Larger Cost Savings Come from Total Cost Sourcing – Part 1

Putting a Dollar Amount on Non-Price Differences When Evaluating RFQ Responses

Our recent article advocates “Outcome Sourcing.” If you are specifying outcom es, rather than thingsin your sourcing RFps and RFQs, you can expect to receive a wide variety of creative bids from your suppliers, making it even more difficult than before to doside-by-side comparisons. Here’s where total cost analysis can be a useful tool. Totalcost analysis methodology and tools rem ove the guesswork. they provide a financial analysis which considers the total financial impact of different sourcing alternatives and their outcomes, rather than relying solely on opinion or subjective scores.

Which Elements of Total Cost Should Be Included

Total cost sourcing has been around a while, but has evolved a lot in recent years. Early versions of total costanalysis simply added transportation costs to the material costs. Then, with globalization came the importance of total landed cost calculation, which included tariffs and duties as well.

Moreover, dramatically different lead times between domestic and off-shore sources have made it necessary to consider such things as transit times and the resulting extra safety stocks required. These other factors become critical in making sourcing decisions, as they can impact a company’s agility – the speed and reliability of product introductions, ability to ramp up and down with demand fluctuations, and the amount of markdowns and write-offs when it is time to retire the product.

The emerging best practice is to consider a spectrum of impacts on a firm when making sourcing decisions, as illustrated in Figure 1 below.

Many of these factors, such as demand/supply matching (the ability to quickly and economically turn the “spigot” on and off from the supplier) are often not measured or quantified financially in the sourcing selection process. Some fast fashion retailers (e.g. Zara, H&M, Hot Topic) have done the analysis on that factor and made the decision to source locally, rather than from the lowest-cost providers overseas. They measured the impact of being able to quickly clear their shelves (and DCs) of the existing items and bring in new stock as soon as fashion changes, and realized that the financial benefits of avoiding lost sales and the high cost of mark-downs outweighed the added material cost.

It is usually impractical and unnecessary to measure every element’sfinancialimpact. Instead, companies should strive to measure those elements that:

A) comprise a significant percentage of the total cost

AND

B) have reasonable data and/or you have a way of calculating their financial impact.

The contribution to the total cost of each element varies dramatically by industry and type of commodity or product, as illustrated in Table 1.

_{Table 1 – Example Relative Cost Contributions by Industry/Commodity}

There are several common obstacles to doing total cost sourcing. These include how buyers’ performance is measured, corporate politics, and lack of data.

Buyer Performance Metrics

In many companies buyers are measured primarily on the price paid, frequently using PPV (Purchase Price Variance) as a key measure of buyers’ performance. Unfortunately the standard costs upon which PPV are based are too often out of date, fail to account for market conditions, or have other serious flaws. More importantly, this kind of metric encourages behavior that may lower PPV but create a higher total cost. To lower their PPV, buyers may do things like buying in larger lot sizes, thereby creating higher inventory carrying costs and higher obsolescence costs (which are not metrics the buyer is measured on). Or they may source from high-priced suppliers for the initial buy, establishing a higher standard cost that makes them look good in subsequent years as they switch to lower-cost suppliers. The metric encourages these and dozens of other behaviors that often actually raise the true total cost for the company.

In some companies, buyers are also measured using basic supplier performance metrics such as on-time delivery, quality, and sometimes transportation costs. Beyond these, however, they rarely have an incentive or the charter to reign in other potentially significant elements of total cost, such as demand/supply matching risks, manufacturability and serviceability, relationship costs, etc.

Corporate Policies and Politics

Purchasing executives who have risen up through the organization, as well as the veteran buyers, are frequently reluctant to change the system that they are all too familiar with and know how to manipulate. Furthermore, the PPV metric is embedded in the information systems and processes. All of these lead to inertia favoring the status quo.

Lack of Complete or Accurate Data

Even in cases where management wants to make the change, it can be very difficult to get the necessary data buyers need to calculate the total cost, for a variety of reasons:

· the underlying required data often has not been captured, is inaccurate, and/or is spread out across the enterprise (or outside the four walls), and often is paper-based

· the company lacks the algorithms or institutional knowledge to estimate the cost impacts, for example estimating the cost impact of various risks

Formula for Success

Successful implementation of total cost sourcing elements include:

· Identify and pursue low-hanging fruit – i.e. those areas where you have the data, the financial gains are substantial, and the changes to process are reasonable and contained (i.e. doesn’t touch half a dozen different departments). For many organizations, this is transportation spend, quality/failure rates, or inventory carrying costs. Gains from these initiatives can be used to justify and fund the next level.

· Invest in systems that provide total cost data and algorithms. These systems may have optimization elements and can provide other benefits.

· Make the financial and strategic case, engaging the CEO or General Manager. Total cost sourcing is very much an interdisciplinary activity that requires strong support from the top to cut across organizational boundaries.

· Get “the troops” on board – some buyers will resist, because they know how to game the current system. But showing them how this approach stops rewarding the dysfunctional behaviors and rewards them instead for “doing the right thing” can be a powerful argument that many will appreciate.

We’ll have more on these points in part two of the “Total Cost Sourcing” series, where we talk about technologies to enable total cost sourcing, and the importance of cross-organizational buy-in and cooperation.

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See also: Applications of Total Cost Sourcing – Part 2

To view other articles from this issue of the brief, click here.