Identify Potential Supplier sources
Solicit Supplier Survey
Use the survey to solicit both information which helps you "qualify" them but also provides you key information about them and their character which can be used in the negotiation. For example, you could ask for information about quality levels, warranty returns, quality returns etc.
Evaluate Supplier survey
Identify gaps to determine additional things to probe during the interview.
Start to determine key information that you will use in the negotiation.
Perform evaluation of Product
Identify any shortcomings that can be used to drive the price down. E.g. lack of features, not an exact match with needs.
Purchasing checks Customers, References, Business terms, Ownership/Potential Conflicts Futures, apacity, Flexibility, Organization, Key Personnel, Customer User Organizations.
Finance (or Purchasing) checks: Basic financials, Annual reports, Financial statements, Creditors, Bank references, Trade references, Major risks.
Engineering and Quality checks: Design resources Design capabilities Design rules Design tools - CAD etc. VA/VE activity Special expertise Quality processes, Quality controls , test, Reliability programs.
Manufacturing Engineering checks: Facilities, capacity, flexibility, production equipment, manufacturing processes, process control, tooling, documentation, change control.
Field Service checks Repair capability, repair quality, repair channels, Long term support, training, parts availability, Repair cost, turn times.
In addition to helping you determine whether the Supplier is qualified to do the work, all this information should be used to understand the Supplier's character, and where controls may be required to manage performance. Identify where the Supplier has shortcomings that can be used to justify contract requirements.
Tour their facility.
See what they are doing, how they manage the business, the tools they have. Look at who their customers are. Look at who their suppliers are to see their qualify and character. Understand their process and quality steps. Look at capacity to understand how much they need your business. Look for indicators of problems (high volume in warranty or returns areas, large re-work area for production). It will give you a better understanding of the character of the Company and where extra controls may be needed or the contract changed.
Probe for information
Drill down from the general information provided in the Supplier survey form to understand the specifics that may impact you. For example, if you were dealing with a company with multiple offices, you may need to find out the specifics about the particular office that you would be using. This is important in service related activities where you are relying upon the people and capabilities of the local office. Each office may have
a different character and different skills depending upon their customer base. Each may be organized to deal with that customer base.
Have them present a representative project
Have them walk through the project and explain how they managed it. Understand their basic capabilities. Probe about who did what. An individual who was a major factor of the success of a prior project may no longer be with them, that would change their true
capabilities. Look for management structure or approach. Is it incompatible with your needs
Ask for representative samples of the drawings and technical specifications
Determine the quality and depth of the product. Look for shortcomings that can be used to help negotiate.
Check their management systems for scheduling, buying of equipment and materials, quality processes, field service and support capabilities.
Understand what you are getting and use the information on shortcomings to help negotiate requirements or commitments.
Use the interview to get you information you need to help you make decisions you need on the Project
Have them recommend contracting approaches, form of contract, estimate of project schedule, critical equipment and lead times. Use that to check your requirements.
Meet the person or team who they will assign to program.
Understand whether they are of the experience and skill level to both manage the program and warrant the cost. Use shortcoming to negotiate additional commitments or reduced fees.
Check references on the Company.
Company provided references will always be positive. Solicit other sources (e.g. customers you identified in the interview, look at who they are shipping to). Find out when, what they bought, the type of job, the supplier's role, the type of contract, etc. Ask for everything the reference would be willing to share, especially pricing, treatment of changes, claims, performance. Use that information in the negotiation to substantiate contract requirements, demands for reduced pricing, incentive, etc.
Perform a financial evaluation of the Company.
Look for critical financial factors which will help negotiate top value items which are critical to them. For example, you might consider a large, upfront payment in return for a substantial discount for suppliers with a large cash flow problem or with a high cost of money.
Review all of the information to determine what changes to your standard contracts are required to effectively manage their performance and how you will use the information against them in negotiating the agreement
Wednesday, January 26, 2011
Many people think that the goal of a supplier qualification process is to ensure that the supplier has the capabilities and financial resources to perform the work. The seasoned negotiator knows that it also provides an excellent opportunity to gather information about the Supplier that they will use to define what additional controls or requirements may be needed in the agreement to effectively manage the supplier. They will also know it represents a opportunity to get at information that they can use to help them in the negotiation.
It is important that information be sought in the pre-qualification stage where the supplier's employees will frequently "open their Kimono" and share information athat may be later used against the Supplier in the negotiations. Once the actual negotiation process starts, the flow of information will be controlled. The following is a sample list of activities you would perform in a qualification, with a description of how you should be looking at them from a negotation perspective.
Stages of Pre-qualification The negotiation perspective.
I have been in a number of negotiations where the Supplier wanted to either charge additional costs because of our requirements or fought accepting some of out terms as they required them to do something unique. The problem for them was I had toured their plant I knew what their standards were. Many times their standards were exactly the same as what we required. When I would point that out to the other side, the request would be withdrawn or the position would change. If you don't tour their operation you'll never know what the baseline is to measure against in price negotiations.
There are five major areas for Supplier Risk
The financial risk to a Supplier is their liquidity and cash flow which can be impacted by external influences such as interest rates, foreign exchange, available credit, and aging receivables. That can be identified from their financial statements.
The Market risks to a Supplier occur from competition, changes in the industry and competition, loss of customers, and general supply/demand changes. That should come from you knowledge of the industry.
The Hazard risks include natural and man made hazards that could interrupt performance.
These you can’t predict well. For example a Supplier may be in an earthquake active area, but when will they occur. Or how many people could have predicted in advance that Mt. St Helens would explode and spew ash for miles.
The operational risks include performance problems that exist or could occur, things that can impact labor such as illnesses, labor disputes, political unrest, and what I call dumb management decisions. These can be partially identified by pre-qualification of the Supplier.
The contractual risks of a Supplier includes both what the Supplier is obligated to provide to other customers and the specific risks the Supplier is unwilling to assume in their contract with the Buyer.
The hardest of these to predict is the operational risk associated with dumb management decisions. These are usually decisions that have not been thought through to understand the impact. Here’s an example, a major electronics component supplier facing a temporary downturn in business layed off an entire plant staff. When demand returned, they sought to rehire all the workers. The problem was that many of the workers were foreign workers and because of the economy the local government was unwilling to allow them to be re-hired to work in the country where the plant was. They had a plant but a huge shortage of trained workers to operate it, and the result was they were unable to meet demand for an extended period. I’m sure anyone that has been in procurement for any period of time has had an experience where a Supplier is not performing because someone made the wrong decision.
You try to understand Supplier risks as part of sourcing decisions, whether you invest in second sources, and if you must hire the Supplier to decide upon what terms in the agreement are needed to help manage the Supplier and the risk.
Many time the best way to understand if there are operational risks that you need to be concerned about is to visit the Suppliers locations to see what that do, how they do it and look at the suppliers they use, the processes and tools they use and the rework or returns area. I was once asked take a look at a Computer Monitor Supplier in Brasil while I was there setting up a plant. What I saw was a plant that was a giant step back in time with no auto insertion equipment being used. Components were being inserted by hand. I also saw a large re-work area where the products when tested didn’t work and immediately decided that they had operational risks that weren’t worth trying to deal with. The cost of labor was so cheap they would never make the investment in automation equipment that would be need to improve their quality.
Similar to why you would do qualification of the Supplier’s financials, checking references can do the same two things in preparation for the negotiation. What you discover can identify the need to add certain requirements of terms to your contract depending upon what you learn. It can also disclose information that you can use during the negotiation as leverage to get the terms you need. For example, if another customer experienced a specific problem with the Supplier, you can bring that up when you are negotiating the term that you have added to help protect against that problem occurring with you.
As part of pre-qualifying a Supplier one of the best things to do is to check references of the Supplier. There are three types of references that would be traditionally checked: bank references, trade references and customer references. Bank references would provide you with information such as the Supplier’s available credit line with the bank. Trade references would be from their suppliers and should help identify how they treat their suppliers and how they pay them. Customer references should help identify a number of things such as: What they did; what team was involved, how they performed, what issues or problems arose, and what the Customer would do differently if they were to use the Supplier again.
If you ask the Supplier to provide you with references you can be assured that the ones they provide you will be positive. To get a more representative list, if you tour the facility where the work is performed, make sure you visit their incoming receiving area. That will show you what suppliers they are currently using. Ask to see the final packaging and shipping area and make note of who the products are being shipped to. If the work is being performed at a customer location, ask to see a representative location and look for the same things.
For customer references, always ask to speak with the individual that directly interfaced with the Supplier on day to day issues. What do you ask them?
- What was the scope of the work the Supplier performed for you? A lot of supplier may list major work on their credentials, so its important to understand exactly what they did as they may not have done the work alone or they may have only been a subcontractor.
- What type of contract was it done under? You want to understand if the relationship was similar to what you plan. For example, in construction a Supplier could function as a Construction Manager or a General Contractor and the focus of the two, the skills needed and the risks are substantially different.
- When was the work performed? You want to make sure that the work was done recently as work done in the past may not be representative of what their capabilities are today as companies evolve over time.
- Who managed the activity for the Supplier? Who were key members of their team. The more critical the personal management of a program is to success the more important this question becomes. What you want to avoid is having the situation where there most successful program was managed by someone who is no longer with Supplier where the skills may no longer exist, or may be reduced.
- How would you rank the Supplier’s performance on delivery and meeting the required schedules? Understanding past performance can either identify problem areas that may make you want to avoid the Supplier or the need to add contract tools to help manage their performance.
- How would you rank the Supplier’s quality performance. Understanding past performance can either identify problem areas that may make you want to avoid the Supplier or the need to add contract tools to help manage their performance.
- How would you rank the Supplier’s contract management performance. Understanding how well they managed performance and how easy or difficult they were in their dealings will identify the level of resources you may need to manage them.
- What was their history of changes? The discussion of changes helps understand the type of supplier they are. If there are frequent and significant of disputes on interpretation of drawings or specifications, you probably don’t want to deal with them as their strategy may be to did low and make their profits back on changes. You also want to know how they respond to Buyer requested changes as that can impact the type of changes provision you may need in your agreement.
- What was their performance to Budget or Contract Amount? This ties closely to the question on changes. It can also help identify the type of contract that you may want to use. For example, if you hired an architect to design a building, you would want them to manage their design to your budget and you probably would want a fee schedule that doesn’t provide them with an incentive to do anything but manage to that budget. E,g, you don’t agree to a fee that is based upon a percentage of cost of the work where their incentive is to drive up the cost to increase their fee.
- How did they manage the work? What type of team was assigned? What tools did they use? How effective was their management? Did you need to intervene? How did the team respond to problems? How often did you need to escalate issues to their management? The key to this line of questioning is understanding what the Supplier contributed to the success of the work. Sometimes a Supplier may be successful because the Buyer dedicated substantial resources to manage them and their performance. The more the Buyer needed to manage them the more you need to decide whether you have and are willing to dedicate the same resources or will do better with another Supplier.
- Were any claims made or was there any litigation or threat of litigation? This helps identify the type of Supplier they are and what the potential cost of doing business with them would be. If you are doing to deal with a supplier that frequently makes claims and sues, you need to manage the work differently.
- In comparison to other suppliers, how would you rank their performance? By now you probably already know what their answer to this would be, but I would still ask it as it allows them to volunteer the name(s) of another Supplier that they have had better experience with.
- What was the best thing about dealing with them? What was the worst? What you really want to hear about is the worst as those can be things that impact your sourcing decision or would require you to include terms in your agreement to manage against the “worst” happening to you.
- If you could do things differently what would you change? This type of open ended question allow the individual to provide you with suggestions that you can use in both structuring the terms of the agreement and staffing the work to manage the supplier and their performance. If their response was to not hire the supplier in the first place, you probably should listen to them especially if the work you want the supplier to perform is similar to what they hired the Supplier to perform. If you must use them, the feedback should provide you with significant leverage in the negotiation of the terms where you identify the specific problems or issues and look to them to identify exactly what they will do and commit to that will prevent the issues from reoccurring with your work.
For trade references what you are concerned about is several things:
1. What is the volume of business they do currently? This gives an indication of their current volume and relationship. Trade references that aren’t current are of little value as much can change in a short period of time.
2. What type of relationship do they have? This can help identify whether the business is occurring because of a long standing relationship they have with the Supplier (which is what you would prefer) or because of the involvement of another customer where they may be buying off that customer’s contract and may not have a contract that would apply to your work.
3. What is the payment history. When Suppliers have cash flow problems the first parties that will suffer is their Supply base. Asking this question provides a more current indication of their financial status than their most recent financial statement. It would also provide an opening to ask they Supplier why? For example if there cash flow problem is the result of customers not paying that can also be an indication of potential problems that are worth looking into.
Just in case you are wondering why a blog on negotiation is discussing financial analysis of Suppliers, the answer is what you find in your analysis of the Supplier’s financial strength can do several things. That knowledge may show the need for additional terms or requirements need to be added to your contract to protect against the risks you have in using them. It may also provide you with information that you can use as leverage as part of the negotiation to gain concessions.
The financial health of a Supplier is important to any procurement situation. The larger the contract, the more critical the purchase, or the longer term of the agreement, the more important it becomes. The reasons for that are simple. The better the Supplier’s financial health, the more likely you will be able to reduce cost. Financially stable Suppliers will provide committed or improved performance, and have predictable deliveries and performance. You have to invest significantly less time and effort managing financially stable suppliers and using stable supplier should need fewer requirements to manage against performance risks. For example, with a Supplier that is financially unstable, as protection you might need to negotiate licenses and escrow in the event the Supplier starts to fail financially. You might dual source the item, which will cost more because volumes are not maximized and because instead of having to manage one Supplier you need to manage two.
The best Suppliers will be profitable and will have sound fiscal management. By reviewing the Suppliers financial statements it allows you to ask questions or learn information that will also be useful in the negotiation. So like other aspect of prequalification you need to not just look at whether or not they will be qualified but you should also be considering the impact to your cost and be looking for information that you can use in your negotiation. For example a high “days sales in accounts receivable ratio” can mean one of two things: either customers are not paying them on time possibly because they are encountering problems with the product or service or the Supplier is extending longer credit terms to get sales. You should find out why.
To analyze the financial health of a Supplier requires several steps.
- Get and review the Suppliers financial statements
- Calculate the 14 business ratios* and compare them against the best in their industry and location.
- Do a credit check on the Supplier using a company similar to Dunn & Bradstreet.
For financial statements here is what you might request
1. A fully audited, unqualified financial statement as of the end of the last fiscal year, CPA prepared.
2. Unaudited interim financial statements
3. The opinion letter from the CPA.
4. Balance Sheet
5. Income statement (P&L)
6. Notes to the financial statement
Exhibits referred to in the financial statement such as sources and use of funds, any noted change in financial position, major work in progress may also be helpful
You want the financial statements to be audited. The external auditor
1. provides safeguards that they were done by a professional CPA,
2. provide an external view of the company
3. they will do enough of an audit of the financial statements that were prepared by Company management to determine the fairness of the financial statements as accurately representing the company
4. will provide a report that is fair and consistent.
The auditors opinion can disclose certain things that may have an impact on the financial stability of the Supplier such as a change in the method of accounting.
If you don’t know your way around financial statements one on the best things to read is a booklet prepared by Merrill Lynch entitled “How To Read a Financial Statement”. That can be found on-line at: www.ml.com/media/14069.pdf
Most financial statements of publicly traded companies can be found on line at the Supplier’s websites. U.S. Corporations also file much more robust financial reports called 10-K’s with the Security Exchange Commission and many of them will post their 10-K’s as part of their financial information on their website.
The 14 key ratios look at three things, solvency, efficiency, and profitability. What is considered to be strong ratios will vary based upon the specific commodity being purchased and geographical location of the Supplier. Dunn & Bradstreet annually publishes “Industry Norms and Key Business Ratios” for one hundred and twenty five lines of Business, but you could also compare the rations of the Supplier you are qualifying against the ratios of a strong supplier in the same commodity and geography to see how they rate.
For training on the 14 Key Business ratios you can go to the Dunn & Bradstreet site where all of the business ratios are explained at:
Here’s a quick summary of the ratios and how you may use them.
- The quick ratio (cash and accounts receivable ÷ total current liabilities) show the dollars of liquid assets available to cover current liabilities. A ration of 1 or less means the Supplier has a need for cash.
- The current ratio (total current assets ÷ current liabilities) shows how much safety they have in meeting current liabilities. A ratio of one or less means the Supplier has a need for cash.
- The current liabilities to net worth ratio ( total current liabilities ÷ net worth) measures the net worth of the company. The small the net worth and the larger the liabilities the greater the risk in dealing with the Supplier.
- The current liabilities to inventory ratio ( total current liabilities ÷ inventory) tells how much a company relies on sales of inventory to meet debt. The more they need to sell inventory to meet their debt, the more they should need your business which provides leverage in the negotiation.
- The total liabilities to net worth ratio (total liabilities ÷ net worth) is a sign if the indebtedness in comparison to what was invested in the company by its owners. The higher the ratio the less the owners have at risk.
- The fixed assets to net worth ration (fixed assets ÷ net worth) describe how capital intense a Business is. If a Supplier has a lower ratio that the best in class Supplier you would want to understand why. If much of the work outsourced? If their equipment old and depreciated? Do they lease rather than own their property?
- The inventory turnover ratio (sales ÷ inventory) shows how quickly inventory is being sold. The worse the ratio means one of two things. Either they have inventory that they need to sell, which provides leverage for the negotiation, or they have significant excess or obsolete inventory that they have not written down. Find out which.
- The assets to sales ratio (Total assets ÷ sales) shows how much in assets were required to generate sales. The higher this ratio the more their price will be heavily influenced by the need to depreciate those assets which are fixed costs.
- The sales to net working capital ratio looks at the efficiency of being able to use the working capital (Current Assets less Current Liabilities) to generate sales. ( sales ÷ net working capital). The more efficient a supplier is in doing this the less likely they may be to rush to discount to make the sale as they may not need the cash to support current liabilities.
- The accounts payable to sales ratio (accounts payable ÷ sales) measures how much of the money to generate sales is through suppliers. If you multiply the ratio by 365 it also provides you with the average number of days the Supplier is paying its suppliers. This can be useful in negotiating payment terms for example its not much of a concession to give you 60 day payment terms if they aren’t paying their Suppliers in 60 or greater days. The ratio can also be an indicator of health of the subcontractor relationships or potential problems with Subcontractors. For any extended periods ask why?
- The return on sales or profit margin ratio (Net profit after taxes ÷ Sales) measure the efficiency of the supplier. It also tell you the average profit margin they have been making for use in negotiating the type of profit margin on your business. Its an anchor against which they would need to justify why they need to make more.
- The return on assets ratio (net profit after taxes ÷ total assets) indicates how profitable the supplier is based upon the invested assets.
- The return on net worth ratio (Net Profit after taxes ÷ Net worth) shows how profitable a company is based on the money invested into the Supplier
- The collection period ratio ( accounts receivable ÷ sales X 365) provides the average number of days before payment is made. A long collection period ratio can mean two things. One is the Supplier is offering extended payment terms or there are problems with customers paying on time which can be a symptom of either their customer base (taking riskier sales to make the sale) or it can be a problem with their product or service where the customer is withholding payment while it is being corrected. Ask why?
· If they are taking riskier Customers to get business look for better pricing for dealing with you company.
· If they are provided extended payment terms to other customers look for the same or ask for a discount to pay in shorter periods.
· If its because of problems, understand what it is and what they are doing to make sure you won’t have the same problem
I can remember doing the ratios with a Construction Contractor that I had been asked to pre-qualify to do some major construction programs for the company I was working for. The one ratio that I found that was completely out of line was their accounts payable to sales ratio. In looking at that in conjunction with their balance sheet what I found was the Supplier was making significant interest off short term investments with the cash for those investments effectively being funded by the fact that many of their payables to their Subcontractors were significantly aging. This meant several things. First in any bids to us with this Supplier the subcontractors would most likely inflate their bids knowing the way the Supplier operated to cover the cost of money while they waited to get paid, so it would cost us more. It also meant that with Subcontractors not getting paid on a timely manner, it would create a bigger potential risk of having problems with the Subcontractors looking for ways to be more profitable by either cutting corners or looking for change order to increase their contract value. The practice also would require is to require a payment bond as protection against them not paying the Subcontractor and the Subcontractor filing liens against the facilities. That payment bond would add to the cost of the construction. My recommendation was to not use the Contractor simply because their scheme to make short term profits off the money they owed the Subcontractors was going to cost us in several ways and create more issues during the construction. Most Subcontractors in the area liked working for us because in lieu of payment bonds, we required the Suppliers to provide a waiver and release of liens from all Subcontractors for their portion of the prior month’s payment and that process helped ensure that they would get paid on time so they wanted our business. That was also one of the things the Contractor didn’t like about our terms. They had their way of doing business and in the end it wasn’t compatible with the way we wanted to do business.
One of the most common problems with performing financial analysis of Suppliers is when they are privately held and are simply unwilling to disclose their financial information. When faced with that my approach has been to offer them three choices 1. They can disclose under confidentiality agreement. 2. We will provide them with certain ratios that we need them to have their Certified Public Accountant certify that they are better than all of the individual ratios provided. 3. We will either not source from them or will give them very limited business as we can’t verify the risk.
The credit check that would be done with a Company like Dunn & Bradstreet is the last step in the process. Fully audited financial statements are only done once a year and there can be significant changes that have occurred since the last statement. So what a D&B report does is capture the current payment performance history of companies as that can be a key indicator of a problem. For example a Supplier whose payment history has significantly gone past due or well past due can be a sign of problems. Just like with the ratios, if you see this occurring always ask why. There could be an acceptable reason for it, like having a force majeure or strike that impacted cash flow, or it could be a sign of the lack of orders and revenue to meet current liabilities.
The Privity doctrine simply means that for a person or entity to have a legal right to contract benefits, they must be a party to the Contract. Even if you are the intended beneficiary of the contract you would still not be able to legally enforce the contract as you were not a party to the contract.
There are several exceptions to the requirement that there be privity of contract to be able to enforce the contract. If a contract is formally assigned to another party, that party would be able to enforce the contract even though they were not an original party to the agreement. The second exception is when the parties to the contract agree to name a third party as a “third party beneficiary” to the contract. A third exception would be if the party separately agreed to allow direct enforcement.
For example, if the Buyer negotiates a Contract with a Supplier and then wants a third party such as an Outsource Supplier to be able to purchase from the Supplier at Buyer’s terms, on its own the Outsource Supplier has no right to do so. They do not have privity of contract with the Supplier.
If the Outsource Supplier were to purchase the products from the Supplier under their own Contract, the Buyer would not have privity of contract on those purchases. Those transactions did not occur under Buyer's contract.
With outsourcing you may need to have Outsource Suppliers make purchases on your behalf, to deal with this there are several approaches.
One approach is to have the Supplier agree to extend the Buyer’s terms to the Outsource Supplier and agree that the Buyer will be a “third party beneficiary” to those purchases. If the Supplier failed to extend the terms to the Outsource Supplier, they have breached the Contract with the Buyer and would be subject to damages. If they have extended the terms to the Outsource Supplier, then both the Buyer and Supplier have the right to enforce the contract as they both have privity of contract. The Outsource Supplier would have the rights as they are a direct party to their agreement with the Supplier and the Buyer would have privity by being named a third party beneficiary in that agreement.
Another approach has the Supplier directly agree with the Buyer that the Buyer may enforce the terms and conditions of the Buyer's Contract with the Supplier on purchases made by the Outsource Supplier on behalf of the Buyer. This makes the Buyer a form of third party beneficiary to those purchases. You would use this approach when either the Buyer or Supplier do not want to disclose to the Outsource Supplier the terms of Buyer's agreement with the Supplier.
If an Outsource Supplier will be involved in the transactions where they will be buying the product or services on your behalf as part of an outsourced arrangement, the reasons why you may want to have privity and be able to enforce the contract directly is your Outsource Supplier may not want to invest the time or expense to enforce the contract on their own, or the Outsource Supplier and the Supplier may have an existing relationship where they simply may not want to sue the third party. Being a third party beneficiary allows you to directly enforce the agreement event if the Outsource Supplier won't.
The alternative to being a third party beneficiary is to make the Outsource Supplier fully responsible for the Supplier under the Outsource Supplier's contract with the Buyer. Outsource Supplier's may be reluctant to agree to that especially if you are telling them the Suppliers you want them to use. Before agreeing to be fully responsible the Supplier would want to make sure that the Supplier has agreed to a flow down of all the terms the Outsource Supplier must agree to with the Buyer and the Supplier has the assets and resources to stand behind the commitments. If the don't the Supplier would still be liable to the Buyer.