Achieving value for money
- Cost reduction strategy
Cost reduction will be a key objective to support the financial goals of the firm (profitability, liquidity, return on capital invested and so on), even in the public sector (with goals such as value for money service provision and efficiency targets). It will be the cornerstone of business strategies based on cost leadership (the strategy of selling more products by tempting customers with low prices).
Cost strategies are about knowing what the costs really are and then looking at how to reduce them. In other words, we must apply effective cost analysis. Then we are in a position to look at eliminating waste, negotiating on price and so on.
At a strategic level, supply chain management may secure cost reductions through measures such as the following.
- Restructuring: delayering, downsizing or horizontalising purchasing structures, to minimize labour and overhead costs and maximise process efficiencies (less duplication of effort, fewer managerial and co-ordinatory mechanisms, and so on)
- Centralising purchasing (to take advantage of larger orders and bargaining power) or decentralising purchasing (to reduce transport and storage costs)
- Process engineering or re-engineering, to streamline and integrate processes, eliminating unnecessary activities and process inefficiencies
- Outsourcing or off-shoring non-core competencies: where value can be obtained at less cost, the organisation can dispose of assets, and internal resources can be more efficiently focused
- Developing supplier relationships for cost and price advantages (whether by using competitive leverage to secure low prices or by developing collaboration to reduce sourcing and transaction costs, encourage mutual cost reduction and so on)
- Applying ICT and automation technologies to streamline processes and to increase productivity and reduce labour costs.
There is frequently a trade-off between cost objectives and quality, service and delivery objectives. This has led to the recognition that cost/price and ‘value’ are not the same thing. ‘Value for money’ is an important strategic objective, particularly in the public and non-profit sector. It has been defined as ‘the optimum combination of whole life cost and the quality necessary to meet the customer’s requirement’.
A number of purchasing techniques can be used to obtain value for money.
- The use of value analysis (and/or value engineering of new products and processes), in order to eliminate non-essential features. This means looking critically at all the elements that make up a product or service and investigating whether they are really necessary, whether they could be done more efficiently or cheaply etc
- Consolidation of demand (eg by aggregating orders)
- Centralised negotiation of contracts and prices
- Proactive sourcing: challenging preferred supplier complacency to ensure competitive value. (Supply contracts may contain provision for year-on-year price reductions, for example, as an incentive to efficiency improvements.)
- Buying complete subassemblies rather than components
- Encouraging standardisation to reduce costs of spares and maintenance
- Adopting whole life costing methodologies (rather than focusing on purchase price). We will look at whole life costing later in this Course Book.
- Eliminating or reducing inventory (and therefore reducing costs of storage, holding, deterioration and obsolescence)
- Using e-procurement for process efficiencies
- Global purchasing (to take advantage of low-cost country production)
- Reducing inventory costs and administration
Not all value additions arise from within the buyer’s organisation. Buyers have a close relationship with external suppliers and are well placed to take advantage of any contribution that can be extracted from them.
One area in which this is possible is the management of inventory. Modern thinking suggests that ‘inventory is evil’. This is because if an organisation holds stock it reduces the amount of cash available. We have paid money to acquire or manufacture the stock, and we do not recover the money until the stock is sold. Stock is also said to be a cover or disguise for inefficient work practices; if there were no buffer stock to fall back on we would have to remedy such inefficiencies, but with stock in hand we can afford to overlook them.
Few organisations (probably no organisation) would pursue this thinking to the point of holding no stock at all. But it is clear that minimising stock is an aid to operational efficiency, provided that we do not disappoint our customers for lack of stock.
This is an area where suppliers can assist. By working closely with suppliers, buyers can minimize the levels of stock needed. One technique is just in time purchasing. Suppliers do not deliver stock until the moment that the buying organisation actually needs it. This implies very close liaison with suppliers, who must be continually updated on production schedules.
Another technique is consignment stocking. This means that suppliers provide a buyer with stock, on the buyer’s premises, but without charging for it in advance. Instead, the buyer pays for the stock only as he uses it. This protects the buyer’s cashflow, while at the same time he benefits from having stock on hand – at the supplier’s expense.
The buyer may still incur administrative and storage costs under this arrangement, but it can work out much cheaper than being charged for the stock as soon as it is delivered. And in some cases, even the administrative and storage costs may be passed on to the supplier. Some firms have an arrangement where the supplier maintains a small store on the buyer’s premises, staffed by the supplier. As and when the buyer requires goods from the consignment stock, the supplier staff member handles the administration and paperwork.
From the supplier’s point of view, this kind of arrangement has the advantage that he gains most or all of the buyer’s business for the items stocked. He is sure of making an immediate sale when the requirement for his goods arises.
- Collaboration on cost reduction
A further area where suppliers can assist the buyer in achieving his objectives is a joint initiative to reduce costs. This can best be illustrated in the context of a manufacturing company, although the principles apply elsewhere too.
An increase in the proportion of external spending by manufacturers means that many such companies can be described as ‘low value added’ firms. In other words, the price paid by the eventual consumer is largely made up of costs charged by suppliers to the manufacturer: the manufacturer himself adds relatively little value.
The implication of this is clear. To achieve competitive prices, such companies must focus on their costs, which increasingly arise outside the boundaries of the firm. Purchasing’s contribution in reducing costs right along the supply chain, while maintaining and improving quality, is vital.
This will require a measure of trust, reflected in open book costing: suppliers should be ready to talk frankly with customers about their cost structures. This has several advantages: it facilitates cost-based pricing; enables the buyer to get to know the supplier’s operations and processes (for closer collaboration); enables joint identification of areas for cost reduction and added value; and reassures buyers that they are receiving value for money (non-exploitative profit margins).
An even more radical approach is cost transparency, where there is two-way sharing of cost information on activities in which buyer and supplier have a common interest. This is more suited to a strategic partnership relationship (and even then, with appropriate confidentiality protection).
- Payment and warranty terms
A supply contract of course contains many terms in addition to the basic purchase price. One area where buyers can exploit this is in the terms relating to payment and warranties.
In relation to payment, a buyer must do all he can (in conjunction with his colleagues in Finance) to honour any contract term relating to the due date for paying the supplier. But that does not stop him from negotiating hard for extended payment terms. Buyers sometimes underestimate the importance of this: ‘If we have to pay the price anyway, what does it matter if we get 90 days credit rather than 60?’
The answer is that it matters a good deal. If we can delay payment by 30 days, it means that the money is working hard in our own bank account, perhaps earning interest on deposit, or reducing the amount that we pay in overdraft interest. This is much preferable to having the money in the supplier’s account earlier than it needs to be. But we repeat that this should only be done within the terms of the supply contract. If the buyer wilfully delays payment beyond the due date, it will have a damaging effect on supplier relations.
Warranty terms are another area, often overlooked, where added value can be leveraged. We run a risk of disruption to operations, or having to compensate a disappointed customer, in the event of product failure. If such failure can be traced to an input purchased from a supplier, it is entirely appropriate that the supplier should bear the cost. A warranty term is one that places an obligation on the supplier in such circumstances to compensate the buyer in whole or in part. Buyers should look out for opportunities to include warranty terms in supply contracts.