The Piece-Price Reduction Trap

July 7, 2014
Does the procurement function in your company have the flexibility to focus efforts on cost reduction strategies other than piece-price?

As laid out in the 19 June blog, the purpose of calling out the phrase “Next Generation Supply Management” is to initiate a change of perception—prevalent among many executives today—that procurement’s sole ability to contribute to a company’s bottom line is through piece-price reduction. Facilitating such a transformation will be difficult but not impossible. Why will it be difficult? The only real executive level financial exhibit currently tied to procurement is material variance, i.e., piece-price. Based on this, how can our functional area break out of the piece-price “box”? It can do so by voicing the counter-arguments in the same language that created the “box” in the first place, i.e., executive-level financial exhibits.

Citing non-piece-price positive impacts on executive level financials can be an effective strategy for raising the stature of the profession, but only if it can be shown that procurement should be given credit for improvements that today are typically assigned to other functional areas. In other words, “turf wars” may be required to overcome traditional mindsets. But, as they say, “nothing ventured, nothing gained.” The good news is that data is available to support these mindsets changes and, eventually—though it may take time—data usually wins out over opinion.

Let’s start with a discussion of finished goods inventory. The sole purpose of the costs incurred in manufacturing and “holding” finished goods is to maintain acceptable customer fill rates. What is customer fill rate? Most companies do not want to lose sales due to lack of product availability. A customer fill rate metric measures what percent of the time—when a customer wants pay you for a specific product—the company is able to deliver the product and accept the money.

Recognizing that they do not have “build-to-demand” capability, most companies rely on a certain amount of pre-built finished goods to ensure that they will be able to support high variability (in both volume and mix) of customer demand. Companies I’ve worked for have had customer fill rate percentage goals in the high 90s.

The levels of pre-built product required to support acceptable customer fill rates is industry specific. In some types of markets customers are willing to wait weeks or months for the product they want, reducing the amount of finished goods inventory needed by a manufacturer to maintain acceptably fulfilled demand. In other types of markets customers expect immediate satisfaction or, at most, product availability in days. In these industries significant amounts of finished goods inventory may be required to achieve customer fill rate goals. Often the costs associated with holding these finished goods inventories are “owned” by a company’s marketing organization, primarily because marketing is responsible for the warehouse where they are stored. Consequently, any reduction in these “costs” is usually credited to marketing.

In the 6 June entry to this blog a case study was discussed in which a company was able to reduce need for $890 million in finished goods inventory yet maintain targeted customer fill rates. This case study pointed out a primary reason the finished goods inventory reduction was possible was “a responsive supplier chain with a manufacturing cycle time (MCT) of three weeks or less.” In fact, the build-to-demand capability of the company had increased significantly as “true” supplier lead-times (MCTs) had gone down and, as a result, customer fill rates were maintained with less finished goods inventory. The case study then went on to point out that this finished goods inventory reduction resulted in an annual recurring savings of $107 million!

Over my career I’ve had responsibility for significant annual “spends.” And I’ve done pretty well in delivering annual piece-price reductions, hopefully in the right way, i.e., through facilitating lower supplier costs. But I will admit to never in any single year delivering $107 million in piece-price reductions! Not even close. Having personal knowledge of this case study, I can tell you that the “traditional” piece-price reductions delivered that year for the studied products—while meaningful—were magnitudes below the savings associated with the reduction in finished goods.

So here we have a case where the procurement function was primarily responsible for delivering an “exceptional” financial benefit to a company through a means other than piece-price reduction. It was accomplished by facilitating reduced supplier MCTs. In a company where the purchasing organization focuses solely on piece-price reduction, elimination of this finished goods inventory and its associated costs wouldn’t have been possible. And the $107 million wouldn’t have been delivered to the company’s bottom line.

I will bring up one possible glitch to the story. Remember, at this company marketing “owned” finished goods inventories. When the need for it was reduced they wanted the credit for the positive financial impact. After all, the inventory was stored in their warehouse. So, turf war indeed. In this case it was easy to show that procurement was responsible for the savings since supplier “before” and “after” MCTs could both be documented and shown to be the reason for needing less finished goods in support of customer fill rates. Regardless, it behooves purchasing professionals to anticipate the need—and to prepare your case—for receiving the credit deserved for making such non-piece-price related positive financial impacts.

After the above discussion it almost goes without saying that a reduction in raw material can also be achieved by working with suppliers on MCT reduction. Similar to finished product, raw material inventory has a purpose, namely, to ensure that factory operational efficiency will not be negatively affected by lack of purchased parts. Current practice is for pre-built levels of purchased parts to be held either by the consuming factory, their supplier, or both. With reduced supplier MCTs, levels of raw material safety stock can be reduced without negatively impacting a consuming factory’s operations since suppliers have increased build-to-demand capability.

A possible turf war issue may be that in many companies raw material is “owned” by manufacturing, not procurement. After all, it is usually stored in their factory. Again, having facts on hand to show the actions that led to the “safe” reduction in raw material inventory should deliver the deserved credit for this savings to procurement.

The dollars saved in the above discussions are real; they have the same positive impact on company financials, dollar-to-dollar, as reductions in piece-price. And they have the added benefit to greatly outweigh the savings available through piece-price reduction. The sole issue then becomes: Does the procurement function in your company have the flexibility to focus efforts on cost reduction strategies other than piece-price?

In the next blog I’ll share more examples of the types of savings—this time indirect reductions—that purchasing can generate outside of normal piece-price reductions.

About the Author

Paul Ericksen Blog

Paul's blog "Next Generation Supply Chain," has moved. You'll find his latest ideas and commentary on IndustryWeek's IdeaXchange. 

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Paul D. Ericksen has 38 years of experience in industry, primarily in supply management at two large original equipment manufacturers. At the second he was chief procurement officer. After this, Ericksen headed up a multi-year supply chain flexibility initiative funded by the U.S. Department of Defense. He presently is an executive level consultant in both manufacturing and supply chain, counting Fortune 100 companies among his clientele. His articles on supply management issues have been published in APICS, Industrial Engineering, Purchasing Today, Target and other periodicals.

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