Know thy Cost/Price

Last week, I read a post from a peer regarding asking a supplier for a cost break-down, and the ensuing “um, ah” response it engendered. While this negotiation practice may be useful, I would like to suggest an alternative approach for certain circumstances.

Before we get started on why you should know the cost/price basis for key commodities and articles procured from strategic suppliers, be sure you understand “purpose” and align your supply chain design with that purpose. Is the supply chain supporting new product development, with a bias toward flexibility and responsiveness? Is the extended value stream being optimized for the growth portion of the bell curve? Is your end customer concerned with competitive threats in a mature market? Is post-sales service and support a key consideration? Is there one partner with the capability to support all phases of the product life cycle, or do you need multiple partners? Are you relying on the supplier’s intellectual property for the ultimate solution you provide? Answering these questions prior to beginning the supply chain design phase can save you a few headaches down the line. Design your supply chain to be “fit for purpose.”

In a perfect world, we would have perfect knowledge of, well, everything. We aren’t quite there, yet. Most of us have finite resources with finite knowledge and capabilities. Therefore, we need to apply scarce resources to the most important things. In supply chain, those important things include:

safety, quality, delivery, cost and risk elements.

While modern organizations can tap into the ever-emerging world of AI, advanced predictive analytics, IoT/factory 4.0, and so forth, this article will focus on more basic precepts; which may help humans interpret the data and apply creative solutions that AI might overlook. The post by a supply chain colleague that I mentioned above was focused on cost, so let’s make that our primary focus for applying our scare resources.

Once you’ve developed your supply chain strategies, you should have a prioritized list of key categories and strategic suppliers that you’ll focus upon. Rather than rely solely on competitive forces to drive to the ‘least-cost’ solution, I recommend that you know what the ‘right cost/price’ is for the article or category. Don’t go into negotiations blind; do your research. You can build a “should cost” model, using publicly available data. You can review a public company’s 10K to pull-out their cost of sales and margins. Cost of sales (or cost of goods sold = COGS) includes the following: input materials, direct labor, and associated overhead. For the suppliers in key categories and strategic suppliers, I “go to Gemba” – that is, I go to where the actual work is performed. You can learn a lot by direct observation. What are their input materials? How many sub-items do they make versus buy? Is their manufacuring process labor or capital intensive? Do you see waste – how much and where is it? The general observations can provide valuable input. You can ask your supplier (or prospective supplier) to share some general percentages around their typical COGS. I think it was Wayne Gretzsky who said, “You miss 100% of the shots you don’t take.” Don’t fret if the supplier doesn’t share; you can back into a reasonable approximation of the figures by using their own or competitor’s 10K. Use a tool like ProPurchaser (I’m not a shill, it’s just an example) to build models and track impact of changes for a variety of inputs.

Most of us aren’t experts in every single item we procure, and we don’t need to be. Our organizations may have people who do have some expertise or insight that we can leverage, and there is a plethora of information available; for free or for a price. Start with your own organization. You might be surprised by the knowledge that exists, or by the connections they have who are willing to help. Universities are a good source of information and long term academic/industry partnerships can serve many uses. I’ll use an example of a D38999 connector; a widely used mil-spec connector family. You can examine its makeup. Gold plated terminals, certain types of plastics (get access to a polymer expert, perhaps at a University), machined aluminum (a local trade school with a machinist program might be a good source of information), etc… You can build-up a “bill of material” for the item and estimate the costs for each. This becomes your C basis for COGS. Based on your gemba, you can estimate the labor and associated overhead. I’m fortunate that I have decades of manufacturing experience. If you don’t have that kind of deep knowledge or experience, it’s ok – seek people with silver hair like me to go to gemba with you. It’s surprising how similar labor and overhead percentages are for wide ranges of industries.

For example, 60% COGS, with material/labor/overhead splits of 40/30/30. The gross margin, SG&A, R&D, and operating margin are usually listed on the 10K of your supplier or their competitor(s). You can build the “should cost” based on your direct observation, research, and analysis. Perfect your organization’s knowledge, using all tools and methods available.

Most of us want a resilient supply chain that delivers the right value. In my experience, it’s important that a supplier remain fiscally healthy, continually reinvesting in their business. Using your market knowledge and spend leverage to reduce supplier margins below that of their peers is likely to introduce risk down the road. Racing to the bottom of cost/price may not be sustainable longer term. Declining pricing agreements are a reality in some industries, but there should be a realistic plan to achieve the desired cost/price without relying on margin % reductions to achieve the targets.

When facts don’t seem to fit. This happens. You do your homework, but the prices you’re being quoted don’t seem to fit the facts you think you know. If you have developed a good relationship with your suppliers, you can discuss your model and obtain their insight into the gaps in your model. If supplier A doesn’t want to help perfect your model, try supplier B or C. Another interesting approach is applying a linear regression analysis. You can leverage information from sources such as the Bureau of Labor Statistics, commodity markets, and so forth. An example from my personal experience: the price for a category of goods was rising exponentially. The online news and market-specific articles were stating that the scarcity of input materials was driving major price hikes and the word “allocation” was being thrown around. In this case, I had been stumbling around for years, at a number of category suppliers, with a senior material scientist and expert on the process of manufacturing for this category. We had many knowns from our observations and discussions over the years, along with more than a decade of historical data on the cost elements for this category. When we performed a linear regression analysis, we found a strong correlation with only one factor; exchange rate. Interesting, right? It wasn’t the price of the input materials, but the exchange rate, that had a strong correlation. The input materials had an infinitesimal impact to the cost/price. A 100% increase in their raw materials SHOULD have had a 0.01% impact on their cost/price, yet this particular industry seemed to be leveraging the ‘press’ to drive their sell price at a rate closer to the input material rate of increase. In this particular example, the Government where these articles were produced was intervening (raw material and finished goods export side) and that resulted in an amplification of fear and driving irrational speculation. In this type of environment, it’s even more imperative that you have a command of the facts, and try not to succumb to fear. Manage the slope in these periods. Make sure the rise and fall of input materials and/or speculation driving the markets closely follow the ultimate prices you pay. If you don’t have contracts tightly linked to input and conversion costs (for key/strategic articles, it’s a good idea to do so), you need to manage the slope or you may just find yourself paying a premium for your ignorance and/or inattention.

It would be unrealistic, under most circumstances, to have this kind of insight for every single article you purchase. You need to pick your battles; focus on the key categories and strategic suppliers. The day is coming, perhaps in the not too distant future, when we will have near-perfect knowledge. Until then…

Know thy cost/price.