Acting under pressure they often take reflexive actions that end
up damaging them in the mid- to long term. They fail to align their
purchasing strategy with their corporate strategy. They grab
whatever costs they can for short-term gain (in some instances even
driving promising suppliers to the brink of bankruptcy), when
slightly more effort would deliver better-and
lasting-results.
Where do they typically go wrong? Based on our observations,
companies instinctively take a short-sighted, bottoms-up and
transactional approach to identifying savings targets. The question
is often: "How much money can we squeeze right now from our
suppliers in each category to meet this year's cost reduction
targets?" Limited by their experience, they'll determine which of
the purchasing cost-saving levers they haven't used-renegotiating
contracts with suppliers, ordering larger volumes, using electronic
auctions-and then estimate how much they can save by using them.
Afterwards, they will implement these tactics. But costs eventually
creep up again since they have failed to implement any sustainable
measures to ensure that these benefits stick.
Consider the example of a US automaker, currently struggling to
stay afloat. In an effort to reduce costs, the company continuously
squeezed prices from key suppliers beyond what the suppliers could
really afford. One of the main suppliers of shocks and struts
acceded to the pricing pressure in order to retain the business. In
fact, it priced its products to the automaker at cost. But the
supplier compensated by increasing its prices of shocks and struts
in the after-market. Not surprisingly, the main buyers of
after-market products from this supplier were the dealers in the
automaker's network and the consumers. In the end, the automaker
was able to price its cars out of the factory lower than
competitors'-but those cars earned a reputation for having higher
maintenance costs, and thus a higher total cost of ownership.
Companies can take a more effective, fact-based and strategic
approach to purchasing while also achieving quick savings. The
process involves addressing four questions:
- What cost reductions, service levels, quality and innovations
should purchasing contribute in the support of the company
strategy?
- What can purchasing do to generate cash for the business within
three to four months?
- What can purchasing do to improve the company's competitive
position beyond three to four months?
- How do you ensure the results achieved don't erode over
time?
This definitely is an area where companies stand to make gains.
Most companies readily admit they lack the ability to optimize
their purchasing costs by selecting the most competitive suppliers
or striking agreements that deliver maximum value. When Bain &
Company surveyed 60 executives from a range of industries, 85
percent said their companies lacked best-in-class purchasing
capabilities. (See figure 1.) We've identified an approach that
allows companies to build supply-management capabilities while also
addressing their short-term needs for cash and profits:
Sizing the opportunity: What cost reductions, service
levels, quality and innovations should purchasing contribute in the
support of company strategy?
When it comes to purchasing, most companies instinctively think
about how to quickly generate cash. Some companies think about how
to boost their long-term purchasing capabilities. Strategic supply
leaders consider both-using the company's overall strategic goals
as a starting point for defining targets or strategies for their
purchasing departments. For example, a company focused on bringing
innovations to market might be more interested in speed, service
levels and innovations coming out of the supply base. A company
intent on being the low-cost leader in its industry would be most
interested in suppliers that offer the lowest cost, regardless of
other considerations-typically large and less-flexible suppliers.
In either case, sizing-and understanding-the opportunity for
purchasing gains is the first objective of strategic
purchasing.
As a CEO, how can you objectively determine how much of your
cost-saving targets can be delivered by purchasing-and link them to
strategy?
Consider the approach taken by a company we'll call FoodCo. The
company had grown through acquisitions-more than 40 since the early
'90s-and had run out of targets in its largely consolidated
industry. Therefore, it wanted to use its considerable size and
continue generating earnings-per-share growth-something of a
challenge given relatively flat overall growth for one of the
company's major products, and a decline in per-capita consumption.
The company's chairman set his sights on using FoodCo's scale to
create a cost advantage, starting with developing purchasing
capabilities its competitors couldn't match. His mandate was to
make the most of the company's volume to get supplier deals, to
standardize purchasing items-centralizing wherever possible-and to
run efficient processes.
The company used some outside-in metrics to determine the size
of the purchasing performance gap in important product categories.
Key to its success was FoodCo's quantitative approach: the company
quickly conducted experience curve and make-vs.-buy analyses, and
used broad benchmarking-looking beyond its company and industry for
benchmarks-to set real targets. Thus, FoodCo was able to not only
strategically set saving targets for purchasing in one of its most
critical categories but also turn around supplier negotiations in
its favor. (How did they do it? See sidebar "Finding free cash in
plastic bottles.")
Quick hits: What can purchasing do to generate cash for
the business within three to four months?
Control demand for internal use and costs
Once they size their savings, service levels, quality, and cost
targets, strategic supply leaders typically look inward for places
to cut demand. Instead of just looking to suppliers for price cuts,
the first thing a company can do is to look internally and quickly
identify means that are entirely within its immediate control. Even
though there are quick opportunities across the company, generally
speaking, companies have the most options for shrinking demand
volume for indirect supplies-everything from travel to office
equipment to janitorial service.
When it comes to shrinking demand for indirect costs,
everything's on the table for consideration. Companies can rapidly
control demand and reduce waste through such measures as tighter
expense policies and approvals, more usage and cost awareness and
accountability-such as publicly posting travel-expenses and
cell-phone-usage accountability. Other options include limited use
of corporate purchasing cards and zero-based budgeting. Often the
right policies and contracts already are in place, but compliance
is not-in tough times, just enforcing compliance can make the cash
register ring.
Companies can cut travel for internal meetings in half by using
videoconferences. They can increase 14-day advance purchases, use a
lower tier of hotels, enforce compliance with preferred hotel
vendors and reduce daily meal allowances. They can put in place
stricter approvals for staffing services-and analyze the top 20
percent in terms of cost with the aim of driving those contracts
down 60 percent to 80 percent. They can save on facilities costs by
renegotiating leases with less than three years remaining, trading
lower rates for lease extensions. For owned buildings, they can
apply for property tax reassessments-with the help of firms that
work on contingency. They can cut back on janitorial and
landscaping, standardizing specs or re-bidding with local
contractors. One US bank was able to save $3.1 million within a
year through such means. Other tactics to quickly unlock savings
from indirect purchases: stopping all non-essential purchases and
revising permission criteria.
The next step is to reduce unit prices for indirect supplies. To
achieve such savings, companies can eliminate off-contract buying,
drive down purchase prices with reverse auctions and substitute for
lower-cost items like printers. In some instances, with the right
suppliers in place, it is possible to begin price negotiations to
immediately close cost gaps. But it's always important to balance
short-term and long-term considerations. Squeezing quick cash out
of an important supplier generally isn't worth it if it will come
back to haunt you. Consider the automaker that saved on the cost of
shocks and struts but wound up with a reputation for selling cars
with high maintenance costs.
While shrinking demand and unit prices for indirect costs,
companies should take on the challenge of pursuing per-unit cost
reductions for direct supplies-those that are integral to a
company's product or service.
On firm footing: What can purchasing do to improve the
company's competitive position beyond the first
quarter?
Consolidate and integrate with the most competitive
suppliers
A downturn is the time to consider whether you are sourcing from
the right suppliers to support your strategy. If your company is
sourcing from the right suppliers, then it is important to ensure
that you're consolidating volumes for maximum savings. This can be
done by evaluating the supplier's performance against experience
curves or a make-vs.-buy analysis, which should help to determine
targets-and can generate quick hits. If your company is not
sourcing from the right supplier, based on the experience curve and
make-vs.-buy analyses, then it is time to search for new suppliers.
In addressing the question above, many companies evaluate suppliers
primarily based on short-term price. In contrast, leading companies
will pick long-term winners by assessing total cost of ownership
instead of invoice price. They also consider several additional
factors in the selection process, such as R&D capabilities and
ability to innovate, quality of management, service levels,
industry position and willingness to collaborate across critical
fronts.
The relative importance of each of these factors should depend
on a company's strategic goals. If your company wants to be a
low-cost leader, total cost of ownership will be a key selection
criterion. If your strategy is to be first to market and on the
leading edge of innovation, other factors may trump total cost of
ownership in importance.
Finally, the strategic supply function can make an important
contribution in the way a company thinks about its indirect-cost
structure. Applying the same make-vs.-buy analysis to overhead
functions can help a company determine whether it is time to
outsource non-core business processes. Outsourcing can improve both
efficiency and effectiveness through such gains as better controls
and more-consistent results. When considering outsourcing,
purchasing should support the business case, statement of work
definitions, vendor assessment as well as the Request for
Information and Request for Proposal processes. In most cases, it
takes more than six months to achieve gains from
outsourcing.
When a company chooses the right suppliers capable of serving
its strategic goals, collaboration could spell the difference
between building long-term purchasing capabilities that competitors
can't match and suffering the ill effects of sending a supplier
down the path toward bankruptcy. If you have the best suppliers,
there's no point in alienating them or driving them out of business
by forcing them into a lower price bracket. So there is an
important question to ask: Is there a way to negotiate for key
products that puts us in a win-win situation?
By placing value on suppliers that are willing to collaborate,
retailer Macy's is able to both achieve quick infusions of cash and
form supplier relationships that are mutually beneficial for the
years ahead. For example, Macy's and a supplier jointly developed
an alternative supply chain to speed time-sensitive products to
stores. It also collaborated with a supplier to develop three
separate apparel items at price points the retailer was confident
would sell extremely well-and did.
Consider total cost of ownership
When comparing suppliers' costs, many companies place too much
emphasis on the invoice price. That oversight paints a notoriously
inaccurate picture of the cost impact. Instead, leading companies
look at the total cost of ownership. That means considering
quality, service levels, lead times and how the purchase fits into
a bigger scheme of things. For Korean construction company SK
Engineering & Construction, looking at the paid invoice price
without taking into account probable fines for delayed deliveries
would lead to the wrong sourcing decisions. For worldwide
building-materials company Lafarge, determining the total cost of
ownership means considering how many hours a piece of equipment
will likely be in operation. The total cost per hour is estimated
from around ?100 if the equipment is used for 2,000 hours to ?20 if
the equipment is used for 14,000 hours or more. The company
compares suppliers not at the invoice price, but at the estimated
overall cost of ownership assuming the optimal lifetime.
Simplify the design, the product and the supplier
base
We can't emphasize enough the long-term benefits to be gained by
actively managing the level of design and sourcing complexity. We
find time and again that companies involve purchasing too late in
the game in the product development process, and fail to consider
the cost impact of their design decisions. Take the case of a
cardboard-box maker that waited until after it had selected a
supplier to call in the purchasing department to negotiate the
contract and try to save on costs. Had purchasing decisions been
considered at the design stage, the company would have had a better
chance at assessing design trade-offs, with a greater impact on
costs. For example, the team could have considered using two colors
instead of three, and a different printing process. One important
insight we have seen over time is that organizations often overlook
the potential savings of "upstream" levers like design
simplification in favor of "downstream" activities like switching
suppliers.
Control or hedge risk with customers, suppliers or third
parties
Companies with world-class purchasing capabilities understand
their level of exposure by type of risk and their preferred level
of risk tolerance. Based on that knowledge, they rely on different
hedging mechanisms to keep exposure in check-using corporate
strategy as their guide. Among the measures they can use: passing
on raw-material price movements to customers or implementing
margin-sharing with suppliers. Or when appropriate, vertically
integrating, deploying flexible production schedules to meet supply
contracts, shifting to input substitutes when supply is short and
building inventories when prices are favorable. They also can
postpone capital investments and use such financial tools as
forwards and options to hedge risk-delivering benefits to both the
profit-and-loss statement as well as the balance sheet.
Sustaining benefits: How do you ensure the results achieved
don't erode over time?
With multiple business units, functions and processes coming
into play, most companies face the issue of managing purchasing
organizations that become increasingly ineffective as they grow in
complexity. This not only precludes continuous improvements but
also reverses gains attained in focused efforts. To keep the
benefits coming, leading companies ensure that there is a clear
owner for each key decision, and that decisions are made swiftly,
at the right level, and with the right inputs. (See figure 4.) And
once decision rights are established, they install a higher caliber
of purchasing talent-and implement the right targets, tools, and
metrics to manage performance. As with every other element of
purchasing strategy, what you choose to track and measure-and how
you compensate purchasing talent-should be dictated by your
corporate strategy. Even though purchasing often is responsible for
managing up to 50 percent of a company's total cost structure, too
often companies fail to make the necessary investments to hire top
talent, support them with the necessary tools, and clarify
accountabilities.
Lafarge, the worldwide building-materials maker, revised its
decision-making process by putting in place a new organization
aimed at helping it sustain savings from all categories of
purchases (Capex, energy, industrial goods and services, indirect
purchases). It defined what decision rights belonged above and
below the business unit line, and reinforced cross-functional input
on key purchasing decisions. Once decision rights were set, the
company established a process to ensure all stakeholders were
involved at the right level at the right time, and that it had the
right tracking mechanisms to measure compliance and performance.
Setting up the right tracking mechanisms was key to reinforcing
purchasing credibility and making sure that purchasing savings were
materialized into the business units' P&L and cash flow.
Such careful attention to decision making and tracking results
means Lafarge is well-positioned to keep purchasing costs from
creeping up long after the economic turmoil subsides. Like other
purchasing leaders, it has learned that it doesn't need to choose
between finding quick cash and building solid purchasing
capabilities. It can achieve both. That meant determining the level
of purchasing improvements needed to further corporate strategy,
identifying means of finding quick cost savings and opportunities
for longer-term gains that also move the company toward its
strategic goals, and imposing the organizational discipline
required to sustain the results.
Finding free cash in plastic bottles When FoodCo learned
that the supplier of the majority of its plastic bottles was
raising prices for many of its SKUs, the company calculated the
price increase would add $7 million a year to its costs. FoodCo was
considering accepting the proposed price increases. But first it
decided to conduct experience curve and make-vs.-buy analyses-a
typical step taken by companies with solid purchasing capabilities,
conducting a category-by-category search for savings.
Experience curves (e-curves) show how unit prices should decline
as volume grows. Our internal analysis of more than 100 products
with data that goes all the way back to 1946 shows that experience
curve costs and prices typically decline 20 percent to 30 percent
for each doubling of experience in a particular good or service.
Experience curves can be generated for an industry or for an
individual company using internal purchasing data or external
market data. Companies use the analysis to determine their own
performance gap and that of their suppliers. E-curves provide a
valid picture of what companies should be paying for each unit they
buy and what their suppliers should be charging. Experience curves
also provide a guide for long-term contracts, and help determine
what the supplier should be able to charge in the future. While
many companies look for across-the-board discounts, leading
companies differentiate what they ask for based on the specific
economics and experience curves of each supplier industry.
Purchasing leaders also use make-vs.-buy analyses to quantify
cost targets. The objective is to compare the cost of purchasing a
good or service vs. producing it in house. The exercise sheds light
on a company's ability to achieve cost savings and helps pinpoint
the true costs its suppliers should be charging. It is particularly
useful for companies facing unstable, monopolistic or oligopolistic
sources of supplies.
At FoodCo, the e-curve analysis indicated that rather than
increasing its prices, the supplier should be dropping its prices
by 0.76 percent per year, based on its ability to more efficiently
produce plastic bottles each year. Meanwhile, the make-vs.-buy
analysis found that by in-sourcing all the bottle production of
this supplier it could generate a net present value of $50 million.
With this information, the CEO of FoodCo communicated the results
to the supplier, but gave them one more chance. Faced with the
quantitative evidence, and the prospects of watching FoodCo make
its own bottles, the supplier decided to decrease its costs rather
than increase them. The end result: FoodCo slashed costs by $7
million per year.
Purchasing leaders like FoodCo also evaluate their ability to
achieve their targets by benchmarking their purchasing capabilities
against best-in-class competitors and, often times, against other
industries. And when sizing targets, these companies will benchmark
a range of factors in addition to unit price, such as quality and
service levels.
Carlos Niezen is a partner in Bain & Company's Mexico
City office. Wulf Weller is a Bain & Company partner in
Munich.
