Source to Gain: Cost accumulation

In the previous article, I started to explore why and how to set key purchase parameters in a firm but fair manner, and gave examples what can happen if it fails. Here, lets explore the basis for it all: cost accumulation. It not only helps on purchase parameters but forms the foundation for many strategic topics as well. This article is a little technical and only intended for sourcing and supply chain professionals! :-)

Simply put it is a graph showing how the cost (to the supplier) is accumulated over time, before delivery to their customer. I will open it up in a few pictures. First shown is a simplified cost breakdown picture for an imaginary camera component.

As we can see, supplier is buying some key components themselves and assembling them together into a camera component, e.g. for a smartphone. With a 21% margin to earn a solid return on the capital they need to employ. As in the other article, this could be a should price breakdown or a breakdown provided by the supplier. This in itself does not help much in understanding cost accumulation.

But it transforms magically when you add the lead time into each row. For example, manufacturing happens usually very close to delivery, so the lead time from manufacturing start to delivery could be 3 weeks. The start of the manufacturing of the sensor (often by a sub supplier) could start for example 10 weeks before the start of the manufacturing of the camera component, i.e. 13 weeks before delivery. Below a picture of graph where this information is shown visually.

The graph points out that the production of the sensor for the camera component we get on week 40 started already on week 27. If we want to secure the availability of the camera component on week 40, some sort of demand signal or committment should have been in place already on week 27 latest. Perhaps we place a PO to the camera component supplier on week 27, so that they place a PO to the sensor supplier on the same week to secure the sensor. But, and here comes the art of purchasing details and the biggest mistake many purchasing organisations do, it would be a huge mistake to issue such a PO without clear cancellation and rescheduling terms. We would commit to 9.3 dollars per camera 13 weeks out, where the cost accumation at that point of time is only 3.56 dollars. Rule of thumb to use: the cancellation term should (at most) follow the cost accumulation. For example, 8 week before delivery date, we should be able to cancel the PO and pay at maximum 4.76 dollars.

Lets draw the cost accumation curve a little differently. Sometimes what you buy is a standard product and sometimes the product is customized to you. Lets separate that out, and for example assume that the sensor is industry standard, but the lens assembly is specific to you. These are assembled into the finished camera at the manufacturing phase. Then the cost accumulation curve looks as below:

The same total cost accumulation has been split to the green part which shows the accumulation for components, semi-finished or finished goods that are specific to the customer. Light red part is standard components, and the dark red is the supplier margin. Rule of thumb: the cancellation term should cover the green part, some part of the light red, but never cover the dark red nor go into the white area.

For example, the PO lead time could be 13 weeks to ensure availability, with full cancellability up to 10 weeks before delivery, then a 1.2 dollar cancellation fee up to 4 weeks before delivery, and 7.3 dollar cancellation fee up to delivery.

This is very simplified of course and can be optimised further both for the supplier's and customer's benefit. For example, the 7.3 dollar cancellation fee could be replaced by a rework fee to rescue the standard components from the customer specific finished goods, if that rework fee is lower. Sometimes, the rework needed is just to remove customer specific software and could be very cheap compared to the full price of the component. Also, the PO lead time could also be set at 10 weeks if the standard sensor is widely available and used by the supplier in volumes.

There is a reason why the supplier margin should not be covered in the cancellation term. In case the customer needs to cancel deliveries, both the customer and supplier loses sales revenue and profit. The customer should cover the direct damages inflicted on the supplier, not more.

Of course, the cancellation term is a key risk sharing element in a contract. But one must be very careful if the cancellation term significantly benefits either the customer or supplier, as the promises/levers used in price/contract negotiation phase can easily be forgotten in execution phase. The supplier's key account manager and factory head are often not incentivized the same way. A firm but fair cancellation fee is much more robust in all supply situations. Green should be covered, and the light red is up for negotiation depending if the supply is constrained (cover more of the light red), or purchasing power is strong or sub components are in strong supply (cover less of the light red).

Also you note, that this text does not mention the inventory and does not include that in the lead time. The reason is that inventory is not part of the cost to the supplier, but rather is part of the capital employed. Therefore, that extra need for capital is covered in the margin needed to get a solid return on the capital employed. More about this in later articles.

I hope this helps in understanding where to start to search for optimal purchase parameters. This obviously works best in direct materials sourcing, but can be used on abstract level in indirect sourcing. Comments and further ideas welcome!

Previous articles:

Leading change: 1. Measuring success, 2. It's all about people, 3. Anchors Aweigh!, 4. Would a rose smell the same...?

Source to Gain: 1. Why do we source? 2. Should Price Analysis, 3. Are purchase parameters strategic?, 4. Cost Accumulation