As a procurement officer, you’ve possibly been in the crosshairs of debate between sourcing locally and regionally versus from low-cost countries endorsed by many executive staff and boards of directors.
Every time I was requested to have a target percentage of our purchases from low-cost countries I felt a pit in my stomach. I worried whether I could successfully convey the message that even with the great prices, the total cost for the parts would be more than what it would cost to source locally or regionally. This led me to create the model described below.
If you graduated from a program focusing on supply chain management or completed professional certification in procurement, the coursework and educators always say that piece price isn’t the total cost of ownership of the item purchased. Everyone agrees with this view, including executives and boards. The common phrase is: Cheap is expensive.
However, how do we move away from flying with a 20,000-foot-high opinion that nearly everyone agrees with — but doesn’t follow — to create an analytical model that allows the organization to make an objective decision based on a known set of cost drivers? We need to understand all the individual incremental cost drivers and how to monetize their costs to compare each option’s cost objectively.
An often-overlooked cost differentiator is hard versus soft cost. Separating these two costs fosters quicker analysis and buy-in.
Hard costs:
- Piece price
- Tariffs
- Shipping cost
- Cost of additional inventory to support longer lead times and supply variability
- The additional cost of maintaining suppliers in a foreign country
- Supplier quality (cost of inspection, sorting, rework, returns and scrap)
- Additional supplier delivery (cost of expediting and premium freight charges)
- Environmental compliance costs
- Currency exchange risk
- Labor market dynamics
- Infrastructure investment
For hard costs, the task simply involves working with accounting and operations to determine each item’s discrete cost for each cost driver. Soft costs can be more difficult.
Soft costs:
1. Supplier quality rating:
Platinum supplier = 0 percent added
Gold supplier = X percent added
Bronze supplier = X percent added
Unknown quality = X percent added
2. Supplier delivery rating:
Platinum supplier = 0 percent added
Gold supplier = X percent added
Bronze supplier = X percent added
Unknown quality = X percent added
3. Does the supplier have an outside professional certification?
Yes = 0 percent added
No = X percent added
4. Partnership potential:
Current partners = 0 percent added
High possibility = X percent added
Moderate possibility = X percent added
Low possibility = X percent added
5. Supplier innovation and technical capability/ Engineering support, local technical support, CAD and design:
High = 0 percent added
Medium = X percent added
Low = X percent added
None = X percent added
6. Dual production site capabilities: (If required, can the supplier manufacture your part(s) at a sister location?)
Yes = 0 percent added
With some effort = X percent added
Not capable = X percent added
7. Resilience to disruptions/ speed of supplier responsiveness:
Fast = 0 percent added
Moderate = 0 percent added
Slow = X percent added
Very slow = X percent added
8. Supplier flexibility:
High = 0 percent added
Moderate = X percent added
Low = X percent added
Very low = X percent added
9. Supplier financial stability:
High stability = 0 percent added
Moderate stability = X percent added
Low stability = X percent added
Unknown stability = X percent added
10. Lead time:
Less than 1 week = 0 percent added
1–4 weeks = X percent added
5–8 weeks = X percent added
9–12 weeks = X percent added
More than 12 weeks = X percent added
11. Distance to supplier:
Less than 300 miles = 0 percent added
301–750 miles = X percent added
751–2,000 miles = X percent added
2,001–3,500 miles = X percent added
More than 3,501 miles = X percent added
12. Ease of international border crossing/ International logistics performance index (LPI):
No issues = 0 percent added
Minor issues = X percent added
Higher than average issues = X percent added
13. Geopolitical issue potential/ Likelihood of issues
None = 0 percent added
Low = X percent added
Moderate = X percent added
High = X percent added
14. Potential slave, child, or forced labor/ Likelihood of issues:
None = 0 percent added
Low = X percent added
Moderate = X percent added
High = X percent added
15. Cultural and time zone alignment:
No issues = 0 percent added
Minor issues = 0 percent added
Higher than average issues = 0 percent added
16. Cyber security risk associated with suppliers in the low-cost region:
None = 0 percent added
Low = X percent added
Moderate = X percent added
High = X percent added
17. Cost of intellectual property Management
None = 0 percent added
Low = X percent added
Moderate = X percent added
High = X percent added
I understand this is a lot of information, but capturing all the attributes to make the most informed decision is essential. For soft costs, I’ve found that outlining a list of three to five possible scenarios, applying an additive multiplier percentage to the base purchase price, and then summing the total produces reliable results that are easy to explain and support.
3 Mistakes while Comparing Prices Between Suppliers:
Beware of these three underlying mistakes that organizations consistently make when comparing purchase prices between suppliers:
Limited Cost Drivers:
The most significant mistake is completing the analysis with only a few cost drivers — such as purchase price, shipping cost, and tariffs — which in the long term can lead to disastrous results.
Partial List of Hard Costs
An additional mistake is only to assume a partial list of hard cost and little or none of the soft cost drivers. The different hard and soft cost drivers I’ve outlined involve a lot of information for an organization to absorb. However, it’s necessary to dig deep and fully understand how the cost drivers will affect the total cost of ownership for an individual part when making such critical decisions.
Distrust Among Team
A third common mistake is not trusting the procurement team with their analysis and overriding their recommendations because a decision has already been made. I’ve often heard, “If our competitors are moving their supply base to low-cost countries, we’d better follow or our margins will suffer.” Just because others are doing it doesn’t mean it’s the correct business decision for your organization.
Don’t let the complacency of incremental decisions define your long-term strategy. Amateurs ignore total cost models. Let this model serve as a road map to more precise decisions when selecting and sourcing parts.
Author Profile: * * *
Art Koch is a globally recognized supply chain transformation expert and consultant with over three decades of transforming business performance at mid-market and Fortune 500 companies. He’s increased corporate valuations by over a billion dollars, utilizing his proprietary methodologies to improve customer loyalty, reduce inventory by over $250 million, and increase EBITDA by $100 million-plus annually. His new book is The Supply Chain Revolution: Unlocking the Sustainable Profit Chain. Learn more at arthurkochmgt.com.
