by David Jacoby
R. David Nelson developed and implemented many of what are considered today to be leading practices in procurement. After spending 30 years at TRW and ten years as a corporate officer of Honda of America Manufacturing, he ran Delphi Automotive’s global supply management task team.
Nelson demonstrated the integrated strategy approach at Delphi. He pursued best-in-world cost (“rationalisation”) by eliminating waste rationally and logically. Then he started to improve on his record by collaboration, in order to achieve new and even lower levels of cost. As part of this, he has been adamant about the necessity to share savings in order to improve the margins of both his company and its suppliers.
He brought collaborative planning to suppliers (“synchronisation”), helping to reduce the total production cycle time for raw material inventory by 35–45% at Delphi’s European and North American suppliers. At Delphi, he also improved operational availability by 12–40% and productivity as measured in pieces per labour hour by 33–80%.
Lastly, Nelson has developed people, suppliers, commodity teams and enhanced relationships to ensure not only efficiency but also flexibility to produce what is needed when it is needed (“customisation”). His work at Honda and Delphi also stimulated innovation through early involvement with suppliers, early sourcing, and timely and error-free product launches (“innovation”).
Supply chain strategies for economic growth
SCM is typically considered to be a corporate issue. However, strategic SCM is also a matter of economic policy when it comes to transportation infrastructure. Just like companies, national and regional economies progress through four stages of infrastructure development: rationalisation (for example, building roads that reduce average unit travel costs), synchronisation (for example, building industrial parks that help minimise inventory), customisation (for example, building information networks that allow data to be accessed individually) and innovation (for example, building universities and learning institutions that spur creative new ideas) – see Figure 5.5.
Figure 5.5 National supply chain maturity model
Source: Author
Capacity needs to be planned far in advance to avoid bottlenecks and to facilitate long lead-time investments such as ports and highways. Governments need to decide how much capacity to buy or build, and how much investment to seek from the private sector.
Links and connectors need to be added to strengthen and increase the reliability of the traffic network, and the supply chain network should be designed for efficient system-wide flows. Since most European import container traffic enters via northern European ports such as Hamburg and is hauled to inland European destinations before returning as empty containers, APM Terminals envisages the construction of a multi-modal north-south link that would carry a surplus of empty containers after they are unloaded in northern Europe to southern European ports such as Marseille-Fos (France) or Gioia Tauro (Italy), where they can be loaded on to eastbound vessels that would take them back to Asia, where most of them originated.
Backbone information technology infrastructure is needed to facilitate strong communication links. The French government’s dissemination of the Minitel in 1984 accelerated that country’s adoption of the internet. In contrast, the United Arab Emirates’ current telecommunications duopoly (between the companies “du” and Etisalat), while stimulating the penetration of mobile phones, prohibits the use of voice over internet protocol (VOIP) add-ons.
Many countries enter into the rationalisation mode at an early stage in their development. For example, Vietnam is building roads where there were only weeds. The move towards synchronisation is catalysed by a liberalisation of financial markets, which brings industrial parks and logistics infrastructure, as has happened in emerging economies such as China. The move towards customisation is catalysed by the relaxation of trade restrictions, which allows technology investments in logistics information networks, as happened in South Africa. The move towards innovation is catalysed by the development of leading educational institutions, which happened in European countries such as Germany and France.
6 Rationalisation: competing on low cost
Low cost is a basic requirement of doing business in the 2000s. Whether measured in landed cost (the delivered cost including freight and duties), total cost (the cost over the life of the product or service) or “should-cost” (what the cost would be if all the cost elements were set to the lowest cost level), cost and therefore price must be competitive or customers will take their business elsewhere. No surprise then, that executives such as Barbara Kux, member of the Group Management Committee at Philips Electronics, espouse the importance of making things “better, faster, and cheaper”. Moreover, the traditional emphasis on cost has been accentuated in recent years by global competition and the extraordinary rise of low-cost country sourcing (LCCS). In numerous Economist Intelligence Unit studies from 2004 to 2007, senior executives ranked cost as a prerequisite for staying in business, especially in the retail sector.1
It is not surprising, then, that the main goal of about a third of companies in embarking on supply chain management (SCM) initiatives is to lower costs. SCM is particularly well-adapted to lowering costs because of its historical association with industrial engineering, lean manufacturing and quality initiatives, which have all focused on stabilising and reducing costs.
Companies that focus on cost management have better profitability than those that do not. Companies that actively manage cost achieve a 2.6% higher net margin than those that do not.2
While actual performance will vary substantially across companies, Table 6.1 overleaf provides a reference point for the performance of companies following rationalisation supply chain strategies in a wide range of product and service industries.
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Table 6.1 Benchmark net margins of rationalisation-focused companies
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Industry
Benchmark net margin of companies with a rationalisation focus, %
Software & services
18.2
Diversified financials
18.1
Energy
16.7
Utilities
12.3
Household & personal products
10.4
Materials
10.2
Banks
9.8
Insurance
8.5
Transportation
6.8
Food & drug retailing
6.3
Capital goods
6.3
Technology hardware & equipment
5.5
Telecommunications services
5.0
Average
9.8
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Source: Boston Strategies International, based on an analysis of data from Thomson Reuters and Boston Strategies International’s 2008 supply chain performance benchmark study
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The cost leverage factor
When companies reduce operating costs, they increase profit more than if they had increased sales volume by an equal amount, because sales are typically accompanied by expenses. Take, for example, a company that sells sunscreen. It sells 200 units at $5 per unit, and earns $1,000. If its costs are $3 per unit, it has a fixed cost of $600. Add to that labour of $100 and overhead of $100. That makes for a total cost of goods sold of $800 and leaves a profit of $200 (see Table 6.2 on page 65).
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Table 6.2 The leverage impact of cost reduction on corporate profit
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Source: Boston Strategies International, based on an analysis of data from Thomson Reuters and Boston Strategies International’s 2008 supply chain performance benchmark study
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If the company is able to reduce its variable cost from $3 per unit to $2.50 per unit (a 17% cost decrease), its cost of goods sold decreases from $600 to $500, and its profit increases from $200 to $300, which is a 50% increa
se. So in this simple case (which assumes labour is fixed), a 17% reduction in direct costs results in an increase in profit of 50%.
But if the company sold $100 more in revenue at the same cost per unit, it would realise only a 20% increase in profits because of the corresponding rise in direct costs. So in this case, a decrease in costs yields two and a half times the amount that would result from an identical percentage increase in revenue.
Across a variety of supply chain areas, improvement programmes can often result in savings equal to about 5% of revenue. Savings from rationalisation can broadly be characterised as a percentage of revenue, with savings from direct spend at about 2%, savings from sales at 1–2%, savings from logistics at 0.5–1% and savings from R&D expenses 0–1% of revenue.
Most companies measure cost savings as a percentage of the acquisition cost. Acquisition (or “first”) cost is the cost to get something at its place of use, including the supplier’s cost, the supplier’s value-added, the supplier’s profit, and the cost of delivery and installation, including inbound freight and duties. For example, the acquisition cost of an office printer is the cost to purchase it, plus the cost of delivery and installation. Acquisition cost is widely used as a measure of cost, but it can be misleading. For example, increasing the number of suppliers can increase competition and reduce first costs, but the savings may be offset by the added costs of repairing inferior quality machines, managing multiple suppliers and maintaining non-standard equipment. Supply chain cost takes these factors into consideration by including the cost of designing, planning and moving a part, item, material or service from its point of ultimate sourcing to its point of ultimate consumption and on to retirement.3 Although very few companies quantify supply chain cost, many use it as a conceptual framework for identifying improvement opportunities.
Supply chain cost starts with the cost of design and launch. (As noted in Chapter 3, SCM excludes the initial manufacturing or conversion activity. An initial basic activity such as extraction or farming would not be considered an SCM activity.) The total supply chain cost includes the following:4
Planning costs, which include the cost of demand/supply planning, including the software applications used for advanced planning and scheduling and inventory management.
Order processing costs, which include the cost of talking, creating and maintaining customer orders, contract administration, channel management (maintaining relations with channel and trading partners), order fulfilment (distribution), and billing and collections.
Sourcing costs, which include the cost of product engineering, the cost of strategic sourcing (see opposite), the cost of source quality management, the cost of receiving and materials storage, document control and inspection of supplier deliveries.
Inventory management costs (raw materials, WIP and finished goods throughout the extended supply chain), which include warehouse operating costs, inventory carrying cost, shrinkage, insurance and taxes, obsolescence, and inventory reconfiguration costs such as kitting.
Supply chain costs also include the cost of externally purchased materials, components and services (which are part of supply chain costs but not part of supply chain management costs), value-added assembly or production and end-of-life costs such as the cost of returns, remanufacturing and recycling.
Then there is the cost of SCM failures, for example:
Excess purchases and inventory management costs due to failure to see and mitigate the bullwhip effect from one end of the supply chain to the other.
Excess capacity investments due to failure to see and mitigate the bullwhip effect as reflected in cyclical supplier pricing.
Excessive prices paid to suppliers due to failure to adequately plan capacity or contract for secure and stable supply at a reasonable long-term price.
Lost orders due to inability to increase production capacity rapidly enough.
Internal and supplier quality failures, including the four dimensions of the cost of quality (internal failure, external failure, prevention and appraisal).
End-of-life costs include the cost of returns, remanufacturing and recycling.
Another related measure of cost is the total cost of ownership (TCO). TCO is the supply chain cost, plus the value of the materials, components and services purchased from other firms, minus the cost of SCM failures. TCO is sometimes referred to as life-cycle cost. There is a wide variance in the use of TCO; roughly 30% of companies use it moderately.5
Elements of rationalisation strategy
For typical multinational companies, some of the better methods of reducing costs – and thus rationalising – through SCM techniques are as follows, in rough order of effectiveness:
Strategic sourcing and outsourcing using integration, scale and value engineering techniques
Lean manufacturing, in so far as it is focused on waste reduction and quality management
Standardisation and simplification of specifications
Transport optimisation, including mode selection, cross-docking and direct-to-store or “DC bypass”
Tier-skipping, whereby companies analyse and make decisions based on the extended supply chain
Supplier kaizen, in which lean principles are extended to suppliers
Consignment and vendor-managed inventory
Design for manufacturability
Electronic data interchange (EDI) and paperless work flow
This set of initiatives delivers particularly high savings compared with other approaches: a benchmarking study of over 100 companies worldwide6 found that centralised purchasing, supplier partnering and long-term agreements offer three of the top five opportunities for supply chain savings. They help to create economies of scale and scope, reduce excess supplier margins through competitive pressure and ensure that the product specifications deliver just the amount of functionality desired by the customer.
Strategic sourcing and outsourcing
Strategic sourcing
Supplier management is an effective way of reducing TCO. The cost of purchased materials and services typically accounts for 40–80% of companies’ cost structures, depending on the industry. In the early days of strategic sourcing, well-known companies realised up to 20% cost savings from purchasing, for example 3% in one year at Ford Motor, 20% over five years at AMR (the parent of American Airlines), 17% over four years at Honda and 4% over one year at Chrysler.7 Today strategic sourcing often reduces acquisition costs by 8–12% on large companies’ largest-spend categories.
A well-conceived strategic sourcing programme starts with a breakdown of the total spend in the company. This analysis identifies the sourceable spend as distinct from other expenses (such as taxes, depreciation and interest) for which the strategies cannot effectively be applied. The top-down analysis should also divide the total spend into waves, and the waves into categories. For example, Bristol Myers Squibb separated its purchases into three sourcing waves. Each wave consisted of approximately 25 categories, which were determined by commonality of suppliers or commonality of users. The categories included direct (raw materials and packaging, for example) and indirect (facilities, software, office supplies, and so on).8
The resulting external expenditure (spend) can be divided into four categories with distinct characteristics and therefore also distinct sourcing strategies:
Low-spend, easy-to-source categories such as office supplies. These are “non-critical”. They usually account for a small percentage of the total spend, and there are plenty of suppliers who would want to bid for the business on a competitive basis.
Low-spend, hard-to-source categories such as cafeteria services. These are considered “bottleneck” and are not usually given much attention in strategic sourcing programmes because they often take more time and resources to address than the savings that come from the effort.
High-spend, easy-to-source categories. These are usually materials used directly in the product such as plastic housings for television sets, are called “leverage” categori
es because they can often result in a quick savings opportunity if the company is going through strategic sourcing for the first time.
High-spend, hard-to-source strategic categories. These are usually in the core competency of the company as, for example, steel stampings would be to a carmaker.
Four specific sourcing strategies – competition, scale, value and integration, as illustrated in Figure 6.1 – address each of these categories of spend. Competition works best for leverage categories; integration for strategic categories; scale and volume aggregation for non-critical categories; and value strategies for bottleneck categories.
Figure 6.1 Sourcing and supply chain strategies
Source: Boston Strategies International adaptation of chart in Rudzki, R., Smock, D.A., Katzorke, M. and Stewart Jr, S., Straight to the Bottom Line, J.Ross Publishing, 2006, p. 124 (credited therein to A.T. Kearney)
Competition-based strategic sourcing techniques are addressed in Appendix 2 because they are based primarily on reducing immediate suppliers’ margins rather than creating win-win value in the end-to-end supply chain.
Value engineering is covered in this chapter since it applies to the supply chain more broadly than just to strategic sourcing. Note that for bottleneck items, the most effective solutions are value engineering, standardisation and simplifying specifications. Reducing the number of products and suppliers can help to simplify the cost structure and make the products more appealing to a broader array of suppliers. Simplifying specifications reduces the number of permutations that are subject to bullwhip, thereby reducing the overall effect of bullwhip on the supply chain.