THE SOURCING TRIANGLE

Dr. Stephen Harwood (TechnoForeSight / University College London, Dept. of Space & Climate Physics)   Twitter: @drsharwood

(This is a slightly adapted version of a white paper published by the author in 2003, “THE PROCUREMENT TRIANGLE”. Copyright © July 2003, Stephen Harwood)

Attention to the supply chain is perhaps the most undervalued part of an organisation’s activities. Nevertheless, as a source of costs its prominence really only surfaces when the business is in trouble. Then the focus is upon

COST REDUCTION.

But cost reduction at what cost?

The cost of unavailable materials… poor quality materials… rework… warranties… liability?

WRONG FOCUS AND TOO LATE

The supply chain, if properly managed can be a source of opportunity.

Consider the opportunities to be gained from seeking economies of scale with regard to purchases… Not bulk buying a year’s requirement of material for it to sit in a warehouse, deteriorating, incurring storage costs and tying up cash, which could be usefully earning. Instead, negotiating with a supplier a price for the period (a year), possibilities for cost reductions, the holding of buffer stock, frequent deliveries as required, consolidated invoices every month, and agreeable payment terms. Benefits include reduced stock holding with associated cost savings, materials always available, less administration and the knowledge that you are paying only for what is required. Further, how often have you utilised the expertise of the supplier? Can they not provide insights into more effective solutions using cheaper yet better materials? If suppliers are involved at the design stage, the time when costs can be designed out, their expertise may be able to generate real cost reductions.

The focus is upon

VALUE FOR MONEY

The up-front cost (price) is no longer the sole criterion for selection.

VALUE FOR MONEY

“Value for money” can be interpreted as the TOTAL benefit gained of an item or service in excess of its TOTAL cost. However, from a cost perspective this needs to be qualified. Cost includes not only the cost of acquisition but also any costs incurred during the working life of the item or service AND the cost of disposal or termination. The benefits include financial gain and also any non-quantifiable benefits such as convenience, efficiency and advantage.

The shift from“ the cheapest price” to “value for money” marks a significant change in emphasis for purchasing and financial managers. It implies a different approach to defining requirements and dealing with suppliers. This distinction has been recognised by Local Government in the UK. Since 2001, a “Best Value” initiative has replaced the practice of Compulsory Competitive Tendering (CCT). The primary objective is to provide better services to the community. This initiative recognizes that lowest price (the selection criterion for CCT) need not provide the best solution or lowest total cost. The pursuit of “Best Value” is a process. It involves demonstrating that local authorities are achieving “Best Value”. This is achieved by means of audit and review mechanisms. Four key principles underpin “Best Value” [1]: “transparency of tendering and competition”, “the personal responsibility of senior officials for value for money”, the encouragement of accountability and the requirment for the continuous improvement of services. The principles are set out in “Best Value: making choices - A Manager’s Guide to the Strategic Framework for Best Value, Procurement and Competitiveness ”, (Dec. 2001, Scottish Executive) [1].

To get “value for money”, however, is not necessarily straightforward. Some form of evaluation process needs to be undertaken to distinguish between different offerings. Furthermore, one should consider what would motivate a supplier to give “value for money”.

SUPPLIER PARTNERSHIPS

If the aim is to get “value for money” then price is not the sole selection criterion. The complexity of the selection criteria and approach will obviously reflect the nature of the requirements.

However, take a supplier’s perspective. Suppliers are unlikely to offer the best deals or give up their expertise if they do not anticipate benefit to themselves. Suppliers will always need to have something in reserve if they are to win the business. Negative signals to suppliers include the practice of “Dutch Auctions” (being played of against each other for better deals), lack of seriousness or commitment in discussions and the hint that there is inequality in dealings with suppliers.  From a customer’s perspective this may be less important for a one-off purchase than for repeat business. However, when will the unexpected arise when you will need to visit that supplier again? Furthermore, what reputation do you gain which circulates amongst your potential suppliers?

Suppliers are more likely to be more co-operative if in a partnership. This is a long-term stable relationship whereby both parties gain. This requires

• commitment.

• confidence and trust.

• good communication.

• sensitivity to each other’s needs.

• the sharing of risks AND rewards.

It does not just happen, but requires effort and time to develop.

However, the reality is that problems can arise. These include

• the selection of the wrong partner, whereby the manner of the relationship changes once the contract has been exchanged or requirements fail to be delivered.
• the loss of internal capability, whereby over time the existing knowledge / expertise is lost resulting in…
• …over-dependence on partner, whereby the business cannot run without the partner. Perhaps internalising this skill is the better option.
• ...the inappropriateness of a partnership  for certain types of  materials and bought in services.

Consider how many non-critical activities can be outsourced. In this specific case the relationship can be assumed to be a long-term partnership. Importantly, control for performance is handed to the service provider. But what happens when the service provider fails to deliver?  It is not uncommon for outsourced activities to be brought back in-house, e.g. cleaning within the NHS. There is risk involved.

Another consideration is that of supplier – customer inequality. The small business customer has little clout with large supplier organisations. Likewise, the large customer can exploit the small supplier. Fact or fiction?  It depends upon the individual organisations. Undoubtedly there are inequalities in relationships. The small customer cannot offer requirements which command the discounts associated with high requirements of large organisations. Likewise there are many documented cases of small suppliers who have been dependent upon a single customer, have been pressured into unprofitable price reductions and have experienced severe problems when they have lost that customer’s business. However, there are many different scenarios. Many of these play upon the relationship between individuals – the salesman and the purchaser. A good relationship may provide benefits not achieved in a sour relationship. Furthermore, some small business customers have grouped together to form purchasing collectives, improving their purchasing power.

Unfortunately there is no crystal ball or simple solution. Each situation has to be considered in its own light. Furthermore, not all situations are conducive to partnerships. However, this does not detract from giving thought to the supply chain and how materials / services are sourced. How is sourcing decided? Is the supplier base large so that there is plenty of choice to shop around and to provide alternatives… just in case? However, it has already been suggested that this is not the best solution if seeking “value for money”. The alternative is a smaller supplier base. But how does one achieve a smaller supplier base?

SUPPLIER REDUCTION

A small supplier base can be achieved by two radically different approaches with quite different results.

The knee jerk reaction is to take the existing supplier base and delete the names of the majority, using some form of criteria such as volume of business, friendliness of customer contact or length of relationship. This is perhaps a relatively quick way of reducing suppliers. Whether the suppliers left on the Approved Vendor List are the best for the business is open to debate. It may well be that longstanding relationships are preserved irrespective of the quality of service. Is this the right approach?

Indeed, story-lines in films have dwelt on this issue. Consider the new executive in the client company. Recognising that the supply chain is a cost drain, this executive targets key suppliers and places demands upon them. One of these suppliers has had a long established trading relationship with this company. After a period of time, during which the supplier has failed to meet performance targets, the decision is made to transfer the business. However, this is revoked upon pressure from colleagues…. after all we have been dealing with this supplier for twenty something years and they are almost family. However an ultimatum is given – improve (within a unrealistic time-frame) or loose the business. A white angel within the supplier transforms its performance and the story ends well for both client and supplier.

Consider the dilemma… loyalty to long established suppliers or looking after the best interests of the business. If a true partnership existed then the client would work with the supplier to achieve the desired performance targets. However, for this to be effective, this supplier may have been selected upon the basis of an evaluation within the context of a Sourcing Strategy.

SOURCING STRATEGY

The SOURCING STRATEGY is a systemic view of how all materials and services will be sourced based upon the concept of partnerships and a lean supplier base. The Sourcing Strategy is outlined in figure 1. It comprises both a formulation and an execution stage.

The formulation stage involves activities 1 to 3, whilst the execution stage – making it happen involves activities 4 to 8:

1. all materials and services are identified and categorised into families. Ideally, this list of families should be of a manageable number.
2. long-term requirements are determined. This will identify and distinguish between high volume / value quantities and insignificant quantities. It will highlight where the emphasis should lie.
3. the manner in which supply is to take place is established.
4. are selected for each of the family in such a way that corresponds to the desired manner of supply. The selection process is likely to involve a systematic evaluation of a pool of potential suppliers using a variety of criteria in addition to cost, quality and delivery.
5. contracts are negotiated with the chosen suppliers.
6. the supplier becomes operational and the day-to-day relationship ensues.
7. the supplier is managed in such a manner as to maintain the relationship.
8. the supplier is periodically audited to ensure that standards and other criteria are being met.

The following two sections will expand upon items 1 and 3. Item 4 is expanded within Harwood (2003) [3] in the context of the selection of a vendor / partner for an ERP (Enterprise resource Planning) system

A.    CATEGORISE INTO FAMILIES

This process requires the categorisation of materials and services into meaningful groupings or families and categories. The significance of this exercise is that each category will have a specific Sourcing Strategy established.

Examination of bought materials and services will reveal perhaps a surprising range. These may include:

• consumables, e.g. stationary, cleaning materials.
• production materials:

o   standard materials – materials that go into the product that are readily available without modification, e.g. electronic components.

o   customised materials – materials that go into the product that require modification, e.g. packaging.

• capital expenditure items, e.g. computer equipment, production machinery, cars.
• utilities, e.g. gas, electricity, water.
• outsourced activities, e.g. catering, cleaning.
• professional services, e.g. accountancy, advertising, insurance.
• government charges, e.g. rates, NI

It is likely that some form of classification has already been carried out either within the context of a part numbering system or for accounting purposes. Examination of the supply history should aid this process. The aim is to identify categories for which a specific Sourcing Strategy is required. Whilst a large number of categories may be identified, these can be aggregated into families and provide a manageable overview. For example, pens and pencils may be sourced from the same supplier as all other non-computing related stationery. Computing related stationery may be effectively sourced elsewhere. In this case two categories can be named, “stationery (non-computing)” and “stationery (computing)”, under the family name “stationery”. Alternatively, a required range of packaging materials might be reasonably sourced by a single supplier. Indeed, there may be several suppliers who are able to supply all requirements. However, it is known that there are a number of potentially good suppliers who could supply one group or another of the requirements, but not both. In this case, the range should be split into two categories. It is possible that whatever classification system is devised, it is revised following investigation of suppliers.

B.     ESTABLISH MANNER OF SOURCING

The preceding classification provides the basis for developing a souring strategy. For each category a specific Sourcing Strategy is developed.

Each strategy will reflect the particular features of its supply chain. This has particular relevance for the sourcing of materials, since the complexity of the supply chain can be greater than for services. For example, issues to consider for the sourcing of materials would include:

• level of requirements and changes, e.g. high volume, on-going requirements, one-off requirement, unpredictable fluctuations, new orders, cancelled orders, requirement ramp-down.
• features of material, e.g. safety approved, customised, commodity, high value, bulk volume, heavy weight, long lead-time, high requirement level.
• supplier characteristics, e.g. raw material availability, capacity, production lead-time, product availability, responsiveness to fluctuating demand.
• location of supplier, e.g. neighbour, a few hundred miles distant, another country, other side of world.
• logistics, e.g. sea, air, customs, bonded warehouse.
• frequency of delivery, e.g. daily, weekly, monthly.
• nature of delivery e.g. just-in-time, periodic delivery.
• in-house inventory levels, e.g. value held, shelf-life, slow movement or obsolescence.

Not all these issues would be relevant to the provision of a service.

The aim is to establish the best means of supply in such a way as to ensure continuity of supply whilst meeting the basic criteria of on-time delivery, no quality problems and the right cost.

One major consideration is how quickly problems can be resolved when they do arise. It may be assumed that, irrespective of source, once the mechanism is in play for ordering, call-off and delivery, all will progress as required. However, there is always an element of risk that something will go wrong.

When a problem arises, attention will naturally focus on the problematical material or service. This is irrespective of whether it is a batch of low-value standard screws or a batch of high-value customised microprocessor semiconductors. Both can stop operations. The speed that a problem can be resolved will be a function of both the material / service features and the nature of the supply chain. A low-value standard screw might be sourced very quickly through an alternative supplier. However, a high-value customised microprocessor might only have one approved supplier who is located 15,000 miles away. It could take a week or longer to get a replacement batch. This difference is summarised in figure 2.

At one extreme there is the material or service that can be described as a commodity: readily available with a variety of substitutes available. The other extreme is the speciality, which is unique with only one source. However, this is to simplify matters. There may be geographical considerations, e.g. uninterrupted electricity supply is fairly certain in most Western Industrialised countries, but may not be so in some Least Developed Countries. Likewise, catering provision will tend to be scare in rural areas compared to cities. Furthermore, the supply chain is dynamic and availability may vary over time between famine and glut in a cyclical manner, e.g. semiconductors, crop harvests.

The Sourcing Strategy should provide for contingencies, taking into account supply chain sensitivity and product / service substitutability. Contingency provision can be established by giving consideration to the main material features that will hinder emergency delivery if required.

For example, a high value customised material is used in a range of products, some of which are high volume but seasonal whilst others are low volume and intermittent. Thus, demand for this material fluctuates wildly.  Furthermore, it is company policy to carry no more than a month’s requirement as stock for any item. This material requires approval by an independent agency (e.g. safety approval of electronic components). Thus, the choice of supplier is limited to those whose samples have been approved. Since it takes many months to get approval, changing supplier is undesirable. The decision has been taken to source from a Far Eastern country, due to the significant price differential when compared to Western Europe. This is despite the duty that is payable on these items. However, since the item is heavy, its transportation by air from the Far East to the UK is undesirable due to the high cost of airfreight. However, a door-to-door sea shipment may take six to eight weeks. In addition, design improvements result in periodic changes to the specification for this material, which involves the supplier producing samples and the approval of these samples by the agency.

 This scenario reveals some of the issues that need to be considered when establishing a Sourcing Strategy. The overseas supplier is chosen for cost reasons, but it is necessary to consider how this overseas supplier is going to be managed. The following questions are likely to be asked:

• How is quality to be assured?
• What happens if there is a quality problem? How will it be handled? Who will be involved in dealing with it?
• Who will bear the cost of an emergency air shipment if there is a possible shortage perhaps due to an upturn in demand or to a defective batch? How can we control transportation costs?
• How much safety stock should we carry? How much buffer stock should the supplier hold?
• What shipping arrangements should we agree? Should we use a shipping agent?
• How should we manage exchange rate fluctuations? How should we make payments?

Indeed, the responses to these and any other questions may make us reconsider our decision. Consider the various options.

When selecting a Far East manufacturer, do you choose to deal direct? There are likely to be both language and cultural issues. Furthermore when difficulties arise, do you fly out to deal with these? An alternative option is to deal through an agent in the overseas location. However, how much confidence do you have in the agent to deal with your best interests? A third option is the selection of a manufacturer that is either UK owned or partnered to a UK operation? This option may give greater confidence about control, since contact will be with UK personnel and it may be assumed that these personnel have good contact with the overseas operation. Furthermore, they can take responsibility for logistics and hold buffer stock at their site in the UK. Another option is to contract a third party logistics, freighting company or distributor to take responsibility for the management of the supply chain. This draws upon their logistics expertise with the assumption that this expertise will provide the most cost effective solutions and thereby pay for itself. However, this may not be feasible for relatively low volumes of business. A further consideration is to dual source, with volume being supplied from the Far East and low volumes being supplied by a local manufacture. The benefit is access to low cost materials for a high proportion of requirements with the safety net of the UK facility. 

Obviously the preceding scenario is an oversimplification. However this example highlights that there are likely to be many issues that should be considered in developing a Sourcing Strategy for a particular category of items. This exercise will be repeated for each identified category. The results can be conveniently summarised in a spreadsheet form. This is illustrated in the following fictitious example (figure 3) of the Sourcing Strategy for “Double Sided PCBs”. High volume is supplied by air from China, whilst a local company supplies low volume. An alternative source has been identified which has production facilities in both the UK and Eastern Europe so is able to supply low cost high volume PCBs from Eastern Europe (though is 50% more expensive than Far East) and more expensive high volume PCBs from the UK.

It may be assumed that the nature of the relationship with suppliers identified in the Sourcing Strategy is a partnership as discussed above. However, it should be appreciated that not all materials or services will be appropriate for a partnership approach. Whilst there are obvious benefits of a partnership, the particular situation or circumstances may not be suitable. Consider the small local restaurant dealing with a national wholesaler. 

THE SOURCING TRIANGLE

 The development of a Sourcing Strategy is likely to have an impact upon various aspects of the procurement process. There is likely to be an organisational impact. For example, the role of the “expeditor” becomes redundant. Traditionally, the “expeditor” would contact the supplier prior to delivery to verify that delivery would take place as required. However, the question can be asked whether this is a value adding activity? In a good customer-supplier relationship, there should be no need for this activity, since the supplier should inform the customer of possible problems and discuss options. Likewise, the buyer’s role will change to that of supplier “manager”. Instead of seeking new quotes for every order, the buyer negotiates a long-term contract then focuses attention upon delivery issues such as weekly schedules and resolving problems. This change may, in turn, focus attention upon the planning and procurement tools available. Are they able to support the change?

The full impact of the transition to a Sourcing Strategy can perhaps be considered within the context of a more holistic perspective of the procurement process. A model of the procurement process is presented in figure 4. Three dominant issues arise: the Sourcing Strategy, the Resourcing Strategy and Availability Management (The Sourcing Triangle). The Sourcing Strategy has already been introduced.  The Resourcing Strategy is concerned with how the Sourcing Strategy is to be implemented and what resources are required. Availability Management is concerned with the activities that ensure the delivery of requirements. Consistent with conventional management practice, performance is assessed in terms of three basic criteria: right price, right quality and at the right time.

Whilst this is simplified overview, it does reveal that the procurement process is a complex activity that can and does go wrong. Unfortunately, when problems do arise, time is of the essence. Having the right suppliers in place can help prevent or quickly deal with problems. The Sourcing Strategy offers one approach for establishing the right suppliers. But then again, it is not unknown for senior management to be dismissive of the purchasing activity. To quote the CEO of one company “ there is nothing to purchasing, its pretty straightforward”. So, why all the attention?

LINKS:

The UK National Audit Office monitors public spending in the UK. This website provides a range of publications, which include good practice, the Public Private Partnership (PPP) and the Private Finance Initiative (PFI).

A set of thirteen standard trade definitions (Incoterms), have been established and published by the International Chamber of Commerce. These standards provide clear definitions of specific trading arrangements and can be incorporated into international trade contracts. They aim to overcome misunderstanding due to language barriers by providing a consistent and shared terminology. The standards are accompanied by guidelines concerning their correct us

[1] Scottish Executive (1999) “Best Value in Local Government: Long Term Arrangements”, Edinburgh: Scottish Executive.

[2] Harwood, S. (2003)  ERP: the implementation cycle.  (2003) (formerly Oxford: Butterworth-Heinemann]. NOW Routledge (imprint of Taylor and Francis)