The Shortcomings of Traditional Procurement
In
today's twenty-first century, global outsourced business world, the traditional
and somewhat simplistic approaches used to measure cost for sourcing decisions
of direct materials fall short. Procurement history is laden with penny-wise,
pound-foolish decisions where the low cost supplier ultimately costs tens or
hundreds of millions in lost revenue, lost market share, expedite fees, or write-offs.
This goes beyond total landed cost calculations and strategic sourcing metrics.
Firms that fail to evolve their method of calculating total cost will find themselves
with an increasingly uncompetitive and profit-eating total cost structure.
Before
the advent of strategic sourcing, procurement focused primarily on material
cost, usually with some consideration of transportation costs. As companies
moved from vertically integrated business models to virtual integration (increased
out-sourcing, design, and build responsibilities spread out across the supply
chain) they found themselves buying increasingly complex components and services
from an increasingly dispersed global supply base. This has placed much more
importance on drivers of total cost beyond the material costs, such as the cost
of quality, manufacturability, serviceability, flexibility of supply, ease of
manufacturing, etc.
Global Strategic Sourcing and the Total Cost of Supply
As
a result, global strategic sourcing evolved as a more sophisticated approach
to selecting and managing the supply base and the procurement of direct materials.
In strategic sourcing, the relationships are longer-term and there is a drive
for continual improvement along many dimensions. Most companies that have adopted
strategic sourcing practices have developed in-depth supplier scorecards for
tracking performance and driving improvements. However, tools and methodologies
for measuring the true total cost of supply have lagged behind. An ideal approach
goes beyond supplier performance ratings to accurately calculating the effect
of the supplier's performance on all aspects of the total cost, as illustrated
in figure 1.
Figure
1 - Total Cost of Supply Elements
This ideal is much easier to visualize than to realize. Take, for example, calculating the true total cost of quality. You need to know the failure rate for each component or assembly at each stage of its life (incoming inspection, final test, in the field, etc.) and the total cost per failure at each stage, including things like inspection costs, repair costs, paperwork costs, transportation, technician's time, slow-downs in production, etc. This requires rigorous activity-based costing. On top of that, you need to factor in and put a dollar figure on the damage to customer loyalty and the resulting long-term loss of revenue and market share from failures in the field.
Total Landed Cost Calculators and In-house efforts
In
spite of these challenges, progress has been made in specific areas of total
cost of supply calculation. For example, total landed cost calculators are available,
often as part of Global Trade or Transportation Management or Strategic Sourcing
software systems1. Total landed cost calculators typically factor
in things like transportation (looking at different modes, quantities, etc.),
customs, duties, tariffs, taxes, fees, and insurance. Some more sophisticated
total cost calculators attempt to model other elements of total cost, such as
quality, the cost of capital, tooling costs, etc.
In
addition, a few companies have made efforts to build their own total cost calculators.
Typically, these contain rough estimates and simple formulas for calculating
the cost of things like late deliveries and quality failures, which are added
onto the material cost in attempt to calculate total cost of supply. While this
is a big step over just measuring material costs, these tools lack the depth
that typically only comes from many man-years of effort put into best-of-breed
software, where significant resources have focused specifically on tackling
the issue.
[1] A number
of companies offer total landed cost calculators, such as PeopleSoft, G-Log,
TradeBeam, Blinco Systems, Xporta, Arzoon, NextLinx, Manugistics, i2, Moai,
as well as many 3PLs.
Risk-Adjusted Total Cost Calculation
One
of the most promising recent advances in total cost calculation is the availability
of off-the-shelf software for calculating the cost of demand/supply matching
risks. These risks are typically very hard to pin a cost number on, yet they
are often one of the largest elements of total cost.
Consider
the example of a typical SMI (supplier managed inventory) program. Most of these
contracts specify a minimum and maximum setting, assuming a stable forecast
and coverage for the FGI (finished goods inventory) and the unique materials
that go into the product. As long as the forecast is stable, the expectation
is that service levels and inventory turns will be high. However, because the
stable forecast assumption is not tested against actual historical fluctuations
or forward-looking scenarios and exposures to sudden increases or decreases
in demand, the prospect of significant shortages or liabilities is not factored
into the total cost analysis.
Which Supplier Would You Choose?
Consider
the following comparison. The first supplier offers SMI, but expects the buyer
to cover raw material purchases in a supply chain that is four months long (to
procure and convert raw materials). The second supplier expects purchase orders
with a two month lead time because that covers their two month long supply chain.
Against a stable forecast, the SMI program offered by the first supplier clearly
dominates by minimizing inventory. How unstable does the forecast have to be
before the second supplier dominates by decreasing the risk of having excess
material in the pipeline? A well-implemented framework for quantifying and measuring
this work will answer these questions.
How
Risk-adjusted Cost is Calculated
As
with quality and other metrics included in the total cost calculation, risk
metrics are also easier to visualize than to realize. Fortunately, there are
tools available today that can help with these calculations. The basic measures
in the risk-adjusted Total Sourcing Cost calculation are "fully-loaded" price,
inventory/liability costs, and shortage related costs. The fully-loaded cost
should reflect most of the terms in the total landed cost model, such as freight
and taxes, as well as volume discounts, price floors and caps, restocking fees,
etc. This part seems pretty straightforward.
The
key distinction in a risk-adjusted calculation is that fully loaded cost and
additional metrics are evaluated over hundreds of forward-looking scenarios,
so that metrics such as the average inventory level, and average percentage
short can be computed across a large number of scenarios. Furthermore, true
risk metrics such as the probability that inventory will exceed, for example
ninety days, or that shortages will exceed 10 percent, or that the backlog will
exceed one month, can also be computed. Price risks can also be projected. A
buyer may want to evaluate the exposure to expedite fees on production at the
suppliers, or on freight, or the exposure to price increases in a capacity constrained
supply market. In companies where these metrics have been successfully introduced,
management is specifying targets on both the average performance of the contract,
as well as performance against different risk metrics across a range of scenarios.
A CPG Example
Figure
2 shows some of these risk metrics in action for a CPG buyer. The report compares
two launch plans and compares them over hundreds of demand scenarios. The report
groups results into the lowest 25 percent, the middle 50 percent, and the highest
25 precent demand scenarios (note this grouping of hundreds of scenarios is
distinctly different from running three scenarios). The top of the report shows
a pro-forma cost statement for each scenario group, and the bottom provides
explicit measures for service level and inventory performance.
Figure 2.
Click
on image for larger view.
There
are several key insights from this report. First, some alternatives may be most
attractive due to their performance in the low or high cases. For example, even
if the new approach showed a 1 percent increase in Totals Sourcing Cost in the
mid range (currently 2.4 percent better), the fact that it was 11.8 percent
better in the low range (because it reduced the inventory write-offs from $346k
to $234k [USD]) and 4 percent better in the high range (because it reduced shortages
from 2.8 percent to 0.5 percent) may make the second approach preferable. Second,
while performance along the mid-range may look pretty reasonable on inventory
and shortage metrics, the exposures to inventory in the low case and shortages
in the high case may be completely unacceptable.
Figure
3 shows even greater detail on the inventory story. The following graph shows
the distribution of outcomes over all of the demand scenarios considered. The
colors, as indicated by the legend, correspond to percentiles. The top of the
gray represents the 90th percentile; 90 percent of the outcomes were below the
top of the gray bar. The top of the dark blue bar corresponds to the 75th percentile;
75 percent of the outcomes were below the top of the gray bar. Revisiting the
SMI example discussed throughout this article, this chart might only show a
gray bar, suggesting that the 75th percentile of inventory was zero, but the
top of the gray bar may show an exposure much greater than zero, just as in
the last downturn, when liabilities ballooned to 180 days, and then to 360 days
of supply.
On
the chart at the left side of figure 3, we see a typical fashion goods launch
strategy; positioning a large supply of FGI (in this case the black line shows
that prior to demand a large buffer was installed) to fill the channel and capture
the benefits of a successful product. In the remainder of the product life cycle,
the legacy of this risky positioning translates into substantial inventory levels.
In contrast, the chart at the right side of figure 3 shows that the suggested
alternative substantially reduces the inventory levels, on average and at each
percentile.
Figure
3.
Building
a homegrown model that can do a decent job of evaluating all these variables
at once (price, demand, lead times, safety stocks, cancellation fees, storage
costs, shortage costs, late fees, buyout options the list goes on) across
numerous scenarios is expensive, time-consuming, and usually requires hiring
several PhDs. Thankfully, tools for doing this type of analysis are already
available from a company called Vivecon
(who hired their own PhDs). This kind of system is a big step forward over using
gut feel or spreadsheets in quantifying the impact of risks in order to make
smarter decisions for sourcing, contractual clauses, launch strategies, and
inventory strategies.
Conclusion
Most
procurement people know they can no longer afford to be dumb low-price chasers
and that they have to become smart lowest-total-cost buyers and relationship
managers. While the ideal dream of a system that magically includes every single
facet into a total cost calculation may be pie-in-the-sky, there's no longer
any excuse for continuing to evaluate only material and transportation costs.
Total landed cost tools that can include duties, tariffs, and a variety of other
costs are available from many sources. And now there are tools that can calculate
risk-adjusted total cost as well. By calculating a total cost that adjusts for
the cost of various risks (price fluctuations, shortages, various demand scenarios,
expedite costs, etc.) sourcing personnel can be much smarter in evaluating their
alternatives. In the end, the organization with the lowest total cost will have
a major advantage over their competitors.
This article is from
Parallax View, ChainLink Research's online magazine, read by over 150,000 supply
chain and IT professionals each month. Thought-provoking and actionable articles
from ChainLink's analysts, top industry executives, researchers, and fellow practitioners.
To view the entire magazine, click
here.
About
the Author
Bill
McBeath, Chief Research Officer of ChainLink Research, leads ChainLink's
research efforts, as well as the procurement, strategic sourcing, design collaboration,
and online marketplaces practices.
Bill McBeath
can be reached at: bill.mcbeath@clresearch.com
ChainLink
Research is a bold new supply chain research organization dedicated
to helping executives improve business performance and competitiveness.