Category Archives: Cost Reduction

Just what is “Best Value”?

In a recent edition of Purchasing Tips over on Next Level Purchasing, Charles Dominick asked What is Best Value Procurement? In the article, he notes that many people use the term “best value procurement” to describe purchasing decisions where factors other than price are used in determining the supplier and/or product to select for purchase and states that he believes that this is “weighted average supplier/product scarring”, which it is.

In his view, value should be measurable in financial terms and expressed in units of currency. I tend to agree, but there are issues with trying to assign a(n exact) hard dollar revenue increase or cost decrease to an event that has not yet happened.

In his illustrative example of choosing between machine A and machine B to automate a production line and reduce the labour needed to keep it running (in an effort to, hopefully, allow the organization to either redeploy the personnel on higher-value tasks or, if not possible, replace those jobs with jobs that could generate more value for the organization down the road), it seems cut-and-dry. Just compute the value-to-cost ratio (where the value, as defined by the estimated labour savings, is divided by the cost of the new machine, which should include purchase, installation, and additional maintenance costs over the expected lifetime). In this case, one machine will generate a higher value-to-cost ratio and that is the machine you should purchase for the organization.

Assuming, of course, that you are sure the machine will have the indicated lifespan and will be useful to you for that lifespan. For example, what happens if you stop making the product in three years but your value calculations are for five years, the expected lifetime of the machine. The value-to-cost calculations will still rank the machines in relative order (as only the value changes), but the return might not look so enticing. And what about the situation where you can instead lease one of the machines from a third party (instead of buying it) and, because that machine in particular is made to a higher quality standard, get an annual lease that is only 1/10th, and not 1/5th, of the purchase cost? In this situation, a machine that cost twice as much would not only have the same value-to-cost ratio but, if you had to sell the machine you bought after three years, the leased machine would have a higher value-to-cost ratio since you’d likely not get the full undepreciated book value for the machine you bought.

And this is just a “best value” calculation on a simple piece of machinery. Consider the difficulty when trying to compute a “best value” on a technology platform purchase, where such platform is intended to improve your sourcing, procurement, supplier relationship management, or similar supply management process. It’s not just up-front cost. It’s implementation. It’s maintenance. It’s operational manpower savings on tactical tasks. It’s efficiency improvements (which have a value in terms of more events or throughput, which translates into generated value) and it’s additional cost reductions identified through the platform (which can be estimated based on benchmarks, but not predicted). How do you do that “best value” calculation? What number do you use? Do you compute a range and use the middle? Do you identify all platforms with a minimum acceptable value-to-cost ratio in terms of guaranteed hard-dollar savings and then select the best-value using the platform with the maximum value-to-cost potential?

There are no easy answers and costs alone don’t always tell the whole story.

You’d Think It Would Be Obvious By Now that You Should Not Poison Your Customer

After the plethora of lawsuits filed in 2008 against Sanlu Group for putting melamine in the milk (or, to be precise, a baby formula that was based on milk) as per this article in the New York Times, against the individuals responsible for importing rip-off toothpaste (that was not manufactured by Colgate) contaminated with diethylene glycol (which is a sweet tasting poison used in anti-freeze and which kills poor defenseless LOLCats), and against Mattel for importing toys coated in deadly lead paint (as per this article from USA Today), you’d think that even if they were run by sociopaths without any ethics whatsoever, corporations focussed on the bottom line would know better than to poison their customers.

However, after reading Pierre the maverick Mitchell’s Friday rant which was “an open call to hotels to NOT poison their customers”, all I have to say is, apparently not!

Maybe they don’t know they’re doing it, or they do but believe that the average customer doesn’t stay often enough or long enough to be exposed to enough toxins to be damaged. Now, this might be the case for the average person who only uses a hotel once or twice a year on vacation, but what about the travelling salesperson or executive who spends more time in hotels than in their own home? How long before BPA builds up to toxic levels in the bloodstream, given that a new study has determined that your body absorbs more BPA than previously thought (rodalenews.com)? If the coffee maker and plastic stir sticks that you use to make your coffee every day leaches BPA, how long before you are sick, whether you realize it or not?
And that’s just the tip of the iceberg! According to Pierre, the non-dairy creamers many hotel chains provide are full of toxins — sodium caseinate, monoglycerides, and diglycerides. We might as well eat glue!

It’s scary. And the worst part is that the cost savings the hotel realizes from buying cheap coffee makers, non-dairy creamers, and other toxic products are negligible. Compared to the revenue a hotel chain can see on a nightly basis from a quality offering that puts them ahead of their peers, a few pennies of savings versus a few dollars in profit is not only negligible, it’s just stupid!

Why TVM Optimizes Spend

Procurement needs to generate value. But Procurement is usually evaluated on savings. It’s a disconnect, but one that needs to be addressed. The best way is to start in the middle. What is the middle ground? Spend optimization. What’s the best way to optimize spend? Focus on total value.

When one focus on total value, one simultaneously optimizes

  • Total Cost of Ownership (TCO)
  • Customer Benefit and
  • Indirect Value Creation

which are the three occasions where one should spend more as per Spend Matters’ UK recent piece on “Three Occasions When Procurement Should Spend More”.

How does one focus on total value? One starts with the definition of Total Value Management as given in the e-Sourcing Wiki Paper on Strategic e-Sourcing Best Practices. In this classic wiki-paper, Total Value Management (TVM) is defined as a comparative cost metric that quantifies the overall cost of each acquired unit relative to the overall value of the spend category as it relates to the organization’s sourcing strategy and supply chain goals.

In other words, TVM not only maximizes the net benefit between the return curve and the cost line, which is computed during a calculation of indirect value generation, but identifies the cost line and associated return cost among all possible cost lines and their associated return curves that allows for the largest maximum net benefit. In other words, TVM does a Pareto optimization and identifies the maximum benefit to the business. Since cost is optimized relative to the return, not only is TCO optimized but the organization has saved as much as it could because any attempts to spend less would result in more dollars being spent somewhere else.

And when we review the three occasions where one should spend more, we now know that

  • TCO is directly optimized because it has to be to compute the cost line,
  • customer benefit is indirectly optimized because the return is only optimized if the activity results in more customer sales or more revenue per customer sale and
  • indirect value creation is directly optimized because marketing, services, etc. spend will be optimized under this model.

Procurement Trend #08. Lifecycle TCO

Five anti-trends remain. We can count them on one-hand, but like LOLCat, we feel more compelled to provide stupid examples of how back-water the futurists really are when they provide us examples of trends that anyone who bothered to poke their head over their cubicle wall ten years ago would have noticed. However, we’ll leave their humiliation for LOLCat, who has obviously received very little enjoyment from this series, but still found time to point out how LOLCats have been sustainable at least since the first corrugated cardboard box was created and instead focus on blasting the myths the futurists continue to propagate.

So why do these Rip van Winkles keep pushing upon us trends from yesteryear? Besides the fact that some of them obviously spent the best part of the last few decades napping, probably because they look around, see the laggard organizations still caught in the muck, and assume they can still sell last decade’s snake oil in today’s marketplace. Why do they think Lifecycle TCO is today’s cure?

  • the supply management lifecycle in a typical company has been expanding
    for decades

    and cost models rarely keep up

  • once the margin has been taken out of the unit cost and the landed cost,
    the definition of cost has to expand to realize savings

    but most companies that claim to be looking at TCO are still looking at T-CAP

  • the most out-of-control costs are typically where you’re not looking

    and that’s the way, uh-huh, uh-huh, they* like it

So what does this mean to you?

Cost Models Have to Expand

Right now, most companies that claim to be focussed on Total Cost of Ownership (TCO) are really only focussed on Total Cost of Acquisition and Production (T-CAP). They are merely focussed on landed cost and costs associated with production (waste, etc.) and distribution and aren’t looking up the supply chain to energy, labour, and raw material costs and forward to maintenance, service, warranty and return costs or even further forward to reclamation, recycling, and disposal (related) costs. Every cost has an impact and any sudden increase or decrease can completely change the model.

Out of Control Costs Have to be Found

Wherever they are. Typically, a company heavily focussed on optimization will be focussed on T-CAP but not look at the expected warranty and return costs associated with switching to a lower-cost supplier or not break down the supplier’s quote to realize that the energy costs are much higher than expected and likely to rise rapidly in the region two potential suppliers are currently located in.

Cost Control Measures Have to Be Implemented

Once the cost models are expanded, the out of control costs are identified, cost control measures are defined, implemented, and performance against them is tracked. If the out of control costs are energy costs, then the organization might decide to implement its own renewable power plant (such as a solar farm or wind farm) for fixed plant energy requirements. A sourcing project is undertaken to source the plant and then, once its up and running, additional projects are undertaken to control maintenance costs, etc. Year-over-year costs are tracked to insure the realized savings on a production-cost-per-megawatt basis are realized so that the organization will see its ROI within a defined period of time.

Piece of Cake, eh?

It’s Conference Season, and that means It’s Travel Season! Part II

And this means it’s time to get your T&E under control.

Since what gets measured gets managed, this means that the first thing your Supply Management organization should be doing is measuring the spend. In particular, it should be measuring:

  • How much spend is under management,
  • How much spend should be under management,
  • How much spend is being spent on each T&E category,
  • How much spend should be spent on each T&E category, and
  • How does the T&E spend compare to business norms?

Why? Let’s take these one by one.

How much is under management?

Supply Management success comes from spend under management. If the majority of spend is not under management, then there is a huge untapped opportunity that comes from getting the majority of spend under management. With enough centralized spend volume, leverage can be used to negotiate better airfares, hotel rates, and car rentals — which may take the form of increasing rebate levels as spend volumes increase.

How much should be under management?

While the goal for most categories is 100% Spend Under Management, T&E is one category where the goal should never be for 100% under management. Why? Taxi and limo companies are different in every city, trains are usually localized to a given country, and while McDonald’s is doing its best, there is no truly global restaurant chain with an establishment in every country. You only want to manage those categories where there is enough spend volume to get leverage and where there are vendors that can meet a significant percentage of global T&E needs. In other words, airfare, hotel rates, and car rentals. For the rest of the spend, you want to set policies that have acceptable ranges by locale. Specifically, you want a range for each country, each state where the averages are off more than 10% from the country, and each city where the averages are off by more than 10% from the state. For example, you wouldn’t use the US average for a 3 star hotel or a dinner in New York, New York, USA or in Pueblo, Colorado, USA where the average cost of living is significantly higher than the norm and significantly lower than the norm, respectively.

How much is being spent on each T&E category?

This information will be critical to negotiating agreements with vendors that will save the organization money in the long run.

How much should be spent on each T&E category?

Before the Supply Management organization begins negotiations with prospective vendors, it needs to understand how much it should be paying. For example, before negotiating with a major airline, it needs to research average fares for its most common travel itineraries, average discounts or rebates for the spend volume it has, and other factors that make it a desirable customer for the airline in question.

How does the T&E compare to business norms?

Specifically, how much is each department spending on T&E relative to the industry norm for that department (measured as a percentage of budget or other standardized measure). If Sales is spending more on T&E relative to the industry average, then either it is traveling more than its peers (and this means it should be getting better results to warrant this travel, and this is up to the VP of Sales and the C-Suite to decide) or it is traveling the same amount and spending more, and this means that its costs are too high and Supply Management either needs to help it get better rates or implement better policies. Regardless of the situation, Supply Management needs to present the T&E spending facts to the C-Suite for every department in the organization so that it gets the authority to do what it needs to do to bring more SUM and so the C-Suite can decide whether any department spending more than industry norms (for its size) has a valid reason for doing so.

And finally, as explained in detail in Part I, despite urges to the contrary, neither Finance nor Supply Management should be attempting to judge the ROI of business travel by function, as suggested in this post over on CPO Rising, or try and measure it with a quantitative metric. It’s job is to prevent over-spending, not to question the validity of the spend. That’s for the head of each department and the C-Suite to debate.