Transforming purchase into strategic sourcing
Indian manufacturers leave money on the table by treating purchase as tactical rather than strategic.
- Blog |
- 27 November, 2019
Indian manufacturers are routinely leaving money on the table due to their tactical approach to purchase. As a result, most purchase departments spend a disproportionate amount of time fulfilling short-term administrative requirements rather than thinking strategically. For example, a typical day for an Indian purchasing manager includes processing purchase requests, identifying suppliers, reviewing quotations, releasing and following-up on purchase orders, checking the receipt of goods, and processing payments.
By contrast, a strategic sourcing department is a value-driver for the organisation guided by a clear business focus. This means the business strategy and objectives are well understood and the department collaborates closely with users across the business to gain a detailed understanding of their requirements. Procurement professionals then map the supply market and develop category level sourcing plans. Subsequently, they negotiate and contract with suppliers according to value rather than price and engage in an ongoing process of active supplier management.
Companies who successfully transition from purchasing to strategic sourcing gain substantial benefits. Firstly, a clearly defined sourcing strategy improves the quality and speed of procurement. Secondly, strategic sourcing significantly reduces the cost of material services. In our work in process industries, we have found that this reduction can be in the range of 10% to 20%. Further, organisations that employ strategic sourcing typically have double the margins of companies with below-average sourcing capabilities.
To transform purchase to strategic sourcing, Indian manufacturers should act on five key areas.
1. Bring spend visibility
The first action is to bring spend visibility. This goes beyond simply tracking spending to providing a detailed and holistic picture of how money is moving through your company. Spend visibility helps companies clearly understand the critical aspects of the purchase and the associated business impact at a granular level. In most Indian companies visibility of spend and the associated costs are opaque which makes them difficult to optimise and control.
Companies can bring such spend visibility by applying the Spend Cube. This tool visualises spending along three dimensions: the supplier, the purchase category, and the cost centre. After capturing comprehensive spending data in these areas it is possible to conduct different analyses such as vendor-wise, category-wise and item-wise spend. This illuminates the distribution of spend, enabling identification of opportunities for optimisation whether through better supplier management, supply chain optimisation or continuous improvement initiatives at the shop floor. Based on a Spend Cube analysis at one leading manufacturer an overspend in raw material purchase was brought to light that was previously overlooked. This contributed to a large part of the total cost but was historically regarded as a routine activity and therefore subject to little scrutiny.
2. Apply advanced sourcing practices
Once there is visibility on the spend, the next step is to leverage advanced sourcing practices to uncover potential savings. In particular, Indian manufacturers should leverage three important methods: Total Cost of Ownership (TCO), supplier consolidation, and best inventory management practices.
Total Cost of Ownership (TCO) shifts the focus away from the ticket price of a purchase and toward the product's lifetime value to the business. TCO is an important practice to employ because it accounts for the consumption of other inputs as well as the costs inherent in the process of procuring and using the item in question. For example, when we applied TCO to a leading paper mill's starch purchases it helped reduce the cost by better understanding the various aspects of its purchase. As a result, the company focused on maintaining the standard quality of the starch mixture which led to a 3% average reduction in consumption of starch per ton of finished paper, reducing the total production cost.
Most companies work with more suppliers than required and are therefore unable to realise economies of scale in sourcing. Manufacturers can move toward effective supplier consolidation by first understanding the supply market including the various categories of suppliers, the associated risks of concentrating supply and the potential business impact. Once they have understood the supply market, companies can build should-cost models of key purchase items. A should-cost model is built by imagining yourself as the manufacturer of that product and calculating all the material, labour, overhead costs, and prevailing profit margins to arrive at a figure of what it should cost. This provides the right baseline on which to evaluate existing suppliers and identify preferred options.
The true cost of procurement is often concealed by poor inventory management practices at Indian manufacturers. Companies with a strategic approach to sourcing use a number of best practices to keep a close tab on inventory and continually drive down cost. Firstly, they formulate KPIs for tracking inventory and optimising the response time. Next, they implement and display best inventory management practices on the shop floor. Further, they shift from excel based inventory management to cloud-based systems to provide real-time status and visibility on inventory. The most progressive companies have embraced Vendor Managed Inventory (VMI) whereby the vendor takes full responsibility for maintaining the agreed inventory levels at the buyer's location.
3. Bring cross-functional engagement
The third area to act on in the shift to strategic sourcing is bringing cross-functional engagement. As long as purchase remains in a silo it is impossible to bring a strategic focus to its activities. For example, an isolated move to reduce procurement cost that doesn't take into account the effect of a cheaper solution on total consumption will lead to sub-optimisation. Therefore strategic sourcing requires close collaboration across multiple departments such as production, engineering, quality, and utilities. In the earlier mentioned case of starch consumption at a leading paper mill, the rising cost was flagged to the operations department who investigated the different factors that resulted in variations in consumption. This investigation found that both seasonality and manual errors in batch preparations were contributing to rising consumption. By seeing rising cost as a function of both the production and purchasing process, the company could act on the right levers to reduce costs without negatively impacting the quality of the finished product - something that may have happened if they had simply switched to a cheaper supplier or reduced the quantity per ton.
4. Build predictive models
The fourth and fast-emerging area in the transition to strategic sourcing is the use of predictive models to improve purchase efficiency. Today most companies rely on recent consumption and pricing data to inform their purchase decisions but this fails to take into account the multiple dynamic factors that influence prices and demand. Leading-edge procurement organisations are building predictive demand forecasting and pricing models that dynamically reflect internal and external developments. For example, one manufacturing company leveraged predictive models to better align its purchasing with both internal production planning and market price fluctuations. Through a demand forecasting model built on an ARIMA model (Auto-Regressive Integrated Moving Average), it was able to more accurately forecast future demand and plan production for different product categories. At the same time, a price prediction model combined historical commodity price data with external variables like seasonality and consumption trends to more accurately predict price movements. With a clearer picture of the company's upcoming demand for key raw materials and likely trends in commodity price movements, it could optimise purchasing to take advantage of the lowest prices.
5. Institute supplier performance management
The fifth and final area to move to strategic sourcing is instituting supplier performance management (SPM). SPM measures, analyses and manages the performance of suppliers to progressively reduce costs but also alleviate risks and ensure consistent quality. SPM brings the concept of continuous improvement to the buyer-supplier relationship and moves away from the zero-sum trade-offs that typify most supplier relationships in India. Through a company's investment in the SPM process, the vendor gains confidence in the long-term business prospects to justify the cost of improvement initiatives while on the other hand, the customer can set clear and quantifiable goals to bring greater predictability and efficiency to its supply.
To evaluate whether your organisation is strategic in its sourcing practices start by asking the following 7 questions:
- Do we have a sufficiently granular picture of our current spend?
- Are we buying from the right type and number of suppliers?
- Do we really need the current varieties of input materials and spares?
- Are we buying on transaction price or Total Cost of Ownership (TCO)?
- Are we collaborating effectively across the company with experts, users, quality control and finance?
- Are we using future forecasts of demand and prices to inform our purchase decisions?
- Are we taking steps to continually improve supplier performance?
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