Category Archives: Cost Reduction

Listen to BrainNet – Invest your Avoidance Savings to Keep Costs Down

In the recent CPO Executive debate on public sector spend and savings measurement, transcribed in “Cuts from the Centre” and previously referenced in our post on how your Organizational Data is Organizational Data — NOT Department Data, Fredrik Henzler, Partner and MD, of BrainNet, made a great point — while there is no incentive for a provider to offer the same product or service at a 10% discount if they can continue to get what you are paying now, if you offer to split the savings and let the provider invest a portion of the savings in long-term operational and infrastructure improvements, then there is incentive. If the provider can reduce the cost of their product or service, then they have money to invest in new technologies to further improve efficiency and reduce cost, which will keep the provider competitive as time goes on.

Furthermore, if you don’t get greedy and allow your provider to keep a larger margin if, and only if, they invest in operational improvements, then you know that costs will continue to drop over time and you have likely bought yourself years of cost “savings” and will be able to acquire new products and services at a lower price point than your competitors. Not only is it a win-win, but it incentivizes your providers to reach new heights of efficiency and effectiveness. So invest your savings, and just like money deposited in a high-yield savings account, watch your savings grow over time.

Remember the Dangers of Centralized Buying

In an effort to combat the inflation across the board, I’m hearing a number of consulting firms emphasize the need to leverage your spend across the board, which is good advice. However, I’m worried about how some firms might be interpreting this advice. I’m getting signs that some firms, not yet as advanced in Supply Management as they need to be, are interpreting this as a need to “centralize”. While this has been the common historical response when a firm needs to obtain spend leverage and Supply Management for the categories in question are decentralized, it’s usually the wrong one. What needs to happen is the firm needs to move from decentralized buying straight to center-led buying and skip the centralization step and the growing pains that will result.

When you centralize, you lose:

  • local opportunities
    while a national temp labor agency can offer you better rates across the board, sometimes a local agency that is 10% more is actually 40% cheaper because you don’t have any travel expenses for local resources
  • local knowledge
    and sometimes a local buyer has a better understanding of the ups and down of commodity or service pricing in a region than a buyer on the other side of the globe and knows that she can spot buy a better price 80% of the time
  • (some) control over supplier performance
    as a centralized buy will typically be with one or two international suppliers who will not only have a lot more weight and leverage, but distributed production; in comparison, if buys are more local, they are typically with smaller suppliers where the buyer has the dominant position in the relationship and more control over quality and the production schedule

In addition, when you centralize, you can pave the way for organizational conflict as a result of:

  • the divergence of subunit goals
  • conflicts of preference between the central units and remote units
  • the lack of subunit inclusion
  • higher costs of certain purchases on the corporate contract as compared with local costs from a local supplier

However, a center-led purchasing organization will work with each subunit to insure that the best buy is made every time. Sometimes that will be through amalgamation of volume to obtain leverage through a larger contract with an international supplier (where costs are high) and sometimes it will be through the provision of best practices to each unit, which will secure the best rates in their region. You only get leverage where it exists to be found.

Time to Shorten those Payment Cycles

If you want a sustained recovery, it’s time to start shortening those payment cycles. During the recession, the average payment cycle time in many companies shot up due to “cash flow issues”, and it’s already coming back to bite them in the rear end. As SI has said before, this is not the solution to cash flow and any “cost savings” that the business appears to benefit from (by having more cash in the bank that can potentially earn interest on short 60 or 90 day notes) is more than eaten up by the higher costs the suppliers have to charge to make up for the high interest rates they have to pay to obtain working capital.

It’s important to remember that late payments put extraordinary pressure on suppliers, especially small and medium sized suppliers, which often desperately need cash to purchase equipment, raw materials, and, most importantly, meet their payroll. Furthermore, in addition to cash flow problems caused by late payments, many firms incur significantly extra costs for the time and money spent chasing payments and securing interim financing, usually at exorbitantly high rates – which can often exceed 20% compared to your rate of borrowing, which can be as low as 5%.

All these costs do nothing but drive up the supplier’s cost of operation, and effectively, the price they will need to charge to maintain enough profitability to survive. That’s why many prices for components are rising faster than the raw commodity costs. The lack of prompt payments has cut many suppliers to the bone. Extending payment terms doesn’t help with cash flow or “cost savings”. Extending payment terms only drives up the price in the long term while increasing the risk of a major supply disruption as a supplier could go out of business if all its customers take too long to pay.

So instead of extending Days Payable Outstanding, consider looking at other strategies that can lower your cost of operations – such as improving forecast accuracy, balanced just in time (JIT) production, and low cost financing options that are available to you, as a large company, and not your supplier. Better forecasts lead to less missed opportunities and a reduced need to clear inventory at significant markdowns, balanced just in time (JIT) production reduces inventory costs, which is much better than just shifting them to a third party, and financing your purchase at prime or less will cost everyone less in the long run that forcing a supplier to take out short term financing at 20% to 40% per annum.

Efficiency is Never Bad. It’s the Focus on Cost-Cutting that Kills You!

Glancing through my notes, I came across this piece in S&DC Executive from the early spring that asked if “too much efficiency [can] be a bad thing”. I bookmarked it because articles like this really grind my gears. We have enough problems without respected publications publishing idiotic articles, such as this, that try to answer difficult problems with findings from studies that identify correlation, not causation. (And as Pinky and the Brain explained in their brilliant lesson in statistics, correlation and causation are not the same thing. Simply put, correlation measures the relationship betwee effects, which have underlying causes.)

And while I fully believe the results from the in-depth study that asked what drives financial performance and analyzed the financial performance of publicly traded U.S. manufacturing firms from 1991 to 2006, as reported in Volume 29: Issue 3 of the Journal of Operations Management, I reject the editorial staff’s claim that the results present empirical evidence to support the view [that too much efficiency is a bad thing]. Efficiency is never a bad thing. It’s the principles guiding the application of the efficiency that is the problem.

As the article states, if there is no slack in the supply chain when a disruption occurs, then this will cause operational problems that will result in a negative financial impact. But the decision to go all-out with a Just-In-Time (JIT) philosophy is not an efficiency decision, it’s a cost-cutting decision. Less stock means less inventory and carrying costs. So some firms, in their effort to save every penny, go ultra-lean and then run into serious problem when a demand surge or supply disruption hits.

Efficiency corresponds to the production, inventory, and logistical processes used to manufacture, store, and ship the goods. It’s streamlining the process to eliminate time and resource waste, not cutting production quotas to dangerous levels. It’s minimizing packaging and storage space requirements by maximizing package integrity and space utilization, not eliminating safety stock. And it’s optimizing the distribution network for quick and affordable shipping, not altering lot sizes to fill an existing truck or lane to save a few pennies on shipping costs (when there are dollars to be saved from a network redesign).

Efficiency is never bad. Only ill-conceived supply chain design decisions and overly ambitious cost cutting is bad. And anyone who thinks otherwise doesn’t understand what efficiency means.

Cost Reduction Strategies to Avoid

Cost reduction as a strategy is dangerous. First of all, a company that is too focused on cost might lose sight of value, which is what Supply Management is all about. Secondly, a company that is myopically focussed on immediate cost reduction is likely to make one or more of the following mistakes and actually increase costs in the long term.

Direct cost focus

This sounds like a great idea, since it’s where many organizations in manufacturing and CPG have the bulk of their spend, but the reality is that these are the categories that get analyzed year after year after year, while indirect categories fall by the way side. And the reality is that it’s much better to save 10% on 40 M then it is to save another 2% on a 100 M category. It’s twice the savings.

Landed cost focus

While it’s true that you can (theoretically) “book” a savings if a hardball negotiation gets you the same widget for $1, including transportation, that the organization used to pay $1.10 for, this is not really a savings if the widget is of lower quality and has a higher failure rate. If 15% break-down during the warranty window, when only 5% used to break-down, this has not only increased the average unit cost from 1.16 to 1.18 (in terms of functioning units), but tripled your warranty costs. If replacement costs turn out to be twice the product cost then, instead of paying an average of 1.20 per unit from a TCO perspective, the organization is now paying 1.30 per unit (from a TCO perspective) when the total cost of the lower quality product is calculated.

Year-over-year price reductions in multi-year contracts

This is my favourite example of cost reduction ridiculousness. Sometimes, anxious to meet the ridiculous mandate of 5% year-over-year cost reductions for the next three years, Supply Management organizations will try to negotiate three year contracts with year-over-year price reductions of 5% built in. And often they’ll exceed, and cost the organization approximately 15% more then if they just negotiated the best deal they could. Why? The supplier is going to have to make a profit each year it is in business. Since it’s likely not going to change the production methodology, the raw materials, or the labor that goes into making the product for the lifetime of the contract, the supplier knows that the price in year 3 has to be enough to be profitable. So the price it quotes in year 2 will be 5% more and the price in year 1 will be 5% more again in an attempt to insure it is still profitable in year 3. As a result, the organization ends up paying significantly more in the first two years than they could have paid by just negotiating the best, flat, deal possible. The right way to get year-over-year savings is to tackle different categories each year, not try to negotiate silly year-over-year savings in a single category.