Developing International Supply RelationshipsTM through Zero Base Pricing

by

David N. Burt Professor of Procurement University of San Diego San Diego , CA 92110

619-260-4868

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A revolution in purchasing is in progress: we are redirecting our attention from seeking the lowest price for supplier furnished materials and services to obtaining the lowest all-in-cost. All-in- cost is the acquisition price plus all in-house costs required to convert a specific purchased material into the end product. All-in- cost includes any costs resulting from the end product's failure to function in the field due to a defect in the specific purchased material. The principle of all-in-cost also applies to the procurement of equipment, plant, and services.

A second revolution has taken place in what is obtained from outside suppliers and how purchasing managers obtain these supplies and services. No longer do manufacturers limit themselves to the buying of materials and components. Now they also purchase many more complete assemblies. Over the past 50 years, the value of purchased materials and services has grown from 20% to 56% of the selling price of finished goods. A similar change has occurred in the supplies and services purchased by non-manufacturing organizations such as banks, hospitals, and governments. Purchasing professionals are their company's managers of its "hidden factories" - the facilities and expertise available at supplier firms.

A third revolution is taking place in the relations with outside suppliers. No longer are suppliers seen as "the enemy" or "necessary evils". At several progressive firms, suppliers are seen as our "Partners in Progress". These partners bring technology, design and manufacturing expertise and managerial skills to the partnerships. They are involved during the design and modification of products. Frequently, they become a single source of supply for the life of the product.

Global competition requires that buyers adopt a proactive philosophy and embrace modern pricing techniques. In 1982, procurement professionals in Polaroid began applying some of these principles under the banner of Zero Base Pricing. Using ZBP, Polaroid was able to buy comparable items for significantly less in 1985 than in 1982. Additionally, by focusing on all-in-costs instead of purchase price, Polaroid procurement helped the company gain may additional cost reductions and cost avoidances.

NON-DOMESTIC SOURCING

Efforts to reduce all-in-cost force professional purchasers to consider sourcing from non-domestic sources. Frequently, such sourcing is essential if the firm is to be competitive in today's global environment.

TM IThis paper is based on the book ZERO BASE PRICING : ACHIEVING GLOBALCOMPETITIVENESS THROUGH REDUCED ALL-IN-COST by David N. Burt, Warren E. Norquist and Jimmy Anklesaria, Probus Publishing Company, Chicago,ILL. 1990.

2Annual Survey of Manufacturers: 1985, U.S. Bureau of the Census,Government Printing Office, Washington, D.C., 1987, p 1-8. 3ZERO BASE PRICING is a registered trademark of the PolaroidCorporation and is used by permission.

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International sourcing requires additional efforts when compared with domestic sourcing, but it can yield large rewards in the areas of improved quality, timeliness and cost. Of equal or greater importance, some of these non-domestic sources will become the firm s supply partners. They become critical links in the firm's value chains, responsible for the supply of technology, design, and manufacturing expertise. Through early supplier involvement, the supplier and the buyer become partners with shared destinies.

But, and it is a large but, establishing such international partnerships is challenging. It can take years to develop the degree of trust required to allow a supplier to become a partner involved in the design and development of our products. It is our experience that the relationship which develops through ZERO BASE PRICING allows members of the buying firm to become comfortable with a prospective supply partner. Therefore, we recommend the adoption of ZBP concepts and tools as the most expeditious of ways of developing international supply partnerships.

ZERO BASE PRICING

During a 1982 sales call on a buyer at Polaroid, a supplier's sales representative drew the cost/price scenario depicted in Figure 1 on the buyer's chalkboard.

"Now, you can see why my company needs a substantial price increase," said the rep. "We've been absorbing rising costs against our profit margin to comply with your hold-the-line pricing. Our company needs to regain its margin. The margin's eroding while we hold our pricing to you stable."

The buyer, who had been trained in Zero Base Pricing, began to explore this argument by inquiring into the supplier's actions during the period of cost absorption. "How are you fighting inflation? Are you working to resist and change the forces that led to increases in cost?" asked the buyer. "What is your company's strategy for handling price increase requests from your own material suppliers? You even show the future cost as a solid line, not a dotted one! How can we afford to do business with a company that projects costs increasing indefinitely"?

"When your labor rates went up last quarter, were they offset by improved productivity? Hasn't the recent emphasis on reducing scrap and rework reduced both your material and labor costs?" the buyer continued. "This product is now mature and you've had plenty of time to recover your initial research and development investment. Besides, a mature product demands less of your general and administrative budget. What else are you doing to reduce your material costs? Have you applied Value Analysis to your product? What is your purchasing doing to reduce the cost of your materials?"

The buyer drew up a mental cost model: fully recovered research costs, labor and materials cost reduced by learning, less scrap and rework, lower break-even points as a result of diminished G&A and factory overhead expenses. The buyer then stated, "An increase in one or two cost elements doesn't justify a price increase without reviewing all of the cost elements."

Figure 1 Supplier's Drawing

NX

Price

Cost

h- Penod ofCost Absorption

Time

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During this fact finding period, it became evident that the sales representative lacked a clear understanding of the elements of his company's costs and possessed no tangible examples of having resisted or influenced inflationary cost factors. The sales representative was asked to go back with a points-of-difference summary, and do his homework by collaborating with his cost accounting, design, and manufacturing departments. He was asked to review all his costs and develop a list of proposed cost reduction alternatives for consideration at the next session.

Simplified DescriptionA simplified description of the acquisition price component of

Zero Base Pricing was developed to help buyers explain the program to suppliers and salespeople. The five cost elements are: material, labor, factory overhead, general and administrative costs, and supplier's profit. These are shown in Figure 2. Suggestions are now presented for each element:

o Material cost- the ZBP approach is to not accept material costs from suppliers without supporting evidence. Alternate sources as well as make/buy decisions are considered. Suppliers are questioned on their use of process control techniques and their efforts to reduce material usage. Suppliers are asked: What are you doing to eliminate scrap? Do you have an active Value Engineering/Value Analysis program? What can we together do to reduce packaging, transportation and storage costs?

o Labor - under ZBP, buyers do not accept labor costs from suppliers without supporting evidence. Supplier's wage increases must be absorbed through productivity improvement or they become a source of inflation and make the manufacturer less competitive in a global market. Emphasis is placed on learning through application of the learning or improvement curve. The supplier's attention to the quality of its purchased materials and its production processes should result in labor savings associated with the "right" material, defect free incoming material, and making it "right" the first time. The professional buyer also recognized that direct labor costs commonly are the basis for allocating indirect costs and thereby can have a multiplier effect.

o Factory overhead - the buyer looks for outdated factoryoverhead allocations. Mature products take less management effort and incur low or no development costs. Overhead should not be increasing when there are reductions in break-even points associated with streamlined management structures.

o General and administration costs - the buyer examines thesefrom a variety of perspectives. For example, when a purchased item matures, the account costs less to service, generates reduced corporate research allocation, and receives less corporate management attention.

o Profit - profits are not an entitlement. Profits must be earned by performance based on assumption of risk, oualitv cost, delivery, and service. The professional buyer varies the profit objective with the situation. «uy«r varies

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Figure 2The Philosophy of Zero Base Pricing

Acquisition Price

Usual Approach:Discussion centers

around current price

Current Price

f t t

ZBP:Examination ofall components

of the price

What has dunged? What might we change?

Current Price

PROFIT

G&ACOSTS

FACTORY OVERHEAD

LABOR

MATERIALAND

PACKAGING

Indicates areas of discussion/ analysis which may result in price reductions.

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The professional buyer's responsibilities have grown to include the quality and timely availability of the purchased material, the supplier's service and technological support, and ensuring that the right material or service is purchased. Many of these responsibilities impact on the firm's in-house costs including: incoming transportation; incoming inspection and testing; storage; production; warranty, service, and field failures; returns; and lost sales. These in-house costs have two components: an unavoidable element which cannot be eliminated at the present state of the firm's personnel, processes and equipment resources and an avoidable component. We define this avoidable component to be one which can be reduced or eliminated if the firm's procurement system operates effectively. Zero Base Pricing describes the procurement professional's role in reducing or eliminating avoidable costs.

Avoidable in-house costs include:

o Avoidable incoming transportation costs. Selection of thewrong carrier or route and failure to negotiate a reasonable rate are examples of avoidable incoming transportation costs.

o Avoidable inspection and testing costs. Failure to select suppliers whose production processes are stable, who demonstrate the capability of meeting the buyer's quality needs, and who are certifiable results in avoidable incoming inspection and testing costs.

o Avoidable production costs. In the area of purchased materials, there are four significant contributors to avoidable production costs: (1) delivery was not on time or the material was not of usable quality. (2) the wrong material may have been specified. For example, brass is more easily machined than steel. The purchase of steel instead of brass for some processes results in the incurrence of avoidable production costs. (3) Use of the wrong tolerances can result in the incurrence of avoidable production costs. (4) Avoidable production costs result when incoming defect rates are above the current state-of-the-art optimal base rate. For example, if it is possible to purchase a material with a defect rate of 50 parts per million (50 ppm) and the firm purchases it at an acceptable quality level (A.Q.L.) of 1% (10,000 defective p.p.m.), then a significant avoidable production cost will be incurred. These avoidable costs will be in one or more of the following areas:

o a general degradation of productivityo reworko process yield losso scrap

o Avoidable warranty, service, and field failure costs. Such costs result from the use of inappropriate materials, materials with sub-optimal reliability, and from defective purchased materials which pass through production.

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o Avoidable customer returns and lost sales. The cost of customer returns and the opportunity cost of lost sales resulting from the use of the wrong materials , materials with sub-optimal reliability, and from defective purchased materials which pass through the production process are avoidable.

Figure 3 depicts in-house costs, with emphasis on their avoidable components.

Both the acquisition price and in-house costs are significantly affected during the design and development of the products incorporating the purchased materials. These factors are depicted in Figure 4.

ZERO BASE PRICING TODAY

Zero Base Pricing is a proven process based on reviewing all the cost elements and working with Jnternal customers and with suppliers to reduce the all-in-cost of purchased materials, equipment, and services. Figure 5 shows the interdependent components of Zero Base Pricing.

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Figure 3 TM The Philosophy of Zero Base Pricing

In-Ho use Costs

Customer Returns and Lost Sales

Warranty, Service and Field Failure

Process Yield Loss

Rework

Lost Productivity

Production

Storage

Inspection and Testing

Incoming Transportation

Unavoidable costs : Base cost which cannot be avoidedas discussed on page 000Avoidable costs, as discussed on page 000.

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Figure 4 The Philosophy of Zero Base Pricing

Cost and Quality Drivers

Tolerances

Specifications

Materials

The Process and the Requirements Placed on It

Design for Automation

Ease of Manufacture

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Figure 5 ALL-IN-COST

ACQUISmON PRICE

Figure 2

ALLIN-HOUSE

COSTS

Figure 3IN

COST

COST &. QUALITY DRIVERS

(REQUIREMENTS PROCESS)

Figure 4

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ESTABLISHING PARTNERSHIPS

Purchasing literature is filled with articles advocating the establishment of long term, mutually beneficial partnerships with our suppliers whether domestic or foreign. One of the benefits of such partnerships is that the buyer will have access to the supply partner's cost data.

At Polaroid, buyers employ a staircase of cost knowledge (Figure 6) approach to identify a supplier's position relative to eight graduated steps. Buyers can see how far they have traveled toward a complete understanding of costs by checking their progress on the staircase. Experience with the existing supplier base demonstrates that progression up the stairway is generally an iterative process. Buyers are encouraged to move up the staircase a step or two at a time in a spirit of trust and collaboration. Sometimes a supplier has gained a better understanding of his own costs: more than one supplier has redone his overhead allocation rules.

Purchasing professionals have found that in many instances they have been successful at starting new suppliers or current suppliers on new programs near the top of the cost knowledge stairway.

Assurance of value through more cost knowledge has made program managers willing to narrow the choice to one or two suppliers at the beginning of a program. Buyers gain the many benefits of early supplier involvement instead of waiting and bidding out the final design.

The trend in America is to treat suppliers more as partners and extensions of one's own facilities. The extend of this trend depends on building up trust. Trust develops through shared cost data that allows both parties to receive fair treatment. In this partnership each is looking for these assurances:

Supplier

o will be adequately compensated for suggestions and innovation

o won't be stuck with losses on materials when production forecast is reduced

o will be kept informed as forecasts change

Manufacturer, Customer

o supplier will keep current in technology of his field

o supplier price will represent value even if there is no competition

o supplier won't take advantage of single source position

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Figure 6 The Staircase of Cost Knowledge

Open Cost Negotiations Plus Goals

Early supplier Involvement Cost Model

Yielded Marls Costs Labor Costs O.H.-Oirect & Est.

Price ModelPlus Limited Escalator Clause

No-Loss Materials Cost Est. Labor & O.H.

Estimate Costs Compare Increase To Index

Littie Info Resist Increase

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SUMMARY

Global competition drives buyers in most countries to consider non-domestic sources of supply. When the buying firm determines that the development of a supply partnership is mutually advantageous , both parties must develop trust in one another.

Trust developed through shared cost data that allows both parties to receive fair treatment is the foundation of such partnerships. ZERO BASE PRICING provides the concepts and tools to share cost data, gain trust , and develop international supply partnerships.

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