Category Archives: Best Practices

An Informative Piece on Making Better Decisions with Cost Modelling

The ISM recently published an informative piece on how to “make better decisions with cost modelling”. Given that projected cost modelling can help supply management organizations reduce procurement costs and generate information that could improve cost performance throughout the supply chain, proper cost modelling is something every organization should have a good grip on.

The breakdown graphic is very good. The cost of any particular good is:

  1. the direct material costs plus
  2. the direct labour costs plus
  3. the indirect overhead costs plus
  4. the (amortized) SG&A costs (of the organization) plus
  5. the (amortized) R&D costs plus
  6. the profit margin

The last three costs in particular should not be overlooked. While they will typically be small in comparison to the other costs, they are there, and they cannot be driven to zero no matter what the volume requirements or the economies of scale. They will always exist, and squeezing a supplier’s profit margin to unreasonable levels seriously jeopardizes the health of the supplier. In addition, while tempting to do so, SG&A costs that are not directly applicable to the good being produced should not be included in the indirect cost. While the indirect costs can be reduced with production line efficiency, SG&A cannot.

And cost models are not hard to build, at least approximately. Direct material costs can be estimated using public indexes, direct labour costs can be estimated using government statistics bureau data, overhead costs can be estimated using government statistics bureau data and industry averages, SG&A can be estimated using public filings, R&D cost ca n be estimated as an industry average percentage, and profit margin can be estimated using a fair percentage.

Furthermore, cost models are even easier to correct. Simply state that, unless the supplier proves the model wrong, you will assume that it is right and base your negotiations off of it.

And once you have a correct cost model, you not only gain deep insight into a supplier’s costs, but into their inefficiencies. For example, you will learn where they are spending too much on raw materials, whether or not they are not competitive in labour costs, and where their processes are inefficient. Then, you can work with them to either help them negotiate better contracts with their raw material suppliers or buy on their behalf (with a larger aggregated demand that you can use to leverage a better contract) and to remove inefficiencies from their processes. This can create win-win situations and give you preferred customer status, which will be beneficial if demand outstrips supply.

Your Free* Holiday Gift from BravoSolution

Those of you who are BravoSolution customers should have already recieved Sourcing Innovation’s latest white-paper on the Top Ten Things to Do in 2013 to Control Costs in your inbox, and those of you who aren’t can download it from BravoSolution’s site (registration is required).

If you were following @sourcingdoctor on that which calls itself Twitter on Saturday (Dec 15, 2012), you would have received a sneak peak into two things that will tank your Supply Management Organization in 2013 if you’re not ready, which were culled from this paper, and those of you who weren’t can still follow @sourcingdoctor and read the post (tweeted in 140 character increments) in his tweet history. (Be sure to use Twitter or another twitter feed reader that presents tweets in reverse chronological order or you will be reading the post backwards.)

For those of you who disdain that which calls itself Twitter, this is why you want to download this paper:

  1. It cleary identifies and explains the seven fates that are going to tank your Supply Management organization in 2013.
  2. It points out the seven elements missing from your Supply Management organization that are exposing your orgnization to the seven fates.
  3. It lays out the ten competencies that you have to master in order to acquire the seven elements that will allow you to fend off the seven fates.
  4. It’s what you need – now. And it’s cool.**


* Registration required.

** Actually, it’s awesome, but making it too obvious wouldn’t be modest.

Can We Make EOQ Relevant Again?

This summer, Supply & Demand Executive published an article on how to make EOQ relevant again. Going through the recent archives, it got my attention because it is simultaneously a metric that should have never lost relevance and a metric that loses relevance when too much emphasis is placed on JIT or avoiding stock-outs (at all costs).

EOQ, short for Economic Order Quantity, is an old-school metric whose function is to identify the optimum order size that has the lowest cost. Defined as the square root(2UA/IC), where:

  • U is the (annual) usage,
  • A is the acquisition cost per order,
  • I is the inventory carrying rate, and
  • C is the cost per item

if demand is relatively constant, or at least known and predictable, the item is purchased in lots or batches, and the order preparation and inventory carrying costs are constant and known, then the formula tells you how much to order (and, as a result, how often to order) to minimize your overall order cost.

But, as the article points out, even assuming you can mesh this with your JIT production schedule (timing the orders so that you don’t carry too much inventory but still keep production running smoothly), these are not all of the costs associated with an order. Other costs include:

  • purchase order processing cost (which should be included in acquisition cost)
  • a true ICC rate (and not the holding cost computed as the extra cost of money invested in stock) that takes into account opportunity costs (which should be included in I)
  • taxes paid on inventory (which can be substantial and why many auto dealers, for example, have year end clear-outs) (which should also be included in I)
  • stock quantity shrinkage loss due to handling, pilferage, and theft (which should also be included in I)
  • stock risk losses due to product obsolescence, deterioration or shelf life expiration (which should be factored into C)

Thus, in order to use EOQ, you need to first insure that all of these costs can be accounted for. Then, as per the article, you need to insure that:

  • the product(s) are offered at a single price,
  • demand is predictable,
  • prices will not change (significantly) during the time the order is in stock,
  • stock will not exceed the shelf-life,
  • a single order can be placed, and
  • freight is included in the purchase price, or can be factored in.

In this situation, if the additional costs identified above are factored in, EOQ is still very relevant and should be used. However, if multiple assumptions are violated, EOQ may not be appropriate, and, more specifically, if demand is slow, or very unpredictable, then JIT is the preferred method.

And, furthermore, if you

  • establish minimum quantities to reflect minimum purchase volumes,
  • set a maximum ceiling stock for difficult, bulky, or large items, and
  • base adjustments on multiples of packaged lots

then you may find that EOQ is still right for you.

One Size Does Not Fit All – That’s Why You Need User Configurable Workflows

Andrew just posted a great post over on CPO Rising on how One Size Does Not Fit All where e-Sourcing and e-Procurement is concerned. As Andrew astutely notes, process standardization is very important within Supply Management, but having only one option for e-Sourcing or e-Procurement events is certainly not the way to go.

One has to remember that even in the simplest classification scheme, you will break your events into quadrants based on dollar value and business impact (or supply challenge and business impact). For low value, low impact events, you’re not going to use a process that requires a lot of time and effort, because you need that on high-value, high impact categories. Similarly, you’re not going to use an automated e-Auction for a high-value, high-impact category and essentially throw the category to the wind. As Andrew notes in the first example in his post, if the process is set up for large, high-value, multi-stakeholder process, it’s not going to work for small, low-value, single stakeholder processes as it will be too cumbersome and your buyers will do everything they can to bypass or ignore it.

In order for your solution to work, it needs to support multiple project configurations that can be defined by the client. For example, the client should be able to configure simple, automated e-Auctions for low-value, low-impact categories; automated e-RFXs for low-value, high-impact categories and high-value, low-impact categories where Procurement personnel only need to get involved in final review and award; and full-fledged multi-round RFX and Decision Optimization for high-value, high-impact categories. (Now, every category should run a baseline optimization scenario before an award is made, but extended analysis does not need to be done for all categories.)

And, further more, it needs to be easy for a Director or CPO to grant exceptions to the process when they are appropriate. For example, as per Andrew’s 3rd example, it should not take months of back and forth to remove a “mandatory” automobile insurance provision when no automobiles are being used! So make sure your solution is configurable, or it might not last long in your client’s Supply Management department.

Do We Have to Send CPOs to Disney for Training?

According to Steve Hall of Procurement Leaders, who was busy blogging while most people were off on summer vacation, the CPO’s challenge is to re-imagine supply chains. Traditional transformation is just not enough – you have to come up with radically different designs. You have to do for supply chains what Walt Disney Imagineering does for Disney – blending imagination and engineering in a unique way to create unique experiences with their creations.

It seems that according to Steve, rapidly escalating issues such as material shortages, commodity price volatility, increasing government regulation, and financial risk in the supply base cannot be tackled by current supply chains unless they are suitably re-imagined. I’m not sure I entirely agree.

It’s not that I disagree that CPOs will need more imagination, and more engineering skills, in the future, but we must remember that:

  • material shortages happen all the time as a result of natural disasters, unexpected spikes in demand, etc.
  • commodity prices go up and down as a result of shortages, or expected shortages, or expected surpluses
  • government regulations are never-ending – going back decades
  • financial risk has always been there – it’s just at a high-point now due to global economic instability

In short, these risks are not new. They’ve been around since trade began, we’ve had, and developed, methods to deal with them since trade began, and we’ve survived. The only difference now is that all four risk categories have simultaneously hit (near) all-time highs — and the situation is only expected to get worse. Plus, whereas shortages always disappeared in the past when production ramped up, in some categories, either due to space restrictions, climate issues, or production issues, the shortages are not going to go away any time soon. In some areas, there is only so much suitable farmland; in others, the climate is no cooperating, and others still, we can’t mine the materials as fast as we need to concern them. So, in these cases, we are going to have to engineer products to use less of these materials, or alternate materials, but this is as much of an engineering challenge as a supply chain challenge (and proof that Supply Management needs to be involved earlier in product development and closely collaborate with the rest of the organization).

In short, CPOs will need to use their imaginations more often and be more creative in their solutions when backed into tough corners, but it’s not time to throw away the time-honoured supply management toolkit just yet. We’ve faced many of these problems before (even if it has been a decade or two), and many of the solutions are still relevant.