Chapter 15 Preparing for partnership with suppliers: cost approaches and techniques

Program How is the purchasing price determined? Pricing methods The learning curve Assessing suppliers Supplier development

How is the purchase price determined? The price ultimately paid for materials and services is the result of environmental factors (internal and external): Internal factors: can bring about a change in the cost of materials before the finished product is placed on the market (logistical, technical or organizational factors). External factors: those factors that change the availability of a product in a given market (economic, socio political or technological factors).

Environmental factors Internal factors External factors Logistics factors Technical factors Socio-political factors Economic factors Organizational factors Technological factors Supplier buyer Black box Trying to raise the price Trying to reduce the price Influences on the price Van Eck et al. (1982)

How is the purchase price determined? Corey (1978) considers prices to be based on three models: Cost-based pricing: The supplier’s offering price is directly derived from his cost price. Market-based pricing: The price of the product is determined on the market and is generated by market circumstances (demand, supply, stock positions, economic factors etc.) Competitive bidding: The price is influenced by market factors as well as cost factors. This situation is most common.

based both on market and cost factors based on market factors Pricing Methods based on cost factors based both on market and cost factors based on market factors purchase product group emphasis on cost factors 50/50 emphasis on market factors Raw materials x Semi-manufactured goods Components Standard Non-standard Finished products MRO Services Van Eck, de Weerd and van Weele (1982)

Pricing Methods Factors suppliers have to take into account to set the selling price: Expected demand Number of competitors Expected development of the cost price per product unit Customer’s order volume Importance of the customer to the supplier Value of the product to the customer

Pricing Methods The following pricing methods can be distinguished: Mark-up pricing, a fixed percentage is put on top of the cost price. Target-return pricing, predetermined total profit per product group. The price depends on the fixed costs and the selling volume. Pricing based on the buyer’s perceived value. Base price on what the market can bear, not on the cost price. Value pricing, high quality offerings for fairly low prices Going rate pricing, based on competitor prices Auction type pricing, tender where the lowest offer is awarded.

Pricing Methods A special characteristic of pricing policies for industrial products is the discount policy: Cash discount: e.g. 2% discount for payments within 10 days Quantity discounts: to stimulate larger quantity orders. Volume bonus: linked to the amounts purchased from a specific supplier for a specific period. Geographical discount: given to customers located near the supplier. Seasonal discount: applied to improve capacity utilization in periods when sales decline. Promotional discount: provided to temporarily stimulate the sale of a product.

supplier's price elasticity. Pricing Methods The following list can help the buyer to gain insight into the supplier’s cost structure: Materials cost: to be itemized according to the major components Direct labor cost: information can be obtained by consulting the collective labor agreements for each particular industry Transportation cost Indirect cost: divided into general management costs and sales costs The higher the share of the fixed costs in the cost price of the end product, the greater the supplier's price elasticity.

The learning curve It was discovered (in American Airline Industry) that the cost price per unit decreased at a fixed percentage as experience increased.. The learning effects result from: Reduced supervision as experience with production grows Increased profits, from improved efficiency through streamlining the process Reduced defects and line reject rates during production Increased batch sizes (less time spent on resetting machines) Improved production equipment (after a while) Improved process control Reduced engineering changes

Cumulative amount produced Required time in hours per unit The learning curve Basic principle Each time the cumulative production volume of a particular item doubles, the average time required to produce that item is approximately x % less of the previously required number of hours. Cumulative amount produced Required time in hours per unit 1000 20 2000 16 4000 12.8 8000 10.24 16000 8.2 80% Learning curve

The learning curve The learning curve is preferably used: When it concerns customized components, manufactured by a supplier at the customer’s specifications When large amounts of money are involved When the buyer cannot request competitive quotations because, e.g., a considerable investment has to be made in moulds and specific production tooling which lead the buyer to single sourcing. When direct labor costs make up an important part of the cost price.

Supplier assessment The need for objective assessment of suppliers increases as the role of the supplier in the business chain grows. Supplier assessment may take place at four different levels: Product level: Focuses on establishing and improving the supplier’s product quality Process level: Not the product, but the supplier’s production process is closely investigated. Quality assurance system level: The entire supplier quality organization is subject of investigation by the customer. Company level: Besides quality aspects also financial aspects are taken into consideration. Also auditors want to get an idea of the quality of management (how competitive is the supplier in the future?)

Supplier assessment Two types of assessment may be differentiated: Subjective methods are used when companies evaluate suppliers through personal judgments. Objective methods attempt to quantify the supplier’s performance. The following techniques and tools can be used (1) Spreadsheets; used to systematically compare and asses quotations obtained from suppliers. Important criteria are listed on one axis and the supplier quotations on the other. Qualitative assessment; used for suppliers with whom exist close business relationships. Specialists who have experience with the suppliers rate them according to a agreed checklist

Supplier assessment Techniques and tools (2): Vendor rating; Limited to quantitative data only. Entails measuring the aspects of price, quality and delivery reliability per supplier. Supplier audit; Entails that the supplier is periodically visited by specialist(s) from the customer. They investigate the production process and quality organization. Cost modeling; Specialist from the buying company estimate, based on the production technology, the cost of the product. This may lead to ‘should cost’ discussions with the supplier.

Supplier assessment Framework for identifying the most important cost drivers: Category Description examples Design Costs attributable to product design trade-offs Materials Product line complexity Facility Costs related to the size of the facility, equipment and process technology employed Facility scale Degree of vertical integration Use of automation Geography Cost associated with the location of the facility relative to the customer Location related wage rate difference Transportation costs to customer Operations Cost that differentiate a well run facility from a poorly run facility Labor productivity Facility utilization Rejection rates Laseter (1998)

Supplier assessment Difference between supplier auditing and vendor rating: Aspect Supplier auditing Vendor rating Orientation Focus on future Based on historical data Application New and current suppliers Current suppliers Nature Mainly qualitative Mainly quantitative Scope Broad, many aspects Limited, few aspects Work Time consuming Standard data Data processing Subjective, manually Factual, computerized Relation with suppliers Co-operation Based on internal administrative data

Supplier development Actions for development of suppliers: Supplier suggestion program: actively ask for suggestions for improvements of suppliers Supplier development, ask questions like: What is going well in the cooperation? What could or must get better? What is needed for improvement? How to measure the improvements? Supplier satisfaction survey, collaborative relationship between business partners requires that expectations between all stakeholders involved are made explicit.

Supplier segmentation BASF Liker et al. (2004)

Conclusions Pricing and cost structures of suppliers are always interrelated, but the effect they have on one another is not always clear. It is crucial to buyers to be able to lift the veil that covers the supplier’s pricing policy Some methods to do so: Closely monitoring the supply market Monitoring individual supplier financial performance Make analysis of supplier’s cost price Monitor developments in the supplier’s performance on price, quality, delivery, etc.