All the costs to consider during vendor selection
Good morning and happy Friday!
After 6 months of training in Turkey, I arrived in Shanghai, China, in January 2011 as a procurement and sourcing specialist for one of Turkey's largest manufacturers. My task was obvious: source new suppliers so the company 1) save costs, 2) reduce supplier dependencies.
I visited hundreds of suppliers, managed existing vendors and contracts, and created new supplier partnerships. I learned how to select quality suppliers, convince internal stakeholders on supplier selection, negotiate costs and payment terms. I also started to get an idea of the total cost of ownership. Through real challenges, where I repeatedly found myself, I grasped that “actual purchase price” didn’t paint the whole picture.
Real-life example 1) Costs incurred from the engineering and technician support.
At one project, we convinced the business that there was a savings north of $100k, and we awarded a new reputable Chinese supplier for about +$1M project. The supplier wasn’t doing a good job. Upon an inspection visit, I noticed that the supplier was far from finishing the project on time. The supplier required our company’s engineering support to finish the project. That’s why we have flown 2 engineers from Turkey to the supplier’s city, where 3 of us had to stay for 1 month and work together to get an outcome of somewhat acceptable. Despite all the hard work, we knew that the components had to be reworked in Turkey by local suppliers - adding extra costs.
And the funny part is?
In the supplier’s facility, working day and night, we met our French counterparts, who were exactly in the same situation. They were working for a vendor supplying components for a famous French car brand.
Based on the actual purchase price, the savings were great. But, in reality, once all other costs were incorporated - did it really make sense? The money and time we spent to fix issues and teach suppliers know-how were expensive and invaluable.
During my time in China, I often received ad-hoc calls from our engineers back in Turkey asking me to visit suppliers and fix the problems. It was my job, and at these moments, I questioned if the suppliers need this amount of support (time and people); were these projects actually resulting in real savings?
Real-life example 2) Costs incurred from carrying/holding the inventory.
I learned this through a painful experience by wasting my own money. In August 2013, after 3 years of procurement and sourcing experience in China, I moved to New Zealand. I was excited about entrepreneurship and trying something of my own. After months of research and product testing, together with my brother, who was still back in Turkey, we decided to set up an e-commerce business in New Zealand. Our product was traditional Turkish towels, a product heritage to Turkish culture.
This time we nailed the supplier selection. We partnered with an amazing vendor, which produced the highest quality of products, which we negotiated at a great price. However, my lack of understanding, particularly around the inventory costs, created significant cash flow problems for our company from the beginning. Due to unclear ordering and inventory decisions, we purchased large quantities (6 months) of inventory upfront.
This was another example that showed I didn’t fully understand the total cost of ownership. In fact, later on, I learned that inventory costs would be the largest part of these costs.
Understanding the total cost of ownership:
From Martin Christopher’s Logistics Supply Chain Management book, the below image perfectly demonstrates that the product acquisition cost (purchase price) is the iceberg's tip - the only visible cost. Below the surface, all the other costs should be considered and incorporated into the total cost.
7 costs to consider when making a purchase decision:
Not all types of costs will be applicable for every product and supplier scenario. Still, the expected result will be much better if you consider these costs and questions when making a purchase decision.
1) Acquisition cost: the visible and sexy part. The iceberg tip will show savings and convince stakeholders to avoid considering all other relevant costs.
2) Management cost: administrative or staff overhead resources required for the supplier and product.
3) Maintenance cost: one-off or on-going maintenance or rework required to use the product.
4) Operating cost: operational steps or labor costs to use the product.
5) Inventory carrying cost: This is probably the least understood part by procurement professionals. This is where I also made tens of thousands of dollars mistake of my own money. I’ve done a deep-dive with this cost below.
6) Technical support cost: engineer and technician support required for the supplier and product.
7) Training cost: training cost required for my staff to use the product.
8) Disposal cost: cost to dispose of the product.
Inventory carrying costs:
This is an annual cost that incurs for holding inventory. It’s estimated that a company will have a minimum of 25% inventory carrying costs on average. The % will vary based on industry. Suppose a company’s average annual inventory value is $1M. The annual inventory holding cost for the company will be around $250k.
What’s included in the inventory carrying costs?
The opportunity cost of capital, operating and storage costs (warehouse, equipment, labor, disposal), obsolescence, shrinkage, deterioration, depreciation, and insurance costs.
If you are part of a procurement team, you may say inventory management is the supply chain’s job, so why should I even care about this? Its correct supply chain will manage the inventory, but procurement supplier selection, supplier’s minimums, and lead times affect the amount of inventory that companies have to bring in. This directly impacts the inventory carrying costs.
How can procurement teams help reduce inventory holding costs?
1) Reduce the amount of inventory your company needs to order.
How? Ask the below questions:
Is there a minimum order quantity or a minimum production run?
What is the total lead time required? (Production + Transit)
What transportation modes are available? (An option to reduce the lead time)
If the supplier doesn’t mandate minimum order quantities, consider further reducing the total lead time required. If the lead time gets smaller, your company can order much less inventory more frequently. With smaller orders, the company will require smaller storage space.
2) Watch out for attractive volume discounts that force you to order more than needed
3) Watch out for suppliers gaming the customers. (E.g., suppliers claiming there is a risk of supply and forcing you to order more than needed)