Monday, November 14, 2011

The Good, The Bad and The Ugly of Cost Savings Programs

The Good, the Bad and the Ugly of Cost Savings Programs

Most procurement groups have goals or targets they need to meet for cost savings. I thought I would write a post about what I consider to be the advantages and disadvantages of such programs.

Let me start by saying that I’ve worked for companies who year after year would report significant cost savings. In fact over time if you added all the cost savings up the suppliers should have been paying the buyer to take the product. That simply did not happen in fact the suppliers still made a profit. How did this occur? I think it all goes back to the fact that most products have a limited life cycle. During the term of a product’s life most products also have a price curve (see Price Curves post). In the introduction of a new product with new features, functionality or improved performance
where there is little or no competition the price always starts high, is driven down by competition, and usually goes up toward the end of its life as competitors exit that market. Supplier’s end of life products when they have replacement products with those
new features, functionality or performance. This means that the prices that the buyer worked so hard to reduce the cost of are no longer available and they need to start the
process over again with the replacement product.

The Good/
What’s good about cost savings programs? It places a clear focus on reducing cost. It eliminates complacency. I remember a commodity manager who reported to his manager that for that year he couldn’t drive any savings. The manager simply replied
“then what do I need you for.” The message was sent and savings were found. It can drive reductions in price because of that focus. Those savings can also do good things. For the internal customer it can expand their budget or allow them to lower their price or simply make more money. For the company it can generate additional cash to make investments. For procurement the programs can help drive you to find new, lower cost suppliers that can meet your requirements

The Bad
What’s bad about cost savings programs? Any metric that people get measured against
will drive the individual’s behavior. If all you measure is reductions in price the individuals may be assuming more costs or risks in dealing with suppliers, more costs or risks in terms, or more total life cycle costs simply to generate price reductions. I’ve never seen a cost savings program where the results were measured against the total life cycle of a purchase. The second thing that is bad about cost savings programs is suppliers that know about your program will plan for and manage that to their advantages. If a supplier knows that every year you will come back to them seeking to further reduce the price, do you think they will take that into account in their initial product pricing and in any reductions they give? Suppliers manage their pricing (See Pricing - How Suppliers manage their pricing). With the exception of commodities that are highly volatile, suppliers know what their costs will be. They know how much they can save from volume, learning curves, liquidation of investments, etc. If they know you will be back next year for more savings, do you think they are going to give you the best price today? Will they hold some in reserve for next year? I think they do.
The other area where cost savings is bad is when you have multiple suppliers for an item. Assume you have three qualified suppliers. At the time of award all suppliers prices are competitive. Supplier A you have a contract with that meets all your requirements. You plan to give Supplier A 60% of your business as that’s equal to their available capacity Supplier B you have a contract with but it has certain additional costs or risks that Supplier A. You plan to give Supplier B 30%. Supplier C has refused to come to agreement on certain terms but they have a product that is qualified. You need to keep them in the event you have a problem with either A or B. You plan to give Supplier C 10%. During the course of the year either Supplier B or Supplier C approaches you and offers you a price reduction of they get a larger percentage of the business. Do you give them more so you can meet your cost savings goal, or do you stick with the original percentages. If a supplier knows that they can not agree to your terms and increase the amount of business by simply giving you a lower price, what impact does that have on your contract negotiations with them? I’ve seen this happen too many times. Then a problem occurs whatever the savings was pales in comparison to the losses.

The Ugly
What’s ugly about cost savings programs? The ugly occurs when they buyer that is seeking to reduce cost is simply over their head in terms of knowledge and capability that’s needed to effectively manage what is required to drive savings. One of the best examples of this is sourcing in low cost geographies. For every one company that has been successful in sourcing in low cost geographies, there are probably 10 companies that have horror stories to share. They had problems simply because they didn’t know what they were doing, didn’t want to invest in doing it right, or because they hired and trusted someone that simply didn’t warrant that trust. They may not have realized that contract protection in low costs countries is simply not the same as contract protection at home. They may think that suppliers will respond like the supplier down the street when they don’t. A second great example of ugly is when companies use “Independent Distributors” to generate savings (see Independent Distributors and Brokers post). I’ve personally seen a number of situations where people went to independent distributors and brokers to wind up with counterfeit product that failed in their application where the cost was in the millions and the chances of recovery was slim to none.

If you would like to read about any of the referenced posts go to my wen site click on the tab hot-links to blog and simply scroll down to the title. It;s hot-linked to the blog topic

Subsidiaries and Affiliates & Franchisees

What is the difference between a subsidiary and an an affiliate?

A subsidiary is usually defined by ownership. For example a parent company have wholly owned subsidiaries where they own 100% of all shares in the company. The parent company may also call a company a subsidiary when they own a majority interest in the company. When a company owns less than controlling interest in a company’s shares they company is usually called an affiliate.

In contracts and in dealing with things like company or parent guarantees you should define the term affiliate. In most cases suppliers do not want to be liable for their affiliates as they only have a minority interest in the affiliate. In some cases that may be true, but in other cases you can have situations where the parent company doesn’t have majority interest in a company but they do have control over the affiliate.

Where this was first very common was when you were dealing with Japanese suppliers that were part of a Keiretsu, which is a family of companies that have interlocking ownership. For example you could have five parties 1) Acme Inc, U.S, 2) Acme Ltd, UK, 3) Acme PTE,Singapore, 4) Acme BV
Netherlands, and 5, Acme GMBH Germany.

The Acme Inc. may not own a majority interest in Acme PTE, in fact they may not own any interest directly. They could however have their three subsidiaries have the following ownership in Acme PTE.
Acme LTD = Forty percent (40%)
Acme BV = Thirty percent (30%)
Amen GMBH = Thirty percent (30%)

None of those subsidiaries have controlling interest in Acme PTE. Together they own the company. If there total interest exceeded fifty percent (50%) they would still have controlling interest in Acme PTE..

Since the parent company (Acme Inc,) owned all or had a majority interest in all three subsidiaries that owned or had controlling interest in Acme PTE, it can be argued that Acme Inc.through their ownership of their subsidiaries, and their subsidiaries ownership and control over Acme PTE, Acme Inc has control over the actions of Acme PTE. They control the companies that control that subsidiary. If they have control over the actions of Acme PTE, they should be responsible for the actions of Acme PTE..

Many companies include a definition of an affiliate based upon their ability to exercise control over that affiliate. When you do that, contractually you treat those type of affiliates the same as the supplier’s subsidiaries where you want the same terms and pricing to apply for purchases through those affiliates. You also want the parent company (in our example Acme Inc.) to be responsible for those Affiliates in the same manner they are responsible for their subsidiaries.

If an affiliate company (even one whose name may include the parent company’s name in their company name) doesn’t meet the defined requirements to be an "Affiliate", buyers need to recognize that they are not dealing with the supplier, they are dealing with a completely independent legal entity. If you write a contract with them, the Parent Company is not a parent to them and they will not agree to be responsible for them. That affiliate will be the only company that is standing behind the contract commitments. The sole exception to this would be when the affiliate company is functioning as an authorized reseller of the parent company's products. As with any authorized reseller you should get any warranties or indemnities that the Supplier authorized
them to pass through to the customer.

Someone posted a comment asking me to also address Franchisees. A franchisee is a completely independent legal entity that has a license from the company to operate with the scope of the license grant. The supplier has no legal ownership in the franchisee company. They could have a potential credit relationship with the franchisee. Since they do not have ownership a franchisee
falls into the same class as an affiliate in which the supplier doesn't have control. The supplier will not agree to be responsible for their actions or omissions. Similar to an affiliate, if the franchisees role is strictly as a reseller of the supplier's products the franchisee can only provide you with any warranties or indemnities that the supplier has authorized them to pass through to the customer.

While the supplier may not be contractually responsible for affiliates (meaning companies they do not control) or for franchisees, the supplier would still be potentially liable for any damage or injury caused by their product.

If you learned from this post, think about how much more you could learn from the book.
The book is only US$24.95 plus shipping. The hot-link to is above the date.