Assume a supplier estimates the following costs on an RFQ…
Assume a supplier estimates the following costs on an RFQ…
Sime Curkovic
Assume a supplier estimates the following costs on an RFQ (Request for Quote — buyer wants supplier to quote on some potential business):
Potential supplier says to you (you are the buyer/potential customer):
Costs of Direct Materials $12,000
Cost of Direct Labor $3,000
Cost of Overhead $4,500
Total Costs $19,500
Profit $2,340
Price $21,840
What is the minimum price a desperate supplier might be willing to quote if this is their cost information?
Answer: $15,000 because it covers your direct costs.
More explanation — You as a supplier would lose money on this business if you took it for less than $15,000 because it would not cover your direct costs which are directly tied to taking on this business. Every company has overhead and you want to spread out these overhead costs to your customers because someone has to pay for your costs and it should be the people that buy your stuff. Remember, there are three types of costs: direct material (the stuff that goes into what you build), direct labor (the people that build what you make), and overhead which is everything else (engineers, salaried workers, toilet paper, hammers, salt for the parking lot during winter, etc.). In some situations and often, there is a little excess capacity built into your business which means you might have some extra overhead whether you get this business or not. So, the overhead might be there either way, so the lowest you would be willing to go is $15,000. However, longer term this customer has to start paying for some of your overhead because you cannot expect your other customers to pay for your overhead while another does not. That will lead to you not competitively pricing your product or service and you will lose business once those other customers figure it out (and they will figure it out).
A good buyer will always figure out if they are paying too much. Also, why would you take on business for less than $15,000 and lose money? Perhaps you are thinking long term and want to get your foot in the door. That is fine but tread with caution because customers that give you business knowing that you are losing money tend to not be the best long term partners.
Also, let’s say you are a buyer. Why would you be OK if you knew a supplier was taking on business and losing money because of it? Did you strong arm them and bully them into this situation? Did you promise something long term that you know that you cannot deliver on? As a buyer, you need to figure out if the supplier’s costs are competitive or not. In this situation, perhaps you identify that their direct material costs are not competitive. Then why not communicate that to them and try to help them reduce their direct costs? The largest component of costs for stuff that you buy from suppliers will be in direct material, so focus on that part of their cost structure. If most of the supplier’s costs are in overhead, then that should be a red flag that implies they have lots of fat and inefficiency (which was the case for American industry during the 1970s and 1980s — we have completely reversed that though thanks to SCM and global competition — and greed).
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From the previous question: Why would a supplier consider a price of $17,000?
Answer: Because it covers your direct costs and you still have some money left over to assign to your overhead costs.
MORE QUESTIONS…
WHAT IS THE FORMULA FOR PROFIT MARGIN?
Answer: (Sales minus Cost of Sales)/ divided by Sales.
Keep this simple, take your company’s total annual sales revenue and subtract your costs (DM, DL, and overhead). Take that number and divide it by your total annual sales revenue. So, how do you widen margins? Cut costs. Where do most of your costs come from? Direct material purchases. This is what you are majoring in. Why do you want to widen margins? To increase ROI (Return on Investment). ROI is PM multiplied by Asset Turnover Rate (ATR). What is ATR? Doing more with less (i.e., reducing inventory, getting customers to pay sooner, outsourcing, buying less expensive stuff). When ROI goes up, the company’s stock goes up. The global economy currently revolves around shareholder value (and that is good and bad). Good for us (people with college degrees in business), bad for low skilled manual laborers, right?
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WHAT IS THE FORMULA FOR NET INCOME?
Answer: Sales minus the Cost of Sales.
This is simply the money left over that a company has when it sells all its stuff, gets paid by its customers, and then pays for all of its bills/costs.
Final thoughts…
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FYI:
Pasted below are the sample stories I read in class about the previous internship experiences of former WMU ISM students. Pasted below each one is the moral of the story (i.e., the sourcing strategy). Thank you. Sime
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Student #1:
Last summer, I was a sourcing “analytics” intern at FirmA and the main part of my job was sending and receiving RFQs for the FirmA Parts and Service Department. We tell suppliers that we will only participate in “one round” of RFQs and we expect their best price the first time.
I had a small tube manufacturer in Iowa contact me one day stating that they were having issues lowering their prices and wondering if they could get assistance so they could be a better supplier. I discussed this with my boss and he sent a quality engineer and a Senior Buyer to the supplier to assist them (I asked to go but unfortunately HR would not approve Intern travel to a facility that wasn’t owned by our company). My internship ended before I could see the results of the visit implemented, but the pair that went estimated that they reduced the cost of some products by up to 10%! I very much enjoyed my internship at FirmA and helping suppliers was a thrill.
“From Sime”: Sourcing = procurement = purchasing (companies use different terms).
Rather than mess with a supplier’s profit margins via competitive bidding to get a lower price, why not just help your suppliers reduce their Direct Costs? That way you do not mess with their margins and chances are you get a much lower price. However, it takes a strategic effort (time).
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Student #2
The single chance to bid is a great option even though it seems counter intuitive. The “single bid only” is the same model that FirmB uses for its commodity bidding. I have used this very technique successfully when purchasing Oil for FirmB (lubricant, not the combustible kind). FirmB had an oil supplier who we felt was too expensive, so I send out a series of RFQ’s to other competing firms (Shell, Exxon, etc.). Through this process I found FirmB was paying significantly more than we should be paying. I then went back to our original supplier and said “We have found significant cost savings with alternative suppliers. You need to come back to us with the most competitive price you can offer, or we will place our last purchase order on [date roughly two weeks away]”. After this they were able to miraculously lower their price by 46% for all oil. This goes to show you that even a novice negotiator can find significant cost savings when using this technique.
“From Sime”: Notice the one shot deal to bid on the business. By giving suppliers only one chance to bid on the business, you tend to get their best price. However, that was not the case with this lubricant supplier. By the way, this sounds like an MRO purchase to support its factories. Remember, your P.O. with your suppliers will likely have terms and conditions that say you can reopen bidding on the business for any competitive reason (i.e., you think you are overpaying!).
Student #3:
The two companies that I’ve worked for choose to have “vendors” bid “once”. At FirmC, our vendors have learned that we expect the best up front and quotes are to be turned around within 3 days. Our quoting process moves insanely fast and we definitely pay for it. At FirmC, I was able to host over 10 Ariba events and we also taught our “vendors” that we expect “one and done”. I did see the problem that you point out there. The vendors at SupplierA for the super specialized, engineered items are not local or utilized as much so their quotes are most definitely padded. I had a few vendors call me to say that if they’re close to the lowest bidder, they would drop their pricing to match. Or they would say that they would have given us better pricing if they were guaranteed the business. I thought this was interesting.
“From Sime”: Notice how this student worked for a company that called their suppliers “vendors”. I think that is fine if you are buying “indirect” material. Otherwise, call them “suppliers”, especially if they design and build stuff that goes directly into your product. It sounds like this supplier did low volume customized engineered work and this supplier did not need their business. It sounds like this supplier had some leverage to talk to a potential customer like this.
Student #4
I would like to defend myself on my previous emails referring to suppliers as “vendors”. The last 4 months at FirmD introduced me to using the term “vendors”. The definition you gave refers to vendors as suppliers of “indirect” materials. Everything bought at FirmD is an “indirect” cost and their acronyms used frequently are as followed: VIMS (Vendor Invoice Management System) and CVM (Central Vendor Maintenance). Now that I know other companies will cringe at that word, I will stop using “vendors” and refer to all suppliers as “suppliers”. I’m very grateful that you pointed this out.
“From Sime”: She made a good point. She worked for a company that did not design and build anything. All of their spend was therefore INDIRECT spend. So, I guess it is OK to call suppliers “Vendors” if they only provide stuff that does not go into anything that you build. In this case again, they do not build anything so all their spend is INDIRECT. Note, 90% of Americans work in the service sector for companies that do not build anything. All of their spend is INDIRECT.
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Student #5
This summer at FirmE, I did some work preparing for engine negotiations with SupplierA (they design and build engines). SupplierA does not provide ANY cost transparency with their engines, because they know they produce the best engines in the world and have the leverage to say NO to providing transparency. As a result, we had to do a lot of “should costing” with SupplierA’s engine components, and even tear down an engine of theirs, to prepare our “cost breakdown” for their engines. That way we could do our homework, and show what price SupplierA should be making their engines for.
If you are working with a commodity like fasteners (a true commodity, tons of suppliers), you can get away with sourcing from multiple suppliers. Fasteners do not vary too much from one another, so it sometimes may be necessary to have a larger supplier base, as a method to assure there will always be a supply of parts.
I was able to learn this first hand, by working in procurement on FirmE’s Powertrain Category Management Team. I was able to work with the Supply Chain Manager for engines, and learned that we (FirmE) used to make their engines! However, FirmE began to outsource their engines to SupplierA nearly a decade ago because they could make better engine’s than we (FirmE) could, and at a better price, therefore, we (FirmE) outsourced their engines and became much less reliant on vertical integration (making our own engines).
Based on my personal experience, it makes a lot of sense why companies would outsource “strategic” parts. This can help companies rely on assembly and their final product, rather than wasting a lot of resources on strategic parts, that another company can make better, faster and cheaper.
“From Sime”: There is so much in this one. FirmE started to outsource a core part (engines). Over time, they lost design and manufacturing capabilities on engines. Once SupplierA of engines realized this, they started jacking up their prices and telling FirmE that the cost breakdown was none of their business. I have no issues with FirmE outsourcing engines for over 10 years, but you better make sure you that you never forget how to design and build them if you sell buses. FirmE should have told SupplierA ten years ago that they can have the business if they have joint ownership of all design and mfg capabilities associated with their business and that a cost breakdown will always be required. Had they done this Day One, they likely would have not lost leverage in this buyer supplier relationship. FirmE got greedy and sloppy. Note, the person that made that decision ten years ago might have gotten a huge bonus ten years ago and retired, and now someone else has to fix this sourcing decision. A sourcing decision today can impact your company 10, 20, 30 years down the road. 10, 20, 30 years ago, a bunch of managers decided to source stuff from China because it was soooo much cheaper (or so they thought on the surface). As it turns out 10, 20, 30 years later, it actually ended up costing them more (i.e., quality, lead times, control, insurance, inventory, etc.).
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Student #6:
I can support the statement of companies mostly outsourcing their “manufacturing” capabilities. Johnson & Johnson just recently sold their entire Medical Device manufacturing plants to a third party manufacturer called Jabil.
“From Sime”: So, if J & J outsources mfg for medical devices, what the heck is their Core competency? Answer: Scaling and ramping up small companies that they buy. J & J has tons of cash and credit and can buy small businesses with great ideas. J & J has a super sophisticated supply chain and J & J manages their supply chain very well. So they can take a medical device that someone is building in their garage and take it global super fast. That start up company in the garage has no idea what supply chain management even means. That start up needs J & J (or Stryker in Kzoo) to help them scale up. Otherwise, the product never leaves their garage.
Back to Jabil. Jabil is a manufacturing subcontractor. Jabil’s core competency is building stuff for entire industries like medical device. Jabil does it for the entire industry (not just for J & J) and gets the economies of scale, so that it does it better, faster and cheaper than companies like J & J could if they built it themselves. Products and technology change so fast for medical devices that the product might be outdated in 6 months, so J & J does not want to build factories to support such short product life cycles. Jabil can make money doing it for them (and everyone else in the industry) and that is Jabil’s thing (core competency).
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Student # 7 (this was a bad day for the WMU ISM program):
I wanted to let you know we had at least three WMU students attend the early session of MSU’s career fair. I was thrilled they made the drive and spent time with our team. Unfortunately, we had a bit of a situation. We selected John Smith as one of our top picks for first round interviews based on multiple members of our team talking to him. He had completed the intake form indicating he had a 3.0 GPA which is our minimum requirement. During the interview we realized his GPA was actually 2.64. This is unacceptable that he lied to us and completely goes against our core values of Integrity, Commitment, Quality and Innovation. I won’t be able to invite WMU students to MSU if we have a situation like this again.
“From Sime”: Do not lie. Be honest on job applications. Sometimes they do not even care about the details. They just want to check and see if you are lying. Lying is a “falsification of records” (kind of a big deal in SCM). Also, do not renege. Be a leader.
Sime Curkovic on LinkedIn: Reneging: Once you commit, quit! | 13 commentsStudents are getting lots of job offers… Reneging: Once you commit, quit! https://lnkd.in/e85beQ2 In U.S., 28% accepted a job offer & reneged! 70% of… 13 comments on LinkedInwww.linkedin.com
In the above link, people came after me a little in the “comments” section.
Student #8:
As I work for a smaller company I have been on the receiving end of the negative impacts of this idea that you strategically source core parts of our valves. A specific example is one of our molded xxxxx, sure we save a lot of money and no longer have to mold a rubber to a metal xxxxxxx but recently the supplier went through a management change, and switched from an outdated ERP system to SAP. This created huge problems for them, and ended up shutting down our lines for almost a week. As a smaller company we do not have a lot of leverage with this supplier. We ended up coming to an understanding and moving molds to another location but shutting down for that long is less than ideal for any manufacturer. Just an example of where it can come back to bite you if you do not upkeep a safety stock or have good relationships with a supplier for a core part.
From Sime: Yes, most of you will work for companies that will be bigger than your suppliers and you will be a hugely important customer to your suppliers. Enjoy that leverage! However, some of you might work for a smaller company and your suppliers might be much larger than you. Further, you might not be an important customer to your suppliers. Finally, you might ask these suppliers to do low volume customized highly engineered stuff for you. In other words, it is NOT a commodity. If you are ever in this situation, good luck with that. Hopefully, your company is very good at something and your customers are OK with paying a premium.
Lastly, when outsourcing strategically, you always want to look at if the supplier makes parts “in-house” or “outsources” themselves because that plays a key role when choosing a supplier. Yes, during covid, some supply chains broke down because companies were outsourcing stuff to suppliers who then flipped it to other suppliers and the companies did not even know about it (until that supplier in China shut down for 8 weeks because of covid).
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Thank you. Sime
Dr. Sime (Sheema) Curkovic, Ph.D., Professor, Operations/Supply Chain
Western Michigan University, Haworth College of Business
