Monthly Archives: February 2013

Supply Management Economics Part II

In Part I, we noted that, as far as the doctor can see, the topic of Economics is too often swept under the rug where Supply Management is concerned. Why? Hard to say, but the recent failure of Macro Economics to predict the biggest downturn since the Great Depression and its continual inability to explain the tortoise-pace of the recovery is certainly a major factor.

But, reasons aside, the reality is that you can’t ignore economics. Not only will you be unable to judge a supply market strategy without a solid understanding of basic economic principles, but when you get down to the basics, as pointed out by Adam Smith in 1776, real wealth is resources and the goods and services produced with them. In other words, all wealth, and economics, revolves around Supply Management.

Remembering that the three basic questions of economics are what to produce, for whom, and how, we need a good understanding of the basics. The first understanding is the production possibility curve/frontier. This is a graph that compares the production rates of two commodities that use the same fixed total of the factors of production. The curve shows the maximum specified level of one commodity that results given the production level of the other. In other words, with fixed resources, there is a trade-off between how many units of each product can be produced. This is the basic theory that underlies your manufacturing planning.

The next understanding we need is that of comparative advantage. This is the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. This is the basis of trade. This is because it’s advantageous to produce goods you can produce more efficiently than someone else and trade them for goods that you can produce less efficiently than someone else. In a more complex way, this is not only the basis for trade between nations but the consumer economy we have now.

To see this, we simply add IOUs into the equation. Let’s say you need shoes, but your skills are bookkeeping. Let’s also say that the shoemaker doesn’t need bookkeeping, but needs a hammer from the ironsmith. The ironsmith is poor with numbers and needs bookkeeping skills to keep the taxman off his back. In this case, the shoemaker can accept your IOU in exchange for the shoes and give it to the ironsmith who needs your skills. In this way, neither you nor the shoemaker have to fumble around for days trying to procure a hammer you don’t know where to get or produce one you don’t have the skills for, and the ironsmith doesn’t need to worry about the taxman as he can quickly produce the hammer the shoemaker needs who can quickly produce the shoes you need to walk to the ironsmith’s forge where you quickly do his books to keep the taxman away. When everyone does what they do best, and trade it, all parties profit. The only difference is that, today, instead of negotiating complex multi-party trades or passing around IOUs, we just use paper money issue by banks, which represent the value of the goods and services we trade.

In other words, when we understand the (multivariate equivalent of the) production possibilities curve and the concept of comparative advantage (which tells us that even if we can’t produce anything better than our competition, we can still profit as long as we produce something of value, although we will do better if there is something we are better at than anyone else), we understand how to determine what we should produce and in what quantity. And that’s the first step to successful Supply Management.

Supply Management Economics Part I

One of the goals of SI is to continually educate its readers on topics that other blogs miss or ignore. One of those topics that continually gets brushed under the rug is that of Supply Management Economics. For a while the doctor has been trying to figure out why. Is it because economics is not that important? Is it because economics is assumed to be implicitly conveyed in the topics covered? Or is it because there is no firm grasp of economics where Supply Management is concerned?

The answer is still up in the air, but part of the problem is obviously due to a lack of understanding, which should not be surprised when one considers that where the economy is concerned in general, there is a lack of understanding. Consider this recent article from the economist on A Brief History of Macro: How We Got Here about macroeconomics and its poor reputation these days due to its continual failure to answer why America’s post-crisis recovery has been so slow and, more importantly, its inability to predict the biggest and most powerful downturn since the Great Depression. (Epic Fail!)

Basically, despite all of economists’ grandiose claims to the contrary, when it comes to large-scale national and international economics, modern macroeconomic theory just doesn’t have a good enough grip on reality, so how can you be sure standard Supply Management economics is right either, even if you understand it? You can’t. But that doesn’t mean that you should ignore it either. There are a number of principles that hold up well and provide insight into the market dynamics that impact your organization on a daily basis. And without a solid understanding of the basics, how will you judge market-based sourcing strategies presented to you by consultants and experts? Before you can judge a supply market strategy, you have to know how much confidence you can put it in, and that requires an understanding of economics, the solidity of the underlying principles that are being assumed, and the assumptions that are unsupported.

In this series we going to cover a bit of the basics, as well as a few recent advancements in Supply Management Economic theory that may advance your understanding of strategic supply (relationship) management and inject more value into your value chain. We don’t know all the answers, but those who do not seek never find.

So where do we begin? At the beginning, or at least close to it. Back in 1776, when America was declaring its independence, Adam Smith, a moral philosopher and Scottish economist published An Inquiry into the Nature and Causes of the Wealth of Nations which offers one of the world’s first collected descriptions of what builds nations’ wealth. (Source: Wikipedia) In this fundamental work of classical economics, Smith essentially states that real wealth is resources and the goods and services produced with them.

Based on this, we are led to the three basic questions of economics:

  1. What to Produce.
  2. For Whom to Produce it For? And
  3. How to Produce It?

Which brings us back to my question of why economics continually gets brushed under the rug when Supply Management IS Economics!

Could Strategic Sourcing Save the US Government?

It’s a hard question to answer, but when you consider the fact that Joe Jordan, administrator of the Office of Federal Procurement Policy just said that our government is the largest purchaser in the world, but it buys as if it were 130 mid-sized businesses. We’ve got to leverage our buying power, you’ve got to think about it. Especially when a recent report from the IBM Center for The Business of Government by David C. Wyld estimated there are 8.9 Billion in Savings to be had in US Federal Government Spending Alone just by using public sector reverse auctions on a mere 75 Billion of Federal Spend identified as appropriate for reverse auctions.

When you think about the fact the the U.S. Government Budget for 2012 consisted of 3.796 Trillion of Expenditures, with 716 Billion going to defence, 56 Billion to International Affairs, 31 Billion to Science, Space, and Technology, 23 Billion to Energy, 43 Billion to Natural Resources and Environment, 19 Billion to Agriculture, 103 Billion to Transportation, 32 Billion to Community and Regional Development, 361 Billion to Health, and 62 Billion to Administration of Justice (which adds up to 1.446 Trillion, where you know manpower costs are probably less than half, you have to believe there is at least 750 Billion of Federal Spend that is appropriate for strategic sourcing. At least. Slap on the expected 12% expected average savings if the Federal Government bought strategically using its buying power, and we would expect there are at least 90 Billion in what is likely low-hanging fruit savings opportunities just waiting to be plucked. At least. Now, it’s true that this wouldn’t even cut 10% off the deficit, but if the US returns to a balanced budget in the near future, and strategic sourcing saves the company 12% of sourceable spend, then even if sourceable spend is only 50% of the entire spend, the company will be saving 150 Billion a year, and that adds up quite fast!

According to Jordan, strategic sourcing could perhaps apply to $150 Billion of $500 Billion under his (direct) purview. It’s only a fraction of the total spend that eventually needs to be strategically sourced, but it’s a good start if addressed. That would likely give the government savings of 15 Billion to 18 Billion and an incentive to force strategic sourcing through all the agencies that receive and/or control government funds.

And the savings will be magnified if the office really does improve the government’s records on contract past performance and takes advantage of inspectors’ general work in exposing waste, fraud and then suspends and debars “bad actor” contractors from getting work. (While some governments don’t believe past performance should be used against bidders in future RFPs, those of us in the private sector know that is the among the stupidest ideas ever and you don’t give a non-performer more work.) It’s one thing to overspend on a contract by 10%. It’s another thing to overspend by 100% because you awarded the contract to an entity that could not deliver.

And if Jordan is convinced that the office needs good, timely and robust past performance information and uses this as an incentive to evaluate the use of data to drive fact-based analytics in the acquisition process and moves to spend analysis and decision optimization / support systems, the savings opportunities for the U.S. Federal Government are an order of magnitude above what even the biggest corporations can hope to save with advanced sourcing efforts. For the US Federal Government, strategic sourcing is definitely worth the effort it will require.

And, for sure, this is another arms race the UK doesn’t want to win.

Don’t Forget the Recovery When Designing For Recovery!

In our recent post on how supplier circles are just loopy, we noted that the only difference between what the McKinsey article on “Manufacturing Resource Productivity” is preaching and what the environmentalists have been preaching for years is that the reduce, reuse, and recycle mantra should pervade the supply chain end to end and influence new business models that improve recovery, create new sources of supply, optimize production, and increase revenues instead of being an afterthought. In essence, as we pointed out, McKinsey is jumping on the Design for Recycle bandwagon that SI and a few other (lonely) thought leaders have been pulling for years (and years and years), but changing the language to make it look like it’s their idea (as all good consultants do — but at least they are not stealing your watch to tell you the time).

Design for Recycle, which is also known as Design for Recovery, is very important as the supply of more and more rare earth minerals become scarcer and scarcer and the most abundant source is in products (going) in (to) the hands of the consumers, who will eventually finish with the product, and without an alternative, toss it in the trash — where it may end up wasted in a landfill! But this isn’t the only reason you want your products back. Even when the initial customer is done with them, most of your products, or at least components thereof, still possess value and can still be refurbished and resold at a profit, even if they are not working. The obvious example is the iPhone 4S still has value when the customer upgrades to the iPhone 5. A less obvious example is that the laptop still has value if only the memory needs to be replaced. If the laptop can be resold for $300 with only $20 for new memory chips and $30 of labour, then recovering it at a cost of $30 of shipping and a trade-in credit of $100 should be a no-brainer as that leaves you with 40% profit — which is probably a heck of a lot more than what you made initially when prices were slashed to be competitive with your most aggressive competitor! And then there’s the fact that many jurisdictions are enacting legislation regarding returns management and proper disposal. If you don’t have a valid recovery mechanism to ensure customers have an option for proper disposal, in some of these jurisdictions, you could be fined if your customer, lacking such an option, decides to throw the product in the trash.

But these aren’t the only reasons to plan for recovery. As pointed out in a recent article on “reclaiming value through reverse logistics”, a retailer’s returns policy is a critical decision making factor in a customer’s purchase. Specifically, 63% of online shoppers look at the policy before making a purchase, and 48% will shop more often with a retailer that offers a lenient, easy-to-understand return policy. And while this is a retailer, and not manufacturer, statistic, it does indicate the significance of returns. Furthermore, the reality is that if you have a good return management process that is headache-and-hassle free for the retailer, then the retailer is likely to offer the customer a headache-and-hassle free policy as it knows it doesn’t have to worry about getting stuck with unwanted or defective products. Putting your customer first helps your customer put the end consumer first, which, according to the UPS commissioned study quoted in the article, increases the chances that they will buy from the retailer who is your customer. Plus, 32% of customers have indicated that they will focus less on price and more on quality of service if given a lenient, easy-to-understand returns policy. That’s how you maximize revenue and profit!