maandag 22 november 2010

Recapturing the Cost-Perspective in Procurement

Recapturing the Cost-Perspective in Procurement
Integrating the Total Cost of Ownership and the Should Cost Model

Author: Kevin Lemmens©
Date November, 2010
Draft version 1

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1 Introduction

Costs have always been one of the main elements with respect to purchasing. Purchasing was seen as a support function, but last decennia the focus of purchasing is shifting from cost to value: purchasing is becoming a value adding activity. It is part of the core-processes of an organization which is indicated by the fact that purchasing functions are more and more reporting to the CEO (Capgemini Consulting, Global CPO Survey, 2010).
Among others, this shift has been a result of the focus on value. The service or product delivered by an organization is highly dependent on the input (material and services) which are purchased by the procurement function. This means that delivering value to your customers starts at purchasing the right input. In order to add value for the end customer, the procurement function needs to know what the customer desires are. It seems therefore a logical consequence that purchasing need to be incorporated in the core processes of the organization.
Undoubtedly, this focus on value has brought good things and it is expected to bring even more good or even better things. Nevertheless, it is important not to get overenthusiastic and with that neglect cost. Cost always remain important as organizations have limited resources; there always exists an ultimate price which a customer can or is prepared to pay for a product or service. Conversely, costs can also be seen as a type of value for a customer. Anyhow, costs and value are dissoluble linked; g
enerally speaking differentiation (increasing value) will increase costs. Conversely, reducing costs will lower value (decrease differentiation). Porter (1989) argues that this does not have to be the case, but when differentiating also results in lowering costs, one or more of the following three issues are likely to be present:
1) the organization has not exploited all possibilities for cost reduction before
2) being unique with respect to an activity was not desired before
3) an important innovation has occurred that competitors have not yet copied
Therefore solely focusing on value may increase costs too high for the end customer. This means that a trade-off must be made here, implying that costs and value must both be taken into account.

Being enthusiast about the focus on value myself, I’m convinced that costs remain very important as well, and therefore I propose in this article a perspective on costs with respect to purchasing.

In this perspective I divide cost into two categories, first cost incurred at your supplier, which is reflected in the price and secondly cost at your own organization.
The last category of costs, can be contemplated with the Total Cost of Ownership (TCO) perspective. This is not a new phenomenon anymore as we can see that supplier selection is bit by bit shifting from price-based towards TCO-based. But do managers exactly know what TCO is? And even more important, do they know how to use it? Although it is sometimes used as a fancy word by management, it sure isn’t just a hollow concept.

The TCO perspective is very useful to estimate the costs of purchasing a product or service of a certain supplier. It extracts the cost-elements occurring when purchasing from a specific supplier. The price is mostly one of the main cost elements appearing from the TCO. It is good to have the wider TCO perspective when selecting a supplier, but as the price of a product or service causes a great deal of the total costs, it remains very important. Therefore price is a cost element which should obtain a solid level of attention. It is important to look whether the price is fair/right. Is the supplier efficient enough? Does it have a fair margin on it? To go beyond the old fashioned negotiation game between buyer and supplier on the price of a product or service, it may be useful to make a cost break down of your supplier’s quotation. A ‘should cost model’ may be useful here. Dependent on the willingness of the supplier and the purpose of the buyer, the ‘should cost model’ can vary from a more cooperative to an adversarial variant. The should cost model can also be used for contemplating other cost elements than price. In the remainder of this article the basics of TCO and SCM are highlighted, followed by an integration of these models, offering a new cost-perspective on purchasing.

2 Total Cost of Ownership
The Total Cost of Ownership considers ‘all’ costs involved with purchasing a product or service from a particular supplier. TCO goes beyond just the price and takes a ‘bigger picture perspective’, considering all cost of purchasing from a specific supplier over the life time of the product or service. Examples of those cost are costs with respect to quality, ordering costs, inspection costs, warehousing costs and elimination costs.
A TCO model, is a tool with which these types of costs can be determined on a structured way. In figure 1 a TCO model is depicted, below is explained how to use it.
 On the horizontal axis, you can find a chronically depiction of the stages of a life cycle of a product or service. In these categories you write down the cost elements of a particular product or service during those stages. Bear in mind that those stages may vary per product, organization, industry, etcetera.
1)      Initial acquisition: these costs relate to activities which take place prior to receiving the product from the supplier (e.g. price and costs for negotiation).
2)      Reception: cost occurred when receiving the goods, processing invoices, performing inspection etcetera.
3)      Possession: cost which occur after inspection but before utilization. Think of internal transportation and inventory holding costs.
4)      Utilization: the costs for utilizing the product or service. Think of electricity costs, personnel training, waste material and maintenance costs.
5)      Elimination: costs for throwing away products, eliminating used products or selling your used products.
These costs can occur at different levels: supplier, order and unit-level.
1)      Supplier-level:  these costs occur each time a supplier is used (e.g. cost of supplier audits and the salary of the buyer responsible for managing the relationship).
2)      Order-level: costs occurring each time an order is placed with a supplier. (e.g. receiving, invoicing, external transportation).

3)      Unit-level: these costs are incurred on a ‘per unit basis’, and often occur in the utilization and elimination stages. They might for example be caused by inventory costs or a production shutdown caused by a defect product of the supplier.

For each level is distinguished between costs/savings realized in cash or costs/savings realized from occupying/freeing up capacity. In figure 1 you can find a template of a TCO model.

Figure 1: TCO-model template
Steps in TCO process

The template given in figure 1 is a useful tool for drawing up the TCO of a product or service. Below is described how to make use of the model in order to estimate the TCO.
1)      Map the process a product or service ‘follows’ through its lifetime.
2)      Identify for each time-category (e.g. initial acquisition)  the process steps which are the cost elements in the model
3)      Determine whether it is supplier, order or unit-level cost.
4)      Determine for each cost element the cost driver. What drives the costs of a cost element. Is it the number of hours in combination with the hourly rate? Amount of material? Amount of time? This is an important step!
5)      Gather data about the (height of) the cost driver and quantify the costs. This data can be gathered on various ways like interviews, workshops, surveys, accounts payable systems or their databases. Be aware of the accurateness of the data, in the end the TCO calculation is as good as its data is.
Senior management approval or involvement in the TCO process may make data-gathering easier.

Data-gathering is a time-consuming process, therefore it can be useful to delineate some things in step 1 and 2. For example, by conducting interviews and facilitating workshops with content-experts you can determine what the expected main cost drivers of the product or service probably are. Then you can focus on these cost elements instead of wasting valuable time on gathering data and quantifying cost elements which have a minor and less important share in the TCO price.
6)      After completion of step 4, put the costs in a time line. The time line for the length of the life cycle of the product or service. Sum all the costs per time period and calculate them to the present values (optional step).

How to use the TCO outcome
Having calculated the TCO of a product or service, it can be used for (at least) two things. First it can be used for supplier and product selection. Compare the TCO of a product of Supplier A with the TCO of a (comparable or alternative) product of Supplier A or another supplier B. Choose the best alternative (while taking contextual qualitative aspects like market situation and the importance of the product/service into account). For example ordering products in China may be cheaper, but the transport costs may increase. What about the quality of the products? And what about the costs of the decreased flexibility. Or is chosen for a larger inventory for keeping the lead-time and flexibility at the same level? These are just a few of the many things which can (or must) be taken into account.
Secondly, the TCO value can be used to search for improvements or cost reduction. Identify the main cost drivers and look whether you and/or your supplier is able to influence those costs. Ask yourself whether the time and effort required to realize the cost reduction are larger than the cost reduction itself.

-          Calculating the TCO for a product or service is a very time-consuming process, therefore make sure whether the process to calculate the TCO of the product or service fits the product or the size of the purchase order(s). Calculating the TCO for a punching machine or an airplane makes more sense than performing a TCO for a pencil. In between these extremes a lot of other products or services exist. Therefore it is important to make the tradeoff between the expected costs of making a TCO and the expected benefits.
-          Reducing costs may be realized by making changes in any kind of process (like production processes and working processes), product characteristics, order and batch sizes, etcetera. Sometimes these changes must (partly) be performed at the supplier side or even a link further up in the chain (sub supplier). This can be a difficult job, depending on things like the kind of relation (is it a cooperative strategic alliance or an adversarial relationship), market situation, power etcetera.
-          Although it is good for organizations to be as efficient as possible and drive down costs, the flipside of the medal is ‘value’. As costs and value are indissolubly linked to each other, it may be dangerous for the profit of an organization to focus on just one of the two. Generally speaking differentiation (increasing value) will increase costs. Conversely, reducing costs will lower value (decrease differentiation). Porter (1989) argues that this does not have to be the case, but when differentiating also results in lowering costs, one or more of the following three issues are likely to be present:
1) the organization has not exploited all possibilities for cost reduction before
2) being unique with respect to an activity was not desired before
3) an important innovation has occurred that competitors have not yet copied

-          If is chosen for a TCO way of driving down organizational costs, it should be integrated throughout the complete organization. If this is not the case, it may be that the wrong performance measures are in place for the procurement department (e.g. if they are still measured on the level of purchase price).

Having performed a TCO analysis you can decide to use it as a supplier selection method (A in figure 2). Choose the supplier with the most beneficial TCO to reduce costs. As already mentioned, a TCO analyses can also be used to trace possibilities for cost reduction. Select the highest cost elements and analyze them why those costs are that high and if anything can be changed by that (B and C in figure 2). Using a ‘Should Cost Model’ could be useful here. A SCM makes a cost break down, and although it is originally used for cost break downs of the price of products and services purchased at suppliers, the methodology can also be useful for the other cost elements of the TCO analysis. The SCM is discussed in the next chapter.

Figure 3: The sequential flow of TCO and SCM

3 Should Cost ModelingSCM was originally designed for breaking down, understanding, comparing and validating a supplier’s quotation, therefore is first is looked to the original way a SCM can be used. The method for analyzing cost elements other than the price will not be very different.

External purchases of products and services account generally for more than 60% of the total costs of an organization. Reducing the purchase price of products drives down an organization’s expenses. Should cost modeling is a valuable tool for determining a supplier's costs, whether those cost are reasonable (for the supplier as well as for your organization) and the model provides insight where in the (production) process and value chain of your supplier cost reductions are possible. A reduction at your supplier may be beneficial for both the supplier and the purchasing organization.

Instead of taking a marketing based view on purchasing by focusing purely on the lowest price, a should cost model focuses on the structure of the price.
Should cost modeling is the process of determining what a product should cost based upon its component raw material costs, manufacturing costs, production overheads, general, selling and administration and reasonable profit margins (see table 1).


Direct material
Bill of material (BOM)
Direct labour
Labour required to convert direct material into a finished product (production workers wages)
Manufacturing overhead
Indirect costs associated with the conversion process (depreciation, other plant costs, supervision, R&D, support, etc.)
Cost of goods sold
Sub-total (DM + DL + MOH)
General, Selling and Administration cost (GSA)
Costs included to keep the organization in operation (R&D, Finance, Procurement, marketing)
Profit before tax
Profit before taxes are subtracted
Total of all cost elements
Table 1: Costs

When properly used, a should cost model is a tool which is able to provide insight in the costs and the value adding activities of your supplier. It is the tool which can be used to open up the black box of the supplier. Knowing what the cost elements and their cost drivers are, is the first necessary step in reducing the costs, because if you do not know where the costs origin from, how could you ever been able to control them? And bear in mind that controlling your costs can be a source of competitive advantage!

You need to know which cost elements are present and what the cost drivers of those cost elements are at the supplier’s processes and wherefore those costs are made and if they are necessary or just waste of resources. You have to think of aspects like:

·         What value does your supplier add with its processes?
·         Are those processes really required for adding value?
·         What costs does it make for creating certain added value?
·         Are those costs reasonable?
·         How do you know whether the costs are reasonable or not?
·         Can he (the supplier) or we reduce those costs?

Should cost modeling actually means: Opening the black box of the quotation!!The benefits of disclosing the black box may be obvious:

·         Calculate a fair price for a product
·         Compare a supplier’s quotations to industry averages
·         Compare two or more supplier quotations with each other (benchmarking)
·         Engage a supplier that has not provided any cost information in a discussion on cost (why his price is different than the calculated should cost price)
·         Extract cost information from suppliers
·         Identify key cost drivers for detailed analysis
·         Estimate a target cost of a final product

By knowing the price composition of your supplier you can judge whether you want to do business with that supplier or not, whether you can expect price decreases, look together for cost reduction etcetera. In other words, organizations can use should cost modeling when their goal is to increase the value of a product (by means of reducing the costs or increasing revenues). A should cost model can be used in two ways:
1)      as a negotiation tool, or in a
2)      cooperative way together with your supplier[1]
Because the product price is dependent on the type of product and the context it is in (like number of suppliers of the product and its alternative products), it becomes more difficult to construct one common type of should cost model for all products. This may be one of the reasons that should cost modeling is not (yet) widely accepted in the western business.

Although SCM was originally developed for contemplating the price of a product or service, the methods used for analysing the price, can also be used for other cost elements. The other cost elements exists of processes, products, services from internal or external suppliers and will also consists of (a selection of) direct material costs, manufacturing costs, production overheads, general, selling and administration and reasonable profit margins. It depends whether it is a product or service (services often don’t need direct material) and whether it is from internal or external suppliers (the profit margin may not be present with internal suppliers).

4 TCO and SCM
TCO is a useful tool which goes beyond purchasing based on the product/service price. It widens the scope and it provides insight in what the actual total costs of purchasing at a certain supplier are. Using TCO as a supplier selection tool is very useful, but you can also go a step further. When having revealed the cost elements of the TCO, SCM can be used to go into depth on those (main) cost elements. You try to extract what drives those costs? And are we (buyer and supplier) able to influence those costs?
Where TCO just widens the scope and SCM only goes into depth, the combinations of the two creates a holistic but detailed approach to purchasing. The combination of the two tools creates a sort of 3D-approach to purchasing (Figure 3).

Figure 3: Cost perspective on purchasing
A: Compare and select (alternative) products and services of (different) suppliers on their Total Cost of Ownership
B: Identify the main cost elements of the TCO’s determined in step A.
C: Apply Should Cost Modeling on the main cost elements identified in step B, to get a thorough understanding of the cost elements. What are the drivers of the cost elements? Can we (supplier and/or buyer) reduce those costs?

Note that step A, B and C correspond with the steps A, B and C in figure 2.

With TCO, an organization takes costs into account incurring in their own organizations, while using a  SCM approach an organization is looking to costs at their supplier. The combination of the two approaches include both sources (buyer and supplier) for costs. It even provides opportunities for synergy, because  knowing where the costs of both parties origin from and the processes of both organizations, actions can be taken to align processes and reduce costs with that.
Without taking notion of the other party in a Buyer-Supplier (B-S) dyad, cost reductions in one organization, may increase costs at the other organization. Conversely, when aligning processes, costs at one organization may increase, but the overall costs of the B-S dyad may reduce. If the buyer and supplier communicate in the last example, an organization may be prepared to increase their costs if it shares in the additional revenues at the other party (or in other words get compensated for their investments and efforts). Agreements about the division of the costs and revenues in order to reduce costs or increase revenues of a buyer-supplier dyad, is important, especially when looking to the future of the relationship.

5 What next?
Having made the first steps for recapturing the cost perspective, much work is still required in the area of procurement. With respect to this cost perspective, publications on my account are expected about Should Cost Modeling (the SCM-philosophy, practical examples, a manual, how to use a SCM outcome) and about Total Cost of Ownership. Compared to SCM more literature on TCO exists and therefore the focus will be more on SCM. Then the interaction among SCM and TCO is elaborated on, and a practical model is expected how to use this perspective in practice.
Although the focus of this perspective on purchasing fully relies on costs, value is the other side of the coin cannot be neglected. Therefore the link between these two will be elaborated on in later publications.
Communication plays an important role when increasing the value of a buyer-supplier dyad (called inter-firm profitability), therefore this will be an important issue which will be elaborated on in a later publication.

6 References
Monczka, R.M., Trent, R.J., &  Handfield, R.B. (2005). Purchasing & Supply Chain Management. 3rd edition. Ohio , USA: Thomson-southwestern. Cousins, P., Lamming, R., Lawson, B., & Squire, B. (2008). Strategic supply management: Principles, theories and practice. Edinburgh Gate, England: Pearson Education Limited.

Porter, M. (1989). : Concurrentievoordeel : de beste bedrijfsresultaten behalen en behouden. Utrecht: Veen.Capgemini Consulting. (2010). Global Chief Procurement Officer Survey 2010. Achieving sustained business value through procurement.

[1] Not part of this publication.

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