THE PURCHASING DEPARTMENT’S DECISIONS

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, but unless procurement is buying pure raw materials, these decisions are often more complex than they seem. For example, procurement may be tempted to switch to a supplier that offers a similar part at a lower price without realizing that the cheapest part uses a different kind of rubber that does not meet the same tolerance requirements, such as the ability to withstand cold temperatures. As a result, the end product may require increased maintenance or may simply not meet the required life cycle.

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. Product design may only account for 5% of a product’s total cost, but it dictates 75% of the product’s total manufacturing cost. Therefore, it becomes critical that designs are done right, the first time. [i]

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.

Besides, 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 procurement goes through the whole validation process again.

Impact on the product’s lead time
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. [ii]

You can avoid being caught between these two evils by asking procurement to negotiate Blanket Order/Kanban agreements with suppliers. Under this type of agreement, the selected 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. As you would expect, 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 supply costs is equal to ten dollars of new sales. [iii]

CONCLUSION AND RECOMMENDATIONS FOR ACTION
True, to remain competitive on the marketplace, it is important to compete on price, but maintaining your competitive advantage involves other considerations as well such as being a value-centric organization.

First, you have to ensure that procurement compensation is tied to metrics that drive the right behavior. Typically, procurement is only being incented by lowering acquisition costs, whereas a better approach would be to agree on cost-savings reporting standards with Finance that take into account the impact on manufacturing and inventory costs.

The second problem, which is interconnected to the first one, is that procurement often operates in “cross-functional dysfunction,” meaning that the goals of the company’s various departments are in conflict. That is the case when procurement selects suppliers purely on price without measuring the outcome of the purchasing decision—higher customer returns, quality issues, production schedule disruptions, etc. —on the other departments. By the time someone diagnoses the problem, procurement’s “cost savings” may have cost the company millions. Collaboration between engineering, production, procurement and suppliers is therefore essential. Sometimes it is as easy as having the engineering and quality assurance departments establish a list of preferred vendors. They are the ones who usually deliver to spec, on time and who can add value throughout the whole product development process.

Last, but not least, you need to treat your suppliers like partners, sharing with them the problems that keep you up at night and making sure they understand your business. You may be pleasantly surprised by the solutions they bring to problems you probably did not even know you had. [iv]

Ultimately, it is this type of vendor relationship you want to nurture because this is what leads to a more sustainable competitive advantage than price cuts alone.

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[i] GlobalSpec. http://www.globalspec.com/Feat... (accessed November17, 2011)

[ii] Demand Planning and Inventory Control http://www.web-books.com/eLibr... (accessed October 26, 2011)

[iii] Ohri, Ajay. 2010 A Career in Supply Chain Management http://www.coolavenues.com/mba... (accessed November17, 2011)

[iv] Thull, Jeff. 2006 Is Your Purchasing Department Stripping Value Along With Reducing Costs http://www.salesvantage.com/article/937/Is-Your-Purchasing-Department-Stripping-Value-as-They-Reduce-Costs- (accessed November17, 2011)