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This week's eSourcing Wiki-Wednesday topic is 'Measuring Sourcing Value'. An excerpt of the article is below, but you can also read the full article on the eSourcing Wiki by clicking here. Have something to add? The eSourcing Wiki is an open content community and you are invited to register and contribute to this resource, which benefits our whole professional community.

Unsure about how to translate something seemingly intangible like "Value" into a measured sourcing approach? Read today's post on "The Point", Identifying Measurable Value When Sourcing.

Measuring Sourcing Value

As Purchasing evolved into Sourcing, so did the ability to measure value. No business activity should be performed unless it delivers value. This section reviews some basic metrics often used to measure sourcing value. The newest metric for measuring sourcing value is Total Value Management (TVM). It builds on earlier measurement methodologies, but takes them further by leveraging today’s sourcing technology.

Level 1 - Price Per Unit (PPU)

PPU is a comparative cost metric that quantifies a sourcing plan according to the cost paid for each acquired unit. Although very easy to implement, it does not produce a complete picture of the true cost of each acquired unit. Sometimes prices wildly fluctuate due to market conditions, thereby skewing value over time. Sometimes a lower PPU might result in higher overall costs if the product quality is lower and results in costly returns or lost customers. The PPU value measurement allows companies to obtain the lowest unit cost in a commodity category where quality and market dynamics are constant. However, unit cost is only one component in a Total Cost of Ownership (TCO) model, therefore, it is an antiquated metric.

Level 2 - Total Cost of Acquisition (TCA)

TCA, the logical successor to PPU, is a comparative metric that quantifies how much it costs to acquire each unit. TCA takes into account multiple variables – PPU, transportation costs, duties, tariffs, temporary storage costs, and any other external cost that is incurred from the time an order is placed to the time the product is received. Although harder to implement, it presents a much better picture of the total cost of each unit of product purchased. However, it does not take into account the costs associated with contracting a supplier, maintaining or adjusting operational processes, bundling or unbundling costs, or incurred costs associated with a specific product, specifically if it is of lower quality. Therefore, it is also an antiquated metric.

Level 3 - Total Cost of Ownership (TCO)

TCO is the most commonly used metric today by analysts, consultants, and vendors. It is a comparative cost metric that quantifies the overall total cost of each acquired unit. TCO takes into account all direct costs (such as PPU, transportation, tariffs, etc), indirect costs (product utilization costs, switching costs, transaction costs, etc), and quantifiable market costs (quality, brand, etc.). In essence, it captures every cost associated with the product and gives a total usage cost and it is often considered the best comparative cost metric.

Although TCO is significantly better than TCA, (which is better still than PPU), it is still a very cost centric approach. When misunderstood, TCO can distract Sourcing Professionals from strategic sourcing’s ultimate goal, which is optimizing the supply chain from a total value perspective and insuring that each sourcing project yields long term gains, and not just short term cost savings gains.

TCO is a good measurement tool and is used by many Sourcing leaders. It is simple and effective. However, there is still room for a new and improved value measurement metric.

Level 4 - Total Value Management (TVM)

TVM is a comparative cost metric that quantifies the overall cost of each acquired unit relative to the overall value of the spend category as it relates to the organization’s sourcing strategy and supply chain goals. This measure allows Sourcing Professionals to determine the highest value to cost ratio (value: cost) of a spend category through the use of integrated decision optimization that aligns the spend decision with the organization’s overall sourcing goals.

In reality, most sourcing projects do not capture all of the identified/projected savings due to “leakage”. The reasons are numerous and can include situations such as the correct product is ordered late; causing additional costs such as increased transportation cost or additional expediting fees. Or situations where planned award allocations are not strictly ordered, resulting in a capacity shortfall based on a specific timeframe, thus additional penalty fees. In these situations, the identified savings of a TCO-based sourcing project deviated from the reality of implementing the savings and the overall supply chain strategy.

A TVM metric not only takes into account the overall total cost of each acquired unit from a direct, indirect, and quantifiable market cost viewpoint, but the impact costs of deviating from the overall sourcing and supply chain strategies. After all, a 5% savings on TCO for a specific sourcing project could actually yield a 10% loss over the course of a three-year contract if the implemented terms do not account for the reality of allocation constraints, penalties and risk aversion tactics.

TVM, a natural extension of TCO, augments TCO to align the projected reality of sourcing decisions with corporate sourcing and supply chain strategies. TVM takes into account current and future costs associated with deviating from the overall strategy. This means that all metrics, tools and frameworks that support TCO can also support TVM once the impact costs of a sourcing decision are quantified.

TVM is the next evolution in measuring value in the strategic sourcing cycle. With the advent of true decision optimization tools for strategic sourcing, TCO is no longer enough. When TCO is the primary value metric, sourcing decisions usually award based on the lowest identified cost. This practice has some significant drawbacks and can lead to short-term thinking. Short-term decisions can lead to increased long-run costs if the implemented award does not adhere to capacity constraints, lead-time windows or high quality standards, among many others. It can produce unintended consequences that pose major barriers to success. Another critical drawback is that TCO often ignores other strategic aspects of sourcing such as risk mitigation, Low Cost Country sourcing strategies, complimentary partnership relationships, and diversification strategies.

Strategic sourcing is sourcing for value, not lowest cost. Sometimes value is gained by selecting a lower cost provider, and sometimes value is gained by selecting a higher cost provider with greater quality and reliability. Producing poor quality products or failing to meet demand hurts both current and future sales. TVM insists all value-based measures and costs are included in the model, thus minimizing potential risks.

Sourcing based on a TVM approach is easily obtainable for all organizations – especially ones already following a TCO approach. TVM sourcing decisions weigh different award scenarios based on various constraints and corporate goals. TVM-based decisions leverage decision analysis tools.

TVM Drivers
These tools drive TVM in the strategic sourcing process – the primary means by which process efficiency is increased, cost decreased, and value delivered to the organization.

  • e-RFx
    An e-RFx, or an electronic Request For Information / Proposal / Quote system automates the process of distributing information to and collecting information from suppliers in a manner that supports apples-to-apples comparisons. Many e-RFx systems incorporate templates that allow teams to initiate strategic sourcing events quickly and easily.
  • Auctions
    An electronic auction is a powerful web-based software solution that allows Sourcing Teams to carry out auctions (the most recognized being the standard English reverse) in very short timeframes. It automates invitations, customizes supplier views, and allows an auction to take place in real-time over the web. Both the buyer and supplier save time because price negotiation is done at a specific, scheduled time with a definitive conclusion (the auction closes). Some commodity markers work better using a sealed bid auction for bid collection rather than open head-to-head auction. Regardless, a sealed bid enables suppliers to submit bid information and Sourcing Professionals to collect bid information in a short timeframe. Sourcing Professionals can also use forward auctions when liquidating company assets. With forward auctions, the company is the seller rather than the buyer.
  • Decision Optimization
    Optimization is the most effective way to solve complex business problems that involve several, hundreds, thousands, or even millions of interdependent variables. Traditional spreadsheets manipulated by a human cannot fully analyze a complex set of data. In addition to the increased analysis time of spreadsheets, is the increased time needed to export data and build spreadsheets. There are even greater efficiencies when decision optimization tools are integrated with the sourcing tool, thereby saving time and reducing errors that may appear through data export and import.

About eSourcingWiki

eSourcingWiki is an open content community of strategic sourcing and procurement best practices. This wiki is intended to be a dynamic document that constantly adjusts and transforms to current trends and thought leadership in supply management. Iasta welcomes global contributors to assist in the ongoing documentation and knowledge building that is essential to creating useful information for supply management professionals.