Next Generation Sourcing
This wiki presents 21 strategies that can be applied to innovate the sourcing and procurement supply and spend management functions in any organization. Going well beyond standard best practices checklists, this wiki attempts to provide forward-thinking twenty-first century strategies that can be used to inject innovation into organizational sourcing and procurement practices of an organization on the road to best-in-class performance. Regular readers of Sourcing Innovation and eSourcing Forum may already be familiar with many of the concepts in this wiki, but this is the first time they have all been brought together. Moreover, some of the offerings herein go further and deeper than those on the blogs. The lead author hopes the reader will enjoy this wiki and add her insights and examples of success as time goes on.
Innovation on Demand
Innovation on Demand is an advanced version of TRIZ, Teoriya Resheniya Izobretatelskikh Zadatch, a topic the lead author first discussed in Purchasing Innovation II: TRIZ on eSourcing Forum.
TRIZ is a methodology, tool set, knowledge base, and model-based technology for generating innovative ideas and solutions for problem solving and the advanced version employed in innovation on demand, sometimes known as invention on demand, is important because, as pointed out in this CPO Agenda article, it can be used by CPOs who want to help their firms escape the clutches of patent-protected, monopolistic suppliers.
Invention on demand extends the benefits of TRIZ from component-level mechanical engineering problems to system level problems in general, be they mechanical, electrical, electronic, or even pure software. The goal is not incremental product improvement, but the creation of a completely new product that can replace the predecessor product without giving the incumbent supplier any leverage to claim intellectual ownership.
The basis for the approach is the fact that over 90% of the problems faced by engineers have been solved before - somewhere. The founder of TRIZ, Genrich Altshuller, screened over 200,000 patents looking for inventive solutions to the problems the patents were addressing. He found that only 40,000, or 20%, had somewhat inventive solutions. (As of today, followers of the methodology have screened 10 times this many patents with the same results.) He then categorized these in a five level system according to degree of inventiveness, a 1 being an apparent solution, a 2 being a minor improvement, a 3 being a major improvement, a 4 being a new concept, and a 5 being a revolutionary discovery. Only 4% of solutions contained a new concept and only 1% a revolutionary discovery. This indicates that, in general, less then 1% of patents will actually contain a new concept, and the estimate of over 90% of all problems being solved before - somewhere - is probably very low and quite safe.
The problem solving model employed by TRIZ is based on four key steps:
- evaluate a specific problem
- translate the specific problem into a general (scientific) problem
- search for general (scientific) solutions
- translate the appropriate solutions into specific solutions
This allows standard solutions and processes to be reused across disciplines, a hydraulic problem may be solved with a mechanical solution, a mechanical problem may be solved with a software solution, and a software problem may be solved with an electrical solution, for example.
In the first step, the system is broken down into its smallest elements and the functional relationships between the elements are established (and usually represented graphically). Each element is assigned a "function rank" that quantifies its importance or usefulness according to its distance from the central output and the number of useful tasks it performs.
In the second step, key elements of the system, typically those that are the basis of the patent protected offering that needs to be replaced, are "trimmed". This results in contradictions (general scientific problems), which define the goal of the endeavor - how to provide the necessary functions of the trimmed element without the presence of the element.
In the third step, the contradictions are conceptually resolved by experts in the scientific process from various fields that use general scientific solutions. For each trimmed element, there may be a number of ideas, many rather exotic, on how to transfer the required functions to the remaining elements.
Finally, the conceptual solutions are explored and those that are feasible are developed into specific engineering solutions. (For more examples of general problem solving methods that can be applied in the last two steps, see the Problem Solving Series on Sourcing Innovation).
The example CPO Agenda provides is that of a yoghurt drink manufacturer that is locked into a supplier that produces the specialized flavored syrups. Following this process, in the first phase the invention-on-demand team would identify the components of the system as the container, the lid, a straw, the plain yoghurt, and the flavor syrup. They would then trim the flavor syrup in the second step and generate the contradiction - how to provide flavor to the plain yoghurt with just the container, lid, and the straw. In the third step, the conceptual directions of incorporating flavor into the container or straw would be identified. In the fourth step, the team would decide that "teaching" the straw to release flavor when the drink is consumed is the best direction and work on identifying the right time release technology.
Once the specific solution is fully identified, it is patented and the company is free to then either produce the new product internally, license the technology to a preferred supplier in a partnership arrangement, or use the patent(s) as leverage in negotiations with the incumbent supplier, who will often come around if the company is a major customer.
Furthermore, as CPO Agenda points out, invention on demand can do more for a company than just improve terms from a patent-protected supplier or bypass it altogether. "It can replace expensive components with cheaper ones. It can generate product improvements in combination with target costing. It can be applied to any technical problem, whether for reasons of technical improvements, the value-price ratio, or both."
The process as a whole can considerably boost a company's performance. As an example, CPO Agenda points out the Korean conglomerate Samsung where TRIZ has become part of Samsung's culture. In 2000, Samsung's market capitalization was less then a quarter of Sony's. Today, it is almost double.
And it's not restricted to technical problems. It can also be applied to an organization's processes. It can help weed out unnecessary steps and components and focus in on the key steps and component tasks. These refined processes can then be implemented to save even more time and money for the organization. Invention on Demand, and the TRIZ foundations it is based on, is one of the few generic problem solving approaches ever developed that actually works, and works well, in practice across a wide variety of problems. Getting to know it is worth the effort.
Give Procurement a Dotted Line
As Jason Busch, co-founder of Azul Partners and blogger extraordinaire of Spend Matters points out in a recent presentation found here, in the future procurement will have a dotted line to every area of the business. Procurement will increasingly be the road that bridges all aspects of the organization. This indicates that a leading organization will not wait for tomorrow to make procurement the center of the organization, but will do so today.
Not only should procurement form cross-functional sourcing teams that cross the organization for each (key) commodity (group), but each group within the organization should involve procurement and its unique expertise and insights in their strategic efforts as well. Engineering needs to involve procurement in design efforts from day one, before up to 80% of the cost is locked in; marketing needs to involve procurement in supplier selection to make sure that costs are appropriately controlled from the outset; and legal needs to involve procurement in the creation of standard contracts, terms, and conditions to prevent issues down the road, for starters.
Furthermore, consider setting up the procurement organization as a networked organization. After all, today's forward-moving organization is global, outsourced, and awash in modern communications technology. It's employee is the networked person, a new species that can be observed in airport lounges, fast inner-city trains, and wi-fi Starbucks. Networked person is always on the move with laptop in case, mobile phone on belt, and blackberry in hand.
Networked person is always on the move, feeds off of information exchange and constant communication, and makes her own decisions all the time, guided by the knowledge base she has access to. Networked person is stifled in the classic organizational structure that impedes the spread of knowledge and limits the economies of scale that could otherwise be reaped. After all, world class sourcing teams not only cross, but eliminate organizational boundaries - and they do it all for the good of the business. They are built on collaboration and knowledge sharing, everything the networked person believes in.
Outsourcing can be defined as the process of delegating non-core operations or organisation man jobs from internal production within a typical organisation to an external organisation that specializes in that operation or organisation-man job. Then crowdsourcing becomes the process of delegating various tasks for which the organization does not have the manpower or expertise from internal production to external entities or affiliations of networked persons with the expertise, access to, or raw capabilities that the organization requires.
A very interesting introduction to Crowdsourcing can be found in a recent article in Wired entitled "The Rise of Crowdsourcing", which is also accompanied by "" 5 Rules of the New Labor Pool" and "Look Who's Crowdsourcing". It describes Crowdsourcing as "the new pool of cheap labor: everyday people using their spare cycles to create content, solve problems, [and] even do corporate R & D" and provides examples of tasks, once exclusively the domain of professionals, that are suitable to crowdsourcing. The four examples it elaborates on in detail are stock photography, content packaging, challenge-driven R&D, and technical repair flows. Other examples listed in the companion article are videography, online virtual-world generation, news, (fashion) design, and even financial services.
The first example elaborated on in detail in the article is stock photography. Once the domain of professional photographers who would charge $500 and above for professionally produced photographs, today they are being hedged out by internet stock photo sites that bring together large bodies of work produced by hobbyists and aspiring amateurs who, with the recent decline in equipment and software costs, can produce photographs of the same quality as those produced by the pros. Furthermore, since they are not dependent upon photography as a source of income, they can sell licenses for a fraction of the price of the pros, often for only a few dollars. For example, on sites such as iStockphoto, ShutterStock, Dreamstime, and " Getty Images, one can license photographs for as little as $1 and high quality images for as little as $5 a shot - a far cry from the $500 often charged by a pro.
The second example is one in content packaging - with in depth material on VH1's Web Junk 20 which was the first regular program to repackage the Internet's funniest home videos and features the 20 most popular (viral) videos making the rounds online in any given week. The costs to produce the show are minimal, in the mid five figures, since all one really needs is an editing / production team and a(n optional) host. Compare this to the average cost of a half-hour TV comedy these days, which now costs nearly $1M to produce (or more if the show has signed superstars pulling that down for a single episode).
The third example, which really is the charm of the article, focuses on how crowdsourcing can be used to solve R&D challenges and how giants like Eli Lilly, Colgate-Palmolive, Boeing, DuPont, and P&G are using it to reduce R&D costs while propelling innovation forward. Back in 2001, pharmaceutical Eli-Lilly funded a new endeavor by the name of InnoCentive as a way to connect with brainpower outside the company - specifically, people who could develop drugs and speed them to market - and threw open the doors to other firms eager to access the network of ad-hoc experts. These companies post their most ornery (scientific) problems on InnoCentive's Web site and anyone interested on the network can take a shot at cracking them, for a prize that ranges from $10,000 to $100,000 per solution. To date, more then 30% of the problems on the site have been cracked, which is 30% more problems than would have been solved using a traditional in-house approach (since these companies typically post the problems only after their internal R&D team has taken a shot and failed). And it's extremely cost-effective - take the quoted Colgate-Palmolive example where they paid an InnoCentive member who found a solution to a fluoride powder injection problem a mere $25,000, a fraction of what it could have cost Colgate-Palmolive to dedicate their R&D team to the problem until it was solved internally.
And if this isn't eye-opening enough to get an organization's interest, note the quote from Karim Lakhani, a lecturer in technology and innovation at MIT who has studied InnoCentive. "The strength of a network like InnoCentive's is exactly the diversity of intellectual background." Lakhani and three coauthors surveyed 166 problems on Innocentive and "actually found [that] the odds of a solver's success increased in fields in which they had no formal expertise". Why? He believes it is due to a central tenet of network theory, "the strength of weak ties". The most efficient networks are those that link to the broadest range of information, knowledge, and experience.
Another explanation not referenced in the article is the general applicability of methods and solutions to similar problems across many scientific and technological domains. Going back to number one, invention on demand or TRIZ, Teoriya Resheniya Izobretatelskikh Zadatch or the Theory of Inventive Problem Solving, the central step was the translation of a specific problem into a general problem since this allows standard solutions and processes to be reused across disciplines. Thus, solving an ornery problem in silicon chip manufacturing may not require access to the world's foremost expert on silicon chip manufacturing processes, but merely access to an experimental physicist who has solved similar problems in research component fabrication. And a network of such specialists only increases the chances of finding the right individual and claiming success. Furthermore, a pay-per-solution scenario costs an organization next to nothing - merely the time required to define the problem in detail and analyze the presented solutions. And even if the presented solutions aren't appropriate, if they are from an expert, chances are the organization will learn something just the same! So check out InnoCentive and similar sites such as YourEncore, and NineSigma.
True Strategic Sourcing, built on sound principles of Total Value Management tightly aligned with an organization's supply chain strategy, is about to become the cornerstone of efficient business operations around the globe. What other function impacts each and every unit of the business with such criticality? What other function requires input from key stakeholders and experts in each area of the business to truly be successful? What other function, when optimized, can have such a dramatic positive impact to the top and bottom lines of the business? The answer to all of these functions is "none". Furthermore, considering that, in an average business, sales and marketing will have to increase sales 500% to 1000% to have the same impact that a single dollar of up-front savings generates, the role of sourcing is only amplified.
As sourcing matures and becomes the center of the business, the view of sourcing will slowly shift from that of a reactive business unit that aggregates needs and demands into a proactive business unit that is looked upon as an enabler, problem solver, and even forecaster of future trends and consulted by the other units of the business. Thus, understanding new sourcing methodologies to reach out and find sources of innovative solutions, like crowdsourcing, will help an organization in its quest to become the "heart" of the organization, a role sourcing truly deserves!
Design for Sourcing
Successful innovation designs for sourcing. Waiting until the prototype phase, after engineers have made material and component choices, increases the chances that all designed-in-costs will be locked in. Considering that the Defense Advanced Research Projects Agency estimates these costs to be, on average, 80% of product costs, this is significant. Furthermore, failure to involve procurement early could risk increased direct material costs, unacceptable risk in supply, unexpected component obsolescence, missed regulatory compliance, the inability to expand into new geographies, the lack of ability to take advantage of sourcing leverage, increased quality inspection costs, raised manufacturing costs, and missed launch dates.
Recent studies from the Aberdeen Group not only qualified the value of innovation to a company, but quantified the significant benefits of introducing procurement into the process at the earliest stages of New Product Design (NPD). Specifically, when procurement is included in NPD in the design stages, product development cost is typically decreased by 16 to 18%, overall product cost is typically decreased 15%, and revenue is typically increased by 19%. Furthermore, quality is improved (through the elimination of late changes due to sourcing considerations), parts reuse is increased (which enhances supply leverage while reducing inventory and complexity), and time to market cycles are improved by 10% to 20%.
When one considers the intensified cost pressures, reduced product lifecycles, increased product complexity, increased rates of commoditization, tougher competition, and the continual reduction in trade barriers in today's global marketplace, the need for continued innovation is essential to a company's very survival. However, when done right, successful innovation can be the key differentiator between survival and massive profitability.
New Product Development is more challenging now than ever before since the majority of products require expertise across disciplines and organizational boundaries. Most products are so complex that it often requires cross-disciplinary teams across the supply base to design, prototype, and bring a product to market. Furthermore, innovation, which is as much as broadening the product development view as it is about managing the product lifecycle, requires input from business units including, but not limited to, design and engineering, marketing and sales, legal, finance, and procurement. The process requires a significant amount of coordination, communication, collaboration, and control.
Managing this innovation is no easy feat, but great results are much more likely if one follows the best practices of best-in-class companies that dedicate leadership, centralize control, standardize processes to capture and leverage results, employ technology to facilitate the process, and measure constantly. A senior manager should be directly responsible for overseeing the full process of identifying innovation opportunities, engineering them, developing them into products, and bringing them to market. Centralizing control allows for the standardization of processes, consistent distribution of best practices, and consistent management of a central knowledge repository. Standardized processes improve efficiency and allow for the capture of knowledge and results that can be re-used in the future. Appropriate technology can simplify coordination, collaboration, and communication and allow everyone involved to focus on innovation, not automation. Best-in-class companies are four times more likely to have Product Lifecycle Management related technology, integrated data and process automation, and collaboration infrastructures than their peers. Constant measurement allows for constant improvement. Best-in-class companies are three times more likely to measure key performance indicators across projects on a monthly basis.
Furthermore, successful innovation incorporates customer needs, evaluates goals in business terms, implements operational improvements that yield tangible results, chooses product opportunities by value and relies on procurement to ensure that product costs and supply risks are addressed up front.
Discontinuous Innovation is where an organization braves the unknown, thinks the unthinkable, and explores the frontier, where they might lose some of their glorious history, and does something completely different. Discontinuous Innovation involves spending time making different connections and building relationships with different groups of people outside of purchasing's core strengths. It involves looking at the business in new ways, at opportunities that would not have been considered in the past, and at markets that do not yet exist.
Examples of discontinuous innovation range from finding new designs for existing products, to new materials for product needs (such as reinforced aluminum, teflon, and carbon nanotubes instead of traditional steel in vehicle construction), to entirely new products and product lines altogether. It's not just thinking outside the box, it's thinking as if the box did not exist.
Center Led Procurement
A center-led model of procurement, where a procurement center of excellence (COE) focuses on corporate supply chain strategies and strategic commodities, best practices, and knowledge sharing while leaving individual buys and tactical execution to the individual business units provides the best of both worlds - all of the advantages of the centralized and decentralized models with minimal disadvantages.
The center led model, built on cross-functional teams that represent all of the key divisions and business units, allows for the creation of flexible supply chain processes and commodity strategies that can be tailored at the local level when necessary to adhere to local regulations or take advantage of local markets or tax breaks. Corporate spend can be fully leveraged on strategic commodity categories well suited for centralized sourcing and non-strategic categories not suited to centralized sourcing can be handled by the individual business units. Operational efficiencies are increased and overall operational costs are decreased and the organization maintains the ability to react quickly to unexpected changes in supply or demand. Best practices can be shared easily throughout the enterprise, maverick buying significantly reduced, and performance maintained at a consistent level.
Furthermore, a recent study from Aberdeen Group demonstrated that organizations with center led procurement considerably outperform their non-center led counterparts in both spend under management and supply cost reductions achieved. Center led companies reported more than twice as much spend under management than companies with a decentralized structure and nearly 20% more spend under management than companies with a centralized structure. Moreover, center-led companies report 5% to 20% cost savings for each new dollar of spend brought under management. That's probably why more than 75% of companies surveyed expect to have either completed, or started a transition to, a center led procurement organization by 2008. However, with that volume of savings, why wait?
Center Led Procurement is so important that it is the focus of its own wiki here on eSourcingWiki.com!
Home Country Sourcing
A lot of companies have hopped on the low-cost country sourcing bandwagon, so many so that many low cost countries are not low-cost anymore. This has inspired some of the more progressive organizations to focus not on low cost country sourcing, but on right cost country sourcing. Right Cost Country Sourcing is a process of not only selecting the right country, but selecting the right country quickly and, more importantly, being able to reverse that decision and select a new country should circumstances change.
However, the most progressive organizations will be those that find ways to source at home and do so competitively on a global basis. After all, when an organization looks at the global risks the World Economic Forum is tracking, it sees retrenchment from globalization, failed and failing states, interstate and civil wars, the US account deficit, and a potential Chinese economic hard landing topping the economic, geopolitical, and societal lists. This clearly indicates that any organization that can source competitively in its own country definitely has an edge over the competition, considering any one of these risks could bring production to a halt in any organization unable to effectively mitigate such risk.
Networked person feeds off of information exchange and constant communication and makes her own decisions all the time, guided by the knowledge base she has access to. Furthermore, she uses the best tools that technology has to offer: analytics, optimization, and dashboards.
Networked person uses true strategic sourcing decision optimization, which is the application of rigorous analytical techniques to a well-defined sourcing scenario to arrive at the absolute best decision out of a multitude of possible alternatives in a rigorous, repeatable, and provable fashion. Furthermore, the strategic sourcing decision optimization tool meets four basic requirements. It is built on solid mathematical foundations, supports true cost modeling, supports four key categories of sophisticated constraints (capacity, basic allocation, risk mitigation, and qualitative), and contains sophisticated What If? capability.
Networked person also uses best-in-class analysis solutions on the front end and the back end. Networked person uses spend analysis to not only identify potential cost saving and cost reduction opportunities, but also to compare bids in an apples-to-apples fashion on different dimensions to understand the advantages and disadvantages of each bid, to monitor invoices for compliance and overcharges, and to monitor spending against industry price trends to determine where the next potential opportunities might lie.
Finally, networked person uses dashboards to monitor their sourcing projects on a regular basis and to gain a deep command-and-control view into their most critical supply performance information. This lets networked person know where she is doing well, and where more attention is needed.
This will take a number of different forms, including front-line sourcing and hedging. Leading companies will increase the frequency of sourcing for volatile categories, such as lodging, travel, and print, to better exploit regional and seasonal fluctuations in availability and pricing. Other companies will lock in long term pricing using hedging when the results of their sophisticated analysis dictate that pricing is likely to only trend upward in the foreseeable future.
Just as the procurement professionals in the future will make expert use of guided sourcing, they will also be focussed on following the transaction from beginning to end. From the award, through the purchase order, invoice, receipt, and payment, each stage of each transaction will be monitored for compliance, efficiency, and financial opportunity.
In addition, tomorrow's procurement professional will place a much greater emphasis on supply chain finance, and maximize value throughout the supply chain by choosing the right financing and right payment terms every time.
Secure, and Securitize, Capacity
Leading companies that require a significant amount of a raw material that is in, or expected to be in, short supply are already locking up what they expect to need in long term contracts. However, in the future, leading companies will not only lock up direct material needs, they'll also lock up corresponding production capacity needs with key suppliers. And the most aggressive suppliers will not only lock up guaranteed capacity needs, they'll also lock up potential capacity needs and then sell off excess capacity when they don't need it.
As Jason Busch of Spend Matters pointed out, such an open-exchange model has considerable advantages for buyers and sellers.
Suppliers could forward sell capacity and realize cash flow to fund investments in equipment, labor, and operations. They would also benefit by better understanding the market price for capacity. Perhaps this type of "capacity" sell would also benefit suppliers by letting them lock-in a portion of future revenue, while letting them float the rest by letting other companies buy on contract based on specified demand. In any event, stable, predictive, operating cash flow is a major benefit of this model, at least on the supply side.
Buyers would also benefit by being able to choose to buy a balance of capacity or the actual parts themselves, and ensure they were purchasing at a true market price. And they could also take a more active role in acquiring the underlying commodities that go into finished parts from suppliers, reducing risk and variability of supply markets pricing, avoiding escalation / de-escalation clauses entirely. In addition, if they were not happy with the current market price for capacity, they could try a direct negotiation technique, or they might hedge their bets by buying a "call" on future capacity rather than the underlying contract itself. And if they know the supply market well, perhaps they might even become a trading party, buying and selling capacity for profit based on their analysis of the market. The possibilities are endless, but the potential for all parties is huge.
Flexible Business Process Management
Traditional Business Process Management is, according to Wikipedia, a field of knowledge at the intersection between Management and Information Technology, encompassing methods, techniques and tools to design, enact, control, and analyze operational business processes involving humans, organizations, applications, documents and other sources of information. More simply, it is the management of the processes the organization uses in its sourcing and procurement efforts.
However, leading organizations don't employ traditional Business Process Management techniques, they employ flexible, adaptive, and system-enabled next-generation business process management techniques that are continually monitored, evaluated, and improved. Leading organizations employ state-of-the-art systems that allow them to model the processes they need, monitor the execution, evaluate the efficiency, identify the bottlenecks, and, upon identification of the solution, alter the processes as necessary and have their systems automatically adapt to the new processes.
Do Less, Not More
This may sound cliche, but it's the future. Have a three-step approval process? Ditch it. The approval process should only need one step. Strategically sourcing all organizational commodities in house? Stop. Focus on the high volume, high cost, and strategic, which should be organizational core competencies, and outsource the rest to a third party specialty BPO that works with the sourcing team. Managing inventory for non-critical commodities and materials in house? Why? Use VMI (Vendor Managed Inventory).
Best-in-Class organizations are efficient and intelligent about what they do, how they do it, and what they expect to achieve from it. They use lean processes and adopt a six-sigma goal mentality. They constantly look for ways to improve and do what it takes to get there because doing less allows them to accomplish more.
Leading organizations are already using the hybrid sourcing model that blends sourcing technologies with third-party supply market and sourcing intelligence that Tim Minahan has been blogging about over on Supply Excellence for a while now.
In this scenario, the e-sourcing technology platform functions much like a cable box, providing the utility to access and organize information and resources required for effective sourcing. This platform connects to a network of subscription-based channels that provide programming in the form of supply market intelligence, commodity costing models, supplier information, and category-specific sourcing templates that are optimized for a specific e-sourcing tool (the cable box). The latter point is critical because, instead of using offline researching, these channels put supply content in the context of an organization's sourcing process and infrastructure.
In the perfect scenario, these third-party content channels would help enterprises capitalize on supply market shifts and minimize risks. For example, a certain channel might predict a tightening of supply or a future price increase for Commodity-X. The organization's contract for this commodity may not come due until next year, but the channel sends an alert recommending renegotiating now. The alert is connected to full programming on Commodity-X, including supply market factors, cost models, and sourcing templates that can be loaded into the cable box. The organization shores up supply and locks in pricing in exchange for long-term volume commitments, avoiding the shortages and rising supply costs that are sure to face its competitors.
Furthermore, leading companies know how to blend in-house sourcing efforts with business process outsourcing services and specialty providers to make sure every item is sourced using the best methodology by the best person for the job. Moreover, everything is sourced, including advertising services, temporary labor, and legal - not just commodities or manufacturing services.
Leading procurement professionals don't just use best-of-breed technologies to collect, analyze, and negotiate bids, they also do should-cost analysis and track market prices, labor rates and exchange rates for key commodities and key source countries. This way, when an item goes out for bid, the buyer knows how much the supplier should be paying for its raw materials, in their currency with exchange rates taken into account, as well as prevalent labor rates and can accurately estimate the cost of production, tack on what they perceive to be a fair profit margin, and estimate, more-or-less, what the suppliers should be bidding. This way they know if a bid is too low, and unsustainable in the long term, or too high and negotiate with the suppliers willing to charge a fair price for a quality part.
The most progressive organizations establish long term contracts that secure capacity at fixed labor and production rates, fixed profit margins, but variable raw material costs tied to current market prices as determined by a base market index and a neutral currency index. A starting price is determined and then updated on periodic intervals, usually every quarter, but leading organizations will have the systems in place to do it monthly. Basically, every quarter (or month) the relative change in the raw material price and the relative change in the currency relative to the buying currency is obtained from the agreed upon indices and the relative change in price is computed. For example, if the raw material is being bought from China and the Chinese steel index shows an increase in steel of 4% while the exchange rate between the yuan and the American dollar increases 13%, then the price to the buyer will drop by an appropriate fraction of 8.65% since the buyer's buying power has increased by this amount relative to the primary raw material, equal to 1.13/1.04. Thus, if steel constituted 30% of the cost, the buyer's price would drop by roughly 2.6%. Alternatively, if the price of steal increased by 6% but the exchange rate dropped by 5%, then the price to the buyer will increase by an appropriate fraction of 9.5% since the buyer's buying power has decreased by this amount, equal to 1 - 0.94/1.06. Thus, if steel constituted 30% of the cost, the buyer's price would increase by roughly 2.85%.
They also track consumer pricing trends on commodities where they have best price agreements. For example, a leading organization will not pay the same dollar amount for the same server they buy today a year from now since the prices for computer equipment and electronics trend downward over time. They also run periodic reviews or pricing trends against their invoices to capture overcharges and charge them back to suppliers.
Finally, the most progressive buyers will apply second generation spend analysis not only to contract purchases, but off contract purchases as well to determine where paid amounts fluctuate significantly enough to consider a contract, where overcharges are rampant and dictate the need for buying policies, and, even though one might hope this would never happen, to find fraudulent charges.
Shape Demand ... For Services
In many large corporations, the dominant spend is not on materials, parts, or products ... but services. When one considers the down-sizing and right-sizing and outsourcing trends of the last two decades, this should not be too hard to imagine. Think about it. If a leading organization has adopted the mantra to do only what their core strengths are and their core strengths are selling customized computer hardware, chances are they have outsourced their accounting and labor management, outsourced hardware manufacturing, outsourced logistics, outsourced inventory management, and outsourced home or business delivery. Obviously, since most of the work is being done by third parties, their services spend is, literally, through the roof.
Of course services management is going to be a big part of the role of procurement and of course a good procurement organization is going to focus on getting the best contracts for, and value out of, those services, but a leading procurement organization is going to go beyond reacting to demand. A leading procurement organization is going to work with marketing to help shape demand to better predict when demand will spike, when it will drop, and what can be done to keep it constant. In services, the biggest cost to an organization is not necessarily the amount of services required - since the work probably needs to be done whether it is done in-house or outsourced, but when they are required and, more importantly, whether ramping up or ramping down is required.
Ramping up adds additional costs since it requires more personnel to be trained, and if it has to be done quickly, usually current resources need to work overtime until enough personnel are trained. Ramping down adds additional costs as well, since labor is usually acquired for a contracted term and early termination usually requires notice and significant early termination fees. Thus, a leading procurement organization will work with marketing to predict when demand will spike, in order to build up supply early to prevent the need for a short term spike in outsourced services and labor, and the ramping down that would otherwise follow.
Manage Suppliers ... Before the Award
Even though one would think Supplier Relationship Management would be the norm, a recent report from the Aberdeen group tells us that only 49% of companies have a formal supplier performance and risk management strategy in place. However, the vast majority of these companies only start managing their suppliers after the contract has been cut and the first delivery made.
A leading procurement organization is different. It starts managing the supplier not only before the contract is cut, but before the full RFP is sent out. How does it do this? Leading organizations start their sourcing cycles on their critical parts long before their current contracts expire. They also use a multi-stage RFX process that has a multi-round supplier selection process. First they identify all potential suppliers and send out an RFI. Then they weed down the list to suppliers who should be able to manufacture the part based on capabilities and references. They then meet with the suppliers to gage expected capability and fit with the organization. At this point, they make a short list of roughly three to five suppliers and give the suppliers a test order either for a small quantity of the part or for a related, less critical part. When the order is received, they evaluate quality, on-time delivery, and other metrics important to the organization. Only then are the suppliers who make the cut invited to the table to bid and be considered for the contract award. This way, the buying organization, who also employs third party supplier information services such as Austin Tetra or Open Ratings to qualify the risks associated with using a supplier before they are even included in the list of potential candidates, has a good idea up front on how well the supplier is likely to perform, how well they will fit in with the organizational culture, and how willing they are to work as a partner going forward.
Forget Savings ... Avoid Cost in the First Place
Most organizations have a myopic focus on cost savings, but considering there ain't no saving in a perfect world, this is a level of foolishness that even the SpendFool wouldn't tolerate! In fact, the SpendFool, in full foolishness, would go Donald Trump on the ogranization! "You're fired!"
A leading procurement organization doesn't look for ways to reduce spend, since this is the result of overspending, which a good procurement organization that does a should-cost analysis on all purchases and makes proper total value awards would not do, but for ways to avoid spend in the first place. This is the ultimate way to increase profit. Bringing in a heavy-hitting consulting firm with hired guns that can find overspending and negotiate rebates and refunds on the organization's behalf is good, but not spending that money in the first place, when it could be invested for profit, is better.
Leading procurement organizations will employ substitution strategies, lead innovation-on-demand initiatives, improve inventory management, revolutionize processes, and find ways to get around "fees" and "maintenance charges" that essentially represent low-value to the organization and pure profit to the vendor.
For more definitions, ideas, and calculations on avoiding costs in the first place, see the Cost Reduction and Avoidance wiki.
Visibility First, Consolidation Second
Some organizations hear the oft-quoted fact that, typically, 80% of spend is with 20% of suppliers and go on a consolidation spree, eliminating as many suppliers as possible as fast as possible to get to a number where all supplier relationships can be tracked and managed and associated risks identified and mitigated. This sounds great in theory, until the organization realizes it just cut the only supplier capable of producing the custom GPS chip for the new model of mobile phone it planned on introducing next year, or, even worse, it cut the only supplier capable of producing the guidance chip for the top-of-the-line SUV it is currently manufacturing.
The reality is that most organizations that do not do proper supplier relationship management and proper spend management probably have three to five times (if not more!) suppliers than they need, but the reality also is that until such organizations have visibility into who their suppliers are, what they are supplying, where it is being used, and how they are performing, they are not in any position to do proper supply base consolidation, which, in some cases, might actually dictate the addition of new suppliers where key parts are being singled sourced. Thus, it is important that they acquire visibility into their supplier network before consolidating.
Like Do Less, Not More, this might also sound cliche, but it is also dead-on. Second-guessing every decision an employee makes isn't productive, and neither is creating an approvals bottleneck for every award they want to make. A leading, innovative organization hires the best employees, gives them everything they need to do their jobs well, provides them with regular training, works with them, and trusts them to make the right decisions. It should be obvious that the majority of an organization's best ideas are going to come from employees, not from management. The employees are dealing with the problems every day, the employees are thinking about the problems everyday, the employees are hired because they are better at their jobs then their managers, and, let's be blunt, there are more employees than there are managers. Good managers select the best ideas from their employees and make them happen.
Harness the Power of Community
One mind is good. Two minds are better. Thousands of minds are better still. Take advantage of blogs, wikis, forums, and other collaboration technology improvements enabled by web 2.0 technology to collaborate internally and externally to identify, improve, and leverage the best ideas available to improve procurement operations. 'Nuff said.
A Selected Bibliography
(The) Benefits of an End-to-End e-Sourcing Suite by Michael Lamoureux, April 18, 2007
Best Cost Country Sourcing by Michael Lamoureux, May 30, 2007
Center Led Procurement I: An Introduction by Michael Lamoureux, August 11, 2006
Center Led Procurement II: A Center of Excellence by Michael Lamoureux, August 12, 2006
Center Led Procurement III: Best Practices by Michael Lamoureux, August 13, 2006
Customer Data Management by Michael Lamoureux, August 6, 2006
Five Types of Supply Risk, and How to Mitigate Them by Jim Lawton, February 14, 2007
Global Trade Management 2007 by Michael Lamoureux, May 17, 2007
Global Trade Management 2007, Part II by Michael Lamoureux, June 13, 2007
Got Talent? by Michael Lamoureux, May 23, 2007
Increase Competitiveness using Supply Chain Finance by Michael Lamoureux, May 29, 2007
New Technology Strategies for Supply Chain Management by Michael Lamoureux, October 6, 2006
Predicting the Future of Strategic Sourcing: Part II by Tim Minahan, August 23, 2006
Purchasing Innovation I: An Introduction by Michael Lamoureux, June 30, 2006
Purchasing Innovation II: TRIZ by Michael Lamoureux, July 1, 2006
Purchasing Innovation VI: CrowdSourcing by Michael Lamoureux, July 16, 2006
Purchasing Innovation VIII: Transforming New Product Development by Michael Lamoureux, September 9, 2006
Purchasing Innovation IX: The Purchasing Evolution! by Michael Lamoureux, September 10, 2006
Show You the Money, Part I by Michael Lamoureux, January 30, 2007
Show You the Money, Part II by Michael Lamoureux, January 31, 2007
Sourcing Innovation: Prediction for Future of Strategic Sourcing by Tim Minahan, August 22, 2006
Sourcing Innovation: Securitizing Direct Materials by Jason Busch, August 28, 2006
(The) Sourcing Innovation Series: Part XI by John Martin, September 12, 2006
Veni, Vidi, Wiki by Michael Lamoureux, March 14, 2007
Wikis are Organic by Michael Lamoureux, May 18, 2007
Michael Lamoureux, PhD of Sourcing Innovation