A Prescriptive Model for Cost Management in the Supply Chain
This study provides a summary of best practices in strategic cost management among
select leading edge purchasing and supply management (PSM) organizations today.
While PSM spends more money than any single group, and is held to a high level
of accountability for spending, there has been limited literature explicitly linking
strategic cost management with supply chain management in general, and with the
role of supply management in particular. This study:
- 1. Identifies and studies a number of best practice organizations across several
industries.
2. Explores both upstream and downstream strategic cost management issues and practices.
3. Synthesizes these best practices.
4. Develops a prescriptive model for world class cost management in the supply chain.
This is a broad and unstructured topic. It examines not only the practices that PSM uses to manage cost, but how PSM interfaces with others inside and outside the organization in delivering savings. Figure 1 provides a high level overview of the strategic cost management process.
Figure 1: Strategic Cost Management Process
Five organizations participated as core case studies for this research project. The strategic cost management processes were viewed from the perspective of the PSM organization, from inside the core firm. The researcher also studied one key supplier for each core organization, which the core organization identified as a supplier with which it had effectively engaged in cost management. The core companies included in this study were Deere & Company, a manufacturer of farm and construction equipment, and home and commercial lawn care equipment; Chip, a major high-tech electronic components and OEM manufacturer; LCP, a large consumer products manufacturer; Tele, a major regional telephone carrier; and Praxair, a large supplier of industrial gases and chemicals. All of these companies were large Fortune 500 manufacturers with sales ranging from around $5 billion to nearly $50 billion. Some of the key characteristics of these organizations relative to this study are shown in Figure 2. Detailed case studies summarizing the strategic cost management practices of each of these organizations are available in the full study, published at www.capsresearch.org.
Figure 2: Key Characteristics of Core Case Studies
Overall Framework
In the course of this study, it became clear that effective strategic cost management has both strategic and tactical aspects that must be well executed in order to deliver results. The strategic framework and tactical elements of cost management as they affect PSM are shown in Figure 3, which also shows the soft and hard results of effective cost management as related to PSM. The actual processes in which cross-functional teams engage to support strategic cost management include many tactical elements. In most organizations studied, the strategic cost management process occurs as an integral part of the new product development process or the strategic sourcing process. It is not a "stand-alone activity," but rather a central part of supplier selection and supply base management. Some of the processes and tools that are part of the strategic cost management process include: online auctions, total cost of ownership, should-cost analysis, target costing, supplier development, benchmarking, standardization, supply base rationalization, and volume leverage.
Figure 3: Strategic and Tactical Elements of Supply Chain Cost Management
A cross-disciplinary team of two or more individuals, including PSM, was the norm for carrying out strategic cost management in the five core organizations studied. Often, the cost management activities were part of another, larger process, such as a strategic sourcing event, a new product development process, or part of an on-going continuous improvement effort. In exploring Figure 1 in detail, it is clear that the cross-functional team that works on strategic cost management has numerous high-level issues that it must consider. First, the price and feature needs of the ultimate customer must be heavily weighted, or the result will be a product that customers cannot afford, that does not meet their needs, or both. The customer information comes to the team through a secondary source, often filtered through the eyes of marketing, sales, or a customer relationship manager. The corporate objectives regarding strategic cost management and cost savings goals must also be considered in terms of meeting the objectives of the team and the business unit or units that the team supports. Next, each organization utilized cost management specialists, for whom all or a major part of their jobs was to support cost analysis, help develop models, and ensure integrity in the data and the analysis results. In some cases, these individuals reported to PSM; in others, they reported to corporate or business unit finance. The key commonality across cost management specialists in these organizations was the expertise, credibility and charter to support supplier cost management. Even with the first three direct inputs, a fourth is needed: a reward and measurement system that supports cost management. The extent to which such a system exists is a function of the corporation's cost consciousness culture. Is everyone in the organization held accountable for cost management? Is it part of their performance reviews, annual goal setting, and overall expectations? A stronger cost-consciousness culture creates greater support for the team and higher commitment to its results.
In the center of Figure 1, the cross-functional team engages in activities designed to reduce the organization's cost, such as identifying cost drivers and changing processes using a total cost of ownership approach, engaging in on line reverse auctions, or working with suppliers on development. The way that the organizations use these processes is detailed in the body of the report. Based on the strategic cost management processes, they aim to achieve a better supply base, defined as one that has a lower total cost (sometimes only a lower price), and performs as well or better than it did before the strategic cost management process. The process should also support customer satisfaction by resulting in the same or lower prices for the same or better quality and service. This should in turn lead to measurable, bottom-line savings, which should translate into higher profit, higher economic value-added for the firm, and higher earnings per share. In general, when PSM thinks about achieving results, the focus is still on bottom-line cost savings rather than how its performance is reflected in the overall corporation's results.
Research Questions and Major Findings
With this framework in mind, we turn to the research questions that formed this study. Much more information to support each of these research questions is provided in the full study.
-
Research Question 1. How important is strategic cost management in the
organizations studied, and why?
Research Question 2. How are firms organized to effectively achieve strategic cost management?
Research Question 3. Who is responsible for conducting cost management in the organization, and who is accountable for delivering results?
Research Question 4. How do organizations determine the focus of their cost management efforts?
Research Question 5. What specific cost management tools do organizations use to support strategic cost management?
Research Question 6. How are the results of cost management efforts reported?
Research Question 7. What other unique processes or organizational structures contribute to the success of strategic cost management efforts in the organization?
Research Question 8. What impact do supplier relationships have on the organization's cost management approaches?
Research Question 9. What is the supplier's perspective on the organization's cost management efforts?
Research Question 10. What impact do customers have on the organization's cost management approaches?
Research Question 11. Does the organization take a true supply chain management perspective of strategic cost management?
Research Question 12. What are the key success factors and barriers to strategic cost management?
Research Question 13. What is the future of strategic cost management in your organization?
Implications of the Study
This study has several implications related to PSM's involvement in strategic cost management in the organization. They are closely related to the results of the research questions presented above.
Organizational Support at All Levels
While PSM is held to a high level of accountability for strategic cost management and delivering bottom-line savings, PSM cannot be successful without extensive support from others throughout the organization. First and foremost, top management support is critical. It sets the tone for the attitude that everyone in the organization has toward strategic cost management. Through the business unit and functional metrics, top management determines the nature and extent of cost management focus as an organizational priority. Based on this, PSM needs the support of other functional areas cooperating teams that have a primary or second goal of managing supplier costs. The participants on cross-functional teams need to be held accountable for the identification of opportunities and delivery of results.
PSM also needs specific support from cost management specialists, who are assigned to support PSM and cross-functional teams in supplier cost analysis. These individuals may be part of PSM or part of finance. The critical requirement is that they have the charter and the qualifications to effectively support supplier cost analysis and management. Supplier cost management must be viewed as one of, if not the most important aspect of their jobs. This focus is critical because supplier cost analysis is often specialized and time consuming. PSM and cross-functional teams need to know that there are internal experts upon whom they can call to support their supplier cost management efforts. Without such support, the analysis may be too complex and time consuming to be done as part of PSM's or the cross-functional team's regular activities.
Supplier Cost Management Is a Good Investment
The suggested approach for dedicating resources to supplier cost management may seem cost prohibitive. However, the organizations studied unanimously agree that they receive extremely high returns on their investments in supplier cost management efforts. The money spent on supplier should-cost analysis, supplier development, and other tools and approaches pays for itself many times over in terms of reducing costs and bottom-line prices paid to suppliers. For large Fortune 500 companies, successful strategic cost management may mean the addition of dedicated personnel to focus on supplier cost management. For smaller organizations which might not have as great an on-going need, or as great an asset base, successful strategic cost management may mean diverting resources from PSM and/or finance, and retraining one or more people to become internal experts on some of the cost management and analysis tools mentioned in this study.
Strategic Cost Management in the Supply Chain Is a Process and a Philosophy
The organizations studied indicate that they live and breathe cost management. It is integrated into all aspects of their jobs and all dealings with suppliers. Top management and functional support is not enough to ensure the success of strategic cost management. Key internal processes, such as new product development and strategic sourcing, must also be designed in a manner that integrates an understanding of customer needs, and the creation of specific cost and profitability goals.
Credibility in Reporting Results
The savings that are attributed to supplier cost management must be believable, and traceable to the bottom line. It is important that there is consensus across the organization regarding how the numbers are calculated and reported. In general, finance reports these numbers to increase the credibility of the results. The focus is on reporting cost savings that can be traced to reduced spending within the organization.
Supply Chain Perspective
Taking a seamless view of strategic cost management across the supply chain is not yet a reality. In most cases, the inbound view of the supplier is handled by a different team/organization than the outbound supply chain view to the customer. It is critical that somewhere in the middle, the organizations dealing with the customers make sure that the customer value proposition is clearly communicated to the organization dealing with the supplier. It is essential that internal organization goals and objectives be aligned in order to align the goals and objectives of the supply chain.
Customer-Facing Supply Chain Perspective
In general, the supply chain managed by the organizations studied included only the first tier of suppliers and the immediate customer. A notable exception was two of the companies whose products are sold to consumers, either through a retail channel or after the product is used to produce another product. Both of these organizations had a very close watch on demands and vagaries of the end consumer, and aimed to anticipate shifts in consumer demand patterns in order to better serve their immediate customers. Who ultimately determines the demand for a product — the end customers or the immediate customers — is an important determinant of where the producing organization should focus its attention.
Supplier-Facing Supply Chain Perspective
All of the studied organizations segment their supply bases and use different tools and approaches for managing different suppliers and purchases. It is critical to use a cost/benefit approach to supplier cost management to use the organization's limited resources wisely. In addition, all of the organizations studied focus their supplier management attention on their first tier suppliers. They also recognize that there is much possibility for improvement in the supply chain in the second tier, yet do not plan to focus on the second tier. There could be significant opportunity for supply chain improvement by working directly with critical suppliers in the second tier and beyond.
Supplier Perspective on Strategic Cost Management In the Supply Chain
The suppliers to the core organizations studied were quite aware of the importance of cost management and continuous improvement in retaining their business with the buying organizations. While all felt continual pressure to perform, some suppliers felt that the pressure was fair, and other suppliers felt that the pressure had become unreasonable. In order for buying organizations to retain good supplier relationships and the image of fairness in the face of continued cost pressure, they should:
-
1. Be concerned with the supplier's underlying cost structure and how they can
support cost reductions, instead of being concerned only with price.
2. Provide resources and ideas to support supplier's cost reduction efforts when requested by the supplier and it is reasonable to do so. If an organization is unable to support the supplier's cost reduction efforts, it should explain why.
Suppliers' Management Of Their Suppliers
While all of the supplier organizations studied were working on managing the costs of their suppliers, none had a supplier cost management system as sophisticated and well-developed as did the core organizations which they supply. As a result, it might be a good investment for buying organizations to provide thorough cost management training to their suppliers, and help their first tier suppliers develop excellent cost management approaches, so that they, in turn, can do a better job of managing their suppliers. This is particularly critical since the core organizations do not want to get involved in the inbound supply chain beyond first tier suppliers.
Characteristics of Companies With Effective Supply Chain Strategic Cost Management Approaches
The key characteristics that organizations with effective strategic cost management systems should display are shown in Figure 4. Figure 4 was developed as a composite ideal of the best characteristics of the core supply chain organizations studied. It is not representative of any one organization. There are specific attributes related to way the organization understands and manages the relationship with the customer, its supplier, and related to their own internal organization. The key organizational characteristics have been divided into cultural/organizational issues, measurement issues, and information/communication issues.
Figure 4: Ideal Organizational Characteristics for Strategic Cost Management
Internal Requirements/Characteristics
Both the customer-facing and supplier-facing characteristics stem from inside the organization. The internal culture and organizational structure create the framework for effective supply chain cost management. Internally, an effective cost-management culture is characterized by top management support for cost management and a high level of cost and value consciousness throughout the company. In addition to dedicated resources to support supply chain cost management, cross-functional teams are used to identify and implement cost management approaches. Rather than an afterthought, cost management is an integral part of all key supplier processes.
The right type of reward and measurement systems is also critical to reinforce the cost management culture. It is critical that the organizations measure what they want to achieve, and the metrics are aligned throughout the organization, reflecting cost goals as well as customer value and supplier performance goals. Supply chain performance metrics and results must be published and receive high visibility throughout the organization. This requires excellent information systems and communication. Part of this communication includes awareness throughout the organization of customer needs and the organization's value proposition in serving the customer.
Customer-Facing Knowledge
Supply chain management is all about meeting the needs of customers better than the competition does. In terms of the organization's culture, the company needs to be customer centric, valuing its customers and working with them to meet their needs while improving the efficiency and effectiveness of the supply chain. From a measurement standpoint, the organization needs to understand the needs of the end customer as well as market trends, and respond to these proactively. From an information and communication perspective, it is critical that the customers' needs and the organization's plans for meeting those needs be communicated throughout the organization. This allows everyone in the organization to align his or her efforts around the customer.
Supplier Facing Knowledge/Characteristics
Effective supply chain strategic cost management relies heavily on suppliers. Culturally, this means a continuous improvement focus on working with suppliers, including early supplier involvement. It also means supporting supplier's continuous improvement with resources and training. From a measurement and reward standpoint, the organization must properly segment its supply base to use the appropriate types of supplier relationships and cost management techniques. It also needs to measure supplier performance, and reward the suppliers who perform well. Clearly communicating expectations and needs to suppliers is essential.
The organizations studied in this research excel in the third column of Figure 4: supplier-facing knowledge. They segment their supply bases, have dedicated supplier cost management resources, emphasize continuous improvement, and in many cases develop the suppliers by providing resources to support continuous improvement. They reward their top suppliers by sharing cost savings or giving them more business. They are working on improving communications and early supplier involvement. One strong recommendation is that they invest more resources in supplier training. In general, their first tier suppliers do not have as well-developed approaches to supplier cost management. Since these core organizations would prefer not to work on supplier cost management beyond their first tier suppliers, the first tier suppliers would likely be much more effective if they improved their cost management systems, and worked more closely with their suppliers.
This paper was excerpted from Ellram, Lisa M., Strategic Cost Management in the Supply Chain: A Purchasing and Supply Management Perspective, Tempe, AZ: CAPS Research, 2002.
