Anyone with internet access and a modicum of interest can access a tremendous amount of excellent business advice very quickly. A lot of it is quite good. But time and again I come back to W. Edwards Deming – he is to my business life what Jelly Roll Morton is to my jazz life. He is also the most sage advisor to turn to in times of economic challenge.
One of his recommend management practices is: End the practice of awarding business on the basis of price tag. Instead, minimize total cost. Move toward a single supplier for any one item, in a long-term relationship of loyalty and trust. While no maxim can be held to be true for all its applicable situations, a lot of businesspeople would benefit from paying better attention to this particular piece of wisdom.
To apply this, one must first examine the concept of total cost. Though cost-based accounting methods can be credited with advancing organizational ability to dissect operating processes and analyze where change might be most beneficial, cost accounting also has a downside. The very process of apportioning costs applies component-based to thinking to system-wide problems. Does this mean that cost allocations are bad and should not be done? Definitely not! (though I have discovered that this topic has a strange knack for bringing out the argumentative extremist in far too many businessmen). The solution is to recognize that component-based thinking creates a certain type of bias, and that bias can be offset by approaching the same problem (or, ideally, set of problems) with system-based thinking. Here's an example of an actual problem that I endeavored for years to solve, but I could never get the relevant players to accept the rationale or change behavior (cue big sigh here). The group in question even hated the term - - supply chain management. OK, here we go: If you ask a 6th grader to make a list of the things they should consider when purchasing a product for resale, they would probably give you a list like this:
- How much the item costs
- How much they can sell it for
With a little additional prompting (i.e., how is it going to get here? Do you have to pay for that? If you don't, does the price show up somewhere else? ) you can get them to add:
- Cost of transportation
- Who pays cost of transportation
Most businesses operate very close to this 6th grade list. They may add a few other considerations, such as:
- How much the item costs
- How much they can sell it for
- Cost of transportation
- Who pays cost of transportation
- Minimum purchase requirements
- Discounts for early pay/penalties for late pay
- Length of payment terms
When Deming says minimize total cost he doesn't mean even this slightly more expanded list. He means to consider a host of other issues that present themselves within the system of the supply chain. That list looks something like this:
- How well the item specifications match with customer expectations
- The extent to which (if at all) features need to be adapted or adjusted
- Who will do the adjustments
- How much time will those adjustments take, and does the timeframe work given customer expectations
- Whether or not the product will be exclusively available to the buyer
- Minimum purchase requirements
- Storage requirements for product (space, climate, management, etc.)
- Whether or not the product is packaged to buyer specifications
- Who will modify packaging, and at what cost.
- Who will manage ongoing packaging. If packaging will be managed by buyer, consider:
- Cost of packaging materials on an ongoing basis
- Cost of packaging labor on an ongoing basis (or cost of purchasing automation, and the ROI)
- Space requirements related to packaging materials and packaging activity
- How much time does packaging add to the supply cycle
- Whether or not custom packaged products can be returned for inventory balancing, and what labor is involved
- How much the item costs
- Cost of transportation
- Who pays cost of transportation
- How product is expected to arrive at buyer location
- Whether or not quality inspections are required at buyer location, and to what degree
- Degree of difficulty in receiving and stocking products
- Exception handling – if there are errors, how are those errors communicated to the vendor and what administration is required
- Who pays shipping costs of return items, what is that anticipated cost, and how does it ultimately affect overall product cost
- A host of quality issues; what level of quality is present in the product, how much time will be spent addressing quality problems - by sales, customer service, purchasing, receiving, accounting, and shipping personnel
- Purchase order processing - how easy is it to navigate the seller's purchasing environment, both for initial purchase and for expediting
- Accounts payable processing - how easy is it for the AP staff to match invoices to purchase orders, apply credits, and take discounts? How often must the AP staff do a complete reconciliation of the vendor to balance books
- Discounts for early pay/penalties for late pay
- Length of payment terms
- Ability to meet delivery requirements - how much time will company sales/service people spend apologizing for insufficient stock situations, how much will those stock-outs cost in terms of customer loyalty and compensatory activities such as subsequent free shipping, and how much additional labor will be expended as a result
This list is more like what Deming was talking about when he said companies must minimize total cost. And though selling price must always be set with a keen eye toward competitive environment and a company's specific value added, product cost considerations should at least involve contemplation of this whole list – not just direct product costs.
As you review the list you can probably think of various supply chain minefields from different companies you have worked at over time or different vendors you have dealt with. Three of the most common areas of inflated total cost relate to quality issues, receiving difficulties, and accounting management. I remember being told by one particularly self-impressed purchasing agent that her time was infinitely more valuable than the time of the people in the receiving department. Well I don't know how she figured it, but a week-worth of her time at, oh, let's say $25/hour ($1,000 total) to problem solve with the vendor to reduce receiving issues, or even another $1,000 week-worth locating a superior vendor and negotiating a contract, would be worth it. Consider the alternatives: three people at $11/hour spending an additional three hours (on top of the two hours already allocated – not in this calculation) to receive the products every shipment (say, 5X year) equals $495. Another accounting person to handle system adjustments, questions of the vendor, and rebalancing accounts (1 person X $16/hour X 2 hours X 5 times per year – or $160). But then, the real kicker. The receiving department and the accounting department each need to hire one additional person, because a handful of accounts like the one I am describing results in their inability to stay on top of their service level agreements. Cost? For wage and benefits loading (at 30%) $29,744 for the receiver and $43,264 for the accountant. For Pete's sake - do the vendor management!
Deming also alluded to the difference between a really great supplier relationship and an average one. Loyalty and trust. Trusting supplier relationships aren't just based on whether or not you pay your bills on time (though that is certainly important). They are also based on whether or not you provide them with timely information, give them information they need to be better performers, make only commitments you can keep, and never promise what you can't deliver in terms of sales volume.
Not to be undervalued at any time, the importance of supplier relationships increases dramatically during times of economic stress and uncertainty. Difficult economic times highlight the difference between excellent companies and those that are merely average. If you want to experience a successful 2008, you'll put your best people or your best effort on managing supplier relationships and operations related to supplies - and you'll take great pains to ensure that those departments work seamlessly together with respect, trust, and cooperation. Managing a business through recession is all about cash flow. Keep in mind the entire system when you try to figure out who is sitting on your cash.
(c) 2008. Andrea M. Hill
