Cost Optimization 102 | Read Your Contract

Taking on from the previous article 101 (Link), I am going to discuss some of the low-hanging fruits for the direct material purchases that can be picked right at the beginning of your cost reduction journey.

As your journey toward impressive cost optimization starts, the first and foremost thing that needs to be done is to pick the contracts (along with Internal approval notes & supplier communication) with each of your suppliers and read them carefully !!

"Ah !! So cliché... So Bossy... !! What's so new in this? Even my Boss tells me so... !!"

While you are right in thinking so, even your boss is right too :). I'll try to elaborate on why this is so.

I have worked on multiple cost reduction assignments, as a consultant, and as a line manager. The first thing I used to do is ask the Category manager to help me understand how the cost has been agreed upon with the suppliers. In most cases the contract will have the following elements:

• Weight / Dimensions of the finished goods
• Wastages (Scrap Recovery)
• Raw material (qty & cost)
• Agreement of Tools cost reimbursement
• Lot sizes Based Costing assumptions
• Processing Cost
• Performance levels / Functional Specifications

When you understand how the cost in the contract is drafted, you need to validate the same on the ground. Here, whatever I am going to explain falls largely as hygiene. And, I am sure, as procurement managers, we always like to ensure these aspects are taken care-off. However, I would like you to read-on, and keep an eye on the aspects where we might have missed out and can be used to save some cost.

In most (not all) of the cost reduction assignments I have been to, I have realized that while the team works on many advanced methods to reduce the cost, some of the hygiene steps get missed.

Weight is Gold

I started work on one such assignment. I was not very familiar with the components that are being procured, so I requested the category managers to show me around the shop floor and the components which we need to work upon. When I was visiting the floor, a fresh lot arrived in the factory from a supplier. The quality team was doing their inspection routine. With a curiosity to understand the aspects, of the checks by the quality team, I ran through the pages where the inspection observations were recorded. I went back and started working on some of the other elements of the projects. A couple of days later, I requested the category manager to run me through the contract and the costing annexures. I noticed a glaring difference. The component, which was made up of 'angle' section & 'plate' extrusions, was costed at a net component weight of 37Kgs per piece. However, the quality papers recordings ranged from 33-35 Kgs. I requested the category manager to have a quick chat with the quality team to arrange for old records. We ran through the inspection data for the past 3 months and realized that the average incoming weight was 33.8Kgs (range from 32.7 to 35 kg). Now there were two possibilities - A. The suppliers have done some value engineering and have optimized the weight or, B. The supplier is supplying the sub-optimal product. We got the components inspected by the Quality team & Design team (beyond the regular Quality checklist). The component was passing all the critical checks of the design, however, there were certain tolerances mentioned in the drawing for which the supplier has re-engineered its manufacturing process to operate on the lower tolerances. By this, the supplier has saved a whole 9% of material cost in the component. The category manager and the supplier were smart and settled the savings for the organization.

The next hygiene method is generally taken care of by experienced procurement professionals. However, in many cases when the prices are settled in a haste, or when the company has taken up new categories of procurements, this check likely gets missed. Almost, all the manufacturing processes generate some waste material. This can be as trivial as packaging material. I was working on a component where the supplier was buying very small precision sub-components and assembling them into the final component. The packing material scrap sale value was 1% of the sub-component cost. Typically the total input weight minus the total output weight (of finished component), will yield some revenue to the supplier. We need to ensure that the same is reduced from our final component cost with the latest scarp/reuse rates. In most of these cases, the supplier will argue that the supplier either does not generate any revenue or to some extent have to spend some money for disposal. In all such cases, it is the responsibility of the procurement manager to generate the optimum sources of revenue generation from the scrap :D.

I have seen cases, where the procurement manager has diverted the scrap from one supplier to the input process of another supplier. In an automotive company, a large number of components are generated from a sheet of metal. There was a case where a large component (say 'A') was manufactured with a thick sheet, and another small component (say 'B') was manufactured from a relatively thin sheet. A smart procurement manager worked with the design team and got the design of B validated with a thicker sheet as well. Now the scrap cut out of A was being supplied to manufacture component B. So now, component B is being produced with 'free' input material !!

In one of the cases, there was a decrease in the commodity prices in the market and the sales guy was reluctant to pass on the benefit. As a counter logic, he presented data that the scrap recovery considered in the costing was on the higher side due to less qty of scrap generation. Again, the smart procurement manager had to validate the same. So he went to the manufacturing facility and checked for the scrap generated, and yes it was less. The sales guy of the supplier was happy. After coming back to his office, the procurement manager checked the finished component weight as well, which was as per the costing agreement. Now,

Raw Material Weight = Finished component weight + Scrap weight.

So if the scrap was going down, the Raw material definitely should have gone down. Here again, the manufacturer has played around with the tolerances and could reduce the input weight. So the procurement manager was happy to reduce the scrap recovery weight and reduce the input raw material Weight & Cost as well !!

Volume Apportioning

In many cost workings with the suppliers, and largely in cases where you buy a self-design product (buyer company IPR), the suppliers will be paid a cost for machinery or tools which will enable the production of that component (Say $1,000,000). In all such cases, instead of paying an upfront amount, the cost of the machinery/component is amortized over a defined number of components that can be produced within the estimated useful lifespan of the tool/machine (say 100,000 pcs). Now, these numbers are so large that it will (generally) take a few years/months to be achieved. By that time there can be a change in category manager or there may not be a tracker in place. So when the 100,001st unit is produced (assumed with the same machine), it should be bought at $10 less. In one such case, the cost of 'Amortization' was 8% of the component cost, and the same machine has already produced 30% more than the anticipated life in the amortization cost calculations. When the supplier's sales guy realized that the category manager had caught the overdue cost reduction, he got "too busy" for the meeting ;)

Similarly, there are other elements of the cost agreement (freight, admin, processing, etc.) with the suppliers which were with certain volume assumptions, and need to be revalidated with the going volumes. Believe me, if it is going to be different from the original assumptions, it will most likely help us reduce costs. Otherwise, the sales guy would have ensured that it was brought to the Procurement manager's notice.

What Did You Order?

The performance levels of components or the specs are something that is generally a part of the Agreement / Contract.

We need to keep an eye on, if the supplier is sticking to the specs we signed the cost on. While we may not be focusing on the utility of all the specs, but, the suppliers may be. In all such cases, the supplier will be doing a VA / VE exercise and may optimize the cost. The good news in all such cases is that we are working with great suppliers!! The only thing we need to do in such a case is to keep ourselves aware of what good optimization the supplier has done.

There are components or equipment that we buy, which are kind-of "off-the-shelf" or some may call them 'Proprietary'. e.g. a fuel pump for an automotive company, or the Intel Processor chip for a laptop manufacturing company. The design & IPR for these components is with the supplier company and they may / may-not modify the product to exactly suit your requirements. Here reading the contract may give a brief idea of cost working (this is an assumption, but, in my experience, that is how it happens), but there will be a lot of communications between the two organizations over mails, spec docs with track change modes, internal approval notes which will give a lot of insights.

In one such case, an additional connection slot in a component was incorporated to accommodate the usage of the same component in one of the old products of the company. However, the slot was not needed after a few months due to the discontinuation of the old product. The supplier was aware of it and discontinued the additional connection slot provision. This saved some cost for him. Our smart Procurement Manager was going through some of the old communications with the supplier and was reminded of the additional cost for the additional slot. Then the only effort required by the procurement manager was to take pictures of the new design and a screenshot of the communication about the cost of an additional slot :).

In another case, the engineering team requested a special quoting all around the component. However, after a year, the supplier realized that one large surface does not need that quoting as it is covered by another protective lubricant while in use. So that surface was not covered with the special quote and was supplied. Since there were no quality complaints, no one noticed it. In our Spec vs Actual product evaluation exercise, it was noticed, and it saved us some cost.

So, in summary, we need to continuously monitor the physical products vis-à-vis our costing sheets. The listed aspects are just the representative areas and there can be multiple aspects of costing assumptions in your cost-working which needs continuous validation.

Hope this will help you save some costs. Do let me know some interesting stories when you identify some opportunities after reading this article.

In subsequent articles, I am going to take up some more tools to explore cost reduction.

Happy Saving !!