Economics

Chapter 9: Managing Costs Across the Supply Chain—The Financial Perspective

Overview

Death, taxes, rock and roll, and the need to reduce costs are all part of a small set of things we know we can always count on. In fact, it is safe to say that unless you work for a university, the government, or certain parts of the health care system, the need to reduce costs will always be relentless and severe. Fortunately, an abundance of techniques are available to help manage costs across the supply chain.

The time has come to view the set of techniques and approaches for managing costs broadly rather than narrowly. This chapter presents a set of techniques you have likely not seen and do not readily recognize.1 In no particular order of importance, this chapter presents some creative ways to manage supply chain costs. While these techniques all rely on cost or financial data for their use, this is one chapter where the presented techniques are not taken from finance.

Learning Curve Cost Models

We have probably all undertaken a task that, as it is performed repetitively, takes progressively less time. What is happening is that learning is taking place. Learning curve models are based on the principle that as individuals become more familiar with a task, the average amount of direct labor required to perform that task or process declines at a predictable rate. The predictable rate is the learning rate or curve. A supplier that experiences learning during production should be in a position to provide a continuous stream of price reductions.

A learning rate is the predictable reduction in direct labor requirements as production doubles from a previous level. A 90 percent learning curve, for example, means that the average direct labor required to produce an item decreases by 10 percent as volume doubles from one level to another. An 80 percent learning curve means the average direct labor to produce an item decreases by 20 percent as production doubles from a previous level. At most firms, learning curve analysis is applied internally. Applying the concept to a supplier's price, particularly during negotiations, is not practiced nearly as often.

Learning curves apply only to the direct labor portion of production costs, even though the term is often used more broadly (and incorrectly). Learning curves also do not apply to simple items or items where the supplier has extensive experience. Even if an item is new to the buyer, it may not be new to the supplier.

Learning curve analysis works best when a supplier is producing a complex item for the first time. Also, the identification of an incorrect learning rate will skew the estimated improvements, as a supplier moves along the learning curve. And, do not expect to go back to a supplier after six months or a year with a new order and expect to see productivity at the same level as where the previous order left off. Something called the forgetting factor must be considered.

Table 9.1 shows how to estimate a price change due to learning. While material changes may result due to higher volumes, the learning curve analysis only concerns itself directly with changes due to direct labor requirements. However, the reader might notice several other secondary effects that will further reduce a purchase price. First, if a supplier applies overhead as a percent of direct labor (not an uncommon approach when a supplier lacks an activity-based costing system), the overhead allocation will be reduced since the amount of direct labor is reduced. This is legitimate since the product is consuming less labor and machine time. We might also see a reduction in the amount of profit per unit. Again, this is acceptable since the profit margin, which remains constant, is applied against a lower total cost base.

Table 9.1: Learning curve illustrated

A company submits an order to a supplier for 200 units of an item not previously produced by this supplier. Studies by industrial engineers reveal the learning curve for this type of item to be 90 percent. The supplier provides the following per unit information:

Materials

$40

Direct Labor

$60 (3 hours on average per unit @ $20 per hour)

Overhead

$90 (150% of direct labor)

Total costs

$190

Profit

$19 (10% of total costs)

Per Unit Price

$209

Analysis:

Step 1: Estimate the Average Hours per Unit

If the 200 unit order requires an average of 3 hours of direct labor per unit, then a doubling of production to 400 units should require 90 percent (i.e.,.9) of 3 hours, or 2.7 average hours per unit.[*] A doubling to 800 units should require 2.43 average hours per unit (.9 × 2.7 average hours). A further doubling of units to 1,600 units should require 2.19 average hours per unit (.9 × 2.43).

Step 2: Calculate the Direct Labor Hours Required to Make 1,200 Units

Producing 1,600 units should require 2.19 average hours per unit, or 3,504 total hours (1,600 × 2.19 average hours per unit). The first 200 unit order required 600 hours (3 hours on average × 200 units).

The total direct labor hours required for the next order of 1,200 units will be 3,504 (the total hours to produce 1,600 units) - 600 hours (the total hours already consumed to make the first 200 units), or 2,904 direct labor hours.

Step 3: Calculate the Direct Labor Costs for the 1,200 Unit Order

2,904 direct labor hours × $20 per hour direct labor costs means the next order of 1,200 units will consume $58,080 in total direct labor costs. This equals $48.40 in direct labor costs per unit ($58,080/1,200 units).

Step 4: Calculate the Unit Price for the Next Order of 1,200 Units

For the next 1,200 units:

Materials

$40

Direct Labor

$48.40

Overhead

$72.60 (150% of direct labor)

Total costs

$161

Profit

$16.1 (10% of total costs)

New Per Unit Price

$177.10

[*]Recall that the learning curve principle states that average direct labor hours decline by a predictable rate (called the learning curve or rate) as volumes double from one level to another.

In this example the buyer calculates an expected price reduction from $209 to $177.10 per unit. Whether the supplier agrees to this price is open to debate and negotiation. This new figure provides a target to work toward with the supplier. Potential improvements in material costs due to greater volumes could further reduce this price.

If learning occurs and the buyer does not capture the cost benefits, then it stands to reason that the supplier will reap the benefits. A buyer must determine if an item will benefit from learning, and then factor that learning into the supplier's pricing. Learning curve is a well-established but not well-understood cost methodology among supply chain professionals.

Theoretical Best Pricing

This approach requires detailed cost data from suppliers to identify a theoretical best price (TBP). A TBP is the result of combining the best cost elements across a pool of potential suppliers. As with many cost topics, the easiest way to demonstrate this technique is with an example. In Table 9.2 the TBP given this set of costs and suppliers is $45.48 per unit. How was this arrived at? Notice in Table 9.2 that the lowest cost in each row is highlighted. The highlighted cells are added together to arrive at the theoretical price.

Table 9.2: Theoretical best price

Open table as spreadsheet

Supplier A

Supplier B

Supplier C

Direct Labor

$12.55

$12.78

$13.10

Direct Materials

$10.77

$10.33

$9.25

Overhead

$13.12

$12.78

$15.12

SG&A

$5.90

$5.75

$6.55

Profit

$5.05

$5.95

$5.50

Price

$47.39

$47.59

$49.52

Open table as spreadsheet

Theoretical Best Price = $12.55 + $9.25 + $12.78 + $5.75 + $5.05 = $45.38

Standardized against the best cost:

Supplier A

Supplier B

Supplier C

Direct Labor

1.0

1.02

1.04

Direct Materials

1.16

1.12

1.0

Overhead

1.03

1.0

1.18

SG&A

1.03

1.0

1.14

Profit

1.0

1.18

1.09

Price-to-best-price ratio

1.04

1.05

1.09

The use of this technique serves two purposes. The first is to arrive at a benchmark or target to measure an actual price against. A standardized performance ratio can be created that compares the actual price paid to the TBP. If the price paid for a component, for example, is $14.55 and the TBP is $12, the ratio is 1.21. This means the buyer is paying 21 percent more than the TBP. The second purpose is to identify areas where costs are out of line for each supplier or where possible improvement efforts should be directed.

The second part of Table 9.2 presents a standardized ratio of each supplier's cost within each row, compared with the best cost for that row. For example, Supplier C's ratio for direct labor is 1.04 ($13.10/$12.55). This means Supplier C's direct labor costs are 4% higher than the best cost across the three suppliers. Calculate and interpret all other ratios accordingly. The standardized ratio is an easy way to see what costs are out of line within each row.

Where do we get the data to calculate a TBP? Requests for proposal packages should include a supplier cost form that allows the development of a TBP table. Unfortunately, suppliers sometimes do not know their costs at a detailed enough level to use this approach. And, at times, some suppliers may not be willing to share this kind of information. Nevertheless, this is a technique worth pursuing.

Configured Sourcing Network

A configured sourcing network is not likely a familiar term to the reader. At times, a buyer will develop contracts with distributors that cover dozens, or even hundreds of items. When configuring a supply network a buyer analyzes price quotations from multiple distributors and configures a sourcing network based on the best quotes from each source. While the buyer may use more distributors than planned, the trade-off of developing a supply network that results in a lower total cost will likely outweigh the costs of maintaining additional suppliers.

Table 9.3 illustrates a configured sourcing network. In this example a buyer has requested quotes for six items from five distributors. (This analysis assumes there are no appreciable differences between the items across suppliers that would create significant price differences.) By analyzing the quotations the buyer can identify the best way (i.e., configuration) regarding how to source these items at the lowest total cost.

Table 9.3: Configured supply network

Open table as spreadsheet

Unit Costs:

Item/Part Number

Supplier A

Supplier B

Supplier C

Supplier D

Supplier E

123661 Gloves

$2.45

$2.76

$3.00

$2.40

$2.30

344296 High-density bulbs

$5.40

$4.95

$5.55

$5.32

$5.60

988373 Safety glasses

$6.59

$6.25

$6.75

$6.44

$6.50

746322 Pens

$1.25

$1.33

$1.43

$1.43

$1.20

854471 Soap

$7.70

$7.05

$7.55

$7.35

$7.60

777432 Paper

$3.12

$3.18

$3.23

$3.40

$3.52

Note: Shaded areas represent the lowest price for each part number/item across each row.

Open table as spreadsheet

Total Dollars Based on Volume:

Annual Volume— Units/Pounds

Supplier A

Supplier B

Supplier C

Supplier D

Supplier E

123661 Gloves 25,000

$61,250

$69,000

$75,000

$60,000

$57,500

344296 Light bulbs 14,000

$75,600

$69,300

$77,700

$74,480

$78,400

988373 Safety glasses 5,000

$32,950

$31,250

$33,750

$32,200

$32,500

746322 Pens 25,000

$31,250

$33,250

$35,750

$35,750

$30,000

854471 Soap 5,000

$38,500

$35,250

$37,750

$36,750

$38,000

777432 Paper 8,000

$24,960

$25,440

$25,840

$27,200

$28,160

Total

$264,510

$263,490

$285,790

$266,380

$264,560

Each cell = (price from the first table) × (volume).

The sum of the shaded areas represents the configured supply network total cost, or $248,260 ($248,260/$263,490) = almost a 6% total price improvement.

An important part of this analysis considers annual volumes, which Table 9.3 illustrates. The importance of accurate demand estimates cannot be overstated. The best annual cost, based on quoted prices is Supplier B at $263,490. Dividing the six items among three suppliers (Suppliers C and D did not qualify for any items) yields an expected configured network cost of $248,260, which is about a 6% price improvement over Supplier B's quotation. The question now becomes whether it is worth the 6% difference to use three suppliers instead of one.

A major assumption when using this approach is that the prices that each supplier quotes are independent of each other. This means a quoted price for one item is not contingent upon agreeing to purchase another item. This independence is what allows a buyer to selectively pick and choose items and distributors. While this example is for a single buying location, the concept can be extended to identify which distributors should supply different buying locations. A buyer may be dealing with hundreds of items from multiple distributors that are being shipped to different locations.

The benefits from this approach are usually worth the effort. Imagine a company with $100 million in indirect spending with distributors that achieves a 6% total annual savings due to a configured sourcing network. Realizing $6 million in savings (less the increased supplier management costs) is not bad for a few weeks work.

Comparisons to External Indexes

This approach features the use of objective, third-party information to verify that the prices paid are reasonable, given actual changes in a marketplace. One website that supply chain managers should become familiar with is www.bls.gov. This site, maintained by the U.S. Bureau of Labor Statistics, contains a wealth of free data and information. It is worth exploring; it is, after all, your tax dollars at work.

Along the top menu bar of the bls.gov website is a category called Data Tools. Simply click on that icon and scroll down until you see Prices Producer. The user now has the choice to select between industry data and commodity data. According to the Bureau of Labor Statistics, a Producer Price Index (PPI) for an industry is a measure of changes in prices received for the industry's output sold outside the industry (that is, its net output).

The PPI publishes approximately 535 industry price indexes in combination with over 4,000 specific product line and product category sub-indexes, as well as roughly 500 indexes for groupings of industries. The PPI's commodity classification structure organizes products and services by similarity or material composition. This system is unique to the PPI and does not match any other standard coding structure. In all, PPI publishes more than 3,700 commodity price indexes for goods and about 800 for services—organized by product, service, and end use.2

Let's illustrate the use of a PPI table and index. Assume you are a buyer of motor vehicle parts to support your company's fleet operations. One of your primary parts suppliers has informed you that his prices will likely go up next year by 6%, reflecting increases in labor and material costs. Without even looking at the supplier's labor and material cost elements, the PPI might provide some insight into whether this increase is realistic.

Table 9.4 presents the PPI for motor vehicle parts. An attractive feature of this tool is that these tables can be easily downloaded for analysis in Excel. A critical point to understand is that the numbers in this table are not prices. They are index numbers for the particular item compared to a base year when the index was established at 100. This particular table was established with an index value of 100 in December of 2003 (Base Date: 200312). The P in the table means the data are preliminary and subject to possible revision.

Table 9.4: Producer price index for motor vehicle parts

Open table as spreadsheet

Series Id: WPU141205

Not Seasonally Adjusted

Group: Transportation equipment

Item: Motor vehicles parts

Base Date: 200312

Year

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

2005

101.1

101.2

101.1

101.0

101.2

101.1

101.4

101.5

101.6

101.6

101.9

102.1

2006

102.4

102.7

103.2

103.9

103.9

104.3

104.8

105.1

105.2

104.9

105.1

105.1

2007

105.2

105.0

105.0

105.4

105.6

105.8

105.9

106.0

106.0

105.9

106.0

106.1

2008

106.0

106.0

105.8

106.2

106.5

106.7

107.7

108.1

108.5

108.7

108.7

108.7

2009

108.6

108.3

108.3

108.3

108.4

108.2

107.9

107.7

107.9

108.3

108.2

108.4

2010

108.2

108.3

108.3

109.4

109.3

109.3

108.7

109.5

109.5

109.5

109.5

109.5

2011

109.9

110.3

110.5

110.8

110.9

111.0

111.4

111.9

111.5

111.6

111.5

111.5

2012

111.6

111.6

112.0

112.1

112.1

112.1

112.2

112.2

112.2

112.3

112.8

112.9

2013

112.9

112.7

112.8

112.7

112.6

112.6

112.6

112.7

112.6

112.5

112.5

112.5

2014

112.7

112.6

112.6

112.5

112.6

112.7

112.7

112.6

112.7

112.8

112.8

112.6(P)

2015

112.7(P)

113.0(P)

113.1(P)

P: Preliminary. All indexes are subject to revision four months after original publication.

The first thing the reader should notice is the stability of the data index numbers. In fact, from January 2014 (Index = 112.7) to March 2015 (Index = 113.1) there has been almost no change in overall price index for motor vehicle prices. Since the index was established in December 2003 (Index = 100), the net increase in motor vehicle prices over a 12-year period has been a paltry 13.1% ((113.1 - 100)/100). That is just over a 1% increase per year.

Is the supplier in this case justified in seeking a 6% price increase? That request is clearly not in line with what we are seeing in the price index. Perhaps this supplier is not managing costs well or is possibly trying to slip in a price increase. It is possible the supplier might provide an item that uses raw materials that are experiencing pricing pressures. After all, motor vehicle parts are a broad category. The point here is the supply manager now has objective data to have a heart-toheart talk with the supplier.

Target Pricing

A traditional approach to pricing generally assumes that the starting point in arriving at a price is the combination of costs associated with producing an item. A traditional pricing approach would be to add up the costs associated with producing an item, add on a desired level of profit, and arrive at a total cost figure that then determines the selling price. Unfortunately, this selling price may not be what the market was expecting. When a company quickly offers rebates or discounts on a new product, this is a clue that perhaps the selling price missed the intended market segment.

A different approach is called target pricing (also called target costing). This method involves (1) identifying the price at which a product will be competitive in the marketplace, (2) defining the desired profit to be made on the product, and (3) computing the target cost for the product by subtracting the desired profit from the competitive market price. The target cost is then given to engineers and product designers, who use it as the maximum cost to be incurred for the materials and other resources needed to design and manufacture the product.3 It is their responsibility, usually working with procurement and suppliers, to create the product at or below its target cost. Product developers work closely with marketing to identify a selling price that matches customer expectations. Target pricing employs the following formula:

Traditional Pricing

Target Pricing

Costs

Selling Price

+ Profit

- Profit

= Selling Price

= Allowable Costs

What happens after arriving at an allowable cost figure? Complex products are broken down into systems, subsystems, and components—each with an assigned cost that rolls up to form the total allowable costs. Eventually costs are managed at the component and production level. Often buyers and suppliers do not even negotiate prices. The price of a component is assigned as part of the target pricing process. The entire focus in target pricing is on cost management.

It is not unusual to find that actual costs are higher than what the cost model says is allowable. This is where the cooperative part of target pricing kicks in. A buyer's design teams and suppliers (internal and external) must work together to simplify a design or production process, search for alternate materials, use standard components instead of custom designed items, or apply any other approach that will reduce cost elements and cost drivers. It is also possible that savings from one part of a project can offset cost deficiencies in another part. A company may also decide to accept a lower profit margin, although that is not a preferred method.

A virtue of target pricing is that it is a disciplined approach to cost management. And, a secondary effect is that the process should result in less time-consuming and costly negotiation with suppliers. Buyers and sellers work cooperatively to achieve allowable costs. Costs are an output of the target costing process, not the negotiation process.

Employee and Supplier Suggestion Programs

A relatively easy way to gain access to cost reduction ideas is through employee and supplier suggestion programs. Thanks to web-based technology, the challenges surrounding supplier suggestion programs are no longer technical. The challenge is in making sure the resources are available to review and then act upon any suggestions. Ideas that remain idle are not valuable.

Firms that are serious about a supplier suggestion program must be willing to commit resources to evaluate the suggestions they receive. Often this means appointing a program manager or steering committee to oversee the process. It also means making engineers available to evaluate the technical merits of suggestions. It takes time to evaluate the hundreds of suggestions that suppliers will hopefully put forth. Suppliers will quickly become disinterested in any program they perceive is a black hole—sucking in ideas that are never seen or heard from again. Another challenge is convincing suppliers to participate.

Progressive firms recognize the important linkage between supplier suggestions and rewards. Rewarding supplier participation should lead to greater involvement with the program. Some firms evaluate a supplier's level of participation and include that in the supplier's scorecard rating. Other firms share any savings realized from the ideas, either directly as payments to the supplier, adjustments to the selling price that reflect the supplier's share, or as credits toward future cost reduction commitments. Direct payments require working closely with accounting since it is often difficult to write a check for suggestions rather than invoices. A later section in this chapter on cost-driven pricing will illustrate how to share savings with suppliers financially.

Best-practice organizations track the suggestions they receive, respond to suggestions in an agreed-upon time frame, and report to executive managers any savings that are achieved through the system. The suggestion system should serve as a central repository for all ideas received from suppliers and employees. Developing a suggestion program can be a cost effective way to manage costs. It is surprising that suggestion programs are not more common.

Value Analysis Workshops

Value analysis (VA), a continuous improvement methodology developed in the 1950s, evaluates the functionality of a product or service against its cost. Formally defined, VA is the organized and systematic study of every element of cost in a part, material, process, or service, to make certain it fulfills its function for the customer at the lowest total cost. It employs techniques which identify the functionality the user wants from the part, material, process, or service. The VA workshops and process are a combination of group problem solving, project management, kaizen workshops, and process redesign. In equation form, the concept of value is defined as:

Value = Function/Cost

The objective of VA is to increase value by affecting the numerator and/or denominator of the equation. It is a continuous improvement approach that is applied to existing products and services. (Value engineering is the counterpart of VA and is applied during new product and service development.) Like learning curve, VA has been around for quite a while. This does not mean it is not an effective way to manage costs.

VA benefits from a cross-functional team approach that may involve suppliers, customers, packaging, logistics, supply management, design and process engineers, marketing, accounting, and manufacturing. VA teams ask a series of questions to determine if the value that a customer attaches to a product or service can be improved. The types of questions asked, many of which apply to the cost portion (denominator) of the VA equation, include:

Are lower cost but equally effective materials available?

Can the design be simplified?

Are standard components available to replace custom-designed components?

Can improvements be made to the production process?

Can features be added to enhance functionality more than the associated cost increase?

Are lower cost suppliers available?

Is there any functionality currently included that the customer does not want?

Can packaging or logistics costs be reduced?

The VA process has five distinct phases. Results should be tracked closely, with improvements widely reported across the company. In fact, progressive companies establish annual improvement targets to be achieved through their VA process. When performed correctly, VA offers a systematic approach for improving value, functionality, and costs. The five phases include:

Information phase: In this phase executive leadership gathers data and ranks opportunities; establishes preliminary improvement targets; identifies the function of a part, material, process, or service under study; and creates the VA team.

Speculative phase: This phase includes the questions presented earlier. Creative thinking techniques are employed in this phase.

Analytic phase: The VA team performs cost/benefit analysis on each idea, assesses the effect of a change on internal and external customers, and assesses the reality of any changes. The team will also review improvement targets. Critical thinking techniques are employed in this phase.

Execution phase: A cross-functional VA group works to secure buy-in to proposed change, develops an implementation plan, breaks down resistance to changes across functional areas, and carries out the changes. In this phase it is important to note the date and baseline metrics to assess the effects of changes.

Conclusion phase: In this phase, the VA team verifies the success of changes, documents and reports savings, works to transfer learning throughout the organization, and disbands or assumes a new VA challenge.

A challenge with a process such as VA is maintaining its intensity. One way to do this is to track and report results and initiatives at the highest levels. It is amazing what executive visibility will do in terms of sending a clear message about the importance of this process. Companies can also recognize and reward VA efforts across the organization, as well as across the supply chain. A company can also create VA displays, provide VA updates, report successes from VA, and offer VA training to suppliers. Since VA is really a continuous improvement methodology, embedding a commitment to this process into the corporate culture should provide long-lasting benefits.

Cost-Driven Pricing

Cost-driven pricing is a collaborative, but rarely used approach for managing the costs, and therefore the price, of critical items. It is a cutting-edge approach that moves far beyond basic cost analytic techniques. This approach, which offers an opportunity to promote cooperative behavior between a buyer and seller, has as its primary objective continuous cost reductions over the life of a purchase contract. Cost-driven pricing enables buying and selling firms to achieve real cost reductions over time, while simultaneously reducing the conflict typically associated with pricing approaches that promote short-term profit maximization.

Cost-driven pricing contracts differ radically from cost-plus contracting. With cost-plus contracting, profits often increase or decrease based on actual costs incurred. Cost-plus contracting results in conflicting goals because increasing costs eventually benefits the supplier at the buyer's expense.

Cost-driven pricing is also not market-driven pricing. In a market-driven approach, the buyer or seller maintains an advantage depending on supply and demand, the level of product differentiation, or the number of firms involved within a market. Suppliers focus on achieving the highest allowable price, while buyers strive for prices that are often unrealistic. Pursuing individual advantages, unstable pricing, and conflicting goals do not promote cooperative behavior. Furthermore, market-driven pricing typically ignores the cost drivers behind a purchase price.

It becomes necessary to discuss several concepts to understand cost-driven pricing. First, a buyer and seller's joint agreement on the target price, profit, and full cost to produce an item becomes the foundation of a cost-driven price. This requires agreement not only about target prices and allowable profit, but also agreement about standard material, labor, and other direct and indirect costs associated with producing an item. Reasonable administrative, selling, and other general expenses are also recognized as fundamental parts of a supplier's cost base.

Perhaps the most important element of a cost-driven pricing contract is that a supplier's asset investment and return requirements provide the basis for establishing the profit for each item produced. Profit is the result of an agreed to percentage of return on investment employed directly by the seller to satisfy the buyer's contract. This differs from traditional pricing approaches that establish profit as a percentage of the selling price or manufacturing cost. Thus, once a buyer and seller agree upon an appropriate asset base, fluctuations in manufacturing costs (labor, material, etc.) do not affect a supplier's return. Establishing profit based on asset and return requirements should encourage the supplier to commit resources specifically to the buyer-seller relationship. In cost-driven pricing, the buyer explicitly acknowledges the need to satisfy a supplier's financial return requirements.

Joint assumptions and agreement on product cost, production volumes, quality, targeted costs, productivity improvements, and contractual sharing of supplier-initiated savings are also essential to a cost-driven approach. Agreeing on these issues requires higher levels of trust, information sharing, negotiation, and joint problem solving. The complexity of cost-driven pricing ensures it will only be applied as a strategic cost management technique in selected relationships that feature trust and a willingness to share information.

Cost-driven pricing contracts require the establishment of joint improvement targets in areas such as cost, quality, scrap, and delivery. These agreed-upon improvement targets help drive continuous cost reduction over time. Furthermore, shared cost savings take effect only after the supplier achieves initially targeted price/cost improvements. For example, if the buyer and seller target a material content cost reduction of 10 percent per year, shared cost-saving would take effect on any savings beyond the 10 percent level. Productivity improvement targets must be aggressive with both parties developing an action plan to attain targeted goals. Shared cost-savings provide an incentive to accelerate cost improvements beyond those agreed to in the purchase contract.

Not all products or items are candidates for cost-driven pricing. In fact, the vast majority of items would never qualify for a cost-driven pricing approach. A cost-driven approach is most applicable when the seller adds significant value through direct and indirect labor or design capabilities. It is also applicable when sophisticated technologies provide opportunities for product design and process alternatives. Raw materials or other commodity items are least likely to benefit from a cost-driven pricing approach.

The supplier selection decision is usually separate from the mechanics of costdriven pricing. Supplier selection almost always occurs before the parties even discuss a cost-driven contractual agreement. A willingness to enter into a relationship that, at some point, might feature approaches such as cost-driven pricing, may influence the final choice of a supplier. The chances are good that the buyer and seller have an extensive track record of working together before they consider a cost-driven pricing approach.

Cost-Driven Pricing Example

This section presents a cost-driven pricing example based on the experiences of two companies.4 Both parties decided to try an innovative approach to contracting that is radically different from anything they had entered into previously. The two parties agreed to analyze jointly the supplier's cost structure for a subassembly, which requires a high degree of trust and confidentiality between the parties. Working together they determined that investment requirements to support this product were $20 million over the contract's expected three-year life. This includes $12 million in working capital requirements and $8 million in capital assets over the projected product life. The parties also agreed to a 20% return on investment target for the supplier. In addition, the supplier committed to annual productivity improvements of 10 percent for direct labor and a 25 percent annual reduction for scrap. The agreement also includes a cost saving sharing agreement for any cost reductions due to design modifications initiated by either party. While not featured here, the agreement also featured a risk sharing formula in the event that demand volumes moved outside of an accepted range of risk. Table 9.5 summarizes the contractual conditions between the buyer and seller.

Table 9.5: Cost-driven pricing agreed upon contractual issues

Product:

Subassembly

Negotiated/Analyzed Cost Structure:

Direct Labor Rate

$20.75 per hour

Overhead Rate

150% of direct labor

Scrap Rate

10% of total material, direct labor, and overhead

SG&A Expenses

12% of total manufacturing cost

Expected Volume Range

120,000 units per year ± 15%

Contract Length

3 years

Agreed to Return on Investment

20%

Contract Specific Investment:

Year 1

Year 2

Year 3

Working Capital

$4 million

$4 million

$4 million

Net Capital Assets

$3 million

$3 million

$2 million

Total Investment over Three Years

$20,000,000

Supplier Productivity Commitment:

Direct Labor Content

10% reduction from previous year level

Scrap Rate

25% reduction from previous year level

Joint Effort Design Revision/Cost Reductions:

Savings shared on a 50/50 basis

The two parties agreed to reestablish the subassembly's price at the end of the first and second year of the contract. This review reflected the changes that occurred over the course of years one and two. Major year-one occurrences included economic increases for material and direct labor. Furthermore, a joint study team developed a substitute material that reduced material costs by $4 per unit, resulting in an equal sharing of savings during year two. Year-two adjustments also reflected positive adjustments due to labor efficiencies and scrap reduction. Tables 9.6 and 9.7 show how each cost element and the unit price were determined for year one and then at the start of year two. While not shown here, a similar review occurred at the end of year two to establish year-three pricing.

Table 9.6: Year one agreement and events affecting year two

Open table as spreadsheet

Dollars

Economics

Productivity Commitment and Changes

Material Costs

$40.00

2% increase

$4 per unit joint design saving

Direct Labor Costs

$41.50

3% increase

10% annual improvement

Overhead (Direct Labor × 150%)

$62.25

Total

$143.75

Scrap ($143.75 × 10%)

$14.37

25% annual reduction

Manufacturing Cost

$158.12

SG&A (Mfg. Cost × 12%)

$18.98

Total Cost

$177.10

Profit per Unit

$11.11

Selling Price

$188.20

Year One Notes:

Cost engineers determined each unit requires 2 hours of direct labor ($20.75 × 2 = $41.50 year one direct labor) and material costs are $40 per unit

Total profit = ($20,000,000 supplier investment × 20% agreed upon ROI)/3 year life of contract = $1,333,333 expected profit per year; $1,333,333/120,000 units per year = $11.11 profit per unit

Table 9.7: Year two agreement and events affecting year three

Open table as spreadsheet

Dollars

Economics

Productivity Commitment and Changes

Material Costs

$36.72

4% increase

Direct Labor Costs

$38.47

2% increase

10% annual improvement

Overhead (Direct Labor × 150%)

$62.70

Total

$135.90

Scrap ($135.90 × 7.5%)

$10.19

25% annual reduction

Manufacturing Cost

$146.09

SG&A (Mfg. Cost × 12%)

$17.53

Total Cost

$163.62

Profit per Unit

$13.11

Selling Price

$176.73

Start of Year Two Adjustments:

Material costs = $36 ($4 material design savings from $40) × 1.02 (2% supplier material cost increase from Year One events) = $36.72.

Direct labor costs = $41.50 × .9 (reflects 10% agreed upon productivity commitment from Year One level) = $37.35; $37.35 × 1.03 (3% increase in supplier labor costs in Year One) = $38.47

$13.11 per unit profit includes supplier share of material design saving ($2.00) plus the original $11.11 per unit profit

This example provides a number of important takeaways. One is that the supplier in this case is motivated to participate because the buyer guaranteed its return on investment requirements. The buyer explicitly recognizes the need for the supplier to maintain a fair profit. Also, a buyer's willingness to share design savings with the supplier in the form of a higher profit per unit certainly supported the buyer's cause.

A second takeaway is an appreciation that even though material and labor costs are increasing during the first year, the price of the item at the start of year two decreases by almost $11.50. This is a direct savings of almost $1.4 million in the second year of the contract, as compared to the first year. And, compared to a market-driven price—which would have increased by almost $5 due to material and labor cost increases with an absence of contractual improvement goals—the buyer realizes a true cost avoidance of $600,000.5 To sum it up, direct savings and a cost avoidance are close to $2 million in year two. While the calculations are not shown here due to space constraints, year three would also show some unit price savings, although not as great as year two. (Year two, for example, did not feature any design savings.) With a cost-driven pricing agreement, costs are increasing while price is decreasing. It's as if we are violating the laws of physics—and liking it!

This case highlights what real collaboration looks like between two parties. While it sounds cliché, this truly is a win-win opportunity as the parties work jointly to increase the value they each receive. It is not hard to imagine how a lower price for an important subassembly could make the end product more competitive, which could lead to a stronger position within the marketplace. And that stronger position could lead to even greater orders that benefit both parties. Cost-driven pricing, which is a rare form of collaboration, is a cost-management technique that stands apart from the rest.

Cost Management Workshops

Cost management workshops include any methodology in which supply chain members come together with the primary purpose of improving costs. The best way to illustrate one such approach is through a case example.6

Achieving continuous cost reductions while expanding a company's global presence are never-ending challenges for multinational corporations. The risk of not exceeding these challenges will have serious consequences for companies that develop highly engineered product systems with long life cycles. Continuous cost improvements often require new ways of doing business that address uncertainty and risk.

This case example features a U.S. defense contractor's efforts at developing a new methodology for identifying every cost element and driver within a complex product. This methodology moves beyond anything previously attempted at this company and combines elements of VA, project management, total cost management, Six Sigma, innovation management, early supplier involvement, and risk management into a coherent cost management process.

This company developed a complex system that was winding down in terms of sales to the U.S. military, presenting an unacceptable financial risk. The company decided to mitigate this risk by targeting a specific international customer to replace the expected loss in sales from its primary domestic customer. The opportunity at the international customer was new and the aerospace company decided this would become a pilot program for developing a new cost management approach. Although this company offered a more superior system than its competition, cost and price reductions were going to be essential to win a contract. This opportunity became the pilot program for identifying, and then managing, every cost element and driver within a complex system. Doing so required a multiphase process.

Phase I: Documenting the current state: Over its history this company has developed sophisticated approaches for analyzing its products, supplier costs, and quality levels. While providing a solid foundation upon which to carry out an analysis of different cost elements, these approaches did not provide the detail required to dramatically alter product cost structures and win new orders. The company needed a methodology that took cost analysis to an entirely new level.

A cross-functional team was charged with documenting in detail the current state of a complex system, including an extensive analysis of each cost element and driver affecting product cost. A primary objective was to determine where design flexibility, and therefore, potential cost reduction opportunities, might exist. The team examined traditional areas including quality, delivery, and operations to evaluate structural opportunities. The team also broke down cost components to understand manufacturing line costs, machine times, labor rate/times, material costs, and costs of goods sold. The team built extensive cost models, much more so than what had ever been accomplished with existing methodologies. The team developed a detailed understanding of every cost associated with this system—an analysis that revealed that materials, not surprisingly, were 50% of total product costs.

Phase II: Internal workshop: After completing the current state analysis, the company conducted a two-day workshop involving company engineers and designers. High-dollar areas became key areas regarding where to focus engineering and design efforts. The first half of the workshop featured the generation of ideas (creative thinking) while the remainder identified savings and ranked ideas (critical thinking).

Next, the participants identified the cost to implement ideas by examining two major categories of costs. The first related to the cost to document an idea and verify its feasibility—or what the company calls characterization costs. These represent about 20% of total costs. The second category, called implementation costs, included the costs to put an idea in place. These costs include changes to manufacturing, designs, or addressing quality issues. While some costs related strictly to internal manufacturing and control, the majority resided with supplier-provided materials.

Phase III: Supplier involvement: At this point a decision was made to involve suppliers in the cost management methodology. The company has extensive experience in working directly with suppliers, after conducting over 50 supplier cost-reduction workshops, and also through its supplier development efforts. As part of this new process, a conference was conducted involving 20 current suppliers. The company also invited potential suppliers to broaden the domain of innovation. An offsite location hosted the first day of the conference, while the second day took place at a company facility.

At a kick-off meeting that was attended by all participants, company hosts identified the workshop objectives and opportunities. Participants then divided into six smaller groups and were placed in various rooms, according to specific tracks or topics. Electrical suppliers, for example, were placed with the company's electrical personnel, mechanical with mechanical, etc. Buyers, subcontract managers, engineers, quality personnel (as needed), and program management personnel from the company also populated the six rooms.

During the workshops, suppliers identified 165 cost-reduction ideas. A champion at the defense contractor was assigned to own each idea. Each idea needed to be evaluated for feasibility and verification regarding whether suppliers could follow through on what they proposed they could do.

Phase IV: Implementation: During this phase, a group met every Monday for updates about progress on the feasibility and verification of ideas. After several weeks the company decided it was time to update its bid to the international customer. The ideas accepted during the workshop resulted in 20% lower product costs, although the resubmitted bid was only 10% lower to provide a margin of safety.

An issue when using revised cost figures is actually achieving these figures. To mitigate this risk, the company's cost spreadsheets included a risk factor column that reduced the savings percentage that was expected for items that have some risk attached to them. The expected benefits might be reduced for an idea, but the expected costs are maintained as a constant. If, for example, an idea has some technical risk or includes a supplier-provided target that might be too challenging to obtain, characterization and implementation costs would remain constant, but the potential benefit is reduced by an agreed-upon percentage. The reduction is agreed to by a team that has a strong feel for the relative magnitude of potential risks across the various ideas.

Looking Ahead

Much to its disappointment, this company did not win a contract with the international customer. Was all this work a waste of time? While it might be easy to conclude this was a failed effort, this company developed a cost management methodology that will help it better understand and manage costs across its current and future programs. And, for this particular product, the company's primary customer in the U.S. realized cost benefits through better pricing for its remaining orders. While the company was unsuccessful in winning new sales from the international customer, it quickly became evident that this new way of managing costs will allow the company to become increasingly competitive when pursuing future opportunities.

A key lesson learned from this experience involves the benefit of supplier involvement. The company expects suppliers to become involved in future projects earlier—compared with their current involvement—perhaps at the two-day workshop stage that featured only company personnel.

The company also expects to validate its cost models as actual data becomes available, similar to the forecasting models that are updated as actual data becomes available. This will help improve cost model accuracy, thereby allowing the company to become even more aggressive in its bidding as its confidence increases.

Overall, the company will be better positioned to develop competitive pricing proposals, given its better understanding of costs and how they might be reduced. The company will also be better positioned to understand the risks associated with achieving product cost reductions, thereby resulting in improved pricing proposals.

Marketing professionals have a term that reflects learning from failed product launches. They call it failing forward. While the proposal featured here failed to land a new contract, the learning gained will be applied to the next opportunity. We all fail at some point. Perhaps the biggest failure is not applying the learning gained to future opportunities.

Chapter 10: Managing Costs Across The Supply Chain— Applying Financial Techniques

This chapter provides the opportunity to apply the techniques presented in Chapter 9. Exercises in this chapter include estimating prices by using learning curves, developing a configured sourcing network, and calculating theoretical best prices (TBPs). The chapter also includes an exercise for conducting a value analysis (VA) workshop, interpreting producer price indexes (PPIs), and recalculating price in a cost-driven pricing contract.

Value Analysis Workshop Exercise

VA is a continuous improvement and cost reduction methodology that applies to any part of the supply chain. This exercise requires you to engage in the information and speculative phase of the VA process for an existing product or part at your company. (Recall that VA can also be used to evaluate services or processes.) Use the following template to guide your VA workshop:

Step I: Identify the product or part that will be the focus of the VA workshop

Step II: Identify other participants to involve in the workshop

Step III: Identify the primary function of the product or part in terms of customer usage. Identify any secondary functions of the product or part.

Step IV: Engage in brainstorming (i.e., creative thinking) to improve value in the product or part. Use the following questions to help promote group discussion:

Are lower cost, but equally effective materials available for the product or part?

Can the product or part design be simplified?

Are standard components available to replace custom-designed components?

Can improvements be made to the production process?

Can features be added to enhance functionality more than the associated cost increase?

Are lower cost suppliers available that are capable of producing the product or part?

Is there any functionality currently included in the product or part that the customer does not want?

Is there any specific waste that can be targeted for elimination?

Can packaging or logistics costs be reduced or improved?

Step V: Perform cost/benefit analysis on each idea, assess the effect of a change on internal and external customers, and assess the overall feasibility and timing of changes. Establish performance improvement targets. Identify any potential risks resulting from changes.

Step VI: Develop an implementation plan for carrying out changes. Create a set of baseline measures to assess the effectiveness of the changes. Identify who is responsible or accountable for owning the changes.

Chapter 11: Best Practices in Worldwide Sourcing

Overvirw

Growth in worldwide trade has increased dramatically over the last 25 years. An increase in the standard of living in emerging countries, generally lower trade barriers, and the rise of the Chinese economy have all contributed to new opportunities on the selling and the buying side of the supply chain. A constant search for what we believe are better sourcing opportunities has taken buyers to just about every square inch of the earth to obtain raw materials, components, capital equipment, and finished goods.

This chapter focuses on worldwide sourcing, an area that has grown dramatically over the last several decades. The first part of the chapter presents worldwide sourcing along a continuum, ranging from basic international purchasing to global sourcing and supply management. The primary focus of this chapter— worldwide sourcing best practices—appears next. The chapter concludes with some predictions about the future of worldwide sourcing.

A Continuum of Worldwide Sourcing

The findings presented throughout this chapter are derived from two in-depth studies that investigated worldwide sourcing. The first study, conducted by Monczka and Trent, investigated the critical success factors, benefits, progress, risks, methodologies, practices, and lessons learned from the development of global supply processes and strategies. This research included data from 162 larger companies that were headquartered primarily in North America with worldwide operations and buying centers.

A second study, conducted by Monczka, Trent, and Petersen included data from 167 companies. While investigating issues similar to the first study, this project featured a greater number of European firms and emphasized sourcing from emerging countries. Both research projects included respondents who were vice presidents, directors, or managers working at the corporate level rather than at the division or site level. Both studies featured quantitative surveys and detailed on-site interviews.

An internationalization of the sourcing process takes place as companies evolve or progress from domestic purchasing to the global coordination and integration of common items, processes, designs, technologies, and suppliers across worldwide locations. Companies that operate at Levels II and III exhibit behaviors that are characteristic of international purchasing, while companies that operate at Levels IV and V practice global supply management.

Supply organizations progress, often reactively, toward a basic level of international purchasing (Level II) because they are confronted by some scenario, such as a lack of suitable domestic suppliers, or because competitors are gaining an advantage (usually cost advantages) from their international practices. Strategies and approaches developed in Level III begin to recognize that worldwide buying strategies can lead to major improvements. Most price reductions sought from worldwide sourcing are gained at this level. A key point is that strategies at this level are not coordinated across worldwide buying locations, operating centers, functional groups, or business units.

Supply organizations often begin to realize that it is in their best interest to begin integrating and coordinating their sourcing activities on a worldwide basis. Level IV represents the integration and coordination of sourcing strategies across worldwide buying locations. Operating at this level requires worldwide information systems, personnel with sophisticated knowledge and skills, extensive coordination and communication mechanisms, an organizational structure that promotes central coordination of global activities, and executive leadership that endorses a global approach to sourcing. Level IV features an extensive focus on global contracting.

Level V organizations have achieved the cross-locational integration that Level IV organizations have achieved. The primary distinction is that Level V participants integrate and coordinate common items, processes, designs, technologies, and suppliers across worldwide purchasing centers and with other functional groups, particularly engineering. This integration occurs during new product development, as well as during the sourcing of items or services to fulfill continuous demand or aftermarket requirements. Furthermore, design, build, and sourcing responsibilities are often assigned to the most capable units around the world.

When looking at this model, supply professionals should view global supply management as a process rather than as a set of discrete activities or approaches. Looking at the global business environment leads to a clear conclusion: pressure to improve is relentless and severe. The winners will understand how to manage their supply activities on a global basis; the losers—not so much. Global supply management offers an attractive and largely untapped opportunity to achieve the performance breakthroughs required to compete in intensely competitive markets.

Differences Between International Purchasing and Global Supply Management Organizations

Not only are there definitional differences between international purchasing and global supply management, there are tangible differences between the companies that populate the two segments. The following presents research-based findings concerning the differences between firms along the continuum presented in Figure 11.1:

Companies that engage in global supply management are larger and more likely to have competitors that are global, compared with international purchasing companies. Global supply management becomes a strategic response to counter global competition.

Companies that engage in global supply management perceive their strategy implementation progress to be more sophisticated or mature compared with international purchasers.

Companies that engage in global supply management believe that performance improvement and cost reduction opportunities are more widely available from their worldwide efforts, compared with international purchasing companies. And, global organizations are more likely to have experienced, firsthand, more significant improvements compared with international purchasing organizations.

Companies that engage in global supply management indicate that the development of global strategies is more important to their executive management compared with international purchasing companies.

Companies that engage in global supply management indicate they face more rapid changes to product and process technology compared with international purchasing companies. While cost improvements will always remain a primary driver behind worldwide sourcing, the need to manage product and process technology from a global perspective drives some companies to pursue more sophisticated sourcing levels.

Companies that engage in global supply management rely on a wider array of communication tools to support their worldwide efforts compared with international purchasing companies. This includes a higher reliance on groupware, video conferencing, web-based tools, and phone conferencing at significantly higher levels, compared with the international purchasing segment.

Companies that engage in global supply management have in place more organizational features to support their worldwide efforts, compared with international purchasing companies. Best practice companies are not surprised by the kinds of features they must put in place to be successful. They know this is what they must do to capture the benefits from global supply management.

Companies that engage in global supply management rate certain factors as more critical to their success, compared with international purchasing companies. Critical factors include a centralized procurement structure, suppliers that are interested in global contracts, availability of information and data, and site-level participation during global contract development.

The differences between the two segments are clear along many different dimensions.

A Comparison of Benefits Between Segments

Why would any company commit scarce resources toward something as complex as global supply management? The short answer is that companies pursue global supply management to realize benefits that are not as readily available from less sophisticated sourcing practices. Research reveals that extensive differences exist between the benefits that international purchasing and global supply management companies achieve.

Companies that engage in global supply management achieve every benefit evaluated during the earlier-mentioned research projects at a statistically higher level than those that engage in international purchasing. In fact, the overall average across 16 benefit areas is 30 percent higher, on average, for companies that practice global supply management, compared with companies that practice international purchasing. The kinds of benefits that global supply organizations achieve at a much higher level include:

Better management of supply chain inventory

Greater supplier responsiveness to buying unit needs

Greater standardization or consistency of the sourcing process

Greater access to product and process technology from suppliers

Improved supplier relationships

Improved sharing of information with suppliers

Greater supplier involvement during product development

Besides an impressive array of benefits, is there anything else that helps make the case for pursuing global supply management? Companies that engage in global supply management rate certain areas as more similar across their geographic regions and buying units, compared with those companies that engage in international purchasing. In the longer term, an important outcome from global supply management will be the consistency this process provides. Engaging strictly in international purchasing—which is by definition an uncoordinated activity across worldwide units—cannot create the consistency that a more integrated approach can provide. Areas where the similarity or consistency across units or locations is greater within the global supply management segment, compared with the international purchasing segment include:

Strategy development process

Supplier assessment practices

Purchasing or sourcing philosophy

Current purchasing strategies

Problems resolution techniques with suppliers

Contracting approaches

Reporting level of purchasing/sourcing

Similarity of purchase requirements

Organizational reporting structures

Supplier performance measures used

Business ethics

Clearly, the data supporting a global approach to supply management is compelling. If global supply management can be so rewarding, why isn't it commonplace? First, many supply chain managers do not understand the complexities of operating a globally-integrated supply network. Next, many supply organizations lack the vision, leadership, resources, or sophistication to coordinate their activities globally. Many procurement organizations are still reactive or maintain a lower position within the corporate hierarchy. Finally, some companies simply do not have as great a need to pursue a global supply model. Rest assured, however, a slow but steady migration toward higher sourcing levels will continue to occur.

Worldwide Sourcing Best Practices

It is not enough to proclaim a desire to gain an advantage from your company's worldwide sourcing efforts; we have to understand the characteristics or best practices of firms that capture that advantage. The following provides a set of best practices characterizing firms that operate at the highest levels of worldwide sourcing (Levels IV and V). These practices are not as relevant for firms operating at Levels II and III (from Figure 11.1).

Access to Qualified Human Resources

A theme that consistently emerges when working with leading companies is the important relationship between qualified personnel and successful worldwide sourcing. Effective sourcing, particularly at the highest global levels, is not a process that can be automated or outsourced. When companies are asked during research projects to identify the most important factor that contributes to global success, access to personnel with the right knowledge, skills, and abilities rises to the top. But, when asked to identify the seriousness of problems that may affect global success, a lack of qualified personnel is the most serious of problems identified. This is why access to qualified human resources is a best practice.

What kinds of skills and abilities are required to support worldwide sourcing? Unfortunately, everyone seems to have a different viewpoint regarding the knowledge and skills that define today's supply professionals. Obviously, the need to communicate well, manage conflict, and demonstrate ethical behavior will always be on the list. The following knowledge and skills are based on focus group research with leading companies. Ideally, individuals involved with worldwide sourcing should have the ability to:

Take a strategic rather than operational or transactional view of supply management

Manage nontraditional procurement areas, including services

Manage critical supply relationships worldwide

Understand strategic cost management, including total cost of ownership models

Work virtually and across time zones and cultures

Understand the global supply management process and its objectives

Be comfortable with using, and perhaps even developing, electronic sourcing and contracting systems

Understand statistical analysis and fact-based decision making

Work cross-functionally and across locations

Understand how to do business in different cultures

Negotiate and manage worldwide contracts

Supporting the sourcing process with personnel who have the right skills will require the development of high potential individuals, the recruitment of talent from other functional groups or companies, and the recruitment of promising college graduates. Regular assessments of employee knowledge and skill sets must also occur with training tailored to the needs of individual employees. This is all done to ensure that qualified participants are available to support worldwide sourcing. Access to the right people is even more important when companies take a global view of their supply chain.

A Well-defined Process Guides Worldwide Strategy Development

Best practice firms develop a well-defined process or approach to guide their global strategy development efforts. Some organizations have taken their commodity or regional strategy development process and adapted it for global sourcing. When that is the case, the global process usually places more emphasis on risk factors (currency, longer material pipelines, supplier switching) as well as the total landed cost.

Table 11.1 presents a generic strategy development process. What's the big deal about having a defined process? A defined process provides a means to monitor and report strategy development progress. And, a defined process helps accelerate learning across a company as participants become familiar with a single process. A well-understood process also facilitates members moving easily to new projects, since they do have to learn new processes. A defined process also avoids duplication of effort across teams and locations. Best practice companies that have a defined process also develop documents, templates, and tools that appear on a company's intranet. Finally, this process, like any other organizational process, can be continuously improved.

Table 11.1: A sample global strategy development process

Step 1: Identify Global Sourcing Opportunities

Step 2: Establish Strategy Development Teams

Step 3: Evaluate Sourcing Opportunities and Propose Strategies

Step 4: Identify Internal Requirements and Develop Supplier Proposals

Step 5: Forward Requests for Proposals to Pre-qualified Suppliers

Step 6: Evaluate the Technical and Commercial Merits of Proposals

Step 7: Negotiate with Qualified Suppliers

Step 8: Award Contract

Step 9: Manage Transition to New Contract and/or New Suppliers

Step 10: Monitor Performance and Review Expiring Contracts

Research reveals that the presence of a defined, well-understood process and access to individuals who are capable of taking a global rather than narrow view of supply chains are two powerful predictors of global success.

Organizational Design Features Support Worldwide Sourcing

Best practice firms understand the connection between an effective organizational design and worldwide sourcing success. Organizational design is a broad term that refers to the process of assessing and selecting the structure and formal system of communication, division of labor, coordination, control, authority, and responsibility required to achieve an organization's goals.1 Important design features that directly support worldwide sourcing success include (1) centrally led decision making supported by strong executive leadership, (2) the use of cross-functional teams, (3) an executive steering committee to guide the process, and (4) strategy review and coordination sessions. Another important design feature—international purchasing offices—is discussed later.

Centrally Led Decision Making Supported by Strong Executive Leadership

Higher-level worldwide sourcing (i.e., Levels IV and V from Figure 11.1) is a process best managed from a centrally led level. The terms centrally coordinated or centrally led do not necessarily mean the presence of large corporate staffs. In fact, best practice firms are sensitive to the concerns of operating units as they think about a loss of control and a bureaucracy that is far removed from day-to-day activities. Central coordination can be achieved across regions, business units, sites, and other functional groups through the use of organizational design features that do not require individuals residing in a central location.

The trend toward centrally led decision making has been evident over the last 15 years. Research findings reveal that almost 60 percent of mostly larger companies say their procurement organization is structured and governed centrally, while 39 percent say the business unit is decentralized with some coordination. Only 2 percent indicate their business unit is decentralized. Over 70 percent of companies indicate that purchasing and supply management decision-making authority, in general, is centralized or highly centralized.

Separation of Strategic and Operational Responsibilities

A shift toward centrally led, centrally coordinated, and/or centralized worldwide sourcing is only part of the story. In many supply chain organizations, strategic and operational responsibilities often take place at different locations. At no time is this truer than when firms pursue higher levels of worldwide sourcing.

Separating strategic and tactical groups makes sense for several reasons. Few people can operate comfortably in a strategic and tactical environment, or switch easily between one mode and another. Furthermore, in a decentralized model, operational or tactical activities must be satisfied first, leaving less time for longer term planning and strategy development.

Activities that are usually centralized or centrally led include developing category or commodity strategies, negotiating and establishing contracts, locating potential supply sources, evaluating and selecting company-wide suppliers, managing important supplier relationships, and managing supplier development and early involvement activities. Responsibilities that generally are decentralized include executing schedules and inventory plans, expediting goods and services, issuing releases or purchase orders, planning inventory levels, and developing requirements schedules. Care must be taken to avoid the perception that one group is better or more important than the other.

Use of Cross-functional Teams

Companies that pursue the highest levels of worldwide sourcing almost always use teams to develop strategies and to coordinate their worldwide activities. Executive managers should plan for and use teams selectively, always keeping in mind any barriers to their use as well as the factors that affect team success. Teams are destined to fail, for example, if they have poor team leadership or lack the time to commit to their tasks. Research findings are clear that teams with the time to pursue their tasks are more effective, on average, than those that did not have the time. The challenge becomes one of making scarce resources more readily available to team members.

Executive Steering Committee

The formation of an executive steering committee or council to oversee worldwide sourcing is an important way to show commitment to the process. These committees engage in some serious work. The following highlights the duties of a worldwide steering committee at a leading U.S. company:

Identify and prioritize worldwide sourcing opportunities

Form project teams and develop team charters

Establish worldwide sourcing project objectives and broad improvement goals

Provide required resources to project teams

Meet with teams to update in-process sourcing projects

Support the development of worldwide systems

Validate and report the success of global initiatives

Manage post-project lessons learned

Coordinate worldwide sourcing initiatives with new product development teams and engineering groups

Strategy Review and Coordination Sessions

Best practice firms also promote the use of strategy review and coordination sessions. These sessions, which can be face-to-face or virtual, attempt to align different participants from around the world with a common global vision. Colgate, a company with operations in almost 80 countries, relies heavily on these sessions as part of its organizational design to create a common set of global objectives.

International Purchasing Offices Are Established

Most supply managers recognize that their ability to manage activities that happen thousands of miles away is usually quite limited. An important element of worldwide sourcing that does not receive much attention is the use of an international purchasing office (IPO). An IPO provides a company with a day-to-day presence in any supply market or region where the buying company has suppliers. It is wrong to conclude that IPOs are located only in emerging countries, although Eastern Europe and China are well represented as locations.

Just under half of the firms participating in the earlier mentioned research projects maintain IPOs. One thing that is certain is the overwhelming agreement about the value these offices provide. Just over 85% of firms with IPOs say they are extremely important to global sourcing success; around 10% IPOs say they are moderately important; and only 5% say they are less than moderately important. No company indicated these offices are of limited importance.

Some companies simply refer to their IPOs as foreign or international buying offices, international procurement centers, or international procurement organizations. No industry standard exists regarding what to call these offices.

IPOs are usually a formal part of a company's organizational design and will increase in importance as global supply management expands. Some companies hire IPO service providers as needed rather than maintaining dedicated offices that increase fixed costs. These companies have taken what is essentially a fixed cost and turned it into a variable cost.

The kinds of services that an IPO provides are varied. At least 70 percent or more of companies with at least one IPO say these offices somewhat or extensively identify suppliers and evaluate their capabilities, negotiate and execute contracts with suppliers, resolve quality and delivery problems directly with suppliers, develop supplier capabilities, measure supplier performance, evaluate product and service designs and samples provided by suppliers, facilitate import and export activities, and perform logistical coordination. These kinds of tasks simply cannot be managed well from a home office located thousands of miles away.

The use of IPOs should increase as supply organizations continue to search worldwide for buying opportunities. However, challenges could also increase as new IPOs are staffed with foreign nationals who have been hired away from other IPOs. Anecdotal evidence has emerged that some companies are experiencing unhealthy turnover in their IPO's due to the poaching of staff by other companies. This will have the inevitable effect of increasing the cost of operating an IPO, as well as affecting its performance.

Able to Measure Worldwide Savings

Best practice firms have the capability to measure and validate the savings realized from worldwide sourcing. Reporting the savings from global supply initiatives usually necessitates meeting three key requirements. The first is a system that captures data from around the world—something that is easier said than done. The second is the active involvement of finance. The need to validate savings makes finance involvement a necessity. The third requirement is a higher set of metrics that show the impact that global initiatives have on corporate performance indicators. Traditional purchasing indicators will be ineffective in this kind of environment.

An important part of measurement when engaging in worldwide sourcing is the use of total cost measurement systems. Best practice companies know that total cost of ownership is a topic they cannot ignore as they search for new sources of supply. Total cost models include the expected and unexpected elements that increase the unit cost of a good, service, or piece of equipment.

The reasons for measuring total cost are persuasive. An earlier study found that over 80 percent of companies that created total landed cost models did, in fact, reduce their total cost.2 These models help to: identify the impact of different cost elements, including supplier nonconformances; track cost improvements over time; identify the areas where cost reduction efforts will have their greatest payback; target specific areas for improvement or elimination; support fact-based rather than subjective supply chain decisions; and provide a better overall understanding of supply chain costs. Chapters 12 and 13 provide greater insight into this important topic.

Access to Information Technology and Communication Tools

There is no question that information technology (IT) enables global success, something that best practice companies know quite well. While it seems intuitive to say that data and information are vital to worldwide sourcing, the reality is that many companies still struggle in that area. While the situation is improving, companies with worldwide operations can still have systems that do not seamlessly transfer data from one platform to another, or from one business unit to another.

Industry leaders address this need by creating global data warehouses that rely on common coding schemes for easier aggregation of worldwide purchase requirements. The ability to perform a global spend analysis is likely just a dream without access to data and systems (refer to Chapter 8 for an overview of spend analysis). These systems should also serve as contract repositories that provide advance notification of expiring regional and global agreements.

Besides data warehouses and contract repositories, leading supply organizations rely extensively on web-based systems and intranets to make information available to worldwide participants. A best practice company recognized for its use of IT has placed a wide range of global support documents on its intranet, including an online manual that describes its global supply management process; a global strategy development template; a contract terms and conditions checklist; a report that identifies the status of completed, in-process, authorized, and future global opportunities; a request for proposal template; and currency risk management guidelines. Participants anywhere in the world can also access information about approved suppliers.

Best practice firms also know that sourcing initiatives have a reduced chance of success without access to communication tools, particularly when participants are located in geographically dispersed locations. Real-time communication tools include web-based meeting software, electronic mail, video conferencing technology, telephone conferencing, and face-to-face meetings. Research findings reveal a clear link between access to state-of-the-art communication tools and a set of desirable global outcomes. IT has become a great enabler of supply chain success.

Risk Management Is Embedded within Worldwide Sourcing

An emphasis on worldwide sourcing has contributed to greater supply chain risk. Longer material pipelines, currency issues, child labor and environmental infractions, quality issues, cultural and language difference, and a host of other issues seem to come to the forefront when expanding globally.

Best practice firms consider risk directly when developing sourcing strategies, whether the strategy involves a domestic or international supplier. To date, most risk initiatives have been separate from normal job responsibilities. As companies understand the true costs of supply risks and disruptions, risk management will increasingly become an embedded part of supply management—much like supplier audits, supplier development, and supplier relationship management are now part of supply management.

Embedding risk management directly into a supply manager's responsibilities does not mean that the importance of risk management will diminish. In fact, the opposite is likely to be the case. As risk management becomes an accepted part of an organization's operating culture, risk issues will be considered early when making sourcing decisions. Supplier selection teams will consider not only a supplier's operating capabilities; they will also consider a potential supplier's financial condition, as well as its risk plans and capabilities. This will be especially true when evaluating suppliers in emerging countries. Selection teams will also consider geographic location to ensure that a supplier is not clustered with other suppliers or located near known hazards. The bottom line is that to be a best practice company, supply managers must become risk managers, particularly when engaging in worldwide sourcing.

Critical Resources Are Available

A factor that is easy to overlook is the resources that support the attainment of global objectives. The availability of needed resources has the potential to separate marginally performing from exceptionally performing worldwide sourcing organizations. The question becomes which resources are critical to success? Best practice companies methodically assess their resource requirements when pursuing worldwide sourcing opportunities.

Figure 11.2 presents a set of resources modified from original work by Peters and O'Connors. While any resource category can affect a global initiative, the resources that are usually the most critical include executive commitment; access to qualified participants; required services and help from others; time, budget, and information; and data. The availability of time remains important since most organizations rely on team members to pursue global opportunities. These team members often have other job responsibilities.

Job-Related Information

Tools and Equipment

The information and data required to support team analysis and performance

The specific tools, equipment, and technology required to support team efforts

Materials and Supplies

Budgetary Support

The routine materials and supplies required to support team activities

The fnancial resources, not including salaries, required to support a team's task

Required Help from Others

Team Member Task Preparation

The services and assistance needed from others external to the team but within the organization

The personal preparation and experience of team members as it relates to the team's assignment

Time Availability

Work Environment

The amount of time that members can commit to team activities

The physical aspects of the team's work environment

Executive Management Commitment

Customer and Supplier Participation

The overall support that executive management exhibits toward work teams and teaming

The support that critical customers and suppliers provide when involvement is beneficial

Figure 11.2: Resources that affect worldwide sourcing success

Let's expand on a resource category that is critical to effective worldwide sourcing—information and data. Crafting a worldwide strategy requires all kinds of information and data, including insight into:

Existing contracts and suppliers

Existing supplier capabilities and performance

Purchased commodities and categories, including part numbers that comprise each commodity or category

Current and future expenditures by part, commodity group, location, etc.

Potential new suppliers by region, and their capabilities

Quantitative improvements sought from a worldwide contract

Internal customer contract requirements

Macroeconomic conditions of worldwide supply markets

Clearly, it takes a great deal of data to feed this beast called worldwide sourcing. It also takes a host of other resources to ensure this process is successful.

Looking Toward the Future

Something we know for certain is that companies will continuously strive to improve their global capabilities, including in the area of worldwide sourcing. With that in mind, let's make some predictions. Only time will tell whether these are correct or not.

Companies that are less proficient at global supply management will stress four enabling areas. In fact, an organization cannot pursue more sophisticated supply chain initiatives without focusing on four key areas: the development of measurement systems, including total cost of ownership systems; access to qualified personnel who have the ability to view the supply network from a worldwide perspective; a supportive organizational design; and IT systems. These areas create the foundation for global excellence.

Another prediction is that the pressure to improve costs will remain severe, resulting in an ongoing search for innovative and aggressive ways to reduce supply chain costs. This includes a continuous search for qualified suppliers in emerging and low-cost supply markets. While economic and risk factors will result in some sourcing shifts across regions, don't expect a mass exodus of work from foreign suppliers back to domestic suppliers. Estimates by the Boston Consulting Group that millions of jobs are coming back to the United States due to reshoring are not realistic. Supply managers will continue to broaden their search to consider a broad mix of countries.

A country that is seeing a benefit from shifting trade is Mexico. A desire by some U.S. companies to nearshore their operations due to the increased cost and hassle of doing business over great distances, a government-industry collaboration that is producing more highly skilled Mexican workers at a reasonable cost, and changing currency values have combined to make Mexico an attractive sourcing spot, even with the country's drug violence. We also expect leading firms to use their supplier development process to improve the capabilities of promising suppliers, particularly in emerging countries.

Looking forward, we expect a continued development and refinement of global supply management processes. Since a majority of supply organizations do not yet practice the highest levels of worldwide sourcing, it is safe to conclude they do not have in place company-wide processes to guide their efforts. If an emphasis on globalization continues to occur, and there is a high probability this is the case, it is almost a given that a continued development and refinement of global supply processes will occur.

We also expect major industrial customers to continue their search for suppliers with global capabilities. The pressure to become a global supplier is partly behind a wave of mergers and acquisitions across certain industries, including the automotive, aerospace, and electronic industries. These mergers and acquisitions are occurring primarily for two reasons. The first reason is to broaden a supplier's geographic reach. A supplier that is North American-centric could find itself at a disadvantage when it competes for contracts against suppliers that have global reach. The second reason is to be better positioned to respond to customer pressure to provide an expanded set of capabilities and services globally.

A somewhat countervailing trend, at least in some industries, is to shift from a reliance on suppliers with global capabilities to a reliance on suppliers with strong regional capabilities. For a variety of reasons, such as logistical issues and trade restrictions, buying companies are showing a preference to use suppliers that are located in the same geographic region as their operations. It seems that corporate strategy is shifting toward a regional perspective and away from a pure global perspective. Sourcing strategy is shifting accordingly.

A shift toward centrally led supply management should continue. Too many companies have experienced firsthand the value of taking a coordinated approach to sourcing to shift back toward a decentralized structure. The challenge will be to create an organizational model that captures the benefits of centrally led supply management, while still being responsive to internal customers at operating sites.

Here is a prediction that is near and dear to this book. Supply managers and finance managers will become better acquainted. Closer interaction between supply, supply chain, and financial managers is inevitable over the next decade. As mentioned repeatedly, a big part of supply chain management is about managing the flow of funds.

It is probably safe to predict that a strict emphasis on global contracts that feature components should gradually evolve toward subsystem and system sourcing. This will involve relying on global suppliers for greater design and engineering support, something that did not happen during the initial stages of globalization. This evolution is a natural extension of global supply management, particularly as leading companies gain confidence in their supply management abilities, as well as the capabilities of their worldwide suppliers.

A safe prediction is that supply managers will increasingly develop global supply strategies for indirect items and services. Whether a manufacturer takes a regional or global perspective, direct items almost always receive more attention than indirect items. As supplier capabilities expand, and as supply managers continuously search for cost reduction opportunities, expect indirect items and services to receive greater attention.

We expect global supply management to move beyond an emphasis on contracting to an emphasis on process consistency. A growth in the percentage of companies practicing Level V global supply management is expected to continue. A defining characteristic of Level V is a movement beyond global contracting to developing standardized global processes and practices. Examples exist (such as Air Products, Colgate, and Whirlpool) of companies that are developing processes and practices that provide consistent practices across worldwide locations. Worldwide consistency, rather than simply worldwide contracts, will define the new normal for companies that compete globally.

Organizationally, the use of global supply teams will increase, making cross-cultural and communication issues more challenging. No evidence appears on the horizon that the use of teams to manage global commodities will diminish. In fact, we expect continued growth in this area, which will create pressure to develop state-of-the-art communication systems. It is safe to conclude that a supply model that features geographically dispersed team members will become more common over the next decade. It is also safe to conclude that a supply model that features dispersed teams will be exponentially more complex to manage compared with ones that feature co-located participants.

A set of predictions also relate to the risk aspects of globalization, which the following summarizes:

As companies increasingly recognize the interdependencies between global events and global risk management, global supply strategies will increasingly incorporate risk management strategies

Expect a shift toward the greater use of total cost models to support global risk management

Supply organizations will increasingly rely on IPOs as a means for managing supply risk in specific regions

As smaller companies pursue worldwide sourcing, they will expose themselves to greater supply chain risk due to a lack of global sophistication

Environmental performance, compliance to rigorous workplace standards, and supplier quality will become more important during the evaluation of suppliers in emerging countries

This set of predictions is certainly not exhaustive. It will be interesting to see how close they are to reality.

References

Supply Chain Financial Management: Best Practices, Tools, and Applications for Improved Performance

Chapter 9 - Managing Costs Across the Supply Chain—The Financial Perspective J. Ross Publishing © 2016

Supply Chain Financial Management: Best Practices, Tools, and Applications for Improved Performance

Chapter 10 - Managing Costs Across The Supply Chain— Applying Financial Techniques

J. Ross Publishing © 2016

Supply Chain Financial Management: Best Practices, Tools, and Applications for Improved Performance

Chapter 11 - Best Practices in Worldwide Sourcing

J. Ross Publishing © 2016