Innovative Strategies for Supplier Partnerships
Many companies seek cost reduction from suppliers by simply trying to negotiate better costs, delivery, and terms. Some customers will require a 3 percent to 6 percent cost reduction every year, without having any suggestions as to how that might be accomplished. This chapter explores how to select your supplier of choice for given parts, how to reduce costs by far more than the 3 percent to 6 percent targets set by many companies, how to use innovative approaches to supply chain management that reduce costs exponentially throughout the supply chain, and how to determine when it’s wise to take your partnerships global and when to keep them at home.
In my past role as VP, Operations, of a rapidly growing manufacturer, I established a culture of partnership with our suppliers where we expected to be their most profitable account, while they provided us with world-class pricing. How did we do that? By promising that we wouldn’t squeeze their profit margins but would instead work with them to reduce costs—materials, labor, overhead, quality, freight, and the other costs included in a total cost of ownership (TCO) model.
We began early in the relationship by asking that our supplier partners (usually the top 10 suppliers in total dollar volume—see Chapter 2) give us their complete cost model breakdown so we could see what drove their costs and what we could do to help them reduce our costs for materials. My buyers spent time reading The Wall Street Journal and other related publications so that they understood the dynamics of costs for the materials they bought. For instance, the buyers who bought printed circuit board assemblies (PCBAs) knew the market benchmarks for profit margin, materials, labor, and so on. We knew at the beginning that the typical industry profit margin was, say, 7 percent, and we started working with that as the minimum for that part. Then, as we worked on cost reduction with the supplier, we would split the savings with them so that each time a reduction was identified, we got half and they got half. It didn’t matter who found the savings, it would be split between the parties. Over time, their profits went up and our costs went down.
Whenever we met with the suppliers, which for our top suppliers was usually quarterly, cost reduction was at the top of the agenda. We pored over drawings, looking for opportunities to reduce costs, such as loosening tolerances that were not important to the design performance of the product. We often found that the engineers would call out the same tolerance for most measurements whether it really needed to be that tight or not. Often, some could be loosened, which significantly improved the supplier’s ability to build the part for less money. We also considered alternative materials, substitute components, parts they could purchase in greater quantities for all of their customers, and so on. Then, as part of our supplier performance reports, we measured cost reduction and reported it back to the supplier during our reviews.
By working together to become more competitive in the marketplace, the increase in our sales benefited both parties through higher volumes, better margins, improved quality, and reduced scrap. Because we were our supplier’s most profitable account, whenever we needed extra support for some reason, like a market opportunity or a design change to help move the technology forward, our suppliers were more than willing to go the extra mile to help us. How did we find suppliers who would do that? We used a technique patterned after the U.S. Air Force Fly-off.
The Air Force Fly-Off
When the U.S. Air Force selects new airframes for fighters, bombers, tankers, and other aircraft, they often use an approach known as the fly-off, in which they provide performance criteria to two selected companies who each build their proposed prototype aircraft; these are then compared through a series of performance tests.
The Air Force actually started this process way back in the 1930s when it was known as the Army Air Corps, for the procurement of postWorld War I (WWI) fighters and bombers. There have been more than six generations of fighter aircraft since 1939 when the first jet airplane was developed. There was a period in the 1950s and 1960s when the fly-off fell out of use due to internal disagreements in the Air Force as to the purposes of fighter aircrafts. Should they be bombers, close air support, or interceptors? Then, with the development of the F-15 and, later, the “Lightweight Fighter” (LWF) that became the F-16 and the Navy F-18, the fly-off returned to use.1
In materials acquisition, the fly-off model can serve as a way to determine which supplier becomes the primary, or often the sole, source for a given part or assembly. For instance, in the company where I was VP, Operations, two PCBA houses provided parts for us. When a new design was released, we gave it to both suppliers to bid and to provide samples for review. While both met the design requirements, our production personnel noticed basic differences. Often, one supplier’s starting costs were very different than the other, or one supplier’s quality was different. For instance, we used conformal coat, which encased the PCBA in a plastic coating to allow the product to function outdoors. One supplier spraycoated, while the other dip-coated the conformal coat, which affected how the PCBA was placed into the assembly. Our production personnel noticed the difference as they tried to assemble the product.
Once we chose our primary supplier for a given product, we would buy 60 percent of the product from them and 40 percent from the second supplier. Then, based on quality, delivery, cost reduction, and other subjective factors, we would either flip who the primary supplier was or give the initial supplier more of the volume, until one supplier was the sole source for that particular part. This “fly-off” might take a year. Usually, the second supplier still provided other parts of a similar nature, so we had the risk reduction of dual suppliers with the cost reduction of sole source supply for individual parts.
Our “fly-off” was particularly effective in providing high-quality parts at the lowest possible cost just in time. The supplier gained the benefit of new, high-volume business, while we got world-class pricing with extraordinary performance. It also helped reduce our overhead by reducing the number of purchase orders (POs) and checks issued. The one difference between our “fly-off” and the Air Force Fly-off is that we provided the detailed design to the suppliers so they built technically identical parts, rather than completely different airframes (as in the Air Force) that met a defined need.2
Auto Replenishment Systems
Auto replenishment systems go back a long way. Two-bin, Kanban, breadman, and other systems have been around since Henry Ford and possibly longer. When Taiichi Ohno created the Toyota Production system, one of the ways he developed level flow was though Kanban. Kanban is a card or signal that indicates when something needs to be done such as a part movement or materials purchase. Vendor-managed inventory (VMI) (also known as supplier-managed inventory) is another widely used technique. It could be argued that material requirements planning (MRP) is also an auto replenishment system, but it’s not quite as “automatic” as others.
VMI is just that, a system where the supplier manages your inventory. In more full-featured implementations, the supplier first helps to rationalize the inventory. There’s no point setting up a replenishment system for parts that are obsolete or exceptionally slow moving, so the first step is to identify parts with no recent activity and remove them from the process. What’s left should be the parts that are used on a more or less regular basis, although high volume isn’t required for a successful VMI system.
In VMI, the supplier visits the customer, examines the bins or storage locations to see what’s been used, and replenishes the items as needed. It’s also known as a breadman system, because in grocery stores, bread is typically resupplied using this process, although I often note that beer is, too, which seems more interesting to me!
VMI is completely different than consigned inventory, although many companies assume that VMI inventory is consigned. Consigned inventory is owned by the supplier until it’s actually used, which can cause problems that hurt the partnership. For instance, what happens if the supplier thinks there should be more parts in stock than the customer wants? Perhaps inventory was taken without being transacted, or parts were damaged upon arrival, but there are arguments as to who is responsible. Perhaps a physical inventory reveals discrepancies, but no one knows why. All of these and other issues can cause bad feeling between the parties, which could lead to the demise of the partnership.
Another interesting problem is whose insurance covers the consigned parts in the event of a disaster such as a fire or a flood. They’re still owned by the supplier, but they’re in your warehouse and under your theoretical control, so whose insurance covers the parts? In my opinion, a well-run VMI system should have such high inventory turns that consignment has little benefit and just isn’t worth the potential problems between the parties. When parts arrive in the bins, ownership should transfer or the parts should be expensed.
VMI is most often used for fasteners and packaging, but I’ve seen very successful systems used for electronics, cable, wood, steel plates, and many other items. The key to a well-run system is to think just in time with high turns. Many companies don’t support VMI because they believe the suppliers stuff the bins, leaving them stuck with too much inventory. There’s actually a very easy fix to that—make the bins smaller. If VMI is founded on a strong partnership, many of these problems simply won’t occur, but like any process, it needs to be managed.
Kanban systems, based on a signal or trigger for replenishment, can be used both internally and externally. In supplier partnerships, they can be used to replenish just in time, yielding very high inventory turns and low levels of stock-outs. When I was VP, Operations, other than VMI parts, we had 100 percent Kanban replenishment with our suppliers. It resulted in turns over 17 with 99 percent demand fulfillment.
Kanban also helped with seasonal parts management issues. For instance, many of our zinc parts were produced almost 1,000 miles away and had to go over a pass in the mountains, which could be closed in the winter due to avalanches. My production managers simply added an extra card to the Kanban mix in November that increased inventory and then removed it in April to bring inventory back to the ideal quantity.
Once again, Kanban must be managed to work effectively. Someone needs to keep an eye on demand to know that the quantities are set correctly, and if anything goes wrong, alarms need to sound immediately. For instance, Kanban size is calculated based on average usage lead time. If parts are late, a signal needs to go to the buyers to contact the supplier to find out what happened and when the parts will arrive; otherwise, a stock-out could occur.
Alaska Communications (ACS) had a series of retail outlets for the sale and service of cell phones. Customers could go to the retail store to select a phone from the large selection, chose accessories for the phones, and sign up for the service to support the phone. The stores had a hard time keeping many models in stock and managers complained that stockouts were hurting sales, so operations set up a Kanban system between the central warehouse and the stores that triggered replenishment. An individual visited each store several times a week to deliver products and pick up the Kanban cards that signaled further replenishment when a bin was empty. They set up a simple two-bin Kanban system that was incredibly effective, dramatically reducing inventory while increasing customer service to the highest levels in recent memory.
ACS also used a variation of VMI they called vendor-managed delivery. This worked in two completely different applications, one to refill technician trucks and one to deliver materials to construction locations. They had a fleet of over 120 technician vehicles for business and residential service and installation, which carried a wide selection of parts and wire. Every day, the technicians visited the warehouse parts counter, turned in their list of replenishment parts, and then went to the coffee machine while the parts were pulled. Then they restocked their trucks before leaving to start their service calls. This process often took 45 minutes, and each technician had his or her favorite parts, which caused significant stock-keeping unit (SKU) inflation over time.
Partnering with a supplier who made most of the components, the company developed suitcase-like containers with pigeonholes for the parts (Figure 3.1). The parts were standardized in the containers, which had the added benefit of reducing the number of SKUs in inventory, since each technician had his or her favorite brand of parts and over time, this resulted in significant SKU inflation. By limiting the parts in the box, the number of SKUs were dramatically reduced, which saved both money and floor space. Now the technicians could simply exchange their two cases for freshly stocked ones and return to their trucks. Total time, with coffee, was five minutes or less. That time savings across the 120 trucks led to remarkable productivity improvement and increased the number of service calls in a day.
Figure 3.1 ACS parts kit
ACS also had numerous projects going on during their short construction season. Most teams had from 12 to 16 people and if they needed a part, the entire team often had to wait until the part arrived, and at union rates, the expense for people standing around waiting for parts was substantial. Parts shortages might be caused by warehouse stock outs, mispicks, or delivery errors. The supplier partner who stocked most of the parts used in construction projects agreed to carry additional parts and kit the parts for direct delivery to project sites. The materials didn’t touch the ACS warehouse, which had several benefits:
Not stocking the parts reduced SKU count, floor space requirements, and warehouse costs.
Kitting and direct delivery resulted in more complete shipments with reduced downtime and higher productivity for the construction crews.
Project cost tracking was simplified.
Time to delivery, if there was an exception, was much shorter, as the supplier could deliver the part directly to the site rather than taking it to the ACS warehouse first.
An unexpected benefit was that more projects were completed during the short construction season.
Recognizing Value in the Partnership
As illustrated in the stories in the preceding text, there is much more value in supplier partnerships than in typical supplier relationships. Cost reductions over time can be much higher than the 3 percent to 6 percent that customers often ask for; in my experience, working in partnership can save as much as 20 percent in materials costs. How does that happen? First, by focusing on a few great suppliers for given commodities, the consolidated purchase volume yields greater discounts and year-end rebates when they apply. Second, having fewer suppliers not only allows for that consolidation, but the indirect costs of invoice processing, check writing, supplier visits, and other supplier management activities are reduced as well.
Relationship pricing can have a dramatic impact on parts costs as well. Relationship pricing involves using annual purchase volumes to establish costs as well as consolidated parts purchases into fewer key supplier partners. If you have two (or at most three) suppliers for given commodities, the consolidation of part numbers and volume purchases can be significant. In addition, having more than one supplier as discussed in Chapter 2 mitigates supply chain risk factors.
The blanket PO can be very effective in relationship management. A blanket PO addresses the quantity of given parts that will be purchased over the long term. It usually covers a year, but the time frame can be longer. Many purchasing professionals don’t like using blanket POs because of the misconception that they’re a commitment to buying that many parts, but the blanket PO is a planning tool, not a commitment. Suppliers can use them to plan their annual parts flow and production run quantities so that they can reduce costs and pass the savings on to the customer.
The commitment represented by the blanket PO can be whatever the partners agree upon. When I was VP, Operations, we committed to the supplier’s lead time for parts. That is, if the supplier’s lead time to produce or purchase parts was 30 days, then we committed to buy/protect the parts represented by that lead time. For example, if the blanket PO is for 1,200 parts annually and the lead time is 30 days, our commitment was for 100 parts. We didn’t need to receive them all at once by any means. We usually received in Kanban quantities that were much smaller than 100, but if our plans or forecasts changed, we could be on the hook for the 100 parts, thus protecting the supplier. What the supplier did to provide the other 1,100 parts was up to them. If they chose to build in larger batching, thinking that it’s cheaper to do so (which it usually isn’t), that’s up to them. Their goal is to do what they need to do to keep us as a customer, and our goal is to partner with them to get quality parts, just in time at the lowest possible cost.
Supplier partnerships go well beyond cost reduction. Many suppliers have great technical capabilities that can help in product design. The CEO of one metal forming and stamping company had such deep knowledge of metallurgy, he would weigh in during product design on issues such as material choice, heat treating, coating, and tolerances. His knowledge kept our engineers from designing things that couldn’t be built effectively and saved his customers many hours of frustration in manufacturing.
In another situation, one company used zinc as a base material in their product. Zinc is traded on the commodities markets, and forward contracts can be purchased during periods of volatile prices that can save a lot of money. Commodities trading can be very risky and your CFO should be part of the team that looks at such approaches, but by working together with supplier partners, you could reach sufficient volumes to set up contracts, when on your own you might not be able to.
International Partnerships
In my role as VP, Operations, our CEO thought all of the VPs should have marketing responsibility. One day he walked into my office and said, “Rick, I finally figured out what you get to do for marketing. You get to open China.” And he turned around and walked out. I thought, “Wow, how do I do that?”
We developed a joint venture (JV) agreement with a large Shanghai-based company to manufacture and distribute our products in China. We made access control devices used to access cell tower sites, postboxes, and other applications that recorded the time of entry in remote locations. Getting access to the markets, however, required close contacts with highlevel government officials, and our JV partner had such contacts. Many companies try to open business in China with wholly owned subsidiaries, but in our case, having a JV partner was key to our success.
Note that we didn’t go to China to try to reduce costs in our U.S. markets. Our inventory turns and service lead times suggested we needed to assemble our products as close to the customer as possible. Add to that the fact that each device was custom coded for the customer and we needed very short supply chains. To open the Chinese market, we needed to manufacture and assemble as much as possible in China to meet government requirements, so we developed the JV.
Partnering with suppliers to provide quality products just in time as close to the customer as possible at the lowest possible cost means using a few, possibly global, supplier partners. Whether they’re manufacturers of components or finished goods, shipping companies, third-party logistics (3PL) providers, or producers of unique materials, having partnerships around the world can help extend your core competencies closer to your customer while keeping costs down. Supplier partnerships are second only to customer partnerships (see Chapter 4) in providing high value.
References
Hallion, R.P. Winter. 1990. “A Troubling Past: Air Force Fighter Acquisition Since 1945.” Airpower Journal 4, no. 4, pp. 4–23.
McChesney, T. “Letter: Fly-off Competitions and Fairness.” Federal Computer Week, October 22, 2008. Web. August 9, 2016.