Creating Value Through Price/Cost Productivity

Author(s):

Frank Haluch, C.P.M.
Frank Haluch, C.P.M., Haluch and Associates Ltd.,165 Lake Avenue. Trumbull, CT 06611, (203) 268-1005.
Robert J. Trent, Ph.D.
Robert J. Trent, Ph.D., Lehigh University, 621 Taylor Street, Bethlehem, Pennsylvania 18015, (610) 758-4952.

82nd Annual International Conference Proceedings - 1997 

Abstract. Executives at U.S. firms increasingly expect purchasing, working with suppliers, to achieve continuous price/cost reductions. However, expecting reductions to occur is different from actually realizing the intended improvement. Given purchasing's historical preoccupation with competitive bidding and price, buyers often find themselves ill-prepared to pursue price/cost reduction initiatives with suppliers. This proceeding presents various approaches for creating value (i.e., price productivity or improvement) by reducing, and eliminating where possible, the cost drivers that influence purchase price. The approaches discussed include (1) authentic pricing, (2) tolling, (3) identifying and removing waste, and (4) focusing on a supplier's operating profit drivers as a way to achieve price/cost improvement.

Introduction. Intense worldwide competition and the increasing sophistication of customers is creating relentless pressure on firms to reduce costs continuously. Given that a typical manufacturer spends 55 cents of each revenue dollar on goods and services, it is not unexpected that executive management now looks to purchasing to make a major contribution toward realizing corporate profitability targets. As AT&T's executive vice president for telephone products maintains, "Purchasing is by far the largest single function AT&T. Nothing we do is more important."

Executives at U.S. firms increasingly expect purchasing, working with suppliers, to achieve continuous price/cost reductions. Research reveals that, on average, firms must attain continuous cost, quality, time, and delivery improvements from suppliers and themselves to remain competitive. It became evident in the late 1980s that most firms had to achieve real year-to-year cost reductions of at least 5 percent throughout the 1990s or risk losing market share to more efficient and effective producers. These cost reduction pressures should increase rather than decrease over the next ten years.

Expecting cost and price reductions to occur is different from actually realizing the intended improvement. In fact, given purchasing's historical preoccupation with competitive bidding and price, buyers often find themselves ill-prepared to pursue price/cost reduction initiatives with suppliers, many of which require collaborative relationships. This proceeding presents various approaches for creating value (i.e., price productivity or improvement) by reducing, and eliminating where possible, the cost drivers that affect purchase price. The approaches discussed here include (1) authentic pricing, (2) tolling, (3) identifying and removing waste, and (4) focusing on a supplier's operating profit drivers as a way to achieve price/cost improvement.

APPROACHES FOR CREATING VALUE THROUGH PRICE/COST PRODUCTIVITY.

The following sections discuss selected approaches for pursuing continuous price/cost improvement. Buyers can execute these approaches separately or include them as part of a total price/cost reduction strategy. These approaches often require a willingness by the buyer and seller to work collaboratively to reduce cost and improve price. Furthermore, suppliers must understand and accept the requirements of end customers placed on the buyer. This recognizes that buyers are not a value chain's end customers, that all tiers of the supply base are stakeholders in satisfying the end customer, and that suppliers must accept end customer demands as a condition of continuing to do business with a purchaser.

Approach One: Authentic Pricing. Authentic pricing refers to the price of goods or services without adders for late payments, inventory carrying charges, or costs due to schedule changes. Price adders support the notion "there is no such thing as a free lunch."

Late Payments. Buyers who delay paying supplier invoices may not realize that prices often contain an adder reflecting the cost of money. Suppliers have responded to surveys that they routinely add the cost of money to the purchase price to compensate for a buyer's payment period. The cost of supplier financing should not be part of the purchase order price. The following formula allows buyers to estimate the price adder that a supplier may be including in the purchase price to compensate for the time a buyer receives material but has not yet tendered payment:


Price Adder ($) = (Selling Price) x [(Cost of Money) x (Average payable/360)]

Example: Selling price = $10 unit, cost of money = 10% or .10, average payable = 60 days
Price adder = ($10 unit) x [(.10) x (60/360)]
= $0.1667

Now, assume that the buyer agrees to pay the supplier in 30 days rather than 60 days:
Price adder = ($10 unit) x [(.10) x (30/360)]
= $.0833

The premium for paying in 60 days versus 30 days is:
$0.1667 - $0.0833 = $0.0834/unit, or 0.834% in this example

By changing the accounts payable period, a buyer could pursue a negotiated price reduction reflecting the amount added by suppliers that reflects the value of money. Buyers will need to discuss any changes with Finance to verify that a negotiated reduction is greater than any other benefit derived from delaying payments.

Inventory Carrying. Many buyers now require suppliers to hold inventory for delivery on a "just-in-time" basis. Womack and Jones argue that most claims of creating lean supply chains are merely wishful thinking. When examined closely, many just-in-time delivery systems involve nothing more than relocating inventory from the purchaser to the next company upstream. These pseudo JIT systems do not come without cost. When surveyed, suppliers have reported they charge price adders to compensate for holding a purchaser's inventory. By working together, the buyer and seller may identify the true cost of holding inventory and develop a better approach for managing inventory investment. This approach could very well involve joint efforts to create a true lean supply chain.

Schedule Changes. Frequent scheduling changes create additional costs as suppliers disrupt their operations to accommodate the purchaser's change requests. Does a purchase price contain a cost adder for schedule changes? Do schedule changes require suppliers to operate outside their range of normal flexibility, thereby creating additional costs? One supplier to a major chemical company approached a purchaser with an offer of a 5 percent price reduction if the buyer "froze" material releases three weeks before their due date. Purchasers must identify the reasons for scheduling changes and then work to reduce or eliminate the conditions creating the need for frequent changes.

Approach Two: Tolling. The objective of tolling is to give suppliers access to lower cost material or services used in the manufacture of components or the delivery of services to the buyer. The purchaser uses its leverage to secure a lower purchase price for items required within a supplier's production process, with savings forwarded to the purchaser in the form of a price reduction. Tolling occurs regularly for copper, aluminum, plastic, and electronic components. The potential also exists for reverse tolling. A supplier may obtain a lower price for items required by the purchaser. It may be a smart business decision to give the buyer access to lower price material. Besides promoting a better buyer-seller relationship, reverse tolling may help a supplier's customers become more competitive.

Approach Three: Identify and Remove All Waste. The move toward closer buyer-seller relationships creates opportunities for identifying jointly and removing waste associated with failures, appraisals, and tasks. Table 1 identifies examples of waste that, left unchallenged, can increase cost and purchase price.

Table 1: Identify and Remove Waste

Failures: Waste in Making Defective Parts
- Non producible design requiring end of line rework
- Scrap
- Cost of corrective action

Waste of Time
- Material waiting for value-added processing
- People waiting for machine to complete its cycle

Appraisals: Waste of Motion
- Incoming inspection
- Interplant inspection
- Any checking activity after design and process capability assured
Tasks: Waste of Over Production
- Receiving storage
- Cash lockup
- Technology lockup

Waste of motion
- Non value added activities

Waste of time
- Expediting

Removal of waste requires close collaboration between buyer and seller. Waste reduction is often a sound reason for establishing buyer-seller problem solving teams.

Approach Four: Focus on Operating Profit Drivers. Several years ago an article appeared in the Harvard Business Review discussing the relationship between price, volume, variable and fixed costs, and operating profit. The article reported on a study that examined the average economics of 2,463 companies in the Computstat data base and reached the conclusions presented in Table 2.

Table 2: Ratios Between Volume, Variable and Fixed Costs, and Operating Profit

A 1% improvement in ....... creates an operating income improvement of:

Price
11.1%
Variable Cost
7.8%
Volume
3.3%
Fixed cost
2.3%

From a supplier's perspective, an improvement in price means a price increase, which yields the greatest operating income improvement. Price increases, however, are unacceptable to the buyer. Conversely, price decreases without accompanying cost reductions can create severe operating strains on suppliers. Therefore, purchasers must focus on variable and fixed cost improvements (reductions) or volume increases for achieving targeted price reductions. This requires focusing on reducing cost drivers, which leads to a lower purchase price (price productivity improvement). Central to this approach is protecting supplier profit margins. Suppliers should be more willing to work with a buyer to reduce purchase price when a stated objective is the protection of the supplier's profitability.

Analyzing the variable cost, fixed cost, or volume changes required to provide a targeted price reduction requires several formulas. These formulas assume supplier operating profit margins will remain constant. In other words, price reductions will be due to cost elimination rather than margin adjustments. The following examples calculate the amount of variable cost decrease, fixed cost decrease, or volume increase required to provide a specific price decrease sought by the buyer.

Example One: Variable Cost Decrease Requirement. Assume a buyer requires a 6% price decrease from a supplier. How much must the supplier and buyer reduce variable costs to realize a 6% price productivity improvement while maintaining a 10% operating profit margin? Recall that a 1% variable cost decrease equals a 7.8% operating profit improvement (from Table 2).

Formula 1: Percent incremental profit improvement (per 1% variable cost decrease) = (Operating profit margin x operating profit improvement per 1% variable cost decrease) x 100
= (0.10 x 0.078) x 100 = 0.78%

Formula 2: Percent variable cost decrease needed for "X%" price decrease = price decrease required ö incremental profit improvement
= 6% ö 0.78% = 7.69%

A 7.69% variable cost decrease yields a 6% price decrease while maintaining a 10% operating profit margin.

Example Two: Fixed Cost Decrease Requirement. Assume a buyer requires a 6% price decrease from a supplier. How much must the supplier and buyer reduce fixed costs to realize a 6% price productivity improvement while maintaining a 10% operating profit margin? Recall that a 1% fixed cost decrease equals a 2.3% operating profit improvement (from Table 2).

Formula 1: Percent incremental profit improvement (per 1% fixed cost decrease) = (Operating profit margin x operating profit improvement per 1% fixed cost decrease) x 100
= (0.10 x 0.023) x 100 = 0.23%

Formula 2: Percent fixed cost decrease needed for "X%" price decrease = price decrease required divided by incremental profit improvement
= 6% divided by 0.23% = 26.09%

A 26.09% fixed cost decrease yields a 6% price decrease while maintaining a 10% operating profit margin.

Example Three: Unit Volume Increase Requirement. Assume a buyer requires a 6% price decrease from a supplier. How much must the buyer increase volume to the supplier to realize a 6% price productivity improvement while maintaining a 10% operating profit margin? Recall that a 1% variable cost decrease equals a 3.3% operating profit improvement (from Table 2).

Formula 1: Percent incremental profit improvement (per 1% unit volume increase) = (Operating profit margin x operating profit improvement per 1% unit volume decrease) x 100
= (0.10 x 0.033) x 100 = 0.33%

Formula 2: Percent unit volume increase needed for "X%" price decrease = Price decrease required divided by incremental profit improvement
= 6% divided by 0.33% = 18.18%

A 18.18% unit volume increase yields a 6% price decrease while maintaining a 10% operating profit margin.

From a buyer's perspective, increasing unit volumes or reducing variable costs will probably be more likely an option than reducing a supplier's fixed costs. Fixed costs are often difficult to allocate to a specific purchased item. Also, fixed costs are a smaller proportion of total costs compared with variable costs. The pricing benefit gained by volume consolidation helps explain why firms actively work to reduce their supply base and consolidate volumes with fewer suppliers. In fact, purchasers should consolidate volumes with fewer suppliers to achieve lower cost and higher quality. It is unlikely that a firm would consolidate volumes with a lower quality producer.

Focusing on operating profit drivers allows a buyer to identify the cost reduction or volume increase required to support a specific price decrease. If a supplier maintains that the figures in Table 1 do not apply, then the buyer should ask what improvement percents do apply. It is not enough to tell buyers to reduce purchase price continuously or unilaterally. Buyers must have the ability to analyze cost reduction requirements and work jointly with suppliers to realize the price reduction targets. A willingness to protect a supplier's profit margin, which is central to this approach, sends a message about a purchaser's willingness to consider the supplier's needs.

Conclusion. Many approaches, including those discussed here, can help purchasers reduce price/cost. Realizing price improvements from suppliers requires understanding and applying price/cost reduction techniques. Furthermore, purchasers who have developed closer relationships with their key suppliers should enhance their longer-term competitiveness due to increased information sharing and joint improvement efforts. Real improvement requires embracing price/cost reduction approaches that deliver price productivity benefits that are difficult for competitors to duplicate. It also requires buyers to focus on the drivers on cost rather than simply price, which is merely an end result.


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