One of the primary elements for sourcing a supply partner is cost and a solid practice to have is receiving at least three quotes from highly qualified suppliers. However, there is more to an RFQ (Request for Quote) than just a financial breakdown of requested parts and/or services.
The use of multi-round competitive bidding ultimately results in a pricing war between suppliers; a war that reduces their costs, but also reduces profit margins. This is always beneficial for the buyer, but what if all parties in the equation could reduce their costs, yet keep their profit margins? Implementing a strategic partnership when sourcing in this instance, which produces mutual value to the end customer by reducing suppliers’ costs, can achieve just that. As a result, we recommend moving toward a single bidding round method for RFQs and taking this strategic approach to identify cost savings opportunities for sourcing decisions.
To help illustrate what this sourcing strategy looks like, we have provided a sample situational analysis below.
Example
Assume a potential supplier provides a buyer with the following costs on an RFQ:
Costs of Direct Materials: $12,000.00
Cost of Direct Labor: $3,000.00
Cost of Overhead: $4,500.00
Total Costs: $19,500.00
Profit: $2,340.00
Price: $21,840.00
What is the minimum price a supplier might be willing to quote if the amounts mentioned above are their costs provided?
$15,000.00 because it covers the direct costs.
Suppliers would lose money on this business if they took it for less than $15,000.00 because it would not cover the direct costs involved, which are directly tied to taking on this business. Every company has overhead and suppliers want to spread out these overhead costs to customers since they are paying for a product or service that incur costs to produce. Remember, there are three types of costs: direct material (costs going into what is being built), direct labor (necessary people to build what is being built), and overhead (everything else – engineers, salaried employees, facility maintenance, etc.).
Often times there is excess capacity built into a given supplier’s business resulting in additional overhead, whether they win the bid or not. These overhead costs are inevitable and the lowest the supplier would be willing to accept the project for in this instance is $15,000.00. However, long-term, the customer must begin to cover some supplier overhead because they cannot expect some customers to pay for overhead while others do not. This circumstance will lead to the supplier not competitively pricing their products or services and will eventually lose future business when other customers discover that. A seasoned sourcing professional will always determine if they are paying too much.
Why would a supplier take on business for less than the $15,000.00 quoted and lose money?
Perhaps the supplier is thinking long-term and wants to get a foot in the door of a given market. Sometimes this practice is necessary for a smaller supplier, or even a supplier new to a given sector, to build their reputation for producing a quality product or service. Tread with caution though, as buyers engaging in this kind of business where they know the supplier is losing money may not be the best companies to partner with in the future.
Why would a buyer accept a bid from a supplier knowing the supplier will be losing money?
It is possible that the buyer is promising this supplier something in return later on down the road, like an introduction to another firm that could use the supplier’s product or service. Or maybe the buyer recognizes that the supplier’s direct material costs are not competitive. A buyer thinking collaboratively would then communicate this fact to the supplier to try and help them reduce these costs to ensure that this supplier is making enough profit to deliver promised products or services.
The largest component of costs when purchasing from a supplier will be in direct material, so focus on this element of the cost structure. Be vigilant of a suppler who’s majority of costs are determined to be overhead expenses, as this is typically an indicator of inefficiency within the organization’s operations.
From the information provided in the quote above, why would a supplier consider a price of $17,000.00?
Because it covers the supplier’s direct costs and leaves some funds to appropriate for overhead costs.
What is the formula for Profit Margin?
(Sales – Cost of Sales) / Sales
Keep this simple, take a supplier’s total annual sales revenue and subtract its costs (direct materials, direct labor, and overhead). Then, take that number and divide it by the total annual sales revenue.
How can a company increase this margin?
By cutting costs. Where do most of a supplier’s costs come from? Direct material purchases. Why do you want to increase profit margins? To increase ROI (Return on Investment). ROI is PM multiplied by Asset Turnover Rate (ATR). What is ATR? Doing more with less (i.e., reducing inventory, getting customers to pay sooner, outsourcing, buying less expensive materials). When ROI goes up, the company’s stock goes up.
What is the formula for Net Income?
Sales – Cost of Sales
Net income is equal to the profit or loss balance remaining after all costs and expenses have been covered for a given time period. Simply put, net income is the money left over after a company sells its products or services, pays for the costs of producing their products or services, and pays for all remaining organizational expenses. Understanding the profit margin and net income are vital for suppliers to determine if the products or services being delivered are profitable after expenses are accounted for. Regular evaluation of an organization’s net income and profitability enables opportunities for suppliers to see patterns, therefore providing the decision makers with valuable information they can use to implement changes when quoting new projects or when re-prioritizing funds set aside for facility maintenance, for example.
Conclusion
Breaking down the above sample situational analysis should begin to reveal some benefits of a strategic partnership approach to sourcing and supply base building; working with supply partners to identify cost savings for all parties helps suppliers improve their cost structures, develop and maintain strong supply partner relationships, and subsequently, increase end customer supply chain value.
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A great read on sourcing strategy with my field notes…
FYI:
Pasted below are the sample stories I read in class about the previous internship experiences of former WMU ISM students. Pasted below each one is the moral of the story (i.e., the sourcing strategy). Thank you. Sime
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Student #1:
Last summer, I was a sourcing “analytics” intern at FirmA and the main part of my job was sending and receiving RFQs for the FirmA Parts and Service Department. We tell suppliers that we will only participate in “one round” of RFQs and we expect their best price the first time.
I had a small tube manufacturer in Iowa contact me one day stating that they were having issues lowering their prices and wondering if they could get assistance so they could be a better supplier. I discussed this with my boss and he sent a quality engineer and a Senior Buyer to the supplier to assist them (I asked to go but unfortunately HR would not approve Intern travel to a facility that wasn’t owned by our company). My internship ended before I could see the results of the visit implemented, but the pair that went estimated that they reduced the cost of some products by up to 10%! I very much enjoyed my internship at FirmA and helping suppliers was a thrill.
“From Sime”: Sourcing = procurement = purchasing (companies use different terms).
Rather than mess with a supplier’s profit margins via competitive bidding to get a lower price, why not just help your suppliers reduce their Direct Costs? That way you do not mess with their margins and chances are you get a much lower price. However, it takes a strategic effort (time).
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Student #2
The single chance to bid is a great option even though it seems counter intuitive. The “single bid only” is the same model that FirmB uses for its commodity bidding. I have used this very technique successfully when purchasing Oil for FirmB (lubricant, not the combustible kind). FirmB had an oil supplier who we felt was too expensive, so I send out a series of RFQ’s to other competing firms (Shell, Exxon, etc.). Through this process I found FirmB was paying significantly more than we should be paying. I then went back to our original supplier and said “We have found significant cost savings with alternative suppliers. You need to come back to us with the most competitive price you can offer, or we will place our last purchase order on [date roughly two weeks away]”. After this they were able to miraculously lower their price by 46% for all oil. This goes to show you that even a novice negotiator can find significant cost savings when using this technique.
“From Sime”: Notice the one shot deal to bid on the business. By giving suppliers only one chance to bid on the business, you tend to get their best price. However, that was not the case with this lubricant supplier. By the way, this sounds like an MRO purchase to support its factories. Remember, your P.O. with your suppliers will likely have terms and conditions that say you can reopen bidding on the business for any competitive reason (i.e., you think you are overpaying!).
Student #3:
The two companies that I’ve worked for choose to have “vendors” bid “once”. At FirmC, our vendors have learned that we expect the best up front and quotes are to be turned around within 3 days. Our quoting process moves insanely fast and we definitely pay for it. At FirmC, I was able to host over 10 Ariba events and we also taught our “vendors” that we expect “one and done”. I did see the problem that you point out there. The vendors at SupplierA for the super specialized, engineered items are not local or utilized as much so their quotes are most definitely padded. I had a few vendors call me to say that if they’re close to the lowest bidder, they would drop their pricing to match. Or they would say that they would have given us better pricing if they were guaranteed the business. I thought this was interesting.
“From Sime”: Notice how this student worked for a company that called their suppliers “vendors”. I think that is fine if you are buying “indirect” material. Otherwise, call them “suppliers”, especially if they design and build stuff that goes directly into your product. It sounds like this supplier did low volume customized engineered work and this supplier did not need their business. It sounds like this supplier had some leverage to talk to a potential customer like this.
Student #4
I would like to defend myself on my previous emails referring to suppliers as “vendors”. The last 4 months at FirmD introduced me to using the term “vendors”. The definition you gave refers to vendors as suppliers of “indirect” materials. Everything bought at FirmD is an “indirect” cost and their acronyms used frequently are as followed: VIMS (Vendor Invoice Management System) and CVM (Central Vendor Maintenance). Now that I know other companies will cringe at that word, I will stop using “vendors” and refer to all suppliers as “suppliers”. I’m very grateful that you pointed this out.
“From Sime”: She made a good point. She worked for a company that did not design and build anything. All of their spend was therefore INDIRECT spend. So, I guess it is OK to call suppliers “Vendors” if they only provide stuff that does not go into anything that you build. In this case again, they do not build anything so all their spend is INDIRECT. Note, 90% of Americans work in the service sector for companies that do not build anything. All of their spend is INDIRECT.
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Student #5
This summer at FirmE, I did some work preparing for engine negotiations with SupplierA (they design and build engines). SupplierA does not provide ANY cost transparency with their engines, because they know they produce the best engines in the world and have the leverage to say NO to providing transparency. As a result, we had to do a lot of “should costing” with SupplierA’s engine components, and even tear down an engine of theirs, to prepare our “cost breakdown” for their engines. That way we could do our homework, and show what price SupplierA should be making their engines for.
If you are working with a commodity like fasteners (a true commodity, tons of suppliers), you can get away with sourcing from multiple suppliers. Fasteners do not vary too much from one another, so it sometimes may be necessary to have a larger supplier base, as a method to assure there will always be a supply of parts.
I was able to learn this first hand, by working in procurement on FirmE’s Powertrain Category Management Team. I was able to work with the Supply Chain Manager for engines, and learned that we (FirmE) used to make their engines! However, FirmE began to outsource their engines to SupplierA nearly a decade ago because they could make better engine’s than we (FirmE) could, and at a better price, therefore, we (FirmE) outsourced their engines and became much less reliant on vertical integration (making our own engines).
Based on my personal experience, it makes a lot of sense why companies would outsource “strategic” parts. This can help companies rely on assembly and their final product, rather than wasting a lot of resources on strategic parts, that another company can make better, faster and cheaper.
“From Sime”: There is so much in this one. FirmE started to outsource a core part (engines). Over time, they lost design and manufacturing capabilities on engines. Once SupplierA of engines realized this, they started jacking up their prices and telling FirmE that the cost breakdown was none of their business. I have no issues with FirmE outsourcing engines for over 10 years, but you better make sure you that you never forget how to design and build them if you sell buses. FirmE should have told SupplierA ten years ago that they can have the business if they have joint ownership of all design and mfg capabilities associated with their business and that a cost breakdown will always be required. Had they done this Day One, they likely would have not lost leverage in this buyer supplier relationship. FirmE got greedy and sloppy. Note, the person that made that decision ten years ago might have gotten a huge bonus ten years ago and retired, and now someone else has to fix this sourcing decision. A sourcing decision today can impact your company 10, 20, 30 years down the road. 10, 20, 30 years ago, a bunch of managers decided to source stuff from China because it was soooo much cheaper (or so they thought on the surface). As it turns out 10, 20, 30 years later, it actually ended up costing them more (i.e., quality, lead times, control, insurance, inventory, etc.).
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Student #6:
I can support the statement of companies mostly outsourcing their “manufacturing” capabilities. Johnson & Johnson just recently sold their entire Medical Device manufacturing plants to a third party manufacturer called Jabil.
“From Sime”: So, if J & J outsources mfg for medical devices, what the heck is their Core competency? Answer: Scaling and ramping up small companies that they buy. J & J has tons of cash and credit and can buy small businesses with great ideas. J & J has a super sophisticated supply chain and J & J manages their supply chain very well. So they can take a medical device that someone is building in their garage and take it global super fast. That start up company in the garage has no idea what supply chain management even means. That start up needs J & J (or Stryker in Kzoo) to help them scale up. Otherwise, the product never leaves their garage.
Back to Jabil. Jabil is a manufacturing subcontractor. Jabil’s core competency is building stuff for entire industries like medical device. Jabil does it for the entire industry (not just for J & J) and gets the economies of scale, so that it does it better, faster and cheaper than companies like J & J could if they built it themselves. Products and technology change so fast for medical devices that the product might be outdated in 6 months, so J & J does not want to build factories to support such short product life cycles. Jabil can make money doing it for them (and everyone else in the industry) and that is Jabil’s thing (core competency).
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Student # 7 (this was a bad day for the WMU ISM program):
I wanted to let you know we had at least three WMU students attend the early session of MSU’s career fair. I was thrilled they made the drive and spent time with our team. Unfortunately, we had a bit of a situation. We selected John Smith as one of our top picks for first round interviews based on multiple members of our team talking to him. He had completed the intake form indicating he had a 3.0 GPA which is our minimum requirement. During the interview we realized his GPA was actually 2.64. This is unacceptable that he lied to us and completely goes against our core values of Integrity, Commitment, Quality and Innovation. I won’t be able to invite WMU students to MSU if we have a situation like this again.
“From Sime”: Do not lie. Be honest on job applications. Sometimes they do not even care about the details. They just want to check and see if you are lying. Lying is a “falsification of records” (kind of a big deal in SCM). Also, do not renege. Be a leader.
In the above link, people came after me a little in the “comments” section.
Student #8:
As I work for a smaller company I have been on the receiving end of the negative impacts of this idea that you strategically source core parts of our valves. A specific example is one of our molded xxxxx, sure we save a lot of money and no longer have to mold a rubber to a metal xxxxxxx but recently the supplier went through a management change, and switched from an outdated ERP system to SAP. This created huge problems for them, and ended up shutting down our lines for almost a week. As a smaller company we do not have a lot of leverage with this supplier. We ended up coming to an understanding and moving molds to another location but shutting down for that long is less than ideal for any manufacturer. Just an example of where it can come back to bite you if you do not upkeep a safety stock or have good relationships with a supplier for a core part.
From Sime: Yes, most of you will work for companies that will be bigger than your suppliers and you will be a hugely important customer to your suppliers. Enjoy that leverage! However, some of you might work for a smaller company and your suppliers might be much larger than you. Further, you might not be an important customer to your suppliers. Finally, you might ask these suppliers to do low volume customized highly engineered stuff for you. In other words, it is NOT a commodity. If you are ever in this situation, good luck with that. Hopefully, your company is very good at something and your customers are OK with paying a premium.
Lastly, when outsourcing strategically, you always want to look at if the supplier makes parts “in-house” or “outsources” themselves because that plays a key role when choosing a supplier. Yes, during covid, some supply chains broke down because companies were outsourcing stuff to suppliers who then flipped it to other suppliers and the companies did not even know about it (until that supplier in China shut down for 8 weeks because of covid).
Please reach out for more information. Thank you. Sime
Dr. Sime (Sheema) Curkovic, Ph.D., Professor, Operations/Supply Chain
Western Michigan University, Haworth College of Business
E-Mail: sime.curkovic@wmich.edu
www.wmich.edu/supplychain