Calculating Total Cost

Author(s):

Mary Lu Harding, C.P.M., CPIM, CIRM
Mary Lu Harding, C.P.M., CPIM, CIRM, Harding & Associates, Bristol, VT 05443, 802/453-5379

81st Annual International Conference Proceedings - 1996 - Chicago, IL

Abstract. Purchasers wanting to implement a Total-Cost-based supplier selection process often stumble over how to include non-monetary issues (lead time, services, social policies, etc.). This paper describes a process that allows you to include any issue you deem relevant and determine its cost factor.

Unit Total Cost. To use Total Cost for selecting and managing suppliers, one needs a common denominator with which to compare them. Unit Total Cost (unit price amended by total cost factors) is one common denominator. To use Unit Total Cost successfully:

  1. Determine the total cost factors important to your organization.
  2. Translate each cost factor into a price adder formula.
  3. Add to each supplier's base price a debit (or credit) for each factor appropriate to that supplier's performance.
  4. Add the base price plus all total cost factors to get Unit Total Cost.
  5. Award the business to the supplier with the lowest Unit Total Cost.

Internally, Unit Total Cost will justify your choice of supplier (especially when they are not the lowest priced supplier) to anyone - while teaching your organization where and how costs are incurred.

Externally, Unit Total Cost calculations shared with each supplier are a very powerful message about what they have to do to get your business. They see clearly what performance factors drag them down, by how much and what improvement will mean to their business.

Performance Factors. Selecting the appropriate performance factors is the first step. Factors such as on-time delivery performance and quality are commonly measured. Factors such as lead time, transportation costs, and inventory levels can also be included. Some businesses also place importance on political / social policy factors such as recycled material content, social responsibility policy, and consentual reciprocity. All of these can be included in the calculation of total unit cost. What is required is the definition of the factor and it's value to the organization. Forcing such a definition is one benefit of using a system such as unit total cost. It makes the values of the organization explicit - both to purchasing and to suppliers.

Establishing Formulae. When establishing the formula for any factor, two things matter:

  1. That the formula makes sense. It is relevant to the factor valued and can be calculated.
  2. That the formula can be applied across suppliers and used to differentiate performance.

As long as these two criteria are met, any number of ways can be determined to measure each factor.

The examples given here are only examples. They have all been used successfully, and they are not the only way to calculate performance factors. Use what works for you and/or devise your own formulae.

On-time Delivery Performance: Use the percent of deliveries that are not on time as a percentage price adder. For example, if a supplier is on time 93% of the time, then they are not on time 7% of the time. So a 7% price adder would be applied to their quoted price. Each supplier is subject to the adder dictated by their performance.

Quality: Several measures of quality have been used successfully. Some organizations calculate the cost of non-conforming material. If your organization has that information, use it. If not, the quality percentage can be used similar to the on-time delivery percentage. Apply the percentage of failures to the quoted price as a price-adder. Each supplier's adder is reflective of their quality performance.

Transportation: If the freight charges show up on your invoices, use that to calculate the freight cost for each unit of goods. If freight costs do not show up on your invoice, where are they being absorbed? Perhaps that is a question worth asking each supplier.

Lead Time: If lead time matters to your organization (and I hope it does!), then establish a tax per week of lead time. Lead time limits your flexibility and may drive high levels of inventory. One percent added per week of supplier's lead time is certainly within the realm of reason. The more important lead time reduction is to you - the higher the tax.

Some organizations use their purchasing leverage to drive social policy issues that they value. Here are some issues that many companies have chosen to address:
Recycled Content: Establish a percentage credit for recycled content of the level you require. Credits of 5% to 10% have been commonly encountered. Many businesses have expressed their credits as rules in purchasing that buyers can pay up to 10% more for recycled products without permission or justification. Crediting the suppliers appropriately is a way to convert that preference into unit total cost.

Consentual Reciprocity: Businesses who wish to favor other businesses for various reasons - such as non-profit organizations who wish to favor donors or companies doing business abroad who are subject to contry-content restrictions - may want to include these as factors in evaluating selection of suppliers.

Any social policy factor can be incorporated into the supplier selection process. Use of the unit total cost process will force the company (usually not just purchasing) to define what issues it wants to consider and how much weight it wants to give to each factor. Once those decisions are made, the formula becomes easy and the decision factors become public. For example, if a non-profit organization that exists only on donations chooses to favor donors in how it awards business, then use of unit total cost will drive the organization policy makers to decide how much more they are willing to pay to give the business to a donor vs. a non-donor. Once the decision is made, then the factor can be used either as a credit to donors or a tax for non-donors (but not both).

The beauty of using unit total cost calculations to select suppliers is that all factors can be considered and that the criteria are public (within the organization and to suppliers). It forces the organization policy makers to decide what they value and how much they are willing to pay for exercising those values. It takes the monkey off purchasing's back to decide how to treat non-monetary issues. It also conveys a very clear message to the supply base about what they have to do to get the business.

Not only is the selection clearer, but when each supplier is shown their unit total cost - by which they won or lost the business - the message is very clear about what they have to do to be competitive.

They can either slash their prices (a choice very hazardous to their long term health) or they can work on improving their performance to their customers needs (a much healthier choice), and they can see exactly how incremental performance improvement will affect the "bottom line" at their customer.


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