Supply Chain Management Institute
Increasing Purchasing Effectiveness through Strategic and Tactical Improvements Today’s procurement practices (such as outsourcing, offshoring, parallel sourcing, relationship management, green purchasing, emphasis on trust, collaboration, information sharing, and others) require corporate purchasing organizations to demonstrate their value to the C-suite. A sound monitoring of the factors driving the microeconomics of operations can often provide important insight into strategic and tactical improvements in purchasing effectiveness.
Basic Concept: The Bottom Line Impact of Positive Buyer-Supplier Relationships In the post-Great Recession new order, demanding cost reductions from suppliers or exploiting market clout are no longer effective purchasing strategies. Indeed, nurturing supplier networks and the buyer-supplier relationships comprising them are increasingly important to effectively managing the supply chain and building true win-win relationships that benefit the bottom line. When higher levels of value-added to your product/service take place outside of your company, more of your competitive success will be determined by your supply management and purchasing tactics. Increased percentages of revenue that are outsourced can also increase the leverage that supplier cost reductions have on overall company performance. Consider a firm spending 65% of sales on purchased materials, and earnings before taxes (EBT) of 4% (or $4 per $100 in sales). With a current price/earnings (P/E) ratio of 18, the market capitalization of the firm would be $72 per $100 of sales. If the firm could collaborate with suppliers to reduce purchasing spend ($65 per $100) by 2%, it would generate another $1.30 in earnings. This leads to EBT of 5.3% and a market capitalization of $95.40 per $100 of sales (or 32.5% increase). Purchasing effectiveness does add value.
Beyond the Basics: From Spend to Determining Total Cost of Ownership When evaluating purchasing decisions, purchasing managers should consider the total cost of ownership (TCO) of the purchased materials (and services). Too often, acquisition price dominates the decision while other critical factors are ignored. The table below lists eleven dimensions that should be considered. Some, such as purchase price or freight costs, are easy to determine. Other dimensions can be more difficult to project. Table 1: Eleven Critical Purchasing Dimensions Easy to cost Difficult to cost Purchase price Lead time impact Freight costs Defective materials Duties and fees Factory yield Quality control Field failures Warehousing and inventory Service General administration
(continued)
For the dimensions that are difficult to cost (often referred to as “hidden costs”), purchasing organizations need to collaborate with multiple content area experts throughout the organization to calculate estimates. With input from experts within the organization, purchasing organizations can generate a clearer view of TCO for purchased materials. This process often uncovers costs that were not originally thought to be significant. As part of the TCO analysis, purchasing organizations also need to consider the five stages of the product’s life cycle from acquisition to implementation, operations, maintenance and replacement. By considering a product’s life cycle, one can determine the timing of the costs associated with the purchase within a TCO view. If the timing of costs is compared with the timing of other projected expenditures, a company may find it beneficial to purchase the material that has a favorable cost timing structure, even if it is not the lowest total cost of ownership. Keeping free cash flow during periods of significant expenses may be one reason a company would favor timing over total cost.
Take-Away: Benchmarking Your Purchasing Organization Measures of performance exist for factories, warehouses and the like, but few measures exist to determine the effectiveness of the purchasing organization. In these cases, benchmarking can be very beneficial, especially if it is conducted against other companies in the same industry. Table 2 below provides an excerpt of 2013 Cross-Industry Benchmark Report of purchasing organization performance in select industries. Table 2: Procurement Organization Benchmarks for SCMI-related Industries Category
Total spend as a % of sales % of total spend managed or controlled by purchasing organization % of companies growing/decreasing size of purchasing organization Purchasing organization operating expense as % of total spend
Metals & Mining
Utilities
Industrial Mfg.
Auto & Transport
Non-Mfg. Industries
All Industries
62.47%
41.91%
54.14%
66.81%
25.51%
47.19%
83.61%
67.91%
85.18%
93.08%
82.72%
82.68%
49.02% / 42.65%
73.62% / 21.43%
44.03% / 33.33%
73.58 / 0%
15.38% / 23.08%
29.8% / 32.38%
0.48%
0.74%
1.06%
0.97%
0.45%
1.06%
By comparing both the responsibilities of your purchasing organization (spend as a % of sales) and its efficiency (operating expense as % of total spend) against the industry, opportunities for improvement can be identified. The full Cross-Industry Report of Standard Benchmarks, including several other industries, is available from the Institute for Supply Management and the Center of Advanced Purchasing Studies (CAPS, www.capsresearch.org) at Arizona State University.
For More Information: Demel, Steven M, Consider TCO to uncover hidden costs. Government Procurement, Aug./Sept. 2009, Vol. 17, Issue 4, p. 12. Morssinkhof, S., Wouters, M. J. F., & Warlop, L. (2006). Effects of providing total cost of ownership information on attribute weights in purchasing decisions. Rochester: http://dx.doi.org/10.2139/ssrn.944459 Ronchi, S. (2012). Total cost of ownership along the supply chain: A model applied to the tinting industry. Rochester: http://dx.doi.org/10.2139/ssrn.2024571
Contact us at sc-institute@uwm.edu or visit us at www.lubar.uwm.edu/scmi