Advice from a consultant and past high-tech CFO on how to recognize hidden costs when making purchasing decisions.
If you ignore the hidden costs of purchasing decisions, you could be in for some rude surprises
You may think your overhead costs are under tight control because you budget carefully and hold your people to their budgets. Unfortunately, trying to control certain overhead costs through the budgeting process is much like trying to screw down the lid on a pressure cooker while turning up the fire below: it's a futile attempt to control the effect while ignoring the cause. And the fire down below -- the cost driver -- is often found in purchasing decisions.
If your company is like many others, you concentrate on only one aspect of purchasing costs -- the purchase price. But attention to total costs -- before, during, and after a purchase -- is key to controlling overhead.
To better show the sorts of purchasing costs that add to overhead, let me list some examples from a typical manufacturing company. (The same theory applies to retail and service companies, but the situation is worse for manufacturers because they must buy so many components.)* * *
Costs before the purchase
Design and documentation. Companies pay people to assign part numbers, list dimensions or other technical characteristics, and often generate drawings for every part that goes into a product.
Vendor selection. Many companies visit prospective vendors, check their references, and may analyze their financial statements. Even the simple purchase of an off-the-shelf component can take hours of haggling.
Other administrative costs. Companies invest in people and computers to schedule the ordering of parts. They may also maintain a staff of clerks and secretaries to support engineering, purchasing, production control, computer jockeys, and so on. They need managers. And they need paper, desks, and copiers.* * *
Costs during the purchase
Ordering. Most companies order by phone and then follow up with a confirming purchase order. This process involves buyers, clerks, telephone charges, computer charges, postage, multipart forms, and so on. Ordering can also involve the finance department to provide credit information, explain past deficiencies, and negotiate payment terms.
Receipt and inspection. When the parts arrive, an employee has to make sure they're what was ordered and in the right quantity. Someone else has to clear the paperwork and update the internal tracking system.
Problems with vendors. If the parts arrive before they're needed -- or too late -- somebody has to deal with that. The marketing department often gets involved when problems with vendors create problems with customers. The accounting department often gets brought in as well, because many of these activities will affect its paperwork and computer systems. Even the company president may be called on to calm emotions or to come on like heavy artillery with recalcitrant vendors.* * *
Costs after the purchase
Inventory. These costs can be astronomical. Inventory requires people to count it, people to move it around, and people to track it. It takes buildings, racks, bins, and vaults to contain it. And it takes interest charges to finance it.
Waste is a large but often forgotten cost of owning inventory. The more inventory you have, the more inventory you're going to drop, step on, drive over, scratch, fold, spindle, and mutilate. The longer you have it, the more likely it is to become obsolete, lost, or damaged.
Training. Whether the training is formal or informal, someone in an organization must be trained each time the company buys a new item. The warehouse foreman learns how to store a new part so that it won't get scratched; the buyer learns how to order a new part so that it arrives on time; the manufacturing supervisor learns how to adapt the manufacturing process to a change in purchased parts. And of course, purchases of computers, robots, copiers, telephone systems, and the like require more formal training.
Other administrative costs. Companies need accounting, legal, maintenance, computer, personnel, and other services to support purchasing activities. And people hired for other purposes are frequently drawn into discussions arising from purchasing decisions. For example, most managers must budget resources to manage their purchasing costs; companies often must move to larger facilities just to store all the stuff they've purchased; and the president and key employees can spend long hours discussing the consequences for cash, customers, and personnel that purchasing decisions have created.* * *
This list is by no means complete -- I haven't even touched the additional overhead costs that poor quality creates, for example (see "Quality Nightmares," October 1987). If you're familiar with traditional management accounting theory, you know that the costs suggested above are generally classified as fixed costs. But these are not fixed costs, nor are they costs that merely vary over time -- a refinement many accountants use when a realist points out that no cost is fixed. Instead, these are costs that management decisions can reduce or eliminate.
Your best overall strategy is to look for ways to reduce the number of purchases your company makes, reduce the number of vendors you deal with, and get the best service possible from those vendors that you keep.
In many companies, for example, the 5% to 10% of products that are at the very bottom of the profitability barrel don't merely fail to contribute to profitability, they damage it. The demands these products make on an organization for quality control, engineering support, documentation, cost accounting, production scheduling, inventory space, and so on often equal or exceed the demands of the profitable products. The point is, many companies could slash purchasing costs significantly by discontinuing their least profitable products.
When Apple Computer Inc. was a young company, it publicized a slogan that every engineering department should remember today: Simplicity is the ultimate sophistication. A redesign of your own products might allow you to reduce the number of parts per product while increasing the fraction of parts used in more than one product. Not only can these changes reduce purchasing costs, they can reduce service costs as well.
If you slash the number of vendors you use, you can slash the administrative costs of dealing with them. And the more business you do with a single vendor, the more that company will be able to work with you to control your costs. You might ask your clerks and line workers which vendors create the most hassle and frustration for them. Some of these may offer the lowest prices, but they make you pay for those prices in poor service, unsatisfactory quality, and general ineptitude -- causing problems for your employees and raising your overhead expenses.
Suppose that twice a day I could deliver just the parts you needed to your factory floor, and that every part would be perfect. If you bought from me, you could eliminate your raw materials inventory, most of your purchasing costs, and most of your costs of poor quality. These reductions would bring further reductions in rent, maintenance expenses, utilities, accounting costs, payroll, and interest charges. If I could provide such a benefit, what premium would you pay for my products? Would you pay 5% more than you're now paying, or 10%, or 20%?
Unfortunately, I don't provide such a service. But some vendors do provide better service, more reliable delivery, and higher-quality materials than others; they just don't always offer the lowest prices. The premium you'll be willing to pay depends on the savings they can bring, but be open to the possibilities.
It's a vendor's job to help you find reasons to purchase from it and not from its competitors -- it might offer technical help, for example, or special delivery services, or special packaging. Your job is to remind your vendor of this responsibility. Ideally, by working together, you'll find ways to save on your company's overhead costs. In the process, of course, your vendor might charge a higher price than the competition charges for the special product and services. But what do you care so long as total costs are smaller?* * *
Charles W. Kyd, a writer and consultant in Seattle, spent 10 years as the chief financial officer of high-technology and turnaround manufacturers.
Five ideas for reducing it . . .
1. Eliminate unprofitable products.
2. Simplify your products to reduce the number of purchased parts.
3. Reduce the number of vendors you use.
4. Invest in quality parts and vendors.
5. Work with your vendors.