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Incentive-Based Cost Reduction Programs

Author(s):

Jeffery A. White, C.P.M.
Jeffery A. White, C.P.M., President, J.A. White & Associates, www.jawhite.com, Columbia, SC 29212, 803/407-1399, jawhite@jawhite.com

84th Annual International Conference Proceedings - 1999 

Abstract. As we move from the role of order placers to strategic resource managers, we are expected to add value and impact our company's bottom line through cost containment and cost reduction. One of the most effective ways that we can accomplish these tasks is by using supplier incentives. This session will lead purchasers through the step-by-step process of designing and implementing a incentive-based supplier cost reduction program.

The Opportunity. There are many ways in which purchasers can seek out cost reductions from their suppliers. All purchasers are familiar with the sledgehammer negotiation approach. This is the "strategy" in which the supplier is offered the business if he agrees to reduce prices by a set amount or a certain percentage. Although this and other similar approaches appear to work, they often result in lower levels of supplier service, decreased quality, decreased supplier morale and increasing administrative costs.

Today, purchasers can implement incentive-based cost reduction programs that are beneficial to both parties. Such programs are designed to offer rewards for increased flexibility and creativity displayed by suppliers when striving to exceeding our expectations. Traditionally, incentive-based cost reduction programs were nothing more than clauses in contracts which stipulate rewards based on obtaining an expected levels of performance or cost savings. When suppliers exceed these levels, they are rewarded with additional business or a percentage of the cost savings. However, incentive-based cost reduction programs can take many other forms. The opportunities that we need to embrace deals with the process of how to involve your customers and strategic partners in the program development process.

Objectives. The objective of this presentation is to inform the audience about the fundamental, step-by-step process involved in setting up an incentive-based cost reduction program. Workshop participates will be exposed to concepts that will enable them to select the best suppliers to participate in the program and to create a program that will encourage suppliers to proactively propose cost reductions. Additionally, participates will learn how to establish effective measures to ensure that the program facilitates continuous improvement. The following are specific issues that will be presented as this objective is accomplished.

The Plan. Whenever an organization is considering the use of Incentive programs, there must be a logical implement plan put in place. The first and most critical step in the entire implementation process is to identify the factors that influence the decision to implement a program. These are the reasons that will help guide a purchaser during the formation of the program characteristics. These factors may include:

  • Unexpected price increases
  • Unstable product design
  • Changing (internal/external) customer expectations
  • Lower than expected profit margins
  • Marketplace conditions and competitive forces
  • Corporate culture issues
  • Technology

As the specific factors are identified in the current situation, it is advisable to use many varied sources of information. Internal and external customers, suppliers, marketing, sales, executives, and technical staff are only a few of the broad range of sources that can help in this process. Additionally, the process of brainstorming and process mapping would be excellent tools to use in this phase.

The next step in the program is to begin the process of identifying potential strategic suppliers to participate in the program. Use a structure approach similar to the initial step used to identify factors as discussed earlier. This would also be a good time to administer a customer survey, focused to obtain the characteristic they value in a program participate. Here are examples of some of those characteristics:

  • Technical expertise
  • Management commitment
  • Customer satisfaction
  • End-Customer focused
  • Resources
  • Business relationship
  • Communication
  • Contribution (in percentage) to your product or service
  • Product/Service mix
  • Level of importance to your supply chain
  • Commitment to quality

Now one can begin to ask questions as to the benefits that the purchaser and the supplier will obtain from the incentive program. Consider the answers to these questions:

  • What is the supplier's motivation to do business with a purchaser's organization?
  • Will the supplier "cut corners" to save or reduce costs?
  • How will the supplier's customer service be impacted by the program?
  • What can purchasers do to make it easier for the partner to do business with us, or what part of the purchasing process results in unnecessary costs within the supplier's process. Examples include:
    • Electronic RFQ's
    • Using Purchasing Cards
    • EDI (electronic purchase orders, invoices, catalogs, etc.)
    • E-mail/Internet transactions and commerce
    • System Integration
    • Effective planning and scheduling with supplier involvement
    • Elimination of incoming inspections
    • Purchasing materials for the supplier
    • Single point of contact within the purchasing and supplier organizations
    • Can purchasers share strategic data with the supplier?
    • Can the supplier obtain publicity from the relationship?

At this juncture, one can shape the identity and desired aspects of the incentive program. Incentive programs can be structured in an endless number of ways. Each method will pose special challenges to the purchaser, and the supplier. One should consider these and other questions, when designing the mechanics of the program:

  • How will cost savings/cost reductions be defined?
  • If cost avoidance is to be used as an aspect of the program, how will cost avoidance be defined?
  • What is the cost reduction proposal submission process?
  • Will in-house technical experts be available to evaluate the effectiveness of the process or product improvement that resulted in the cost savings or reduction?
  • How will pay outs be made?
  • What role, if any, will value engineering play in the program?
  • Will there be negative incentives for cost increases or non-adherence to the program?
  • What are the other measures, besides cost reduction, savings, and avoidance that will need to be tracked?
  • What is the time frame for the program?
  • How long does the supplier have to accomplish goals and how long will incentives be offered?

After resolving these and many other similar questions, then the incentive clause can be drafted. Don't forget to write an operating procedure to describe how the incentive program will be administrated. Additionally, have your legal advisor review the legal merits of the program. Once this incentive program is created, you can administer and measure to ensure that the program is yielding the desired results. Finally, purchasers need to take a hint from our supplier base and learn to market the results of our program to our senior executives.

REFERENCES

Journal or magazine articles:
White, Jeffery A., "The Search for Savings." Purchasing Today, October 1998, 8.


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