The Future of Industrial Material Supply Relationships
The time was October 1991 on the U.S. eastern seaboard. A rare combination of forces unleashed Mother Nature's power, which in meteorological terms, was referred to as a perfect storm. While meteorologists marveled in its fury, those caught in the devastating storm would likely have chosen a different adjective to describe the event.
Today, companies that depend on the global metals market for their supply of critical materials are facing their own perfect storm. Market forces align to create a rare, but likely prolonged, supply event that will challenge the fortitude of many industrial businesses. The resulting effects have sent pricing for steel, as well as critical production inputs for this material, skyrocketing to unprecedented levels. Some of the market forces at play include:
- Strong demand and rising prices in the world's largest-consuming markets, with China as a major driving force;
- North American consolidation and corresponding reduction of capacity on the heels of European industry consolidation, five to seven years earlier;
- Strong demand and corresponding shortages of critical raw materials inputs, such as scrap and coke; and
- A global ocean freight market trading at more than five times the operating rates of three years earlier, impacted by dramatic increase in traffic and cargo volume to Asia.
These conditions in the global metals market have cast a spotlight on the increased importance of developing an effective raw material buying strategy. Top executives have set materials management as a corporate priority to counteract the volatility of the industry (see Figure 2).
Now, steel-consuming manufacturing companies have come to realize that they must make changes to their supply networks to ensure stability, at the lowest possible total cost. Similar actions are under way across a wide range of complex material environments, including engineered polymers, and other materials in the chemical supply market. Many of these supply networks are complex, because they involve multiple tiers of supplier relationships. This effect is a result of efforts to externalize manufacturing and logistics assets in favor of flexibility and lean enterprise operations. To manage this complex environment, companies are pursuing a strategy that provides visibility and control to critical raw material activity throughout the supply network.
For most automotive and industrial manufacturing companies, raw materials account for nearly 50 percent of part and/or component cost. The value trapped in these materials represents significant savings opportunities for the entire network. To put the opportunities in perspective, consider that direct spend on parts can range from $100 million to several billion dollars, depending on the particular commodity and size of manufacturer.
What changes are taking place? What should change? Historically, most companies that manufactured parts and assemblies in a multi-tier supply network sourced their own raw materials. In this traditional model, the purchasing power of the network was fragmented. The situation caused an unnecessary proliferation of requirements and created conditions of supply uncertainty. This sourcing model limits visibility to the raw material inputs and leaves control over cost, quality, and the guarantee of supply continuity in the hands of companies that may not always be best positioned to deliver.
To remain competitive, leading companies are taking action to change the model. In the very near future, most companies will move to control raw material purchases throughout the supply network. Some companies have already regained control of their material activity and are working toward optimizing their supply networks. Others, in response to the current market conditions, have begun to lay the groundwork to successfully transition to this new operating model. Companies will need to clear the following hurdles:
- Gain complete and continuous visibility of material specification and spend throughout the supply network;
- Organize information so that product development and purchasing can work effectively together; and
- Employ collaborative processes that include strategic suppliers.
Visibility Throughout the Supply Network
Industrial material markets have historically been cyclical. Traditionally, both supplier and customer chase the cycle with only one party winning. To overcome this frustrating process, some companies have abandoned predatory buying practices in favor of a longer-term view of the supply market that softens the pricing peaks and valleys inherent in the industry.
One such industrial purchasing executive has adopted "a deal's a deal" strategy. Just one year earlier, when conditions did not favor steel suppliers, it would not have been unthinkable for a major steel consumer to force renegotiation of an established contract. This company chose to pursue a longer-term strategy and is now realizing the benefits through stability and supply continuity. "Price is simply what you pay for supply continuity," said the executive.
With suppliers now approaching their customers to recover increased operating costs, either in the form of surcharges or price increases, this executive had an established policy that respected the sanctity of existing contracts. As a result, most of these surcharges have been deflected. So how did this purchasing team establish advantages and remove supply risk leading up to the perfect storm? The short answer - visibility and direct relationships.
In the late 1980s to early 1990s, a few companies began to look at the supply chain differently. Instead of taking an enterprise-centric view of the world, these companies understood the effects of disaggregating manufacturing assets and the resulting fragmentation of purchasing power, two and three tiers deep in the supply market.
With this insight, the companies developed a purchasing and supply flow model that introduced more control of material flow versus the traditional cascading approach to supplier relationships. In a cascading model, an OEM negotiates and orders from a tier 1 supplier, who in turn negotiates and orders from a tier 2 supplier, and so on.
These highly competitive companies created a supply management model where direct relationships led to sustained benefits for the network. In the case of steel as a raw material, the OEM negotiated and ordered steel through a direct relationship with producers. The OEM also directed the flow of materials through their outside processors, who would convert the materials into metal parts. This holistic view of dependencies and coordinated signaling of supply movement throughout the network has continued to deliver benefit. The model creates increased price stability for the OEM and its network of processors, and ensures that every supplier in the network would maintain supply flow according to the OEM's rules.
For suppliers, it should quickly become evident that innovation is the only defensible variable in the new model. Just as an OEM must innovate in order to maintain a profitable relationship with their customers, processors must continue to deliver manufacturing efficiencies and service. Likewise, material sources must continue to develop innovative materials, offer additional design services, and deliver supply consistently.
Integrated Product Development and Purchasing
Some companies were able to get ahead of the curve and insulate themselves from some of the volatility of the market. For companies that find themselves behind the curve, there is still an opportunity to gain control during the storm. Inventory remains an opportunity for most manufacturers due to the current lack of coordination between product development and purchasing and the resulting proliferation of materials.
It's natural to think that because of supply pressures in the market, companies are operating at efficient inventory levels, perhaps even too low. However, a careful review of balance sheets shows a fairly healthy supply of inventory. In practice, while inventory exists, it may not be the right inventory to service demand. In the case of raw materials, if the properties of available supply do not match the design requirements for a part, then additional material of the correct type must be ordered.
So what is the source of this specificity that affects supply continuity in the worst of times? We recently tackled this very issue at a Fortune 500 company. We reviewed hundreds of metal components that were ultimately part of a larger assembly. Through analysis of critical material dimensions, we identified more than 40 unique dimensional requirements expressed in the data. We arranged the data to highlight the subtle differences from one part to the next.
After a series of interviews with a cross section of design and material engineers, we learned that certain tolerances could be relaxed, requiring just 20 expressed dimensions or a 200 percent reduction in complexity. As a result, the team agreed to commonize dimensions of the material so that one material specification could be used in multiple parts, allowing for less inventory and greater supply continuity.
The surprising discovery for all participants in this process was the level of value trapped in the current decision process. While engineers had incentives to design functional parts that met weight and cost reduction objectives, something was still missing in the process. It turned out that the proliferation of material requirements resulted from part-by-part design optimization.
By executing slight changes to the dimensional requirements on purchase orders, the team has been able to reduce inventory and material costs (avoiding premiums) in an order of magnitude equivalent to a 3.5 percent reduction in negotiated material cost. This value comes at a time when a customer is not in the best negotiating position with material suppliers.
What's Next?
The industrial company plans to implement a governance model across programs to guide engineers to select from a commonized set of material options. The goal is to optimize materials so that each package of requirements can be sourced to the most capable suppliers. The approach will be applied to other parts that involve a wide range of industrial materials. To increase commonization through improved chemistry and mechanical properties, the company plans to involve strategic suppliers early in the design work and will likely make greater use of innovative materials.
Collaboration With Suppliers
With so much at stake and the potential to unlock value trapped at the bottom of the bill of materials, one might ask why more industrial companies are not working directly with their material suppliers to create relationships that weather the storm.
Companies with advanced supply management practices have effectively segmented material sources into core, near-core, and commodity suppliers and the suppliers have done the same with their customer base. Though many companies have adopted this approach to strategic relationships, much of the industrial sector is still far from collaborative, and could even be characterized as adversarial. The constant pressure to deliver year over year cost savings in markets whose raw material inputs are historically volatile, rewards this type of behavior. The path of least resistance has been to transfer the cost pressure to the supplier relationships behind a "customer is king" mentality.
We recently engaged two companies in a process demonstrating an innovative approach to delivering short- and long-term benefits by focusing on a total cost model. The philosophy from the start was to pursue a joint value proposition for a tier 1 manufacturer seeking to convert aluminum and zinc die-cast parts to plastic, and a chemical company intent on identifying new revenue streams for their innovative materials. The result will deliver short-term benefits to the customer through material substitution and long-term benefits to both parties through joint innovation. There is an additional benefit from the integration of what was previously supplied as two metal parts that fastened together, to a design that molds the two functions into one part.
Similar collaborative approaches have been in practice in the retail and consumer goods industry for many years. For example, companies such as Wal-Mart and Procter & Gamble, work closely together to maximize return for a category of products in a store. The model works through the role of an assigned category captain and uses consumer research and experience to make recommendations to the retail customer. Processes exist to monitor the relationship to ensure that the role is executed in a manner where everyone will benefit from category growth, versus an individual product's success.
The industrial sector will apply similar principles to the management of key materials (i.e., categories) with core suppliers (i.e., category captains). Companies will play the role of category captain for resins and other chemicals and these roles will likely focus on how specific materials perform within a target application. For example, DuPont is continuously investing to develop their competency for the application of engineered polymers in safety systems.
To overcome the traditional barriers to collaboration, suppliers will package full-service solutions that customers can easily bring together in an assembled product. The uniqueness of the innovation and the packaged relationship will fuel collaboration.
Conclusions and Recommendations
It's clear that companies that depend on the global metals market for their supply of critical materials are facing their own perfect storm. Through the examples presented here and observations of other industry practices, more companies will learn from market leaders and find ways to address the volatility of the industrial material market.
To get started, we recommend challenging the answers to some basic questions: What am I buying? How much am I buying? From whom am I buying? Gather and organize this data such that you can identify cost savings. This work will serve as the foundation for longer-term opportunities that can be implemented under less severe market conditions. Begin to arrange your supply network to include direct relationships with material sources.
In the short term, look for commonization opportunities to reduce the number of material requirements in your operations. This effort will lead to a reduction in complexity and overall inventories. Investigate creative ways to package up your newly commonized business to bring greater efficiencies to your suppliers, and get them to the table to discuss alternative ways to share cost savings.
The future of industrial material markets will certainly be volatile. The most competitive companies will use this understanding of the business cycle to their advantage. More companies will employ multi-tier supply relationship models, commonization of designs, and collaboration with strategic suppliers to stabilize supply flow and profits in the market.
