In our previous article, we introduced the importance of Supply Chain Management and how through effective management, it can drive value throughout an organization and mitigate risk.
This time we will explore how we can use effective supply chain management to improve volatility in the prices we pay for materials and produce the best products.
To begin, we must first understand the function of purchasing. Purchasing is, “the function of and the responsibility for procuring materials, supplies, and services” according to the Association for Supply Chain Management. In manufacturing, purchasing oftentimes has the largest effect on profitability as direct materials make up the greatest percentage of total costs.
If purchasing direct materials make up the largest percentage of total costs, then how can we establish mutually-beneficial relationships with our suppliers to reduce price volatility and improve profitability?
1. Establish Functional and Quantity Requirements
Think about the product you are making. Then, think about the customer’s expectation of that product. Before you begin looking to purchasing to reduce costs, a business must first establish the requirements of the materials that make up the end product. If you are making a car, what grade of steel does your customer expect the car to be made of? This step is critical in creating a product that meets the customer’s exact demands and expectations.
Next, consider how much of that material it takes to make that end product. Then, think of how many units of that end product you will make over certain time horizons like one week, one month, one quarter or one year. Depending on the production rate it may not be practical to tie up working capital on low usage or expensive materials.
Once you have established these criteria, then you can begin to explore selecting suppliers.
2. Supplier Selection
Once a company has established the expectations for the materials needed to create a product, it must consider all the suppliers in the market and the criteria that sets each one apart.
The price of choosing a supplier can involve many different criteria. Does the supplier have the technical/manufacturing capabilities to produce the quality & quantity of material we need? How close is the supplier to our facility? Does the supplier offer us value that cannot be created in house? Does one of your dependable existing suppliers offer other services that can be bundled to reduce price?
A competitive supply chain strategy places strong emphasis on suppliers adding value. For example, supplier A might be able to produce fabricated parts, but supplier B might offer the same components but they treat their metal to protect against rust in addition.
Consider this: a supplier whose expertise is in an area that is only a small portion of your in-house operation. For example, a component that requires precision accuracy, such as a hydraulic cylinder, may be difficult to make in house but there is a supplier who specializes in these. This could offer great value to free up labor/machines internally and eliminate quality defects.
Selecting a supplier is highly dependent on what excess value they are creating, are they helping you to reduce cost / defects? Are they helping you to improve your production capacity? Are they helping with inventory management? While it may not show up on the balance sheet, this supplier expertise can reduce your risk to quality, costs and product failures. Another aspect of reducing price volatility.
3. Creating Mutual Relationships and Negotiating Long Term Agreements
Using outside suppliers does not have to be a win-lose situation for both sides. Nor should it be. Sometimes paying a supplier premium means not having to sacrifice on service and delivery. Vice versa, partnering with a lower-cost supplier for a price reduction does not mean always mean a sacrifice on quality.
Both sides of an agreement should feel that the deal will offer them both long term value. If sales begin to increase, your supplier will make more revenue. You will be able to meet the demand and exploit better on volume pricing. A classic win-win situation.
The two ways to accomplish such a relationship are through negotiating details up front and by sharing information.
Don’t skip the details, it does not have to always be about price: consider quality inspection, delivery logistics, financing, inventory management, etc. Supplier collaboration means finding ways to help one another. For example, if the supplier prefers fully loaded delivery trucks then find a way to place a monthly order as opposed to a weekly order. This type of consideration will foster a healthy relationship.
Another way to improve supplier collaboration and reducing price volatility is information sharing. If you are aware that sales increase seasonally it is beneficial to let your supplier know ahead of time so they too can adjust their operation accordingly. This type of information sharing means your supplier can adjust for operational efficiency and your deliveries remain on time. When the supplier is more efficient, they can pass on cost savings to you.
Organizations that establish their functional & quantity needs, consider suppliers that add value to their supply chain, and create mutually beneficial supplier relationships, unlock the most value out of their supply chain and reduce price volatility.
The above article is the second in our Discipline in Supply Chain (DiSC) series. Watch for more coming soon. If you’re interested in learning more now or talking with our supply chain team on how they can help improve your Supply Chain processes, please contact John Herzig at email@example.com.