A couple of columns ago, I wrote about how OEMs are extending supplier payment terms in order to increase their working cash flow; i.e., using supplier monies to finance their businesses. I referred to this as pilfering. The word pilfer is usually defined as “stealing things of small value.” In this case, however, the summation of “small values” can add up to a rather large financial gain for an OEM. But it also can amount to a significant financial hit to a small- and/or medium-sized manufacturer who supplies to OEMs. While suppliers may not consider payment terms-related pilfering a game, it has become a standard OEM tool for gaming-the-system.
The extending of payment terms has become so widespread that it has the same effect as had OEMs collaborated—operated like a cartel—in deciding to jointly impose a change in traditional business practice. Regardless, it seems neither fair nor moral.
I got a lot of response to that column, primarily in two forms. First, people were glad to have visibility into this practice, although there isn’t a lot of data on the impact it is having, both on OEMs and their suppliers. Hopefully, some academic will pick up on the challenge I laid in the column and remedy this.
Second, I was asked whether there were any other similar gaming practices that OEMs unilaterally apply in managing their supplies. The answer is, of course, yes. In this column I will lay out details of three of them.
Annual Supplier Price Reduction Goals
OEMs typically set an annual material cost reduction target. Purchasing, then, translates this into a generic, across-the-board supplier price reduction goal. I generally think it is “OK” to expect some level of annual price reduction from suppliers since—as they become more familiar with the manufacture of specific parts—they (should) gain insight on how to increase the efficiency of their processing. However, I do have a lot of issues with how most OEMs structure their price-reduction programs, which I will outline below.
· A material cost reduction goal is generally is set by finance department without—or with very little—input from the purchasing function. This implies that it is likely not linked to the reality of how much supplier waste is actually available for pruning, meaning it may be unrealistic. No department is better positioned than purchasing to understand supplier waste elimination potential. Because of this—at least in my mind—an OEM’s overall material cost reduction goal should be handed up rather than handed down the annual financial planning ladder.
· Probably the biggest failing of most OEM supplier cost-reduction programs is that they are generically applied across their supply base in the form of a uniform price reduction percentage. What I mean by this is that there is no distinguishing between the price-reduction expectations for different product categories, nor is the level of a supplier’s lean-ness taken into account. In the first instance above, the percent of the Cost-of-Goods-Sold under the control of individual suppliers is not taken into account. It varies greatly, depending on product category and the amount of supplier vertical integration. This means that some suppliers would have to take a higher percentage of cost out of their internal operations—or reduce their margins—to hit their price reduction goal than will others. That doesn’t seem fair.
In the second instance—by definition—lean suppliers have less waste than non-lean suppliers, meaning they have less potential for cost reduction. Most OEMs preach the need for lean to their supply base, but by setting generic across-the-board price reduction goals actually penalize those who have implemented lean practices. Go figure.
· Supplier price reduction goals generally exceed the internal cost-reduction goals OEMs set for themselves. I suspect most suppliers don’t have knowledge of this disparity, but if they did, would regard it as their customer telling them “Do as I say” rather than “Do as I do.” I’m not sure of the reasoning for OEM executives to believe suppliers have more potential for waste elimination than they have in their own operations, especially without first-hand knowledge of how their suppliers operate.
· Exceeding a price reduction goal in one year typically does not carry over towards the next year’s goal. Again, with generic goals, this incents suppliers to bank cost reduction that could be extended earlier to their customers.
Supplier Performance Categories
Most OEMs have programs designed to differentiate supplier performance. Suppliers are categorized as (for example) as platinum, gold, silver, etc. based on things achieved on-time delivery, As-delivered Quality and Price reduction performance. Such awards and honors are generally rolled out in annual supplier conferences.
The intent of these programs is two-fold. First, to incent suppliers to hit the OEM’s supplier performance targets. Second, to give recognition to and otherwise reward suppliers for high-level performance.
The banquets at these annual award ceremonies are usually top notch, but other than that, I’ve seen very little in terms of meaningful rewards. For instance—at least from my seat in the ballpark—Platinum category suppliers seem to be treated pretty much the same as all others in subsequent years. In other words, there is no meaningful business-related reward for a supplier achieving high performance other than being served a good meal. A meal that—for many suppliers—represents a significant expenditure in terms of travel-related expenses and lost manpower.
What kind of reward would high-performing suppliers want instead? I’d think that an increase in the percentage of business within their product category would provide a lot of supplier incentive to excel.
On the other hand, the opposite sometimes happens. I heard of one OEM where—one week after a supplier had been named Supplier-of-the-Year—awarded 90% of their business to a competitor! I’m glad I didn’t have to sit at their table during the banquet knowing they were about to be sucker-punched. By the way, word of what happened spread like wildfire and I suspect soured many suppliers on the supposed importance of annual supplier performance classifications.
OEM vs. Supplier Margins
OEM financial performance is typically monitored by Wall Street, mostly on margins and profitability. To drive stock prices up, large corporations do whatever is needed to achieve high levels of financial performance.
Small- and medium-sized manufacturer (SME) performance is usually privately monitored by private owners—sometimes actual ma’s and -pa’s—mostly on whether their business has generated enough profit to remain in business another month or quarter.
Read more of Paul Ericksen's supply chain management articles
There is a double standard in business between profitability expectations between OEMs and their SME suppliers. An example of this is where one OEM publically announced it expected 20% Operating Revenue On Assets while at the same time giving its purchasing function an expectation that no supplier margins should be over 6% and, the lower the better. Hmmm.
Added to this, executives at many OEMs believe price and manufacturing efficiency are highly correlated. In other words, suppliers with the best operations are able to both quote the lowest costs and yet achieve good returns. Because of this, lower prices do not necessarily mean lower supplier margins. This is a false premise. After all, there is always someone who is willing to “buy the business” from incumbent suppliers by trimming margins.
I’ve was never considered a pushover with my suppliers. I was considered firm but fair. Why? I set high performance standards but then through a supplier development function showed them how they could be achieved. I followed a philosophy that everyone has got to eat and tried to understand when an optimal equilibrium had been reached between price and margin.
During my day I knew many other purchasing managers who operated in a similar fashion. I’m not sure where that philosophy has gone, but from what I hear from suppliers, they don’t run into OEM customers that look beyond their own financials.
Believe it or not, I am not anti-OEM. Rather I am a strong advocate of purchasing functions contributing more to their employer’s bottom line. Actions as the three described above might lead to short-term incremental financial advantages. Why short-term? First, because similar practices can easily be adopted and implemented by the competition. Second, because suppliers take measures to mediate the impact of these actions on their profitability. For instance, does anyone really think that after an OEM increases their payment terms that suppliers don’t find a way to increase pricing on new and revised parts?
Anyway, as I’ve written, for this to happen, purchasing needs to become less tactical and more strategic. One step in making this happen is to point out the inadequacies of current OEM practice.
Paul Ericksen is IndustryWeek’s supply chain advisor. He has 40 years of experience in industry, primarily in supply management at two large original equipment manufacturers.
