The
MBA program in Supply Chain Management
at NC State University is unique among business schools.
With the support of the Supply Chain Resource Consortium,
an industry/university partnership, the program brings
the industry into the classroom, involving students,
faculty and supply chain professionals in finding
solutions to the real industry problems. This project-based
approach to education reflects the new model for business
schools described by Peter Drucker.
For
more information...
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Peter
Drucker...
"Management is a practice, like medicine;
and the model should have been the medical school,
where the bulk of the teaching, especially the most
important teaching of the M.D. in his or her residency,
is performed by practitioners. Unlike medicine, where
you can bring sick patients into the classroom, business
education does not allow you to bring an organization
into the classroom. You can, however, bring experience
in through your faculty and students. Business educators
should be out as practitioners where the problems
and results are." |
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5/5/04
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Cost
Reduction Measures
Compiled
by:
Erik Kruse, SCRC
|
According
to a study by the Center for Applied Purchasing
Studies (CAPS) Research, the primary goal of most
purchasing executives is to reduce total costs
(1). Supply managers in general are under an increasing
amount of pressure to assure the accuracy and
validity of their cost reduction measures. Their
goals are often directly linked to promotions
and bonuses as an incentive help their purchasing
department reach its goals. As such, cost reduction
measures must be able to withstand rigorous questioning
from top management (2).
In a later study, CAPS Researchers Smeltzer and
Manship presented the results of their research
on cost reduction in a recent Supply Chain Management
Review article. They studied a bank, an airline,
a software provider, a consulting company, a national
restaurant franchise, a hospital, a mining company,
and five manufacturing companies. In each of the
case studies, the authors interviewed key managers
and analyzed supporting documents to identify
seven different techniques for measuring savings.
Smeltzer and Manship’s synopsis of each of
the seven techniques follows:
| 1. |
Price over Price. The new contract
price is compared to the previous
contract price, and any downward variances
are recorded as a savings. But to
record an accurate savings, market
adjustments must also be considered.
For instance, if the price of the
appropriate Producer Price Index (PPI)
decreased for the year by 2 percent
and the new contract price decreased
by only 1 percent, did the new contract
save anything? It is true that the
cost decreased by 1 percent, but no
savings is recognized against the
PPI. In fact, the price variance compared
to the competition may be a 1-percent
increase.
items if they are raw commodities
such as aluminum, copper, or iron
ore. However, when components or finished
products are compared, it is difficult
to make exact comparisons from one
year to the next because of continual
changes. |
| 2.
|
Successful
Bid vs. Average Bid. All of the bids
received for a particular good or
service are averaged to obtain the
mean price. The successful bid after
negotiation is then compared to the
average bid to calculate the savings.
When using this approach, it is important
to assure that each bid is for the
same item. Also be cautious when determining
which bids to include in the average.
It is possible to obtain an extremely
high bid that is not competitive for
some reason. Should this outlier be
included with the other bids that
make up the average? Furthermore,
the averaged bids may have been offered
with the anticipation of further negotiation;
however, only the successful bid was
negotiated. If the unnegotiated figures
are compared to the negotiated successful
bid, an inordinately high "savings"
may result. |
| 3. |
Market Comparisons. This is often
considered a "catalog approach"
because the purchase price is compared
to other posted prices. A market comparision
is similar to how many consumers buy
their everyday goods. They go to the
shopping mall or look through a catalog
and obtain comparative prices on the
same item. The difference between
the average catalog price compared
to the purchase price is the savings.
But two warnings are necessary. First,
if the purchase price was negotiated,
could the catalog prices also have
been easily negotiated? Second, if
the purchase price resulted from a
volume discount, could the catalog
prices have been easily lowered with
a volume purchase? |
| 4.
|
Total
Cost. Rather than just considering
purchase price, total cost perspective
also includes all the related costs.
Typical total costs may involve such
items as transportation, inventory,
warranty, payment terms, and disposal.
Total cost is often a more accurate
cost measure than purchase price.
The necessary cost data, however,
can be difficult to obtain because
it must come from a number of different
departments. For instance, the inventory
cost figures may have to be obtained
from the manufacturing or materials
management group in addition to the
finance department. Or it may be extremely
difficult to put cost figures on some
items such as periodic maintenance
or disposal. Finally, putting all
of the cost figures together to make
a meaningful comparison can be a time-consuming
and complex process. |
| 5.
|
Target
Price or Cost. This approach is often
used in the initial stages of a new
product development cycle to establish
and meet a price or cost goal. The
challenge is to design a product with
the required functionality and quality
within the pricing parameters. The
marketing and/or product-design group
generally establishes the target.
A cost or price savings is recognized
if the components or materials that
make up the product can be purchased
for less than the target.
Two cautionary notes are necessary
with this method. First, the purchased
materials must meet the quality requirements
of the product-design team so that
the savings are not met by sacrificing
quality. Second, the initial target
price or cost must be accurate. To
ensure accuracy, make sure the purchasing
or sourcing group helps establish
the target. |
| 6.
|
Cost
Avoidance. Is cost prevention the
same as a savings? Many would argue
that cost prevention or avoidance
should be considered the same as a
cost savings. However, how can something
that does not occur--or is avoided--be
measured? In some cases, it is relatively
easy to measure a cost avoidance.
For instance, a higher grade of upholstery
on the office chairs for a large banking
institution reduced the amount of
annual furniture replacement and repairs
over a three-year period. The problem
with this example is that it took
three years to determine and document
the actual savings.
In other instances, it is extremely
difficult to document the actual savings.
For example, one purchasing department
attempted to use cost avoidance to
justify the use of an application
service provider's XML purchase-order
system with its suppliers. The justification
was that the XML system would reduce
the number of errors and speed up
the processing of orders. The new
system may avoid costs but those costs
were extremely difficult to quantify,
and the finance group did not accept
the figures as cost savings. Similar
situations occurred in several of
the other companies studied. |
| 7.
|
Innovations
or Product Improvements. If an improved
component is purchased at the same
price as the one that lacks the improvement,
is there a savings? In one situation,
an instrumentation device had a digital
panel that was difficult to read in
certain light conditions. The buyer
worked with a supplier to develop
a nonglare panel. The buyer was also
able to purchase the instrument with
the improved panel at the same price
as the original instrument. This improvement
provided a competitive advantage to
the instrumentation manufacturer.
While its competitors still had the
glare problem, this company could
sell the better device at the same
price as the older models. How should
this improved component be measured
in cost savings? Should it even be
considered a savings? In this situation,
the purchasing department asked a
second supplier to estimate the cost
of developing and producing the nonglare
panel. The purchasing department then
used the second supplier's estimate
as the cost-savings figure.
The same savings-estimate problems
exist with service agreements that
include service-level improvements.
If an enhancement is added to the
service agreement but the purchase
price remains the same, should this
be considered a savings? And if so,
how should it be measured? One possibility
is to conduct a benchmarking study
to determine what other suppliers
may charge for the same service. Another
possibility would be to conduct a
cost analysis of the service provided.
|
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Smeltzer
and Manship believe almost every company can benefit
from re-assessing the way it determines cost savings.
Identifying best practices is a good place to
start. For more on cost reduction, see “Six
Best Practices in Cost Management.
References:
(1) Hendrick, T. and Ogden, J. (2002). Purchasing
and Supply Managers' 2001 Compensation Benchmarking
and Demographics CAPS Research Focus Study. CAPS
Research.
(2)
Smeltzer, L. and Manhsip, J. (July, 2003). How
good are your cost reduction measures? Supply
Chain Management Review.
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