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That Cash Won’t Hatch Part Deux

I received a lot of email on the supply chain article from last week (click here to see previous article), nearly all of it positive (except for one seemingly misunderstood soul who felt the need to inform me that they did not mind the term supply chain management, they just didn’t like the fact that I was so focused on it). Well. Anyway, I received a few questions regarding target pricing and negotiating tactics, and that presents an opportunity to discuss a very important topic given our current economic climate.

In an ideal world, every professional buyer would be a technical expert on all of the products they purchase. If a buyer is responsible for buying a handful of products in extremely large volumes, they should certainly step up to that ideal. But in most cases, buyers are responsible for a broad spectrum of products, and technical expertise on all of them is something to strive for but perhaps unattainable. For the latter type of buyer, how does one know which products absolutely demand his or her technical expertise, and which products can be more entrusted to the vendor (assuming one has done the work of building trustworthy vendor relationships – a different article entirely)?

Buyers have particular responsibility related to high volume/high profit potential products. If any product is responsible for a significant percentage of the firm or division’s profitability, it is not enough to make sure the product or its components arrive on time and are of acceptable quality. It is also important to understand the manufacturing process related to that product, the market conditions affecting the components of that product, and the vendor’s ability to manage those manufacturing and market conditions.

Beyond those obvious high-focus products, where is the next best place for a buyer to focus their attention? On products where the labor cost is a high percentage of total cost. Why is this so important? Because your opportunities to work on productivity improvements with vendors are very high on these products.

Let’s say you negotiate with a manufacturer to produce a product for you, and their quoted cost is $60.00 per unit. If the labor costs associated with the product are $30 and the material costs are $30, figure the manufacturer’s profit is 10% of material and labor, or $6.00. The manufacturer sees this as $54.00 cost and $6.00 profit. The manufacturer’s material costs are difficult to negotiate (though you should always try), but there is opportunity in the labor cost. If the manufacturer can be motivated to reduce their labor costs through productivity improvements related to better work flow, improved use of technology, or process innovation, they could pass a portion of those savings along to you – or all of it if you present a compelling enough business argument. If the manufacturer can reduce their costs by 15%, that’s another $4.50 per unit that is available for negotiation. Given how often a concerted effort at efficiency improvement leads to 15%+ gains, it is reasonable to expect that type of result.

If you don’t know how much labor goes into your manufacturer’s cost quote, you don’t know how much negotiating room you have. Will manufacturers always quote labor costs? It depends on what type of products you are buying and what type of relationship you have with them. If the manufacturer is producing a contract good for you, then a labor quote should always be part of the manufacturer’s price. If your purchasing represents a significant percentage of your manufacturer’s business, or if the product you are purchasing represents a high-volume opportunity for the manufacturer, they should be willing to break down their costs for you. Alternatively, if you are staying on top of industry and market trends you can back out the costs of materials for yourself to see if there is additional opportunity for negotiation.

It is somewhat shocking to me how often purchasers have not visited vendor manufacturing facilities, and how few purchasers would understand what they are looking at once they actually arrived at those facilities. If you don’t know whether or not your manufacturer is an efficient producer, you don’t know whether or not there are opportunities to work together to improve the cost.

Here are a few things to look for when assessing the efficiency of your manufacturer:

  • Does your manufacturer use disciplines to build quality into the system? An operation that inspects for quality at the end, rather than incorporating quality into their process, is spending unnecessary money. Once unqualified products reach the end of the production cycle they have already expended materials and labor, and the policing process will prevent those products from getting to customers, but they won’t save the manufacturer from incurring the costs again. Some disciplines that build quality into the system include Lean Manufacturing, Six Sigma, and TQM.
  • Does your manufacturer use visual productivity tools? If you can’t see anything in the work environment creating a focus on metrics, they probably aren’t doing a good job of measuring efficiency. Look for visual tools in each work area that communicate piece or part production goals, efficiency and production targets, and performance reports. Of course, it’s possible that a manufacturer will remove those types of visual cues from the walls before taking an important customer on a tour (though it doesn’t make much sense – it’s difficult to deduce anything about the financial size or health of a company from local production metrics), so if you don’t see anything, you might ask. If the manufacturer can’t speak to their productivity programs, you’ve either got a tremendous opportunity to work with them for reduced costs, a reason to worry, or both.
  • Is the environment clean? This may seem like a small detail, but it has been observed over and over again that clean manufacturing environments are generally more efficient manufacturing environments.
  • Ask about productivity improvements over the past five years. If your manufacturer has been focusing on being more efficient, they will be able to speak to those efforts.
  • This last tip goes back to the comments at the beginning of this article related to the extent to which purchasers can be technical experts on all of their products. It helps to understand the manufacturing processes used to produce your products. If you understand manufacturing best practices, you can assess whether or not your manufacturer is using them.

Of course, you also must take into account how many layers there are between you and the manufacturer. If you are dependent on distributors, you want to make sure that the distributors from which you purchase are sound operators that constantly negotiate with the manufacturers on your behalf. The distributors are dependent on you to stay in business, so they need to keep their prices reined in to keep you in business. The distributor takes on the burden of carrying inventory and possibly some value-add activities, and there are costs associated with that.  But you can still demand that your distributor use its muscle to keep manufacturers’ costs under control as a condition of your loyalty.

In these times of threatened inflation combined with likely recession, a business must do everything in its power to reduce costs. Please note – that may not (probably should not) mean that you will choose to reduce prices! I am not a fan of selling cheap to gain business, because it rarely works. If you have the operational efficiencies of a Wal-Mart you can afford to compete on price. But if you don’t have that kind of muscle – the kind of muscle that enables you to put your competitors out of business – you can’t afford to sell cheaply as a strategy.

Rather, your reasoning behind controlling costs is to enable you to keep as much of a lid on price inflation as possible. If your competitor’s prices are increasing and your prices are able to hold steady or increase at a slower rate, you may be able to claim competitive advantage. Because you don’t want to do this at the expense of profit margin, you need to create efficiencies in your supply chain. Hence our focus on reducing labor costs.

Difficult economic climates call for increased skills in strategic areas, and supply chain management is certainly the big one. Of course, it’s always good business to maintain a very lean and efficient supply chain operation. But if you don’t think you’ve been doing as great a job of supply chain management as you should, now is the time to correct it.

(c) 2008. Andrea M. Hill

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One Response to That Cash Won’t Hatch Part Deux

  1. Bill says:

    Very interesting and useful material. You seem to confuse “cost” and “price”, however. In a supply chain, your cost is the price set by your supplier. You have advocated several times not to compete on price even though you may be able to reduce your costs. Stepping back to the suppliers view, the supplier should not reduce its price even though is costs are reduced. One added point – 10% profit. If your supplier is only making 10% profit, either you are talking a commodity product, or your supplier will soon go belly-up due to lack of innovation. In one industry I’m familiar with, electronics, price is 3X material + labor costs. Profits are obviously much lower, but not as low as 10%.

    REPLY TO BILL:

    Hi Bill. I don’t think I’m confusing cost and price – though I did find one place where it was useful to insert the word “manufacturer’s” before the word price for the sake of clarity. Very much to your point, I agree that if each level in the supply chain is following this advice there will be tension between each level as to who can/should reduce their costs while each level is also trying not to reduce their prices. That is the inherent nature of supply chain dynamics, and that sort of dynamic tension should actually lead to innovation in the supply chain.

    Regarding the 10% profit comment – as a consultant I see a lot of business operating at this level. Some of this is due to falling prey to the temptation to compete on price, and some is – as you point out – failure to innovate.  Sometimes it is due to the dynamics of the particular industry they operate in. But if the point can be demonstrated at this conservative end of the spectrum, it is valid at higher profitability levels as well  Take care!  Andrea

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