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Waste More … Win More?

Jan. 23, 2020
Why across-the-board supplier price reduction goals are a bad idea.

In a recent article, I made a negative comment about OEM across-the-board supplier price reduction goals. A few who read that article noted this comment and asked for clarification. This issue was discussed in detail in a 2014 IndustryWeek article I wrote, “Supply Management Strategies to be Avoided,” parts of which I’ve included below:

OEM broad-brush strategies generally do not support the creation of a lean performing supply chain, which should be the primary goal of all purchasing functions. I’ll use one such broad-brush practice—the setting of annual across-the-board price reduction goals—to illustrate this. Overall purchasing cost reduction goals are usually set by functions outside of supply management, primarily Finance. Too often, however, these general goals are translated by purchasing personnel into common individual supplier price reduction expectations.

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 counterproductive unanticipated results.

The Logic Argument

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, 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 since it increases the size of the profitability pie, allowing OEMs to get lower prices and suppliers to maintain or increase margins. To have rational goals for supplier price reduction, however, you need to have a handle on the amount of available supplier waste.

Setting common broad-brush cost reduction goals across all suppliers, then, makes no sense whatsoever unless they have comparable waste available to reduce and /or similar margins to pare. In a sense, setting the across-the-board price reduction goals actually rewards suppliers that have a higher percentage of waste in their overall cost since they can more easily hit the price reduction goals set by their customers.

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 their productivity, or deliver a combination of the three.

Paul Ericksen's columns are part of IndustryWeek's Supply Chain Initiative.

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 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. Because of this a more practical version of a purchased material cost reduction strategy would be for goals to be set within individual product types. Better yet, to tailor individual supplier price reduction expectations against product type goals based on their “true” lead times, which are an indicator of waste.

This leads to a question.  Would it make sense that OEMs share the same internal cost reduction goal they set for their suppliers?  Of course it would.

My experience is that internal OEM goals for cost reduction are set below those applied to suppliers. This practice 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, many OEMs tend to set the same price reduction goal rates on a year-to-year basis.

The Negative Impact Argument

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 can make up 50% of the COGS, a 5% Price reduction goal actually means a 10% reduction in supplier controllable costs. That type of reduction is not inconsequential. The way many suppliers have delivered OEMs the price reductions has been by deferring needed investments in their factory and / or reducing or eliminating functions 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 cost reduction. Unintended negative consequence indeed!

I agree commodity suppliers can be managed differently than engineered product suppliers where setting annual broad-brush price reduction goals can be a reasonable strategy. 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 costs; i.e. you may get a supplier to reduce their margin a time or two but not perpetually.  So when across-the-board goals are applied to engineered products, the negative impact can be that suppliers come to the understanding they are playing in a game they can’t win unless they make their own rules. And those rules can negatively impact OEMs, although these negative impacts often are not recognized.

One result of setting 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 who had previously been employed a large domestic 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 that were the basis for measuring his performance. 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.

Broad-brush, across-the-board Price Reduction Goals are, in my mind, is a strategy of someone looking for a silver bullet that doesn’t really exist.

Paul Ericksen is IndustryWeek’s supply chain advisor. He has 38 years of experience in industry, primarily in supply management at two large original equipment manufacturers.

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