Total Cost Visibility: The Key to Strategic Sourcing Success
By Greg Anderson, President of Directworks
Among manufacturers, total cost visibility is the holy grail of direct materials sourcing. It is recognized as the number one improvement opportunity for strategic sourcing and supply chain professionals across the manufacturing industry (survey of 400 sourcing professionals, 2013). Total cost visibility is a complex challenge, yet it is one that can be mastered when you properly align people, process, and technology.
Manufacturers agree that a clear understanding of total cost provides a competitive advantage. Such insight leads to higher margins, more successful new product introductions, and more stable supplier relationships. Best-in-class manufacturers leverage a deeper understanding of total cost to negotiate the optimal price for guaranteed capacity, lower supplier risk, and the right level of quality. In short, improving total cost visibility leads to better sourcing decisions. So where should you start if you want to improve visibility into total cost? The following is a proven framework.
Step 1 of improving visibility into total cost is to define the concept and to identify the discrete elements that contribute to total cost. We define total cost as:
Total Cost = Component Costs+ Transit Costs+ Finance Costs+ Compliance Costs+ Cost of Poor Quality
A discussion of each of these elements follows.
- Component Costs -
For many manufacturers, component costs account for a significant portion of total cost. One of the most critical steps of enhancing visibility is to make sure suppliers provide detailed breakdowns of component costs. The more a supplier aggregates, the more likely it may be trying to hide additional margin. Careful examination of this area can pay big dividends during negotiations. Also be sure to ask for clarity around component costs tied to commodity indices or other market factors. And don't be afraid to ask the supplier to spell out its profit margin. If it is seeking to establish a true win-win in relationship, it will be willing to share this information. Component costs are:
- Labor / burden
- Tooling & setup
- Selling, general, and administrative
- Supplier profit
- Transit Costs -
Costs associated with getting the components into your plant can vary greatly from supplier to supplier. A supplier on the other side of the globe may have a cheaper piece price, but when you factor in the expense of bringing the parts to your plant, they may actually cost more. One of the interesting aspects of transit is that you have the ability to make your own shipping arrangements, shifting the cost from the supplier to another party. Best-in-class manufacturers can often secure more favorable pricing when they drive the terms with transportation companies and the other third parties involved along the way. Transit costs are:
- Customs, duties, tariffs
- Agent fees
- Consolidation fees
- Finance Costs -
You usually need help from finance to determine the impact of these factors on cost. These can include working capital costs related to the amount of inventory you need to carry based on the lead time associated with the suppliers you choose, as well as factoring in the strength of the dollar. Best-in-class manufacturers have discovered that finance costs can be critical to the final decision of which suppliers to select, as well as playing a more important role in strategic decisions regarding make versus buy, reshoring, etc. Finance costs are:
- Payment terms
- Foreign exchange fees
- Currency exchange gains and losses
- Inventory carrying costs
- Financing fees
- Compliance Costs -
These are costs that are generated due to efforts to conform to government legislation or regulation. Such expenses often include headcount hired specifically for compliance activities, costs associated with data collection and reporting, and any fines that resulted from compliance issues. Conflict minerals is the latest regulatory event grabbing manufacturers' attention. Others include International Traffic in Arms Regulations (ITAR); Registration, Evaluation, Authorization and Restriction of Chemical substances (REACH); Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (RoHS); and carbon or sustainability reporting. Compliance costs are:
- Regulatory reporting expenses
- Legal fees
- Cost of Poor Quality (COPQ) -
In Six Sigma terms, the cost of poor quality is equal to the cost of internal failures plus the cost of external failures. COPQ can be a critical piece of the puzzle, as it may be better to spend more on better quality components rather than to have to cover COPQ costs. Note that the cost components (e.g., warranty claims, inspection, etc) do not include lost sales, lost customers, reputation damage, and brand erosion. It isn't just the product P&L that may suffer, but the top line of the company as well. COPQ are:
- Warranty claims
- Administration costs
Step 2 involves developing a roadmap to collect the detailed cost information for any given sourcing project. We have no delusions that data collection will be an easy task. You are dealing with numerous suppliers and third-parties, as well as multiple internal departments and systems. Your roadmap will be implemented in phases over time.
One key to success is determining which factors you need to focus on first in order to help improve your near-term decision-making. The priorities can be different from manufacturer to manufacturer. Some may not have involved their finance departments to understand inventory and working capital costs. Others are not collecting enough detailed information from suppliers. Roadmap development should not be done in a vacuum. Create a cross-functional team of engineering, sourcing, logistics, finance, etc.
Step 3 consists of building a complete total cost template that incorporates the five categories of cost discussed in Step 1. Because of the detail required in the final template, we suggest you proceed in two steps. First, create a simple template that will be used during the first round of the quoting process to assess supplier competitiveness. Then narrow the list of suppliers and complete the quoting process with the detailed total cost template.
The detailed template should be segmented into fields that the supplier will complete (e.g., component, transit, etc) and fields that you will primarily complete (e.g., finance, compliance, COPQ costs). In some cases you may choose to give suppliers visibility into the fields you complete in order to provide selective feedback that can be used in negotiations.
Two challenges are often encountered when using detailed quoting templates. First, some suppliers will refuse to provide the visibility you have requested. The solution is to give them little choice. Make it clear that not completing the template will remove them from consideration for the business.
Second, if you do not have the right tools to help enable the direct materials sourcing process, your staff may get bogged down in spreadsheet chaos. In today's global sourcing environment, e-sourcing automation tools are becoming a must. Such tools eliminate the need for combining spreadsheets and building your own analysis. The hours you spend compiling data can be used for more strategic sourcing activities.
Step 4 consists of overlaying the internal costs. Here, working with other departments, especially finance, is critical. While some costs may be a simple allocation formula (e.g., compliance costs), others will be based on information you will need to collect from suppliers (lead time, capacity, currency, etc). Get finance involved early and make sure it provides clear input on how your total costs are being impacted at the project level. Finally, take the time to build a reliable COPQ model. Separate formulas will be needed for existing suppliers (where you should have existing quality data) and potential suppliers (where you will have to estimate).
Step 5 of the process involves comparing quotes, conducting negotiations, making the decision, and learning from the information provided. Once again, you will make better decisions, and save more money, if you can automate the comparison and analysis process and spend more time on developing a winning negotiation strategy.
Using software built for direct materials sourcing can be a significant enabler here. The negotiation process itself can provide a very enlightening view into total cost as you can gain a consistent understanding of market trends cutting across all suppliers, as well as costs that seem to be padded. After your decision, be sure to track the quoted costs of the awarded suppliers to the actual costs to assess potential gaps in the process. Also update any should cost or target cost models based on your market findings.
It is a proven fact that having greater visibility into total cost leads to better sourcing decisions and higher profit margins. Applying this framework and aligning your people, process, and technology around a total cost sourcing strategy can improve both the efficiency and effectiveness of your direct materials sourcing team.
Greg Anderson is president of Directworks, a software platform specifically built for engaging suppliers and sourcing direct materials. Greg has 25 years of experience in enterprise software, strategic sourcing, manufacturing, and supply operations. Before becoming president of Directworks in 2011, he was the Wexford, Pa.-based company's executive vice president of sales and marketing. Earlier in his career, he had roles at Tenzing Consulting, SmartOps, FreeMarkets, GE, and PPG. Greg holds a bachelor of science degree in engineering from Alfred University.
Directworks is a cloud-based solution that allows sourcing professionals to do their job faster and more efficiently by automating and streamlining tactical activities. Sourcing teams are thus free to concentrate on more important activities: collaborating effectively with suppliers, gaining a deeper understanding of cost drivers, and negotiating best total cost. The results: significant sourcing savings while maintaining quality and effectively managing risk. Directworks' customers are leading, global product companies across the spectrum of manufacturing: aerospace and defense, automotive, consumer goods, diversified industrial, high tech, and medical devices. For more, visit www.directworks.com.