“Absolute Best Cost” in Procurement Negotiations

Procurement groups have been using many techniques to successfully negotiate the best cost for their purchases. Typical techniques have been through Competitive Quotes, eAuction, Tendering, Request for Proposal (RFP) and others, depending on the type of industry, business model, etc.

One of the proven techniques but not utilized much is the Absolute Best Cost Technique or CleanSheet Technique. This technique uses a grounds up methodology to build the “Should Cost” for any given part or product or service. This involves considering all the cost elements that go into manufacturing of a part/product or a service and then estimating scientifically what the optimized cost of the part/product or service should be.

The elements that can be considered for computing the cost can be numerous and depends on the ability of the procuring entity to have access to commercial and technical data. If the entity has never used this technique, it can commence with limited information and then keep expanding the scope on a need basis.

As an example, if we consider an injection moulded part, some of the parameters to be considered would be the type of material and its cost in the country where it is being planned to be moulded, the part weight, the regrind % if any allowed, the annual volume, the number of tooling cavities considered depending on the annual volume, the type of runner system, the optimal size of the moulding machine (please note, we do not consider the nearest capacity moulding machine that the supplier has at this moment), the machine hour rate for the country considered for moulding (here again, the machine hour rate needs to be computed bottoms up from the cost of the machine, depreciation, interest, maintenance, power, water, rental, labor, etc.).

However, as mentioned earlier, if an entity wants to use this technique for the first time, they could start off with the best available market rate for the machine hour rate, the theoretical cycle time, the least rejection % possible, etc. With the above data, we can arrive at the basic cost of the part. We need to also input the cost of the packaging that is required, the terms of delivery and any other Value Added Services (VAS). Then we can add additional labor (if any), overheads (if any) and profit (if any). The reason for considering “if any” is to give room for the business model. If there is only job work done with material supplied by the purchasing entity, the machine rate would include all the LOHP (Labour, Overheads & Profits). 

From the above grounds up approach, we get granularity of the cost build-up. If we compare the breakup received from the supplier(s), it will very clearly show the delta in cost parameters and opens up an opportunity for very healthy negotiations. The Absolute Best Cost would be the best possible cost that can be achieved. Analysis of the cost elements can help the procurement person to decide on a long term sourcing strategy (for example, raw material strategy, tooling strategy, sourcing country strategy, process improvements, etc.).

This activity of cost build-up is done by engineers in partnership with the procurement specialists. The purchasing entity which did the cost breakup should have data to justify their assumptions and partner with the suppliers to achieve, as close to the theoretically computed values. There can be a cost delta of 5 to 10% depending on the type of part/product or service when cost maturity is achieved over time.

There are certain exceptions where Intellectual Property is involved with supplier monopoly. Then, negotiations would be more in terms of supplier driven strategy but once competition comes in, it becomes easy to rationalize costs.

The cost breakup can be done by country if a multi-country manufacturing/sourcing strategy exists but the fundamentals of cost remain the same.

From a long term perspective, it would be good to build a database of the basic cost elements by Country and Commodity for Raw materials, Labour, Profits, Power, Rental, Depreciation, Currency rate, etc. Typically, it is the raw material and currency which fluctuate. It would be a good practice to update the costing sheet/cost library once in 3 months and re-compute the costs to see the impact and trend. This also helps forecast future costs from an accounting perspective to set “Standard Costs”.

Some companies have a practice of having a specific cost reduction expectation over a fixed time interval. Even those companies could use this technique as it gives insights into the cost elements and can help in win-win partnerships with suppliers. The time-bound fixed cost reduction technique ends up with some missed opportunities for the procuring entity as the supplier enjoys higher margins in the beginning itself. 

The costs can be computed using Microsoft Excel and once the buying entity is comfortable, they can use Macros to extend the techniques and run it in an automated manner at predefined time intervals. The data for the raw materials, currency, labour, etc., could be got from standard websites.

This is a very transparent methodology and its elements can be shared with the suppliers. Very soon suppliers will understand that negotiations/cost management is a two-way street and they will start accepting the process, as it is very objective. The maturity in achieving closer to the best costs takes about 2 years and repeated costing exercises with the suppliers for a few varieties of parts/products and services. This technique will yield positive results for suppliers to optimize/improve their existing infrastructure, processes and strategies.

In closure, it is up to the procuring entity to decide on the depth to which they want to go in the costing exercise and also the types of commodities that they would like to consider. 

This is a journey…