Applying Total Cost Concepts in Purchasing

HCS Consulting June 2003 Newsletter

Welcome to my first newsletter. I have been thinking about a value added way to stay in touch with all of you:

  • Clients, current and former
  • Colleagues from my corporate "alma maters"
  • Networking colleagues
  • People who I have had the pleasure of meeting who had expressed some interest in my work.
An e-newsletter seems to be a good way to accomplish my objective (although that's my opinion, I look forward to getting some feedback). This newsletter will be sent as the body of the email, no attachments to open, no viruses to worry about.

My work focuses on assisting companies primarily in two areas of the supply chain - Purchasing and Inventory Management. Each edition of this newsletter will have at least one section on those topics as well as one section that will address a broader management issue that I have learned about or experienced with one or more clients.

So here we go…..


It's an ugly world today for most purchasing people, pressure to reduce costs is unrelenting. Asking suppliers to find ways to lower their prices has never been easy, but as most industries have become part of the global market with bigger customers and in some case bigger suppliers, what can purchasing do?

Interestingly, this same concern is on the minds of the suppliers as well. It has come to me in the form of a question - Why are purchasing people tougher to deal with today than ..(you fill in whatever date you want).

One of the best techniques available is something that the large corporations have been using for years - Understanding Total Cost. Total cost in this context is defined as all the cost associated with obtaining material (or service) from a supplier including:

  • Cost of the raw materials and production process
  • Supplier's cost to accept your purchase order, plan, and execute production
  • Transportation, warehousing, and distribution costs
  • Quality costs - inspections, certification, rejections, etc.
  • Profit margin
There may be more, or some could be defined differently, but the concept is that the more you understand about what makes up the total cost of the items that you purchase, the better able you are to work with your supplier to reduce that cost.

So how do you discover the elements of total cost? Easy - ask your supplier to start sharing this information. In a workshop I did recently, one of the participants questioned whether or not this was a "fair" question to ask. Sure it is, in a win-win relationship, there has to be a common understanding of cost or else you are left with using quotations and the threat of adding new sources as the way to leverage your supplier. Working together to address opportunities to lower costs, as compared to demanding lower prices should be welcomed by your suppliers. If not, then I would ask what they are hiding.

Try this with your purchasing people and one of your important suppliers on just one item. I think you will be pleased with the results.

Inventory Management

Whenever I talk with business owners about how to lower their inventory, one of my first questions has to do with measurements. Most companies know how much inventory they have either in dollars or in units, but unfortunately, a lot of the time that's the only metric they have. There are two key measures for inventory:

  • Accuracy
  • Turnover
I suggest at least two measures of accuracy - record accuracy and bill-of-material (BOM) accuracy for manufacturers and record accuracy for distributors. Record accuracy measures how often the physical count of an item/location varies from what is in your system for that item/location. Measure both the frequency (how many times a discrepancy exists) and the magnitude (how much do the counts differ by in units or dollars). If the accuracy of your inventory records is not 95+% you have a serious problem and lowering inventory may create stock-outs, late deliveries, missed promises, and customer service issues.

BOM accuracy measures the correctness of the items in your bill and the correctness of the usage quantity for each item. It should be evident why mistakes in your bills will cause all sorts of issues in your production planning and scheduling process to say nothing about the impact in manufacturing. 95+% is a minimum here as well.

Lots of companies measure customer service issues - late delivery, out-of-stocks, fill levels, etc. These are all valid, but they really address the symptoms of the problem. Often, the root cause is inventory accuracy (or the lack thereof), so if you don't have these measures in place, get started.

I'll discuss turnover in the next edition.

Has the Economic Recovery Started?

My answer is a cautious yes. The stock market has had a nice three month run and seems comfortable with itself in the 9000 range for the Dow. More importantly, at least for my clients and friends, the small to mid-size manufacturers in Chicago report improvement in orders and backlogs. Now, if we can just avoid any really bad news, I am sure that 2003 will be recorded as the start of a new business growth period.

However, as I discussed earlier, the need to control and reduce cost has become a priority for CEO's and executives at all levels.

Thanks for reading this newsletter. Please feel free to reply with questions or comments to me at herb@hshieldsconsulting.com. If you know someone who might find this discussion of interest, please forward the newsletter to them. If you do not want to receive future newsletters, please send a reply and let me know. All rights reserved. Please do not duplicate or reprint other than for personal use.