Real cost reduction lies beyond price of parts

Electronic News, Nov 3, 1997 by Terry R. Weaver

Countless hours have been devoted to the measurement and management of supplier performance. Despite that effort, the inability to relate supplier performance nce to a cost-based metric many times results in purchasing decisions that are largely price-based, calling into question both the expense and the bottom-line value of measuring supplier performance at all. The missing link is a measurable economic relationship between supplier performance, component price, and the internal cost of Supply Chain Management.

For most electronic circuit assemblers, components account for 80 percent or more of the total cost of goods sold, thereby focusing considerable time and effort on their procurement and management. Passive components, however, present a unique cost/price equation. Passive components account for approximately 60 percent of line items purchased and 80 percent of total board placements, yet make up only about 5 percent of the total component cost. Thus, a great deal of effort (and cost) is expended to chase a tiny fraction of the total value of a product.

Total Laydown Costs

Some organizations have begun analyzing the "Total Laydown Costs" of their assembly operations. This is generally defined as the entire cost stream from the moment the need for a component is visualized until the circuit board is headed to a customer. For passive components, Total Laydown Costs can range between two and five times the price of the parts. Therefore, the real cost reduction opportunity lies beyond the price of the parts, but most organizations continue to spend an inordinate amount of time analyzing, comparing, and haggling over the fourth decimal place of a passive component's price.

Part of the problem lies in the systems by which most companies measure and reward their materials organizations. Active and passive components are generally managed using the same metrics and practices, despite the fact that there are substantial differences in both the ratios of overhead to price and effort versus reward involved in managing these commodities. Internal measurement and reward systems focus heavily, if not solely, on component unit price, although most of the costs related to passive components are internally generated.

Some years ago, Phil Crosby wrote a book called Quality is Free. Mr. Crosby made the case that it is no more expensive to produce products of good quality while eliminating the cost of poor quality. The world has since largely subscribed to this point of view, and there are few markets in the world today where a supplier can trade low price for poor quality. Unfortunately, it appears that, even today, a supplier can trade low price for poor service and delivery performance. Traditional supplier scorecards have produced positive results for supply chain management over the past decade by "raising the bar" for all suppliers.

Metrics based on relative scores, however, fail to provide any real comparative insight because they give little or no indication as to the cost advantage of dealing with an outstanding supplier versus a mediocre one. Worse yet, they are often dismissed as irrelevant when actual price-related supplier selections are being made. Conversely, cost-based supplier performance metrics would relate the impact of a supplier's performance directly to the price of the parts by valuing outstanding performance in quality, delivery, service, responsiveness, etc., and monetizing those impacts to the customer's profit statement.

To begin defining cost-based supplier performance metrics, costs associated with a commodity must first be placed into one of two categories:

1. Costs of Supplier Performance--Costs expended in dealing with suppliixpended in dealing with suppliiers should be limited to those necessary to manage a world-class supplier using best-known supply management practices.

2. Costs of Supplier Non-Performance--These are costs that are incurred due to the supplier's failure to perform--costs that occur when something goes wrong. Many organizations have remarkably poor systems to document and manage these costs. Even larger and more insidious, however, are the costs of activities that are in place to protect against possible supplier failures. These have become institutionalized and, therefore, accepted by most organizations as necessities.

Incoming inspection is a perfect example. Many organizations still perform incoming inspection because some suppliers deliver parts that are incorrectly labeled, packaged, counted, or simply defective. This is not "non-value-added" work--it is clearly preferable to screen these problems on the receiving dock instead of on the plant floor--but it is a cost of supplier non-performance.

From a world-class supplier, a customer should expect only bare minimum supplier performance costs. In the ideal supply chain, a customer would electronically transmit a forecast of short-and long-term production plans. The supplier would manufacture and ship parts within the forecast leadtime to ensure sufficient quantities are available to meet the customer's production schedule. The supplier would have such a history of on-time delivery and packing accuracy that the customer could confidently take the incoming parts directly to the assembly line, bypassing incoming inspection. Moreover, one could make a case that matching packing slips, receiver tickets, purchase orders, invoices, etc. is largely a waste of time--why not just deal with suppliers whose billings are always correct, and pay them electronically upon receipt?