Friday, February 17, 2012

Can you use Six Sigma Methods with Contracts and Contracting?

Six Sigma projects follow two methodologies The DMAIC methodology is the approach that would be use to improve both contracts and contract processes as it is focused on improving an existing business process. DMAIC methodology has five phases that make up the acronym.

Define the problem and the goals
Measure the current process and collect relevant data.
Analyze the data to find verify cause-and-effect relationships. Seek out the root cause of problems.
Improve the current process based upon analyzing the data analysis and implement
Control the future process to avoid deviations and monitor progress.

While there are many tools that may be used, the primary ones that I think apply are

1. The five whys. The “five whys” was invented by Toyota to understand the root cause of a problem. You first start with a statement of a problem and keep asking why until you understand the root cause of the problem. I think 5 may have been a common number, the key is you need to keep asking why until you find the root cause of the problem and sometimes why that root cause exists. Borrowing from an example in Wikipedia here is and example of the 5 whys.
The vehicle will not start. This is the problem that you need to correct.
Why won’t the vehicle start? - The battery is dead. (first why)
Why is the battery dead? The alternator is not functioning. (second why)
Why is the alternator not functioning? The alternator belt has broken. (third why)
Why is the belt broken? - It was old and not been replaced. (fourth why)
Why was the belt not replaced? (fifth why)
a)The vehicle was not maintained according to the recommended service schedule.
b)Replacement parts are not available because of the extreme age of the vehicle.
If the answer was a) the next why would be: Why was the service schedule not followed? That would identify the root cause or the problem.
If the answer was b) that would be the root cause which would then lead to a discussion about what can be done to solve the problem.

You could use the “five whys” to question whether certain contract terms are needed or whether they actually match the way the business is being conducted.

2. Business process mapping. Business process mapping documents all the steps that you do in performing each task. When you map business processes you can identify dependencies between steps, deliverables that must be provided, what processes can be done in parallel and which need to be done serially. You can also look at the business processes for duplication, consider them from a value added perspective and look at where control points are or should be. Business process remapping is an activity that is frequently used in re-engineering activities to eliminate redundancies and low value added activities and reduce cost.

You could use business process mapping to analyze all the steps in your contracting process to do things like understand whether the steps are needed, whether there is redundant activity or to see whether the value added from the steps are worth the investment of time and resources to perform.

3. Cause and effect or fishbone diagrams that are also called Ishikawa diagrams. In this activity at everything from the perspective of what caused you to do something and the effect that has. Causes could come from a number of sources and part of this activity could be to consider whether what caused something to be done and the affect that has still applies. I wrote a separate blog about cost drivers which are things that drive costs in relationships. There are also causes that can have a huge impact on your contracts or contract negotiations because of the activities they drive. A manager or group may require something to be done without fully understanding the impact or cost of meeting that or the real value that it will provide. If they become aware of the affect and the cost, the value from that may not warrant the expenditure or complexity it drives. Within companies the sales terms and risks a company accepts in their sales terms will have an effect on what procurement contract terms are needed to support those sales. Cause and effect is everywhere and almost every cause has an effect and those effects have costs associated with them.

Using these three simple tools individuals that do contracting can work to solve problems with their contracts or contract management. They can be used simplify contracts and contracting processes. They can be used to potentially simplify negotiations. Let me give you a few examples of what I mean.

Contract Templates.
Many companies have standard contract templates. Every time a new activity, program or problem occurs there is usually a rush to address the new activity or program or to solve the problem. The problem is that business continually continues to evolve and change, so how you managed things in the past that drove what you did and how you did it, may not be what’s needed today. In fact what you have may no longer be needed as the activity or program may have come and gone. The problem may have been a single or point in time occurrence. You simply may not be having the same problem as your business model or approaches to doing business may have changed. Everything that doesn’t match how you are doing business today provides no value and adds to the time and complexity to your negotiation.
Not matching the business model also leaves potential gaps or problems that could occur in the future or as I refer to it create “an accident looking for a place to happen.” Everything included in your contracts that were driven by an activity or program may either be too costly for the value it provides or it may no longer be needed. Leaving those in your contract can be driving costs to your supplier that increases your cost. Leaving them in also adds more time and complexity to your negotiations. Suppliers constantly improve or they shouldn’t be your supplier long. This means that problems you may have had in the past may no longer exist. If they don’t exist, why do you need terms in place to manage them?

Buying approach affect on terms.
A change in your buying approach will significantly change what you need. When you outsource manufacturing and have the contract manufacturer perform procurement on your behalf what is needed in contracts changes. You can have the contract manufacturer manage all that under their agreements with suppliers. If suppliers will agree to it, you could have the contract manufacturer purchase off your agreements. If the suppliers won’t allow that you may need an alternative model in effect where the Supplier will sell to the CM at your pricing but under the supplier’s standard terms and still have an agreement in effect with the supplier so you can enforce certain key terms directly against them on CM purchases. This would be especially true if the supplier provides you with terms that they wouldn’t provide to the CM. As you can see, each approach has different contract needs. If they will do it all under their agreement, you would no long need to have agreements with the suppliers. If they purchase against your contracts it would be business as usual and they only thing you would need to address is that specific activity. If you had a mix where the CM did the purchasing but you retained certain commitments you need to be able to enforce directly with the supplier, you clearly need those terms, but you would no longer need many of the terms you would traditionally need if you were doing the purchasing. The circumstances no longer require it. Leaving terms you don’t need or won’t use in a template means you are wasting time negotiating for things you don’t need and won’t use. You may also be adding costs to the supplier for benefits you simply don’t get. It can also be including thing in your contract that you will get audited for compliance against even though you no longer use them. Things like outsourcing require that you take a hard look the terms you use.

Impact of goals.
I worked for a company where a major goal was to drive payment terms to 60 days. It was a measurement that was tracked and reported frequently with great management interest. We had a large number of suppliers who would sell directly to CM’s at our price but not with our terms. Since management had the goal of 60 days to meet those goals we had to negotiate 60 day payment terms with all suppliers, even the ones that we were no longer were purchasing directly from and even though those terms would not be extended to the CM’s. Extending paying terms is a credit worthiness decision and many suppliers didn’t feel the CM’s financials warranted extending that much credit. We also included 60 day payment terms in the CM agreements to meet the 60 day goal. What that meant since CM’s were not getting those terms from some of the suppliers it added to their cost. On suppliers where they had more leverage they were paying those suppliers in terms longer than 60 days. Those suppliers undoubtedly would take that additional cost and reflect that in their prices to the CM. The CM would wing up making more money as part of their compensation (overhead and profit) was based on percentages of the cost of the materials they purchased. If you ever did a six-sigma audit on the real benefits that the requirement for 60 day payment terms actually provided the results would have been interesting. On paper it may have looked good. In reality it probably added to the cost of the purchases.

Six sigma is a quality management tool. In contracting quality means that you have contracts that are effective and match the way you are doing business. It means that contracts are current and don’t include out of date or unnecessary requirements that add cost or unneeded complexity. Quality in contracts further means that your terms are managing costs, risks or programs that are real.

Thoughts on Negotiating Supplier Managed Inventory, Pull’s, Pull Liability

Supplier managed inventory or VMI programs are where the Supplier stocks product at certain agreed locations for the Buyer to pull the products when needed for their use.

Standard Buyer purchase templates usually need to be modified to implement these programs:
•Instead of ordering, the Buyer Provides forecasts.
•Instead of having delivery at the Supplier’s dock, delivery occurs when the product is pulled from the Hub.
•Instead of the inventory needed for production being held by the Buyer, it’s held by the Supplier.
•The Supplier’s ability to get paid is based not when it left its dock, but when it was actually pulled.
•The warranty period for the product that traditionally would be measured from when the Supplier ships it, needs to be measured differently based on when it was pulled or the lag time it will spend in transit and in the Hub needs to be built into the warranty.
•Because the Supplier is responsible to get it to the Hub, all shipping costs and risk of loss transfer to the Supplier.
•If a third party manages the Hub, additional issues of insurance and risk of loss at the Hub come into play.

Since the Buyer isn’t actually purchasing the product until the pull, Suppliers also are concerned with:
•Liability for custom product in the event of a termination of the program
•Obsolescence of a product
•The impact major reductions in volumes of consumption may have on the inventory levels
•The accuracy of Buyer’s forecasts
•Their ability and costs to do re-balancing of inventory for standard products.

Most of these negotiations will focus on these issues and the extent and nature of the product profile (Items held, quantity), but especially Buyer’s liability when pulls simply do not happen as they were forecasted.