Category Archives: Cost Reduction

VFS: Are You Ready?

Last week explored the four levels of Value Focussed Supply (VFS) as put forward in CAPS’ recent research report on “Linking Supply to Competitive Business Strategies” and the holistic approach put forward by CAPS to get more value out of your Supply Management Organization.

There were a lot of good suggestions in the four levels of value focus put forward by CAPS, but a lack of realistic starting points for an average organization that needs to merge onto the value focussed path. As per the second post on the elimination of value leakage, it’s hard to protect revenue if the key revenue streams are unknown. It’s hard to reduce cost if cost has not been baselined. It’s hard to reduce working capital requirements if they, and the reasons for, aren’t understood. And it’s hard to protect corporate reputation if the risks are unknown. But how do you identify key revenue streams? How do you baseline costs? How do you document working capital requirements? And once costs are baselined, how do you go about reducing them in such a way that working capital and corporate reputation are not negatively affected?

You start with information. Information helps an organization baseline costs. Information tells the organization what its working capital requirements are. Information tells an organization what its corporate risks are. And, most importantly, information tells an organization what options it has for reducing costs that won’t negatively affect working capital and corporate reputation.

So where does this information come from? Data, and an analysis of that data. Where does the data come from? Some of it should come from internal systems, from which it will be amalgamated with a spend analysis system into meaningful reports. But the rest should come from (prospective) suppliers, who have access to data that the organization does not.

But how does an organization get that data? The obvious answer is through an e-RFX application, but it’s not that easy. Why not? It’s one thing if the organization is spot buying silver and there are only three suppliers with a surplus available within the immediate area of the factory that needs it within three days and the only information that needs to be collected is the purity, price per pound, and cost of transportation if the supplier delivers, but it’s another thing completely if the organization is renegotiating it’s global transportation contracts. The first situation is a few dozen bids. The latter could be a few hundred thousand bids. Assuming the organization can identify all of the bids that it desires, how does it get the suppliers to provide that much information? No supplier wants to get a bid sheet that requests multiple LTL rates and TL rates for 5,000 lanes … especially if it only services 2,000 of them. A simple RFX isn’t going to solve the problem. So what is?

Tune in tomorrow because, as Number 2 would say, “we want information … information … information“.

VFS Level 1: Eliminate Value Leakage, Part II

As indicated in yesterday’s post, this week will explore the four levels of Value Focussed Supply (VFS) as put forward in CAPS recent research report on “Linking Supply to Competitive Business Strategies” and the holistic approach put forward by CAPS to get more value out of your Supply Management Association.

According to CAPS, this starts with the elimination of value leakage, and, for the most part, SI is in full agreement (with the disagreements being around where an organization starts plugging the holes). In CAPS’ view, this starts by focussing on four primary components of the balance sheet — revenue, cost, assets, and intangibles — in an effort to find ways to improve them such that the overall corporate position is improved. At this first level of VFS, this means that a company would:

  • Protect Revenue
    by improving quality and stability of supply
  • Reduce Cost
    by reducing unit cost and managing demand
  • Reduce Working Capital Requirements
    by improving working capital management
  • Protect Corporate Reputation
    by taking steps to prevent the media fiascos that would result if
    tainted food or dangerous products were released into the marketplace

and CAPS goes on to give the following examples of:

  • working with key suppliers,
  • looking at alternate fee arrangements,
  • adding better inventory management strategies or early payment discounts, and
  • improving testing and quality inspection process.

These are all valid, and great ways, of eliminating value leakage, but, at least in SI’s view, there are some basic steps a company needs to take before it starts these processes. In particular, SI feels that a company needs to start by:

  • Identifying Key Revenue Streams
    Before revenue can be protected, it has to be identified. Start with a sales analysis to identify the products that are generating the most revenue and then do a cost analysis to determine which of these are, or could be, the most profitable and then focus on these categories as improvements to key revenue streams will be the most effective.
  • Understanding Current Cost, Demand, and Actual Spend
    Before cost can be reduced, it has to be baselined. Do a spend analysis to determine where money is being spent, what the current demand is, and how much the demand is costing you. This will help you identify which categories need the most effort and which suppliers are really key to your success.
  • Understanding and Optimizing Working Capital
    Before working capital requirements can be reduced, they have to be understood. What is the current level of working capital required? Why? And how long is it being tied up for, on average? If capital is moving quickly, inventory optimization might not buy the organization much in terms of working capital reduction, in which case it will have to focus on early payment discounts or baseline cost reduction. But if significant amounts of working capital are tied up in inventory, that is the only thing the organization should focus on until the product is fixed.
  • Identifying the Risks to Corporate Reputation
    If the primary risks aren’t identified, they can’t be protected against. Depending on the type of product being produced, quality might not be the biggest risk to corporate reputation. So a batch of cleaning solution was accidentally watered down by 10%. Is anyone going to notice? Probably not. But if the chemicals used may pose a danger to the environment, then the company has to focus on finding safer alternatives.

SI feels that an organization cannot effectively stop value leakage until it has a good handle on its current situation and has identified where the greatest leakages are. Otherwise, its efforts will likely find only limited success (as the chance of a category having minimal value leakage is just as great as the chance of a category having high value leakage when a category is chosen at random). And even then, there are a few more basic steps a company might have to take but these will be discussed in subsequent posts.

VFS Level 1: Eliminate Value Leakage, Part I

This week will explore the four levels of Value Focussed Supply (VFS) as put forward in a CAPS recent research report on “Linking Supply to Competitive Business Strategies” and the holistic approach put forward by CAPS to get more value out of your Supply Management Association.

According to CAPS, you start with the elimination of value leakage. While this is a good place to start in theory, in practice, at least until now, most organizations increased value in supply management purely by accident. They were given a mandate to reduce cost and when they were no longer able to negotiate better prices or optimize incurred costs (logistics, storage, VAT, etc.), they looked for new ways. Not knowing any, they got creative, and sometimes they got lucky and found strategies that not only lowered costs but increased the overall value of supply management to the organization. At this point, the organizations began an effort to find more value, and began their progression up the supply management value curve, which, in the view of CAPS, and the author, starts with the elimination of value leakage (although the author believes one or two critical steps were overlooked in the report).

According to CAPS, value is obtained at each level of the value curve by focussing on four components of the balance sheet — revenue, cost, assets, and intangibles — and finding ways to improve them such that the overall corporate position is improved. At this level of VFS, this means that a company would:

  • Protect Revenue
    by improving quality and stability of supply
  • Reduce Cost
    by reducing unit cost and managing demand
  • Reduce Working Capital Requirements
    by improving working capital management
  • Protect Corporate Reputation
    by taking steps to prevent the media fiascos that would result if
    tainted food or dangerous products were released into the marketplace

Furthermore, such a company might go about these actions by:

  • Working with Key Suppliers
    to implement Lean, Six Sigma, or TQM (Total Quality Management) processes to reduce defects, streamline production, and increase schedule accuracy like Powercon worked with a key supplier to correct dismal delivery performance and increase customer loyalty in the process
  • Looking at Alternate Fee Arrangements
    like Pharmacare did with ancillary legal services which could be contracted on performance-based fee arrangements and other ABM (alternate billing methods) to reduce costs by 20% to 40%
  • Adopting Better Inventory Management Strategies or Early Payment Discounts
    as reduced inventory translates into a reduction of cash locked up in inventory (as well as reduced storage costs) and early payment discounts not only reduces invoice payments, but reduces a supplier’s need for financing (which is often at higher rates), which reduces future costs
  • By Improving Testing and Quality Inspection Practices
    even though this might increase costs slightly up front since having a better brand increases revenue in the long term and the up front cost quickly translates into long-term savings

These are all great strategies, and, for the most part, great starting points for any supply management organization that wants to increase the total value it provides (and do true “Total Value Management” [e-SourcingForum] [Sourcing Innovation]), but a few of them seem to skip the starting points, at least in SI’s viewpoint. This will be the focus of Part II.

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.