Tuesday, March 1, 2011
Cost is based upon the simple formula of rate times demand. To reduce your costs requires reducing the rate for the item, reducing the demand, or both. For example, if you wanted to reduce your cost of electricity, you need to reduce the price per kilowatt that you pay for the electricity or, you need to reduce the demand. If you focus only on reducing the rate, you are addressing only a portion of the cost reduction opportunity. It’s important to understand what drives your demand to see if there are opportunities to make changes that reduce the demand as demand drives cost.
For example, a high number of defective products will drive demand for a number of things. It can require more quality management such as incurring inspection costs. It will drive a higher demand for spare parts and finished goods inventory.
It will drive more time to manage it. It will drive more effort and cost to manage returns, etc. Managing this type of demand usually requires several things. One is contract terms that transfer some of the costs of that increased demand back to the Supplier and an approach such as "Six Sigma" to force the Supplier to define, measure, and analyze the defects to understand what is creating them. Six Sigma requires you to take steps to simplify and improve the process to reduce the number of defects. Finally it requires that you have the discipline in place to keep the process under control. By working a six-sigma program to eliminate the defect you are also, at the same time, taking steps to reduce the demand for those things that the defects caused.
Supply chain management is also another example of managing demand. In most supply chain management decisions, the goal is to increase the velocity of the supply chain while reducing demand for inventory at each stocking point and reducing demand for the supply chain pipeline distribution costs. The cost and complexity of a supply chain is driven by the geography of where the item is sourced, where it is produced, where it is inventoried and where it is delivered. The cost and complexity of the supply chain is further driven by the level of production or value added that is performed at each location. Inventory levels in a supply chain are driven supplier lead-times, raw material transit times, production times, inter-plant transit times, production and distribution locations, and by the customer service levels and committed lead-times. Distribution costs are driven by the number of locations in the supply chain. It’s also driven the velocity required (which dictates the method of shipping). The most expensive supply chain is one that has multiple sub-level production locations together with an immediate availability requirement for shipment.
Demand may also impacted by a number of other business factors such as the business model and goals, metrics and rewards of all individuals and groups involved. Items such as the skill level of the individuals or a company’s personnel turnover rate are clear factors which drive demand. The character of suppliers and their performance will drive certain types of demand.
Service requirements, such as frequency of an activity, also have a huge impact on the demand and your costs. Something as simple as custodial cleaning has its cost driven by the both the tasks to be performed and the frequency. The tasks and frequency are often impacted by the design. Some designs, materials and colors require more care than others. So part of managing demand can require designs be selected with potential demand life cycle cost factors in mind.
Managing Demand means managing all of the different factors that can ultimately drive up the total cost of the service or total cost of the relationship. For each area of spending it’s important to understand what is driving both costs and demand. Once you know what is driving your costs and your demand you can take the necessary steps make the necessary changes required to reduce either your cost or demand or both.
Here is an example of managing demand that shows that managing demand applies to many things.
I worked for a Bank and a procurement group was negotiating an agreement of network services for use by customers of multiple businesses within the bank. Because of delays that had occurred I was asked to bring closure to the agreement. During that process I seriously questioned the bank’s ability to control the cost of this service. My concern wasn’t the ability to manage the rate, it was the ability to manage the demand.
The cost to the bank was based on:
· The method of access (dial-up or internet)
· The infrastructure required to operate it.
· The rate for the utility times the usage when dial up was used.
· The banking functions being used by the customer as that drove the average time of use.
From my understanding of the application and services, I was very concerned with the Bank’s ability to manage the demand for the dial-up service and strongly advocated an Internet only solution. As customer’s had been previously provided with Dial-up access, the Management Team was extremely reluctant to take away that part of the offering. The time was critical as were about to launch a number of new offerings.
To convince them I needed highlight how demand could be managed, where they stood in terms of being able to manage it and the potential risks if demand wasn’t managed.
I determined that the following factors would need to be managed to manage demand::
· Managing the access channel (Dial up or Internet).
· Managing the speed by which the customer could enter and use the site to accomplish their needs.
· Managing the infrastructure to ensure up-time, availability and performance.
· Making sure the system was reliable.
· Controlling abuse by the customer (include automatic time outs from in-activity).
· Managing the design of the infrastructure (lines, mix, redundancy, customer satisfaction goals (response, wait, connection times).
· Managing the amount and breadth of the content and activities offered.
· Manage how the system could be used and the managing potential that use may not provide any benefit to the Bank. For example we were about to offer and investment application and I was concerned with dial up customers using the Bank for investment research, but have their trading done elsewhere where we paid for the access but saw no benefit.
Of the list there were some items they knew they didn’t want to manage like the breadth of the content. They wanted that to grow. They also knew that there were some they could manage like having a reliable system so the customer wouldn’t need to access the system multiple time to accomplish their transaction. There were clearly some that they knew they couldn’t manage.
The one thing that they could manage that had the most impact to the cost was method of access.
· With dial up there was an access cost that would be a major driver in the cost.
· With internet only use, access demand didn’t drive an access cost.
With both you had the cost of the infrastructure to manage it. I also highlighted that both offerings under development and planned expanded offerings would increase the urgency to manage demand.
In the end they elected to totally eliminate the higher cost dial up channel and offer only an Internet only based solution. They also took significant steps to manage demand by simplifying the customer interface, reducing the graphics and downloading time, etc. as while those may not have drive access cost they would drive infrastructure costs or customer satisfaction issues.
To effectively manage cost you need to understand what is driving both your cost and your demand. I also knew that it would be a lot it easier to reduce the cost by managing the demand than it would be to reduce the cost of the purchased service. That highly price sensitive to differences in demand unless differences were huge.
If you do reading about Supplier Scorecards most of the time the authors will talk about the roles in evaluating performance and using them to improve performance. My opinion is that Supplier scorecards real value scorecards is in their potential use:
- If your collect and retain the information from the scorecard for use by others in your company, the scorecard should help others from making the same mistake in hiring a problem Supplier over and over again.
- The scorecard should be used to drive performance during the term of the agreement.
- If you have objectively measureable performance levels, they should be contractually linked to additional commitments or remedies.
- Scorecards should be used in subsequent negotiations to either:
- Get contractual assurances that there will be improvements in performance to committed levels or
- Used to reduce the price you pay the Supplier because of the cost their performance is causing you.
The most difficult thing in contractually linking performance to additional commitments and remedies falls in three areas:
- What levels of performance are unacceptable, acceptable, or superior?
- How do you come up with timely, credible, objective measurements?
- If commitments or remedies are tied to an overall score, what are the items that will be measured and what is the weighting?
Traditional measurements that can be timely, credible and objective are things such as late delivery, order accuracy quality and meeting cost or cost reduction commitments. Slightly less objective are most customer satisfaction measurements such as overall responsiveness, response to changes or problems, management oversight required, customer support provided. Overall management ratings tend to also be slightly less objective and would include management processes and problems such production control, MRP, 6 sigma implementation and use and complexity of customer facing systems and processes,
At the end of the day all Supplier caused problems wind up costing the Buyer and provide no added value. Scorecard processes are needed to not just highlight the Supplier’s performance but to also remind them of the cost of doing business with them. You use them to remind the Supplier that if they want to either retain the business they have or be considered for new business, they need to change. They other message all of the costs they have created will be take into account in awarding new business, so if they don’t change they will need to price their product or service that much lower than their competition to offset the difference.
I can remember the first time we implemented scorecards at one of my previous employers. There was significant reluctance on the part of the Suppliers. Some readily accepted it and started to work on improvement and some didn’t and spent most of their time arguing over whether the numbers were real and whether the measurements were objective or not. When we implemented the program we told all Suppliers that the scorecard measurements would be one of the criteria we used in awarding future business. When some long term suppliers didn’t get any business, or had their business dramatically reduced, they all complained. Our simple response was they were the ones that made the decision. We told them what we would do. We told them what was important. They opted not to take the necessary actions and they were now feeling the result of their decisions. They were costing us money, and their price wasn’t low enough to competitively offset the difference from Suppliers who were meeting all the commitments.
If your company uses Supplier Scorecards, make sure you read them as preparation for preparing your contract or amendment and for your your negotiation. Identify any problem areas that need to be corrected and address those as commitments in your new agreement or make them conditions of any new award and include them in the amendment to add new business to an existing agreement. If they
won't agree to them and you have other sources use that to negotiate a better price or buy from the alternative source.