Supply Management

By Thomas A. Crimi, C.P.M., and Ralph G. Kauffman, Ph.D., C.P.M.
Thomas A. Crimi, C.P.M., is supply chain team coordinator/strategic sourcing for ChevronTexaco, Houston. Ralph G. Kauffman, Ph.D., C.P.M., is associate professor at the University of Houston-Downtown, and chair of the ISM Non-Manufacturing Business Survey Committee.

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Reduced cost is perhaps the most sought-after goal in the practice of supply chain management. A primary reason for this is the leverage effect by which supply chain savings produce a proportionally greater increase to the bottomline than a sales increase of similar size. Many organizations have achieved "first-level" or "easy" savings such as price reduction from competitive bidding and elimination of obsolete inventory. How to find cost-saving opportunities at the "second level," beyond low-hanging fruit, is often a challenge to supply managers because the process of identification and achievement of opportunities becomes more complex.

Many organizations are attacking this problem using an overall strategic sourcing approach that employs various techniques to achieve the desired cost savings. Savings from such an approach may range from 5 percent to 30 percent of existing costs. The two primary requirements for strategic sourcing to achieve cost savings beyond the first level are: (1) an organized approach and (2) techniques that work. This article will identify potential sources of second-level cost savings, describe a best-practices approach, and illustrate two cost-saving techniques: market basket review and alliance savings model.

Sources of Second-Level Cost Savings

The following represent sources and tools for obtaining second-level cost savings:

	Total cost of ownership analysis — measures all of the cost components connected to a purchased material or service
	Process improvements — the increase in value (or decrease in applicable costs) resulting from a modification in any phase of the purchasing and/or supply process
	Transaction cost reductions — activities or process changes that decrease the cost to process a purchase order for requisition, ordering, and payment cycles
	Material substitutions — cost savings achieved by identifying and qualifying acceptable material alternatives that meet specification requirements but cost less than existing materials
	Quality improvements — activities that focus on reducing material quality costs or improving performance of materials or equipment
	Cycle time reductions — activities that focus on reducing the total time it takes to complete the elements of a procurement or supply cycle
	Outsourcing of non-core activities — evaluating purchasing and supply activities in order to place non-core activities with outside contractors or suppliers
	Volume leveraging — activities that attempt to capture as much spend in a materials or service category as possible in order to potentially reduce costs through economies of scale and enable a buyer to negotiate more competitively with suppliers
	Cross-organizational synergies — proactive activities by supply management to identify opportunities to share best practices or coordinate sourcing programs to reduce costs, usually accomplished through cross-functional teams
	Standardization — efforts to reduce the number of specifications, material variations, and contractors in order to reduce inventory carrying costs
	Product design improvements — activities that enhance the functionality or performance of a material or piece of equipment
	Investment recovery initiatives — systematic efforts to manage material and equipment surplus in order to recover as much of the original cost and investment as possible

A Five-Step Best-Practices Framework

The following five steps can be used to identify, implement, and achieve the benefits of cost savings mentioned above.

Organization and support. Use a cross-functional, cross-organizational team. Involve all departments, functions, suppliers, customers, third parties, and other stakeholders who are necessary to success and who could be affected by cost reduction efforts. Obtain management support for the cost-saving initiative. In large organizations, a mandate from top management may be necessary to achieve the cooperation of all segments of the organization. Ensure that the team has knowledge and (preferably) experience in applying current concepts, techniques, methods, processes, and systems to improve supply chain cost performance.
Know your supply chain. Study your supply chain to determine how it operates, what and where the costs are (as well as the cost drivers), and what has to be done to reduce current costs. Create a process map of the supply chain. Determine what constitutes customer value and how value can be added to information, product, and money flows. Identify potential areas for cost reduction.
Select targets and build the business case. Select target areas for improvement that have significant cost reduction potential and high probability of successful implementation. Ensure that cost-saving efforts are aligned with organizational goals and strategies. Determine improvement methods, and metrics to measure results. Develop a business case for management review and approval that describes changes to be made, expected cost savings, and a plan for implementation and evaluation.
Implement improvements. Communicate changes to be made, and train personnel affected by the improvements.
Evaluate and improve. Measure results, evaluate against goals, and adjust implementation as needed. Practice continuous improvement.

Two Examples: Market Basket Review and Alliance Savings Model

Two models are available to help organizations as they seek to find the second-level cost savings. One is the market basket review, and the other is the alliance savings model.

Market basket review. Identify major high-spend items for each significant category of materials and services. Organize the items by alliance agreement, business unit, geography, or domestic versus foreign, and then combine them into an overall market basket to determine which is the best supplier overall, but segmented by business unit/geography to determine which is the best supplier for a particular market. This approach can also be used to evaluate a supply alliance to determine if the pricing is competitive and/or to identify weaker subcategories of materials or services. If the suppliers are not the manufacturers of the items, manufacturer identification should be included to evaluate the supply side of the supplier's supply chain. If an alliance supplier is not competitive on particular items, it must find more competitive manufacturers or risk losing the business or that segment of business. A rule of thumb for assembling market baskets: include items that represent about 15 percent of current total spend for current supplier(s).

Bid the market basket to best-in-class suppliers for that market including incumbent suppliers. Request pricing, and associate with manufacturer names and country of origin. Seek a uniform currency and units of measure that are standard. Ask for out-of-stock ("run and maintain") pricing and also for long-leadtime or project pricing that optimizes shipping quantities and leadtimes. "Run and maintain" refers to routine spending activities to support typical business or manufacturing activities. Asking for "optimal shipping quantities" should guide the potential suppliers bidding on the market basket to search for the most economic quantity of materials to ship in order to reduce buyer costs and improve the competitiveness of their offers. Have an additional column in the market basket analysis for "dollar quantity discounts."

Market baskets should go out for update/review once per year, preferably when prices tend to be more stable (midyear in some markets). Market baskets become an important part of total cost of ownership evaluation.

Alliance savings model. Establishment of partnerships and alliances with suppliers or customers usually has the objective of reduced costs. These savings may be achieved from a large number of potential sources. All identifiable potential savings sources in a proposed or existing alliance should be identified and agreed upon as achieved or feasible by the alliance partners. These savings should be reviewed at regular intervals to ensure that savings targets are being met and to identify actions needed to bring below-estimate savings up to expected levels. Continuous improvement should be practiced by both alliance partners jointly to maintain and improve cost savings realized.

Alliance partner savings come in the form of materials management:

	Reduction in inventory/carrying costs
	Inventory buyback — This refers to buyer-owned inventory that is within the seller's existing product line and is marketable, which may or may not have been purchased from the same seller, but which a seller has agreed to buy — usually with applicable restocking charges and at less than full purchase price.
	Return of project surplus materials — This indicates that an agreement was made with a supplier to return usable excess materials purchased from that supplier at full purchase price.
	Use of available surplus materials

Transaction process management savings come from:

	Consolidated purchases
	EDI, e-commerce — savings versus previous method
	Reduction in business unit/project transactions \
	Consolidated invoicing savings

Managed services/personnel redeployment represents another area for alliance partner savings through:

	Reduced personnel/hours
	Contractor procurement — personnel time savings/project
	Integrated services savings
	JIT II — managed open stores savings

Achieve savings through product/commodity cost management using:

	Standardization
	Material substitutions — improvements in supply chain
	Price increase/cost avoidance
	Leveraged purchasing power (price reductions negotiated due to leveraged spend, volume discounts, order size discounts, etc.)

The quality/process area is another opportunity for savings including:

	Reduction in inspection, testing, downtime
	Improvements in transportation, expediting, and logistics costs
	Improvements in cycle times
	Reduction in rework

Another miscellaneous savings area with alliance partners is in project savings.

If alliance partners are included in a market basket analysis, a proportionate amount of alliance savings should be subtracted from potential market basket cost for such suppliers. For instance, if the market basket analysis includes 15 percent of the items from which the savings are generated, then 15 percent of the savings, or $120,000, for example, must be subtracted from the current alliance supplier's market basket cost.

Use an organized approach, and employ a cross-functional, cross-organizational team. A key enabler for achieving second-level cost savings is the development of a solid, well-written, benchmarked, documented, and well-presented business case that will gain organizational acceptance and management support for the capture of cost savings.

EXAM ALERT
MODULE 3

Example 1

Market Basket Model

The chart demonstrates that the suppliers with the lower prices are not necessarily the best option since in the example, other cost issues come into the analysis to impact the overall total cost of ownership.

Out-of-Stock Review across Suppliers
Market Basket $	Supplier A (e.g., Incumbent Supplier-Alliance Partner)	Supplier B	Supplier C
Total Price	$1,000,000	$950,000	$975,000
*Plus Cost Issues*
a. Logistics, FOB	0	+60,000	0
b. Late deliveries	+10,000	0	0
c. Approved mfr.?	0	0	+50,000
d. etc.
*Minus*
Alliance Savings	-120,000	0	0
TCO per Supplier	$ 890,000	$1,010,000	$1,025,000

Example 2

Alliance Savings Model

This is an example of the types of savings that may be realized from a particular alliance. Dollar values are for illustration only.

Example: Alliance Supplier A in Market Basket Model (see above table)

Alliance Savings
No.	Savings Item	Savings $
1	Materials management	$200,000
2	Transaction process management	150,000
3	Managed services/manpower	150,000
4	Product cost management	175,000
5	Quality/process savings	100,000
6	Miscellaneous savings	25,000
Alliance total annual savings		$800,000

March 2003, Inside Supply Management®, Vol. 14, No. 3, page 6.