Five steps to purchasing cost reduction
The following five-step approach attempts to provide a general framework from which individual initiatives can be developed.
Step 1: understand the drivers for reducing cost
Purchasing and other stakeholders must be fully committed to the cost reduction process. They therefore need to fully understand where the drivers for reduced cost are coming from. To ensure clear understanding at the outset, purchasing should engage in a meaningful communications exercise.
Step 2: understand why excess costs exist in the supply chain
At the outset of cost reduction exercises it is useful to have some understanding of why ‘excess’ supply costs exist in the first place. This can be useful intelligence for subsequent stages of the project. Here are some possible reasons for excess costs in the supply chain.
- Passing on increased costs – this has been described as the ‘french fries principle’. The consequences of a bad potato harvest are immediately passed on to the next in line of the supply chain who passes this on to the end customer of French fries. Conversely, the consequences of a good potato harvest mean a reduction in the supply price of potatoes but this reduction is rarely passed on to the end consumer of French fries.
- Over-specification – this is particularly relevant where products and services have been designed by isolated functions such as R & D. This often results in excess costs being incurred through over-specification.
- Supply cartels – despite various legislative directives, there is still much evidence of inflated supply prices as a consequence of supply market cartels (suppliers colluding with each other to stifle competition and maintain artificially high prices).
- Mechanistic bidding- traditional ‘poker style’ negotiation processes where suppliers artificially increase prices in advance of some concessionary negotiation tactics.
- Traditional buyer-supplier relationships – adversarial relationships have meant that the potential to reduce supply costs has remained largely untapped.
Step 3: supplier segmentation
Buyers should consider supplier segmentation models to ensure appropriate cost focus. In other words, they should distinguish between suppliers in choosing the kind of relationship they wish to establish with each one. For suppliers of critical items, a close collaborative relationship may be appropriate. For suppliers of routine items, a more traditional adversarial relationship, based on tough negotiation for the lowest possible price, may be more appropriate.
Step 4: cost reduction strategy and tactics
This involves developing the appropriate strategies and tactics to achieve ongoing total cost reductions along the supply chain.
Step 5: performance measurement and review
Cost reduction programmes should be viewed as dynamic processes. The alignment of purchasing initiatives with overall business strategy is essential. However, as business priorities change then so must the alignment and focus of cost reduction programmes.
Finally, it is important to measure the effectiveness of the cost reduction initiative. Appropriate measures should be established to demonstrate the effectiveness of the actions taken. This should be reviewed to highlight where successes have been achieved, with good practices being cascaded throughout the supply chain.