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The Essentials of Supply Chain Management Strategic Sourcing: Cost Management

Cost management has taken on increasing importance in all aspects of the business. And in no part of the business is it any more critical than in procurement and sourcing activities. In this fifth installment of our “Beyond the Basics” series, professor Wendy Tate of the University of Tennessee explains the principles and techniques that enable effective cost management as part of an overall strategic sourcing approach.
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The series is titled “Supply Chain Management: Beyond the Basics” and a new installment will appear each week on our website. It picks up where our original series of articles from Tennessee—the “Basics of Supply Chain Management” — left off. Among the topics we’ll be covering in this latest series are successful collaboration, supply chain risk management, strategic sourcing, supply chain finance, and more.

By Wendy L. Tate, Assistant Professor of Logistics, Department of Marketing and Logistics, University of Tennessee
May 16, 2011

Managing the cost of purchased goods and services continues to be a key concern of executives.  According to the U.S. Census Bureau, the cost of purchased materials is approximately 54 percent of the value of shipments for manufacturers. The importance of services to the global economy as well as to individual organizations continues to grow, meaning that the purchasing spend for services is continuing to increase.  More emphasis is being placed on strategic cost management and on the sourcing professionals who are responsible for locating and managing the suppliers that provide the materials and services. Strategic cost management takes a broad view of the organization’s costs, both internal and external, in such a way as to enhance competitive advantage. Typically, the management of costs is perceived as an accounting or finance responsibility because these functions have a fiduciary responsibility for cost control. However, the purchasing organization generally controls much of the organization’s expenditures. Purchasing has to be able to think creatively about ways to strategically manage the supply base to better manage costs.

Purchasers should first assess and segment purchased materials, services, and components in terms of importance to the organization and the difficulty or complexity in accessing the materials.  As discussed in the previous “Back to Basics” article on strategic sourcing, segmenting the spend allows purchasers to apply the appropriate cost management tools and establish the foundation for successful negotiations and relationships. Using terminology from a segmentation process developed by Kraljic (1983) there are four major categories of segmentation: non-critical purchases, leverage purchases, strategic purchases, and bottleneck purchases. For each category, there are more effective relationship and cost management strategies. The cost analysis techniques that are applied should support the relative importance of the item being purchased and also the type of relationship that the organization desires.

Non-critical Purchases
These are generic purchases, of low importance to the organization, with the focus on obtaining the lowest possible purchase price from a field of many suppliers. With these types of purchases, there are typically low switching costs involved in changing suppliers. Supplier relationships are transactional and arms-length.

The focus in this category is on price analysis. The goal for these types of purchases is to get the best possible price while still maintaining customer value.  Purchasers can use competitive bidding or publically posted price lists to compare the price being paid with the market value. Another key way to assess the price being paid is by using established market indices to determine the state of the market and comparing market fluctuation to historical data. One way to access market data is through the Producers Price Index (PPI), published by the Bureau of Labor Statistics. Comparison of market (PPI) versus actual (historical) trends is one way to measure purchasing’s effectiveness. The example below is a comparison of historical prices paid for packaging with the market trend for packaging. 

                                                 
PPI (Market)
Percent Market Change
Actual (Historical)
Percent Actual Change
Jan-10
Jan-11
Jan-10
Jan-11
Packaging
246.5
225.8
-8.40%
132.75
124.0
-6.60%

In this scenario, the market index decreased 8.4 percent whereas the prices that the company paid only decreased 6.6 percent. The commodity manager potentially missed out on some price decreases (depending on contracts and supplier availability). For these non-critical purchases, watching market trends is an important metric in ensuring that the organization is receiving the lowest possible price.

Leverage Purchases
This category of items is purchased in large quantities; they are often made-to-stock, have many available sources, and often are listed on the commodity exchanges . There is relatively low complexity involved in these purchases, but these products and services have an on-going impact and high importance to the organization in terms of volume purchased, percentage of total purchase cost, or impact on product quality of business growth. 

For leverage purchases, the focus is on cost analysis.

The goal of purchasing is to ensure that the organization is paying a fair price based on the assumed or calculated cost of the items being purchased.  The benchmarking concepts used for non-critical purchases are also appropriate methods for items in this category.  Many organizations use a technique called “white-sheeting,” which is a combination of price benchmarking and cost analysis. The intent is to start with a blank page and build a breakdown of all of the cost elements of an item by using industry knowledge and averages, price indices, and other benchmarking techniques to develop a “should cost” of the product.  By understanding what the item should cost, you can better understand the price you should be paying once a fair and reasonable profit is applied. Organizations that use this technique have realized extensive cost savings.

Suppliers call looking for price increases because “labor rates are increasing,” “the cost of materials is increasing,” or for many other reasons. The ability to assess the price increase in comparison to the change in the market helps purchasers protect the company from paying too much. For example, a representative from a supplier calls and explains that they have to increase its selling price by 25 percent because its LABOR rates have increased 25 percent. The purchaser had compiled cost information when the company first started doing business with this supplier.  The buyer used the initial cost breakdown to determine the potential impact of the labor increase.

                                                                                                   
Cost ElementInitial Cost EstimateCost Estimate with 25 percent Labor Increase
Material$1.25$1.25
Direct Labor$2.00$2.50
Mfg OH (150% Direct Labor)$3.00$3.75
Tooling$1.75$1.75
Factory Cost$8.00$9.25
SGA (20% of Factory Cost)$1.60$1.85
Total Cost$9.60$11.10
Profit (10%)$0.96$1.11
Selling Price$10.56$12.21

The supplier is expecting you to pay a 25 percent increase on top of the initial price of $10.56 or $13.20. However, the increase is actually occurring only in the category of direct labor.  By increasing the labor cost element by 25 percent (and adjusting the associated overhead allocations), the projected increase in selling price should be approximately $12.21, or $1.00 less than was being requested!  These savings are significant in the leverage category where the goal is to consolidate volume to achieve economies of scale and then reduce price. There are many benchmarking databases available to help compare and estimate the different cost elements.

Strategic Purchases
This category consists of the items that are important to an organization’s competency. There is much more complexity and risk involved in these purchases because of limited availability of supply or fewer capable suppliers. Contracts and relationships with suppliers are more long-term and strategic.

The cost techniques used in this area are generally the most thorough and time consuming.

These techniques move away from price benchmarking and focus more on continuous improvement.  The primary tool used here is a total cost of ownership analysis. Total cost seeks to identify the costs associated with the entire acquisition process including service costs, failure costs, administrative costs, special handling costs, transportation costs, and other elements. The idea is to identify the cost elements that the buyer incurs in doing business with a particular supplier.  Once these cost elements are identified, the buyer and supplier can work together to continuously improve the process and reduce the cost. 

The price paid to the supplier is only the tip of the iceberg in a total cost of ownership analysis!  There are many costs beyond the initial purchase price that impact the true cost to the organization.  A total cost of ownership analysis can also help to compare the purchase from differing locations – for example offshore suppliers versus homeshore suppliers.  Once the cost elements are defined, a total cost model can also help show different “what if” scenarios, and negotiation strategies. Below is an example of a simplistic total cost model for the purchase of dressers.

                                                                                                                                           
Cost ElementQuoted PriceCost per Container
Price paid to Supplier$225 (96 per container)$21,600
Shipping Costs$4750 per container$4,750
Customs Fees2.5% Value of Container$540
Duties7.5% Value of Container $1,620 $1,620
Security Fees$1250 per container$1,250
Insurance$350 per container$350
Transportation port to Warehouse$1000 per container$1,000
Transportation from Warehouse to Customer$900 per container$900
Warehouse Charges$175 per pallet (12 per container)$2,100
Quality Control$25 each dresser$2,400
Travel$20,000 per 100,000 dressers$19.20
 Total Cost Per Container$36,529
 Total Cost Per Dresser$380.51

Note that the cost elements over and above the price paid to the supplier add approximately $155 to the cost of doing business with this supplier. There are also many other cost elements not included in this model, for example what happens if the quality from the supplier is less than expected?  Purchasers should consider which cost elements are relevant to the analysis. One word of caution with total cost models is that they only represent the costs at a specific point in time. Purchasers must proceed with caution when the market is in a state of flux.

Bottleneck Purchases
The final category contains items that may require long-term capital investment and are often project-oriented.  The relationship with the supplier may or may not be strategic, but the supply market is highly complex. Bottleneck purchases usually represent one-time (or infrequent) expenditures, generally of large sums of money. Capital equipment, information systems, or other long-term assets tend to fall in this category. Total cost models are appropriate here, as well. However, these total cost models tend to focus more on the cost elements across the total life cycle of the item; for example, extended service, warranty costs, replacement parts, and disposal costs. The total cost models include additional cost elements that represent an integrated life-cycle management approach.

The intent of this document was to introduce some essentials of supply chain management, specifically in the area of strategic sourcing and cost management. The appropriate application of cost/price analysis techniques is key to successful spend management in all organizations. Each of the techniques introduced in the above paragraphs has benefits and pitfalls.  With the continuing emphasis of cost savings and reductions in many organizations, the above techniques are a potential starting point. Proactively involving purchasing in the proper application of cost/price analysis techniques could potentially have the greatest strategic impact to the organization.

Editorial Note:
This series is titled “Supply Chain Management: Beyond the Basics” and a new installment will appear each week on our website. It picks up where our original series of articles from Tennessee—the “Basics of Supply Chain Management” — left off. Among the topics we’ll be covering in this latest series are successful collaboration, supply chain risk management, strategic sourcing, supply chain finance, and more.

To be notified of all the latest Supply Chain Management Review editorial information and updates, including this series “Supply Chain Management: Beyond the Basics” make sure you are on our eNewsletter subscriber list.


About the Author

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Wendy L. Tate
Assistant Professor of Logistics, Department of Marketing and Logistics, University of Tennessee
Wendy L. Tate, Ph.D. joined The University of Tennessee’s Department of Marketing and Logistics in 2006 after completing her Ph.D. in supply chain management at Arizona State University. Her research focuses on strategic sourcing/purchasing in the context of the services supply chain and environmental sustainability. She teaches strategic sourcing to undergraduate students, MBAs, and executives. She can be reached at .(JavaScript must be enabled to view this email address).

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