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Gauging total cost, supplier by supplier

Because it reveals hidden costs, the "unit total cost" approach to purchasing can help companies accurately evaluate the cost of doing business with individual suppliers.

Many companies want to create the optimum supply chain for their organizations. Often, however, they don't have the information they need to reach that goal. The problem is that optimization requires visibility into all supply chain costs—yet companies frequently limit their focus to supplier- and transportation-related expenses.

Such a limited view fails to consider costs that organizations absorb internally. This is especially true when it comes to purchasing products and services. Because these internal costs can significantly increase the total cost of supply, organizations should have a method for identifying and quantifying them; otherwise they are likely to make purchasing decisions based on incomplete information.

Article Figures
[Figure 1] Sample process map
[Figure 1] Sample process map Enlarge this image
[Figure 2] Calculating cost factors
[Figure 2] Calculating cost factors Enlarge this image
[Figure 3] Calculating performance factors
[Figure 3] Calculating performance factors Enlarge this image
[Figure 4] Calculating policy factors
[Figure 4] Calculating policy factors Enlarge this image
[Figure 5] Calculating total cost
[Figure 5] Calculating total cost Enlarge this image

The first step in determining total supply chain costs is to create a context and a format for assembling all cost factors. It also is important to identify relevant internal "issues" and translate them into their dollar values. Examples of internal issues that could affect overall costs include physical occurrences, such as scrap rates, in-transit damage, or quality problems; administrative problems, such as incorrect invoices or recurrent expediting of shipments; and preferences, such as disadvantaged business status or a high cost to switch sources.

One proven method for evaluating both internal and external issues is "unit total cost" (UTC).

Unit total cost is defined as the unit purchase price amended by an appropriate monetary factor assigned to each issue. UTC creates a clearer picture of what a given source of supply actually costs an organization; it is most useful when selecting or negotiating with suppliers. It also provides a context for all stakeholders to see the total picture of their organization's costs.

In this article, we will outline how to calculate and apply unit total cost, step by step.

Five-step framework
Five basic steps provide a framework for successfully applying unit total cost in purchasing decisions. They include:

1. Identify all of the total-cost factors that are important to the organization. This is best done by inviting all stakeholders to identify cost elements and other issues of interest to them regarding the source of supply that is under evaluation.

2. Develop a "price adder" formula that will translate each total-cost factor into dollars based on its perceived level of importance.

3. Add to each supplier's quoted price a debit (or credit) for each total-cost factor, appropriate to that supplier's performance in relation to those factors.

4. Add together the quoted price plus all total-cost factors to get unit total cost.

5. Award the business to the supplier with the lowest unit total cost.

People who are involved along the supply path are stakeholders who have a vested interest in the choice of a product or supplier, and they should be invited to participate in determining the total cost of a given source. They participate by identifying issues of concern and potential cost drivers in their particular areas. Stakeholders need and usually want to be involved so they can champion their own issues, and by participating in this process they will also learn about other groups' issues. This cross-functional sharing of information is one of the benefits of the UTC approach. Before applying unit total cost, therefore, it's important to get stakeholders and management to agree on how to treat issues that are likely to come up repeatedly.

Once agreement has been reached, select a purchased item as the first total-cost candidate and begin the process of identifying total-cost factors. Be sure to flush all relevant issues out into the open by mapping the processes associated with that item as far upstream and downstream as possible—not only its physical movement but also administrative processes such as purchasing and accounts payable. Document that flow and make notes, including the name of a key stakeholder for each step along the way. Ask these people what issues affect them relative to the item being evaluated. Then map the process flow and its associated issues. Figure 1 shows a sample process map with stakeholders and the concerns they identified.

Next, quantify the costs associated with those issues. These can be sorted into two groups: "hard costs" and "soft costs." Hard costs are those for which there is an invoice or a direct cash outlay, such as freight payments or inventory. Soft costs consume resources but have no direct cash outlay; they measure productivity. An example is the cost to an organization of lost time caused by correcting errors or expediting shipments. Time has value, and time that is repeatedly lost is a cost the organization can potentially recover.

Some organizations may be hesitant to include productivity losses in their calculations of supply chain costs, but it is important to understand that those losses are indeed costly. They can be kept separate from hard costs but they should be considered.

Monetary measures
Once the question of how to handle soft costs has been resolved, sort the cost factors that have been identified into three categories for inclusion in UTC calculations:

Cost factors: Hard costs that have already been quantified.

Performance factors: The cost to the organization of a supplier's failure to perform.

Policy factors: Issues of policy, preference, and all other issues that are not data-related.

Although the costs for each of these categories are calculated differently, money is a good common denominator. When every issue is measured in terms of its financial impact, all of those factors can be added together to determine the total cost of doing business with a particular supplier.

Let's look at each of the three categories.

Cost factors. Cost factors are the easiest to calculate because they already are measured monetarily. The calculation converts costs into their per-unit equivalent. For each factor, divide the total cost by the number of units over which it applies. Since each occurrence may not be identical, calculate the data for several typical examples and average them to derive a mean cost. Then use this mean cost in totalcost calculations.

Take transportation as an example. To calculate the per-unit freight cost, divide the total freight charges incurred over a period of time by the total number of units shipped during that period. Using the total charges over a period of time yields an automatic averaging of the costs.

Cost factors should also include areas where suppliers save money. Cost savings can be included in UTC as subtractions from the total cost. Figure 2 provides examples of cost-factor calculations.

Performance factors. Calculating the cost impact of anything classified as a performance issue requires data on the actual level of performance, which usually is measured as a percentage. Commonly measured performance factors include on-time delivery, product quality, and lead time.

Unlike cost factors, performance factors do not have costs directly associated with them, so a "price adder" formula must be established for each one. Two sets of criteria matter:

1. The formula must be relevant to the factor in question and easy to calculate.

2. The formula can be applied to multiple suppliers and used to differentiate performance.

Performance factors can be calculated exactly or approximately. Approximations that meet the above criteria are valid. They also are much easier: Simply use the nonperformance percentage as a price adder. For example, if a supplier has an on-time record of 89 percent, then it is not on time 11 percent of the time, and 11 percent would be added to its quoted price.

Several methods of measuring quality have been used successfully. Some organizations have calculated the actual cost of dealing with nonconforming material. Others apply a price adder based on the percentage of products with unacceptable quality.

Long lead times limit flexibility and may drive high levels of inventory. If lead time matters (and it should!), then a "tax" on lead time is a relevant price adder. One percent for each week of a supplier's quoted lead time is certainly within the realm of reason. The more important lead-time reduction is, the higher the tax should be.

Examples of three types of performance calculations are shown in Figure 3.

Policy factors. Policy factors can be applied either as a credit to suppliers that comply with the policy in question or a tax on those that don't. Policy issues often are subjective and normally are not considered in monetary terms. Examples include stakeholder preferences, risk management issues, disadvantaged business status, and social responsibility commitments.

Because policy factors often are not quantified, the sponsors who put them on the list of issues need to provide a statement of value for each one. The purpose of this statement is to develop numeric data that can be used in total-cost calculations. This is not necessary for other types of cost factors because they already have quantifiable data.

The sponsor defines the boundary between policy-related costs that are allowable and those that are too high by answering this question: "How much more are you willing to pay to give preference to a supplier who incorporates your issue in its business activities over a supplier that does not?" Please note that this is a boundary definition only and does not necessarily mean that prices will change in actual practice. Once such a boundary has been defined, suppliers that comply with the relevant policy can be credited up to the established limit. An example of policy-factor calculations is shown in Figure 4.

Examples of policy issues that some organizations have chosen to address include:

Consensual reciprocity: Companies that want to favor other businesses for various reasons may want to include these as factors when selecting suppliers. For instance, companies that do business in countries that require a certain level of local content may give local suppliers a policy edge.

Contributions: If a nonprofit organization would like to favor donors when it awards business, unit total cost will allow policy makers to decide how much more they are willing to pay in order to give the business to a donor rather than to a company that is not a donor but whose products or services may be cheaper.

Recycled content: As environmental awareness increases, recycled and recyclable materials are becoming more important to many companies. To include this issue in UTC, establish an appropriate percentage credit for recycled content. (Credits of 5 percent to 10 percent are common.)

Heroics: If a supplier has put forth extraordinary effort to support a customer in times of distress, the customer may wish to reward that company by giving it preference.

Design support: Development groups such as research or engineering often push for favoring suppliers that have supported research efforts with fast prototyping and other special services.

Some policy factors—for example, disadvantaged business status—can be considered on a yes-or-no basis when definitions are clear and either a business fits a category or it doesn't. For this type of factor, credit a qualifying supplier up to the boundary limit.

Other policy factors—heroics, for example—are variable in nature. Depending on how a company has defined "heroic," a supplier might meet those criteria more than once. For this type of factor, develop an agreed-upon amount of credit per occurrence. Multiply that amount by the number of times a supplier has met the criteria to determine the total credit.

After all of the factors in all three categories have been calculated, add them into the unit price of the item to get the unit total cost, and use the resulting totals to make business decisions. Figure 5 provides an example of unit total cost calculations.

Making healthier choices
Applying the unit total cost approach to supplier evaluation will provide benefits both within and outside the organization. Internally, using total-cost calculations to select and manage suppliers allows all cost factors, not just the obvious ones, to be included. UTC will make clear the justifications for choosing a particular supplier—especially when it is not the lowest-priced supplier—while teaching the whole organization about where and how costs are incurred. It forces policy makers to decide what they value and how much they are willing to pay to exercise those values. Moreover, it gets the monkey off supply management's back when it comes to deciding how to treat issues that are not monetary in nature.

Externally, companies can share UTC calculations with suppliers to provide a powerful message about what they have to do to earn their business. When suppliers are shown those costs, they can clearly see which factors drag them down and by how much, and they can see how improvement would affect their competitiveness. In response, they could choose to slash prices (a choice that might be hazardous to their long-term health), and/or they could work on improving performance to meet their customers' needs (a much healthier choice). In short, they could see exactly how performance improvement affects their "bottom line" from their customers' point of view.

Supply chain costs include many factors beyond logistics, transportation, and physical handling. When examining a supply chain for ways to reduce expenses and control costs, managers should look carefully within their own organizations. In many cases, internal issues offer more opportunities for improvement than do external issues.

It is important to have both the knowledge to recognize those opportunities and the analytical skills to capitalize on them. Unit total cost is a simple but valuable tool that can help supply chain managers achieve both of those objectives.

Mary Lu Harding, CPM, CPIM, CIRM, is a principal of the consulting firm Harding & Associates.

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