In the first article of this series I described stakeholders as legs of a three-pronged-stool each of which must be adequately supported for businesses to be successful. I also pointed out that focusing on one of the legs to the de-emphasis of others was usually a mistake, at least over the long term.
On the other hand, many companies believe that to support optimum performance of one type of stakeholder, one or both of the others must accept under-performance. For instance, when OEM revenues go up but wages and/or piece-prices do not, owners over perform while employees and/or suppliers underperform. When this happens there will be push-back, both visible and unseen. For instance, employees/suppliers may become combative and decline to continue giving “above and beyond” effort.
When you get down to the nuts and bolts of OEM metrics you often find that performance goals put the three legs of the stakeholder stool at odds with each other. I believe that metrics and performance goals for these three stakeholder groups can be set in harmony such that all can be treated fairly. This is done by considering revenue generation and cost reduction.
If you are asking questions like:
”How can employees/suppliers help us sell more product — other than just helping us increase sales (and revenue) through lower pricing?”
“How can our customers help us increase revenue other than through paying more for our products, which may backfire by reducing sales?”
Then read on!
Introducing Revenue to Supply Management Metrics
Companies are in business to make a profit. Manufacturers do this by producing goods and selling them for more than it costs the organization as a whole to make them. Sounds easy, right? Just work to reduce all cost, including that of purchased product, i.e., piece-price!
Not so fast. Profit is not just increased by reducing cost.
Underlying all sales is market demand. OEMs that don’t understand the extent of their possible customer base will probably not be able to accurately predict the potential market — both in quantity and timing — for their products. This means that the forecasts OEM’s use to set production schedules and order purchased parts will likely contain error. The further these forecasts are from predicting actual customer demand, the greater the risk of OEM’s being unable to effectively support customer order fulfillment. Order Fulfillment’s relationship to profitability, then, comes down to three main parts:
- How an OEM supports unanticipated demand for specific products before the customer decides to spend their money elsewhere, or even forego a purchase. The metric that measures this is typically called “Customer Fill Rate.” There is lost revenue (and lower overall profitability) associated with reductions in Customer Fill Rate.
- How an OEM maintains high Customer Fill Rates. Slow response times will lower overall profitability by increasing waste (translate: extra costs).
- How an OEM deals with — or otherwise regards — product where demand was forecast but never materializes. There are costs associated with producing product for which there is no demand, which also lowers overall profitability.
The solutions to all three of these points intertwine highly with supply chain/supplier order fulfillment capability but very few OEMs actually take into account the costs of being unable to effectively support unanticipated demand when selecting suppliers. In other words, they don’t tie sourcing decisions to supplier order fulfillment agility. This is a gap in their assessment of the Total Cost of doing business with specific suppliers.
How OEMs Deal With Forecast Error
Supplier products normally take the form of parts, assemblies and components that are assembled into an OEM’s finished product. As stated above, OEM and supplier production are both driven and tied together by the same thing: customer demand. In spite of this, it is telling that few OEMs have supply chain order fulfillment policies that define the parameters of how errors in forecast will be accounted for.
In other words, very few OEMs have a policy that suppliers be able to deliver X percent above the scheduled amount with Y amount of notice, with X and Y linked tightly with historical forecast error. If they do have such a policy, it is usually Generic and Unconfirmed. Generic, meaning the policy is not tied to historic — or otherwise projected — forecast error, and therefore does not relate directly to the customer. Unconfirmed. meaning that the OEM customers do little if anything to verify supplier ability to actually follow through on the policy, if one does exist. This means that they don’t really understand supplier capacity and/or lead-times. Again, this represents a lack of tie-in to the supplier.
“It is telling that few OEMs have supply chain order fulfillment policies that define the parameters of how errors in forecast will be accounted for.” –
OEMs typically overcome these two shortfalls by instituting redundancies in their order fulfillment process that can result in significant waste, both internally and at their suppliers. Similarly, OEMs seldom link the costs associated with excess product to their longer-lead-time-suppliers that drive reliance on extended forecasts. The longer out you need to forecast customer demand, the higher the risk of increased forecast error.
What are those areas of OEM redundant internal waste? I provided extensive detail on that in a previous article I authored for IndustryWeek, but will list a few of the bigger hitters here:
- Raw Material Safety Stock. This is kept on hand to ensure that OEM schedules can be maintained even when supplier shipments are late or the parts they provide are found defective. When supplier parts must be sorted, reworked, sent back and replaced, there are OEM costs associated with this, too.
- Raw Material Reserve. These are not the same as the Safety Stocks described above. This is raw material held on-hand to account for forecast error and either a supplier’s inability to react to short-fuse orders or lack of OEM knowledge about supplier capacities and short-fuse lead-times.
- Pre-Built Finished Product. This is product built ahead of demand, either because an OEM and/or its supply base are unable to respond quickly to actual demand. Almost all OEMs rely on some amount of pre-built finished product. The issues are how much is built and how far before the demand materializes — if ever — it has to be held.
It probably doesn’t need to be said, but any amount of pre-set inventory is usually not the correct amount — it is either too much or too little. The further the quantity of inventory is from the needed amount, the higher OEM costs. OEMs that can successfully reduce the need for such inventory — yet still maintain needed Customer Fill Rates — will reduce costs significantly. In my experience, these cost reductions far outweigh what is usually obtained through traditional piece-price squeezing.
“The longer out you need to forecast customer demand, the higher the risk of increased forecast error.” –
Keep in mind these wastes don’t even consider the potential loss of revenue due to not being able to satisfy unanticipated demand. Again, under certain conditions this lost revenue can far outdistance increased profitability due to overall cost control including that obtained through the squeezing of piece-prices. This is a point I didn’t discuss in detail in the previously cited article and so will discuss in detail here.
Adding OEM Internal Costs and Potential Revenue to Total Cost Formulas
The fact is that most competitive OEMs today are able to react internally very quickly to unanticipated demand. The issue, then, becomes whether or not suppliers can too. This means that sourcing with the wrong suppliers can lead to reduced profits when the forecasts have error.
I know, I know — most suppliers include lead-times (both regular and short-fuse) in their quotes. On the other hand, most OEMs have no understanding about the “hows” and “whys” behind these quoted lead-times. And because of that, OEMs often find that those lead-times (especially the short-fuse ones) are not based in factory physics. This means that OEMs find out when they have need for quick turnaround of new part orders whether their suppliers can fill them on time. What does this lead-time uncertainty mean relative to OEM forecasts? It means lower Customer Fill Rates and lost sales.
Many OEMs today say they assign business with a particular supplier based on the Total Cost calculations, though my experience in reviewing dozens of such formulas have found this usually ends up being nothing more than a sum of piece-price, some form of logistics and other tactical (such as import/export fees) costs. I am aware of only a few OEM Purchasing Total Cost Formulas that assign to suppliers based on their order fulfilment capability (actual lead-times that support their Order Fulfillment Policy – if they have one) or the costs of Raw Material Safety Stock, Raw Material Reserve and Pre-Built Finished Product, etc. that the OEM must maintain internally to meet their Customer Fill Rate goals. And it is even rarer for OEM Purchasing Total Cost calculations to take into account the risk of lower revenues due to lost sales because they do business with long-lead time suppliers.
“OEMs that can successfully reduce the need for inventory — yet still maintain Customer Fill Rates — will reduce costs significantly. These cost reductions far outweigh what is usually obtained through traditional piece-price squeezing.” –
If OEMs wanted accurate assessments of the Total Cost of doing business with specific suppliers they would factor elements such as these into supplier quotes. The answer is always related to understanding customer demand and either the extra costs incurred or the potential revenue lost due to doing business with suppliers who have poor response capability. For example, some companies have had success adding a certain percentage of a supplier’s quoted piece-price (say 1%) to their quote proposal for every week of quoted lead-time.
Similarly, OEMs today measure supplier performance based on as-delivered quality, on-time delivery and piece-price, but adequate quality and delivery performance is usually assumed and expected so suppliers know that they must keep a firm control on prices — usually delivering annual price reductions — in order to keep the business. So again, it seems that selecting sources and rating supplier performance boils down to initial piece-price and annual price downs, rather than being related to Customer Fill Rates and internal OEM costs. I hope that based on the above you can see the gap in that logic.
Lean Supply Chain Performance Should be Supply Management's North Star
Lean Supplier (or Supply Chain) performance should be the goal of all purchasing departments. It implies the following:
- Suppliers focus on on-going waste reduction so their customers can be assured that pricing is competitive.
- Suppliers deliver usable parts as per schedule.
- Suppliers can support a pre-defined level of unanticipated demand within a timeframe that will allow their OEM customers to support customer demand (and realize un-forecast revenue).
Where is this in the evaluation of potential sources? If Supply Management’s primary focus on piece-price were effective in delivering Lean Performing Supply Chains that state would have been accomplished decades ago. But, it hasn’t.
This is why I have a negative view of purchasing functions placing priority on piece-price during sourcing decisions as well as in year-to-year supplier management.
Rather than focusing primarily on piece-price, a sophisticated supplier evaluation process must have the following:
- An understanding of the OEM”s own likely forecast error. You’d be surprised at how few Purchasing Departments have this on their radar screen.
- A supply chain schedule revision policy that supports the OEM being able to satisfy a significant amount of the un-forecasted demand. Many OEMs in the consumer product business forecasts but do not measure forecast accuracy so have no way of understanding supplier impact of real Total Cost.
- An understanding of supplier capability of supporting this policy, either through adequate capacities and lead-times (preferred) or through a pre-built amount of their product that aligns with the difference between their capabilities and the policy.
Having an understanding of the relationship between demand and sourcing is something I rarely see. When I do, I recognize purchasing departments that are involved in crucial executive level decisions. When I don’t, I see tactical purchasing departments pursuing a so-called Total Cost largely based on quoted piece-price, which is largely ineffective.
My next article will tie this series together by looking at the issue from a supplier’s perspective.
Learn more about Paul Ericksen and his over 40-years in the manufacturing industry here.