Category Archives: Cost Reduction

Is Your SUM adding up?

When the word comes down to “cut costs”, the first thing that an average fire-fighting Procurement department tends to do is focus on the “big spend” categories. These will either be the categories identified by the spend analysis/reporting system (if one is possessed), an external cost reduction consulting firm (who will do a “spend analysis” if retained), or, if neither is available / approved, the high-spend categories identified by Finance or the long-term Procurement professionals that know which events in the past typically came with the biggest price tags.

If the identified categories haven’t been sourced recently, chances are there are some savings to be had. But how much depends on current market pricing, how much inventory and production capability is in the supply base, current transportation costs, and a whole lot of other factors. If the cost has risen 20% since the last contract due to raw material surges, if demand can barely keep up with supply, or if fuel prices are soaring and the products are heavy, there may not be much savings to be had, even on a 100M category.

That’s why the real trick to cost reduction success is to focus not on the highest value categories, but the categories with the most cost reduction potential. In order to identify these categories, an organization will have to do should cost modelling on all of its high-value and mid-value categories, but first, it will need to get as much of its spend under management as possible. Until its Spend Under Management (SUM) is at least in the 80% to 90% range, it will be impossible to identify all of the relevant high-value and mid-value categories that need to be modelled in order to identify the most likely opportunities in the immediate future.

So ask yourself, is your organizational SUM adding up? Because if it’s 50% or less, half of your organization’s greatest cost reduction opportunities are passing you by.

A Should Cost Model Is Great For Negotiations

But whatever you do, don’t stop there.

But let’s back up. In his recent edition of PurchTips (#221), Charles Dominick of Next Level Purchasing discussed “Using a Should Cost Model in Negotiation” because it’s one way to ensure that a custom item price is fair. And he’s right.

Not only will a good model help you better understand your supplier’s true cost model, and what is driving the price of your final product (raw materials, labor, expensive tooling, shipping, etc.), but it will help you get a better deal. Either the projected costs will be right and you’ll be able to negotiate the supplier down to a fair profit margin, or the costs will be wrong and the supplier will have to point out precisely what is wrong and back it up with real cost data, and you’ll have a better understanding of true costs. (And even if the cost is more than you expect, you’ll still be able to avoid paying more than you should based on the true cost. So even if you don’t “save”, you’ll still “avoid”, and that’s better since, in reality, you only have “savings” if you’re spending money that you shouldn’t be spending in the first place.)

But a good should-cost model is more than an opportunity for negotiating cost savings during negotiations — it’s an opportunity for across the board cost reduction. With a good should-cost model, you’ll not only know how much you are spending on each cost component, but which cost components are the most expensive. You can then focus in on the most expensive cost components one by one, determine why that particular cost component is high (possibly with another should cost model if the component is not an unprocessed raw material) and determine if you could help your supplier reduce that cost or if you should be looking for a substitution. Maybe you’re using expensive natural rubber (which is skyrocketing) and can use a cheaper synthetic rubber. Maybe the supplier is relying on an inefficient logistics carrier and you can identify a cheaper one. Maybe labour costs can be drastically reduced with processed changes. Every cost presents an opportunity for reduction and improvement.

So start with the negotiate to make an immediate cost impact, but continue until you’ve reduced costs across the board. That’s how you make a lasting impact.

VFS: Accident or Planned?

If you haven’t figured it out by now, I’m in the process of dissecting the latest report from CAPS Research on Value Focussed Supply (VFS) with ultra-fine tweezers because it might just turn out to be the most important report of the new decade — if you can get past the fact that they’ve thrown YAMA (Yet Another Meaningless Acronym) our way. Or, it might just be a trivial summary of obvious supply chain improvements from the past few years and have no lasting impact. However, unless we dive in to the details of the 90 page report, we won’t know for sure.

Early in the report, the authors state that the aim of the report is to understand how a holistic value approach differs from traditional competitive sourcing approaches. The hypothesis is that companies that are successful at VFS (which The Mpower Group would term next practices) do two things:

  1. Follow a Value-Focussed Process for Key Categories
    that links to current and future business and technology needs, establishes fact-based value goals for the category, and formulates, implements, and measures strategies designed to achieve the fact-based goals
  2. Invest in Process Enablement
    to conceive, identify, deliver, and sustain value for the near and long term

And while one must agree that any organization that does these two things has a good chance of increasing the value obtained from supply management — as the organization will be looking beyond simple cost reduction to sustainable value creation through supply risk reduction, alternate supply sources, quality improvements, and increased value add to the core product — there is also a chance that, for an average organization, VFS is arrived at by accident. A significant disruption occurs. The team steps up and finds a creative way to solve the problem and restore quality supply in a timely basis, and, in the process, creates additional value as a side-effect because the new process is more efficient or the new materials are more reliable, etc.

Consider the case study for Powercon Co. It had 300 part numbers that could only be obtained from a sole-source supplier that was 40 days late, on average, when a delivery date was missed and that only managed to achieve 50% on-time delivery performance. As the company could not identify any alternate suppliers that would meet all of the company’s needs (affordably), the company had to do something about the problem to improve the supplier’s performance in order to maintain its productivity (and, presumably, profitability) as the late orders brought about a host of problems for the company which did not want to delay its own shipments and face customer service level issues due to a supplier’s problem. In addition, the late orders were also limiting the company’s ability to optimize its manufacturing operations, forcing it to keep excess inventory on hand.

In this situation, even though the company eventually took a formal effort, based on Six Sigma, to improve the situation, VFS was as much an accident as a planned project. The Supply Management team didn’t wasn’t sitting around looking for new ways to add value, they were responding to a dire situation and looking for a way to put out the flames. With the help of an external expert who designed the Six Sigma program, the company improved the supplier’s performance by over 95%, achieving an on-time delivery of 98%, and reaped all the benefits that came from the improvement, but not all of the value was by design.

But sometimes value is by design as well. Consider the case study of F&B that rationalized specifications to reduce SKUs and requirements to those that customers valued and paid more for. This effort had a significant design element up front. But is it really VFS from the get-go? The ultimate goal was cost reduction, and this was a way to achieve the same goal since increase profit per unit is sometimes just as good as reduced costs since it reduces the percentage of revenue spent on raw materials.

What do you think? Is VFS by design or is it by accident?

More to come.

Remember: Cheap Gas Comes At The Expense of the Environment … And Your Supply Chain

I was pleased to see this recent article in Fortune on why gas costs more — and is more profitable — out West because it hammers home three points.

  1. Gas prices are not uniform across North America, and, thus, it’s not all about the price of oil.
  2. If gas is cheaper, it’s not just because transportation costs or taxes are less, it’s because it’s dirty.

And as badly as we may want cheap gas, we should want clean air more. We need agreement on a Kyoto protocol that will mandate consistent EPA requirements across North America. Not only will our lungs thank us, but so will our CFOs — because, then, for once, we’ll have consistent fuel prices across the board and planning will be easier, and cheaper. We will be able to locate DCs at a point that minimizes the total distance across all lanes, because we won’t have to account for fluctuations in fuel prices due to local EPA laws.

Right now, because of so many fuel price variations above and beyond carrier rate variations, an average company requires the most advanced and expensive optimization solution on the market to even attempt to optimize a distribution network. This advanced software is still well beyond the budgets of smaller mid-sized companies. But if the model simplifies, the software requirements for basic network analysis decrease, and lower-cost solutions become sufficient — solutions that are within the budget of the average mid-sized company. And now its clear why cheap gas not only damages the environment, but your supply chain.

The Nature of Energy as a Purchased Item

Robert Rudzki, a regular contributor to Sourcing Innovation, recently edited a great two-part series on the nature of energy as a purchased item (Part I and Part II) by Ted Eichenlaub over on the Supply Chain Management Review that should be added to your reading list if energy is a reasonably significant cost of your operations, as the price of energy is only going to increase in years to come.

In these pieces, Ted, who is a senior advisor in the energy practice at Greybeard Advisors, elaborates on the increasing complexity of energy buys in today’s Procurement environment as the commodity cost of energy is only one part of the total cost of energy to the end-user.

Some important points to keep in mind are:

  • Price and Volume
    Energy is expensive and its price is volatile. In order to take advantage of price volatility, the buyer must know what price will achieve the desired cost ledger performance, the volume requirements, and and the nature of the volume.
  • Hedging
    Hedging can be used to reduce price volatility, but it can also increase price volatility if the hedges are not made by an expert.
  • Credit Worthiness
    A supplier may be unwilling to grant a major long-term contract with price that is very likely to below the price it could command in a month or two if it thinks there is a good chance that the buyer might not be around to utilize the full volume of energy that the buyer is committing to.
  • Standardized Contracts
    Most suppliers use standardized contracts and there is little room for negotiation beyond price and volume.
  • Worldwide Sources
    The energy might be produced locally, across state lines, or internationally (in Canada). Depending on where it is produced, and where it is purchased, there may be documentary requirements, energy credits, or other concerns that need to be taken into account.

In addition, there are concerns regarding transportation and delivery, regulation, and responsibility that also need to be understood. For more information, check out the two part series on the nature of energy as a purchased item (Part I and Part II).

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