For a long time, I’ve believed that prior to selecting sources, Original Equipment Manufacturers (OEMs) should take into consideration the customer-demand characteristics of the market(s) they participate in as well as the historical accuracy of their sales forecasts. Why? So that supplier order-fulfillment capabilities can be aligned to optimally support OEM sales.
Again, why? Because suppliers with Build-to-Demand order fulfillment capability can dramatically reduce OEM internal costs, yielding them financial benefit often far-and-away higher than what incremental piece-price reductions can deliver. And, after all is said and done, do you really think that two competing OEMs ever gain sustainable advantage over each other through a supply management function focused primarily on piece-price reduction? In general, that’s not what I’ve seen.
What does being Build-to-Demand-capable imply? Specifically, that product is available to customers within the time span they are willing to wait for it, without relying on significant pre-built Finished Goods Inventory. In other words, it implies operations and logistics that are responsive and flexible relative to the market served. The advantage of sourcing to Build-to-Demand-capable suppliers has the potential to deliver longer-lasting strategic competitive advantages, especially when a critical mass of strategic suppliers are able to perform to this standard.
Related to this, I also believe that OEMs should manufacture and source within their primary markets. Why? Because location is intimately related to supporting the needs of market-demand scenarios. I’ll use this article to delve more deeply into this position.
Divisive Divisions
What does taking into account supplier order fulfillment capability mean relative to OEM sourcing products? Take the following example.
Paul Ericksen's columns are part of IndustryWeek's Supply Chain Initiative.
One division of an OEM—call it division A—participated in a market where demand was both highly seasonal and variable. It had annual-requirement magnitudes bigger than that of another division – call it B – whose market was less seasonal and had very steady, predictable demand. Most of the demand for the products from both divisions came from customers located in the United States. Each division sourced a part that, for all intents and purposes, had the same design specifications—we’ll call them “brackets.”
Due to the different demand characteristics of their markets, the two divisions based their sourcing decisions on entirely different supplier capabilities. Because of the significant error associated with forecasts for Bracket A, parts for it were sourced with highly flexible and responsive suppliers in order achieve targeted Customer Fill rates. This meant that due to transportation and logistics times, all parts for Bracket A were sourced with Build-To-Demand capable suppliers located in North America.
The sourcing plan for Bracket B was quite different. Because market demand was typically very steady and its SKU mix could be accurately forecast, Division B really didn’t need to focus on supplier flexibility and responsiveness to attain their Customer Fill Rates. Consequently, they sourced primarily based on piece-price, which meant many of their parts – including Bracket B – were awarded to overseas suppliers.
This became an issue within the company when the division responsible for Bracket B proposed taking advantage of the combined annual volumes of the two parts to negotiate a lower piece-price, which would be available to both divisions. And of course, Division B wanted to present this proposal to their current overseas supplier. Due to business considerations, Division A balked. The issue reached such a point-of-contention within the company, that the question was raised whether those Division A personnel responsible for selecting sources were actually competent at their jobs.
Division A's primary arguments for not combining their annual requirements with those of Division B were their significantly seasonal market demand and forecast error. In other words, the lead time for the parts they sourced had to be a lot less than that Supplier B was capable of. In fact, the lead-times of Bracket B’s source were greater than the Product A’s sales season, meaning that to have a chance at maintaining Customer Fill Rates, they’d have to build a huge amount of pre-built Finished Goods Inventory and hope that what they built was aligned with what customers ended up buying.
The people in Division A estimated that the amount of pre-built Finished Goods Inventory they’d need to build to do this would require an investment of hundreds of millions of dollars. This money would result in millions of dollars in up-front carrying charges and, in a worst-case scenario, risk losses in the hundreds of millions of dollars should the pre-built inventory not sell. You might think this a convincing argument and the two divisions would continue using their own sourcing processes. Unfortunately—at first, anyway—this was not the case.
Why? Because within that company there wasn’t the recognition that the amount of pre-built Finished Goods Inventory was linked in any way to sourcing decisions and supplier order fulfillment capability. Along with this, the primary metric used to measure the performance of Division B purchasing personnel was almost solely based on piece-price reduction. Because of this, the Division B people responsible for sourcing the bracket felt their proposal would be “money in the bank” relative to how they got rated at the end of the year. As you might expect, the question of how to source the brackets became a political issue.
In the end, the decision was based on facts—and common sense won out, to the overall betterment of the company.
Why did this issue lead to so much conflict within the company? Because the thinking, here, is much more than out-of-the-box. It is groundbreaking. It requires that executive leadership understand that the total positive impact supply management can have on company financials is much more than just through piece-price reduction. And that these impacts can, in some scenarios, deliver financial benefits in magnitudes higher than a sole focus on piece-price can.
To make this change, however, companies need to revise how they evaluate the performance of the purchasing function. Supply Management will need to get credit when their sourcing strategies and supplier development are tied to internal executive-level metrics. Those metrics may include costs associated with receiving inspection; the level of raw material inventory needed to support production; reduced costs associated with downtime due to lack of usable purchased parts; etc.
Progressive companies should take a look at their mindset relative to Supply Management’s function within their company. I suspect, if they do, many will start to consider their purchasing function in a completely different light.
Paul Ericksen is IndustryWeek’s supply chain advisor. He has 38 years of experience in industry, primarily in supply management at two large original equipment manufacturers.
