Why a Low Price Sourcing Strategy Will Doom Your Lean Efforts

From Dr. W. Edwards Deming’s 14 Points: End the practice of awarding business on the basis of price tag. Instead, minimize total cost. Move toward a single supplier for any one item, on a long-term relationship of loyalty and trust.  

In one of the classes I teach on lean and Six Sigma, as part of a business simulation, I separate a few of the class members into another room. They are asked to use markers to copy a design onto a paper product that the rest of the class is producing.

At the beginning of the exercise, these participants work hard to get the design just right so the finished product will pass a final quality inspection. However, as time moves forward, the quality of the product these participants receive from the rest of the class begins to deteriorate. At first, they complain to their supervisor (who is also played by someone in the class) but nothing improves. In fact, the quality usually gets worse. They might try to rework the parts before putting on the design, but they are told that they do not have time for rework if they want to keep up with demand. The quality of the design they are adding begins to suffer, and by the end of the exercise, it is barely recognizable. The total time of the activity: 30 minutes.

After the exercise, I ask the class members who were putting on the design why they did such poor workmanship, especially in the last 10 minutes. The most common response: “I figured no one else cared about doing a quality job, so why should I?” The participants might be mechanics, engineers, management, or even quality professionals; it does not matter. The response is usually the same. Thirty minutes. It does not take long to go from focusing on doing good quality work to just not caring any more.

So, if your company is focused on a low price buying strategy and defective parts keep showing up from a few suppliers (and no one seems to be doing anything about the problem), what message does that send to the employees in your company? Why should they get excited about achieving excellence through the use of lean and Six Sigma if some of the parts they receive are wretched?

The sad thing is that the $800,000 is going to hit our ‘manufacturing variance’ account..."

Dr. Deming spoke about the need to partner with suppliers and to focus on total cost instead of price. What does it mean to partner with a supplier? How is total cost calculated and how can it be used to make sound business decisions? The following might shed some light on these questions. (The scenario below is based on an actual example.)

Dave Robinson glanced at the clock in his office. “4:15 on a Friday afternoon,” he thought. “Less than an hour till my first full weekend in months.” As the quality manager of a major manufacturing plant, Dave felt that if the production lines were running, he needed to be there as well. Demand for their product was unexpectedly high and the production lines were struggling to keep up. So, the plant had been working mandatory Saturdays and volunteer Sundays for over three months. It was getting old.

Just when Dave thought he might get home at a decent hour, his phone rang. “Why would Jim, in the purchasing department, be calling me at this late hour on a Friday afternoon?” he thought as he picked up the phone.

...and the purchasing folks are going to get credit for the $90,000 in savings."

“Hey, Dave, we’ve got a bit of a problem I need your help with,” said Jim. “We have a new supplier producing the x1z component and he has a question about the engineering specs. I suggested he give you a call.”

“Wait a minute. We have a new supplier for one of the most critical components used in all of our assemblies? Why wasn’t my department involved? Who certified this new supplier?”

“Don’t worry about all of that,” said Jim. “One of our purchasing folks verified that this supplier can meet our needs. They just need a little help getting up and running. This supplier’s price came in 11% below our previous supplier, so this is a big win for the company.”

After agreeing to do what he could to help, Dave waited for the phone call from the new supplier. He did not have to wait long.

“Yes, this is Dave from the quality department. What can I do to help?”

“Hi, Dave. My name is Frank. I am the plant manager and I understand we will start supplying your x1z part. Everything is set up on our end and we have passed an internal first piece inspection. We just have one question you might be able to help us with.”

“Wow. That is a relief. I am glad to hear you guys are up and running. We keep our supply chains pretty lean, so we only have a day’s worth of x1z parts on hand. What is your question?” asked Dave.

We Have a Small Problem

“We noticed that there are several words stamped on the x1z with all sorts of safety information.”

“Yes, it is required by law that those words are there and can be easily read,” said Dave.

“Yes, we figured as much,” said Frank. “Do you guys stamp the words into the metal or do you want me to send them to someone else?”

“Uhhh. No. Neither one,” stammered Dave with concern creeping into his voice. “The supplier of the x1z component stamps those words. That is part of the print, which means it is included in the price when you quoted the job.”

“Hmmm. That is going to be a bit of a problem,” said Frank. “We don’t have that kind of equipment on site and have no experience stamping words into metal. I think I can borrow an old stamping press. Do you have some folks who can come down to our plant and help us figure this out?”

“I will try to catch a flight tonight and bring along one of our manufacturing engineers and a QC inspector,” said Dave. At that moment, he realized that it would be a while longer before he could enjoy a full weekend away from work.

Oh, the Havoc

It took Dave and the rest of the team three long days to get the word stamping process operational. The plant ran out of x1z parts and was shut down for over a day, resulting in several orders being shipped late. The stamping operation also caused another key dimension to drift out of spec on 20% of the parts. So, a 100% sort was set up in the incoming inspection area to try and keep any defective parts from making it to the assembly line. Even with this inspection, however, a few bad parts did sneak through resulting in sporadic line stoppages. Some defective parts even made it to the customers’ locations, causing field failures. Dave decided to do a “post mortem” a few months later to see what could be learned from this fiasco.

“So, let’s try and calculate how much money we lost on the x1z part transfer to a new supplier,” said Dave to start the discussion. “The plant was down for a day resulting in 500 employees being sent home. This resulted in several late shipments with late charges kicking in from our customers. The employees have had to work every weekend since, racking up a ton of overtime pay, in order to address the backlog.” Dave wrote the amount of the late charges and overtime on a whiteboard. “Also, we have two inspectors working full time to sort parts and share quality information with the supplier. I figure they will be in place for at least a year until we can get some confidence built up about this part. The assembly lines have had multiple line stoppages, and morale on the assemble lines has taken a hit as the workers struggle to make the x1z parts fit.”

“This does not include the ‘ill will’ we now have with several of our key customers,” said the V.P. of sales. “We are giving them deep discounts so they will continue to buy from us, plus my sales guys are spending so much time keeping our current customers happy that they are not selling to new customers. We will never be able to put a real dollar amount to all of this.”

After adding up all of the costs that could be captured, the result stunned the audience. Over $800,000 had been lost. “So, how much did we save moving this part?” wondered Dave.

“I heard we saved about $90,000,” said the V.P. of manufacturing. “The sad thing is that the $800,000 is going to hit our ‘manufacturing variance’ account, and the purchasing folks are going to get credit for the $90,000 in savings. They will easily meet their productivity goals for the year since they do not get penalized with any of the costs.”

“So, departmental goals are driving sub optimization to the point where we are all going to fail and our customers will eventually leave us in frustration.  What a way to run a company,” said Dave.

3 Myths About Suppliers

Myth 1: Suppliers don’t care about profits and margins as much as the buying company. Most suppliers work hard to keep their profit margins as high as possible. This should not be a surprise since the buying company does the same thing. So, when a supplier is asked to reduce their price, they will look for ways to offset this loss in profit by changing other aspects of the buyer/supplier relationship. I like to think of these as levers or switches that can be adjusted to change the cost/price/profit equation. Suppliers may use one or several of these levers to keep their margins from eroding:

Lever 1: Change the terms in the contract to adjust when the supplier gets paid. Time is money, so if a supplier can demand payment in fewer days, this will result in a quicker turn of their cash, which can then be invested or used for other purposes. They may also add severe penalties for late payments or want to charge an interest rate on outstanding payments.

Lever 2: Change who pays for freight. If the supplier is currently paying freight charges, they may want to shift this to the buyer. If this is not acceptable, then expect the supplier to charge a premium for any "rush orders" that the buyer requests. The supplier might also switch to an inferior freight company that may have lower prices but may also have higher freight damage.

Lever 3: Adjust who owns inventory of provided components. Many plants have worked out a deal where the supplier manages and owns the inventory up to the point where the buyer uses the part. Expect this to change if a price reduction is asked for. In fact, the supplier may want the buyer to own the inventory throughout the supply chain, including parts sitting in the supplier’s warehouse.

Myth 2: Suppliers are capable of meeting all quality specifications all of the time. It takes focus and effort to make a perfect product all of the time. It is easier, however, to make sort of good parts most of the time. This leads to additional levers suppliers can use to make up for a price reduction.

Lever 4: Begin to use inferior raw materials. If the prints do not clearly spell out what raw material must be used, then the supplier may think that they have flexibility in what is used to make the parts they supply. So, instead of buying high grade materials, they may choose to use less desirable materials in order to reduce their costs.

Lever 5: Start making parts on the lowest end of the drawing specifications. In order to use less raw material, the supplier may want to adjust their processes to shoot for the lowest end of the specification. Of course, this means that any variability will probably result in parts that are out of spec and could result in failures at the buyer’s plant.

Lever 6: Reduce overhead such as quality professionals and improvement initiatives. The buying company may have eliminated incoming inspection if they use certified suppliers. However, if a supplier feels that their back is against a wall after being asked for a price reduction, they may start cutting corners in their quality, problem solving, and improvement efforts to try and recoup lost profits. So, if a quality problem does occur, the buying company may not see the problem until the parts get to the production line or even to their customer.

Myth 3: Suppliers will make perfect parts even though the buyer was never able to make the part consistently to spec before outsourcing. A strategic plan to dump all of the difficult to make parts on to a supplier and expect that the problems will magically go away is fairly foolish. In one plant, for example, when they outsourced their press operations, they provided the supplier all of their presses and tooling and raw material. Then, a few weeks later, management could not understand why they were seeing the same quality issues as they had when they made the parts in house.

Lever 7: Quit making the difficult parts and focus on the high volume, wide tolerance components. Suppliers make the most profit on doing the easy stuff. So, if a buyer asks them to lower their price on all purchased parts, then the supplier may want to "no quote" the difficult pieces or just get out of the business altogether if the difficult parts are eating up too much of their profits. For example, at one plant, after asking for a price reduction on parts that were difficult to produce, the supplier got so angry that they told the buyer that all of the tooling they were given to make the parts was now sitting in their parking lot and that they had better hurry to pick them up because it was about to rain!

Lever 8: Begin charging a high premium for any change requests. Once a supplier has been asked to drop their price, they will want to recoup lost profits by looking for ways to upcharge the buying company. This includes any special requests such as engineering changes, special deliveries, changes in quantities ordered, faster delivery times, holding safety stocks, etc.

As you can see, requests for supplier price reductions begins an adversarial relationship that results in both sides playing a game as to which one can get a better deal. This can lead to inferior quality and delivery issues that will doom any lean and Six Sigma initiatives and total costs will skyrocket.

Partnering with Suppliers

If companies follow Dr. Deming’s guidelines, the supplier/buyer relationship changes significantly. One plant I worked with did a pretty good job meeting the spirit of Dr. Deming’s point regarding suppliers. They developed long term (seven-plus years) contracts with their key suppliers. The price was automatically adjusted each year due to inflation and raw material cost changes. Their suppliers also had an open invitation to participate in all of their lean and Six Sigma training. Twice a year, they held improvement events (one at the buyer’s site and one at the supplier’s location) where both parties worked together to try and improve quality, cycle times, and costs. They had an agreement where both operations would share equally in any cost savings achieved.

Also, for several suppliers, the buying company set up storage racks with two boxes of each supplied component. Web cameras were installed that focused on these racks. Every morning, the supplier turns on the camera and if one of the two boxes is missing, they automatically send another box of that part which arrives early the next day. There wasn’t a purchase order issued (or any paperwork) and the buying company pays the supplier whenever they open a box… a true partnership built on trust. Since going to this arrangement, the buying company has gone years without running out of a single supplied component.

A sourcing strategy that focuses on price reductions results in “fool’s gold” -- savings that look good on the books but can easily be offset by other cost increases. This can disrupt the supply chain resulting in a failed lean and Six Sigma initiative. However, companies that have altered their approach from an adversarial relationship with their suppliers to one of a partnership, usually realize better quality and delivery (and happier customers) and total costs drop significantly.

John Dyer is president of the JD&A – Process Innovation Co. and has 28 years of experience in the field of improving processes. He started his career with General Electric and then worked for Ingersoll-Rand before starting his own consulting company. Dyer can be reached at (704)658-0049 and [email protected]. See his LinkedIn Profile. He is on Twitter: @JohnDyerPI.