While the focus of the previous blog was on a specific tool that is fundamental to the practice of Next Generation Supply Management—namely, “policies”—this blog will focus on a widely applied traditional supply management practice that is actually counter-productive to effective supplier management. Before I get specific, let me remind you that suppliers need to be assigned to different supplier categories and that different strategies should be employed in the management of those categories (see my September 16 blog). Because of this, recognize that the comments that follow may apply more to some supplier categories and less to others.
OEM broad-brush strategies generally do not support progressive supply management. I’ll use one such broad-brush practice— the setting of annual across-the-board price reduction goals—as an illustrative example. I understand that such across-the-board goals are generally set by management as an average target for overall material price reduction. Too often, however, they are translated into common individual supplier price reduction expectations by buyers—the people charged with delivering supplier price reductions.
You might ask, what is wrong in putting a common price reduction goal in front of all suppliers? I’ll try to answer this question in two ways. First, I’ll do so by showing that it doesn’t make sense from a logical point-of-view. Second, I’ll show how it can actually lead to counter-productive results.
The Illogic of Across-the-Board Price Reduction Strategies
Let’s start by reviewing the ABCs of price setting. Prices are set based on “cost” and “margin.” If a supplier is unable to lower its cost through waste elimination, price reduction negotiations become a “zero-sum game,” with OEMs being “winners” when they get lower pricing and suppliers being “losers” when they have to reduce profitability. I don’t know about you, but if someone approaches me with a zero-sum proposition I generally fight like the dickens to make sure I end up on the winning side. I’m pretty sure most suppliers do, too.
Cost reduction, on the other hand, is a more sustainable strategy for price reduction since it increases the size of the profitability “pie,” allowing OEMs to get lower prices and suppliers to maintain/increase margins. To have rational goals for supplier price reduction, however, you need to have a handle on supplier waste available for cutting. In previous blogs I pointed out that Manufacturing Critical-path Time (MCT) can be a great tool for assessing available supplier waste.
Setting common broad-brush cost reduction goals across all suppliers, then, makes no sense whatsoever unless all suppliers have comparable waste available—to be reduced—and/or similar margins available—to be pared. Having the same price reduction goals for lean vs. inefficient suppliers doesn’t recognize the different amounts of available waste and in giving lean suppliers the same price reduction goals as their inefficient counterparts/competitors, OEMs actually reward supplier waste! Does this make logical sense? No.
Next, let’s review basic cost accounting. Prices are comprised of material, overhead, labor and margin. For a supplier to reduce their cost-of-goods-sold (COGS), they need to reduce the cost of their material, reduce their overhead, increase productivity, or deliver a combination of the three.
So far, so good. The problem is that over the years the percentage of the COGS that suppliers have control over has gone down significantly. It must also be recognized that the relative contribution that material, overhead and labor make to COGS varies considerably by industry, supplier tier and product specifications. The combination of these two factors is a “double whammy” indictment against a broad-brush price reduction goal strategy.
Why do suppliers have less internal control over their costs? Most industries have, over time, raised the competitive bar by reducing the contribution labor and overhead make to COGS, some more than others. Does it make sense that those that have done a better job at this be penalized by being given the same price reduction targets as those who haven’t? No—these suppliers have less waste available to reduce. At a minimum, then, if a more focused version of a broad-brush price reduction goal approach is to be used, it would make sense for individual goals to be within specific commodities, not across-the-board. Better yet, to set general price reduction expectations by commodity and then tailor individual supplier price reduction goals based on their MCT, i.e., longer MCTs imply greater waste.
Delving further into COGS analysis, it is well known that purchased material today can represent over 80% of an OEM’s costs to be in their purchased content. It is also well known that the same ratio applies to many large Tier 1 suppliers to OEMs. Understanding this, does it make sense that OEMs share the same internal cost reduction targets they set for their Tier 1 suppliers? Yes. Does this happen? Usually not.
My experience is that internal OEM goals for cost reduction are set significantly below those applied to Tier 1 suppliers. Does this make sense? No. OEMs setting across-the-board price reduction goals contributes to messaging suppliers, “Do as I say, not as I do,” which, when you get down to it, is a hard argument to sell.
A final point needs to be made relative to the illogic of broad-brush, across-the-board supplier price reduction goals. Over the years, you’d expect the goals being set to be trending downward, right? Why? Because over those same years waste has (at least theoretically) been being squeezed out of supplier operations. In fact, though, analysis shows that even as waste and margins have gone down over the last two decades, OEMs have continued to maintain the same price reduction goal rates on a year-to-year basis. For instance, there are OEMs that set their across-the-board price reductions goals at the same level, year after year. Does this make sense? No.
The Negative Impact of Across-the-Board Price Reduction Strategies
What can the ongoing pressure for waste elimination and margin imposed by across-the-board price reduction goals result in? First, understand what is being asked for. For smaller and medium-sized suppliers where the cost of purchased content makes up 50% of the COGS, a 5% price reduction goal actually means a 10% reduction in the costs that the supplier has control over. That type of reduction is not inconsequential, by any means. The only way many suppliers have delivered OEMs the price reductions needed for them to keep their business with them has been by deferring needed investments in their business and reducing positions not seen as imperative to getting the product out the door on a daily basis.
The irony is that this can result in elimination of positions most essential to ongoing continuous improvement. For instance, I’ve known many small and medium-sized suppliers that don’t have an Industrial Engineering-type person on-staff. In this case this type of broad-brush strategy has resulted in suppliers adopting a tactical, rather than a strategic, focus. Negative impact, indeed!
As I implied at the start of this blog, commodity suppliers should be managed differently than engineered product suppliers. Annual broad-brush price reduction goals can be a reasonable strategy for “spot buy” product suppliers. But if you are buying an engineered product there is really no way to reduce price sustainably without either reducing specification and/or reducing processing related costs, i.e., you may get a supplier to reduce their margin a time or two but not perpetually. Yet how many OEMs actively involve suppliers in supply chain integration? Only a relatively small percentage based on what I’ve seen. So when across-the-board goals are applied to engineered products, the negative impact can be that suppliers—and buyers, for that matter—get to understand they are playing in a game they can’t win unless they make new rules. And those “rules” can negatively impact OEMs, although these negative impacts often are not acknowledged or even measureable.
One impact brought on by annual across-the-board, broad-brush price reduction goals is more savvy suppliers and more savvy procurement personnel. For instance, several years ago I worked with a purchasing director of a large automobile manufacturer. He told me he had learned to pay more than he needed to in the early years of a supply contract just so he could deliver the annual price reductions his bosses expected. And he said that this was not an isolated practice. That’s certainly a “rule change,” and not in a positive way.
Most of the time, though, the rule changes are more subtle with suppliers understanding that only by padding their initial price quotes can they actually meet customer annual reduction expectations. So unless one of the bidding suppliers is willing to leave this padding out and “buy the business,” it is not unusual for every supplier quote the OEM receives to be padded. Again, current OEM price reduction strategies drive an unmeasurable negative impact.
Broad-brush price reduction goals, then, are short-term strategies that may not reduce supply chain waste. And when waste exists, OEMs will eventually pay for the lower prices they get in terms of lower quality, reduced order fulfillment support, etc. Broad-brush, across-the-board price reduction goals are, in my mind, a strategy of someone looking for a silver bullet that doesn’t really exist, unless you are actually buying a true commodity.
An Effective Price Reduction Strategy
An alternative approach, especially for engineered products, is to understand your supplier’s cost structure and help them remove them in a collaborative basis either through supply chain integration reduction of unneeded and inefficiency driving specifications or supplier development reduction of processing waste. Knowledge of supplier MCTs play an integral role in this. This type of strategy takes more effort and requires more time to deliver results, but the results delivered are sustainable and, over the course of working together to reduce a supplier’s wastes, both sides can end up as winners.
The next blog will tie together the management of suppliers and the management of employees. You might be surprised at how they are tied together.