The Timeless Procurement Challenge of Supplier Price versus Cost

By Supply Chain Digest Editorial Staff , December 2013,

Need to Understand Cost Drivers at Suppliers, and Manage for Total Supply Chain Costs; Using the “Sourcing Grid”

Most supply managers understand that a supplier’s unit price does not necessarily equal that vendor/item’s total cost to the buying organization.

But understanding does not necessarily mean adopting the principles. Most procurement organizations still measure supply management effectiveness based on unit cost changes, not improvements in total supply chain costs. And few really understand what drives a supplier’s own supply chain costs.

Several years, SCDigest did a classic interview with Dr. Ed Marien on this topic of “Supplier Price-Cost Management.” Marien was for many years at the University of Wisconsin, and after that has his own consulting firm, Marien & Associates.

Those thoughts from 2007 are still just as relevant today as they were then Part 1 of this interview can be found here: The Timeless Procurement Challenge of Supplier Price versus Cost. Part 2 is below.

Supply Chain Digest:  How do the concepts we talked about last time – such as understanding the difference between purchase price and actual cost, relate to strategic sourcing programs?

Marien: What you begin to do is to look at procurement decisions through a couple of specific filters.

The first is how critical the product or service is to the operations of the buying company. The second filter is to understand whether this is a buyer or seller’s market and who is in control.

So, using these filters, you have to look at different price-cost models. I’ll give you an example, using capital equipment. I know one utility company that has a cycle buying process where every year they replace four backhoes.

So once a year they bid these backhoes out. Part of the deal may be for the seller to take the old ones off their hands and dispose of them. But they have a full maintenance department, which will repair and maintain this equipment. So, purchasing goes out to alternative dealers and does a great job of getting bids and selecting sellers for this equipment, which might cost $150,000-250,000 each.  Often, purchasing is using one of the reverse auction services to enable this process.

But the equipment has to be maintained, so the question is this: What sorts of parts and supplies inventories need to be kept to do that? What is the mix of brands and models across the equipment fleet, and how does the mix impact inventory levels and overall maintenance costs? And if you really begin to take a big picture view of this, you may get into a single brand strategy and pursue a full lifecycle leasing and service contract with which the supplier does the service and the buyer eliminates some or all of the maintenance and inventory management functions.

Supply Chain Digest: Meaning finding the lowest total cost of ownership option?

Marien: Exactly. Many utilities companies, just to stick with that example, are looking at the cost of the maintenance function – the people, facilities, inventory, capital equipment, etc. Is there a lower total cost solution available?

This may result in a changing strategy from a once per year, single bid type of approach to a single source, long-term strategy that may result in a lower total cost solution.

It may not be the lowest per unit cost, but it will be the lowest total cost to the company, and may result in increased equipment uptime at the same time.

In the traditional view, cost was associated directly with price – what the company paid for the backhoes. With Supplier Price-Cost Management, I may be looking instead at a lifecycle approach that evaluates total lifecycle system costs.

Supply Chain Digest: What is the “Sourcing Grid”?

Marien: It dates back to the 1980s, and relates to the two filters I mentioned previously. Many others have developed variations on this theme over the years. But the basic concept underlying all of them is pretty simple. On one axis, I look at to what degree the market for this product or service is characterized by buyer or seller control. In a buyer’s market in which supply is plentiful, it may be a more commodity-oriented item with pricing being straightforward as the appropriate costing approach.

In a seller’s market, the opposite tends to be true – constrained supply, differentiated products, and/or more complex pricing.

On the other axis, we look at how critical that product or service is to our business. What you wind up with is a two-by-two matrix that can help you organize how you are going to approach procurement of different goods and services.

For some items, we want to develop strong relationships with our suppliers, and examine the buyer’s costs, the supplier’s costs, and possibly intermediary costs together to design the lowest total cost solution, as well as define other performance metrics that address uptime of equipment and customer/user satisfaction.

Supply Chain Digest: If a product is commodity like, does that mean I should always just buy it like a commodity, very transactionally?

Marien: A couple of thoughts on that  – first, the frequency of the purchase is another consideration. It is usually just not worth the effort to put too much time in price-cost analysis or relationship development for infrequently purchased items.

As buyers begin supplier price-cost management analysis, they start to look at cost structures, or what the real cost drivers are that effect the price the supplier charges.

Second, I may certainly want to look at total cost in detail even for very commodity-oriented items, rather than just considering the purchase price. Let’s take something like office supplies, which in general are highly commoditized products.

But until recently, here at the University of Wisconsin, as with many organizations, purchasing office supplies was a long and not easy process, with a lot of hand-offs. And we often had large pockets of inventory – mini-warehouses – all over the campus.

Now, we use a service that enables us to order the products easily, get them delivered quickly, and at very attractive prices. So, we took something very much in the commodity category – office supplies – where normally you might just go out and get the cheapest price, and took a much more strategic approach that lowers total cost and improves user satisfaction.

Supply Chain Digest: So what’s the bottom line here?

Marien: The bottom line is to assess product/service criticality with the goal of calculating the value and payback of moving from commodity-type buys of products and services to strategic sourcing.  Strategically, top management must review their buying processes and determine if they will allocate resources to strategic sourcing with suppliers for cost efficiencies and/or competitive advantages.