Patent-protected suppliers are a particular challenge for procurement. The traditional sourcing strategies are ineffective with these suppliers, who are able to demand just about any price for their product. Simply ignoring the patent protection and in-sourcing the product or having it produced by another supplier is one option. However, the prospect of a very expensive patent lawsuit stands as a clear warning against this approach. Nevertheless, procurement directors are increasingly searching for alternatives to patent-protected suppliers. One such strategy is “invention on demand.” This is based on TRIZ, an expression that comes from Russian and stands for “theory of inventive problem-solving.” TRIZ utilizes basic empirical laws of inventive thinking and provides a wealth of systematic problem-solving tools.

The invention on demand model of solving problems comprises four steps:

1. Evaluation of the specific technical problem: The technical system is broken down into its smallest elements, and the functional relationships between these elements are depicted in graphic form. This functions model focuses on the end result or end product of the technical system. All other elements are assigned a functional ranking, which takes account of the distance to the end product and a balancing of their useful and detrimental functions. The closer an element is to the product and the more useful functions it possesses, the higher its functional ranking.
2. Translation of the specific technical problem into a general scientific problem: Starting with the one with the lowest functional ranking (that is, the least useful element), the elements are systematically eliminated. This makes contradictions in the technical system visible as it generates general scientific questions such as: “How can the useful functions of the eliminated element be performed in the absence of that element?” or “How can the remaining elements be made to assume the useful functions of the eliminated element?”
3. Search for general scientific solutions: The contradictions are systematically resolved. To do this, algorithms are used to search widely diverse areas of physics for potential solutions. This produces a number of ideas—some of them highly exotic—for each of the eliminated elements. These ideas are typically very general in nature and allow for wide scope in implementation. Bundling of these ideas leads to hundreds of rough concepts. At this stage, it is crucial that none of the rough concepts be prematurely discarded. On the contrary, completeness is one of the key aspects of an invention on demand project, and ensures the ability to pursue all possible solutions.
4. Translation of general scientific solutions into specific technical solutions: The last step in a project of this kind is to develop the rough concepts further into specific and viable technical solutions. To do this, the rough concepts are reviewed in intense discussions with those responsible for the various corporate functions involved; this allows the insights of developers, product managers, marketing, and, of course, procurement, to be taken into account. (At this stage resistance is common, so strong leadership is essential.) One or two dozen rough concepts will usually emerge which are then transformed into commercially viable concepts, most of which are capable of being patented. The duration of a typical invention on demand project, from kick-off to a product capable of being developed commercially, is three to four months.

The results of a project of this kind can be used in many different ways. Some companies use them to build critical capabilities internally. Most see them as a lever for negotiating with their current supplier. With invention on demand, a company can sometimes not only solve the problem of patent-protected suppliers, but also replace expensive components with cheaper ones.

How many people in a company are engaged in finding innovations? An average SME company with sales of around $1 billion has around 50 core employees working on R&D. Such a company also works with 200 core suppliers. If the company can get just one developer at each of these suppliers to think about innovations, the number of “brains” at work is increased fivefold.

This is the underlying idea behind innovation networks. At a time when competitive pressure is high and engineers are in short supply, innovation networks are increasingly important. The benefits are obvious: companies with successful innovation management enjoy stronger and more profitable growth. The best starting point for an innovation network is the suppliers, since they are well acquainted with the needs of the company and the industry as a whole. Besides suppliers, innovation networks often include customers, competitors, research institutes, market researchers, business consultants, and former employees.

Within the company, the innovation process involves not just R&D and procurement, but many other units as well—marketing/PR, sales and distribution, production, quality, trend scouts, and service, plus the company’s top management.

In this way, an innovation network enables development to acquire insights into new technologies. These insights can then help the company free itself from dependence on suppliers. For an innovation network to be effective, the following features are essential:

• Top-down driving of innovation as an integral part of corporate strategy
• Clearly defined (in writing) strategy and search fields
• Corporate culture-embedded receptiveness toward innovative ideas
• Fostering of close collaboration and internal/external networking
• Active management of the ideas pipeline
• With regard to process and product technologies, a consistently high level of company-wide standardization and reutilization
• Systematic pursuit of goals and establishment of structures for learning from experience
• HR tools to help integrate innovations

In companies that are innovation leaders, structured processes are used for evaluating ideas. A number of factors have proved successful in this context. First, it is important to make systematic use of all ideas and their sources. Great weight and care need to be accorded to pre-qualifying ideas so as to avoid tying up resources unnecessarily. Also, feedback should be given for every idea within a short time (approximately six weeks). To enable an actual decision to be reached quickly within the evaluation process, a special governance structure should be introduced—here, web-based technologies can also be helpful.

How many of the functions offered by a mobile telephone does the typical user actually use? Or the functions available in computer programs such as Microsoft Excel? Which of these functions provide genuine benefit for the typical user? What could the typical user do without, and what would he or she be prepared to pay for if they were not already included in the cell phone or computer program? In many cases, far too many functions are offered. Since this also creates excess costs, it makes sense to assess each function in detail.

Functionality assessment calls for an interdisciplinary team, consisting not just of procurement staff but also of specialists from engineering, production, and sales. The process takes place in five steps:

1. Identification of functions: First, the product has to be broken down into its various subsystems and components, and their respective functions identified.
2. Naming of the functions: Next, all the functions identified need to be given a meaningful name. This should consist of two expressive words: an active verb and a measurable noun, which together clearly illustrate and define the significance of the individual components. Examples would be “Prevents corrosion,” “Positions parts,” or “Absorbs vibration.”
3. Classification of functions: The functions are assigned to one of four classes: basic, critical, supporting, and non-supporting.
4. Valuation of cost-function ratios: This step is essential for identifying potential improvements. The information is listed on an evaluation sheet along with all components and their functions. On each individual line, the relationship between part, function, and cost is valued. Adding up all the columns produces total costs.
5. Identification of potential improvements: The following are general rules for identifying components to optimize:
   • The product can be viewed as cost effective if the costs predominantly occur in the area of basic or critical functions
   • If significant costs are found in supporting functions, savings can be achieved without changing the basic concept
   • The highest savings can be realized in non-supporting functions

The above process enables potential to be identified, with a list of possible improvement measures as the outcome. However, the basic and critical functions should be reviewed as well in order to find alternative solutions, if appropriate.

R&D and engineering departments are continually learning as material prices change, substitute materials emerge, experience in production or use provides new insights or creates new issues, and production processes stabilize and create a clearer understanding of acceptable or necessary tolerances. Concurrently, a growing product line expands the material requirements and expands the complexity of specifications even within common material families. During product development, compromises are sometimes made under time pressure even though, on closer inspection, better solutions would have been possible. In short, framework conditions change. So it makes sense to subject originally justified specifications within and across product requirements to a critical review and analysis from time to time. Specifications that are no longer necessary can be revised and adjusted in line with current needs or to reflect new commercial options.

One important factor in this analysis process is complete openness toward every specification change. The assessment has typically been conducted in a workshop-like process that includes engineers, production experts, financial controllers, purchasers, and suppliers. This means all relevant parties can consider all aspects of a change in specifications, and decisions can be made with no unnecessary delays. The analysis should begin by focusing on underlying customer requirements since current specifications represent the original solution for meeting a need. The workshop approach is still valid, but it has been enhanced with the advent of using expressive bidding techniques to collect market-driven specification alternatives. With all stakeholders present and armed with the most up-to-date commercial information and established technical data, the workshop approach facilitates fast decision making with greater alignment on the alternatives for specification changes. The discussion process asks whether these requirements could also be met by modifying specifications—for example, by using another material, a different thickness, or new tolerances, especially in light of changing framework conditions or new information about the market. The main focus of the analysis will naturally be on the specifications that are most responsible for driving costs and which of those might be reconsidered. However, smaller changes can also create considerable cost savings, especially if they are easy to implement. After the workshop, an evaluation of savings is carried out, and a business case is produced.

Lego bricks have fascinated generations of children. The wonderful thing about them is that the same bricks can be used to build new things. Value chain reconfiguration works along the same lines. The aim is to create flexible, intra-company structures to fulfill specific customer needs along the entire value-creation chain, from raw materials all the way to the end consumer.

Reconfiguring the value chain involves seven steps:

• Defining and weighting the drivers of customer value and growth
• Setting up a detailed value chain for the company
• Identifying the dependencies of the customer-value drivers, and allocating them to the segments of the value chain
• Allocating costs to the value chain
• Breaking down the value chain into core and non-core activities
• Screening various options: performing certain steps internally or out¬sourcing, omitting, or leapfrogging them, and/or networking more closely with suppliers
• Choosing the best options and implementing them

When using this approach, sometimes major technological advances enable key steps in the traditional value chain to be re-designed or dispensed with altogether. Examples are Dell’s simplification of sales by letting customers configure their own computers, or online selling by Amazon, which revolutionized retails sales. In some cases, consumers are no longer prepared to pay for process steps that they can do themselves. Additionally, because of reduced transport costs and shorter transport times companies have more flexibility in how they produce and sell products and services throughout the world.

The goal of value chain reconfiguration is to acquire or maintain maximum control over key steps and processes, thus internalizing core competencies as a competitive advantage. At the same time, the aim is to have the least possible ownership of capital or assets involved in the value chain.

Revenue sharing means allowing the supplier to share in business opportunities and risks. The basic precondition is that the supplier must indeed play a significant role in the success or failure of the business. As the sales revenue of a product is a clearly defined factor, it provides a solid basis for the partnership between customer and supplier.

Either the customer or the supplier may strive for revenue sharing, though with different goals in each case. The customer takes the initiative when the supplier has particularly attractive products and services that the customer wishes to obtain exclusively for itself. The supplier takes the initiative when it launches a new product or service and is looking to the customer to act as a multiplier in establishing new sales channels.

Profit sharing means a complete involvement on the part of the supplier in a company’s business opportunities and risks. A precondition is that the supplier should exercise an outstanding influence on the success of the business. As the term “profit” leaves much room for interpretation, clear rules and mutual trust are essential.

As the business is dependent on the participation of both partners, both also strive for profit sharing.

Strategic alliances especially make sense when two companies have complementary capabilities and contribute equally to the partnership. Strategic alliances with suppliers—that is, long-term collaboration with a particular partner—are often formed when one of the companies is unwilling or unable to maintain certain strategic capabilities in-house, or has no possibility of integrating vertically.

A strategic alliance between companies can be used, for instance, as a means of avoiding supply bottlenecks in times of high capacity utilization.

The core aspect of a strategic alliance is that it is designed for the long term; that is, it is not subject to any project-oriented limits. This does not mean, of course, that strategic alliances are intended to last forever, since they may become obsolete in the event of a change in strategic direction by one of the companies. Nonetheless, a characteristic feature of a strategic alliance is the long-term intention of the partnership.

In forming a strategic alliance, attention has to be paid to certain matters. First, a management model has to be defined. Management models may take the form of ordinary business agreements as in, for example, simple outsourcing contracts. The issue of mutual control also needs to be defined. A strategic alliance needs to be based on mutual trust and openness.

Strategic alliances also call for effective risk management. The more unstable, unpredictable, change-oriented, and dynamic a market is, the greater the risk associated with relying on just one partner. The procurement company needs to be sufficiently flexible to correct the course of the alliance, or even end it, in a timely manner.

Partner selection and assessment is the basis of a strategic alliance. Alongside the assessment phase, the selection process should allow sufficient room for negotiation, giving both sides the opportunity to introduce themselves and to question the concepts of the other side. Only then need the formal aspects be discussed and agreed in writing. Once the alliance is established, managing the relationship (which will not be the only close cooperation in procurement) will be a highly demanding process.

Without a governance model that includes the factors crucial for success or failure, it will be difficult to maintain the relationship over time. Where a partnership already exists, there are various possibilities for making it more stable and productive. In this context, various questions arise: Does my partner fulfill the requirements that help me keep my value promise? What capabilities of the partner can I use as assets on the market? Could other partners contribute just as much? On the other hand, how important and how effective is our own performance for our partner(s)? Could our contribution to the alliance also be provided by other companies?

Is the relationship built on give and take, or does one side contribute more than the other?

In general, all companies seeking new alliances, or wishing to maintain existing ones in the long term, should communicate openly and directly with each other, especially in the event of problems. And in case the ownership of a partner should change, it is always advisable, integration notwithstanding, to maintain market transparency in such a way that outsiders can still clearly see which partner makes which contribution.

What is a cheap car? If this question had been put to a European engineer 15 years ago, the answer would probably have been, “One costing less than $20,000.” Today, the answer would likely be, “A Tata Nano.” At its launch, the Tata Nano was priced at around $1,500.

The different answers result from the different methods used by the manufacturers in question. The usual method of manufacturing a cheap car is to look first at the lowest-cost competitor. Tata adopted a different tack and asked: What are the absolute minimum requirements that a car needs to fulfill (that is, transporting four persons from A to B with protection from the weather)?

The core-cost analysis strategy works in the same way. Instead of trying to cut the costs of an existing product through incremental measures, the idea is to start with a blank sheet of paper and ask what basic requirements the product needs to fulfill and what the cost structures would look like under ideal manufacturing conditions. The result is usually savings of up to 40 to 60 percent. The next step is to move toward reality again by asking:

• What additional features are customers prepared to pay for?
• What measures are necessary for risk management?
• What production processes are actually available?
• What suppliers are available?

Even with these concessions, the cost is usually still 20 to 30 percent below that of current products. This strategy seriously questions existing structures and calls for completely new ways of thinking. Procurement, being particularly well placed for finding alternative solutions through its contacts with suppliers, is ideally suited for driving this process.

The majority of supplier monopolies are brought about by customers themselves. According to investigations by A.T. Kearney, two out of every three situations in which only one supplier is able to fulfill a customer’s requirements arise not because of the supplier’s proprietary technologies, but due to the customer’s own actions.

The main reasons for such customer-caused supplier monopolies stem from departmental goals that deviate from the company’s corporate strategy. The R&D department, for example, will often exclusively pursue the goal of creating a product as near to perfection as possible. Production, on the other hand, will be primarily interested in a lean-assembly process, while the aim of procurement will be to buy from as few suppliers as possible at the lowest prices. In themselves, all these departmental goals are perfectly valid, but taken together they can drive a company to ruin.

A clever supplier takes advantage of this mix of departmental goals by tailoring a special solution for the company in question, thus drawing as much development and production know-how as possible into its own hands. After a few years, the customer is completely dependent on the supplier.

In order to remedy this situation, a cross-functional effort is required. First, it needs to be determined whether the item provided by the supplier is a differentiating factor for the end product or not. If not, it can be replaced by a standard industrial article. If the product is a differentiating factor, however, the solution is often more complicated, and requires the needed development competence to be created internally to regain control of the process. Further, the solution needs to do at least as good a job of meeting the expectations of end customers as the current solution does. And, of course, the new solution needs to offer greater freedom to maneuver in the supplier market.

Kids delight in pulling their new toys to pieces to find out how they work. R&D personnel do much the same thing when they analyze competing products in detail. In the case of product teardown, a product is disassembled completely into all of its constituent parts. Product teardown is a common method for analyzing the competition’s products, and was developed in the 1960s by Japanese firms trying to understand how European cars and cameras worked. During product teardown, very careful attention is paid to the materials and components used, and their costs. This form of analysis enables one to identify the best solutions employed by competitors.

The product teardown process consists of three steps:

• Analysis of technical differences: First, the product is broken down into all of its individual components. These are precisely labeled, and their suppliers identified. Then, differences between the company’s own parts and the teardown components are recorded in detail, including variations in dimensions, weight, and design approach.
• Analysis of possible technical improvement: Based on the results of step one, optimization potential is the next goal. All significant improvement possibilities are recorded in a list and reviewed for technical feasibility.
• Identification of potential cost optimization: The possibilities identified in the second step are discussed and assessed by an interdisciplinary team. This will often generate proposed modifications that require detailed technical validation following which the changes are implemented.

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Design for manufacture is a systematic method for designing products so that they are easy and cheap to produce. The method consists of four steps:

• Analysis of the costs of manufacturing a product: First, all of the pre-material and processing costs have to be established in detail so as to identify the major cost blocks.
• Generation of a cost driver tree: A cost driver tree is created as a means of analyzing the source of costs.
• Generation of recommendations for action: On the basis of the cost driver tree, ideas are generated for lower-cost design.
• Implementation of the new, lower-cost design: In the course of calculating the costs of the new product, the solutions with the highest savings are applied.

Application of the design for the manufacture process highlights strengths, weaknesses, and success factors in the field of design. Besides procurement, financial controlling, production, engineering, and sales, all other stakeholders should be involved right from the start, with everyone working together.

Based on the experience gained in numerous projects, five main factors have been identified for ensuring successful design for manufacture activities:

• The work starts only after a detailed cost structure is implemented.
• Suppliers are closely involved in the design for the manufacture process, so their ideas can be included.
• All departments involved understand the needs and interests of the other departments.
• Ideas without actual relevance to cost cutting are dropped as quickly as possible.
• The service to the customers is not affected by cost reductions, either in perception or in scope.

At any company, there are meaningful scopes of management responsibility that should not be exceeded. Dividing responsibility over a corresponding number of tiers allows even very large firms (100,000 employees and more) to be managed efficiently. Many companies also apply a similar tiering principle to managing suppliers.

Supplier tiering originated in the auto industry and can be best understood in the context of automakers’ changing priorities over the past 50 years:

• 1970s: The typical automaker was still characterized by strong vertical integration, making practically all key vehicle components itself.
• 1980s: Under the pressure of recession and the oil crisis, automakers sought to reduce volume risk and embarked on large-scale outsourcing of parts production to external suppliers.
• 1990s: The large number of suppliers—some automakers had 2,000 or more—became almost unmanageable. Supplier tiering was therefore introduced, whereby automakers deliberately assigned responsibility for modules and systems to so-called “1st tier suppliers.” The latter acted as integrators, with the task of managing 2nd tier suppliers and improving quality and efficiency.

For procurement, supplier tiering means finding the best structure in each particular case. In situations with a highly complex supplier landscape, it makes sense to follow the same path as the auto industry. On average, 20 percent of suppliers are responsible for 80 percent of spend; an initial solution may be to make these 20 percent 1st tier suppliers.

However, it is also possible to go the other way by actively managing 2nd tier suppliers of major modules or systems.

“Some customers buy our products because of our commitment to sustainability.” Are these better-informed consumers who take time to think about the sustainability of the value-creation chain, or are they simply idealists going after a “green” vision and paying slightly less attention to cost?

Sustainability management jointly prioritizes economic, ecological, and social sustainability. The aim is to preserve or create an environment fit for the next generation to live in. Summarized by the motto “Go green, get sustainable, and be ethical,” sustainability management espouses long-term thinking and action, as well as respect for ecological and ethical values.

What are the drivers behind this mindset?

• Increasing resource scarcity: A growing need for water, energy, land, and soil driven by population growth remind us that resources are valuable and limited; the same is true for many raw materials.
• Stronger activism: In the past large corporations could to a certain extent control media and public opinion. But NGOs and society, together with social media, mean public opinion is increasingly difficult to control.
• De-fragmented global supply chains: Outsourcing of non-core activities and transfer of value chain steps to low-cost countries made sustainability an increasingly important topic.
• Rising consumer expectations: Global customers are becoming more concerned about environmental protection.
• Increasing regulations: Stricter national legislation and policies, as well as international environmental agreements, mean sustainability is something everyone has to work with.

So what does all this have to do with procurement? Serious sustainability management is bigger than just saving energy and ensuring good practice. It begins right at the start of the value-creation chain and requires companies to ensure that parts bought from suppliers have been produced in an ecologically compatible and socially acceptable manner. “Ecological compatibility” means that no harmful substances are used in production, and the environment of the supplier country is left undamaged. “Social acceptability” means, for instance, that no child labor is used and that working conditions are reasonable. Increasing numbers of companies are demanding that these criteria are met by their suppliers. It is important that customers do not simply rely on information provided by a supplier, but that they also carry out their own regular inspections. Companies are increasingly held responsible for all problems along the value chain.

Sustainability management in procurement, in its basic form, means ensuring supplier compliance, actively assessing the risk of certain suppliers, and developing appropriate measures to mitigate risk. This prevents supply bottlenecks happening as a result of statutory restrictions on certain materials or negative impact on brand image.

Leading companies, however, go one step further. They use sustainability management to collaborate with suppliers and differentiate themselves from the competition, save resources, benefit society, strengthen their brands, and create real value. Sustainability management can also be relevant to procurement by monetizing externalities during supplier selection, so besides looking at costs, also putting a price tag on environmental impact (for instance CO2 emission or water consumption) or social benefits (for example workplace safety or wealth generation).

Project-based partnerships represent a meaningful form of cooperation between two or more companies wishing to collaborate for only a defined period of time or within a defined scope of activity. They are especially suitable if the intention is to take advantage of each other’s capabilities without being committed to a long-term partnership. This can make sense, for example, when a procurement company is looking for a development supplier to develop a new product. In this case, the project-based partnership is limited to the lifetime of the product and to the scope of the defined product. Project-based partnerships are intended to produce results relatively quickly; to ensure their success, four preconditions need to be in place.

• The distribution of tasks and competencies between the two partners needs to be clearly defined. This avoids demarcation disputes and duplication of activities.
• A clear timetable needs to be drawn up for the joint project, with firm deadlines and milestones. The timetable ensures that the project is implemented and completed in a purposeful manner. It should also incorporate the following: adequate buffer times to allow for unforeseen events; possible correction scenarios; various exit scenarios should certain milestones not be met; a winding-up program for the end of the project.
• A clearly defined steering organization. A mechanism needs to be put in place for taking the final decisions and for mediation in the event of disputes.
• The final important factor is a clear definition of how the fruits of the project are to be shared between the partners.

Besides these systematic aspects, regardless of its necessarily limited time span and scope, a project-based partnership also requires a high level of trust and cooperation between the two partners.

One industry where procurement is not only looking at cost but at overall value creation is retail. What good does it do if you can buy something 10 percent cheaper but your customers do not like it? Always consider the overall value: the absolute margin per available shelf space you are driving with your sourcing decisions. Price per unit—and cost savings there—are not so important. What really matters is the absolute margin your supplier can drive on your shelf space. On one hand, this is driven by your suppliers’ level of innovation, their market funds, their promotions, and many other factors. On the other hand, it is also driven by factors such as the strength of the brand, substitution rates, volume lifts through promotions, and assortment constraints.

Many retailers focus on annual negotiations, market shares, and revenue. But the future lies in using advanced analytics tools to find the optimum value resulting from all the described drivers. This thinking is true not only for retail, but also for many other industries.

Originally driven by capital markets seeking to limit volume risks and reward a focus on core competencies, vertical integration has seen a general decline in the course of the last few decades. This strategy was underpinned by dependable suppliers, rising productivity and, as a result, continually decreasing prices.

In the volatile market now in evidence, the pendulum is swinging back. Companies that still have access to raw materials through the last remnants of vertical integration find themselves better placed to compete in the marketplace than their trimmed-down rivals. Consequently, a renaissance of vertical integration can be observed in many industries, with customers buying suppliers. The primary objective is to secure availability of short capacities and access to scarce resources. In special cases, the motivation may also be an anticipated technological competitive advantage or the ability to gain access to new customer groups. Besides these primary effects, vertical integration may also provide benefits in terms of transactions, logistics, dealerships, and so on.

In addition to ensuring that the acquisition is commercially justified, it’s important to always keep in mind that acquiring a supplier also means acquiring its customers. So in a roundabout way, the buyer can also become the supplier of its own competitors. If this new state of affairs causes competitors to stop buying, the newly acquired supplier may lose its business base.

Especially in a volatile environment, the careful drafting of contracts is of paramount importance. Well-produced contracts can be a significant competitive advantage in guaranteeing the availability of resources and capacities in the face of scarce supplies and supporting growth. Similarly, when raw material prices escalate, contracts can help ensure budgets are met.

In drafting the appropriate contract structure, the first step is to identify the risk position. This involves determining how high the exposure of the company is (that is, what proportion of sales revenues, costs, or net income would be affected), and how controllable the influencing factors are. This risk position then forms the basis for defining a goal.

If the goal is “planning certainty over the budget period,” this can be achieved through hedging. Depending on the company’s appetite for risk, various instruments exist. The three most important are as follows:

• Swap: A fixed price is agreed to independently of the actual market price
• Cap: Only an upper limit is placed on market price fluctuations; if prices fall, the company can take full advantage of them
• Collar: A range is defined, within which prices can follow the market fluctuations

One thing all these hedging instruments have in common is that they do not prevent, but merely delay, the effects of permanent rises in raw material prices, and they naturally give rise to costs. Nevertheless, airlines that undertook aviation fuel hedging, for example, are in a much healthier economic position than their competitors who did not do so. Coping with raw material price increases over the long term, however, demands that these higher costs are passed on to suppliers or customers. Once again, intelligent contracts rise to the occasion.

If “supply security” is the goal derived from the risk position, then implementation calls for even more creativity than hedging. Drafting contracts that can secure capacities in a tight market is anything but easy, since they have to combine security with flexibility. They also need to include reliable rolling forecasts of demand in order to provide suppliers with transparency about the volumes that will be required in the future. When preparing such contracts for an airline, for example, the following should be asked:

• What price mode applies in the case of reservations?
• What is the time span for confirming/canceling/postponing a reservation?
• On what terms can a reservation be canceled/postponed?
• What pledges apply in the case of “rolling” forecasts?

Every company is interested in knowing what lies beneath the skin of competing products so that it can make its own products even better and win over customers. However, many companies lack the resources and knowledge to perform the necessary analysis of a product and its components. The idea of composite benchmark is to send a choice of competing products to several suppliers for expert examination. These analyses are often intensive, revealing information about a supplier’s production costs. The result is a cost model of “the best product from the best supplier with the best production processes.”

This approach is suitable for products consisting of a number of different (but not overly complex) components, insofar as a sufficient number of existing and potential suppliers can be recruited for the composite benchmark process.

A crucial factor for success is the make-up of the supervisory team, which should comprise specialists with both technical and commercial expertise. Composite benchmarking is carried out in seven steps:

1. Agree on the approach with suppliers: First, identify new potential suppliers (besides the existing ones) on the basis of their product portfolios, competencies, and capacities. To motivate suppliers to take part, offer individualized incentives. These may include exchange of technical information, opportunities for more business, or the establishment of new business relationships. It is also crucial to talk with the suppliers in advance about methodology, allocation of tasks, and expectations.
2. Identify appropriate competing products: An internal procedure should be used to identify competitors’ products suitable for comparison. On the basis of functional comparability, select and purchase the best products.
3. Produce standardized cost-calculation sheets: The various factors that go into cost calculations are materials, individual components, and other processing steps.
4. Have the questionnaires completed by suppliers: Send the cost-cal¬culation sheets to participating suppliers along with the competitors’ products. Ask the suppliers to disassemble each product and evaluate the individual components along with the production steps needed to make them. At the end of this key phase, you will have questionnaires completed by the suppliers, and offers for each product and its components.
5. Evaluate the offers: Incoming offers should be carefully compared with one other; it is essential to clarify any discrepancy with suppliers right away as only then will the offers be genuinely comparable.
6. Identify potential savings: On the basis of the offers and the information provided by the suppliers on the cost-calculation sheets, procurement can now identify potential savings on three levels:
   • Identification of the supplier with the lowest price for each of the products in the existing configuration.
   • Reconfiguration of a product using components with the lowest costs.
   • Identification of the lowest production costs. The optimum production costs for each combination of products are determined. To this end, the benchmark costs of the “best of the best” (with optimum functionalities and lowest manufacturing costs) are identified for the original product.
7. Implement the target costs: As a last step, the target costs are implemented with the aid of suppliers. Each supplier is provided with individual feedback as to where it stands in terms of target costs. In addition, improvements at both the component and production-process levels are identified and discussed in detail.

The procedure for identifying savings potential by benchmarking the production processes comprises four steps:

• Preparation for benchmarking: First, both the production steps that most strongly impact the product price and the suppliers taking part in the process benchmark need to be identified. Existing suppliers and new ones may be included.
• Involvement of the suppliers: As the next step, an invitation to tender is sent out to the chosen suppliers. The invitation includes ques¬tionnaires on the cost and time required for individual process steps.
• Identification of best practice costs: The offers from the various suppliers are compared in detail. The first thing to check is which production steps are the main cost drivers. Summarizing the least expensive production steps, together with a comparison of external data sources, determines the best practice process. Computing the difference between each supplier’s process costs and best practice determines the amount of potential savings.
• Implementation of savings potential: Part of the savings potential is achieved directly in negotiations with suppliers. In the case of complex changes in production processes, the suppliers need to submit an implementation plan.

For procurement, the benefits of process benchmark are a high level of price transparency and fact-based decision making. Knowing the suppliers’ production processes and the costs associated with them helps negotiations, as these can be conducted in a more substantive and targeted manner. The database of best practice process costs created during the benchmarking procedure can also help determine future target prices for new products. A crucial factor for successful process benchmark is the involvement of production and engineering at an early stage.

Capacity management was an important production topic even when card systems were managing machine usage. Advances in technologies, richer application of analytics, and broader acceptance of eSRM and ePDM solutions and practices have made market-driven capacity management between companies and external suppliers possible for even low-volume made-to-order highly specified parts. Collaborative capacity management enables continuous communication and collaboration among suppliers, procurement, and logistics. Four elements are essential:

• Internet-based solutions enabling communication of demand and capacities
• Assurance of critical capacities and simulation of production program scenarios
• Integration of the supplier into the program-planning process
• Embedded make-or-buy analytics

Procurement breaks down planned demand for a given period (usually six months) into smaller segments (usually several weeks) and loads this data onto the solution, updating the planning forecast routinely as better insight becomes available. Internal and external suppliers also upload their capacities into the solution by capability (by line, machine, location, and time) and economics. The application then optimizes the best make-or-buy award allocations, which allows the combined network capacity to be applied in the most efficient manner. Procurement then reviews the suggested scenarios with operations and executes as agreed.

The early and rapid detection of potential bottlenecks or underutilized capacities improves both cost management and supplier utilization.

Inventory management is a precondition for capacity management. A company needs to have its own inventories and those of its suppliers fully under control, and timely knowledge about all stock, in order to optimize its inventories to the benefit of the company and its suppliers. The goal of good inventory management is to minimize “unofficial” safety-buffer stock, which has a negative impact on current assets. Knowledge of complete inventory levels avoids excessive levels of safety-buffer stock, for example, and identifies little-used articles. At the same time, production losses and the resulting disruption need to be prevented.

A well managed inventory depends largely on efficient IT systems. Incompatibility of systems between locations has a negative impact on inventories because the information is often inadequate. If existing systems do not supply integrated stock data, alternative solutions such as an Internet-based platform, for example, should be able to provide an integrated view at least for the most important items.

It is particularly important that manufacturing has access to its own receiving warehouses and, if need be, its own central warehouse. Production must also be able to monitor the following: stock at company-owned plants managed by suppliers; stock at suppliers’ delivery warehouses; and “rolling inventories” (that is, all goods in transit by road, rail, air, or water, and not currently in any warehouse).

All products, whether cars, fast-moving consumer goods, or high-value capital goods, have their own individual life cycles. When falling sales indicate that a product life cycle is nearing its end, the company has to go back to the drawing board and either modify the product to bring it back into line with customer requirements, or put a completely new product on the market.

Before a product is launched, it has to be developed and market tested. The total life-cycle concept attempts to describe the collaboration with suppliers from the time of the product’s market launch. A product goes through five typical life-cycle phases, each of a different length:

• Introduction phase: Sales rise slowly, depending on the marketing push. However, no profit is earned at this stage due to previously incurred product development costs and ongoing spending on communication. The introduction phase decides whether and how well the product is accepted by the market, and ends when break-even is reached.
• Growth phase: Profits are made for the first time. This phase is characterized by rapid growth that is accelerated by further intense marketing activity, and ends as soon as the sales curve becomes digressive.
• Maturity phase: As the product no longer requires intense advertising, and economies of scale are able to take effect, the highest profits can now be recorded. Later in this phase, however, profits decline because of increasing competition. Nevertheless, this is when the product has the highest market share.
• Saturation phase: Begins as soon as market growth ceases. Both sales revenue and profits decline. This phase can be extended through modifications and product re-launching.
• Degeneration phase: The market shrinks. It is no longer possible to stem the fall in sales revenue, and market share is inevitably lost. Profits also fall, and the time has come to readjust the product portfolio.

To earn high sales revenue and profits for as long as possible with one product generation, the product’s attractiveness needs to be improved periodically. In the auto industry, the terms “major product upgrade” or “facelift” are used. In both cases, the basic technical structure of the product remains largely unchanged. Usually only those components subject to short innovation cycles (for example, electronics) or fashion trends are replaced.

To ensure that product upgrades can be carried out on reasonable economic terms, the milestones of the product life cycle are defined in advance with suppliers. The total life-cycle concept then determines in detail how sales revenue, and in particular the costs for upgrades, are shared between the company and suppliers over the complete product life cycle.

Companies often have only a small development department, but a large number of suppliers. Collaborative cost reduction enables the experience and intellectual capital of suppliers to be used to supplement a company’s own development capabilities. The suppliers are closely involved in the process of making cost cuts and, in return, the savings are shared. Sharing in the savings gives the suppliers a strong incentive to help find new cost-cutting ideas, and to communicate these to the customer.

To achieve a spirit of partnership and open cooperation between equals, it is essential to initiate a process of systematic communication with the suppliers identified as the best candidates. Communicating clearly and directly the intention of sharing savings is highly recommended.

As a first step, all the ideas contributed by the suppliers are collected; sending suppliers a standardized form makes the process easier. Where a large number of suppliers and individual contributors are involved, consider making the form conveniently accessible online. Besides a description of the idea, the form should include other important information such as the amount of potential savings, the possible timing of implementation, the likelihood of implementation, and the effort and expense involved. Having just this basic information will make it quick and easy to select and prioritize the ideas.

One of the most important factors for success is ruthless and rapid prioritization and selection of the ideas. During the creative brainstorming process, it is perfectly legitimate to consider any and all concepts, but spending too much time discussing flimsy ideas ties up valuable resources and gets in the way of successful implementation. (In this context, the warning about “not being able to see the forest for the trees” is very apt.)

The selected ideas are then reviewed in terms of feasibility in a discussion process that includes the engineering, quality, production, and controlling departments. Often, an idea will have to be ruled out because the supplier has failed to consider the bigger picture or certain knock-on effects. But if nothing is standing in the way, a business case and an implementation plan can be drawn up and the appropriate responsibilities defined.

Special importance should be attached to the subsequent control of implementation—many companies develop lots of ideas with their suppliers, but subsequently fail because neither takes ownership.

It happens even in the best business relationships. Sooner or later, a bottleneck occurs, no matter how long the company has been working with the same supplier, and no matter how closely the relevant departments at the two companies work together. A supply bottleneck can easily trigger hectic troubleshooting, but the first thing to do is examine the situation in greater detail. What was the actual cause of the bottleneck? Was it just an unfortunate coincidence that caused production to break down? Or was there some systemic flaw that could reappear at any time?

In order to prevent future supply bottlenecks, the first step is the most important one: conduct a detailed analysis of the circumstances. Quite often it turns out that the bottleneck affects only a few critical parts. Future procurement strategy should focus on gaining as much freedom of action in the supplier market as possible.

Bottleneck management starts with three short-term measures:

• Establishing targeted program management and focusing resources on problem components
• Implementing near-term change of supplier (focusing on development and testing resources for short-term approval)
• Dispatching a number of employees to the supplier; obtaining delivery forecasts from the supplier which can be updated daily; ensuring timely internal communication

Over the medium term, more incisive measures are possible:

• Substituting parts or eliminating variants
• Making further supplier changes in order to achieve greater diversification
• Focusing on new developments and new technologies in order to reduce dependence on old technology

The three long-term recommendations for avoiding supply bottlenecks are:

• Building up additional suppliers with capabilities identical to those of current suppliers
• Identifying suppliers who, while not yet at the required level, can be developed further with measures already in the drawer
• Dual sourcing (that is, using at least two suppliers in parallel for critical components)

The deregulation of the telecommunications and air travel markets in Europe has led to undreamed-of competition and low prices. Without the corresponding regulatory interventions, purchasers in these suppliers’ markets would still be in a very difficult negotiating position today.

In exactly the same way, the hurdles created by regional oligopolies can be overcome through the abolition of import duties (for example, on steel from Asia). If illegal cartels or price agreements are suspected, an individual company can report its suspicions to the antitrust authorities. Similarly, close cooperation with the competition authorities in advance of a planned merger has the aim of preempting too much concentration on the supplier side (and hence excessive supply power). Suppliers will also often attempt to establish their own technologies as standard, restricting the customer’s freedom. The customer needs to take timely action to nip these kinds of efforts in the bud.

Left to its own devices, a company generally has little power to influence the political status quo. So it is important for it to know exactly what it wants to achieve and then work consistently toward this goal by lobbying in industrial associations, mobilizing others who share the same views, and carrying out targeted media work. If undertaken correctly, political framework management has the ability to shift the balance between supply and demand power like no other strategy.

Product benchmark is a method for cutting the costs of products of limited technical complexity, with the focus on the specifications and the production process. A tried-and-tested product benchmark process can be broken down into four steps:

• Identification of comparable products: The initial step is the identification and procurement of comparable products from competitors. To identify competitors’ products requires interviewing sales, development, customers, and suppliers. The competitors’ catalogs are also evaluated. The outcome is a list of relevant competing products.
• Evaluation of competing products: The individual products are compared, with the help of development and production. Each product is rated according to functionality, technology, usability, and compliance with specifications and dimensions. Products that fail to meet internal requirements are eliminated at this stage.
• Invitations for bids for existing products and alternatives: Suppliers are invited to tender offers for existing products and appropriate alternatives. As part of the tender process, suppliers are advised of possible design solutions that could be adopted from competitors. Especially for alternative products, it is crucial that the process includes new suppliers along with existing ones.
• Analysis of results: The final step is to analyze the results and identify potential cost savings. Individual alternatives need to be prioritized on the basis of feasibility and potential. For high-priority offers, the next steps of implementation should also be identified.

Product benchmark allows various alternatives available on the market to be compared quickly and with relatively little effort. The involvement of procurement, development, sales, and suppliers is crucial, but should be strictly limited time-wise. The results can normally be implemented rapidly, insofar as it has already been determined that comparable products are available from suppliers. Product benchmark should be carried out right at the start of developing a new product, so that any necessary design changes can still be incorporated in time.

A number of studies have demonstrated a negative correlation between a company’s complexity and its earnings performance. What applies at the overarching corporate level applies equally to product complexity and, as a result, to the interaction with suppliers.

More companies find themselves beset by the effects of increasing product complexity. The drivers of this complexity are diverse, and include the goal of meeting different customer needs, shorter product life cycles, high innovation rates, and, sometimes, a lack of discipline in development and prod¬uct management. Consequently, it is virtually impossible to obtain volume-based concessions from suppliers.

When it comes to controlling product complexity in a systematic manner, a four-step approach has proved useful:

• Build variant trees: The aim is to generate transparency and help explain the complexity existing within product groups. To this end, the factors driving complexity are identified. In the case of gearboxes, for example, these factors are as follows:
  • Type: Manual, automatic, or double-clutch gearbox
  • Mode of installation: Lengthwise, transverse, or rear engine
  • Performance range: Torque above or below 300 Nm

In this example, around 50 complexity drivers can be found. The existing gearboxes are then depicted in a tree structure, in accordance with their complexity drivers. The variant trees are enriched with additional data (for example, prices of parts, quantities, warranty costs, and so on), so that a complete visualization is available by the end of the first step.

• Develop a maximum scenario: This involves recognizing similar variants within the variant tree and identifying potential through amalgamation or elimination.
• Create a business case: In this step, the cost savings potential and income effects are compared with investment and resource requirements. A fact-based decision can then be taken on the basis of the business case.
• Create an action plan: Interdisciplinary discussions are held between product management, sales, R&D, production, and procurement. Decisions are taken with regard to detailed complexity reduction measures and the production of an implementation plan.

These measures enable procurement to buy fewer parts with higher volumes in the future. Savings are achieved not only by procurement, thanks to better procurement prices, but also by R&D, production, and logistics.

The past decade has seen a great deal of M&A activity in many industries. The new, large companies appear to fulfill many of the success factors postulated in the mid-1990s—for example, global presence, comprehensive product and brand portfolios, and especially critical mass. Nevertheless, the conglomerates created through these mergers and acquisitions are often less profitable than smaller niche players. What is going on?

One reason is that niche players have simple decision-making structures and usually know their customers well. Large companies, on the other hand, have complex hierarchies and have to meet a wide range of customer needs using intricate internal and external production networks.

In response, many large companies have taken steps to improve their synergy potential. In the pharmaceutical industry, for instance, a number of firms have used M&As to replenish their product pipelines and boost competitiveness. Through the use of platform and shared-part strategies, the auto industry has succeeded in standardizing those parts that are invisible to end customers, across product lines, and even across brands. These measures allow product development times to be significantly reduced and model variety to be increased.

Thus, determined efforts are being made to tackle technical complexity by means of standardization. However, reduced technical complexity leads directly to an increase in management complexity: in a company with several divisions already using shared parts, it becomes difficult to coordinate market demand with the production resources installed at the company’s own plants and at suppliers. This coordination has to take place not only among the functions for a given division (procurement, production, and sales/marketing), but also among all the divisions within a single function. Unless this is done successfully, one cannot ensure, for instance, that the procurement departments of all the functions involved are able to forward useful demand information to a shared supplier.

Managers regularly complain that coordinating market demand with production resources within the group works poorly in practice. As a rule, planning processes are sequentially structured, and seek to produce a precise and sustainable plan for departmental silos for the coming planning period (typically from two to six months). The sub-plans created by the departments and divisions involved are only aggregated once during the entire planning period. If events occur during the period that run counter to plan, the corporate culture often causes them to be ignored until it is too late.

Having to admit that a plan needs to be changed is seen as a personal failure by many. As a result, departments often stick to their plan, despite obvious deficiencies, until the problems become so overwhelming that the entire plan has to be scrapped. By then, however, the decision backlog has become so long that no single department is able to effect a solution. The outcome is that a problematic package is escalated to group top man¬age¬ment. Due to a lack of detailed knowledge, however, the group’s top management may also be unable to find a decision beneficial to the business as a whole.

Visible process organization (VPO) is an innovative model that can turn the black box of “operations” into an efficient and effective organization whose processes are transparent and whose decisions can be taken in real time. Consequently, the company is able to respond quickly and effectively to changes in customer demand, in the supplier market, or in the competitive environment as a whole. Visible process organizations are closely modeled on the Mission Control Center of NASA. After a detailed study of the Johnson Space Center in Houston, a team of A.T. Kearney consultants identified the following success factors for NASA process management:

• Permanent deployment of decision makers in one place: From lift-off in Cape Canaveral all the way to landing, space missions are managed by the Mission Control Center. The Mission Control Center itself is manned with one representative for each of the critical disciplines, for example, Propulsion, Navigation, Systems, Payload, and Communications. Each Mission Controller in turn is just the “tip of an iceberg,” and is backed up by support teams of up to 1,000 staff.
• Dynamic re-planning process: NASA process management is designed to continuously monitor complex data streams for unforeseen events. If such events occur, they are immediately evaluated by the Mission Control team in terms of import and urgency. Adjustments are made to the plan as necessary. As NASA puts it: “We are not in the planning business—we are in the re-planning business.”
• Rule-based decisions: Clear, pragmatic decision-making rules are in place for handling the most critical situations. These rules ensure that when time is of the essence, the Mission Control Center focuses on solutions rather than engaging in abstract discussions.
• Delegation of decision-making powers to the Mission Control team: NASA’s top management delegates full decision-making competence for a mission to the Control Center. Any subsequent intervention is conducted in accordance with the decision-making rules.

Based on A.T. Kearney’s experience, the following are critical success factors for the introduction of VPO:

• Focus and commitment by top management
• Careful selection of the VPO team
• Concomitant change management

The introduction of VPO invariably engenders resistance within a company: VPO can be misunderstood as a centralistic approach; particular departments may shun the transparency associated with VPO; employees may refuse to move their office or to work in the open-office atmosphere of a VPO room. As opposition at any of these levels can cause a VPO project to founder it is crucial to obtain total commitment from the group’s top management even before the project begins. Unity among the group’s top management will keep the project’s launch on course even during critical phases.

The group’s top management needs to be aware that it is setting a milestone for the entire industry by opting for VPO. As a member of a major automotive group’s management put it, “VPO will be the defining organizational structure for the group during the next 10 years. It will assist us in translating the benefits of our platform and shared-parts strategy into corporate success.”

The selection of the VPO team is of key importance. Besides their professional expertise, ideal candidates are highly regarded within their regular work spheres and have strong team-working skills. In particular, the selection of initial team members should be made under the supervision of experienced HR experts. Appointment to the team should be seen as both a unique distinction within the company and a positive career move.

Change management for the introduction of VPO should be supported by specialists with experience in both the organization and operation of mission control centers in space travel or similar fields. This will ensure that the VPO team can continually refer to the relevant benchmarks when defining modes of operation. In fact, A.T. Kearney sometimes enlists the services of NASA experts in its VPO projects.

In many cases, it is not important for the company itself to have the responsibility for stocks of materials or pre-products. Inventory management is entrusted to the supplier, who usually handles it on the basis of electronically transmitted consumption data. As long as regular supply entails logistical problems, this is a partnership solution that substantially reduces storage costs while giving the supplier the advantage of strong customer loyalty. The supplier has greater freedom in planning deliveries and can, as a result, produce in more economical batch sizes, while at the same time responding more rapidly to demand fluctuations. VMI also makes for better utilization of transport capacities, fewer emergency deliveries, and reduced response times. Vendor-managed inventories often take the form of consignment stocks as far as transfer of title is concerned. The stocks remain the property of the supplier until actually requisitioned for use. VMI arrangements are especially suited for merchandise stocks with predictable, relatively high consumption rates.

Mutual trust between customer and vendor is a critical success factor for a vendor-managed inventory system. Any company intending to introduce it should do so in seven steps:

• Define the parameters: The more carefully parameters are defined for each situation, the more successful the implementation of VMI (safety-buffer stock, minimum size of delivery batch, and so on)
• Specify prices for vendor-managed inventories: VMI pricing must reflect the true costs to the supplier. This also indirectly determines the value of financial benefits
• Exploit an opportunity for supplier consolidation, since greater volumes with one supplier are more likely to produce meaningful VMI arrangements
• Share responsibility for designing the process: A VMI model requires close cooperation and complete disclosure of information by both sides
• Introduce key performance indicators (KPIs): These indicators (for example, forecasting accuracy, warehousing bottlenecks, and so on) will promote cost reductions in spite of high service levels
• Introduce a forecasting model: Base the model on historical data that factors in seasonal and other influences
• Have supplier buy up stocks: To start a program of vendor-managed inventories, the supplier should buy up all existing stocks

To summarize: VMI arrangements work so well because they identify those cost drivers along the value-creation/supply chain that influence inventories, allowing prices to the customer to be reduced without a loss of savings by the supplier.

Even after a painstaking selection process, a company was still struggling to find the right supplier. Supplier development, a process that can take several months or even years, was needed to transform a supplier into the reliable partner the company needed.

Supplier development can be used with both new and existing suppliers. However, “new” can mean that an existing supplier has not yet covered a certain product line or portfolio or that a previously unimportant supplier can be developed into a key partner. Or it could mean finding an entirely new supplier. Whatever the case, the focus is on the relationship with the supplier, and for this reason, the relevant term is “supplier development.” Only where there is high demand power can new suppliers be built up.

The process of developing and implementing meaningful strategies can be divided into four steps:

• Identify categories where supplier development efforts are warranted
• Profile and prioritize current or prospective relationships in terms of supplier development potential and the specific pool of candidate suppliers for consideration
• Assess and create specific strategies for the candidate suppliers, applying a common framework to assess gaps, potential value from improvements, and readiness to collaborate. Key stakeholders drive this shared assessment and prioritization in joint workshops
• Develop tools for strategy implementation. Focus on developing an implementation plan with the appropriate tools, including instruments such as a scorecard covering all key parameters from procurement volume to supplier dependability to competitiveness
• Implement measures, and report on the results

Best practice strategies for recruiting and developing suppliers show how successful companies develop their suppliers. Resources need to be made available and dedicated to the development of suppliers and joint offerings to create a relationship that generates more value. Focus not only on the home region, but beyond—to think and develop globally. To ensure this happens, involve suppliers in the customer’s business processes, pledged to the same goals and, if possible, certified. Communication needs to be open and should leave room for learning on both sides.

It should be apparent that some of these best practice strategies also lead to nearby squares on the chessboard. In any case, the key to supplier development is purposeful enhancement of the supplier-customer relationship to grow the supplier into an enterprise that makes an important contribution. In addition to developing new suppliers, the process may also involve cultivating existing suppliers and developing them to supply new products.

Supplier development may also be applied in the case of a low-price supplier that does not yet meet the procurement company’s requirements, either in technical or quality terms. Any company that decides to undertake supplier development has to be prepared to put its money where its mouth is, but the company will harvest positive returns eventually. The financial commitment can take various forms, including investment, volume guarantees, exchange of know-how, and initial price premiums. Provided the collaboration is long term, any amount can be considered well spent.

Fitness is just as important for a supplier partnering up with a customer as it is for an employee hiring himself out to an employer. In sports, fitness programs have the goal of burning excess fat, building muscle fiber, and achieving a sound and balanced physique. Many people engage a personal trainer to design a fitness program matched to their individual needs and using the correct approach.

The same is also true of a supplier fitness program, which finds the right strategies and employs the right levers, identifying and implementing cost reduction potential, to help a company’s supplier eliminate weaknesses and become more competitive.

In contrast to supplier development, which primarily strives to create new suppliers or increase the use of existing smaller suppliers, supplier fitness programs focus on existing large suppliers. The object is to improve the supplier’s cost position. This encompasses numerous measures that have a direct or indirect impact on costs and are developed and implemented through a structured program:

• Preparation and selection phase: First, appropriate suppliers need to be chosen for the program. (Supplier fitness programs are a complicated matter and cannot be undertaken for all suppliers—consider how complex this would be for an industrial company with some 8,000 group suppliers, for example.) Then sector-specific questionnaires need to be created, and internal and external analyses of product/process benchmark data undertaken. At the same time, visits to the supplier have to be planned. The aim of this preliminary work is to gain an understanding of the entire cost structure and product portfolio of the supplier.
• Opportunity scan phase: Evaluation of the supplier initially means analyzing its processes, with a particular focus on procurement and production. After identifying the cost-cutting levers, concrete activities that can boost the supplier’s fitness are devised, reviewed, and recorded. Each of these levers needs to be based on positively identified cost improvement potential.
• Implementation phase: The measures are implemented in close collaboration between the supplier and the customer, initially in a pilot area. The pilot project is then successively extended throughout the supplier’s operation.
• Reporting phase: Implementation results and the consistency of implementation are kept under constant review.

As many companies are not able to maintain the broad base of in-house expertise required for this activity, consultants are frequently called in at this stage to work on supplier fitness in joint client/consultant teams.

Companies with low demand power can join forces in order to achieve savings. Many have opted to outsource the management of certain product groups—especially those not at the core of their value-creation process—to allow them to focus their procurement resources on issues of strategic importance. In the case of sourcing communities, companies organize themselves within a formal structure, with the intent of collaborating on a long-term basis. If the collaboration is managed properly, savings of 5 to 15 percent can be gained—and as much as 50 percent in special cases.

But sourcing communities can do more. Because they are able to share resources (for instance, analysts or infrastructure) it becomes possible to pursue sophisticated strategies, even for low-volume sourcing categories—the aims of sourcing communities are closely linked to the size of the companies involved:

• Smaller companies at the same location can arrange joint purchases of technical items from one supplier, or achieve better terms for operating materials and supplies.
• Medium-sized firms in favorable sourcing regions can share the effort and expense of identifying and qualifying suppliers.
• Large companies can consolidate their demand for raw materials and have the materials bought on global markets by experts at the best terms.

In line with these widely differing goals, different types of sourcing communities can be identified according to a number of characteristics:

• Size: A distinction is made between communities involving partners of equal strength and those with a mix of small and big partners
• Geography: Is a geographical cluster what’s needed? Or a sourcing community open to companies from various regions? This is a decision that needs to be made
• Sourcing category: The focus may be on just a few product groups, or it may cover virtually the entire demand of its members
• Roles and responsibilities: A fundamental distinction needs to be made between sourcing communities whose activities are restricted to identifying suppliers (and perhaps negotiating master agreements), and those that also handle ordering on behalf of their members
• Interests and corporate strategies: A study by A.T. Kearney finds that 81 percent of companies form sourcing communities with partners in their own industry

The success of sourcing communities depends to a large extent on the choice of suitable partners—the partners should all pursue a similar business philosophy and have similar expectations regarding the collaboration. Since working together in a sourcing community means a major cultural change for many companies, strong backing by top management is essential, especially in the beginning. The group should also be a manageable size. Although the underlying idea of a sourcing community is an aggregation of procurement volumes, small organizations with just a few members have proved to be more agile and more effective. Attention should therefore be paid to exclusivity. Irrespective of the legal structure of the sourcing community, it should be headed by a single individual who is impartial toward all the members of the sourcing community. As he or she needs to ensure a balance of interests internally and communicate externally (toward the suppliers) with one voice, the definition of management rules (for example, sourcing principles and decision-making guidelines) should take place early in the process.

Buying consortia is the term applied to groups of companies that collaborate in the sourcing market. As well as achieving better terms, buying consortia may aim at pooling the know-how of partners so as to best fulfill the specific requirements of the project—safeguarding supply security is normally top of the list.

Buying consortia normally take the form of horizontal pooling arrangements—that is, procurement volumes are bundled with those of competitors working jointly on a major project. Special trust between the companies involved is not necessary; it is sufficient for all parties to consistently support the project goals.

Organizationally speaking, various types of buying consortia are conceivable. One promising approach involves internal or external networks of procurement managers who consult and coordinate with each other periodically throughout the project. This enables sub-projects to be distributed among several experts.

In many cases, customers will raise the issue of payment terms, bonus agreements, and discount rates right at the end of negotiations with suppliers, in the hope of obtaining some small additional concession. Once obtained, however, these benefits are often never exploited, either because differing agreements are in place within the group or because of a lack of transparency.

In this situation, a thorough analysis of cost data can help. In the “cost-data mining” approach, data available internally on purchased products and services is exploited for potential savings—the potential for savings is often much greater than originally expected. The specific procedure requires analyzing the cost data from various angles in order to identify correlations or patterns among the dozens of fields in the internal databases. To this end, the fields are organized in clusters and associations are formed. Some examples:

• Comparing bonus agreements between suppliers and categories
• Comparing discount rates between suppliers and categories
• Comparing payment terms between suppliers and categories
• Comparing delivery terms and delivery times between suppliers and sites
• Comparing rejection levels between product lines and suppliers

Almost since industrialization first started, industrial standards have existed in Europe and the United States for small parts such as spacers, distance sleeves, slide bearings, insulating sleeves, nuts, finishing washers, quick connectors, screws, bolts, circlips, drive fasteners, and washers. So why do we see a huge increase in the use of non-standard parts?

This question is also being asked by plant managers, who face increasing difficulties in finding the space for the enormous number of containers required, each holding a different type of small part. Standardization—that is, striving to use as many standard parts as possible—is an antidote to this trend. The savings that can be realized in material costs, production, service, and logistics are obvious. Ultimately, this approach reflects the idea behind introducing industrial standards in the first place, namely to make life easier for engineers.

The process of standardization is easy to manage. The first step is to identify parts or groups of parts that can be replaced by standard parts. This is followed by selecting the standard parts best suited for the job, based on simple substitution criteria—that is, similarities in material, material properties, dimensions, and tolerances; comparability of surface coatings; and similar or enhanced functionality.

Standardization programs tend to face a number of obstacles. Here are some of the objections frequently heard:

• “Every technical change also means changes to the drawings, and that will take too much time.”
• “Small parts are parts with very low costs, so it’s not worth making any changes.”
• “The customers don’t want changes; we would have to get every single change approved by customers.”
• “To implement standardization, we would have to make major changes to our processes.”

The most powerful lever for overcoming these obstacles is to bundle all the standardization ideas into one big program. This usually allows a convincing volume of savings to be achieved, and consequently, an acceptable ROI.

The first step of the process is to obtain a small amount of key information from a large number of theoretically capable suppliers using RFIs (requests for information). The next step is to obtain highly detailed information from a small number of interested, qualified suppliers using RFPs (requests for proposal).

The RFI/RFP process has become part of the basic repertoire of purchasers, who have gained wide-ranging experience in its use. Nonetheless, there still seems to be room for improvement in its application.

The RFI has two main functions. The first is to obtain basic information from suppliers concerning their product range, capabilities, customer references, and technologies. This data provides a basis for selecting the suppliers to whom an RFP will be sent. Second, the RFI has a communicative function: sending the RFI to a large number of targets communicates to a broad audience that new suppliers are being sought. This has the effect of waking up the competition at an early stage of the sourcing process and producing a speedy improvement in negotiating position, especially on the part of existing suppliers.

An RFI should be as concise and simple as possible. (Frequently, due to its numerous pages and questions, an RFI looks like a commercial or technical audit!) As its main goal is to achieve the highest possible response rate, those completing it should be able to do so in a matter of minutes, preferably by simply checking boxes.

An RFI typically consists of three parts:

• A cover letter to introduce the inquiring company and arouse the interest of the supplier
• A general section, typically the same for all RFIs, requesting details about a small number of key aspects such as sales, employee numbers, and customer referrals
• A section specifically relating to the sourcing category(s) concerned. This includes a limited number of questions that enable the inquiring company to determine whether the supplier can meet specifications and is interested in an RFP

The RFI is then sent to the maximum possible number of potential suppliers of the goods in question. The list of potential suppliers should be based on a wide variety of sources and resources—for example, databases, Internet research, and known suppliers. Formerly, RFIs were sent manually by fax. Today, more elegant methods such as specialized portals are available.

The RFI responses become the basis for selecting those suppliers that will receive an RFP and the relevant technical data. Note that it’s also important to make the RFP as supplier-friendly as possible, to avoid tying up their resources. Suppliers do not have an unlimited number of engineers and cost accountants at their disposal, and have to prioritize their deployment.

A key component of the RFP process is a clearly structured proposal sheet that lists required parts, with space for the supplier to enter its prices. It is important to clearly define what price level is being requested (for example, ex works or delivered duty paid; with or without tooling costs; and so on). The proposal sheet should be easy to understand and complete, and should allow a simple and systematic evaluation of responses.

All the necessary technical information, including drawings for each part number, specification, or data sheet, and generally applicable technical standards, should accompany the proposal sheet, and the supplier should be able to clearly identify what technical information refers to which component. Ideally, data files with technical drawings should have the same name as the parts being inquired about. Unclear inquiries are one of the most common reasons suppliers discontinue preparation of an offer and turn their attention to another inquiry instead.

Feedback should be given to participating suppliers immediately after an offer is received, and should compare the offer’s terms with those of existing suppliers. Providing feedback allows the opportunity to improve on an offer right at the start, and has the double benefit of ensuring a supplier has properly understood all the requirements. Finally, since preparing offers requires a great deal of time and effort on the part of suppliers, the practice of providing feedback also ensures that excluded suppliers bid again in future (this time perhaps successfully).

In the traditional tendering process, suppliers are able to decide on only two variables: first, whether to submit an offer or not; second, what product price to offer. However, the world is not that black and white. Suppliers are often prepared to make price concessions if they know they will be given a bigger slice of the pie.

Cases such as this can be described as an “if-then” condition. An example: “If” a supplier is awarded Part B in addition to Part A, “then” he will reduce the price for Part A by a further 10 percent. Provided only a small number of total offers contain “if-then” conditions, it is easy to consider them during the evaluation process.

As soon as offers contain a large number of “if-then” conditions evaluation becomes more difficult, especially if such offers are submitted by suppliers bidding for different segments of the total volume available. In the face of a large number of “if-then” offers and a large number of bidding suppliers, it is almost impossible to identify the maximum possible savings using conventional means.

Expressive bidding is a strategy that allows price bids with “if-then” conditions to be submitted. On completion of the bidding process, an algorithm integrated into the expressive-bidding tool calculates the maximum possible savings at the press of a button. By changing the framework conditions or by specifying individual suppliers, procurement can then calculate savings for various scenarios. For suppliers, expressive bidding offers a great deal of flexibility and myriad opportunities for differentiation. For the procurement company, it enables the cost-cutting potential to be fully exploited.

Although total cost of ownership has been part of the purchaser’s toolbox for years, it is understood and applied to varying degrees. TCO encompasses all the costs arising from the purchase, utilization, maintenance, and ultimate disposal of a product within a company. Anyone who investigates all the influencing factors will acquire insights that help in comparing two suppliers. Hidden costs, which often far exceed primary costs, will become visible. Only then can meaningful comparisons of suppliers be made and effective sourcing strategies developed.

In the best case, the TCO strategy can lead to value creation partnerships whose focus is not exclusively on price reductions. TCO also helps to eliminate activities that do not contribute value from the life cycle of a product or service. Moreover, the savings possible through strategic procurement can be more accurately predicted by TCO than by other means. The process is simple and follows logical rules.

The first step is to define all relevant costs (particularly material and production costs) and cost drivers, and then calculate the costs for each part. Integrating the TCO strategy at an early stage of a tendering process will allow basic costs of the company to be completely depicted, which in turn allows RFPs to be compared.

All in all, a disciplined and structured approach is critical in focusing on those cost components that can be most easily influenced. The application of TCO is particularly worthwhile in certain areas:

• Transportation: What is the cheapest method for shipping materials, and how does this differ from the current method? Can packaging material be returned, for example?
• Parts logistics: How can parts logistics in the production process be improved? How can the throughput time of parts deliveries be shortened? How can inventory costs be reduced?
• Set-up times: What causes the longest set-up times? Are there other machines that could be used in order to shorten set-up times?
• Production process: How should volumes be changed so as to justify either a manual or an automated process? What would be the most difficult, most expensive, most time-consuming component?
• Administration/indirect costs: Is there a more efficient interface with ordering systems? What could be achieved by changing the duration of contracts?

It will be clear by now that TCO should be part of any sourcing process. Only then can total costs be meaningfully included in all deliberations. This especially applies to the procurement of sophisticated capital goods, the pooling of procurement for the whole company, and the consolidation of redundant parts numbers.

A total cost overview can also produce many positive effects in other areas. Contract damages can be avoided, simulations can be used in advance of prototyping, and returnable packing materials can be employed, for example. Other possibilities are the use of Electronic Data Interchange (EDI) or a simple evaluation of the profitability of individual suppliers.

Market imbalances are phenomena that usually only exist in economic theory. In this strategy, the aim is to systematically identify market imbalances and exploit them for procurement purposes. Such imbalances can come about as a result of differing capacity utilization across certain regions, variable price mechanisms, or currency fluctuations.

Market imbalances can be recognized by checking core indicators for certain supplier markets at regular intervals. These core indicators include national price indices for various material groups (in combination with exchange rates), or capacity utilization figures for certain industries. Examination of the differences in these core indices or comparisons across countries can provide a good overview of the materials costs. It may be found, for instance, that certain cost developments are restricted to a specific region and can be circumvented by changing to a supplier in another country.

We are seeing increased outsourcing of not just customer service and payroll, for example, but also of activities that more directly affect a company’s value generation process. And, indeed, procurement has now joined the outsourcing market. Before the step toward outsourcing procurement is taken, two core questions need to be answered:

• What services are expected? Outsourcing partners offer companies the complete range of activities on the transaction side including ordering materials, comparing invoices with orders, paying suppliers, making optimum use of contracts and spot buying, administering (consignment) inventories, handling demand management, and looking after the standardization and administration of master data. Procurement even takes responsibility for strategic issues such as the definition of sourcing strategies and the implementation of cost optimization.
• What material and service groups are suitable for contracting out to outsourcing partners? They specifically include materials and services used by a large number of companies across a wide range of industries. A classic example is operating materials and supplies. While there are numerous suppliers and dealers in this highly competitive market, procurement usually has little price leverage because of the small quantities involved. By bundling the volume for all of their clients, outsourcing partners are able to obtain significantly better terms from suppliers. And at the same time, process costs are optimized because multiple firms’ orders are dealt with simultaneously.

Outsourcing of the procurement function (or at least parts of it) is prepared and implemented in four steps:

• The first step is to assess the feasibility of outsourcing, by identifying and comparing the internal costs for procurement personnel and additional process costs for the maintenance of data occurring outside of procurement with the costs of external providers. The internal potential should be based on historic figures, while the external potential is defined directly by the prospective supplier. The potential for minimizing the costs of procurement in each case should also be determined. Because of bundling effects and the corresponding significantly higher demand power, the external potential for savings is usually higher. Any outsourcing decision should require the approval of top management.
• The next step is to define the outsourcing model. This includes the preparation of a service agreement with targets, roles, and responsibilities, and a description of the procurement process.
• The procurement process is then given over to the external provider. The materials data, requirements, supplier information, and specifications for delivery are also handed over. During implementation, all contracts are newly concluded. For companies with several sites, implementation normally takes 12 to 18 months.
• Ongoing control of the external provider then needs to be put in place. A mechanism needs to be created that allows performance to be continuously measured, and conflicts resolved, as quickly as possible.

By outsourcing procurement, a company is able to both take advantage of the lower prices and process costs arising from the much greater demand power of its outsourcing partner and minimize its business risk. In addition, outsourcing enables procurement to focus on strategic questions.

Besides clearly defining the distribution of functions between internal and external services, procurement outsourcing also clearly—and crucially—defines the scope of services to be performed by the external provider.

It sometimes happens that two divisionally structured groups of companies have a mutual business volume worth dozens of millions of US dollars, but are virtually unaware of this fact. This can happen when the customer-supplier relationship is handled on a decentralized basis on both sides—for example, when a local profit center of the supplier serves a local profit center of the customer. If these profit centers do not operate under the group name and the spend is spread over many different product groups, it can be challenging, even with the best efforts and intentions, to determine just how big the business volume actually is.

If most of these relationships are not on the radar screen of top management at both groups, it will be extremely difficult to achieve any real optimization at the level of procurement. This is precisely where the mega supplier strategy comes in. By making transparent the huge procurement volume transacted with a big, divisionally structured supplier (“mega supplier”), the many-to-many relationship is turned into a one-on-one relationship.

The essential step in creating a mega supplier strategy is to determine the mutual interests of both sides. This means determining the degree of dependence on the mega supplier for each product group and identifying the special concerns associated with each group. These concerns may encompass a large number of topics, from the urgent need to cut costs to a requirement for product innovations. Thus scenarios for future business development will have to be presented to the mega supplier. These scenarios can range from the total loss of a prestigious reference customer to highly attractive sales growth.

Following an internal consultation process, the customer’s top management should then meet with that of the mega supplier. If the meeting is well prepared, it usually turns out to the customer’s advantage.

Nobody knowingly builds his house on sand. Nevertheless, the master data of many companies is in a pitiable state. This means that all the systems, evaluations, sourcing strategies, and reported savings that are based on such unreliable master data are very much like houses built on sand.

Procurement, for its part, draws on data from a large number of sub-systems in order to compile comprehensive information on suppliers, demand and supply factors, payment terms, and prices. Hitch-free master data management is thus a major prerequisite for bringing transparency into procurement data. Master data management encompasses the standardized classification of material and supplier data, consistent linking between master data and the ordering system, and the avoidance of free-text ordering.

Many companies face considerable challenges in this process. This is because the role of data management is often restricted to that of mere administration, while the master data structure is often non-standardized insofar as the company was created through merger or acquisition.

These challenges can be tackled by master data management, which is especially important for groups of materials not shown in parts lists, including indirect materials such as lubricants, occupational health and safety items, or spare parts.

The first priority in optimizing a company’s master data management is to review the quality of data. This involves ascertaining the extent of coverage the maintained master data provides, the data’s level of detail, the volume of inactive data present in the system, and the extent to which harmonization of individual data systems is ensured. This is followed by an analysis of the categorization systems, the required level of detail, and the appropriate solution for categorization. The sorting and restructuring process, undertaken with the aid of innovative and intelligent tools, encompasses the following:

Classification system

• Limitation of categories
• Introduction of sustainable and understandable logic
• Avoidance of gaps for particular sectors
• Avoidance of the category “Miscellaneous”
• Clear demarcation between categories

Material master data

• Classification of all materials and services
• Link-up between electronic catalogs and the classification system
• Link-up between suppliers and material groups

Orders

• Avoidance of orders with free-text entry
• Requirement for users to use valid keywords for categorization
• Manual review of orders

This is followed by an analysis and definition of the process for specifying, deleting, amending, and administering master data, and an analysis and definition of functions and responsibilities. The results can be used as a basis for spend transparency, procurement management, and sustainability of savings.

Like parched travelers in the desert who chase after every mirage, many companies engage in massive SAP or Oracle projects, hoping to come up with the perfect integrated solution that can supply any desired corporate data at the press of a button. At this time of seemingly never-ending mergers and acquisitions, however, it is simply not possible to achieve such a goal. Large-scale IT projects will always lag behind corporate reality and—especially in the post-merger phase—will never answer the question that most interests procurement: Who buys what from which supplier?

What is needed is an alternative solution that can provide precisely this information with the aid of a spend cube, using the three dimensions of “location,” “product,” and “supplier.” The cube itself enables intersections to be made on all planes and allows initial fundamental analyses to be carried out—for example, identification of bundling potential between sites, comparisons of the number of suppliers, or the proportion of sourcing in countries with high-cost factors. All the data needed for creating this sort of cube can already be found in the internal system. The cube itself can be created using various methods.

The choice of tools depends on the complexity of the company and the desired sustainability of the cube. If the company has a homogenous, uncomplicated structure, the data needed for the cube can normally be retrieved from existing systems using standard interfaces. In cases of this kind, the only tool normally needed is a standard spreadsheet program.

In heterogeneous and complex companies, on the other hand, highly sophisticated tools are often required. Many companies only produce a small volume on the basis of parts lists; these companies have much higher expectations with regard to data transparency. This is often accompanied by a wish to “dynamize” the cube—that is, to update the data it contains at periodic intervals (often monthly). In this way, the cube acquires great importance as a management tool. As a periodically updated tool, it allows the tracking of procurement at individual sites; in addition, procurement management can use it to monitor compliance with master agreements. A spend cube’s capabilities can vary widely, with the expense involved differing accordingly.

As a strategically important department, procurement needs to have and maintain a thorough knowledge of the supplier market. Systematic supplier market intelligence is therefore one of procurement’s core tasks. Supplier market intelligence can be divided into two major areas:

• Existing suppliers: Procurement, analysis, and interpretation of internal and external information on existing suppliers is the goal. Internal information should comprise not only purely cost-oriented figures (for example, spends, price development, and so on), but also key figures on supply capability, quality, results, and innovation, and should be supplemented by external data such as credit and press information. Another important aspect of supplier market intelligence: keeping an eye on the supplier market (by attending trade fairs, for example) to obtain a first-hand perspective.
• New suppliers: Since it is also vital to be up to date on the latest developments on the market, supplier market intelligence also has the goal of obtaining information about new suppliers. External supplier market intelligence is gathered through the ad hoc use of external supplier databases (for example, http://www.alibaba.com), the creation of a web-based supplier portal, and the establishment of an international sourcing office.

Regardless of whether the information is available externally or internally, an important factor in successful supplier market intelligence is the systematic compiling of supplier information, ideally in the form of a central supplier database. In this respect, procurement can learn from marketing: by analogy with “customer relationship management” (CRM), systematic supplier market intelligence requires “supplier relationship management” (SRM). The key is that relevant information be systematically collected, entered, and evaluated, so that it can be easily accessed and used by relevant members of the procurement department.

For a long time reverse auctions were considered to be the same as online auctions. Since eBay came on the scene, online auctions have become much more common for both private and business users; they have been a regular feature for years where the aim is to attract simultaneous offers in a secure environment. Online auctions are a way of creating markets with significantly shorter handling times for buyers.

Before holding an auction, there are five main questions to consider.

• Which type of auction is best suited? There are lots of different models that can be used, depending on the competition. There is, for example, the typical British reverse auction, with prices starting high and decreasing with each bid, and the winner is the one with the lowest bid at the end. Different from this is the Japanese reverse auction, with prices also starting high but going down automatically in rounds, with the suppliers having to confirm the new lower price in each round, or dropping out. The winner is the last man standing. The Dutch reverse auction is often used in big market halls for mass auctioning: here the prices start low and automatically go up every few seconds. The auction comes to an end when the supplier presses the buzzer and accepts the current price level. There are many other types of reverse auction.
• At what point should the auction be held? One option is immediately following the initial negotiations with selected suppliers. Timing is important—an auction can shorten the entire tendering process.
• How many suppliers should be included in the auction? (An auction can also be used to identify possible suppliers from the get-go.) If the main objective is to complete the tendering process as quickly as possible, no more than 20 suppliers should be considered. However, if the purpose is to obtain information on the suppliers’ pricing structures, this limit can be disregarded.
• What will the pricing structure be? If the intention is to procure a large number of individual items via the reverse auction, pricing should relate to a whole basket of products. Where only a limited number of items are involved, individual bids and pricing offers are preferable.
• How long should the auction last? A meaningful auction cannot be completed in less than 30 minutes. On the other hand, if it takes more than two hours, time will be wasted. Timings need to be set in advance and stuck to, depending on the number of items to be procured, the price structure, and the complexity of specifications.

The online auction should relate to clearly specified product groups in order to avoid any misunderstanding. But even the most efficient auction cannot operate without open-minded and Internet-friendly suppliers.

Reverse auctions are more than just online auctions. When online auctions first came on the scene, a great deal of attention was given to this new way of buying and selling. Nowadays the same principle is applied by many companies to niche categories not particularly suited to online auctions: that is, parallel negotiations are conducted without an online tool. Strictly speaking this is not an auction, but the principle remains the same. Companies invite shortlisted suppliers at the same time and conduct parallel negotiations in different rooms, constantly providing immediate feedback to competitors and driving down prices while sorting any queries.

Price benchmarking is a flexible and comparatively simple method of analyzing the price situation for different components or material groups. It involves comparing the prices of a company’s sourcing category with the prices paid by other companies under similar conditions and with the same specifications. As with every comparison, the improve¬ment potential is indicated by the difference between the two figures.

Price benchmarking is only possible for identical or similar products. If differences are found, the values have to be “normalized.” The price benchmark can be applied not only to unit prices or price distributions, but also to contract conditions. Unit price benchmark consists quite simply of comparing unit prices. To take account of price discounts or other allowances (as customary with software), unit price benchmarks are often also compared on the basis of price corridors. Price distribution benchmarking is especially suited for services of all kinds—for example, IT services.

TTo perform the comparison, distinctions are made between different levels of skills or services. A project manager, for instance, needs to have different abilities than a technical assistant or a consultant. Benchmarking of contract terms is done by comparing the individual parts of agreements. The aim is to analyze contracts with regard to pricing options and search for references to possible price adjustments. To this end, comparisons can be based on external price indices or information provided by suppliers with regard to their cost structure. New contracts can then be negotiated using the resulting data and benchmarks.EXT

In the past, there was a trend for companies to purchase modules or systems, specifically as a way of reducing the complexity of their own procurement. This frequently resulted in the loss of technological or commercial transparency, particularly for parts with a high share of service or development costs, or those bought as a complete system but having clearly definable components.

Unbundling of prices addresses this challenge and generates transparency with regard to the price structure of a module or system. It does so by breaking down the total price of a product or service into the relevant price elements for individual components or process steps. The price transparency gained in this way can then be used for determining target prices.

After breaking down modules or systems into smaller components or process steps, target costs for the individual part-products can be identified in one of two ways, either by submitting an inquiry to potential suppliers for the individual component, or by determining target costs using cost analyses based on specific cost drivers (for example, cost-regression analysis or cost-based price modeling).

The resulting price transparency for individual components can be exploited in different ways. It can be used in renegotiations with the system supplier; or the buying company may stipulate the use of parts by lower-cost suppliers. Alternatively, the company may be able to abandon system procurement altogether and buy components instead.

Of what use are carefully negotiated contracts if product users within the company do not order from the corresponding suppliers? Due to inadequate transparency, badly defined responsibilities, or simply a lack of incentives, framework procurement agreements often remain unused. Instead, preference is given to relationships with local suppliers.

The purpose of compliance management is to bring order to this kind of slackness. A key component of the control process is careful and detailed documentation, in the form of noncompliance reports, of all procurement that takes place outside the selected supplier circle and all deviations from the rule.

These reports are completed by the product user as part of the ordering process whenever he or she wishes to source from a supplier outside the preferred circle. Noncompliance may be sanctioned in certain cases, such as the following:

• Business needs that generally cannot be met by the scope of products and services of the selected suppliers
• Specific, short-term demand that the selected suppliers are not able to meet

Initially, deviations of up to 10 percent are tolerated, with only bigger deviations triggering a reaction. After a certain time, the margin can be reduced to 3 percent or even zero. In order to achieve complete compliance with the company’s contracts and agreements, a number of conditions need to be fulfilled:

• Since product users obviously have to be aware of the agreements and know who the preferred suppliers are, procurement needs to ensure this information is clearly communicated within the company.
• The ordering process needs to be structured in such a way as to prevent inadvertent noncompliance—for example, by making it impossible for certain product users to place orders outside the selected circle of suppliers. Similarly, the catalog of products that can be ordered from these suppliers is restricted. This is frequently done in the case of office equipment.
• The processes need to be sufficiently user-friendly for users to comply voluntarily (and not because the “bureaucracy” forces them to comply).
• Guideline compliance needs to be supported by positive (and also negative) incentives, both for the product user and the purchaser, whose work is naturally oriented to the needs of his or her internal customer.

Ultimately, it is up to top management to set an example by adhering to the rules and making it clear that it is serious about its compliance requirement.

Many companies have substantially intensified their sourcing efforts during the past few years, with sometimes remarkable outcomes. Nevertheless, the sustained effect on results has often fallen short of expectations. Closed loop spend management offers an all-encompassing approach to address “value destroyers” in a way that is geared to the specific sourcing situation. The challenge usually lies in the fact that procurement only has real influence on a very small segment of the value-creation process. In the case of direct materials, for instance, procurement often becomes involved only after specifications have already been defined by the technical division—it has some leeway in selecting the supplier and concluding the contract but little influence on the process. Moreover, there is often a lack of transparency into how demand planning is done, when the order is actually placed, when the goods are received, and when invoices are paid.

The aim of closed loop spend management is to optimize expenses throughout the value-creation process and generate sustainable value for the company. In a targeted analysis for specific product groups, potential value destroyers (imperfect spend transparency, demand management, user and supplier compliance, payment management, and process costs) are identified and concrete measures are initiated. Successful companies have established closed loop spend management as an end-to-end process within the responsibility of procurement. This means procurement is given not only the required information but also the power to implement necessary measures in conjunction with product users, internal users of third-party services, and those with functional responsibility.

However, there are several challenges when establishing and implementing a closed loop spend management solution: incongruent taxonomies as well as incomplete and inaccurate data from desperate bad data sources. To overcome these challenges, closed loop spend management should be forward looking and anticipatory about the coming age of big data, machine language, pattern recognition, and natural language processing. Because data integration is a continuous process, machine learning techniques should be leveraged for developing ontology-driven (textual attributes such as product descriptions) classification algorithms and mathematical model-driven clustering methods with the intent of reducing integration costs and accelerating deployment of these new capabilities over time.

As companies continue to invest in supply chain and procurement-related systems, big data and machine learning-enabled closed loop spend management solutions provide the most accurate, unified, and real-time visibility into spending across the organization, enabling procurement to conduct performance-instinctive analysis and answer crucial questions. The big-impact areas will be faster and provide more accurate visibility into “dirty tail spend areas” (such as facility or line-level MRO and fragmented temporary labor spending), procurement merger synergies, transportation contract billing audits, and other previously painful data integrity challenges.

A paradox frequently observed is that companies often depend on a monopolistic supplier for items crucial for success, while they maintain relations with a large number of suppliers for standard items. Here, action needs to be taken to reverse the situation. Too many suppliers for uncritical items tie up resources, distract from issues of real importance, and are ultimately not even able to produce good prices. Thus, supplier consolidation means, above all, eliminating smaller suppliers by shifting to bigger or strategically important ones, creating savings through economies of scale. But maintaining less supplier data and fewer contacts in the system also results in savings. The procedure for supplier consolidation is found in the basic procurement toolbox and consists of the following activities:

• Collecting data (who buys what from which supplier) for at least 80 percent of spend
• Leveraging competition from existing and new suppliers
• Negotiating with interested, qualified, and competitive suppliers
• Choosing the preferred future suppliers on the basis of cogent criteria
• Changing over to these preferred suppliers in a consistent manner

The success of this measure depends first and foremost on being open toward new suppliers and willing to give up cherished habits (such as favoring suppliers who maintain a high profile and take care of the little things, but charge a high price for it).

Every company can bundle, even those with only one product and one site. How is that possible? By bundling across product generations. This approach has practical applications above all in the project business. By definition, a project is an undertaking with a clear goal and an end. To avoid treating each project as an isolated, one-time affair, and to succeed in bundling across generations, an appeal needs to be made to the entrepreneurial imagination of suppliers.

Even though only minimum negotiating strength may be associated with a current project, it is possible to gain substantial concessions from a supplier through the prospect of inclusion in actual or possible future projects. If the supplier can supply the same products for future projects, it may even be possible for tooling and development costs to be amortized over several projects.

According to a rule of thumb, activities that constitute a company’s core competence or that are based on a sustainable cost advantage should be performed internally.

Core competencies can be recognized on the basis of two criteria:

• First, a decision needs to be made on whether or not a certain product or process is strategically important for the company. Strategically important products or processes are those that embody a proprietary technology or have high customer value. One way of measuring strategic importance is to determine the R&D expenditure on the product concerned.
• The second criterion is of an operative nature, namely the extent to which the company’s own abilities to produce a particular product are better than those of other existing suppliers. This “operative performance” can be assessed on the basis of three factors: process reliability, service, and product quality. Important indicators in this regard are the number of (internal) complaints or the fault rate for certain products. The criterion of operative performance also measures the extent to which suppliers or production capacities are available in sufficient numbers/quantities.

Competitiveness can be assessed on the basis of these two criteria:

• The first criterion involves evaluating the extent to which a process or product currently produced in-house is cost efficient. This can be done by comparing the company’s own cost structure with that of alternative sources. In this context, a high degree of “costing honesty” is necessary. Especially when it comes to the valuation of activities performed in-house, it frequently happens that cost-effectiveness is rated too optimistically because of a failure to adequately factor in overhead. This criterion also includes assessing the rate of internal capacity utilization and how, in the event of underutilization, in-sourcing can serve as a lever.
• Besides cost effectiveness, the second criterion for evaluating competitiveness is the extent to which the cost can be improved upon. This question calls for an objective analysis of profitability. As soon as a gap is found between the in-house cost and the outsourcing possibility, an assessment is made of how the profitability gap can be closed.

The expression “IT offshoring”—the outsourcing of processes to geographically remote regions—first came into use when, in response to the Y2K computer threat, programming and software activities were outsourced on a grand scale to low-cost software firms in India. Among the main drivers for offshoring to India were the cost advantages and educational levels comparable to those in the West.

The initial hype was soon followed by disillusionment, however. Outsourcing turned out to be more expensive than envisaged, deadlines weren’t met, cooperation proved difficult, and many companies were dissatisfied with the results. The reason for this failure was the one-dimensional nature of the outsourcing decision, which was based solely on costs and failed to account for other factors such as productivity, quality levels, operating risks, manpower availability, and cultural issues.

The bestshoring strategy involves a comprehensive evaluation of which region or country is the most suitable match for producing a certain item or service. Basically, there are three different types of bestshoring: onshore, nearshore, and offshore. Onshore refers to production of the goods or service in the home region, where cost structures are similar (in Europe, this would mean Western European countries, and in North America it would refer to Canada and the United States); nearshore refers to a region that is geographically and culturally close but offers major cost advantages (in Western Europe this would particularly include Eastern Europe and Turkey and in North America, Mexico); and offshore refers to a geographically distant region (traditional offshoring countries for both Europe and the United States are India, China, Malaysia, and the Philippines).

The bestshoring evaluation process selects the most favorable location by applying a comprehensive set of criteria which includes not only cost-effectiveness and scenario analyses, but also an assessment of service and quality levels, the question of warranty, and risk analysis and assessment:

• Experience shows that cost-effectiveness analyses tend to lowball both the expenses involved in managing resources in the new region and transaction costs for know-how transfer and training. For example, many companies that shifted production processes to Eastern Europe underestimated the rate of subsequent pay increases, which in some regions were in the double-digits. The cost-effectiveness analysis should encompass detailed consideration of all relevant personnel costs. Also, wages/salaries and payroll deductions, costs associated with the availability of qualified personnel, productivity issues, and possible wage increases need to be factored in.
• Besides cost effectiveness, it is critical to evaluate service and quality. Managing service and quality over great distances and across cultural divides is difficult at the best of times; the current short supply of skilled personnel (which is the case even in India) increases the challenge.
• A further factor that needs to be considered when evaluating locations is the possibility of making warranty claims. Warranty claims are virtually unknown in some low-cost countries. Further, for some industries, damage or compensation claims can threaten the very survival of the business. The issue of warranty claims needs to be taken very seriously.
• Finally, the bestshoring strategy also includes analysis and assessment of potential areas of risk such as difficult, emotionally fraught know-how transfer, high levels of personnel fluctuation, political instability, and limiting bundling to one location.

Sometimes, procurement and its extended cross-functional team will not have enough knowledge or power over suppliers to build a detailed bottom-up cost model as described under cost-based price modeling (G1) or factor-cost analysis (H2). Many suppliers will not be willing to provide a cost breakdown, or they will manipulate the data. In addition, the procurement team may be under time constraints to negotiate a final price and may not have enough time to develop a detailed model. In this case, cost-regression analysis is the right method because it uses data that already exists within the company to assess suppliers’ cost positions.

Procurement will typically have access to two sets of information about each part or service:

• Commercial data such as price, volume rebates, and delivery and payment terms
• Specifications for parts (technical parameters such as weight, volume, material type, tolerances, and other technical parameters that define the part) or services (element of service level agreements, such as frequency, scope, technical knowledge, and the capability level of the people delivering the service)

This data can often be found in past requests for proposals. A method is needed to help understand the dependency of the price from the respective (mostly technical) specifications. Cost-regression uses statistical tool regression analysis to help estimate the relationship between many variables. In particular, it describes how the dependent variable—the price (p)—will change when the independent variables—the specifications (x)—change. For example, the price for using Uber services depends on three variables: distance of travel, type of car, and the current usage level of Uber cars in service.

Mathematically, the dependence of the dependent variable p from the independent variables xi is described as follows:

p=α_0+α_1 f_1 (x_1 )+α_2 f_2 (x_2 )+ ...+α_m f_m (x_m )+e
where α_i is a weighting coefficient, f_i (x_i ) is any function of xi, m is the number of different parameters, and e is the error (residuum) of the model. In procurement, you have usually a linear dependency. Therefore the price-specification relationship simplifies to the following:

p=α_0+α_1 x_1+α_2 x_2+ ...+α_m x_m+e.
Given a set of data points with prices and specifications (pk; x1k; x2k;… ; xmk), the cost-regression analysis statistically calculates the weighting coefficients α_i in a way that the sum of the squared residuum δ is minimized—that is, identifying the set of α_i for all:

p_k=α_0+α_1 x_1k+α_2 x_2k+ ...+α_m x_mk+e_k that minimizes δ=∑_1^k▒e_i^2.
Knowing these weighting coefficients, you can calculate a price for any combination of specifications xm, the target price.

As shown above, cost-regression analysis is a linear, multivariate regression model. This model helps you to:

• Understand what parameters have an influence on the price (dependent variable) and how strong (quantitatively) this influence is
• Forecast the price (target pricing)

Because this model is based on statistics, several preconditions need to be fulfilled to get reliable results:

• Certain level of complexity of specifications (cost drivers): A minimum level of technical complexity of the products to be analyzed is required to prevent certain parameters from becoming dominant. If this happens, a simpler linear performance pricing can be used instead. We recommend this tool for products that are assembled from different sub-components, require a high content of manufacturing value added, or are based on different manufacturing technologies.
• Enough variation among the specifications: Even if we have enough parameters identified, we will need sufficient variation of these parameters between the products to be analyzed. If one parameter shows only minor difference between products, the parameter will most likely be useless because the statistical model will not be able to determine its influence on the price.
• Sufficient number of products to be analyzed: To ensure a proper statistical environment, a sufficient number of parts need to be included in the model. Based on past application among many different category groups, we do not recommend applying cost-regression analysis on a sample with fewer than 40 parts. If there are too few parts, the regression will have too much influence by outliers, resulting in poor quality of regression (statistically described by low R2 ratio).

For application in daily procurement practice, verify the availability of the data within the organization upfront. Procurement usually has all commercial data, including prices, supplier names, and volumes, already on hand from the ERP systems. Nonetheless, technical specifications often need to be collected from the engineering department in a structured format. The team will have to evaluate how much effort will be required to collect these parameters. Most of the time, it can be done by a junior engineering resource in a limited amount of time.

In general, a cost-regression analysis occurs in four phases, beginning with collecting and preparing data. In this phase, it is essential to define the right set of parameters that are expected to drive costs. We recommend doing this with your technical department or perhaps with the supplier, which significantly increases the acceptance of the results. The collected data needs to be checked for completeness and plausibility, and qualitative information has to be quantified. For example, for material specification, we may estimate material cost levels; for quality, we may use proxy to describe the level of quality; and for color, we may use price differentials between different color groups.

During the second phase, the regression model will be built and tested for its statistical relevance. In several iterations, the model will be adjusted to optimize the quality of the regression (increase R2) by potentially removing parameters that show mutual dependencies (such as weight and density or volume), and linearizing some parameters to better fit the linear regression model. After the model has been optimized, the results will be validated within procurement and with engineering or other departments that provided technical parameters. Here, outliers will be discussed to understand a potential rationale and see if any parameters have been omitted that should instead be included to explain the difference.

Finally, data will be extracted from the model to aggregate the results and prepare a negotiation strategy. Renegotiating with suppliers based on target price identification is the core application of the cost-regression analysis within procurement. With this model, procurement can quickly analyze the cost position of a particular supplier or of selected parts and identify opportunities to reduce costs. These reductions are calculated by taking the difference between the purchase price of a selected part and the respective value of the target-price curve. To increase your identified savings potential, you can also calculate the target price function based on the first one or two quartile parts. The results of this method give you a strong argument to renegotiate for rapid cost reductions with a supplier. Suppliers also welcome this approach because it gives them transparent feedback about their cost position with like-for-like suppliers as all suppliers included in the analysis are delivering parts or services to the same company.

In addition to renegotiations, cost-regression analysis can be used for other applications. For example, it can be used to compare prices for the same parts from different business units. It can be used to identify which variants should be removed during a complexity reduction effort by comparing similar parts with similar technical parameters and identifying less competitive ones. Finally, it can be used for target cost during early stages of the product development process to be able to quickly calculate the cost of a new specification.

Who has not read about the low cost of labor in China or India, which despite recent surges is still only a fraction of what is being paid in the US or in Western Europe? The costs for the resource “labor” obviously differ enormously across the world; in extreme cases, labor costs amount to only one-fiftieth of those in the United States. But the costs of land, rent, waste disposal, and energy can also differ widely in price.

The aim of factor-cost analysis is to render these differences visible and allow them to be exploited. The analysis starts with identification of the resources required by the existing supplier to make a product. This information is supplemented by cost-driver data—for example, set-up times, productivity, machine-hour rates, or alternative prices for the principal materials. The data is then compared with that of other suppliers or other regions in order to develop strategies for optimizing the cost structure in a targeted fashion; the aim is to create a basis for choosing measures to be implemented by the supplier. For example, measures for cutting the costs of materials could include providing one’s own sub-suppliers, or (if the share of staff costs is high) even suggesting the possibility of relocation.

What would it be like to not have to buy anything? In the 21st century, certain groups of indirect material can be eliminated. For example, a paperless office is now feasible since all work can be performed with technologies that enable our decision making, operating processes, documentation, and communications. And in the face of rising energy prices, it is also conceivable to have a company where no one travels because a virtual conference room makes it possible to meet with colleagues and customers at the other end of the world in a way that feels almost true to life.

These are only a couple of the ideas behind the concept of reducing demand. Going entirely paperless and eliminating all travel may not be likely, but encouraging the use of new methods, technologies, and policies to reduce demand is a valuable way to manage costs. Appropriate strategies can be found in many areas. By adopting a systematic and well-communicated procedure, a company can, for example, lower its energy bill at no detriment whatsoever to either its personnel or its processes by switching computers off at night instead of leaving them on standby or by turning the heat down or the air conditioning up by one degree. In addition, simple systems are available to monitor office supplies such as paper and pens, which employees tend to view as items they can appropriate for their own private use. These systems do not normally need any follow-up. The fact that the company knows what supplies an individual is removing increases discipline.

The core elements of demand reduction are as follows:

• Establish cost awareness and corresponding standards
• Improve and streamline approval processes
• Make greater use of lower-cost substitutions
• Reduce the frequency of use
• Limit the scope of requirements
• Reduce purchased quantities
• Eliminate demand for certain products

These elements are most effective when they are all used at the same time, but even applying a few will result in savings. Because a savings mentality does not match the corporate culture at some companies, consistent change management—accompanied by an explanation of the broader context, the reasons why the measures are meaningful, and what alternatives exist—is a success factor well worth considering.

Even the best contracts are of little use if nobody is familiar with them. It often happens, especially in the larger conglomerates, that one group company enters into a contract without anyone in the rest of the group knowing anything about it. Contract management aims to create transparency and consolidate existing contracts. Result: better terms for all internal customers.

There are a number of basic rules that need to be observed:

• A contract needs to apply to all. It should include a clause making the terms of the contract available to all the group companies.
• A contract needs to be easily accessible. The intranet is an optimum solution as it allows contracts to be accessed from all sites of the corporate group.
• The product users/internal users of third-party services need to be informed of the new contract location. This may seem to be stating the obvious, but contract management of this kind is often implemented centrally, and although head office is happy, the whole system fails to work because no one else knows about it. A broad-based information policy fills the gap.
• The product users/internal users of third-party services need to be able to work easily with the intranet solution. This can mean having the ability to gain access without a lot of red tape, or being adequately trained to navigate the system.
• The implemented system should be user friendly—it is not enough to simply file master agreements centrally. The system also needs to offer search functions and include an automatic notification of updates.
• Feedback should be possible: When procurement staff start using the system and the master agreements on a large scale, they need to have the option of giving feedback and suggesting improvements without encountering red tape. Otherwise the system will never really be accepted by product users/internal users of third-party services.

"Have we gone completely crazy?" According to the German business publication Manager Magazin, this was the reaction of one of Germany’s premium automotive OEM CEOs when confronted with the company’s huge array of different wing mirrors and V-belt pulleys, not to mention its 27 different cooling units. However, this OEM is not alone here, for developers apparently find it easier to design a new component from scratch than look for existing ones to incorporate into a new product.

The deep-seated human ambition to create something new and individual evidently plays a major role in this context.

And yet the rational approach of using the same components across various product lines makes sense. The benefits offered by scale effects, with resulting lower prices for parts, simplified logistics, and more efficient repairs, are obvious. The only question is how to actually implement bundling across product lines.

The simplest case is, of course, when the same components are already in use across several product lines, but are being bought at different prices. Here, potential savings can easily be realized. As a rule, however, components only resemble one another in function, but differ in terms of performance, size, connections, and so on. Consequently, it is only possible to achieve isolated, minor successes for the current product generation, and even this will require concentrated, interdisciplinary effort.

True bundling across product lines calls for a long-term visionary concept in which the strategies for modules, platforms, and part-sharing are clearly defined. Once this concept is in place, all product development projects need to be undertaken in accordance with the new guidelines.

The principle of structuring companies by profit centers with local business responsibility is frequently applied in both North America and Europe. As these companies are often highly successful, there is evi¬dently nothing wrong with the principle as such.

Consulting practice shows, however, that the autonomy granted to the individual sites is often excessive, with the result that considerable savings potential remains unused. Also, the responsibility of profit centers for P&L is often taken to mean that they need to handle all procurement, given that purchased materials account for a high proportion of turnover (often more than 50 percent). This way of thinking leads to a proliferation of sub-critical procurement organizations, all working in parallel in the market. In many cases, the sites buy similar products, sometimes even from the same suppliers.

In order to identify potential savings, information on precisely what demand which site has in terms of quantity and quality needs to be gathered from the individual site purchasers. Next, the necessary data should be compiled in order to draw up a joint invitation to tender. The invitation is issued to all those existing and new suppliers theoretically able to supply several sites. Negotiations are then conducted for all the participating sites at the same time. It is essential to decide in advance which sites should lead the negotiations and which ones should only participate in a supporting capacity. Conducting the negotiations need not be entrusted to the site with the highest demand, but rather to whichever one appears most capable. Thus, the chief negotiator should be a local purchaser who is especially well versed in the relevant technology and has expertise in the supplier market.

In many cases, a project for identifying savings potential across sites will form the core of a future lead-buyer structure. In this case, lead negotiators who previously acted in only an informal capacity will grow into an official organizational role and assume procurement responsibility across sites. This responsibility may be restricted to simple market research, but may also include concluding master agreements or even taking overall charge of ordering.

Try the following: First, mark the headquarters of randomly selected major companies on a map, and then enter the locations of their active suppliers as well. This will reveal the following phenomenon: companies situated more toward the middle of a country are more or less surrounded by a circle of suppliers. In the case of companies close to the border, the suppliers form a rough semicircle. In other words, German companies still tend to use mostly German suppliers, just as French companies continue to use mostly French suppliers. Thus, we can reasonably conclude that it is not always the best supplier for the job who actually gets the contract.

This is where global sourcing comes in. The core elements of global sourcing are utilization of the worldwide supplier market and the issuance of offer-solicitation documents designed for international use.

Nowadays, identifying suppliers throughout the world has become a great deal easier thanks to the supplier directories available on the Internet. Provided it is done professionally, the goal of procurement should be no less than to identify all potential suppliers throughout the world—it is not unusual these days to send inquiries to 5,000 suppliers or more for just a single product group.

Since the primary language of procurement is English, all documents used by procurement in its interaction with suppliers must be in correct and clearly comprehensible English. This applies to image brochures, quotation forms, drawings, specifications, standards, and business terms.

In addition to these “hard factors,” it goes without saying that the parties involved must, of course, be open to doing business with suppliers from other cultures.

“We want to become Number 1 in all sectors, everywhere in the world!” This seems to be the general goal in China today. Starting with raw materials and semi-finished goods, China is now building efficient industrial infrastructures all along the value chain. In many areas, however, the production capacities in place already exceed domestic demand. Many companies that invested in China hoping for a market of more than a billion consumers have had to learn this the hard way.

One strategy a company can use to benefit from China’s growth is LCC (low-cost country) sourcing. On average, manufacturing costs in China are 50 percent lower than in Western Europe. (In fact, China is only the most prominent example of a whole series of important low-cost countries, such as Brazil, Russia, India, or Turkey.) However, anyone wanting to enter into serious collaboration with Chinese suppliers needs to achieve the following, some of which will require overcoming a number of barriers:

• Be able to offer attractive volumes
• Identify interested and qualified suppliers
• Identify appropriate price levels
• Establish a robust relationship at top-management level
• Overcome internal resistance
• Manage operations and risks
• Overcome cultural barriers

Identifying interested and qualified suppliers in China is challenging. Chinese firms are operating in a domestic market growing at double-digit rates every year and are bombarded day in, day out with inquiries from Europe and the United States. As a result, the Chinese supplier market cannot be conquered with cautious test inquiries—potential European or American customers need to stand out from the crowd and offer genuinely attractive volumes that stoke the imagination of the Chinese entrepreneurs.

A good approach is to make initial contact in writing, in Mandarin, and have a native speaker immediately follow up by telephone.

As soon as offers have been received, a process of intense negotiation takes place. The first offers from China are usually not far below European or American price levels. From the Chinese point of view, the mirror image of LCC sourcing is “selling to Europe at European price levels.”

Once a price level has been found that is acceptable for both sides, the next step is for top management to take a trip to China. Chinese entrepreneurs want to talk with their counterparts face to face. Establishing a robust relationship, based on trust, is the best guarantee for overcoming all subsequent hurdles.

The first obstacle to overcome is an internal one and may require a creative approach—users at the European or American company back home have to be convinced of the validity of the Chinese offer.

For managing operations, there is no practical alternative to establishing a procurement office in China. Someone has to be present on the ground at the Chinese supplier to ensure that quality standards are complied with and (for instance) that worn-out tools are replaced. In the first few months of production startup, an almost daily presence may be required, though this can later be reduced to a once-a-week schedule.

The final hurdles are cultural barriers. Genuinely close collaboration with Chinese suppliers will ultimately result in the European or American company becoming slightly more “Chinese,” while the Chinese supplier will adopt some of the culture of its Western customers.

This method of calculating target prices requires a significant understanding of the product’s production process or the service delivery model. Cost-based price modeling is grounded in a bottom-up calculation of the price using a detailed breakdown of the cost structure along the value chain of the product. We start by building a model to price a product based on all value-adding steps in the creation of the product, starting with production. Each production step is evaluated based on key cost drivers. Using this approach, we can determine a target cost along with a reasonable target margin for the supplier. Employing the method across several supplier bids, we can compare not only total cost by variances across production steps but also the productivities of each supplier. In negotiations, best of breed can be used as a target for suppliers, which may also include productivity improvement measures after the product launch.

Cost-based price modeling begins by mapping the overall manufacturing process into individual steps. For example, for desktop PC production, the steps would be stamping, bending, and sub-assembly of steel chassis; assembling the printed circuit board including mounting the component surface, soldering, and testing; and the final step, assembling the final product, including packaging and preparing for shipping. For each step, we develop a cost model using cost drivers to determine a cost per unit. Typical cost categories covered and respective cost drivers could be raw materials (estimate weight, scrap rate, material type, and cost per ton or kilogram), purchase parts used (estimate which parts and the cost per piece), direct labor (measure man hours required to perform the manufacturing process using cycle and takt time and unit per hour), equipment cost (estimate the value of equipment, depreciation, capacity and utilization, and cycle time), indirect material used in production (estimates), and overhead (estimate indirect labor, utilities, plant cost, and general percentage mark-up). The same logic can be repeated for any additional level of sub-components. At the end, you can also add costs for overhead (sales, general, and administrative) and engineering (related to product development, product servicing, and factory support).

With this cost model, you can calculate the target price by applying a reasonable margin—one that is competitive in the industry. Visit at least one of your supplier’s production lines to validate the hypothesis related to cycle time, output, typical labor content, and equipment use.

Once the basic model is built, the easiest way to validate and expand it is to request a detailed cost breakdown from the supplier during the request for proposal (RFP) phase. Because suppliers tend to be reluctant to agree on an open-book policy that allows this level of transparency, especially at this early stage, you need to be in a very strong buying position. If you are in a less favorable position with suppliers or have sufficient in-house knowledge, you can use internal experts to conduct a product costing analysis. Refer to your product engineers and manufacturing process engineers to understand how a product is being built. Usually, mechanical, electrical, and system engineers can provide enough insights into production processes. However, there is a risk of overestimating the manufacturing cost since suppliers tend to be more specialized and cost-efficient in their process. It is also possible to involve third-party experts—for example, for very new or special technologies.

When we want to calculate the price of a similar product compared with an already known and analyzed product, we can look for analogies in production steps and materials used and then quickly adjust the model. The initial model can be validated further with the supplier during the RFP or negotiations process.

The final output of the model is a detailed analysis of the target cost. This can be compared with one or more supplier quotes. Have at least some level of cost break-down available from suppliers. Their improvement potential can be drilled all the way down from general cost-reduction potential on the final product price to the cost for each process step (cost per unit) and the key cost drivers, such as scrap rate for material and inefficient assembly process steps. The biggest gaps can be analyzed in detail with the suppliers. Then, either negotiate a cost reduction directly or define productivity improvement targets for the supplier after the product launch.

Cost-based price modeling might seem like a monstrous task that is not worth the effort. However, it makes sense to apply it for products and services that are crucial to your core and where the buyer company will have sufficient knowledge of specifics to be able to develop such a model without too much effort. It can also be applied to parts that have a shorter value chain, are produced in fewer and rather homogeneous production steps, or have low complexity in terms of materials used and limited product development effort. Typically, such products or services will also have high competition—and thus low supply power—and procurement can quickly develop a model to evaluate the target cost. When this is not the case, the next method—cost-regression analysis—may be a better way to quickly derive a target cost and enter into negotiations with a supplier.

Most companies lack a sound, objective basis for defining target prices. The linear performance pricing strategy is one way to identify a technical cost driver crucial for the product price of a sourcing category, which can then serve as the basis of objective target prices.

MIn the case of simple components where the crucial cost driver is evident (for example, weight) a straightforward “rule-of-three” calculation is sufficient to determine the target price. Simple steel parts and products sold by the yard/meter are good examples.

At first sight the method may appear straightforward; however, the devil is in the details—the crucial cost driver is not always so easy to identify. Then there are cases in which the cost effect is far from clear. In the case of a casting, for example, both the weight and also the cross-section area of the mold can be relevant cost drivers.

The challenge is to pick the crucial cost driver out of all the possible ones. An appropriate method for this is simple correlation analysis. The result indicates the strength of the correlation between the cost driver and the price. The cost driver with the highest correlation to the price is the relevant one. After identifying the relevant cost driver with the aid of correlation analysis, the target price can then be determined, again using a rule-of-three calculation.

To be able to use linear performance pricing, however, there must be only one relevant cost driver, which usually means that the item concerned has to be relatively simple. Simple parts that contain a large proportion of raw material, such as simple castings, crude steel, or copper wire, for example, are highly suited to this method. More complex parts, such as those involving various process steps, are not suited to linear performance pricing.