CEOs are becoming increasingly aware of the value a great procurement function can bring to their business.Procurement continues to be a very fruitful source for cost reduction yet many procurement organizations fail to achieve their potential by making one or more of five common missteps.
Companies delivering the greatest value out of procurement each adopt five practices
Excerpt from Introduction to Improving Procurement
CEOs are becoming increasingly aware of the value a great procurement function can bring to their business. And report after report of massive cost reductions or improvements in quality and service, as well as faster time to market indicates that such interest is well warranted. Great procurement organizations work collaboratively with other functions and with their suppliers to drive broad improvements in total costs. However, in order to be most effective these organizations are ensuring they have the best talent arrayed against each strategic segment of procurement expenditures, even if they have to outsource some portion of their function. The leading organizations also recognize that information is more important than organizational structure, thus their technology investments are focused and frequently deliver value upon implementation, unlike many other misguided procurement automation efforts. Finally, these groups recognize that they are unable to build a competitive business without competitive suppliers, and make every effort to ensure relationships are such that the total system wide cost are being reduced collaboratively, for in so doing, these partnerships can deliver the greatest improvements in procurement.
Go here to read the first part of this series: Introduction
Go here to read the second part of this series: Improving Procurement – Common Missteps
What To Do
Against each of the missteps described earlier, is a vast array of opportunities for procurement improvement, that is to reduce procurement costs, both transactional and item specific. And despite well-intentioned efforts by companies to manage their procurement strategically and to drive automation at reducing transaction al costs, still we find significant opportunities for procurement organizations to deliver more to the bottom line. So what should a company do to ensure that procurement improvement occurs, the procurement function is in fact delivering value, and the promises of investments to reduce costs are valued? Companies that are delivering the greatest value out of their procurement functions each adopt five practices:
- Implement a TCO measure that captures all procurement effects.
- Segment and refocus the organization tailoring approaches to the different requirements, including leveraging transaction-less procurement.
- Drive strategic sourcing with executive involvement, and focus the procurement function on product and process simplification.
- Focus on information rather than structure.
- Attract, develop and retain world-class buyers and professionalize all sourcing functions.
Implement Total Cost Analysis
The ultimate goal of any strategic sourcing initiative should be to determine the mix of products, suppliers, and services that can support internal requirements at the lowest total cost. Total cost is the sum of invoice price and other off-invoice factors, including quality, delivery, warranty, financing, and other elements that impact what a product will actually cost an organization. For example, a procurement organization might contract for products from an overseas supplier at a significant discount to the current purchase price from domestic suppliers. However, not factored into the equation would be incremental costs incurred for transportation, import clearance and extra inventory required in case of supply disruptions. These additional factors, though not readily apparent, create real incremental costs, which may offset the appealing price savings.
Few companies do a good enough job of tracking their finished product costs appropriately. Current cost systems are designed to spread costs evenly across a broad cross-section of products regardless of cause and effects. Proponents of Activity Based Costing (ABC) have demonstrated the folly of such a naive methodology. The same could be said for procurement costs, which are likely to receive far less attention than product costs. The problem for procurement though is that unless these costs are tracked and attributed back to the root supplier or material, little improvement could really be experienced in costs. Procurement organizations would literally be driving their improvement programs blindly. Take for example the wool felt manufacturer that discovered by paying a 20 percent premium for higher grade wool, fewer needles would be broken in the process, machine uptime would increase, and quality product output would increase by far more than the price increase. Or the window manufacturer that discovered higher-grade lumber would produce more useful long pieces, requiring less splicing and would produce more useful window frames than the price premium.
IT buyers have been hearing the term “Total Cost of Ownership” (TCO) used in product pitches for some time now. Simply put, TCO is the present value of all costs associated with product, service or capital equipment that are incurred over its expected life. And it is used primarily in helping make decisions when the purchase price is only one of many other costs that can significantly change the decision. The value of TCO thinking is that it begins to force organizations to think more broadly about the choices of suppliers, materials, or technologies than just the price paid.
Take for example the electronics designer who has been trained in the use of application specific integrated circuits (ASIC), which have to be custom designed and made. These ASICs have a large design and testing cycle, and require significant up-front non-recurring engineering charges. But in some cases a programmable device made by companies like Altera or Xilinx can replace an ASIC. These devices require a far shorter design and test cycle, and the functionality can be changed up to the moment the product is manufactured. While the programmable device has no minimum volume requirements, they do have higher variable purchase prices. So if time to market and flexibility is valuable or, for a large range of low-volume products, the programmable device may be preferred to the ASIC design, despite the higher per unit cost. And if the procurement and design organizations are not measuring all of the costs and weighing these trade-offs appropriately, the business is probably missing a large opportunity.
Understanding the detailed cost elements of a chosen component or supplier helps procurement organizations make more informed decisions about which item or supplier is a better fit strategically, and how to achieve the targeted procurement improvement.
Segment and tailor approaches
“There is nothing so inefficient as making more efficient that which should not be done at all.”
Segmentation, though used primarily in marketing organizations for customer grouping, is incredibly important from a procurement perspective because of its value on focusing an organization on the different types of decisions or issues that need to be addressed. Take the ABC Pareto example described earlier. Suppliers that sell a lot of stuff to a company or items that represent a large value of the total procurement expenditure require a different level of activity than those at the other end of the spectrum. Where the ABC is misused is in the assumption that lower valued items do not require as much focus as the others. For as we described earlier, the low value items frequently incur significant transactional costs and because they are not managed professionally or strategically incur severe price penalties. The reality is every segment of suppliers or items no matter how trivial require both strategic and transactional efforts. The level of such effort and the impact on opportunities will depend on the specific business and degree of review previously expended on those segments. If for example, you have never reviewed the lowest 30% (C items) strategically, then you may be missing opportunities to reduce total costs in these products by as much as 50%.
One of the challenges with good segmentation is knowing what to include. Amazingly, few companies think of procurement beyond the most obvious production or service items that have the highest visibility. The reality is that a vast level of expenditure is under- or un-managed. What about copiers, travel, office supplies, temporary help, house keeping or security? Do these come under the purview of procurement, or are they part of an organization with even less training in procurement methodologies? Employee benefits are one of the largest expenses yet are managed wholly within the Human Resources function without real procurement assistance or focus. While these areas may have complications that require them to be managed under other functions, non-traditional procurement represents far too much in expenditures to be given short shrift. These, like other expenditures demand some level of rigor and a tailored approach to the inherent strategic and transactional issues.
Probably the most effective segmentation we use is one that arrays procurement expenditures in categories or items and by suppliers within a four-box grid as shown. The two axes we use are the original ABC Pareto analysis arraying procurement by the value spent, and an assessment of the risk to the business of supply. Expenditures can then be broadly group into four groups or segments requiring similar challenges and procurement focus.
|Non-critical||Transactions vary from low to high
Supply is readily available with multiple suppliers
Typically includes items like Office supplies, MRO and other incidental purchases
|The large volume of transactions and the general unpredictability of demand makes this a difficult segment to manage
Procurement functions typically take simplistic approaches to this segment abdicating responsibility to others and resulting in premiums which could be very large in the overall scheme
|Put in place transaction-less replenishment approaches when possible
Look for a narrow selection of suppliers such as distributors who can provide a variety of products and services at the lowest total cost
Consider e-Procurement solutions where transaction-less approaches cannot be put in place
Supply is readily available with multiple suppliers
Significant number of substitutes available
For a large company this segment will include items such as personal computers
|The value spent in this segment makes it critical for managing well. However, because the risks are low, the management issue is primarily that of getting the best total cost||Put in place transaction-less replenishment approaches when possible
Narrow supplier selection might increase opportunities for cost reduction
Consider auctions and vertical exchanges
Supply is not broadly available
Markets might be monopolistic with high barriers to entry
Substitution may be difficult
|The small value involved belies the importance of this segment which because of the risk needs to be monitored and managed carefully
Because of the supply challenges, the procurement priority is to ensure supply is available at a reasonable cost
|Vertical exchanges or other aggregation mechanisms allow more even balance between supplier strengths and buyer needs
Focus should be on developing alternatives (preferably of a leverageable product or supplier)
|Mission Critical||High Value
Supply is not broadly available
Markets might be monopolistic or oligopolistic with high barriers to entry
Substitution may be difficult or time consuming
Includes items that are strategically important
|The value and criticality from a supply stand-point make this a very important segment to manage well both to affect total cost as well as risk
Relationships and cross-functional collaboration are important in getting this right
|Put in place transaction-less replenishment approaches when possible
Drive towards better supplier integration
Seek out alternatives to reduce risk
Consider make versus buy, alliances, long-term contracts, etc.
Consider private exchanges or portals
What should be obvious on perusal of a procurement segmentation framework is that a variety of issues are evident requiring tailored approaches, skills, and systems.
While the layers of strategic effort and the opportunities for reducing total cost or supply risk are different, every segment shares one common requirement – that every item must be procured and therefore requires a similar set of activities or transactions. These activities may range from searching for a supplier, managing several bids, placing an order all the way to receiving the product and eventually paying the supplier upon receipt of an invoice.
For some companies a procurement transaction may cost as mush as $100. And frequently, particularly for non-critical items, the total value of items being purchased in a transaction might be less than the transaction cost itself. Which is why so many organizations, recognizing that large number of transactions cost real money, will drive towards automated solutions precisely to reduce the cost of each transaction. And, in many cases, the systems solutions will reduce those transactional costs. What this solution fails to recognize though is that every transaction requires two parties, the buyer and the seller, on two separate systems, performing a similar set of activities.
The reality is that many companies can achieve far greater savings by implementing transactionless approaches whereby one of the parties is responsible for a single transaction that is valid for both parties. Electronics distributors such as Arrow or Avnet do just this for customers when they implement stores within the factory and replenish production lines. They track the usage of materials and replenish based on the customers’ production schedules. The transaction costs for one party are entirely eliminated. This approach unfortunately is severely underutilized and remains a significant opportunity for total cost reduction.
Drive supplier relationships
We have said earlier that too many companies focus on leverage and miss greater opportunities to reduce cost. That is not to say that supplier negotiation skills are not necessary. Far from it, leading procurement firms negotiate with their suppliers as aggressively as their customers do with them. To do less would be to relinquish your business to a long-term margin squeeze with customer prices shrinking faster than costs. No, negotiations are necessary, but they must be coupled with a more collaborative approach with the supplier, not the traditional adversarial approach. Both the organization and its suppliers are beneficiaries of the sale of a product or service in which their value or component is utilized. Driving down total costs and increasing total market penetration is advantageous to both parties. For both, the complete supply chain is one seamless whole regardless of corporate boundaries and opportunities to reduce total costs are eagerly embraced. Back in 1986 Honda selected Donnelly Corp to build all the mirrors for the cars built in North America. Until then, Donnelly made the interior mirrors, and another supplier provided the exterior mirrors. Donnelly did not even have a factory to build exterior mirrors. Yet Honda had confidence in the alignment of the companies’ goals, culture and values such that they agreed on this partnership and Donnelly built a new plant to make exterior mirrors. A decade later, Donnelly sales to Honda had increased more than twelve-fold.
Product and process design are the primary determinants of cost. Choose to deliver a service in a certain way, or manufacture a product with a certain specification and component, and the cost is cemented with small layers of variability. However, engage and integrate good suppliers in the design and you can reduce total costs significantly and significantly accelerate the time to market. Michigan State University’s Global Procurement and Supply Chain Benchmarking Initiative found that cross-functional teams involving suppliers drive revenue and profit growth from access to new technologies and process innovations much faster than not. The reason why integration early in the design process leads to such massive benefits is that product and processes are simplified for both supplier and customer simultaneously. Transactional redundancy can be eliminated, designs can be reused, and components can be rationalized, best practices shared and concurrent engineering can be brought to bear on the problem.
Great supplier relationships don’t just require supplier integration in product and process design, there is far more to it than that. For one, they are stunningly fact based. This means that procurement teams that want to work effectively with their suppliers have to be astute at Market/Industry Analysis, Target Costing, Cost Sharing/Cost Breakdown, Competitive Assessments/Teardowns, Value Analysis, Activity Based Costing, and Total Cost of Ownership among other skills. And these relationships are not merely between procurement organizations and suppliers selling organizations. They are across the board, from top to bottom. Strange as it may seem, companies feel slighted when their senior executives are unable to gain access to the most senior customer executives, yet they commit the same behavior in their treatment of their own suppliers. Great supplier relationships require senior executives to become personally involved in the process of cementing a true partnership.
Focus on information
The perfect supplier provides great service, has very short lead times, always delivers the correct quantity on time, never has a quality problem and does all of this at reasonable prices. The value of a supplier should at the very least factor in performance on each of these six goals, in addition to other strategic dimensions such as capacity or technology investment. But if your company is not measuring these variables or not explicitly making them a part of the total cost equation, then how do you expect to see improvements other than price?
Primarily because of a lack of information, many companies are compelled to drive towards centralization only to find themselves experiencing service and other problems. Should the solution for better procurement be collaboration and coordination or a structural change towards centralization? Some companies find it easier and faster to make a structural change, but whichever the solution put in place, the fundamental requirement for information does not change. As described before, procurement is a team activity, requiring broad cross-functional involvement and collaboration to be most effective.
Today, procurement functions must depend on a mix of online and offline information sources. Sadly, the lack of integration or basic data collection and analysis seriously inhibits knowledge transfer and collaboration within and across enterprises. Without such fluid information flows and knowledge sharing, a procurement organization is unable to understand its spending patterns and purchase requirements and wont be able to develop the most effective sourcing strategies. Why then are companies struggling to build the requisite data warehouses across their multiple factories and divisions? Unfortunately, while this lack of data integration continues, the results are that procurement teams are forced to start each project from the beginning rather than building on existing learning.
The bullwhip effect has been documented and discussed quite extensively. The effect is demonstrated when small consumer variability is misinterpreted by each participant in a supply chain resulting in significant variability at the end of the chain. The lessons learned upon observation bring to clear focus the impact of poor information quality, in this case distorted by participants in the supply chain, resulting in extra costs due to missed production, inventory pile-ups or lost customers due to stock-outs or improper service.
The challenge of making big, decentralized conglomerates behave more like single companies when it comes to procurement requires a great deal of collaboration and coordination, and as a foundation a credible base of information.
Hire the best (outsource if necessary)
“The ability to learn faster than your competitors may be the only sustainable competitive advantage.”
Though systems and information are vital elements of a good procurement improvement effort, they are only necessary to drive more valuable utilization of critical procurement skills. The basic operational mantra of procurement organizations should be to drive non-value added activities out such that the skills of the team could focus on the most fruitful elements of value creation. From the preceding discussion, it should be clear that procurement organizations, in order to be most effective, require a variety of skills. What is clear is that firms that are delivering the largest short- and long-term benefits are focused on skill building, procurement organizational productivity and strategic focus. These great companies:
- Hire the best and pay correspondingly
- Diversify their skill base having diverse talent and backgrounds in place
- Provide a management career path
- Promote general management skills rather than years of experience
- Provide significant opportunities for internal and external training
- Create and utilize quantifiable metrics and set tight goals, and
- Promote moves across business units to promote best practice sharing and knowledge transfer
The skills required to build a world-class procurement organization are quite broad and comprehensive. And, it is unlikely that every firm could afford to reach the level of appropriate talent with its own staff. In those cases, it may be in the best interest of some firms to find an outsource solution whereby talent can be shared with other companies, as in constrained procurement described above.
Procurement automation and standardization, and building high quality procurement data warehouses are all actions that make procurement outsourcing (partially or wholly) a reality. There are two basic rationale for business process outsourcing: first, an organization cannot perform the process competitively, or second, the process does not contribute to an organization ‘s competitive differentiation and could be outsourced to reduce costs or free up resources. Portions of the procurement function could be outsourced, in some companies, and justified under both of these conditions. Strategic procurement can provide an organization a competitive differentiation if performed to excellence. Commodity procurement excellence can save organizations money, but rarely can it provide competitive differentiation, at least for any length of time. Rather, commodity procurement can provide a negative differentiation when it’s performed poorly. It is a process that only gains visibility when there is a problem. Services procurement and management has both strategic and commodity dimensions. So as the question of building the appropriate procurement skills shifts towards outsourcing as a choice, it is becoming increasingly obvious that for some portions of the procurement portfolio of activities, outsourcing is a viable alternative.
Procurement driven performance improvement opportunities are real, they are large and they are capturable. Great procurement functions understand cost, not just price. They are not monolithic, they use a variety of approaches for managing suppliers driven by well thought out segmentation. They understand the value of a supplier and strive to leverage these cherished relationships. They are data-based, analytical and value information. Finally, they recognize the value of creativity and the requisite talent to enable a rich flow of great ideas.
Let’s face it; one way or the other, procurement has the potential to shape the performance of your company. Done poorly, your procurement function could force you to exit otherwise attractive businesses, leave a lot of money on the table, or worse. When performed well, the procurement function adds enormous value to the strategic equation, helping to reshape the economics of your business and the fundamental basis by which your business can compete.
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