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New Purchasing Measures Produce Better Results


Michael Harding, C.P.M.
Michael Harding, C.P.M., CPM Principal, Harding & Associates, Bristol, VT 05443 802/453-5379

81st Annual International Conference Proceedings - 1996 - Chicago, IL

The Issue. Most manufacturing purchasing departments are measured against the usual three: (1) last price paid or standard cost, (2) delivery against promise or standard lead times and (3) quality as determined by the pass or fail standards of incoming inspection. While these measures are easy to apply, they are completely wrong for most businesses.

Measurement Drives Behavior. Well-intentioned companies tend to set absolute goals (numbers and percentages) for all managed functions. These numbers can take the form of labor hours, sales dollars, cost reduction dollars, units produced, head count, budgets, service levels and the like. They are top management's best guess as to what micro-measurements will yield the desired business results and these goals are often set months before the effective dates. Often the goals will remain in fixed for twelve months and are set or influenced by those who are measured by them.

Predictability, not profit, becomes the real goal of the organization. Investors, shareholders and owners want assurances that their investment and yields will be certain. Surprises, even good ones, are not welcome. To meet investor expectations, top management works with the finance department to convert these desires for predictable and stable results into terms of dollars. If every function of the business including customers, technology, competitors and operations performs as expected, there will be no surprises at the end of the financial period. Each piece of the entity gets its separate marching orders, and to make it all work and all must conform to the plan. What happens next is that the numbers become self-fulfilling prophecies. Each manager works to do whatever it takes to make the numbers. Seldom does he or she stop to question the goal, driving department or operation, often blindly, to attain it. Predetermined numbers goals relieve the managers of having to consider the impact of their actions on the total organization.: in fact the measurement systems often preclude this. The end result is that achieving the numbers take precedence over producing a profit.

The assumption behind achieving predictable numbers performance is that if all the numbers come out as expected a company will be able to price its products accurately to cover costs and profit. Further, it can control expenses through departmental adherence to budgets. The market has changed, however. The days of pricing products based on traditional costs are gone. Now the market that tells companies what their costs must be to have a product that will sell -- prices are market-driven rather than cost driven.

People and organizations no longer have the luxury of setting goals they know they can meet. In fact, yesterday's goals may not be appropriate for today's business environment. Predictability of performance as the measurement, in this environment, will produce predictably mediocre results far more often than unpredictably great ones.

It has become a truism that you get the behavior you measure and reward. The business conditions you have, good or bad, may well be the result of the measure and reward systems in place.

Purchasing Measures. A predictable purchasing function is expected to do what it says it will do in the areas of price, delivery and quality. If the right goal is profit, then let's look at how better to assess purchasing's contribution to profit rather than assuming that matching the goal results in profit.

Price is a major area of concern and a primary measurement for purchasing. Who knows what price should be paid? Other than traded commodities, prices are an amalgam of the history of prices paid, current manufacturing processes, availability and forecasts. Standard costing is a favorite measure of many companies - set a price for the coming year or quarter and then hit it. If a buyer hits the target, is it the right business decision? Did the buyer contribute to profit? If a buyer does the "right thing" that may involve paying a higher price for a better item, will the organization require a lengthy justification?

Purchase price is the wrong measure. "Installed Value," that is, what it cost to use the item. This is more difficult to calculate as it adds the purchase price, transportation (time and costs), quality, added inventories, yields, availability and lead times, ease of doing business with suppliers, product support, ease of use or assembly, scrap and rework rates, customer returns and warranty costs to determine the item's true value. The total will vary with each item purchased. It is more important to recognize the added costs of use than it is to determine variation in purchase price from one buy to another.

The Installed Value approach requires that purchasing be intimately involved with the processing or use of the product to track all the added costs throughout the process. A low purchasing price that increases assembly time, rework efforts or warranty costs may be of no value to the organization or even detract from profit. Let's look at an example.

A buyer has an opportunity to reduce the purchase price of a transformer from $10.00 to $9.10 by switching suppliers. Annual use is 40,000 and so on paper, there will be a cost saving of $36,000. However, the new supplier has an eight week lead time versus four weeks from the original supplier. The buyer's company may want or need to increase on-hand inventory of transformers due to the lengthening response times. Furthermore, the new supplier does not manufacture in exactly the same manner as the original supplier. It will now take manufacturing one longer to put the transformer into the assembly. Here are the anticipated impacts in the manufacturing process:

  • Assembly time is one minute greater
  • Yields are down 4%
  • Rework costs are .$.20 per unit variation
  • Incoming inspection costs are up $70 per lot

What are the real costs?
Purchase price - $9.10 $ 9.10

Four weeks' added inventory
($9.10 X 3200 units X .015/3200 = .14

[.015 is the weekly cost of carrying inventory]
Added assembly time at $45/hour .75

4% yield loss ($91.0 X .04 X 2.5 value added time) .91

Rework billed back to the supplier. Administrative costs .08

Final inspection cost increase .15

Installed Value = $11.13
a gross profit loss of $45,200/year

Without the above Installed Value analysis the buyer is likely to go for the lower price and report a cost reduction. With the analysis, the buyer can make the right decision for the company. There is an added benefit as well: gathering the information requires information from other functions, and perhaps open up the way for better partnerships.

Purchasing should ask for an "affordable bill of material." If the components can not be purchased and used at an affordable cost, the company will not have an affordable product.

Delivery measures are a similar problem. Most users want an items when they want them. Yet purchasing is often measured by performance against standard lead times (perhaps in MRP) or against a supplier delivery promise. A supplier's lead time reflects the way they elect to do business. All of these affect lead times:

  • desired levels of backlog
  • scheduling and prioritization systems
  • length of process cycle time (in turn affected by) equipment selection, lot sizing, and quality problems
  • sourcing issues (raw material, out-sourcing, etc.)
  • their competitors' lead times
  • what the customer has been willing to accept for lead time in the past

Buyers know that the actual process or value-added time is a small percentage of the total. It is the buyer who pays for the difference in terms of added in-house inventories and the supplier's overhead and added operation costs. The shorter the supplier's cycle time, the lower the cost to produce and, presumably, the lower the selling price. Therefore, there is a direct cause and effect relationship between cycle time (lead time) and cost to produce. Buyers have a vested interest in assisting suppliers to address the factors that enable them to reduce their cycle times.

While supplier delivery times tend to remain static, effected only by changes in the general economy, customers are becoming more demanding and requiring delivery on demand, JIT deliveries, and replacement based on consumption. A supplier to the market has two choices in responding: (1) add finished goods inventory or (2) match production lead times to meet market requirements. As a company's customers increase their demand for fast response, so must that company have suppliers which can respond within the accepted time frame. The market is unforgiving. It does not care the a buyer met standard lead times. Customers want product when they want product. There may be no "fair" way to measure a buyer's performance in obtaining goods within a reasonable timeframe. When suppliers and buyers are measured against need, 100 percent on-time delivery may never be achieved. Until everyone in the supply food chain can respond to the demands of the market, 100 percent on-time will not be achieved.

Quality of purchased components and material is a prime concern of purchasing, and many buyers are active in influencing product improvements by their suppliers. In all too many cases, however, measures of supplier quality end after the goods pass incoming inspection. Since incoming inspection will discover only catastrophic failures, purchasing often gets involved in a reactive mode when purchased goods fail in-process.

To measure the real quality of purchased material, purchasing needs to look at the entire spectrum of purchased material performance. This data includes incoming, in-process, final inspection, yields, rework, changes in manufacturing cycle times and effort, warranty repairs and customer returns. At each stage, supplier-assignable errors must be identified, measured and furnished to suppliers. Some software packages provide for tracking of component failure in-process, and this information is valuable in feeding back component performance to suppliers. Defects or unplanned variation have different costs, depending on where they are discovered. One computer company uses the following chart to assign costs to each component failure:

Discovery Point Cost
Supplier $0
Incoming inspection $17
In-process $361
Customer $2000

Ultimately, these costs must be factored into the installed value calculation, and used to judge the effectiveness of various suppliers.

A New Approach to Effective Measurements of suppliers and purchasing departments alike should be build around contribution to profit and constructed to promote desired behavior. If improvement is a corporate objective, then the managers must recognize improvement, relaxing the constraints of preordained numbers to allow for floating targets. In the areas of price, delivery and quality, the three elements are interdependent in the way they affect affordability.

To prevent the negative effects of the "numbers game," pay attention not merely to the discrete numbers. Are total costs, as influenced by purchasing, decreasing? This breaks down into

  1. Are deliveries against need getting better?
  2. Has the quality of the end product been enhanced?
  3. Are costs to use the purchased material (installed value) affordable, and improving

Plot the trends over time to determine if the process is working and to determine where resources are best applied for improvement.

Where We Are Headed. As we focus on improvement and profit contribution, rather than on predictability to fixed numbers, we begin to measure behavior in addition to results. We are moving away from the traditional purchasing measures of price, delivery and quality to look at the overall effectiveness as purchasers in three areas:

  • Time
  • Quality
  • Relationships

Time means supplying goods and services to customers when they are needed. Quick response is a powerful competitive weapon.

Quality means appropriateness to the application and predictability in performance. Integrity -- of goods and behavior -- is the standard.

Relationships refers to the ability to forge alliances with internal users and functions, suppliers and end customers to produce seamless flows of information, services and goods without regard for structure or organizations.

Companies who are paying attention to new realities and looking at measurements in a new way will be the ones to identify, capture and dominate the markets of the future.

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