Cost Reductions - We Don't Get Enough Credit

Author(s):

Mark S. Miller C.P.M., C.I.R.M.
Mark S. Miller C.P.M., C.I.R.M., Purchasing Manager, Case Corporation- 700 State Street, Racine, WI. 53404, 414-636-6565.
Hank J. Mate C.P.M.
Hank J. Mate C.P.M., Senior Buyer, 414-636-6108, Case Corporation- 700 State Street, Racine, WI. 53404.

82nd Annual International Conference Proceedings - 1997 

Purchasing doesn't get enough credit and it's our own fault. There are significant contributions we are making to cost reduction that aren't being recognized . The reason these cost reduction contributions aren't being recognized is that we ourselves don't understand there value. The goal of this presentation is to identify these "unclaimed " cost reductions and show how they impact your company's bottom line. The six "unclaimed" cost reductions that will be explored are: 1)direct reductions that don't affect variance, 2) cost avoidance , 3) inventory reduction , 4) quality improvements, 5) reduction of the supplier base, and 6) establishing EDI partners.

1) Cost reductions that don't affect variance.
According to the Glossary of Key Purchasing Terms published by NAPM, cost reduction involves the examination of existing products or services, contractual arrangements, or processes to determine potential changes that could help cut costs. Purchasing action that achieves a decrease in current price from the last price paid is a cost reduction . Figure 1 below demonstrates how cost reduction has a dollar for dollar impact on the bottom line.

Figure 1 - Not included in this text only version

Our company "values" cost reductions that affect material price variance , but fails to appreciate cost reductions that do not. Material price variance is the difference between actual price compared to a benchmark. The benchmark most often used in this measurement is standard cost. Standard costs are usually reset annually based on current market price for the part. Material price variance is reported as a separate line on the income statement . Material price variance is visible and cost reduction impacts that affect price variance are easy to see. There are other legitimate cost reductions, however, that don't impact material price variance. The following are two examples of cost reductions that don't impact price variance:

A) Part number changes - When a cost savings project requires a new part number to be set up , material price variance isn't affected. When the new part is set up the new "low cost" is set as the standard cost . The following (Figure 2) part cost is reduced $10 , but the impact on variance is $0.

Figure 2 - Not included in this text only version

In one of my first purchasing assignments , I spent many hours with the supplier and engineering establishing an alternate material for a key part. This material proved to offer superior performance and significantly lower cost. A new part number was set up so we could easily identify the new part from the old. I proudly reported this cost reduction only to have it rejected, because it didn't impact material price variance.

B) Timing of Setting New standard costs - The impact of cost reduction on material price variance depends on when the savings are implemented, compared to the timing of the annual standard cost build. Figure 3 shows a cost reduction implemented in July, with standard costs being reset on January 1, 1996. Purchases from July, 1995 to the end of the year affect material price variance by $600 , but purchases after January, 1996 has no affect on price variance.

Figure 3 - - Not included in this text only version

Don't get cheated by the accountants who only recognize cost reductions that affect price variance. All cost reductions should be reported regardless of their impact on price variance

2) Take credit for cost avoidance.

The NAPM Glossary of KEY Purchasing Terms defines cost avoidance as a purchasing action by which certain material or supplier increases are not incurred. Cost avoidance involves avoiding a future increase by delaying or reducing the impact of a proposed price increase, or proposed specification change. If a supplier proposes a 2% price increase to be effective January 1- and as a result of the buyers negotiations the increase is accepted for 1% and delayed until March - the difference from the supplier proposal and the settled amount is the value of the cost avoidance.

Cost avoidance does not lower the cost of materials , but it does minimize or avoid the negative impact on net income that a price increase would have. Most accountants don't give purchasing credit for cost avoidance efforts. Many feel that reporting cost avoidance is inappropriate, but consider the sample income statement in figure 4 below: - Not included in this text only version

To those who doubt the value of cost avoidance, show them figure 4. Doing a good job of negotiating and avoiding the impact of an increase is just as important as working on direct cost reduction projects . Make your buyers feel good about their accomplishments in reducing the impact of a proposed price increase. Report , track and reward superior accomplishments in cost avoidance.

3) Purchasing actions to reduce inventory is cost reduction.

A major cost reduction opportunity for purchasing is to work with suppliers to reduce inventory levels. Recent surveys of purchasing professionals indicated that the average supplier's on time delivery performance experienced is only about seventy percent. With such poor performance, our choice is either: 1) carry great amounts of backup inventory at our locations, or 2) drain purchasing resources by expediting parts to keep the production line running. Either choice adds costs to our operations. As the Japanese have taught us: inventory is evil . Much of purchasings' time is spent working with suppliers to reduce our investment in inventory by: improving on time delivery, reducing lead times, and establishing JIT, line stocking programs. Figure 5 below illustrates how our efforts to reduce inventory has a direct impact on the bottom line.

Figure 5 - Not included in this text only version

To eliminate the popular view that purchasing is just focused on price, show how our efforts help the rest of the organization. Purchasing can work with suppliers to reduce the investment in inventory , and at the same time reduce stock outs . Customers, manufacturing , finance and eventually management will all see the results of your efforts. Track and report : amount of surplus excess inventory sold to suppliers or reworked , the average supplier lead times and progress in reducing them, and supplier on time delivery performance improvements. Reducing inventory is a true cost reduction action and should be declared as such.

4) Quality improvements are cost reductions.

There is tremendous opportunity to reduce costs by improving quality. Many companies are using a tool called "cost of quality" to calculate the cost of non conformance within the company. The cost of non-conformance is the cost associated with unnecessary waste incurred by the company. Purchasing can reduce the cost of defects by working with suppliers to decrease or eliminate: rejections, supplier caused warranty costs, the need for incoming inspection , internal expediting costs and the amount of customer dissatisfaction caused by rejects or late deliveries. The first step is to establish a benchmark cost for these items. The following are the quality costs we have assigned :

Item Definition
inspection costs actual cost center costs
warranty actual cost center costs
expediting costs actual cost center costs
supplier rejects $25 per reject
late customer shipment
$5,000 per instance

Use the cost of quality measures to report and track cost reductions in quality. Show that Purchasing plays a major role in improving quality and track and measure contributions in quality cost reduction so these contributions are known and appreciated.

5) When we reduce the supplier base, it should be claimed as a cost reduction.

Purchasing reduces costs by decreasing the number of suppliers it deals with. By leveraging our purchasing power with fewer suppliers, we substantially increase our volumes with the survivors. The increased volumes allow the suppliers to reduce material, overhead and labor costs. There are less contracts to write, less EDI partners to establish, less quality audits to do and less salesmen to see. We have included supplier reduction as a cost of quality item ,and calculate each supplier reduction as being worth $1000.

6) Establish EDI partners to reduce Administration Costs

An aspect of cost that is often ignored is the paperwork and administrative costs needed to support the purchasing function. One way to reduce these costs is to establish electronic, computer to computer links (EDI)with your suppliers. Information that can be passed electronically include: purchase orders, releases, invoices, advance shipping notices, freight bills and price lists. Purchasings' role in this is to sell the benefits of EDI to our suppliers and then get their commitment to institute it.

Accounting at our company has several times audited the actual cost reductions achieved by EDI. They have established the following benchmarks:

Transaction
Savings per
Purchase order
$1.50
Invoice
$2.00
Advance shipping notice
$1.00

These are direct savings in administrative costs achieved by : reductions in accounts payable staff, savings in postage, paper , envelopes and inventory reductions. There are other harder to measure benefits that are not included in our benchmarks such as: reductions in errors, efficiency improvement and better customer service. With EDI you won't be trying to expedite orders that the supplier hasn't even received yet. Savings in administrative costs by increasing the use of EDI or improving internal processes has a direct impact on the bottom line as shown in figure 6 below:

figure 6 - - Not included in this text only version

Getting the credit we deserve.

A manager in the engineering department is a master of getting recognition for his group. He has large charts posted on the bulletin boards that track performance. This manager also includes in his monthly reports and his annual reviews results in these key areas. The measures he reports on are items he feels are important. Some of these items are: part numbers reduced or standardized( $2000 per part) and number of customers helped($100 per). The accounting department doesn't recognize these as reportable cost reductions, but he doesn't care. He believes these items are important activities of his department and that they should be measured and recognized. He has the right idea. His team's achievements in reducing part numbers and helping customers are recognized and appreciated , because he believes they are important and reports them.

This is a good role model for us to follow. Don't be constrained by accounting rules or company policy. Be aware of the cost reduction actions purchasing is making and how they impact the bottom line, then tell the world about these achievements. Take credit for:

  • All direct cost reduction, regardless of the impact on material price variance.
  • Take credit for cost avoidance, it's important.
  • Reducing inventory is a cost reduction.
  • Report quality improvement as a cost reduction.
  • Supplier reductions is a cost reduction.
  • Establishing EDI partners reduces administrative costs.

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