At the end of the previous article two critical elements were cited that will need to be established to provide a framework for supply chain-based economic development policy. One of these elements—which involves the How’s of providing the support necessary to implement such a policy—will be discussed in a subsequent article. The other—defining supply chain capability and competitiveness needs—will be the focus here. In other words, this article will lay out the What’s.
Total Cost and Supply Chain Competitiveness
Original equipment manufacturers (OEMs) attempt to assess supplier capability and competitiveness in sourcing decisions through evaluating quotes on Total Cost. The point of these calculations is to accumulate all costs associated in doing business with each individual supplier such that sourcing alternatives can be compared on an “apples-to-apples” basis. A spinoff of this is that if properly focused, the factors these formulas are based on can provide suppliers with a roadmap for doing what is needed to secure OEM business.
Most OEMs use home-grown Total Cost formulas even though the generic capabilities and competitiveness they seek from suppliers are essentially the same. Because of this there are many Total Cost formulas out there that, for the most part, are pretty much alike and include common elements such as piece price, the cost of packaging, freight expense, etc. Most that I’ve seen include a dozen or two costs elements but I am familiar with one that applies 143 of them! Regardless, these formulas provide valuable guidance towards understanding how OEMs view suppliers. Unfortunately, my perception of existing OEM Total Cost formulas is that they don’t really take into account beneficial factors of supplier capability and competitiveness and, consequently, are not very effective in delivering “apples-to-apples” comparisons.
Why is this? From what I’ve seen it is because they primarily apply only standard accounting exhibits. These are cost elements that are called out separately and tracked in separate accounts, making them highly visible. They are generally reported on a monthly basis and used to evaluate and manage a firm’s performance. At first glance, basing Total Cost calculations on such cost elements may seem reasonable. After all, what better way to figure projected Total Cost than to base it on routinely tracked financial exhibits? And even better yet, using them provides an aura of credibility to sourcing decisions based on them.
To answer this question, first let me cite the old standard used when taking shots at Standard Accounting Principles—namely setting production run lot sizes. In the accounting world overhead costs are allocated to the number of parts being made to establish a price per part. Many times the processing needed to produce specific parts involves set-ups to prep production equipment. I don’t think I need to mention that in supplier quotes, piece price is a prime Total Cost factor. In allocating set-up cost it quickly becomes apparent that an easy way to minimize set-up overhead costs is to run larger lot sizes since, in that way, overheads can be allocated across a greater number of parts. Of course, the problem here is many times this leads manufacturers to produce volumes greater than what is necessary to satisfy customer demand in order to lower the accounting piece price that gets put on the quote. Historically, a lot of waste has been produced because of this. Today, I might add, running excessively large lot sizes is a well understood trap and doesn’t occur as often or to the extent it did a decade or two ago. Based on this example, though, it should be understood that sticking exclusively to Standard Accounting Principles may not always help you make the best business decision.
With that being said I will go on to say that Standard Accounting Principles are here to stay and must be accommodated. I say this because in addition to OEM Total Cost formulas, people and organizations have proposed generic Total Cost formulas that try to circumvent traditional cost reporting by including cost elements in part-specific Standard Costs that generally aren’t broken out individually as standard financial exhibits. I’m talking about costs such as material handling and inventory management. It’s true that these costs are real but it is also true they are buried in overheads to the point that they cannot be easily quantified and assigned to specific parts.
None of these generic Total Cost formulas have really caught on and in my mind this is for two reasons. First, if a cost is buried within overhead it is not likely that part-specific estimates of cost impact will be recognized as legitimate. Years ago when I first starting working on Total Cost I was an advocate of this generic approach, took a lot of “hard knocks” in promoting it and in the end wasn’t successful in getting my accounting people on-board. Based on this experience I’ve come to the conclusion that—at least in my lifetime—it’s probably a bit quixotic to think that supply chain realities are going to change Wall Street quarterly financial reporting, and this is the process that dictates to a chief financial officer how to structure their internal financial exhibits. In other words, these costs are going to remain buried in overheads.
The second reason is that evaluated individually, these buried costs usually don’t amount to much. Sure, if you accumulate enough of them you can make source selection differentiation, but in general most companies aren’t willing to take on the effort that would be required to define and apply each of these individual “hidden” cost elements.
Because of the above, Total Cost formulas as they exist today don’t really provide suppliers guidance on the capabilities and level of competitiveness needed to obtain new business above-and-beyond the well understood piece price, shipping and packaging. On the other hand—and this is an important point—current Total Cost formulas also don’t provide OEMs with visibility to those suppliers that can help them significantly improve their bottom lines. This represents a gap in OEM practice that may provide an opening for adding a true differentiator to Total Cost calculations and offer real guidance to how the U.S. delivers supply chain-based economic development. So what is this element? It is a factor significant enough that it can’t be ignored by CFOs and—this is important—is fairly easy to quantify. What, you may ask, is this “holy grail” factor? Incremental Revenue.
Incremental Sales are those above and beyond what was forecast. Cost-of-Goods-Sold is based on those same forecasts, so the interesting thing about Incremental Sales is that units sold above the forecasted amount don’t have overhead allocated to them. So Incremental Sales deliver profits/revenue way above-and-beyond what is delivered by a sale of a unit within the original forecast amount. Consequently, a supplier’s ability to support Incremental Sales is something that CFOs should be very interested in understanding and including in source selection decisions!
The point here is that some potential sources are able to efficiently support an OEM’s ability to satisfy incremental demand and others are not. If a company is interested in supporting Incremental Sales, sourcing decisions should consider supplier Order Fulfillment Capability relative to market demand characteristics of the end-use product the purchased part will be used in. The more that forecasts are relied on and the more historic error in those forecasts, the more potential for Incremental Revenue. But to ignore this factor completely in selecting sources would seem to be a mistake.
Most OEMs do not include this Order Fulfillment Capability in their Total Cost comparisons because extra revenue is not a cost. And, neither forecast accuracy nor incremental sales are standard financial exhibits. But shouldn’t sourcing decisions be made based on the amount of revenue that suppliers can facilitate rather than just basic costs? In today’s world of constantly varying customer demand, OEMs that do not consider supplier Order Fulfillment Capability in sourcing decisions will (in my mind) go the way of the dinosaurs.
Customer demand is a forecast value and there are errors in every forecast—some significant, others not so much. In business where forecasts are consistently accurate, piece price, shipping expenses and packaging costs should probably be the primary consideration for source selection. On the other hand, how many businesses can say forecasts are not important or that significant forecast error does not consistently have to be dealt with? It is important to understand that error in forecasts is mostly based on markets and products and not on company forecast capability. For instance, if you are a supplier of lawn maintenance equipment, no one can really predict a drought. This means that at least for certain markets, forecast error cannot be avoided, regardless of the effort OEMs put into making them.
In cases where forecasts significantly over-predict demand, most OEMs feel they do a pretty good job of shutting down costs. On the surface, this may seem true, but down the supply chain I would take exception to this point. Very few companies, on the other hand, would acknowledge they can react to and satisfy demand that comes in higher than expected. The Christmas season is perhaps the most visible example of this. Popular toys can be sold-out prior to Thanksgiving. Think about how much money could be made if the companies marketing them could respond in short order and provide additional product that could still be delivered (and sold) prior to Christmas: a lot. The reason they can’t is they’ve sourced with suppliers that don’t have the Order Fulfillment Capability to support the error in their demand forecast. Just as in lot size, when you ignore customer demand (and your ability to support it) you can make poor financial—translate: sourcing—decisions. So wouldn’t an evaluation of Order Fulfillment Capability (capacity and responsiveness) be a good thing to include somehow in Total Cost calculations and—for the purposes of our discussion here—be included in the roadmap for making U.S. suppliers more competitive? In a word, yes.
Until this happens OEMs will continue to leave a lot of revenue on the table. Suppliers need to be viewed as both cost and revenue centers. Current Total Cost formulas only recognize the cost side of this equation. And even though the revenue available through sourcing suppliers with efficient Order Fulfillment Capability is called Incremental Revenue, it is in no way incremental! When forecasts underestimate demand and OEMs can respond to and support that demand through an agile supply chain, the revenue can be of the grand-slam home run variety! I experienced this once and it was like our factory was printing currency.
The bottom line is that the knowledge exists to add supplier order fulfillment capability to Total Cost sourcing formulas. It’s just a matter of bringing the right people together to git r done. To that point I would like to see the U.S. Chief Economist pull together a select group of targeted academics as well as OEM financial and purchasing people. The point of this group would be to analyze cost elements related to demand and forecast error and design a Total Cost formula that takes them into account. The cachet associated with such an effort would probably get a lot of OEMs to look the formula over. Companies that tried it out would find that revenues would increase when forecasts underestimated demand. And that sourcing decisions had contributed to company revenue “above and beyond” evaluation of supplier cost.
The end result could be a Total Cost formula that would define the type of capabilities that suppliers need to have to be competitive in all types of markets, including those with high variability. This formula could then be used as the roadmap to plot out the manufacturing competitiveness support provided by a supply chain-based industrial policy. And an industrial policy based on increasing order fulfillment capability would differentiate U.S.-based suppliers from their global competition.
I’ve got my ideas of how to proceed to get this proposal in front of the U.S. Chief Economist. But, if you think the proposal is a good one, I’d be interested in any ideas you may have.
The next article will discuss how to deliver this type of manufacturing competitiveness support.