Procurement has strategic significance in almost every industry, but rarely has sufficient stature in firms. Every value activity employs purchased inputs of some kind, ranging from raw materials used in component fabrication to professional services, office space, and capital goods. Purchased inputs divide into purchased operating inputs and purchased assets. The total cost of purchased inputs as a percentage of firm value provides an important indicator of the strategic significance of procurement. In many industries, the total cost of purchased inputs is a very large percentage of value, yet it receives much less attention than reducing labor costs.
The cost of purchased inputs is an integral part of the cost of a value activity, and the cost drivers described above determine the behavior of input costs. However, isolating purchased inputs for separate analysis will often yield additional insights into cost behavior. The cost of purchased inputs in an activity is a function of three factors: their unit cost, their rate of utilization in an activity, and their indirect effects on other activities through linkages. While utilization of inputs in an activity and linkages with other activities are best analyzed as part of the overall cost behavior of an activity, the unit cost of purchased inputs often has similar drivers across activities. Firmwide procurement practices also affect the unit cost of many inputs. Thus a firm can gain insight into how to lower unit cost by analyzing the unit cost of purchased inputs as a group.
In separating the unit cost of purchased inputs for analysis, however, a firm must recognize all three factors noted above. Better quality steel may improve the yield of a forging operation, as well as simplify machining. In some instances, then, a firm may lower total cost by spending more on purchased inputs. Minimizing the unit cost of purchased inputs is not necessarily appropriate. However, it is still clearly desirable to seek the best possible unit cost for purchased inputs after choosing the appropriate type and quality of inputs.
Firms’ analyses of purchasing typically focus on the most visible items, especially raw materials and components. However, purchased inputs other than raw materials and components, when aggregated, often constitute an even greater percentage of cost. Standard cost systems often distribute the costs of such inputs among many cost categories rather than highlighting their importance. Purchased services such as maintenance or professional services are often overlooked in purchasing analyses, while purchases from sister units seldom receive the level of examination that is applied to outside purchases. Finally, purchased assets are frequently bought outside the normal procurement system and without the associated expertise. A comprehensive analysis of the unit cost of purchased inputs can be an important tool in gaining cost advantage.
1. PURCHASING INFORMATION
The starting point in analyzing the unit cost of purchased inputs is to develop purchasing information. A firm should begin by identifying all significant purchased inputs and determining its yearly or quar-terly expenditures on them. The list should include inputs purchased from sister business units. For purchased operating inputs, usage per period represents a relatively easy means of calculating cost. This analysis, however, must account for prepayments, discounts, and inventory changes. For purchased assets, total purchase price can be used as a measure of cost, adjusted for supplier concessions such as free service, free spare parts, or low-cost financing.
All significant purchased inputs should be identified, and listed in the order of importance to total cost. They should then be divided into purchased operating inputs and purchased assets and, within these categories, into items purchased regularly such as raw materials and office space, and irregularly purchased items such as equipment and consulting. Categorizing purchased inputs in this way can direct attention to areas where opportunities for cost reduction are frequently present. Small purchased inputs often provide fruitful opportunities for cost reduction. Managers tend to focus their attention on those few purchases that represent a significant percentage of costs. As a result, suppliers frequently generate their highest margins on purchases that represent a small cost item to the buyer. Irregularly purchased inputs frequently receive inadequate attention as well, while regular purchases are monitored and most firms have procedures to govern them. A firm should also compute the change in the inflation-adjusted cost of each input over time. Such a calculation further highlights those inputs that should be scrutinized. An increase in the real unit cost of an input may indicate that a firm has either paid inadequate attention to controlling cost or that supplier bargaining power has grown.
After sorting purchased inputs by size, regularity of purchase and real cost change, a firm should then identify where it makes the purchasing decision. Authority for many purchases rests outside the purchasing department. Yet the purchasing department is the place where procedures, procurement expertise, systems for tracking the costs of purchases, and the mandate to manage cost reside. Although the de facto delegation of procurement authority to other parts of a firm is often a practical necessity, it tends to obscure the cost of many purchased inputs and can lead to less efficient procurement unless the firm applies the same care as it does in the purchasing department.
A final step in developing information about purchased inputs is to record the suppliers for each item and the proportion of purchases awarded to each supplier over an ordering cycle. The number and mix of suppliers will play an important role in determining the cost of purchased inputs. A firm must also systematically track potential suppliers that it does not currently purchase from. This will ensure that alternative suppliers are regularly considered and that a firm can gain perspective on the performance of its own suppliers. Often a simple list of suppliers for each input will lead to some interesting conclusions. For example, single-sourced items may represent a significant fraction of total purchases. Unless special circumstances are present, single sourcing is an indication that suppliers have created switching costs and that unit costs of inputs may be unnecessarily high.
2. DRIVERS OF PURCHASED INPUT COSTS
The same cost drivers identified above shape the cost behavior of purchased inputs, in combination with the bargaining relationship between the firm and suppliers that grows out of industry structure. The structural bargaining relationship reflects the broader industry determinants of supplier margin, while the cost drivers address how a firm’s specific circumstances can influence it. While a firm must expect to pay suppliers higher margins on some imputs for these structural reasons, the cost of all inputs can be reduced by controlling the drivers. Some drivers have similar effects on the cost of many purchased inputs, and Table 3-3 summarizes some of the most important ones. For each purchased input, position vis-à-vis the drivers will determine the unit cost of purchased inputs of a given quality.
As discussed in Chapter 2, a firm should seek to coordinate or jointly optimize supplier linkages to lower overall costs in addition to create bargaining power with its suppliers. Effective communication with suppliers is necessary to achieve linkages. Ideally, a firm can exploit the available linkages and capture its share of their benefits by exercising its bargaining power. Procurement policies have an important role in both harnessing supplier linkages and improving a firm’s bargaining power.
3. SUPPLIER COST BEHAVIOR AND THE COST OF INPUTS
The cost behavior of suppliers will have an important influence on both the cost of inputs and the ability of a firm to exploit supplier linkages. Suppliers of a given purchased input will often vary in relative cost position, and identifying the lowest cost source may lead to lower unit purchasing costs in the long term if the firm can exercise its bargaining power. Supplier cost behavior will determine whether placing larger orders will lower suppliers’ cost. Supplier cost behavior will also determine the impact on suppliers’ cost of other practices a Arm adopts or asks its suppliers to adopt. Supplier cost behavior is analyzed in the same way as a firm’s cost behavior. Understanding the cost behavior of key suppliers will thus allow a firm to establish better purchasing policies as well as to recognize and exploit linkages.
Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.