Continuous Cost Reduction for Direct Materials
Continuous cost reduction in the manufacturing industry is a supply chain best practice, but all too often it is mistakenly seen as unsustainable by strategic sourcing and procurement departments. For many companies the question is, ‘how can I reduce costs while limiting the impact on quality?’ Before jumping right to substituting materials, there are other options for delivering cost savings - yes, even over time.
The three primary best practices that work towards achieving continuous cost reduction with downstream suppliers include:
1. Leveraging economies of scale,
2. Streamlining transactional and manufacturing processes, and
3. Decoupling value added services such as design and development from a product’s unit cost.
Decreases to Price Increases Don’t Count
Once a year, typically at the beginning of each new fiscal year, it is common to receive price increases from downstream suppliers. Their justifications often include the pass through of material and index price increases as well as more ambiguous reasons such as inflation or “our costs went up.” It is important for procurement professionals to get documentation justifying the need for any price increase. This means obtaining official letters/memos of pass though costs such as “the cost of stainless steel went up 10%, so our cost to you [the customer] will go up 10%.”
In my time supporting cost reduction initiatives for clients, I’ve observed countless procurement professionals stray away from the habit of negotiating these annual price increases. This can unintentionally shape supplier behavior over time, encouraging them to pass through nebulous price increases in anticipation of customer negotiations. In other words, suppliers may publish superficial price increases which they can then reduce during the negotiation process. This results in a net price increase for them while satisfying the procurement professional who negotiated “savings.” As an example, if a packaging or plastics supplier receives a 5% increase on the LPDE Index (a lower grade polyethylene often used in injection molding and thin film packaging) they will pass on a 10% price increase to their customers in anticipation of coming negotiations. If the supplier then reduces the price increase to only 8%, the customer can report a 2% cost reduction. The supplier appears to have given concessions to the customer, and the customer appears to have achieved costs savings, but when you look at the effective price difference, the supplier has added 3% to their margins.
Best-in-class procurement organizations understand supplier pass through costs and know how to deal with them. As a procurement professional, I strive for transparency with suppliers to avoid vague or unclear price increases and decreases. Customers should always ask detailed, commodity or service specific questions which require suppliers to “open their books” to show their actual costs. Once the cost drivers behind price increases are understood they can be managed and hopefully mitigated.
Collaborative Cost Controls
The next level of continuous cost reduction requires a joint effort by customers and suppliers. Even if costs do go up for a supplier, they can be offset and/or exceeded by leveraging economies of scale, streamlining processes, and identifying product and component improvements that result in lower costs.
Let’s first take a look at how to reduce costs by leveraging economies of scale in the production and ordering processes. For example, by evaluating and planning optimal, demand-based production schedules, OEMs can reduce the variable unit cost of the goods they produce by leveraging larger run sizes. For distributors, the ability to forecast demand and delivery schedules and leverage their total volumes across the customer base for common parts reduces costs. Over time, synergies should be developed between the supplier and each customer’s forecasting/planning team, allowing the supplier to leverage economies of scale where possible and, ideally, pass those savings on to the customer.
In addition, suppliers should be able to streamline manufacturing processes over time as they develop familiarity with the customer’s product portfolio. Again, this is a joint effort between customer and supplier. For example, by investing in equipment and machinery, the supplier can cut costs through reduced labor and overhead costs. In this example, strategic capital investment works to reduce the effective cost of the products. This is especially prevalent at mature supplier organizations where trial and error have given the supplier insight into the most effective and efficient way to product a product. Such knowledge provides procurement with a strong incentive to seriously consider the effort required to switch suppliers.
Quantify and Track Design and Development Costs
Lastly, it is important for customers to track and monitor design and development costs. When a customer approaches a supplier for a new product or service, the supplier typically incurs development and setup costs to configure a solution that will work for the customer. As with our previous example from the packaging industry, the supplier must obtain or manufacture tooling for any custom molded foam pieces and has to design the corrugated carton dimension/structure to fit the customer’s product. Oftentimes, shock and drop testing must also take place before the packaging assembly can be mass produced. This service is not free. Suppliers either charge the customer up-front or amortize the development and engineering costs into the unit costs of the products being sold.
It is critical for procurement to decouple development costs from the unit cost of a product. If design/development costs are not charged up front, it is important for the customer to establish a period of time during which the supplier can charge a higher unit cost to recoup their development costs. The break-even point for the supplier all depends on the scope of development. This is relevant to continuous cost reduction since it is an industry best practice to either completely separate development costs from unit costs or to establish in the supplier contract a period of time where pricing needs to be re-evaluated.
Procurement and strategic sourcing professionals need to challenge the widely accepted notion that annual price increases are an acceptable part of buying in the manufacturing industry. Generating cost savings, like any other business strategy, requires collaboration that promotes transparency and efficiency. Suppliers should always be evaluating ways to leverage economies of scale and optimize manufacturing processes to drive the cost of goods down over time. They should also be transparent about development/testing costs and decouple said costs from the selling price of a product. This removes the possibility of amortizing development fees into the unit cost which is difficult to track and oftentimes incurred by the customer well after development costs have been recouped. If customers continually pursue ways to achieve efficiencies with their suppliers over time, and are aware of the different components of their total cost of ownership, these best practices and increased awareness will help to achieve continuous cost reduction.