7 January 2010 | Paul Livingston and Mike Fogg
The issue of cost has never had such a great focus. Irrespective of sector, size or situation, the economic downturn has driven cost high up organisations’ agendas.
Some buyers still seek to shout and bully suppliers into cost reductions, but the supply chain situation of your organisation may not afford that opportunity. We would argue, too, that such an adversarial approach would probably lead to suppliers seeking to hide more cost anyway.
A more skilled, subtle, satisfying and sustainable approach is to dissect the cost structure of the goods and services you purchase from key suppliers. The more you understand, the better the deal you can potentially make. So how do you do this?
What’s in a number?
The starting point is recognising that every price we pay – from our morning newspaper to a complex software solution – is a total amount comprised of labour, materials, overheads and a margin for profit. Market situations will in some cases influence and dictate how these prices move over time.
The initial first-level analysis involves the realisation that there is no fixed arithmetic formula between the cost of producing the goods and services sold to us and the price charged for them: sellers charge what the market will bear.
When suppliers first meet us they will have price expectations and may start conditioning us about what we will have to pay. Purchasers need to help them understand that we won’t bear all the costs they wheel our way.
To break down the figures we need to know the proportion of each area of cost that the goods or services are likely to attract. For example, it is likely that goods will comprise more material content than services and that what we pay for a service could be almost entirely built up of labour costs. In relation to overheads we should ask two questions:
1. How much of the supplier’s overhead costs is applied to the goods or services we are purchasing?
2. Which methodology is being used to apportion overheads?
It could be that the overhead is being unfairly allocated to our purchase and that a more equitable allocation will reduce our total cost.
Aiding us in our quest to break down the numbers are a number of tools and concepts. These include:
● Break-even analysis Buyers may be able to determine the quantity at which their supplier breaks even on a production run and therefore when the supplier is making a profit or loss.
● Marginal costing This principle can enable buyers of small quantities to achieve low unit costs by helping suppliers to recognise an opportunity for both organisations.
● Total absorption costing This is a method of calculating unit cost that entails applying the full cost of manufacturing or providing a service, including overheads, to the quantity produced without separately identifying fixed and variable costs. Buyers need to understand it, and also understand how suppliers may be applying it to their purchases.
● Purchase price cost analysis This is a structured PMMS technique to evaluate the cost elements in the purchase of goods or a service. It enables buyers to step through each element to examine cost drivers and levers.
● Open-book costing A technique familiar to buyers who “require” their suppliers to indicate the breakdown of costs. Aggressive buyers use this as a means of mercilessly driving cost down; others use it to explore and develop cost reduction opportunities with people working for suppliers.
● Cost transparency This is where both sides reveal their cost breakdowns. Advocates recognise there is no monopoly on wisdom and invite suppliers with whom they have a close relationship to identify savings in their own cost model.
● Total cost of ownership (TCO) Ever heard of “cheap and nasty”? TCO is another well recognised, though less well practised tool. It considers acquisition, ownership, operating and disposal costs when making a purchase. For example, a low-price purchase may use more fuel over its life and be worth less at the time of disposal than a higher-price purchase.
All of these tools give buyers a greater appreciation of the cost of the goods, works, materials and services they purchase. This understanding leads to negotiation opportunities and negotiation opportunities lead to lower cost. So spending time on cost analysis is a no-brainer.
Some organisations approach the issue of supplier’s costs with a sledgehammer. They send specialists into their supply base to seek cost reductions, and take all of that reduction for themselves.
If you’re considering that approach, put yourself in the supplier’s shoes and ask yourself this: “How would I feel if a customer (here the purchasing organisation) said it had, working with my service delivery team, identified a 9 per cent saving by delivering the service a different way and the customer wanted the reduction completely passed on to it?”
The supplier would doubtless be unhappy. As a consequence it would probably seek to hide costs, create or justify cost for future visits, and lose interest in generating further savings ideas.
Take a second purchasing organisation. It does the same as the first and achieves a 9 per cent cost reduction. The difference is it asks where the idea originated and when it discovers the idea came from the supplier it feels it appropriate that the supplier keeps a significant proportion of the saving, which still leaves some cost reduction for the buyer.
Some buyers reading this are probably going through the roof, and would want to keep the full sum. But the $64,000 question is: which approach is likely to lead suppliers to be proactive in seeking cost reductions? The answer is the approach taken by the second organisation.
We have met people from UK purchasing organisations on our training programmes operating both philosophies.
We also know a person who, as an accountant, was employed full-time with a sales team to hide cost in the pricing mechanism and “assist” buyers from customer organisations when they visited to look for cost reductions. This person was able to charge overhead recovery rate three times to the same component.
Collaboration is the key
Breaking costs down collaboratively with suppliers can lead to significant reductions and working with tools such as absorption and marginal costing helps us to understand how costs are made up.
But before we visit or engage with suppliers we should do our homework. Look at the specification.
Work with others in your organisation to ask:
● Where are the cost drivers in these goods or services?
● What cost levers can we apply?
● What is the thing made of and what is happening in the market for that material?
● How can you buy that material most effectively?
● Can we give our suppliers access to our contracts to reduce cost?
● Does our supplier have contracts we could access to cut cost?
All of these questions and more lead to opportunities to investigate cost with the people who work for our suppliers, whether that investigation takes place in the form of a confrontational negotiation or a collaborative workshop.
Relationships are the key to any business. CIPS president Shirley Cooper – who has made relationships part of her theme for her year – has said: “Does squeezing suppliers until it hurts help your relationship or reputation?” She adds: “Continued building of relationships even in times of difficulty can have a direct financial impact.”
We advocate building relationships with suppliers to work together to reduce cost wherever possible, while being aware that there are people and organisations who exploit customers and continually stall – even on starting cost-reduction discussions. In this case, a more assertive approach is appropriate, and you could use the time they take delaying to look more deeply into their cost model to be prepared for the negotiation that must come.
Paul Livingston and Mike Fogg are from PMMS Consulting Group
CIPS is running “Dissecting a supplier’s cost structure”, a two-day course with PMMS trainers exploring the techniques outlined in this article on 19 January in Manchester and on 20 April in Birmingham. Call 01780 756777 to book a place.