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Key Enablers for Strategic Cost Management in the Supply Chain

Author(s):

Thomas A. Crimi, C.P.M.
Thomas A. Crimi, C.P.M., Supply Chain Team Coordinator, Texaco, Inc., Houston, TX 77402, 713-752-3981, crimita@texaco.com
Ralph G. Kauffman, Ph.D., C.P.M.
Ralph G. Kauffman, Ph.D., C.P.M., Assistant Professor, University of Houston-Downtown, Houston, TX 77002, 713-221-8962, www.dt.uh.edu, kauffmanr@dt.uh.edu

85th Annual International Conference Proceedings - 2000 

Abstract. Competitive pressures and supply chain partners require costs to be strategically managed. For many organizations, the cost of purchasing goods and services makes up more than 60% of the cost of goods sold (Copacino, 1999). This paper first defines what is "strategic cost management," then identifies key enablers (necessary factors to the application of strategic cost management) found in many supply chain situations. The paper also considers how to identify and apply the enablers in particular individual company situations, and environmental considerations in strategic cost management including: market conditions, cost structures, cost impact on the supply chain, cost modeling, and the impact of dominant members of the supply chain.

Definition of Strategic Cost Management. A number of definitions of cost management can be found. The Future of Purchasing and Supply: A Five- and Ten-Year Forecast indicates that cooperation between firms is required to establish cost drivers and individual/joint cost reduction strategies. These efforts are necessary to achieve cost reductions necessary to maintaining a competitive position. Also, formula pricing approaches are needed for engineered and specified products and services to assure sufficient profit and return on investment. Other definitions include relation of cost management to the total supply chain and beyond any single transaction or supplier relationship (Kauffman, 1999). Another definition is "scrutinizing every process within your organization, knocking down departmental barriers, understanding your suppliers' business, and helping improve their processes" (Northaft, 1999). The common threads in these definitions appear to be: planning and working ahead of the need for a product or service, and working across a number of relationships or requirements.

Key Enablers That Facilitate Strategic Cost Management. Each individual organization needs to review their various supply needs and supply chains and determine what enablers are of prime importance to their situations. We will discuss an approach to that problem later in the paper. In this section we will discuss a number of generally applicable enablers, some of which are likely to be present in many supply situations. The enablers are grouped by the three phases present in most cost management approaches: analysis and planning, implementation, and ongoing management and control. Some apply to more than one phase and are so listed but discussed only at the first listing.

Analysis and Planning Enablers:

  • Top management support and sponsorship - Without this forget the whole idea of cost management. However, to get this support, top management must understand the value of supply chain management to the bottom line. If management seems reluctant to recognize this from internal efforts alone, cooperative efforts with suppliers and/or customers may help to convince them.

  • Information systems - To capture spending by commodity or service, supplier, and geographical area. Information can be used to: identify opportunities for synergy with other supply chain members in areas such as leveraging spend, pooling knowledge, acquiring/providing/sharing technology, identify areas where transfer of best practices will reduce costs, optimize location and use of resources, such as inventories, in the supply chain, and help to identify total cost drivers.

  • Identity of total cost drivers - What are all of the elements that make up the total cost in a given supply chain? Total cost drivers may vary by geographical areas and may include items such as logistics, transportation, inventory, lead time, lack of infrastructure, lack of qualified or trained personnel, lack of qualified suppliers, and production impact of particular products or services. Additional drivers that may be present in a global analysis could include tariffs and duties, currency exchange rates, hostile political or geographical environments.

  • Cost models - If models of major costs in the supply chain are not available, they may need to be developed. Cost models may have to be adjusted by country or region in global supply chain situations. Some techniques for modeling costs include learning curve analysis, experience effect analysis, price productivity analysis, implied set-up cost analysis, should-cost analysis, comparative process analysis, and cost breakdown analysis. Some approaches to cost and price modeling and analysis are presented in Chapter 19 of the current edition of The Purchasing Handbook.

  • A strategic cost management plan - There must be known cost management objectives and a plan as to how you are going to achieve them. One approach to prepare such a plan is to use a three-step approach that includes: classifying purchases, matching cost analysis tools with the purchase classifications, and focusing on strategic cost management techniques to achieve cost management results (Ellram, 1996).

  • Effective cross-functional teams - Vital to the success of any cost management effort because of the varied departments and functions that are affected and need to be involved to implement cost management initiatives. All parties either affected by the costs in question or involved in generating those costs need to be involved in the applicable cost management teams.

  • Known Business strategies - To develop purchasing cost management strategies, overall business strategies must be known. The maximum effect of strategic cost management in the supply chain can only be achieved when supply chain strategies are aligned with overall business strategies. Obviously, to achieve alignment, overall business strategies must be known to the supply chain team.

  • Alignment of supply strategies with business strategies - To be most effective, purchasing cost management strategies must be aligned with overall business strategies. This enabler is key to successful strategic cost management and also to obtaining full support of top management. Do not make the mistake of concentrating cost management efforts in an area that management considers unimportant, or in an area of the business that is not strategically important to the company and/or may be up for divestiture.

  • Total cost approach to procurement - Frequently the most significant cost reductions in a supply chain do not result from lower prices. Price is important but it is not the only cost. Costs other than price may have more reduction potential or may be easier to reduce than price itself. Do not overlook any cost element. Sometimes costs that are indirectly linked to the use of products or services may contain large reduction potential as a result of changes in the purchased products or services.

  • Balanced approach to sourcing - It is inefficient to either purchase everything through alliances or purchase everything on a transactional basis. All purchases must be analyzed and categorized according to criteria such as total spend, long-term vs. short-term need, strategic importance, and supply base capabilities. From such an analysis individual purchase categories can be identified as candidates for strategic alliances, small-value purchase techniques, and transactional approaches.

  • Performance measurements - Without measurements you don't know where you are, where you came from, or where you are going. Performance measurements should be established for all aspects of a strategic cost management plan that are critical to its success. Therefore the first step in establishing measurements is to identify critical success factors and then develop indicators to measure how well they are being achieved. The results of measurement can be used to report success, to identify problem areas, and as the basis for taking corrective action.

  • Redefinition of procurement business processes - Necessary to accommodate balanced sourcing and efficient methods for handling transactional purchasing activities. Adoption of a continuous process improvement approach to supply chain operations will cause continual redefinition of business processes in the supply chain.

  • Maximize the leverage effect of purchasing - Use the information available from data systems to determine global spend by product, supplier, and geographical area to identify leverage opportunities. Leverage benefits can include price, quality, service, availability, knowledge, and other factors

Sharing of Risks and Rewards - Necessary to the successful integration of activities in a supply chain to achieve strategic cost management in the chain. Provides all chain members with incentives to cooperate and participate in cost management initiatives

Implementation Enablers:

  • Supply chain visioning - Brainstorm cost improvement possibilities with affected business units and others in your organization and supply chain members/partners. Do this through working sessions with the active leadership of business units or internal customer groups to develop a common understanding of internal customer requirements and to develop a value proposition, i.e. a distinctive competence that can be used to better serve internal customer needs and how operations must be changed to implement the envisioned improvements. The visioning process is most effective when customer focused (aligned with customers' evolving needs), and strategy driven (consistent with how value is added by the organization). Examples of possibilities from the visioning process include volume leveraging, best practices diffusion, and outcome-based objectives (focused on desired results such as return on investment, cycle time achievement, and inventory reduction).

  • Flexible programs - Improvement programs must be capable of being customized to meet the needs of different internal customer segments in a cost-effective way.

  • Diffusion of best practices in the organization - Without organization-wide application of best practices, cost management objectives cannot be fully achieved. Frequently a best practice in one part of the supply chain is a good model for application elsewhere in the chain to achieve the most effective cost management.

  • Strategic alliances - Necessary in key supply chains to achieve the close cooperation required for effective cost management. The set-up and maintenance costs of strategic alliances rule them out in many purchase situations but they are necessary in high-spend, critically important areas.

  • E-commerce - The ability to communicate, exchange information, and conduct business transactions with suppliers and third parties via EDI or the internet and to execute purchases without paper documents. Effects on strategic cost management can include reduced purchase process costs, shortening of order cycle time, improved control of operations, and increased or broader market access that may result in reduced purchase costs from awareness of additional product or supplier alternatives.

  • Planned change management - Changes in processes and procedures must be well-planned and executed. Use techniques such as pilot implementation of changes (make mistakes on a small scale). Also, adequate training in new or changed processes must be provided for all affected groups and individuals.

  • Supply base rationalization - To effectively manage costs, the number of suppliers must be reduced to a minimum. Qualification and maintenance of large supplier bases is expensive. Leverage potential for price, quality, service, delivery, and technology cannot be maximized without reducing the number of suppliers.

  • Existence of shared supplier-customer strategies - An absolute necessity for successful cost management in a supply chain. Shared strategies are best and most easily obtained by use of cross-functional teams. Such teams must include supplier, critical third party, and customer representation in addition to key functions of the buying organization.

  • Minimization of transactional activities of purchasing - Eliminate, automate, or shift non-value-added activities, e.g. processing of low-value purchase transactions out of purchasing. Purchasing coordinates the strategic decision as to where and how to obtain items such as MRO but the daily transactions of obtaining individual items and processing payment for them are handled by individual users.

  • Shifting of supply chain costs - Find the member of the chain that can perform the activity most efficiently and move the activity there. Be sure that actual cost reduction (and not merely cost shifting) is achieved in the total cost of the supply chain.

  • Outsourcing - If an activity can be performed more efficiently by someone who is not a member of the supply chain, shift the activity outside the supply chain, effectively enlarging the chain but making it more efficient. Guard against potential loss of technological advantage when outsourcing state of the art processes.

Effective cross-functional teams

Top management support and sponsorship

Performance measurements

Management and Control Enablers:

  • Continuous improvement philosophy - Never be satisfied with the current state of cost management. Completion of one set of cost management improvements must be viewed as setting the stage for the next improvements. Search for breakthroughs, new paradigms, and wall-leaping ideas as well as incremental and generational improvements.
  • Top management support and sponsorship
  • Effective cross-functional teams
  • Information systems
  • Performance measurements
  • Sharing of Risks and Rewards

How to Identify and Apply Key Enablers. Following is one approach:

  1. In any particular supply chain situation identify the chain participants and the boundaries of the situation to be studied.

  2. Within the study boundaries identify all supply chain participants, and groups that are affected by the material or service provided by the supply chain, both internal and external to the buying company.

  3. Create a cross-functional team from the affected groups.

  4. As a team, map the chain, identifying all flows of materials or services, flow volumes, dollar values of flows and of services, and other activities (e.g. transportation, handling, storage, inspection) or materials (e.g. packaging) that are part of or necessary to the operation of the supply chain. Also identify the time dimension of all activities and movements and the organizational identity of all direct and indirect participants in all activities in the supply chain.

  5. Having thus documented the chain, the team should use the list of key enablers provided in this article as a checklist to determine which enablers apply to the supply chain in question.

  6. For those key enablers that apply, determine to what extent they have already been applied to improve operation of the chain and to what extent they have not been applied.

  7. Develop an action plan to put in place or revise the use of those key enablers which are not in place or which need modification.

  8. Implement the action plan.

  9. Monitor results and adjust implementation as needed.

  10. Use performance indicators to monitor operation on a continuing basis.

  11. Practice continuous process improvement to maintain cutting edge supply chain operation.

Environmental Considerations that Affect Key Enablers. The principal environmental elements that will affect the relative importance of the strategic cost enablers in particular supply chains include the following. Some considerations relative to these are:

  • Market conditions - Relative supply and demand in buying and selling markets and up and down multi-tier supply chains. Who in the chain has the market power? Do not forget third-party chain members such as transportation providers

  • Cost structures across the supply chain - How are costs structured across a given supply chain? Are most costs incurred upstream in the chain, are they concentrated downstream, or are they relatively evenly distributed? The location(s) of the greatest costs must be the prime targets of cost management efforts

  • Cost impact across the supply chain - Where do costs most significantly impact the flow of materials and services through a supply chain? Which costs are least competitive with competing chains?

  • Cost modeling feasibility - Do good cost models exist? Can they be easily developed?

  • Dominant chain members - Presence of dominant members in the supply chain who have relative strong influence over the chain and its activities. Dominance may appear in a variety of forms including product or supply volume, possession of technology, or control of costs or markets.

REFERENCES AND RESOURCES

Copacino, William C., Supply Chain Management, St. Lucie Press, 1999

Carter, Philip L., Joseph R. Carter, Robert M. Monczka, Thomas, H. Slaight, and Andrew J. Swan, The Future of Purchasing and Supply: A Five- and Ten-Year Forecast, A joint research initiative of Center for Advanced Purchasing Studies, National Association of Purchasing Management, and A. T. Kearney, Inc., Tempe, AZ, Center for Advanced Purchasing Studies, 1998

Ellram, Lisa M., "A Structured Method for Applying Purchasing Cost Management Tools." International Journal of Purchasing and Materials Management, Winter, 1996, 11-19.

Kauffman, Ralph G., "The Future of Purchasing and Supply: Strategic Cost Management." Purchasing Today, September, 1999, 33-35.

Nothaft, Mark, "Orchestrating a Successful Cost Management Program." Purchasing Today, October, 1999, 33-40.

The Purchasing Handbook - A Guide for the Purchasing and Supply Professional, 6th ed., Joseph L. Cavinato and Ralph G. Kauffman, editors, New York, McGraw-Hill, 2000


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