The Cost of Purchased Inputs in firm

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 im portant  indicator  of the strategic signifi­ cance 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 sepa­ rate 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 utiliza­ tion 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, how­ ever, 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 pur­ chased 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.

Firm s’ 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 sys­ tems often distribute the costs of such inputs among many cost catego­ ries rather than  highlighting their importance.  Purchased services such as maintenance or professional services are often overlooked  in pur­ chasing   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 im portant tool in gaining cost advantage.


The starting  point in analyzing  the unit  cost of purchased  inputs is to develop purchasing information.  A firm should begin by identify­ ing 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 inven­ tory 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 atten­ tion 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   im portant  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 signifi­ cant fraction of total  purchases. Unless special circumstances are pres­ ent, single sourcing is an indication  that suppliers have created  switch­ ing costs and   that  unit  costs of inputs  may be unnecessarily   high.


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.10 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 struc­ tural 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  impor­ tant ones. For each purchased  input,   position   vis-a-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 im­ portant role in both harnessing supplier linkages and improving a firm’s bargaining power.


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 plac­ ing 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.

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