Michael Harding, Principal, Harding & Associates, Bristol, VT 05443, 802/453-5379, Harding@Sovet.Net
Abstract. Fifty years of purchasing expediting suppliers for improved deliveries has not produced the desired results. The reason is that there has been no financial consequences or cost of lead time associated with the buy. In this session we will demonstrate that the cost of lead time is 1.5% of the purchase price for each week of lead time and that this sum should and must be added to the purchase decision.
Purchasing has for decades used competitive pricing in the market place to influence and shape prices which are paid. Many companies have been forced by a competitive market to improve their efficiencies and costs. Beginning in the 1980s the quality revolution was announced by buying organizations insisting that the market produce quality in terms of PPM and CPk which were previously unheard of. These were improvements which many suppliers did not volunteer to make but which were dictated by the market. Cost/price improvements were easily measured by dollars. Ultimately, quality was also measured in terms of the "Cost of Quality" and the "Price of Non-conformance." The common denominator of measure is dollars. Everyone in business can and does relate to dollars. Dollar decisions are easily made.
Many purchasing professionals spend forty percent or more of their time expediting and they expedite the same items and suppliers week after week, month after month. We are very good expediters. Through much effort we do get results. Some of the reasons we get to do so much expediting is that there are no permanent results of our effort and there are no changes in business behavior on the other side. Few people value lead times as much as purchasing personnel. The reasons boil down to dollars. Lead time is not measured in terms of dollars. What is the cost of a week's lead time to the buying company? The answer is 1.5 percent of the purchase price for each week of lead time.
The answer begins with the cost to carry inventory. Many financial departments use a very low cost to carry inventory figure, often in the range of 10 to 25 percent per year of the acquisition cost or two times the current prime interest rate. It is difficult to trace the origins of these figures but they are deeply held beliefs by accounting professionals. The result on business of the low cost to carry figures has been higher inventory levels, lower inventory turns and problematic cash flow. Companies have used inventories to compensate for long supplier lead times -- an "affordable" strategy. If the buying company is surprised by a void in the inventory or projected need, purchasing is called in to expedite the required material. Also, the longer the supplier lead times, the greater the quantity of inventory which will be placed in raw material or "safety stock."
The actual cost to carry inventory is in the order of 75 percent per year calculated as follows:
|Visible Cost||Approximate % per year|
|Interest rate of money||10%|
|Taxes (vary by state)||5%|
|Space, occupancy and utilities||4%|
|Equipment (storage and moving)||3%|
|Scrap and obsolescence||5% (can run to 20%)|
|(less visible) costs Personnel (planners, warehousers, analysts)||15%|
|Transactions: counting, sorting, moving,receiving, issuing, reconciling||10%|
|Inspection, reinspection, return of defective material||10%|
|Rework, handling damage, loss||10%|
Although specific costs will vary by industry and company, activity-based accounting (ABC) has confirmed these figures to be reasonable accurate; certainly more representative of actual costs than figures of less than 25 percent.
For the sake of this exercise, let us assume that a company will maintain one week's of inventory for each week of supplier lead time. Therefore, if a supplier quotes a buyer eight weeks lead time, the buying organization will have eight weeks of inventory on hand (at a cost of 1.5 percent of the purchase price). This plays out in the following example:
A buyer has sent out a request for quote for 10,000 widgets per year. The standard cost or last price paid was $13.35 each. The following are the responses received:
|Appleby Corp.||$14.00ea||1 week|
|Barnaby Co.||$13.50||6 weeks|
|Carousel Inc.||$13.20||10 weeks|
From whom would you buy? Most buyers would like to buy Appleby's lead time and Carousel's price. Most cost accountants might say 'buy from Carousel; it's the lowest price and it beats the standard cost - a savings.' Now factor in the cost of the lead times to the buying company:
|Appleby||$14.00 X 1.015 X 1||= $14.21|
|Barnaby||$13.50 X 1.015 X 6||= $14.715|
|Carousel||$13.20 X 1.015 X 10||= $15.18|
Perhaps Appleby is a better business decision. The magic of this approach is that the buyer must act according to what the numbers tell him or her. When the Carousel salesperson learns that the order went to Appleby because "I cannot afford your lead time," Carousel has the option of improving their lead times or loosing more business. The Appleby salesperson will understand that they won this order due to better lead time but that future business may well depend on reducing their cost to produce.
There are those who may take issue with the science behind the 75 percent cost to carry and the resulting 1.5 percent but when evenly applied across all suppliers it will have the desired effect of putting lead times on a competitive and dollar basis. Prices adjusted for lead times and resulting inventories with not only facilitate better business decisions, they will dramatically reduce the amount of expediting purchasing performs.
Harding and Harding, Purchasing, New York, Barrons' Business Library, 1991.
Moody, Patricia, Leading Manufacturing Excellence, New York, John Wiley & Sons, 1997.