Manufacturing

A Look at Purchasing Strategies Part 1: Piece-Price

Paul Ericksen / Feb. 26, 2018

In previous columns, I’ve taken indirect swipes at organizations that focus primarily on piece-price when making sourcing decisions.  It’s probably time to elaborate a bit on why I think this is a mistake. The best way to introduce the subject, I believe, is to discuss the history of pricing and how it has been regarded, both by purchasers and suppliers. The next three columns will focus on this topic.

Piece-Price Sourcing Tactics Were Fine 100 Years Ago

Nobody wants to pay more than they have to. This is not only human nature but also business instinct. When there are a variety of sources to choose from, you are essentially dealing with a commodity “spot buy” since, if the company you purchase from today is not around tomorrow, you can easily re-source in short order to another manufacturer for the same — or a comparable — product.

Sourcing based on piece-price might have been okay one hundred years ago when Henry Ford was stoking the fires of this country’s first industrial revolution at his Rouge River, Michigan factory.  At that time, most Original Equipment Manufacturers (OEMs) fabricated the majority of the parts and assemblies they used in their products directly from raw material. In fact, over 80% of the Ford model T’s material-related cost was due to in-house processing. Spring forward to today and you’ll see just the opposite. The purchased percentage in an average OEM’s material content is approaching 70%, and, with many OEMs, can exceed 80%.

Because of their commodity focus, 100 years ago the purchasing function was a tactical function in most OEM organizations where the best purchasers sourced the lowest priced materials for use in their factory. Today, though, purchasers typically buy engineered products — rather than commodities — for direct assembly onto their finished goods. Because of the significantly higher impact of purchased content on material cost, today’s purchasing departments are positioned to be strategic within their business enterprise. Purchasers that have a sole focus on piece-price, however, will have difficulty climbing out of the tactical rut and gaining a seat at the table in corporate decision making.

Quality Suppliers: The Lost Pieces of the Piece-Price Puzzle

With engineered products, then, the bigger issue actually becomes continuity of supply, since other sources are not likely to be immediately available. For instance, when an alternate source is new to your supply base, the due diligence involved in bringing them on adds both time and cost. If tooling is needed in the manufacture of the part, the existing tooling may then need to be transferred from the current supplier and refitted (usually necessary) to fit the new source’s machines (which again, takes time and money). In some cases, new tooling will be required, which takes big time and big money.  Once in production, new suppliers will likely be required to demonstrate process capability as part of the OEM’s new part approval process. You guessed it — more time and more money.  So, when sourcing engineered products you really need to select the right source up front.

While piece-price is still relevant, it is not sufficient as a sourcing decision-making criteria. When selecting sources of engineered parts, then, purchasers need to make sure that their suppliers are both competitive price-wise and healthy business-wise.

What's Good for the Gander is Not Always Good for the Goose

Up until a generation or two ago, the prevailing view was that a supplier’s piece-price in itself was an indicator of business well-being.  The thinking from the purchasing perspective went something like this:

  • Suppliers will never enter into a contract that would be detrimental to their business.
  • Because of this, suppliers will never sell below the price they need to maintain a healthy business.
  • Thus, suppliers offering the lowest prices were likely the healthiest, business-wise.

This philosophy does not take into account that there are actually several scenarios in addition to the one above, including:

  1. The supplier is desperate for business.  They will do just about anything to generate cash flow, even if this means setting artificially low prices, i.e. “buying the business.”
  2. A healthy supplier “buys the business” through low-ball pricing, knowing once they have a contract they have leverage, which includes the time and cost involved with resourcing and approving new parts.  They feel this leverage will, in effect, support future price increase proposals, through which they hope to backfill whatever profitability was lost up-front through their low-ball initial quote.
  3. The supplier doesn’t understand their costs and so sometimes sells at a lower price level than needed to support their business.  Over time, they will either need to increase prices or cut back on elements needed to maintain competitiveness.  Again, they will have a bit of leverage to support these increase proposals.

While this piece-price problem can’t completely be laid at the feet of OEM purchasers, falling for any of these three scenarios undoubtedly does set a purchaser up for anything but a healthy low cost. At the very least, we can agree that relying on piece-price to assess both supplier competitiveness and sustainability is not the way to go when you are not buying commodities.

Yet, even progressive purchasing departments continued to rely on a piece-price strategy into the 1990’s until a new approach — still related to piece-price — evolved.  Namely, to require that suppliers detail the internal elements driving the costs their pricing is based on.

Stay tuned — my next column will describe how this works and discuss how it influenced both OEM and supplier quoting strategies.

Learn more about Paul Ericksen and his over 40-years of experience in the manufacturing industry here.