Among manufacturers, total cost visibility is the holy grail of direct materials sourcing. It is the number one improvement opportunity for supply chain professionals and although it can be a complex challenge, visibility can be mastered by properly aligning people, process and technology.
A clear understanding of total cost provides a competitive advantage. Such insight leads to higher margins, more successful new product introductions and more stable supplier relationships. It can help negotiate the optimal price for guaranteed capacity, lower supplier risk and the right level of quality. In short, improving total cost visibility leads to better sourcing decisions.
So where should you start if you want to improve visibility into total cost?
Step one is to define the concept and identify the discrete elements that contribute to total cost. Total cost = component costs + transit costs + finance costs + compliance costs + cost of poor quality
For many manufacturers, component costs account for a significant portion of total cost. This can involve materials, labor, production, tooling, scrap, packaging, prototypes and supplier profit.
One of the most critical steps is to make sure suppliers provide detailed breakdowns of component costs. The more a supplier aggregates, the more they can hide additional margin. Careful examination can pay dividends during negotiations. Be sure to ask for clarity around component costs tied to commodity indices or other market factors and don’t be afraid to ask suppliers to spell out their profit margin. If they are seeking to establish a true win/win in relationship, they will be willing to share this information.
Transit costs such as freight, customs, duties, tariffs, drayage, agent fees, consolidation fees and shrinkage should also be considered.
Costs associated with getting the components into your plant can vary greatly from supplier to supplier. A supplier on the other side of the globe may have a cheaper piece price, but when you factor in the expense of bringing the parts to your plant, they may actually cost more. Interestingly, you have the ability to make your own shipping arrangements, shifting the cost from the supplier to another party and this can sometimes secure more favorable pricing.
Finance costs include payment terms, foreign exchange fees, currency exchange gains and losses, inventory carrying costs, financing fees and insurance. You usually need help from finance to determine the impact of these factors on cost. These can include working capital costs related to the amount of inventory you need to carry, based on the lead time associated with the suppliers you choose, as well as factoring in the strength of the dollar.
Other factors can include compliance costs associated with regulatory reporting, legal fees or fines. These costs are generated by trying to conform to government legislation or regulation. Such expenses often include headcount hired specifically for compliance activities, costs associated with data collection and reporting and any fines that resulted from compliance issues. Conflict minerals is the latest regulatory event grabbing manufacturers’ attention. Others include ITAR, REACH, RoHS and carbon or sustainability reporting.
Finally, cost of poor quality (COPQ) can have a major impact on total cost. Factors include warranty claims, inspection, rework, returns, allowance and administration costs.
In Six Sigma terms, the cost of poor quality is equal to the cost of internal failures plus the cost of external failures. COPQ can be a critical piece of the puzzle as it may be better to spend more on better quality components, than to cover COPQ costs. Note that the component costs do not include lost sales, lost customers, reputation damage and brand erosion. It isn’t just the product profit and loss that may suffer, but the top line of the company as well.
Build a roadmap
Step two involves developing a roadmap to collect the detailed cost information for any given sourcing project. Data collection is not an easy task. You are dealing with numerous suppliers and third-parties, as well as multiple internal departments and systems.
One key to success is determining which factors must be addressed first, in order to help improve near-term decision making. The priorities can be different from manufacturer to manufacturer. Some may not have involved their finance department, others are not collecting enough detailed information from suppliers. Roadmap development should not be done in a vacuum and will require a cross-functional team of engineering, sourcing, logistics and finance.
Create a template
Step three consists of building a complete total cost template that incorporates the five categories of cost. First, create a simple template that will be used during the first round of the quoting process to assess supplier competitiveness. Then narrow the list of suppliers and complete the quoting process with the detailed total cost template.
The detailed template should be segmented into fields that the supplier will complete and fields that you will complete. Two challenges are often encountered when using detailed quoting templates. First, some suppliers refuse to provide the visibility you have requested. Make it clear that not completing the template will remove them from consideration. Second, if you do not have the right tools to enable the direct materials sourcing process, your staff may get bogged down in spreadsheet chaos. E-sourcing automation tools are a must.
Overlay internal costs
Step four consists of overlaying internal costs. Here, working with other departments, especially finance, is critical. While some costs may be a simple allocation formula, as in the case of compliance costs, others will be based on information collected from suppliers, such as lead time, capacity or currency. Get finance involved early and make sure they provide clear input on how total costs are being impacted at the project level. Finally, take the time to build a reliable cost of poor quality model. Separate formulas will be needed for existing suppliers where you already have quality data and potential suppliers, where you have to estimate.
The final step of the process involves comparing quotes, conducting negotiations, making the decision and learning from the information provided. Once again, you will make better decisions, and save more money, if you can automate the comparison and analysis process and spend more time on developing a winning negotiation strategy. Using software built for direct materials sourcing can be a significant enabler.
The negotiation process itself can provide an enlightening view into total cost, as you can gain a consistent understanding of market trends cutting across all suppliers, as well as costs that seem to be padded. After your decision, be sure to track the quoted costs of the awarded suppliers to the actual costs, to assess potential gaps in the process.
Applying this framework and aligning your people, process and technology around a total cost sourcing strategy can improve both the efficiency and effectiveness of your direct materials sourcing team.
Directworks can help by providing manufacturers with a software platform specifically built for engaging suppliers and sourcing direct materials. This cloud-based solution empowers sourcing professionals to do their job faster and more efficiently, enabling them to focus on strategic work and contribute greater value.
By automating and streamlining tactical activities, sourcing teams are free to concentrate on more important activities, such as collaborating effectively with suppliers, getting to grips with cost drivers, and negotiating best total cost. The results: significant sourcing savings while maintaining quality and effectively managing risk.