RFQ

Should You Should-Cost? (The Answer is Yes)

Christopher Meyer 1 Comment

Your supplier says they’re giving you the best deal. They promise they are saving you tons of money compared to their competitors.

But something in the back of your head tells you otherwise.

The supplier didn’t budge in negotiations during your last RFP. Nothing was gained, and the supplier said they actually had to raise prices, regardless of your business with them. They were the lower bid compared to the other bidders, but you still think that you’re not getting the best pricing.

Enter the Should-Cost Analysis

A should-cost analysis is a detailed breakdown of what a material or service should cost compared to what a supplier wants to charge for it.

Once complete, companies can compare their analysis against the bids of potential suppliers, or the pricing of a current supplier.

While there are some programs out there that enable companies to do this, a spreadsheet can generally fill this need.

Dig Into the Details

Should-costing is an in-depth process, and can take quite some time.

We will use a hammer as an example.

In order to should-cost the hammer, you will need to find out what kind of metal is used to make the hammer head. By weighing it, you can determine how much of that metal is used. Is there a rubber handle? Strip the rubber off and weigh it to determine how much rubber there is.

With these weights you can now search online for the current price of the steel and rubber, and determine the cost of the amount of material used.

Was the hammer made in the U.S.? Or China? Include the base salaries of workers in the country the product is made.

How long does it take to make one hammer? How many people are on the assembly line for the hammer? Machinery is most likely used in the process, too. Using an internet search, you can find videos on how things are made to give you a general idea of cycle times and personnel on the production line. (This “How It’s Made” video is perfect for helping you should-cost hammers: https://youtu.be/7xHVyT5oEL4)

Along with this information, corporate overhead, shipping, and any warranties will need to be factored into your should-cost analysis. Many times you can ask the supplier – in supplier workshops or in the RFP itself – the percentage of overhead they include. Or, for publicly traded companies, they include this in their annual report.

 

Putting It All Together

Once all of your information is gathered, organize it and add it up in a logical format.

How does your should-cost analysis match the supplier’s pricing? Is the supplier’s margin close, and they actually are giving you the best pricing? Or is there a large delta that you need to discuss with your supplier?

This information is excellent leverage during negotiations. Calling out suppliers on too-high pricing gives your organization a major advantage.

Note: Do not show the suppliers your should-cost analysis! Giving them an idea of the difference in terms of a percentage is enough. If they ask for it – tough! They came up with their pricing, they need to explain it to you.

To give you an idea what this looks like, here is a rough example of a should-cost analysis for a mini-excavator that I did. Again this is very rough, and doesn’t include shipping and warranty data.

Should-Cost 2

Conclusion

A should-cost analysis can be time consuming, but it is a valuable tool to your organization. With a solid should-cost analysis you and your team can gain a great deal of leverage over the suppliers you negotiation with.

Remember, this can be done with services, too. And, the more detailed the material or service analyzed, the more time it will take. But it will be time well spent!

Negotiations Don’t Stop at Contract Award

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Finally! Both you and your supplier have signed a strategic agreement for the next five years. KPI’s and milestones are enshrined in the contract, and it’s a win-win for both of you. You have begun managing the contract and working with the supplier in their roll-out of materials and services to your organization.

You’re done, right?

Wrong.

With any strategic procurement agreement there is always room for improvement. While, overall, your strategic supplier may be saving you money overall, there may be parts and/or services that the supplier is still pricing high. It’s these handful of materials or services in strategic agreements that are ripe for negotiation.

For example, say you have a strategic agreement with a supplier for maintenance, repair, and operations (MRO) materials. You have over 10,000 line items in this master procurement agreement, and the supplier was the lowest total cost for 80%-85% of those materials – that’s why you awarded them the agreement. It’s that 20%-15% that can, and should, be negotiated down.

It’s up to you as the sourcing professional responsible for the agreement to regularly review chunks of the MRO materials list for pricing. Other suppliers may have offered some lower pricing on some of the materials in the bidding process, and the sourcing professional can use this information to negotiate with the awarded supplier.

The organization’s buyers are integral to this process, too, as they buy the materials everyday at the tactical level and may be able to spot materials in ones and twos that seem priced high. You can also send out RFQ’s for handfuls of materials at different intervals to see if there is better pricing. This RFQ process may be driven by a purchased dollar threshold set by the organization.

Key performance indicators are another way you can ensure the supplier is offering you the best pricing on these MRO materials. Having a KPI, or several KPIs, that focus on the supplier ensuring they are providing cost savings can help reduce pricing on materials in an already awarded agreement. Maybe a manufacturer has slashed pricing due to increased production, or there is a substitute part that is the same quality but another company produces it at a lower cost.

Once the MRO materials that are higher priced are identified, it’s up to you as the sourcing professional to bring in the supplier’s representatives and negotiate this. Generally speaking, the supplier will be open to reducing the pricing in order to retain your business and have hopes of winning the award again five years down the road.

Using these principles in other agreements, whether materials or services, will ensure you are getting the best pricing for your organization.

Standardization In Processes to Reduce Costs

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Go to any department in your organization. How consistent are the ways people are doing things? How consistent are the results in that department? Is everyone on the same page, each person executing their job by a set of processes? Or is everyone doing their job their own way?

If your company is like the company I work for, standardized processes are a near-term goal – or in some cases a far off dream. Each person in a department has their own way to do work, and feels their way is best. Their way has worked thus far, why change it?

Standardizing processes is key to streamlining a department, and in procurement it can mean money saved that directly affects the bottom line.

Purchase Orders

Purchase orders are a primary issue when working to standardize. Some procurement agents process purchase orders one way, some another way. Some buyers have a checklist they follow each time, while other buyers just run the PO through the ERP system and send it to the supplier without another thought.

Standardizing purchase order processing should include, at minimum, the following:

  • Check pricing against negotiated numbers.
  • Consolidate duplicate line items.
  • Confirm material need dates.
  • Confirm shipping method and carrier.
  • Receive order acknowledgement from the supplier.
  • Update expected/promised delivery date from supplier in the ERP, and notify the stakeholder.

Just these simple standardized steps can ensure consistent outcomes each time. Consistent outcomes mean dollars saved internally in time worked on purchase orders and externally in keeping supplier pricing of materials and freight consistent with pre-negotiated prices.

Contracts

Contracts may be more complex than purchase orders, but standardization can be achieved in the process. The procurement specialists that are responsible for RFPs and contracts should have a checklist of everything they need to do, from the moment they receive the RFP/contract from their stakeholder, up to award. This checklist may even include contract management.

Templates are another way to standardize RFPs and contracts. While stakeholder specifications and requirements may differ, the organization should have a single template for procurement specialists to follow with standard information that each RFP and contract must include, such as RFP timeline, milestones, and evaluation criteria. The organization may have two or three checklists and templates for different RFP/contract situations, but each should follow a standardized, enforced process.

Conclusion

Standardization has many benefits, and in an organization’s procurement processes it translates into savings that directly affect the bottom line.

In fact, the German Institute for Standardization, DIN, recently published a report on how standardization positively effects companies. In the report, they found that not only did standardization give companies competitive advantages, but also lowered transaction costs and had positive effects on the buying power of the companies surveyed.

Now is the time to begin process standardization in your procurement organization.

How Strategic Sourcing Can Improve Your Organization’s Processes

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Originally posted on my other blog, The Red Renegade.

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Your organization is working to improve its sourcing processes and strategy. Like areas of spend have been grouped together to determine what the organization spends annually. The department or division responsible for sourcing has identified areas of spend where savings can be realized.

But, as the organization delves deeper, they find that reducing outside drivers of cost isn’t the only hurdle they face.

There are materials and services within the organization that people have been dependent on for years, perhaps decades. Leaning these materials and services, or removing them altogether, will be a major culture shock. Senior management is even wary of cutting off these materials and services.

Senior management wants to save money, but the sourcing group knows that changing how materials and services are sourced, what will be sourced, and when will have a major impact on the organization’s processes as well as its budget.

Sourcing the material and/or service is just one part of the larger sourcing strategy. A lot of work goes into transforming the rest of the organization and how it does business in order for the wins in sourcing to have their full effect – one more part of total cost ownership. Process improvement in other parts of the organization are just as important as improvements in the sourcing function itself.

Total Cost Ownership

As discussed in a previous blog post, Total Cost of Ownership is everything that goes into before, during, and after the sourcing of a material and/or service.

Generally speaking, this includes administrative processing costs, technology costs, overhead, freight, the cost of lead times, if items are damaged, and rework that needs to be done.

Rarely do organizations look at total cost of ownership in terms of what their own organization is doing.

Does each project manager or department use the freight carrier they like the best?

Is there a service the company uses, but could be eliminated if project managers were held to better standards of planning?

Do employees make parts runs because favored suppliers “don’t deliver”?

It’s internal processes like these that need to be looked at in tandem with the improvement of sourcing the material(s) and/or service(s) and organization buys. They are as much a part of Total Cost Ownership as overhead or lead times on materials.

How so?

Let’s use an example from my experience.

The company I work for uses a freight service that only delivers between facilities in my company in the city we’re in. This freight service costs about $300,000 per year for them to move material from one facility to the other. We love this external freight service so much, their drivers park their trucks at our facilities.

Why do we use them?

Because sometimes project managers cut work orders associated with one facility, only to draw the material out of another. So materials needs to be shuttled around to ensure the proper materials are in the proper place at the proper time.

We also junk out some of our larger equipment, and this service transports the junked out equipment (they’re rather large) to our central processing facility here in town.

On the face of it, this is $300,000 expended by my company per year.

Immediately some will note that, if PM’s were held to a standard, and their work orders assigned to the correct facility, this would eliminate the need for this service. And can’t we use internal personnel (we have personnel qualified) to load the equipment and drive it to the central processing facility?

But it goes deeper than that. PM’s not assigning work orders to the right facility forces them to draw from that facility, which causes work in the warehouse, and then those materials aren’t there for jobs that are properly assigned to that facility, creating wait times as items are shuffled between facilities. Sometimes its time sensitive jobs that are forced to wait as the warehouses figure out where material went and what needs to be brought in from other warehouses. Sometimes people get lazy, and instead they just put in an order to have it bought from the supplier, costing the District even more.

So it’s not costing the company I work for $300,000. It’s costing them hundreds of thousands, or perhaps even millions, in additional man hours, rework, opportunity cost of inventory, and delays on projects.

Why do we still use this “shuttle” service then? Because we’ve had them for almost twenty years. Because no one has pushed back on PMs and other internal business partners to assign work orders to the correct facility. Because our warehouse personnel are doing the best they can within this system and the shuttle service is a Band-Aid that people have become comfortable with.

In this case, it’s not just a process – it’s a part of the culture.

Where to Begin

So where does a sourcing professional begin?

Start with the sourcing strategy.

The sourcing group has identified a need, and then they go and gather their facts. But they don’t just gather the facts on the surface. They have to dig deeper.

  • What are like materials/services that can be grouped with the one being looked at?
  • What vendor(s) provide this material/service and those grouped with it?
  • What internal stakeholders use these?
  • Why are they using them?
  • Why are they using them the way they are?
  • Are they still needed?
  • What would need to be done to consolidate or remove materials/services?
  • If this is done, how will it affect the processes and procedures of the different divisions and departments of the company?

These are just some of the questions that must be asked to challenge the status quo, especially if that status quo is costing the company substantial amounts of money.

And it has to be the group responsible for sourcing in the organization that must do this.

While part of sourcing strategy is definitely cost savings and value adds, it’s also process improvement around what is being sourced, and how it will affect the organization.

I caveat this with the organization should not mold itself around its sourcing department. The organization should mold itself around its overall strategy, and the sourcing strategy should support this. But if there are procedures (low level/tactical) changed by sourcing that will help the company achieve its goals, then these should be pursued.

Buy-In

As the sourcing organization moves to change the processes – and perhaps even some of the culture – of the organization, they cannot operate in a vacuum.

Any change initiative needs a guiding coalition, preferably upper management, and buy-in from managers at all levels. It will be up to the Director/Division Manager of the sourcing organization in the company to win that buy-in, and to communicate with upper management for their support.

This isn’t unique to sourcing. Any change initiative requires this. I would argue that sourcing needs it more since most people view sourcing or supply chain management generally as order takers, and resistance to change coming from this area may be greater.

Conclusion

The processes surrounding and effected by sourcing strategies within the organization for different areas of spend are just as much a part of total cost ownership as external factors. Sourcing professionals must take this into account when sourcing materials and services from a strategic level. Some organizations call these individuals Category Managers, and category management is a discipline all of its own with that broad focus. It’s up to the organization to determine how they will conduct their strategic sourcing, and they must do so with an eye to internal process improvement.

Finding Savings in Sourcing Before Cutting Headcount

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This post originally appeared on my author blog The Red Renegade on February 24, 2017.

The Office Space Effect

Many remember (and chuckle, and seethe) at the scenes in the movie “Office Space” when the consultants are grilling the employees of the company to determine what they do to see if they are needed. Many in today’s workforce can relate to this. When companies need to save money or are trying to find efficiencies, where is the first place they look to cut?

Headcount.

The men and women that do the actual work in the company.

I am not advocating that executives cut their pay (though, that may help image-wise). I am a firm believer in free market capitalism and the freedom of people to amass as much wealth as they see fit. If the executives’ pay is the thing hurting the company though…

But cut the people that are making the company operate every day? Especially if those people are effective at their job? That makes no sense to me. (Note: I said if the people were effective at doing their job. If they’re not: fire them.)

Rarely do companies look at their sourcing activities, as well as other internal processes within the company, to cut the budget.

Developing more effective sourcing techniques and improving processes, and reducing total cost ownership will do more for a company, both up front and long term, than slashing headcount.

NOTE: I use the following terms here interchangeably.
•RFP/RFQ/Solicitation for Bids
•Supplier/Vendor/Contractor

Developing More Effective Sourcing Techniques and Improving Processes

This is anecdotal and I don’t have any hard data to back it up, but I am finding that many medium and even larger companies don’t have a central procurement/sourcing department, or a department within their organization that leads and monitors that function. Purchase orders are done as lists on excel spreadsheets, or over the phone. Many times supervisors or crew leaders simply go to the vendor with a credit card. This is an ineffective way of sourcing the company’s needs.

How do these companies know they’re getting the best price? Because the vendor tells them? Unfortunately, “Our supplier tells us we are getting the best price.” is the answer I hear time and time again, both in other companies and in the company I work for.

Developing effective sourcing techniques can help reduce costs almost immediately. Just a simple RFP can produce lower purchase prices. (We’ll talk more about purchase pricing below under reducing total cost ownership.)

The company I work for did this with their MRO. They discovered on some items which suppliers were telling us we were getting the best price we were being charged a 400% mark-up. When we asked the supplier why, the supplier’s response was, “You never asked.” It was no wonder these suppliers “loved us” so much – we took them at their word when they said we were getting the best price, and were able to overcharge us exponentially.

Control of bidding, purchase orders, and contracts – everything that goes into sourcing – with a central sourcing department, or at least one department within the organization that is given responsibility and accountability for this function, helps, too. They can work to set company policies, processes, and procedures around sourcing and, with upper management support, enforce it.

This is where your Lean and Six Sigma ninjas come in, too. Perhaps there are already procurement processes within the company, but there is clearly room for improvement. Mapping the processes and their sub-steps, and leaning them out by removing steps and/or red tape will save in work hours alone – and time is money. It doesn’t take spending millions on a consultant like McKinsey and Company, or Accenture to do this. Companies can do this themselves.

Developing better negotiating tactics and techniques can help, too. The Institute for Supply Management (ISM) includes many techniques for negotiations in their CPSM Study Guide. And there are lower cost consultants and webinars out there that can help your company hone their negotiating skills. (Yes, I do have a bias against the bigger supply chain consultants. There might be some bitterness there. (There’s definitely bitterness.))

Finally, control of the procurement process, and by extension payment of suppliers, helps save. While there are some instances where parts or services are needed in less than 24 hours – I emphasize some – 95% of the time this is due to poor planning on the part of the Project Manager, the sourcing department, and the warehouses. (Note my use of and not or. It’s a team effort, and if one fails, they all fail.)

The company should limit who can input requests for orders, who can approve and issue these requests and orders, and then keep a close eye on invoices to ensure they match quoted pricing.

Working closely with the company’s warehouses can help set minimums and maximums (min/max) on materials so that what is needed most is in stock when it’s needed, while working estimates and forecasts on past spend and usage and upcoming project earlier can ensure that if additional materials or services are needed they are sourced well in advance. Having pre-negotiated agreements across the company with a handful of suppliers can ensure that support is provided when needed, and new one-off contracts aren’t being constantly issued.

Reducing Total Cost Ownership

So your company has a handle on its sourcing of materials and services. Controls are in place, and the processes have been made lean, mean, sourcing machines. Money is being saved.

But not enough.

The next thing a company should look at is the total cost ownership of the materials and services they are sourcing.

Here’s an example:

Lean Corp wants to go out for bid for buying and installing widgets. (Very original, I know.) They send out a RFP to five vendors. The bids come back, and Lean Corp short lists two of the vendors: Cheapo Co, and Quality Co.

Cheapo  Co can provide the widgets for $10, and charge $10/hour for installation.

Quality Co can also provide the widgets for $10 (widgets are probably a commodity, like steel), and charge $20/hour for installation.

At face value, Cheapo Co is the low bidder.

But there’s a catch.

Cheapo Co takes 3 hours to install each widget! That’s $30 of installation per widget!

Quality Co, on the other hand, only takes an hour to install each widget; $20 of installation per widget. And the equipment is up and running faster, meaning less downtime, meaning Lean Corp can produce more, sooner.

Lean Corp brings both vendors in for negotiations.

Cheapo Co won’t budge on their pricing, and offer very little extra for their services. C’mon, they’re clearly the low bid! They know it! They’ve been working with Lean Corp for over a decade and the working relationship is great. And Cheapo Co’s owner is golfing buddies with two of the VPs of Lean Corp. Why would Lean Corp want to award to anyone else?

Quality Co, on the other hand, offers extended warranties on the widgets they install, and they offer up to 10 business days of training per year at no charge, a value of $15,000.

That training has downstream effects in Lean Corp: the training which Quality Co provides increases the knowledge of Lean Corp mechanics and reduces rework they have to do, and reduces downtime of the equipment by dozens of hours per year – remember time is money. The additional cost reduction is compounded by the value added services Quality Co provides.

This is an extremely simplified example, but it gets the point across well.

Total Cost Ownership is a pricing model that takes into account everything before, during, and after the sourcing of a material or service. This includes (but is not limited to) materials that go into producing the thing being bought, labor hours that go into producing the material/service, overhead, freight, mark-up, how long it takes to provide the material or service, number of deliveries per week/month, estimated downtime, and inventory holding costs, to name a few.

Reducing the total cost ownership of the materials and services sourced, while working to increase the value added services the supplier provides, should be the goal of the organization trying to cut its costs, especially when trying to not cut overhead.

This can be done through negotiations with suppliers, or through internal efficiencies within the company itself.

Conclusion

Companies looking to reduce costs should develop more effective sourcing techniques and processes, and reduce their total cost ownership of materials and services before slashing headcount. This will not only create short-term wins, but a long-term, sustainable model of keeping costs low. It is up to senior and middle management of companies to enforce this so that it takes hold in the company’s culture.

Don’t misunderstand me: I am not advocating for never cutting headcount. If positions are completely outdated and unneeded, then they need to go. No need having the ten Accounts Payable clerks that were kept because that’s how many they had in the time before computers and now everything is automated so six of those clerks are being paid to check social media. And if individuals are truly underperforming, even after corrective actions, then they need to go.

Improving sourcing is where companies should start to cut their costs.