In business, financial results are where the rubber meets the road. Supply-management-related financial risks—which result in reduced profitability—are intertwined with the supply chain risk areas discussed in the previous three articles of this series: strategy; operations, and; acts-of-man/acts-of-God.
Original Equipment Manufacturers (OEMs) usually don’t address supply chain risk reduction in a meaningful way. Why? Because executive level performance goals are—for the most part—tied to the price of company stock, i.e. when stock prices go up, overall executive level compensation also increases, usually in the form of bonuses and stock grants. And a short-term boost in the price of stock will occur when supplier piece-prices go down, since this reduces the overall price of the OEMs finished product, thus increasing profitability.
This is why many OEMs focus the bulk of their supply management resources on obtaining piece-price reductions. Consequently, very few resources are available for anything else, including reducing supply- chain-associated risks.
This tie-in represents a tremendous incentive for the people overseeing management of a company to prioritize the actions needed to increase short-term stock appreciation. Consequently, executive level performance metrics usually focus on tactics rather than strategy.
For instance—according to various analyses—the majority of the financial windfall OEMs reaped from the 2017 federal reduction in corporate taxes was spent on stock buybacks. This, of course, was a tactical action used to increase stock price, increasing executive level compensation. I’m pretty sure that outcome wasn’t the intent of Congress—at least let’s hope so—and makes one wonder whether the cash windfall could have been used in a more strategic way, such as to increase a company’s competitiveness. By the way, this should be the overall goal of every business.
My observation is that over time, corporate activities associated with longer-term strategic goals play a much bigger role in a company achieving a competitive advantage. Based on this, you may ask why companies don’t align their activities with more strategic executive-level performance metrics? In part, because strategic actions don’t necessarily result in short-term increases in stock price. This situation poses a type of chicken-or-the-egg dilemma. Do increases in stock price lead to a competitive advantage, or does achieving a longer-term competitive advantage lead to more significant and consistent stock appreciation? What do you think?
Below I’ll detail three areas where a strategic focus can lead to a longer-term competitive advantage. These activities reduce supply-management-related risk and have the potential to have a significant positive impact on financial results. Unfortunately, financial improvements resulting from these activities are seldom credited to the purchasing function.
Purchasing activities can positively affect profitability in areas other than the ones discussed below. As you look through these three examples, ask yourselves whether your company understands how supply management activity—other than those that support piece-price reduction—can improve company financials. And, if so, whether supply management performance metrics are set to drive these activities?
Finished Goods Inventory
Efficiently satisfying customer demand is necessary for a company to be successful. OEMs typically rely on a combination of internal/supply chain build-to-demand capability and pre-built finished goods inventory to mediate the risk of losing sales due to lack of product.
The lower the reliance on pre-built finished goods, the lower the product cost and the higher the potential for realizing incremental profits, satisfying demand that comes in above forecast. Incremental sales typically do not carry an overhead allocation since product cost is based on forecast volumes. Consequently, they can have a dramatically positive impact on a company’s financial results.
The longer the supply chain, the higher the risk of not supporting market demand. When supply management sourcing takes into account supplier build-to-demand capability—including logistics times—supply chain upward order fulfillment flexibility is increased and OEM customer internal overhead costs associated with customer fill rates are reduced. This strategy is usually based on awarding non-commodity business to lean, more local suppliers. For instance, supplier development is a strategic approach that increases supplier lean-ness, leading to improved supplier build-to-demand capability, reducing the need for both supply chain and OEM pre-built finished goods inventory.
Unfortunately for the purchasing function, should it be successful in designing and/or developing a supply chain with increased build-to-demand capability, the marketing department usually gets credit for the savings, i.e. they own the pre-built finished goods metric. As a point-of-reference, savings available from a reduced need for pre-built finished goods inventory can overshadow what is available through piece-price reduction, sometimes by magnitudes. I haven’t seen too many OEM’s compare the potential for improved overall company financials available through piece-price reduction vs. allocating resources to reduce the need for pre-built finished goods inventory.
Raw Material Inventory
Raw material should also be regarded as pre-built inventory. Whether it is held by a supplier or customer it represents additional cost. When held by an OEM it usually takes two forms, specifically standard and safety stock raw material. The former is related to the frequency of supplier deliveries—the more frequent, the lower the quantity of raw material needed to support scheduled production. The latter is to account for potential interruptions within the supply chain. The more local the supply chain—at least on critical parts—the lower the cost of increasing delivery frequency and the less the risk of supply chain interruptions.
Holding inventory requires a storage facility; material handling; carrying charges, etc. This inventory is typically “owned” by operations. Consequently, should supply management work activity with suppliers to reduce the need for—and costs associated with—pre-built raw material, operations is usually given credit for the savings.
It makes a big difference whether a supplier ensures delivered quality based on knowledge of their equipment’s statistical process capability vs. inspection. There are several ways that basing quality on assessing ability to consistently deliver part features on-target and in-control can reduce OEM internal costs, for instance, in receiving inspection.
I once managed a purchasing group where we taught and required our suppliers to provide statistical evidence of their equipment’s process capability. This led to a significant reduction in receiving inspection activity, reducing the number for related inspectors by over 90%. Talk about cost reduction!
Yet although the bulk of the work to reduce the need for receiving inspection was due to supply management, the quality function got the credit for the savings since it reduced their department costs.
To Sum Up
I think you get the picture. Since purchasing seldom gets credit in improvements in more strategic executive level performance metrics—other than improved material variance—they are reluctant to allocate resources to activities other than ensuring sourcing with lowest piece-price suppliers.
I could go on and on. For instance, internal OEM costs are also associated with expediting purchased parts, logistics, the costs associated with giving suppliers firm schedule commitments, etc. Bottom line, I’ve seen very few supply management functions focus on mediation of supply chain risk as a method to positively impact organizational financial results.
I’ll end with a comment.
Just as supply management expects their suppliers to demonstrate their value add above and beyond piece-price, I believe it is up to supply management executives to demonstrate that purchasing can positively impact company financials, also above-and-beyond piece-price.
It may a bit of gumption to do this, but it is a characteristic of good managers to be willing to take personal risks for the betterment of the company. If I worked for an OEM that refused to recognize purchasing’s overall potential for value-add, I’d look for another employer.
Paul Ericksen is IndustryWeek’s supply chain advisor. He has 40 years of experience in industry, primarily in supply management at two large original equipment manufacturers.