SUPPLY CHAIN OPERATIONS
333905000-KM-02
KNOWLEDGE MODULE 02
This document is a ‘Knowledge Module’ Learner Guide for:
Occupational Certificate: Supply Chain Practitioner
QCTO Curriculum Code: 333905000
SAQA Qualification ID: 99111
NQF Level: 05
Developed by Global Maritime Legal Solutions (Pty) Ltd for the:
Transport Education Training Authority (TETA) and the Quality Council
for Trades and Occupations (QCTO)
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SAQA 99111 Knowledge Module 2
Table of Contents
Knowledge Module 02 | Overview and Specifications............................................................ 3
Purpose of Knowledge Module.................................................................................................3
SAQA Exit Level Outcome Associated with this Module.......................................................... 3
Associated Assessment Criteria for Exit Level Outcome 2................................................................3
Theoretical Components and Weightings................................................................................ 4
Introduction to Supply Chain Operations................................................................................. 4
Chapter 1 – KM-02-KT01: Main Techniques for Added Value through Supply Chain
Operations................................................................................................................................. 5
KT0101: Obtain supplies to the organisation’s requirements.......................................................... 6
The five rights of supply chain........................................................................................................................8
KT0102: Secure competitive pricing.................................................................................................13
Sources of added value in the supply chain................................................................................................. 13
Value for money (VFM)................................................................................................................................ 18
Obtaining quotations on prices using competition and historical price analysis........................................ 20
Suppliers approaches to pricing................................................................................................................... 24
The link between costs and pricing.............................................................................................................. 27
Approaches to negotiating improved prices................................................................................................ 29
The process of securing competitive prices through collaboration with suppliers..................................... 34
Techniques of measuring achieved savings................................................................................................. 40
KT0103: Achieve quality supplies.................................................................................................... 49
Quality standards, processes and procedures............................................................................................. 49
Quality assurance in supply chain................................................................................................................ 54
KT0104: Secure required quantities at required timescales...........................................................57
Internal, external and total lead time.......................................................................................................... 58
Techniques used to expedite and measure delivery performance..............................................................60
The role of scheduling, planning milestones and activities and its impact on the supply chain................. 65
Techniques to optimise value added through effective inventories and low costs.................................... 73
Chapter 2 – KM-02-KT02: Main tasks associated with stages of the sourcing process........80
KT0201: Supply needs identified......................................................................................................81
The process of identifying supply needs from customers as a basis for the make or buy decision............81
KT0202: Criteria for creating specifications.....................................................................................86
The importance of specifications for products and services in contracts with external customers and
suppliers, with specific reference to conformance and output-based approaches and the role of key
performance indicators (KPIs)...................................................................................................................... 87
KT0203: Sourcing of supplies........................................................................................................... 95
The role of surveying the market and its relevance to the supply chain function...................................... 96
Explain the use of e-sourcing technologies..................................................................................................99
The relevance of measuring supplier performance to the supply chain function.....................................101
The potential impact of queries and clarifications on the supply chain.................................................... 106
The possible impact of mistakes and delays on the supply chain............................................................. 109
The use of reverse auctions/ e-auctions.................................................................................................... 114
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KT0204: Formation of agreements with external organisations.................................................. 116
List the key elements of forming agreements with customers and suppliers...........................................116
The context of transition and mobilisation arrangements........................................................................ 122
Chapter 3 – KM-02-KT03: Technology and Supply Chain Information................................ 128
KT0301: Electronic procure to pay (P2P) systems and the supply chain......................................128
Definitions of (P2P) procure to pay or purchase to pay.............................................................................129
The procure to pay process........................................................................................................................129
The process of creating approvals and their timescales............................................................................132
KT0302: Internet technologies and supply chain operations....................................................... 134
The impact on the supply chain due to integration of systems between organisations...........................134
The importance of web-based solutions such as e-requisitioning, e-sourcing, e-ordering, e-invoicing to
the supply chain function........................................................................................................................... 138
Chapter 4 – KM-02-KT04: Integration of Supply Chain Information................................... 148
KT0401: Information parameters impacting the effectiveness of the supply chain...................148
The need for integrated supply chain information within the organisation............................................. 149
Information requirements linked to the different supply chain processes and used as a basis to measure
effectiveness of the supply chain............................................................................................................... 150
KT0402: Decision making processes regarding supply chain information systems.....................153
The process of effective decision-making regarding supply chain information systems.......................... 153
Stakeholders involved in the decision-making process............................................................................. 155
KT0403: Effectiveness of supply chain information systems........................................................155
Criteria for effective information systems in accordance with needs and stakeholder requirements.....156
The effectiveness of the information system measured against specific criteria..................................... 157
Tools used to effectively determine and introduce improvements.......................................................... 157
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Knowledge Module 02 | Overview and Specifications
Module Code 333905000-KM-02
Module Title Supply Chain Operations
Allocated Credits 10
NQF Level 5
Purpose of Knowledge Module
The main focus of the learning in this knowledge module is to enable learners to understand
the techniques for added value through supply chain operations, tasks associated with
stages of the sourcing process, the impact of technology on supply chain operations and
integration of supply chain information.
SAQA Exit Level Outcome Associated with this Module.
The ‘Exit Level Outcome’ associated with this module as found in the relevant qualification
document for SAQA qualification ID 99111 is:
Exit Level Outcome 2: Implement supply chain operational activities within an organisation.
Associated Assessment Criteria for Exit Level Outcome 2
The ‘Associated Assessment Criteria for Exit Level Outcome 2’ for this module, as found in
the relevant qualification document for SAQA qualification ID 99111 are:
Legal obligations for the supply chain are identified and evaluated for compliance
against statutory requirements.
The implications of compliance and non-compliance are analysed, and the
advantages and disadvantages listed as per industry best practice.
Potential operational risks are identified and documented in line with organisational
risk management policies and procedures.
The impact on and likelihood of each risk within the division/element are analysed
and prioritised according to importance.
Contingency plans are developed to reduce risk impact on supply chain according to
organisational procedures.
Documentation is used correctly as per organisational quality management system.
Quality standards are maintained during the execution of operational activities.
Activities are performed in cross-functional teams to ensure leaner operations.
SLA terms and conditions are implemented as per demand and supply ratio.
Effective communication is maintained with supply chain partners. 3
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Suggestions for improvements are made to management in line with operational
and strategic key performance indicators (KPIs).
Technological systems are used to capture and share supply chain information.
Theoretical Components and Weightings
This knowledge module is comprised of the following main theoretical components and
weightings:
Component Code Description Weighting
30%
KM-02-KT01 Main Techniques for Added Value Through Supply Chain
Operations 30%
KM-02-KT02 Main Tasks Associated with Stages of the Sourcing 20%
Process 20%
KM-02-KT03 Technology and Supply Chain Operations
KM-02-KT04 Integration of Supply Chain Information
Note: The chapter headings of this module have accordingly been aligned to the main
theoretical components as highlighted above.
Introduction to Supply Chain Operations
The element of supply chain operations is crucial in the improvement of productivity in
business around the world. Establishing a competitive advantage through effectively
managed supply chain operations requires an understanding of how the operations and
supply chain functions contribute to productivity growth. Enhanced supply chain operations
can reduce the cost of supply chain processes, and aid in value-adding integration and
collaboration with customers and suppliers.
Optimal supply chain operations are thus more sustainable and can result in minimising the
long-term cost of products and processes.
Image Credit: https://www.absoft.co.uk/media/content/0354ffda1a7a83aa808bafa3c6ed4ee6_32459.png
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Chapter 1 – KM-02-KT01: Main Techniques for Added Value through
Supply Chain Operations
The topic elements to be covered in this chapter include:
KT0101 Obtain supplies to the organisation’s requirements
KT0102 Secure competitive pricing
KT0103 Achieve quality supplies
KT0104 Secure required quantities at required timescales
The internal assessment criteria or learning outcomes relevant to this chapter are as
follows:
IAC0101 Describe the five rights of supply chain
IAC0102
IAC0103 List sources of added value
IAC0104 Define value for money
Describe how best to obtain quotations on prices through the use of
IAC0105 competition, and historical price analysis
IAC0106 Describe suppliers' approaches to pricing
IAC0107
IAC0108 Discuss the link between costs and prices
Describe the approach to negotiating improved prices
IAC0109 Discuss the process of securing competitive pricing through competition or
IAC0110 collaboration with suppliers
IAC0111
IAC0112 Identify the most appropriate technique of measuring achieved savings
IAC0113 Define quality standards, processes, and procedures
IAC0114 Discuss the use of quality assurance in the supply chain
Distinguish between internal, external, and total lead time
IAC0115
Discuss techniques to expedite and measure delivery performance
Consider the role of scheduling, planning milestones and activities and its
impact on the supply chain
Identify techniques to optimise value add through effective inventories and
low costs
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KT0101: Obtain supplies to the organisation’s requirements.
Knowledge Theory (KT) and corresponding Internal Assessment Criteria (IAC) / Learning
Objectives (LO) covered:
KT0101 Obtain supplies to the organisation’s requirements
IAC0101 Describe the five rights of supply chain
In its most basic sense, obtaining supplies to the organisation’s requirements is essentially a
procurement and/or sourcing function.
1Most organisations use terms like Sourcing and Procurement interchangeably, yet the
fundamentals of supply chain regard these as separate processes.
Sourcing is often defined as the outcome of management decisions to improve the bottom
line (i.e., reduce travel spend by 5% in the next three years), whereas Procurement refers to
streamlining business processes and the tools available to action the sourcing decision in
place.
The following are the main differences between sourcing and procurement:
Sourcing:
Precedes procurement and is often the qualifier for procurement activities.
Sourcing is strategic in nature as it involves:
o Finding new suppliers
o Getting Request for Quotes (RFQ’s) for the best possible price for raw
materials, consumables and other supplies of goods or services.
Sourcing helps evaluating suppliers.
Sourcing activities involve:
o Getting RFQ’s for new products
o Obtaining vendor information
o Uploading the vendor information into the system
o Minimum order quantity
o Standard packing quantity
o Lead time
o Pricing
1 https://www.absoft.co.uk/blog-article/sourcing-procurement-what-is-available-in-sap 6
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These activities could be one time or frequent depending on the size and nature of
the business, it also involves capturing price changes and other factors that may
affect a business process of a given company in the system.
Procurement:
Follows sourcing.
It is operational in nature as it is a frequent process of:
o Placing a purchase order (PO) with a supplier
o Getting confirmation of the order
o Follow up with the supplier until receipt of delivery.
Involves invoicing when Accounts Payable is not a separate business function.
Typical Sourcing Flow
Typical Procurement Flow
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The five rights of supply chain
Risk is something that is inherently present throughout the supply chain. As such, all risks
must be properly identified, mitigated against, and managed. The proper execution of
certain supply chain management functions such as procurement and/or sourcing must
therefore be conducted under the ‘right’ framework or set of guiding principles in order to
optimise the efficiency of the supply chain.
In general, there are five fundamental ‘rights’ under which supply chain transactions
particularly in the procurement space are executed. The five rights are sometimes covered
in procurement literature as ‘key performance variables’ or ‘procurement factors’2.
These Five Rights3 are:
1. The ‘Right Quality’
A company must purchase goods that are of satisfactory quality and fit for purpose.
They must be suited to internal and external customer needs.
This is attained through:
Getting accurate specifications of product requirements and quality
standards.
Supplier-side and buyer-side quality management. A good working
relationship between buyer and supplier is crucial and the development and
maintenance of these relationships is crucial.4 The relationship between
buyer and supplier is, however, often a constant tug-of-war by both sides.
Suppliers may complain that buyers give short notice on orders while buyers
may on the other hand complain that suppliers do not deliver the orders on
time or that the quality of the product is no correct. The truth is that both
sides need each other, and the management of these relationships is key to
good business practice.
Implications of the ‘right quality’ not being achieved could mean that:
Stock may have to be rejected or scrapped. This would be dependent on the
extent to which the product varies from the requested quality.
Production machinery could be damaged where the product has to be
manufactured to specific specifications and cheaper materials are used.
Finished products could be defective and must be scrapped or re-worked.
If the defective products reach the customer, this could result in recalls,
returns, compensation claims, lost goodwill and damaged of the company’s
reputation.
The firm will incur unnecessary costs decreasing profitability.
2 Abouzied E, The Five Rights of Procurement, https://procure-web.com/the-five-rights-of-procurement/ 5 April 2019.
3 Chong R, The Five Rights of Procurement, Jan 2017, https://www.sitespade.com/single-post/2017/01/05/The-Five-Rights-
of-Procurement 5 April 2019: Abouzied E, ibid.
4 RBW Logistics, The 4 biggest challenges in managing supplier- buyer relationships, http://blog.rbwlogistics.com/4-
challenges-with-balancing-the-buyer-supplier-relationship-and-tips-to-overcome5 April 2010.
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2. In the ‘Right Quantity’
This implies obtaining goods in sufficient quantity to meet demand and maintain
service levels while minimising excess stock holding as this leads to incurring costs
and risks.
This is attained through:
Demand forecasting - This is the process of predicting the future demand for
the firm’s product (or services) and is made up of a series of steps that
involve the anticipation of demand for a product in future under both
controllable and non-controllable factors.5
Inventory management - This is the management of inventory and stock. It
includes aspects such as controlling and overseeing ordering inventory,
storage of inventory, and controlling the amount of product for sale.6
Stock replenishment systems - Inventory replenishment or stock
replenishment is the process of inventory moving from reserve storage to
primary storage, then onto picking locations. Inventory replenishment is
sometimes used to define both ready-to-sell inventory as well as raw
materials received from suppliers.7 To ensure that they have the correct
stocks on hand, it is important that firms have a proper inventory
replenishment system.
Implications of the ‘right quantity’ not being achieved could mean that:
There could be insufficient stock being held which could lead to failure to
meet demand.
There could be stockouts which may cause bottlenecks or shutdowns in
production; costs of idle time; late delivery to customers, lost credibility,
goodwill, and sales.
There could be excess stock which may tie up capital in ‘idle’ stock. This
would result in a wasting of storage space. The risk of stock deterioration or
perishing, theft or damage, obsolescence, or disuse, would increase. Firms
will also incur holding costs.
3. At the ‘Right Place’
The delivery of goods has to be made at the correct delivery point. Goods must also
be packaged and transported in such a way as to secure their safe arrival in good
condition.
This is attained through:
5 Business Jargons, Demand Forecasting, https://businessjargons.com/demand-forecasting.html5 April 2019. 9
6 Trade Gecko, What is inventory management? https://www.tradegecko.com/learning-center/what-is-inventory-
management5 April 2019
7 Glynn F, What is Inventory replenishment? https://6river.com/what-is-inventory-replenishment/5 April 2019.
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Distribution and transport planning - This is a systematic approach which
ensures that the process around the delivery of goods to different
distribution centres is done properly.
Planners are constantly aware of which goods are to be supplied in what
quantity and at what location in the desired time.8 Planners consider demand
trends over the years, accounting for seasonal variations and also the
anticipated demand according to the current year’s prediction.
Where distribution planning is done correctly, it increases efficiency. Goods
shortages will be minimised as demand is accounted for during the time of
distribution and costs of ordering, transporting, and holding goods is also
reduced considerably.
Implications of the ‘right place’ not being achieved in terms of delivery could mean
that:
When goods are delivered to the wrong place, delays emerge, and correction
costs are incurred.
Products will be subject to unnecessary transport and handling (and related
costs).
Extended handling and transportation increase the risk of damage,
contamination, or theft in transit.
Transport may cause unnecessary environmental damage.
4. At the ‘Right Time’
Goods must be delivered at the right time in order to meet demand, but also not too
early as to lead to the incurring of unnecessary inventory costs. This for example is
tied into ‘Just-In-Time’ (JIT) and ‘Just-In-Sequence’ (JIT) delivery systems and is
secured through:
Demand management - Demand management within supply chain
management is an over-arching, cross-functional process that ranges from
market sensing and sizing, understanding customers, forecasting, and
influencing demand (sometimes called demand shaping, which includes
pricing and promotions), to supplier forecasting to demand capture to
analytics.”9
Supplier management - Because organisations are under pressure to find the
most profitable ways to bring products to market, they increasingly rely on
third parties and outsourced relationships. It is important that they have a
highly collaborative working relationship with their suppliers. Visibility into an
organisations suppliers’ business processes that impact its customers is
fundamental to that business’ success.10 The management of these
8 MBA sk. Definition, Distribution planning, https://www.mbaskool.com/business-concepts/operations-logistics-supply-
chain-terms/15951-distribution-planning.html5 April 2019.
9Teck target, what is the true definition of demand management, https://searcherp.techtarget.com/answer/Whats-the-
true-definition-of-demand-management5 April 2019.
10Viewlocity, Supplier Management, http://www.viewlocity.com/solutions/supplier-management.htm 5 April 2019.
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collaborations is supplier management and is part of the broader aspects of
integrated supply chains.
Implications of the ‘right time’ not being achieved could mean that:
Goods may be delivered too late thus leading to production bottlenecks and
associated costs. This could lead to delays in delivery to customers,
depending on the nature of the product and the stage of delayed production.
Where goods are too early, this could lead to undue risks and increased costs
of holding inventory.
5. At the ‘Right Price’
All of the above ‘rights’ should be secured at a price which is reasonable, fair,
competitive and affordable. Procurement costs can be minimised, and profits can be
maximised, through:
Price analysis - This is the evaluation of bid prices through:11
i. comparing submitted bids or quotations,
ii. comparing current quotations with previous quotations for the same
or similar items,
iii. comparison with own cost estimates, and (4) the use of standard
measures.
Supplier cost analysis - This is analysis of the supply chain activities, mainly
on the supply side, by procurement personnel will reveal in some cases
process delays, repetition of work processes, redundancies and or waste. 12
Competitive pricing and negotiation – Suppliers are often open to and
willing to negotiate their pricing in a manner that leads to win-win situations
because the well-being and sustainability of their customers ids often tied to
theirs. Furthermore, when issues have been identified from a supplier cost
analysis exercise, they can accordingly be taken up with suppliers and more
appropriate pricing levels can be negotiated.
Implications of the ‘right price’ not being achieved could mean that:
Suppliers are free to charge what they like, without checking.
Alternatively, supplier’s profit margins will be unfairly reduced, leading to
insecurity of supply.
Materials and supply costs will rise.
Profits may decline. Thus, in order to mitigate the loss of revenue or profits,
prices charged to customers will have to rise, which in turn may lead to lost
sales.
11 Business Dictionary, http://www.businessdictionary.com/definition/price-analysis.html 5 April 2019. 11
12Linkedin, Nyika C, Strategic cost analysis in procurement, https://www.linkedin.com/pulse/strategic-cost-analysis-
procurement-charles-nyika 5 April 2019.
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Falling profit margins are a disincentive to shareholders and discourage re-
investment in the business.
These ‘rights’ are both simple and critical to the successful operations of any entity. Each
right requires serious market research and insight, knowledge and understanding of one’s
target market, product, competitors, and supply chain. It is also a criterion, against which a
procurement function is measured, and an acid test, of whether it makes meaningful
contributions to an organisation.
The true meaning of these ‘Five Rights’ differs from industry to industry. Because of the
general description of these rights a blanket meaning has been given to the ‘Five Rights’
throughout all spheres of industry. They are called the ‘Five Rights’ for ease of reference.13
These rights do not negate the value that can be derived from an efficient supply chain. The
‘right’ individual makes the ‘Five Rights’ come alive and makes a difference between the
success and failure of a supply chain.
The rights individual(s) can therefore be the differentiating factor that makes the most
important value proposition to any organisation’s supply chain. They help remove elements
of risk from the supply chain.
With regard to trained and skilled staff, it means that organisations that do not identify the
right individuals are bound to obtain mediocre, moderate, or unimpressive results.
Conversely, organisations that identify the right combination of skills in an individual stand a
better chance of making it in the real world.
Where organisations strive to be on the leading edge of commerce, the right differentiator
is a blessing. A differentiator is someone who is competent – the sum of their knowledge,
skill and attributes effectively and efficiently meets the needs of an organisation.
Competence is the ability to do a task effectively. It has also been defined as an area or
areas of personal capability that enable employees to successfully perform their jobs by
achieving outcomes or successfully performing tasks.
Therefore, it is imperative that organisations strive to obtain the right incumbents for
employment or adopt strategies such as job training and coaching to skill their existing
workforce.
Furthermore, individuals should try to reciprocate the gesture by ensuring that they adopt a
workable personal development plan that would make them become better and make a
difference in the success of their organisations.
Depending on the scope, complexity, value, and risky nature of the job a mismatch maybe
risky but will depend on the risk appetite of the organisation. In the South African context
for instance, because of BBBEE rating and scorecards, most organisations may accept
individuals with defined criteria only to boost their Employment Equity ratings without
consideration to also ensuring the necessary transfer and acquisition of transformative skills
which in turn would build capacity and competency of individuals and the organisation as a
whole.
It is thus important to always make strategic decisions in full view of the relevant internal
and external factors relevant to the organisation.
13 Op cit 1 12
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KT0102: Secure competitive pricing
Knowledge Theory (KT) and corresponding Internal Assessment Criteria (IAC) / Learning
Objectives (LO) covered:
KT0102 Secure competitive pricing
IAC0102 List sources of added value
IAC0103 Define value for money
IAC0104 Describe how best to obtain quotations on prices through the use of
competition, and historical price analysis
IAC0105 Describe suppliers' approaches to pricing
IAC0106 Discuss the link between costs and prices
IAC0107 Describe the approach to negotiating improved prices
IAC0108 Discuss the process of securing competitive pricing through competition or
collaboration with suppliers
IAC0109 Identify the most appropriate technique of measuring achieved savings
Sources of added value in the supply chain
Value-added describes the improvement or additional value a company gives its product or
service before offering the product to customers. Value-added applies to “instances where a
firm takes a product that may be considered a homogeneous product, with few differences
(if any) from that of a competitor and provides potential customers with a feature or add-
on that gives it a greater sense of value.14”
Adding value can either increase the product's price or value. Offering one year of free
support on a new computer or a life-time guarantee, as with AMC pots, would be a value-
added feature. Additionally, individuals can add value to services that they perform. This
would include bringing advanced financial modelling skills to a position in which the hiring
manager had not foreseen the need for such skills or with insurance companies, returning a
certain percentage of the client’s insurance premium yearly where the client has not been a
car accident etc.
In the digital age, when consumers can have access to almost any product they want, and
have it delivered in record time, companies can struggle to find a competitive advantage.
Companies are therefore being constantly challenged to find a way to add value to justify
their pricing to a more discerning market.
Companies are also learning that consumers are less focused on the product, and more
focused on what the product will do for them. Finding out what the customer truly values is
critical to how the company produces, packages, markets and delivers its products.15
An example is Bose Corporation which has successfully changed its focus from being a
company that produces speakers to a company that delivers an uncommon sound
experience.
14https://www.investopedia.com/terms/v/valueadded.asp 11 December 2017. 13
15 Ibid.
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When a BMW rolls off the assembly line, it sells for a high premium above the cost of
production because of its reputation for high performance and sturdy mechanics. The
added value has been created through the brand and years of refinement. It has through
consistent performance built up a level of trust upon which it can base its claims. This is
called consumer goodwill.
Thus, in general, value added is the difference between the price of a product or service and
the cost of producing it. The price is determined by what customers are willing to pay based
on their perceived value. Value is added or created in different ways.
Strong Branding16
Companies that build strong brands add value just by adding their logo to a product. Nike
Inc. can sell shoes at a much higher price than some competitors, even though
their production costs are similar. The Nike brand, which shows up on athletic apparel and
uniforms of the top college and professional sports teams, is perceived as being a quality
enjoyed by elite athletes. In South Africa, Discovery, Vodacom and FNB are amongst the
most valuable and recognised South African brands.
Superior Service and Additional Features and Benefits17
Buyers of luxury cars from BMW and Mercedes-Benz are willing to pay a premium price for
their vehicles because of the ongoing maintenance programs that the companies offer. The
brands are also associated with luxury and social achievement as well as the status appeal
attached to the product.
Amazon has been at the forefront of e-customer service due its policies of issuing
automatic refunds for poor service, free shipping, and price guarantees on pre-ordered
items. Consumers have become so used to their services that they are willing to pay annual
fees for Amazon Prime memberships for access to the two-day turnaround on orders.
The concept of adding value can be either product specific, i.e., looking at how to add value
to a particular product or adding value through the supply chain.
Product specific ‘value added’ would be linked to value -added through procurement while
in supply chain specific ‘value added’ we are looking at sources of value added within and
across the supply chain.
18Value-adding activities transform materials and information into something the customer
wants. Non–value-adding activities consume resources and do not directly contribute to the
end result desired by the customer.
19The value stream consists of the value-adding and non–value-adding activities required to
design, order, and provide a product or service from concept to launch, order to delivery,
and raw materials to customer.
16 https://www.investopedia.com/terms/v/valueadded.asp 11 December 2017. 14
17 Ibid.
18 Jacobs, FR and Chase, RB (2018) Operations and Supply Chain Management. New York: McGraw-Hill Education.
19 Jacobs, FR and Chase, RB (2018) Operations and Supply Chain Management. New York: McGraw-Hill Education.
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When applied to supply chains, waste reduction relates to the optimization of the value-
adding activities and the elimination of non–value-adding activities that are part of the
value stream.
Value added through the supply chain.
Supply chains seek to add value to production and distribution. Depending upon the
markets and the value chains they are servicing, supply chains can be differentiated from
others according to criteria such as costs, time reliability and risk. Efficient logistics can
contribute to added value in four major interrelated ways:20
Decreased production costs 21 - These are derived from the improved efficiency of
manufacturing with appropriate shipment size, packaging, and inventory levels.
Logistics can therefore contribute to the reduction of production costs by
streamlining the supply chain.
Location - Logistics adds value by taking better advantage of various locations. This
provides access to expanded markets and more customers with lower distribution
costs.
Time - Added value is obtained from having goods and services available when
required along the supply chain (e.g., lower lead times) with better inventory and
transportation management.
Control - Added value comes from controlling most, if not all, the stages along the
supply chain, from production to distribution. By synchronising cycles and lead times
more efficiently, logistics creates a better marketing and demand response. This
results in greater ability to anticipate flows and provide for the allocation of
distribution resources accordingly.
A variety of factors work together to shape the configuration of supply chains22:
Logistics costs - These are all the costs incurred to make products available to the
final consumer, namely transport, warehousing, and transhipment. Supply chain
managers are particularly sensitive to the stability of the cost structure and seek
consistency in costing, Routes that have cost fluctuations may be discarded in favour
of routes with higher cost, but with less volatility. Costs are therefore a standard
criterion in which the cheapest routing option is sought, so long as the cost structure
remains stable because supply chains are unlikely to be modified if a cost advantage
is only temporary. The concept of cost is relative as its importance is directly linked
to the value of the cargo being carried.
Cost considerations become more important when dealing with more containerised
goods that have a low value, such as commodities (e.g., paper) than with high value
goods (e.g., electronics).
Transit time - This s a factor that is increasingly being considered because it strongly
influences inventory carrying costs and inventory cycle time in supply chain
management.
20https://people.hofstra.edu/geotrans/eng/ch5en/conc5en/logisticsaddedvalue.html 11 December 2017. 15
21 Ibid.
22 Ibid.
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For cargo that has a higher value for example electronic goods or clothing or is
perishable as in reefers goods, the routing option that is the fastest and/or shortest
will be preferred.
Reliability - Relates to a factor that is mitigated by current supply chain management
practices. For many supply chains, time can be a secondary factor if shipments arrive
at the distribution centre within an expected time frame. Where shipments are
regular, and this reliability remains consistent, it is possible to organise supply chains
accordingly. Provision can be made to have more inventory in transit.
Supply chain risk - Relates to a factor that is generally unnoticeable and involves the
level of confidence parties have that the shipment will reach its final destination
within expected costs, time, and reliability considerations. In some cases, additional
risks that can also involve potential cargo damage or theft. Low risks routes are
preferred over higher risk routes.
Product specific sources of value added.
The real sources of value -added are those factors that result in higher capacities for
generating cash flow, they can emanate from various aspects. These include:
great customer service,
great products,
extremely efficient operations: and
A firm’s ability to innovate. Tom Peters has pointed out in his book The Circle of
Innovation, that innovation is what separates winners from losers when it comes to
value-creation.23
Value -added through innovation.24
Peter Drucker, the father of modern management, once declared that “the ability to
innovate is the one core competency every organisation must have.” innovation is critically
important because of change. Markets are constantly changing and being transformed.
With change, companies are forced to innovate, they can choose to be reactive, forcing
themselves to innovate thus changing what you they are doing, or they can be pro-active,
purposely seeking to innovate in order to control the changes forced upon them. As might
be expected: the latter more deliberate pursuit of innovation is the “value added” option.
So how do we create innovation? Innovation is fuelled through ideas. Ideas bring about
innovation and ideas are fuelled by creativity. Creativity emerges from people with different
skill sets who work together to spark innovation from one another. Creativity must be
pursued in the right environment.
People need to feel they can raise questions and take the initiative needed for innovation.
The combination of competent people and the right environment is a powerful force for
creativity and innovation.
23 http://www.exinfm.com/board/measuring_sources_of_value.htm 11 December 2017. 16
24 http://www.exinfm.com/board/value_through_innovation.htm 11 December 2017.
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A common approach to innovation is through new product development. While there is
nothing wrong with redesigning products and services, innovation should not be limited to
this single area.
Innovation can take place by changing the customer mix, adjusting the business strategy,
rethinking how a company applies its core competencies and managing complex differently.
There are many areas where innovation can take place.
The timing of innovation is really important. The best time to pursue innovation is when the
company least needs it. Because innovation does not happen easily, it is best to pursue
innovation when all is going well. A company should not have to force innovation during bad
times or especially, during a crisis. Time is required to test alternatives, run pilot programs,
and discuss results and shortcomings before full-scale implementation of new ideas can be
launched.
In his book ‘Idea Power: Techniques and Resources to Unleash Creativity in Your
Organisation’, author Arthur B. van Gundy outlines seven important factors for creating a
climate for innovation:25
1. “Risk Taking – Any change requires some acceptance of risk.
2. Autonomy – Creative ideas are best generated when there is some degree of
freedom of thought.
3. Performance / Reward – You must link rewards to specific performance.
4. Tolerance of Differences – An innovative climate recognises that everyone is not
alike, and innovation works when everyone can express their ideas.
5. Top Management Support – Creating an innovative climate begins at the top, not at
the bottom.
6. Initiating and Encouraging Ideas – Innovation requires a continuous flow of ideas –
lifeblood of the organisation.
7. Positive Response – Innovative ideas should receive strong positive response, not
just passive encouragement.”
Another powerful driver behind innovation is comparison. This involves studying the ideas
of one’s competitors and other companies, monitoring business innovation on a large scale
and seeing how those changes can be adapted to fit an organisations goals and strategy
framework. The best ideas that fuel innovation usually come from existing ideas. This is how
the many Japanese companies captured market share in the United States.
Borrowing of existing ideas is permissible. The genius comes in adopting it for that particular
companies’ specific needs.
In this regard, some questions for consideration could be:
“What could you adopt?
What could you substitute in the approach, materials, ingredients, or appearance?
What could you combine with an existing idea?
What could you magnify or minimise?
25 Ibid. 17
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How could you put it to other uses?
What could you eliminate?
What could you reverse?
What could you bring back?”
Business experts agree that innovation is at the core of business growth. Over half of all
growth in the United States comes from new products and services. In South Africa,
innovation has been greatly lacking and the World Bank has encouraged South African
business and government to turn to greater innovation in order to turn around the ailing
economy.26 We now see books titled: “If It Ain't Broke, Break It“, which emphasise the need
to jump start innovation or in Tom Peter's book The Circle of Innovation , the
transformation of the CEO into a Chief Destruction Officer.
Two major drivers behind innovation are creativity and existing ideas. Creativity involves risk
and the acceptance of failure. Ideas, on the other hand, are usually a function of watching
and learning from others, finding ways of how to apply, and fit the best ideas of others into
one’s business.27
Value for money (VFM)
The Global Negotiator defines value for money “as a measure of quality that assesses the
monetary cost of the product or service against the quality and/or benefits of that product
or service, taking into account subjective factors such as fitness for purpose, along with
whole-of-life costs such as installation, training, maintenance and disposal, and wastage.28”
Regardless of how it sounds, value for money is more than just saving money. Instead, it is
rather about ensuring that the business is efficient, effective, and economical.29 While many
analysts use these three factors to measure VFM, these lists elements are basic to
determining VFM but are not exhaustive, as the Independent Commission for Aid Impact
(ICAL)30adds equity as an additional element.31
Efficiency
This is a measure of productivity, that is, how much you get out in relation to what you put
in. It is the efficiency of converting resources or inputs into results or outputs. It is also
defined as the value of outcomes in relation to the total cost of inputs.32
Effectiveness
This measures the impact of obtaining value for money. It can be quantitative (the amount
of effectiveness) or qualitative (the value of effectiveness).
26 Times live, Get real about innovation to grow the economy, South Africa is told, https://www.timeslive.co.za/sunday-
times/business/2017-09-20-get-real-about-innovation-to-grow-the-economy-sa-is-told/8 April 2019.
27 Ibid.
28http://www.globalnegotiator.com/international-trade/dictionary/value-money-vfm/ 11 December 2017.
29https://www.gatesheadhousing.co.uk/value-for-money/ 11 December 2017.
30 https://icai.independent.gov.uk/8 8 April 2019
31 Better Evaluation, VFM, https://betterevaluation.org/en/evaluation-options/value_for_money 8 April 2019.
32 Ibid
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It is also viewed as the extent to which program outcomes are achieved in relation to the
total cost of inputs. Equity considerations are sometimes factored in here.33 Where total
project objectives are achieved without additional costs or having incurred projected costs,
there was effective use of resources.
Economical
This is the price paid, the impact on people as well as actual money spent, for providing a
service at best value, having taken price and quality into account. Put more simply, inputs
have been obtained at the least cost for the relevant level of quality.34
Equity
Business must ensure that the benefits obtained are distributed fairly. For example, a
government - run small business incentive program (such as the DTI small business incentive
schemes) that did not reach the most remote and vulnerable parts of the population may be
seen as inequitable.
Tools for measuring VFM:35
There are six main methods that are currently used to determine VFM. The six methods can
be broken down into three sets of methods that each evaluate VFM in different ways. Each
of these methods and sets of methods is summarised below:
Cost Effectiveness Analysis and Cost Utility analysis. They are useful for evaluating
programs that aim to reach the same goal. These methods evaluate the
effectiveness of programs in non-monetary terms. For education programs this
might mean a goal to increase school enrolment, attendance, completion, or overall
degrees attained. Qualitative measures could be cognitive development, academic
achievement, or non-cognitive skills. The difference between the two methods is
that CU takes the perspectives of beneficiaries into account. A well-known
application of CU analysis in the health sector is the use of Quality Adjusted Life
Years (QALYs). The QALY evaluates programs according to how they extend life
expectancy while also improving the quality of each year lived. This indicator would,
of necessity, involves working with beneficiaries to determine their satisfaction from
different health programs.
Cost benefit analysis and Social return on investment evaluate whether a program or
project is beneficial in an absolute sense. The question raised here is: do the benefits
outweigh the costs? To make this assessment, they both evaluate outcomes in
monetary terms. Because of the use of a common currency, the methods allow for
comparison of programs with different objectives or from different sectors. The
difference these methods is that SROI measures social, environmental, and
economic costs and benefits.
Rank correlation of cost vs impact and Basic Efficiency Resource Analysis. These both
evaluate the relative costs and benefits of many programs. The first method ranks
and correlates costs and impact while the second examines relative value by plotting
programs on a four-quadrant graph based on costs and impacts.
33 Better Evaluation, Ibid. 19
34 Ibid
35 Ibid.
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Securing value for money
VFM is secured by continually assessing opportunities that enhance customer services and
actively involve employees and customers in the quest of achieving value for money.
The best value for money is found by sourcing the best materials at the best price.
Companies should continually be looking for ways to make their services work more
efficiently and effectively. A culture of “do the right things” and “do things right”, helps
ensure that service delivery is equitable, efficient, effective, and economical.36
Obtaining quotations on prices using competition and historical price analysis
To get the right price, businesses need to research their market and understand pricing and
commodity trends. Businesses will often ask for quotations from suppliers. In many
businesses, suppliers seek to create relationships with big manufacturing concerns in order
to become a part of the supply chain. In this section, we will discuss and define quotations,
the ways in which firms obtain quotations using competition, historical data, and price
analysis.
Quotations37:
In its most basic definition, a quotation is a “38formal statement setting out the estimated
cost for a particular job or service”.
The Business Dictionary defines quotations as “either contracts or securities.”
1. Contracts: A formal statement of promise that is usually submitted in response to a
request for quotation by a potential supplier to supply the goods or services required by
a buyer, at specified prices, and within a specified period. A quotation may also contain
the terms of sale and payment, as well as warranties. Acceptance of the quotation by the
buyer constitutes an agreement binding on both parties. In line with South African law,
where a buyer offers different terms that means that the original quote terms have been
rejected and parties have entered into a period of negotiation.39
2. Securities: “The bid and asked price cited for the sale or purchase of a commodity or
security.40”
A Request for Quote
A request for quotation (RFQ) is “a standard business process whose purpose is to invite
suppliers into a bidding process to bid on specific products or services. RFQ generally means
the same thing as IFB (Invitation for Bid). An RFQ typically involves more than the price per
item.41”
36 Ibid
37 http://www.businessdictionary.com/definition/quotation.html 11 December 2017.
38 https://en.oxforddictionaries.com/definition/quotation
39 Business Balls, Contracts and Agreements, Legal Terms and Definitions Glossary, https://www.businessballs.com/legal-
and-procurement/contracts-and-agreements-legal-terms-and-definitions-glossary/8 April 2019.
40 Ibid.
41https://en.wikipedia.org/wiki/Request_for_quotation 11 December 2017.
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Comparison of Competitive Bids42
The best, most effective way to create competition is to ask for two or more written bids.
While three bids are preferred this is not always possible. This comparative method ensures
that the selected supplier is providing goods and services in the most cost-effective manner.
Business best practices encourage the use of written competitive bidding at all levels of
purchasing43 This is one of the best means for proving the accuracy of prices. By asking three
or more suppliers for their prices for the same product, a firm can determine if a particular
price is reasonable. This does not prevent total cost analysis, however. The lowest bid does
not always represent the lowest cost. The total cost of acquisition must always be analysed.
There may be costs associated with making the lower cost product perform to standards.
These costs include the additional cost of early replacement or the cost of redesign and/or
testing required to make the lower cost product applicable. This total cost of acquisition is
the main cost that must be compared. A brief statement as to why a quotation is selected is
required.
Historical Data Analysis44:
In the world of active trading, market participants dedicate substantial time and effort to
gaining insight into how a market’s past behaviour relates to its future. Obtaining timely
market data and relevant news accumulates large capital allocations. Firms around the
world spend nearly US$27 billion on market-related information annually.45 Whether a firm
approach to the marketplace is rooted in fundamental or technical analysis, profitability
depends on the recognising future opportunities and eliminating past mistakes.
Historical data analysis is” the study of market behaviour over a given period of time.” The
phrase “market behaviour” is used to refer to the many different facets of the market and
their interactions. Recorded market-related information such as price, volatility and volume
can be measured and studied over a defined period.
Through detailed examination of a market’s past behaviour, traders and investors can gain
understanding on the inner workings of the market. The information obtained in the
process may prove useful in developing a competitive trading plan or improving an existing
methodology.
Historical data analysis can be useful in several ways46:
Market insight: Intensive and in-depth study of the past behaviour of a financial
instrument or market can provide a trader with an idea of which revealed
characteristics are normal and which are extraordinary.
System development: A clear definition of when, what, and how to trade in a given
market are the beginning points for the creation of a trading system. Historical data
analysis provides a means for a statistical edge to be identified and developed for
active trade.
42 https://www.whoi.edu/procurement/price-analysis-techniques11 December 2017. 21
43 https://www.whoi.edu/procurement/competition-bidding 11 December 2017.
44https://www.fxcm.com/insights/what-is-historical-data-analysis/11 December 2017.
45 This is based on 2017 data. These figures are increasing as the correct data if critical to correct decision making.
46 Ibid.
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Consistency: The selection of trades with a predefined expectation gives the trader
confidence in the potential outcome. Understanding how a given trade has
performed over time reduces unexpected results.
George Santayana is the author of the phrase: those who cannot remember the past are
doomed to repeat it. “ The discipline of historical data analysis aspires to equip businesses
to avoid the mistakes of the past and establish a working advantage moving into the future.
Historical price analysis:47
Historical Quotes provides up to 10 years of daily historical stock prices and volumes for
each stock and can indicate the future direction of a stock. An example of historical prices
was taken from the NASDAQ.
Results for: 3 Month, From 08-SEP-2017 TO 08-DEC-201748
Date Open High Low Close / Last Volume
12/08/2017 1.52 1.6 1.52 1.54 217,243
12/07/2017 1.5 1.55 1.5 1.52 193,841
12/06/2017 1.5 1.524 1.5 1.51 264,205
12/05/2017 1.52 1.57 1.5 1.5 335,471
12/04/2017 1.64 1.67 1.53 1.53 404,163
12/01/2017 1.69 1.69 1.57 1.63 412,868
11/30/2017 1.69 1.71 1.66 1.69 322,880
11/29/2017 1.73 1.75 1.65 1.68 352,043
11/28/2017 1.7 1.76 1.68 1.73 447,280
11/27/2017 1.7 1.77 1.65 1.68 811,068
11/24/2017 1.66 1.7 1.62 1.7 357,167
11/22/2017 1.58 1.64 1.56 1.63 679,473
11/21/2017 1.45 1.59 1.45 1.56 910,260
47 http://www.nasdaq.com/quotes/historical-quotes.aspx 11 December 2017. 22
48http://www.nasdaq.com/symbol/mvis/historical 11 December 2017.
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Date Open High Low Close / Last Volume
11/20/2017 1.4 1.45 848,958
11/17/2017 1.45 1.49 1.41 1.46 605,994
11/16/2017 1.36 1.49 1,777,002
11/15/2017 1.48 1.4855 1.55 1.57 471,094
11/14/2017 1.56 1.58 210,733
11/13/2017 1.59 1.6 1.56 1.57 347,713
11/10/2017 1.56 1.64 564,963
11/09/2017 1.58 1.6199 1.55 1.6 524,620
1.56 1.6
1.65 1.65
1.56 1.66
1.62 1.64
Comparison of Prior Quotations:49
In some circumstances, it may be most effective to compare recent quotations for the same
product or service to determine how appropriate a current quotation is. Recent prices are
those which occurred within a 24-month period. This is helpful when the timing of the
acquisition is critical and looking for competitive quotes would delay the procurement. An
explanation must accompany the use of this procedure and reasons given as to why the
method of comparison of prior quotations was used.
Comparison of Published Price List
This method should only be used where materials are sufficiently similar to items or services
are available to the general public and whose price would appear in a published price list. In
comparing these price lists, it is important to consider standard industry discounts for the
items or services. As an example, most wholesalers will offer standard discounts to
purchasers for a particular rand or quantity volume. These discounts must be considered
when comparing list prices and noted in the procurement documentation.
Prices Set by Law or Regulation
Prices can also be set by a law or regulation. When this occurs, there is usually a
government pronouncement of some form type that references the pricing structure. This
must be referenced when procuring such items.
49 https://www.whoi.edu/procurement/price-analysis-techniques 11 December 2017 23
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Similar Item Comparison
When an item or service is unique, it is possible to compare items that are similar to those
being purchased. A statement stating why the common item will not meet the specification
should accompany the price comparison.
Rough Yardstick Comparisons
This technique uses a rough comparison between like items. Comparison is based on
measurable similarities such as price per rand, cost per horsepower or price per test sample.
Again, an explanation of the similarities must accompany this analysis.
It is often difficult to find comparable items or services. In these situations, it may be
necessary to rely on a technical analysis. Although this method is time consuming, is the
best method to use when checking prices for complicated sole source items. In this analysis,
the supplier of the goods or services will be asked to provide:50
a) “A list of materials and their cost.
b) The number and kinds of labour hours required.
c) Any special tooling and facilities proposed.
d) A reasonable plan for use and disposal of scrap.
e) Any other cost, including profit, relevant to the cost of providing the service or item.”
Suppliers approaches to pricing.
Common pricing strategies
Pricing a product is one of the most important aspects of a suppliers marketing strategy.
The price of a good or service is critical to the success of a company, especially where the
service or product being sold is part of a bigger supply line towards the completion of a
finished object, for example, a motor vehicle. Generally, pricing strategies will fall into one
of these five categories mentioned below or a mix thereof. 51
1. Cost-plus pricing. This is done by simply calculating costs and adding a mark-up.
2. Competitive pricing. Here prices are set based on what the competition charges.
3. Value-based pricing. The supplier will set a price based on the value the customer
places on the good or service.
4. Price skimming. Suppliers will begin by setting a high price and lowering it as the
market evolves.
5. Penetration pricing. Here the supplier will be entering the market. By setting a low
price to enter a competitive market which they raise later a supplier can make its
product more attractive.
50 Ibid.
51 BDC, how to price your product: five common pricing strategies, https://www.bdc.ca/en/articles-tools/marketing-sales-
export/marketing/pages/pricing-5-common-strate10 April 2019.
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These strategies are discussed in a bit more depth below:52
1. Input cost and mark-up strategies. In many sales, a supplier must pay for materials
and/or labour that are needed to manufacture or provide the goods or services
provided to the buyer. Suppliers want to recoup those expenses, which are called
direct costs together with an additional percentage which is called a mark-up. Pricing
would therefore include direct costs plus a mark-up cover indirect costs and profit.
For services where the direct costs of serving a single customer cannot be easily
determined, the supplier's overall profit margin goals will guide pricing decisions.
2. Pricing of the Competition. Where the supplier's mark-up percentage was too high,
customers will source their goods or services elsewhere. The pricing of competing
suppliers will therefore influence some suppliers pricing strategies. They may limit
their mark-up in order to match or beat competitors' pricing.
3. Buyers' ability or willingness to pay. For certain categories, suppliers will determine
their pricing by how much they anticipate that a certain buyer or buyers are willing
to pay. Where the buyer is not too concerned with pricing e.g., where a big company
is purchasing a low-cost service, the supplier is often able to inflate its mark-up. If on
the other hand, the buyer appears to be struggling to find the budget to make a
purchase, the supplier may be more willing to find a price point that the buyer
considers affordable while the supplier still makes a profit. This is important as the
buyer- seller relationship is mutually beneficial.
4. Sales goals or quotas. In some situations, the supplier may value revenue above
profit. This priority will be magnified where there is an imminent deadline for a sales
quota and sales are lagging. In such cases, suppliers can be flexible with pricing and
may even agree to an unprofitable sale if it can be subsidised by other higher-margin
sales.
5. Perceived Value. Some suppliers work on the philosophy that the higher something
is priced, the more likely that it will be perceived as being a higher quality product or
service. Where the supplier matches its competitors' pricing this may lead to the
perception that the product or service is cheap or of poor quality. Where this is the
case, a supplier may price their product higher than that of competitors.
Consequently, this can allow them to invest in offering a truly higher-quality product
or service.53
From the above we can see that supplier pricing is either value based, or cost based. The
differences are discussed in greater depth below.
The differences between value based and cost-based pricing methods.
Value-based pricing depends on the buyer’s subjective assessment of a product's worth,
while cost-based pricing considers what it costs the supplier to produce the product and
how much customers are willing to pay. Value-based pricing is used more for services and
cost-based pricing is utilised more for physical products.
52 https://www.nextlevelpurchasing.com/articles/supplier-pricing.php 11 December 2017. 25
53 Ibid.
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Reliance on marketing messages
Both cost-based and value-based pricing strategies rely on marketing messages. This is,
however, done in very different ways. Cost-based pricing considers price relative to that of
market competitors. A company may choose to offer a lower price, rather than using other
options to attract cost-conscious customers. They may also choose to establish a price in the
same range of other suppliers so that their product is deemed to be overpriced.
Regardless of the approach, prices are being compared with those of competitors and a
choice is made based on what the supplier believes its customers will accept. Value-based
pricing, on the other hand, uses retail cost to send a message about quality. Products such
as BMW and Mercedes and Porsche automobiles and Rolex watches are status symbols and
are regarded by their customers as being worth the additional cost.
Practical Considerations of Pricing
With cost-based pricing, a price is set between a floor amount, which is the least a supplier
can charge and still earn a living, and a ceiling amount, which is the most the market will
tolerate. Floor price offers the advantage of providing a competitive edge, with customers
looking to pay as little as possible. The supplier will need to sell more products with a lower
profit margin than it would at a higher price to earn the same net profit. Value-based pricing
enables suppliers to earn an even higher net profit, but they need to earn the respect and
trust of their customers to get them to pay more.
High-quality operations and engineering which ensures that the product works well will
enable a supplier to earn trust and respect even if the product or service does not cost extra
to produce. This can also be promoted by building a solid reputation over time and
generating word-of-mouth loyalty.
Products vs. Services54
Because physical products are made from materials that must be purchased and labour paid
for at a specific rate, they will most probably fall under a cost-based pricing strategy, rather
than under services, which are more subjectively valued. While traders and professionals
who perform services need be paid for their time, as well, their service offerings are often
less interchangeable, and are thus more value based.
The pricing of suppliers is also determined by the power of the supplier in the marketplace.
Supplier power is affected by the following factors:55
1. Number of Suppliers
A leading cause of bargaining power is the number of suppliers available to meet a
company’s demands. If a firm can choose from multiple suppliers, the suppliers’
bargaining power reduces. In the case of a monopoly or oligopoly market structure,
54 Ibid.
55 CFI, Supplier Power, https://corporatefinanceinstitute.com/resources/knowledge/economics/supplier-power/10 April
2019.
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where a supplier has the ability to dictate market prices and buyers have limited
alternative suppliers, suppliers gain a lot of bargaining power.
2. Over-reliance
Where companies agree to long-term contracts with just one or a few suppliers to
reduce supplier risk this practice favours the suppliers,. It leaves very little room for
flexibility on the part of the organisation however, Suppliers are able to exert more
control over the terms and conditions of the contract, and hence the price.
3. Switching Costs
Switching costs” refer to the additional expenses that a company will incur if it
decides to shift from one supplier to another”. These costs include setup and
configuration, infrastructure costs, legal fees, cost of customisation and more.
Where the switching costs are too high, the firm owner may just decide to stick to
their current supplier. This, in turn, gives their supplier a great deal of power.
The link between costs and pricing 56
Cost refers to the amount that a business spends in bringing a product or service to market.
Price is the amount a customer pays for that product or service. The difference between the
price that is paid and the cost that is incurred is the profit the business makes when the
product sells. If a customer pays R10 for an item that costs the company R5 to produce and
sell, the company makes a R5 profit. As prices climb, the cost-of-living increases.
When calculating the cost of goods sold, a business must include in the cost everything
necessary to produce that product.
In the case of an appliance, for example microwaves or fridges, this calculation would
include the parts, the labour to assemble the item and the appliance's transportation from
the factory to the retail location. If a business runs a retail store, the cost of the item would
also include a portion of the building's operating expenses and the sales assistants’ salary.
For items that are sold through a website rather than a physical store, for example Loot, the
expenses of designing and operating the site are included in the cost.
Business owners must factor into their cost their profit margin when setting a price. The
customer ultimately determines the price, however. Items that are priced too high may
remain unsold until the price drops to a point that matches the customer's perceived value.
Perceived value is the value which customers believe the item is worth, given their
current cost of living.
Companies can legitimise their pricing decisions by educating customers about the process
of bringing a product to market. If a product is more expensive because it includes extra
safety features that are labour-intensive to install, companies must show how the higher
price represents a better value to the customer.57
56 https://www.investopedia.com/ask/answers/101314/what-difference-between-cost-and-price.asp 11 December 2017.
57 Ibid.
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Most companies are not producing interchangeable goods in a perfect market. They have
some amount of market power and can influence prices rather than accept the market
price. They set prices to maximise profit.
This they do by considering their own costs, the behaviour of competitors, the elasticity of
demand, and various other pricing strategies. This leads us to the following phenomena:58
Loss leaders. Here goods are sold at prices below their production cost to generate
demand for other goods. A common example is the sale of video game consoles
below cost to increase sales of highly profitable games.
Price discrimination Similar goods are produced aimed at customers with different
price tolerances. The need to have items available at different price points is often
more important than production costs. The well-known example of this was
computers available with and without a math coprocessor. The lower-priced model
was more expensive to produce, since it was built with a coprocessor which was
then disabled in a separate production step.
Predatory pricing. Firms adopt artificially low prices aimed at driving competition out
of business. Once the competition is driven out of the market, prices go up.
Generally, the price of a product is related to the difficulty in obtaining it and to the desire
of buyers to obtain it. This will be the lesser of two costs: 59
1. The first situation relates to the minimum price needed to persuade one of the
current owners to transfer ownership of one of the existing products to the buyer
plus the cost of transporting it to the buyer (or the buyer to it).
2. The second situation relates to the cost of the buyer producing a new product or
persuading someone else to do so. In this case the actual price is not directly
dependent on the cost of production but rather on how much value the buyer and
the current owners of the product place on money and on the product.
That is the general situation. Some more specific cases are as follows:
Firstly, when the product can be bought from an existing owner or created at will, an
example being an axle. The most that a rational buyer is willing to pay will be the lesser of
the cost of buying from the least expensive owner without a buyer and the cost of
producing a new product. The least that a rational owner will accept is the price that
another buyer would pay the owner for the product or the price that the owner himself
would pay to replace the product, whichever is the greater. In the case where there are no
other buyers, and the owner desperately wants to get rid of the product the minimum price
may even be less than zero.
Secondly, when the product can be bought from an existing owner but cannot be created by
the buyer, a laptop, for instance. The minimum price is as above but the maximum price
does not include the option of the buyer creating the product for legal reasons. The
maximum price is therefore the cost of buying from the least expensive owner without a
buyer.
58https://www.quora.com/What-is-the-relationship-of-the-price-of-a-product-to-the-cost-of-producing-it-Is-it-directly-or-
inversely-proportional-If-it-depends-when-is-11 December 2017
59 Ibid
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Thirdly, when the product can be bought from an existing owner but cannot be created by
the buyer or the owner, a Rembrandt for instance. This is like the second case but not
identical since the current owner cannot replace the product by creating a new one.
Fourthly, when the product does not exist but can be created by the buyer, a mission to
Mars for instance. In this situation the maximum and minimum prices are identical and are
the actual cost of production.
The examples above refer to just the maximum and minimum prices. The actual price will lie
between but is dependent on the number of buyers and sellers and their preferences for
money and for the product. The actual price will therefore not be directly proportional to
the cost of production in the first two cases but there is some relation. In the third case,
there is no relation as there is no cost of production. Only in the fourth case is there a
directly proportional link between the price and the cost of production.60
Approaches to negotiating improved prices.
From the discussions above we see that prices are dependent on many factors in the market.
Where there are few suppliers and many buyers, the suppliers will hold and have the
greater negotiating power and could dictate the prices that need to be paid. It is in these
instances that the buyer will have to move strategically.
In many industries, the balance of power has dramatically shifted from buyers to suppliers.61
A classic example comes from the railway industry in the USA. In 1900 North America had
35 suppliers of cast rail wheels; railway builders could pick and choose among them. A
century later no one looking to build a railroad had this luxury, because only two suppliers
remained. Today there is just one, which means that railroad builders have no choice but to
accept the supplier’s price. In South Africa most utility suppliers are monopolies. A clear
example is Eskom. All businesses require electricity to run. Eskom, as the sole electrical
power supplier in South Africa, dictates the prices it will charge.
The shift has come about for many varied reasons, any, or all of which may be in play in a
given industry. In some industries, suppliers have eliminated their competitors by driving
down costs or developing disruptive technologies for example smartphones, cross-
functional products such as TV/ PC screens/Monitors etc.
In others, fast-growing demand for inputs has outstripped supply to such a degree that
suppliers have been able to charge what they want. Here demand for outweighs supply, so
suppliers can name their price. In other sectors, buyers have consolidated demand and
forced suppliers’ prices down so far that many suppliers exited the market. This gave the
remaining few more bargaining powers.
Regardless of the reason, companies that have lost their power with suppliers need to
approach the situation strategically. They cannot rely on hard negotiations through their
procurement offices. To help regain their strategic buying power below is an analytic
60 Ibid.
61 Paranikas P, Whiteford GP, Tevelson B, and Belz D, “How to negotiate with powerful suppliers”, Harvard Business Review,
July- August 2015 Issuehttps://hbr.org/2015/07/how-to-negotiate-with-powerful-suppliers 12 December 2017.
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process with four steps, in order of ascending risk which companies can follow. Companies
could begin by62:
1. Assessing whether they can assist the supplier realise value in other contexts. If not,
2. Considering whether they could change their buying patterns.
3. Looking at either acquiring an existing supplier or obtaining a new one.
4. If the above steps fail, they may consider taking more drastic, stringent, and firm
measures. This can have a lasting and often damaging impact on the relationship and
should be last resort.
These steps are discussed below, in detail:
1. Bring New Value to Your Supplier
This is the easiest way a buyer can redefine their relationship with a powerful
supplier. It can rebalance the power equation and turn a purely commercial
transaction into a strategic partnership. Buyers can provide new value in several
ways. For example:
a. Be a gateway to new markets - The quickest and least expensive way to
redress a power imbalance is by offering the supplier a market opportunity
that is too good to pass up in exchange for price concessions. It may take
some research to find the right incentive. An example of this is a beverage
company that was facing annual price hikes from a beverage-packaging
supplier. There seemed to be no way out as the supplier had patented its
manufacturing process, and its pricing was lower than that of other sources.
It so happened however, that the buyer was about to enter two large
developing markets which the supplier had tried but failed to get a foothold
in. The procurement manager realised that their company could give the
supplier’s products a foothold in those markets. She presented the supplier
with an offer that was hard to refuse: In exchange for a 10% global price
reduction, the company would use the supplier’s cans in the new markets.63
b. Reduce the supplier’s risks - Where a company is positioned to help a supplier
reduce its price risks, it can demand some concessions in return. For example:
a large chemical company had a single, difficult supplier.
To produce titanium dioxide, it required feedstock manufactured to tight
specifications, and only that supplier was able to meet its needs. When the
chemical company wanted to increase its order, the supplier claimed to have
limited capacity and demanded a price premium.
Because of the cyclical nature of the industry, the company realised that the
supplier would be very interested in a long-term contract This was a
commitment other customer lacked the financial strength to make. The
procurement department worked closely with a team from finance, which
62 Ibid 30
63 Ibid.
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created detailed models to determine a price range that would let the
supplier generate returns of 15% on invested capital.
The supplier then agreed to a multiyear contract which stipulated that prices
would not fluctuate more than 10% annually. The chemical company was
able to get a 10% discount from the original quote.
2. Change How You Buy
Where no opportunities exist to help the supplier create new value, a firms next best
alternative is to change their pattern of demand. This strategy can have implications
for many parts of organisation, and it requires close collaboration with any functions
that could be affected. A company can change its demand patterns in three ways. All
these avenues may require intensive data collection and analysis.
a. Consolidate purchase orders64 - This is the least-risky option and the easiest
one to implement. It only requires a company to act on an internal audit of
procurement data.
At one aircraft manufacturer, different business units were independently
purchasing components from a large supplier, which was doubling or tripling
the prices it had originally quoted. The supplier was able to achieve gross
profit margins of about 20%, whereas that of the aircraft manufacturers was
only 10%. Unreliable deliveries also drove up the manufacturer’s overall
costs. Individually, the business units lacked the power to force the supplier
to change its behaviour. The unit CEOs got together, consolidated their
spending data, and went to the supplier’s top executive with a threat to
suspend all purchases unless changes were made. The supplier became far
more responsive. It cut prices so that its margins were also about 10% and
improved the timeliness of deliveries.
Small companies who do not order through multiple units can form purchase
consortiums with other firms in their industry. In one European country an
oligopoly of four suppliers controlled the ATM market. To counterbalance the
group’s power, four banks created a purchasing consortium for ATM parts
and maintenance. This enabled them to cut their ATM costs by 25%. To be
successful, consortiums must align their members’ interests and have the
right governance structures in place. They should also not be too powerful
themselves, as this could violate competition rules. This approach is
therefore best suited to relatively fragmented, competitive industries.
b. Rethink purchasing bundles65 - When a company cannot create large
purchasing bundles within product categories or areas, it should consider
purchasing across them. A telecom company dealing with a powerful supplier
for a particular component gained price concessions by pointing out that it
also bought other components from that supplier which it could easily obtain
elsewhere.
In a similar manner a global chemical manufacturer was accustomed to
buying a key ingredient from two suppliers, one in the United States and one
64 Ibid 31
65 Ibid
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in Europe. Each supplier had a monopoly in its region. It announced that it
was considering consolidating to a single supplier and began a qualification
process to choose which one. The awarding of a single global contract would
have given the winner greater access to the loser’s monopoly territory. When
faced with the threat of competition, each supplier agreed to a 10% discount.
Sometimes the right strategy is for a firm to pick apart its existing bundles.
This will enable it to create competition among suppliers where none
previously existed. When a consumer goods company decided to renegotiate
its contract with a powerful information provider that offered an integrated
global product and services package, the procurement team realised that it
needed to differentiate between data (for which the supplier held a
monopoly in some regions) and analytic services for which the market was
generally competitive.
It also decided to negotiate at a country level. This enabled suppliers that
could cover some but not all regions to participate. As a result, it obtained
savings of 10% on data and 20% on analytics.
c. Decrease purchase volume66 - The third way to change demand is to shift
volume away from a powerful supplier. This could ideally be done by
switching to a substitute or lower-cost product. The mere threat of this
change can increase the supplier’s openness to negotiation. The buyer’s
organisation needs to support its negotiation team and be willing to revisit
what it purchases. Determined to reduce IT costs, a retailer decided that
most of its staff members did not need to create documents, they needed
only to read them. It was thus able to remove 75% of its office software
licenses and replace them with a lower-cost, read-only alternative.
3. Obtain a New Supplier
If a company does not have the options for changing its demand profile, it should
explore creating a completely new supply source. Like the first two strategies, this
ultimately shifts demand away from powerful suppliers. It is most likely to be
needed in industries where price negotiations have gone so far as to drive most
suppliers out of business, thus giving the survivors a monopoly.
Action so drastic puts a company at risk of alienating its supplier completely and may
change the company’s business model. It will also alter the competitive dynamics
and perhaps even the structure of the supplier’s industry and that of the business.
For these reasons, it is a risky proposition. If it is well executed, it can transform a
company’s prospects. There are basically two options:
a. Bringing in a supplier from an adjacent market.67 - The easiest way to create
a new supplier is to bring in a competitor from an adjacent region or industry.
This is usually one that might not otherwise have entered the market. One
major airline reduced its food costs and improved quality by enticing a
European catering company to enter the U.S. airline-catering market. The
market had previously been controlled by two well-entrenched suppliers that
66 Ibid 32
67 Ibid.
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were reluctant to lower prices. The new entrant had an innovative, off-
premises production model that enabled it to offer higher-quality food at
much lower prices. The benefits came in exchange for longer-term contracts.
Because the airline would need to give the new supplier a multiyear
agreement, the procurement team had to share its plans with the airline’s
chief operating officer, its head of airport operations, and its head of catering.
After aligning these key functions on the strategy, the airline announced to
whom it had awarded its contract at a major U.S. hub. After losing the
airlines business, one of the established suppliers replaced its management
team and took a more collaborative approach with the airline.
b. Vertically integrate - Where here are no plausible new suppliers on hand, a
company could consider making itself the new supplier by investing in the
needed assets and capabilities. This could be made possible through a
strategic partnership or joint venture with a company that has some of those
assets and capabilities. In some cases, a credible threat to take this action will
be enough to shift the balance of power, as was the case with a paper
company that relied on a regulated utility for electricity.
Unable to secure a better rate from the utility, the company began planning
to build its own power plant, and it made sure the utility knew about its plans.
It spent nine months finding a location, securing pipeline capacity, getting
permits, and partnering with a dryer company that wanted to use the steam
that the plant would generate. The strategy worked because the utility
company agreed to reduce its rates by 40% to prevent the company from
building the plant.
In South Africa, this strategy would not work on Eskom because of its total
monopoly. The danger with this approach is that a company’s threat to
vertically integrate may be called. Before a company embarks on this option,
it should make sure that the new venture could deliver value that exceeds
the investment costs and compensates for the added management attention
and the hidden risks and challenges that might arise.
4. Taking more drastic, stringent, and firm measures (Play Hardball)68
Where everything else fails, a company may cancel all its orders, exclude the
supplier from future business, or threatening litigation. A combination of these
actions may be the only answer, short of a company going out of business. These are
truly tactics of last resort.
A global financial services firm was in major difficulty because it had to reduce costs
by $3 billion. To cut IT infrastructure costs, it asked its major hardware supplier for a
10% price decrease.
When the supplier refused, the firm’s chief information officer contacted the
supplier’s CEO and suspended the supplier’s projects in the company, effective
immediately. Within an hour the supplier was deactivated in the payment system,
68 Ibid. 33
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and the procurement, IT, and development teams were notified that they would no
longer to work with it. Faced with the c loss of existing and upcoming projects, the
supplier quickly agreed to the price cut.
There is then the litigation alternative. In the early 2000s a security company that
provided cash transportation services to banks decided to increase its rates by 40%.
Because it controlled 70% of the market, the banks had few alternatives. One bank
that faced significant margin pressures was not prepared to accept the price hike.
To better understand what was driving the increase, it asked to review the security
company’s financial statements, which revealed only a 10% cost increase. This was
nothing that would justify the dramatic price increase.
The bank took a two-pronged approach. Its COO met with the COO of the security
company to explain that the increase was unacceptable and would undermine their
relationship. The procurement team then threatened to join forces with the other
banks and bring the matter to the attention of the national authorities in charge of
restricting monopolies. The security company relented and instituted a price
increase more in line+ with its cost increase.
Companies negotiating with powerful suppliers have plenty of ways to rework the
relationship. Whichever option they choose, they need to have a clear
understanding of the problem, the ability to work cross functionally, a willingness to
think outside the box, and strong analytical capabilities that can reveal the wider
picture and generate useful insights. Senior executives should commit to strategic
rather than tactical moves. When these elements are in place, what had seemed to
be an impossible negotiating task will become one that is merely challenging.
The process of securing competitive prices through collaboration with suppliers.
We briefly discussed this approach in the discussion above but will discuss the topic in
greater depth below. Most companies recognise the need to promote cooperative and
collaborative working in their organisations, and many have worked hard to break down
internal barriers and foster closer working relationships.
As an increasing percentage of the value of products and services moves out into the
extended supply chain, companies are finding it much harder to extend these collaborative
methods across corporate boundaries.69
Some companies have tried to collaborate with suppliers with limited success. Others
believe there is no more room for collaboration. Most companies can get more from
supplier collaboration if they begin again from the basic principles. They need to rethink the
nature of their strategic supplier relationships.
Supplier collaboration can be defined as” the joint development of capabilities for both the
customer and supplier for the purposes of reduced cost, process improvements, and
innovation in products or services.” In 2012, McKinsey surveyed more than 100 large global
companies on supplier collaboration practices. The survey separated traditional sourcing
69 Noor J, Sathpathy A, Shulman J and Wullenweber J, The power of successful supplier collaboration, February 2013.
https://www.mckinsey.com/practice-clients/operations/the-power-of-successful-supplier-collaboration 12 December 2017.
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tools such as clean-sheet cost models 70 from strategic investments and long-term projects
with suppliers for co-development.
The results were insightful. Even though over a third of the respondents said they had
collaborated with suppliers, less than 10 percent could demonstrate consistent efforts on
supplier collaboration. Among those who did collaborate, the Earnings before interest and
taxes (EBIT) growth rate was double that of their peers. One of the conclusions reached is
that companies that collaborate consistently with suppliers grow faster.71
Suppliers also benefit from such relationships. Benefits include more stable businesses,
greater cost-competitiveness, and improved core capabilities. Suppliers can then deploy
these capabilities to win more business externally.
In a survey of the auto industry, McKinsey found the suppliers that gave Toyota and BMW
the highest cost reductions also rated the two companies as their best customers. The long-
term collaboration was clearly mutually beneficial.
Experience has revealed three keys needed for developing profitable supplier collaboration.
1. Building a foundation of internal collaboration before external collaboration72
Before beginning a new program that requires a significant amount of time and
resources, it is important to determine if the company has the internal capabilities
and strategy alignment to make the external collaboration a success. Under-
investing in these internal activities is one of the main reason’s supplier
collaborations fail.
How can companies assess or determine whether the organisation has the
capabilities to make this kind of collaboration a success?
a. They must consider the skills required for the particular type of collaboration
desired. Some considerations to be made include:
i. Whether your buyers have a solid foundation in clean-sheet
modelling and sourcing strategy development?73
ii. If you have access to internal expertise in lean, supply-chain
management, and product development on what would become the
supplier collaboration team? Only after you have addressed these
needs would your organisation be ready for supplier collaboration.
70 Clean sheet is an exercise in thought. It allows corporate and government leaders to ponder “what if?” What if we had
a clean slate? What if we could be organised differently, be staffed differently, or use our resources differently? What if…?
The beauty of an exercise in thought is that the cost to the organisation is fairly low. The outlay of resources to
just think about things in a new way is relatively small. In fact, if you consider the total cost over the lifetime of any type of
project or programme– from inception to implementation – the initial costs for research and development are fairly low,
with costs rising over the life cycle of the project to final implementation.
https://www.tofflerassociates.com/vanishing-point/a-clean-sheet-approach-to-decision-making 12 December 2017.
71 Noor J et all, Ibid.
72 Ibid.
73 “clean sheeting” is an advanced procurement technique mostly used in the direct material space. The approach involves
modelling the raw material and conversion costs of a good, this allows for a better understanding of a supplier’s overhead,
profit, and manufacturing efficiency. Clean sheeting has traditionally enabled negotiations for specialized products with
high costs and limited supplier alternatives. AZUL partners, Expanding the Scope of Should-Cost Analysis
http://spendmatters.com/2014/09/03/expanding-the-scope-of-should-cost-analysis/ 12 April 2019.
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As an example, take a procurement function that is made up mostly of tactical
buyers who spend much of their day fulfilling orders. They may not have the
knowledge and skill to identify joint cost-reduction opportunities or to work with
suppliers to improve the product development processes.
Organisations in this situation need to begin by investing in traditional sourcing and
leadership capabilities Until this happens, suppliers have little incentive to go beyond
the basics.
Where companies have the fundamentals in place they will need to focus on more
advanced, collaboration-specific skills, such as value-sharing mechanisms and
developmental agreements.
Value-sharing models need to be simple, and correctly encourage performance for
both the customer and the supplier. Common incentives for suppliers range from
extending contract length, splitting cost savings 50/50, negotiating pre-determined
benefits to the buyer (e.g., 5 percent cost reduction per year) with the rest going to
the supplier, or to joint investment in capital projects to increase capacity.
Joint Developmental Agreements (JDAs) are recommended in cases where
intellectual property (IP) might be created. They need to clearly define the scope of
the work, confidentiality obligations, intellectual property rights, exclusivity terms,
and release criteria, to name a few.74
Building momentum with small wins is important. Supplier collaboration teams
should ultimately work on large and ambitious projects for the maximum impact. For
this to take place the collaborating companies must align on which suppliers,
products, or service lines to invest in. This should preferably be done with the input
of relevant cross-functional leaders internally such as manufacturing, R&D,
engineering, and product line leadership.
Together, the following questions will need to be answered:
“What business units, product or service lines should be prioritised based on
factors that include potential profitability, urgency, risk, and cross functional
leadership support?
Which suppliers are providing critical components or services?
Is the spending for prioritised products or service lines growing?
Is it specific to a particular region?
Is the opportunity to reduce cost, improve performance, or conduct product
innovation big enough to justify the resources required?
Will this help to gain a competitive advantage?”
A large North American industrial equipment manufacturer wanted to unlock the
potential of supplier collaboration. To determine which suppliers it could work with,
it took a three-point approach.75
74 Ibid. 36
75 Ibid.
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First, it ranked their suppliers’ strategic value. This was done by mapping the
importance of the products they supplied versus the ability to obtain them.
Second, it reviewed each supplier’s performance as opposed to their expected
capabilities. This helped the company define what the supplier would bring to a
developmental program.
Finally, the manufacturer assessed these results to determine which suppliers to
partner with to increase collaboration.
Another benefit of this exercise was that the manufacturer obtained a clear
understanding of the relative value or lack thereof of their different suppliers. This
led to insights on which suppliers needed to be replaced, motivated, or rewarded. In
this introductory phase, the goals of the program as well as the roles, responsibilities
and time commitment of the teams are to be clearly outlined. Business and
functional leaders must provide support from the beginning, and cross-functional
leadership teams must be committed for the long term.
2. Design the program to meet a specific business imperative76
There are three types of supplier collaboration programs. Each meets different
business objectives and requires differing levels of skill to execute.
a. Collaboration for cost reduction - This program focuses on cutting costs for
both sides and goes beyond traditional sourcing levers. Because suppliers are
treated as partners, not as cost centres, the development of long-term,
trusting relationships is necessary. Buyer- supplier interactions change in the
following ways:
i. negotiations are based on full transparency into costs. Healthy
margins and growth guaranteed.
ii. specifications are jointly perfected to eliminate unnecessary features.
iii. demand transparency is produced based on production patterns to
optimise inventories.
While this type of cost-based program requires mature procurement
abilities it is also the least complex compared to other collaboration
options. Companies with no or very little experience in supplier
collaboration programs may choose to begin here and work their way
up.77
b. Collaboration for value beyond cost78 - This would be the right program for
companies that want to:
i. improve safety or the quality of their products,
ii. develop additional sources of supply for a new or capacity-
constrained component, or
76 Ibid 37
77 Ibid.
78 Ibid
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iii. work with a supplier on lean improvements.79
Even though these changes can and will reduce costs, the work is focused on
value beyond purchase price. It therefore requires more cross-functional
expertise to carry out. An example would be an oil major company
collaborating with an upstream drilling services provider to minimise the cost
and time of capital projects. In another example, a leading freight railroad
had outsourced the repair of its railcars to a sole supplier. Even though there
were high rates of idle time and waste, the supplier continued to win the
yearly contract.
The railroad company decided that it wanted to partner with a competitive
supplier who would also work with it to reduce the operational and capital
costs that would eventually be charged back. It approached multiple
companies, including the sole supplier. The incentive given was a long-term
contract in exchange for competitive pricing and a collaboration program to
improve the supplier’s operations. This resulted in a significantly more
competitive bid price from the supplier. The parties identified an additional
16 percent savings through joint lean initiatives focused on operational
efficiency and capital cost reduction. When the railroad had mastered the
basics of supplier collaboration, it moved onto supplier innovation, a more
complex process.
c. Collaboration for innovation - “This is the practice of working with suppliers
to improve the pace and quality of product or process innovation.” It enables
value to be created in areas like design, speed-to-market, and consumer
insights. This form of collaboration needs the most time, money, and trust. It
also carries the greatest risk because of the experimental nature of
developmental work and the need for greater two-way trust. The partners
may have to negotiate sophisticated agreements on IP rights, licensing
agreements, and warranties. The payoff can be significant, taking the form of
a better, timelier, and more competitive product.
In the case of the railroad, which was discussed above, a new program was
started to de-specify head-hardened rail steel with an existing supplier and
design a new rail steel specification. The result was tens of millions in value
creation per year. To begin with the project, the railroad company needed
advanced skills.
3. Build transparency and trust80
Transparency and trust are essential for long term success. A survey of 35 strategic
suppliers to a large, global medical device company, which dealt with quality and
cost issues, found most of the suppliers did not trust that their innovative solutions
were consistently and seriously considered by the customer. They saw this as the
main reason for poor collaboration. The survey indicated to the company that it
79 Lean improvements The core idea is to maximize customer value while minimising waste. Simply, lean means creating
more value for customers with fewer resources. Lean Enterprise Institute What is lean? https://www.lean.org/WhatsLean/
14 April 2019
80 Ibid.
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needed to restart its relationships based on transparency i.e., it needed more clear,
two-way feedback. The expectation was that greater trust would follow.
Where transparency and trust are successfully created however, it can deliver
remarkable value. A financial services company used this approach to address
persistent poor performance by its network of litigation service providers. It started
by changing the way it interacted with vendors. It simplified lines of communication
and established regular weekly calls with them. Then it introduced a transparent
vendor performance management system, through which it tracked results and error
rates, and discussing them with each vendor in monthly reviews. These efforts were
supported internally through the creation of dedicated teams for vendor
performance management and collaboration.81
The company thereafter changed its working processes in ways that addressed key
problem areas and allowed both it and its vendors to benefit. It gave vendors power
of attorney to sign documents on its behalf. This reduced frustrating delays as
documents were sent back and forth.
It also changed the way work was allocated, giving higher performing vendors more.
It also collaborated with its vendors to identify and eliminate unprofitable lines of
work. The result of this effort was a major shift in vendor performance. The cash
recovered by litigation rose by nearly 80 percent. The company found that it needed
a third fewer staff to manage its vendors and saved even more in filing fees and
expenses. More importantly, the relationship between the company’s line teams
and vendors was transformed, with free, open communication and a constant
exchange of ideas.
Creating successful partnerships like this one is complicated as it has several
requirements. Some are preconditions that must be in place before the collaboration
kicks off. Others follow through the collaboration itself.
Preconditions82
The parties’ different commitments must be clearly defined and expressed.
This includes the minimum, capital expenditure and personnel on both a
leadership and working level.
Align the length of the agreement, renewal terms, and volume and price
ranges to standard contract terms.
Be specific about the product range covered and the scope of the
development effort. Options and agreements on the use of alternative
suppliers and use of the capabilities developed by the supplier with any other
customers must be clearly expressed.
A value-sharing model which details the targets of cooperation, defines the
benefits, and agrees on how to share those benefits must be created. The
81 Ibid 39
82 Ibid
333905000 – Occupational Certificate: Supply Chain Practitioner | SAQA Qualification ID: 99111
Module 2: 333905000-KM-02 – Supply Chain Operations
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customer often proposes a model that does not offer enough value, or the
right value, to its suppliers. This stalls the program before it even begins.
As an example, lithography equipment manufacturers for the semiconductor
industry deal with extremely short product lifecycles, new technologies, and wildly
fluctuating demand patterns. To incentivise suppliers to partner up with them, a
leading lithography system manufacturer offered high margins (as a volatility buffer),
equipment financing, and purchase guarantees with narrowing windows from
systems to components. This value-sharing mechanism sustained the supply chain
through the cycle, jointly reduced costs, dealt with wild swings in demand, and
stabilised throughput and delivery. Both the customer and suppliers benefited.83
Ongoing work through collaboration84
There are matters that need to be co-developed and re- worked throughout the
collaboration. Supply chain management and operations teams must decide how to
deal with exceptions to the agreement for example, through a joint review board. In
the same way, for the collaboration to grow and prosper, there needs to be a
mechanism to generate, evaluate and prioritise new ideas. Where there is a
foundation of trust and transparency, the collaboration will continue to grow.85
Techniques of measuring achieved savings.
Regardless of the industry sector, the size of an enterprise or the maturity of the
procurement area, one of the most important objectives of the procurement function will
always be realising cost savings.86
This occurs because in most organisations, the percentage of revenue that is spent on
procurement has grown to 50%-70%, depending on the type of business. The most
important reason for this growth is the ongoing trend of outsourcing tasks that were
normally performed within the organisation.
The procurement function has also become responsible for commodities that were normally
outside of its sphere of responsibility. Examples of these are business travel, insurances,
marketing and communication, professional services, etc.
As a result, procurement has a huge impact on the profitability of a company. For large
organisations, a reduction of unplanned buying of between 5-10% can easily generate
millions of Rands of savings. Cost control is an important shared responsibility of both
procurement and finance. Both spheres must therefore be aware of each other’s frame of
reference. Finance professionals are often focused on costs and think that reported savings
translate immediately into decreased costs. This will not always be the case, however. With
procurement savings, it is sometimes difficult to distinguish between the various costs. In
83 Ibid 40
84 Ibid
85 Ibid
86Putters M, How to measure procurement savings, 2013https://www.capgemini.com/consulting/2013/09/how-to-
measure-procurement-savings / 12 December 2017.
333905000 – Occupational Certificate: Supply Chain Practitioner | SAQA Qualification ID: 99111
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addition to helping to improve profitability, other reasons for measuring and reporting
procurement savings are.
Continuous improvement - Measuring brings knowledge .and Insight into price trends.
The extent to which procurement knows how to deal with them sheds light on
deviations from the planned results and makes it easier to take measures to deal with
the unwanted consequences.
Demonstrate added value - Because of the impact of procurement on the profitability
of an organisation, proving the contribution to effective cost control helps to
demonstrate the added value of the procurement function.
Improve credibility - Procurement is marked by its relationships with all disciplines
within an organisation. It can only be successful when it works in cooperation with
these disciplines. A good track record in cost savings improves the credibility of
procurement and helps it get involved early in new ventures that will lead to new
spending.
Motivation - Where an organisation can link the realisation of cost savings to the right
key performance indicators (KPIs)87, it will be able to motivate buyers.88
Types of savings
From the perspective, of procurement, there are three areas to look for cost savings. These
are represented by the three sides of the triangle shown below: the demand side, supply
side and total cost side.
Image Credit: The sourcing triangle (© Capgemini)
87 These are measurable values used by marketing teams to demonstrate the effectiveness of campaigns across all 41
marketing channels, www.klipfolio.com 13 December 2017.
88 Ibid
333905000 – Occupational Certificate: Supply Chain Practitioner | SAQA Qualification ID: 99111
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Purchase Demand Management
The easiest way to achieve cost savings is by decreasing demand. This can be done in three
ways.
Reduce consumption - The question to ask is: “Do we really need this?”
Organisations often purchase goods that they could do without, especially in times
of economic growth. This stops when the situation becomes less positive. Examples
include forbidding business class flights and reducing air travel by deployment of
video conferencing.
Consolidation of spending - A widespread cause of hidden costs is needless product
variations where a harmonisation of specifications (one size fits all) could lead to
attractive savings. Examples of this are mobile phones, laptops, and lease cars.
Improvement of specifications - Technicians are a group who are often striving for
perfection. To this end they often look for the most beautiful, but often most
expensive solution where other less expensive options would be suitable.89
Supply Base Management
The supply side is normally associated with procurement. This relates to the strategy of
using suppliers to save costs. These strategies include:
Restructuring supplier relationships. The question asked is: How can we get more
value from our relationships with suppliers? It is possible to gain additional cost
advantages through greater collaboration with suppliers, starting up partnerships
and pursuing sustained cooperation.
Increase competition. This is the opposite of restructuring supplier relationships.
Here competition between potential suppliers is stirred up to create favourable
conditions.
Restructure supplier relationships. Depending on the nature of a commodity, cost
advantages can be obtained by sourcing from low-cost countries or by spreading the
total demand for a certain product over multiple suppliers, thus maintaining
continuous competition.90
Total Cost Management
Decreasing demand or reducing direct purchasing expenses are obvious ways to realise
savings. It is also possible to assess the total costs related to the purchasing of products or
services This might offer different opportunities such as the following:91
Optimising total supply chain costs. This is an area that has expanded greatly over
the last 30 years with the leading of the Japanese who introduced methods like JIT,
Kanban, and Kaizen.
89 Ibid. 42
90 Ibid
91 Ibid
333905000 – Occupational Certificate: Supply Chain Practitioner | SAQA Qualification ID: 99111
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Reducing of total life cycle ownerships costs. This involves the assessment of costs
additional to the product price. Examples of this are special tooling that must be
developed, for example, moulds.
Questions raised are: Is there a possibility to buy a standard product instead of
developing a unique part? Would it be better to lease a product rather than buy it?
Can ownership of an installation be shared with other parties?
Reducing or eliminating transaction costs. Costs that may easily be overlooked are
the costs related to the process of ordering, receiving, and paying for purchases.
These costs could be reduced through vendor managed inventory, electronic
ordering and invoicing and using P-cards.
Complexity
From the presentation above, it is clear that cost savings cannot be measured using one
standard formula. Because procurement is not an isolated function but, instead, operates in
cooperation with other business functions on which it is partially dependent both measuring
and gauging the value of savings is complicated. Another issue is the definition of saving.
When is it fair to claim a procurement saving? The examples below illustrate why discussion
may arise between procurement and finance about the legitimacy of reported savings.
Procurement has been able to negotiate lower prices for a specific product in the
next period, however, there is a higher demand for this commodity. Despite the
lower unit price, the overall expenses for this commodity rise. The opposite is also
possible: a price increase combined with a decreased demand leads to a reduction of
expenditures.
There is a need for new products or services. A buyer starts a tender process based
on their business requirements. Through negotiations with the supplier with the
most attractive offer, the buyer obtains an additional discount of 10 %. The formula
applied to calculate the procurement saving is the average price of all received
quotes minus the negotiated contract price multiplied by the real number of items
bought in a certain period. This is a common practice. Despite a reported saving
expenses will increase
A buyer is responsible for a volatile product. In a specific period, there is a price rise
for this category of 25 %. Through excellent negotiation the buyer limits the price
increase to 15 %. He reports a saving of 10 %, this being the difference between the
two percentages although the real expenses rise by 15 %.
A sourcing project leads to an acceptable savings number. This is, however,
counterbalanced by the abnormal usage of hours and other means to achieve the
savings amount.
A sourcing project delivers an acceptable savings number. At the same time, there is
an increase in costs is detected because of late deliveries, bad quality goods, etc.
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Effectively measuring and reporting92
Based on the information above, it may incorrectly appear to be impossible to register
savings in a proper way. It does, however, require a proper approach and clear choices. This
approach consists of three parts.
Determine method and framework.
There must be agreement on the types of savings that can be claimed (see figure 1).
Because these types are very different, it is important to determine how savings will be
calculated. This relates to both the formula for calculation and the starting points that are
applied. Where there are index figures or benchmark data that may be used, the starting
point for savings to follow or the level on which calculations are measured must be
determined. The question raised are: Do we measure per product or category of products?
Are savings realised per month, quarter, calendar year or contract period? It must be clear
how savings will be documented and validated.
As sourcing projects are often carried out by interdisciplinary teams, there must be an
answer to the question of which party is allowed to claim savings. Where R&D proposes a
simplification in the specification of a component which leads to a saving, can this be
claimed by procurement? No matter what the answer is, what is important is that there be
clarity about which choice has been made.93
Identifying and quantifying saving opportunities
Cost savings projects must be based on a solid spending analysis. This is a starting point for
identifying saving opportunities. It is also a benchmark to verify claimed savings. In this
analysis, the following types of data are gathered:94
Spending
Number of suppliers
Spending per supplier
Spending per cost centre and general ledger account
Comparison of measured values with benchmarks
The identification of saving options is done per commodity. It should preferably be done in
interdisciplinary teams to ensure involvement of the different stakeholders. Identified
alternatives are analysed to determine the savings potential which is quantitative and
impact which is qualitative. The outcome of the analysis is used to set priorities and to
decide on the saving projects to be carried out.
Implementing and securing savings 44
92 Ibid
93 Ibid
94 Ibid
333905000 – Occupational Certificate: Supply Chain Practitioner | SAQA Qualification ID: 99111
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It is impossible to describe a constant method for implementing savings, because it depends
on the type of saving. What matters is that a savings opportunity can really be turned into a
reduction of expenses. Good intentions alone do not bring results. A point to be considered
is the relevance of assessing a savings initiative to determine if the gal has really been
achieved. This is best done by conducting a new spending analysis, preferably one that can
also bring new saving options to light.
For the sake of credibility, it is important to report the good as well as the bad. While we
savings, are consistently spoken of, it is unfortunately not always possible to avoid price-
rises. A correct, complete report which gives a clear insight into the performance of the
procurement function will increase the esteem and trust of the management.95
The savings & benefit measurement process
Savings and benefits usually result from three broad types of procurement:96
a. Renewal - Here the term of a contract (or agreement) has ended and is renewed
through a procurement activity. A renewal activity often has a strong historic
baseline that can be used to compare and quantify the savings/benefits the activity
creates. All specification changes must be identified and considered in the
comparison. In a property maintenance contract, for example, the buildings involved
may have changed. A contract for new vehicles also may have different safety
specifications from the original.
b. New - When procuring products/services for the first time, outsourcing existing
services or undertaking a one-off procurement activity. New procurement also
requires a proper baseline for comparison, for example, the budget in the original
business case if it is realistic.
c. Renegotiation or improvement of terms - Contact with an existing supplier that
results in savings to the business without a formal procurement process. The
savings/benefits might be simple to measure, for example those that result from
reduced delivery costs, or bulk ordering that leads to supplier discounts or rebates.
How you go about measuring the savings/benefits of a specific procurement activity will be
affected by the type of procurement the company uses.
Five-step method for calculating procurement savings:97
The five-step measurement process works as follows:
1. Define the scope of the procurement activity and the related savings/benefits that
you are measuring. You will need to:
95 Ibid. 45
96 Ibid at p5.
97 New Zealand Government. Guide to Measuring Procurement savings and benefits,
https://www.procurement.govt.nz/procurement/pdf-library/agencies/Guidetomeasuringprocurementsavings.pdf 13
December 2017 at pp1 -19
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a. Collect and combine any sub-categories or divisions of the savings/benefits
categories into ‘baskets’ of related items.
b. Include any cost component that could be influenced by the product/service
selection. If additional services are involved, it is essential to ensure that their
cost does not offset any agreed cost reductions.
c. Beware of leakage which essentially entails spending that should be within
the contract’s scope but has been defined as a special purchase and has
therefore been excluded from the scope.
This can lead to lower potential savings because of not using aggregated contracts98, or
through reduced asset standardisation.99
2. Define the units of comparison – Calculating the savings/benefits of your
procurement activity involves comparing its current, baseline, and predicted costs. It
is important to define these costs, units of comparison, clearly, so you can compare
similar costs. Your baseline costs could include one or more of:100
a. The outline business case
b. The total cost of ownership
c. The cost per employee
d. The cost per unit area (e.g., per square metre)
e. The final contract prices.
f. The first price from the successful bidder
g. The allocated budget
h. The previous cost
i. The previous cost of a representative basket of items
j. The final negotiated cost with the supplier
k. The average of the bids received.
3. Baseline the current costs – Using the units of comparison from Step 2, it is time to
quantify the current situation. As this will have a major influence on the result, this is
a critically important step. You will need to:
a. Split your capital and operational costs when assessing your baseline
spending,
b. Start collecting information about the non-budgetary benefits, which you will
need in Step 5. This could include anecdotal or factual information about
staff productivity or service times under the old and current arrangements.101
98 An aggregate limit is a contract provision used in insurance to limit the amount that can be paid in the policy period. An
aggregate limit is the maximum rand amount the insurance company will pay to settle your claims. www.
Investopedia.com 13 December 2017.
99https://www.procurement.govt.nz/procurement/pdf library/agencies/Guidetomeasuringprocurementsavings.pdf at pp8.
100 Ibid at p9.
101 Ibid at p10
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4. Predict the future costs – This step involves using the units in Step 3 to determine
the revised spending under the new or proposed procurement arrangement. You
will need to:
a. Consider any changes under the new arrangement, such as:
i. New components or categories,
ii. Higher or lower service levels,
iii. Different consumption levels: any change in consumption should not
be included in the savings,
iv. A different product/service; costs should be for the same
product/service.
b. Distinguish between capital and operational costs.
c. Keep collecting information about the ‘non-budgetary’ benefits, which you
will need in Step 5.
d. Adjust for inflation if appropriate. If a contractual term is longer than a year,
you could use CPI or another relevant index adjustment to calculate the out-
years, offset by any inflationary price increases agreed during the contract’s
term. If the contract simply specifies adjustments aligned to CPI, the
inflationary distortion is zero.
e. Factor in products/services that are supplied at no charge and used in the
normal course of business. This includes products used for evaluation or trial
or provided through a supplier’s promotional activity. The budgetary savings
will the equivalent value of the item(s) being substituted.102
5. Compare: what are the savings and benefits? Step 5 involves calculating the
predicted savings by considering the before and after difference in spending and
evaluating the other benefits of the procurement activity.
Volume changes must be included in savings reporting. While these changes in volume
should be recorded, they must not be attributed to the procurement activity itself. It is
important to ensure at this stage that you are comparing the same volume of units being
procured even if there will be a change between the baseline and predicted activity.
The savings from a procurement activity can be calculated as:
Current baseline spending (volume x unit cost) [LESS] Predicted spending following
procurement (volume x unit cost) = REALISED SAVINGS.
Your analysis should include:
1. An analysis of budgetary savings:
a. Operational expenditure savings,
b. Capital expenditure savings and associated capital interest savings,
102 Ibid at 11. 47
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c. Clear differentiation between savings resulting from an improved deal and
those resulting from efficiency improvements,
2. An analysis of non-budgetary savings resulting from:
a. An improved deal,
b. Efficiency improvements delivered through the new arrangement.
You will also need to consider:
1. Whether the new arrangement includes any new components or categories,
2. Whether the new arrangement has higher or lower service levels,
3. Any supplier-imposed volume commitments that could limit your potential savings
for example, if your auditor has quoted a discounted rate if you commit to a specific
number of audits,
4. The savings timeframe. This measurement process assumes that savings will be
identified and reported upfront for the entire life of a contract, agreement, or
procurement activity. If your procurement activity creates a saving that is not
associated with any term, a full-year (12-month) effect should be reported unless
otherwise agreed,
5. Currency fluctuations if a product/service has been negotiated in a foreign currency.
Any fluctuations will be a treasury gain/loss, not a procurement benefit/increase,
6. The time value of money. If you are comparing current and predicted costs/savings
over multiple years, and depending on the expenditure amount, your finance team
might require you to define each year’s cash flows in terms of their present value,
using what is known as Present Value analysis. If you are unsure, talk to your finance
team.103
Calculating capital interest savings
To determine your capital interest savings, identify the difference between spending on
capital at baseline and after your procurement activity.
Then multiply the capital savings or increase by the capital charge rate (your finance team
will know what this is). As an example, if the difference in capital paid is a reduction of
R50,000.00 at 7.5% as interest, then the capital interest savings would be R3,750.
At its simplest level, the savings/benefits from a procurement activity can be calculated as:
Baseline spend [less] Spend after procurement = Savings/Benefits
(Volume x Price) [less] (Volume x Price)
Before you start using the measurement process, you need to determine whether the
savings/benefits from your procurement activity are budgetary or non-budgetary104
103 Ibid at 12 48
104 Ibid at p7.
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1. Budgetary benefits are also referred to as cashable, tangible, or hard benefits, such as
price reductions: these generate cash or a budget surplus that you could choose to
reallocate.
2. Non-budgetary benefits are also referred to as non-cashable, intangible, or soft benefits,
and include cost increases avoided: They represent a procurement benefit but do not
release cash or budget for reallocation.
While budgetary savings can be redistributed within or across agencies, non-budgetary
savings/benefits are less realisable.105”
KT0103: Achieve quality supplies.
Knowledge Theory (KT) and corresponding Internal Assessment Criteria (IAC) / Learning
Objectives (LO) covered:
KT0103 Achieve quality supplies
IAC0110 Define quality standards, processes, and procedures
IAC0111 Discuss the use of quality assurance in the supply chain
A long-term relationship is critical factor in sustaining competitive advantage. It ensures
stable relationships with comparatively few suppliers who can deliver high-quality supplies
and delivery schedules and remain flexible relative to changes in specifications and delivery
schedules.
Quality standards, processes, and procedures
105 Ibid at p 7. 49
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