In a talk by Mr Haaije van der Brug, Procurement Manager for Shell in Russia, on October 18, 2011, he described the 40/40/20 practice at Shell. The claim is that cost savings are generated only 20 % of the time through price reductions, but 40 % of the time through adjustment of specifications and 40 % of the time through demand management. He describes an example involving Shell’s use of standby ships in Sakhalin (Russia). While the cost of the ships were stable and thus difficult to decrease, their fuel use cost $ 5 million annually. This fuel use was driven by the ships circling the island constantly throughout the year. Adjusting their routes to anchor when weather was good enabled cost savings of between $ 0.5 and $ 1 million, without affecting performance. His contention was that one should expect 3 to 5 % cost savings year-on-year through continued focus on such processes. Do you agree that effective supply chain management i.e., adjustment of demand and specifications for supply significantly dominate prices in improving cost of goods sold ? Should suppliers be incented to discover such savings for appropriate rewards or is the continued right to supply sufficient incentive ? Could there be unintended side effects (such as potential future holdup) from continued specification adjustments to decrease costs from existing suppliers ?
Effective supply chain management does provide the opportunity to improve cost savings. As suppliers and customers are added and removed the routes will always have room for optimization. However, if the routes remain the same and we are constantly looking at process improvement diminishing returns will set in. Additionally, it is difficult to monitor all external factors that affect demand and specifications for supply chain because the customer demographic is constantly changing. By having multiple changes in the supply chain this could also increase costs because it limits the company’s ability to create standardization and economies of scale. It also hinders the ability to create long term partnerships. If the company is constantly looking to improve, the unintended side effects may be a lack of trust among suppliers because they do not know if they will have the company’s business or not. This may hinder them from making future deals with the company which could reduce the company’s ability to meet future demand.
Effective supply chain management is one aspect of improving COGS. However, it does not necessarily dominate the price of a product. The potential for reduction in costs depends on the manufacturer’s current supply chain, their manufacturing process, labor costs, marketing, and regulation. However, detailed analysis of a supply chain, will in many cases reduce the COGS. Suppliers incentive of continued right to supply should be enough for them to analyze a supply chain. By doing so, they gain a price advantage over their competitor which will retain existing business and expand to more business. Suppliers that adjust their supply chain to reduce cost must also be aware of the lead time implications associated with changing their supply chain. Some customers are willing to pay more for a product that has a shorter lead time.
Procurement’s role has changed from simply desk work to becoming a strategic source for lowering a company’s costs. Changing specifications can lower the costs by having common parts to pool demand and standardization to increase manufacturing efficiencies. Demand management can also decrease cost because of the proper inventory levels that avoid obsolescence and over ordering.
Additionally, to continue changing specifications depends on the supplier’s capability. Is it part of their goal to continuously improve and innovate? Because of this, companies would need to select suppliers with a long-term goal of not only building a relationship but aligning business strategies.
Procurement plays a large role in an effective supply chain, and procurement costs can be reduced by focusing on other aspects of the product besides just the price. In a recent MIT News article, global food assistance from the U.S. Agency of International Development (USAID) sees great benefits from improved procurement in the supply chain. Last year, the USAID delivered 1.7 million metric tons of food to 30 million people in 50 countries. However, $10 million of food never made it to the people’s plates due to food safety issues such as spoilage. MIT researchers worked with the USAID and USDA to study the supply chain of the assistance and identify methods to reduce spoilage. They optimized the procurement process by purchasing larger bags made from more effective chemicals and materials with better technology. This resulted in not only in allowing the food to have a longer time before spoilage occurred (the primary focus), but it also reduced cost for purchasing bags to deliver food since the materials were actually cheaper than their previous process.
I don’t think the cost saving will be 3-5% year-to-year by continuous focusing on improvement of supply chain. It should be a diminishing growing rate instead of steady increase, which means that great outcomes of cost saving only show at the fist several years. After few years, the supply chain either hit its optimal position, or some parts of the chain like suppliers have been squeezed too hard to continue. Information Asymmetry is a problem, while there also could be some problems that the specifications and information are too transparent within the supply chain. As we say in Chinese culture, “No fish can survive if the water is too clean”. Same logic applies here.
Adjustment of demand is not under control. The demand is influenced by many different factors and hard to forecast. But, the specification for supply is an effective way to improve the cost of goods sold in the supply chain. I think that it is a good idea to motivate the suppliers to discover savings. The information sharing is the most important issue between the suppliers and customers. The suppliers should ensure the quality to save the costs, so all the detail information should be transparent to the customers. Otherwise, it could lead to many problems.
I agree that specification adjustment or demand management could help to reduce cost in a more efficient way. Sometimes, the suppliers know more about the market. For example, whether the specification accords with the standard that is widely used, which buyer is wasting cost on unnecessary designs, and etc. Therefore, giving the suppliers incentives to discover such sights could reduce the information asymmetry and assist the buyer to achieve potential cost saving. However, from a long-term perspective, the buyer should also pay close attention to be stuck with a certain supplier.
I do agree that effective supply chain could help to save cost in someway. However, it is not the dominating way to achieve cost saving. Because once the the efficiency of the supply chain management reach it’s maximization point, in other words, once there are no more room for improvement, the cost can not be reduced anymore. Therefore, I don’t think improvement on supply chain is a sustaining way to reducing cost.
Appropriate adjustment to supply chain will improve the current performance, by monitoring the route out the harbor can somewhat decrease the fuel cost. However, the adjustment is not that easy to be done. It may take them a long time to figure out the best way with lowest cost, plus there will be the labor cost involve in the series of supply chain improvement activities. Accurate demand forecasting is also a good way to reduce the cost of good sold, but the forecasting will never be accurate. The information sharing is important at this time, the supplier knows the market better than others, if procurement can coordinate with supplier and be in a stable partnership, both of them will reduce the cost and get more benefit. suppliers should be incented to discover such savings for appropriate rewards.
Because demand is fairly unpredictable, adjustments can and must be made on the supply side to reduce overall costs. Whether discovering new shipping routes or changing the supply of ships, there are multiple strategies that can cut costs on the supply decide while still responding to uncertain fluctuations in demand.
I do agree that adjustments of demand and specifications of supply significantly dominate prices in COGS. There are various instances where these adjustments could not be made due to the problem of information asymmetry resulting in a higher COGS. I think suppliers should be incented to discover such savings both in the interest of the buyer and the supplier. Cost savings has the potential to earn more profits for the supplier and lower the price for the buyer.However specifications should not be adjusted just to reduce the cost if the specific design is absolutely imperative for the end product to perform and sell well in the market. There could be a potential held up if specifications are changed on a continuous basis and as a result delay the time to market the product and suffer from lost sales. So the buyer should restrict the number of adjustments and try to refrain from finding the perfect match of cost and design.
The 40/40/20 perspective is interesting. The specifications adjustment approach however seems a little tricky, while one wants to look for innovative supplier who always looking for improvements and cost saving accompanied by incentives, exerting pressure for continuous adjustments bears many risks, i.e “holdup”.
On the other hand, I see that the 40% from demand management seem to be very effective if one can reduce variability to the minimum. It also helps to build good relations with one’s customers as well as suppliers to ease the pressure of surging demand.
Cost saving in supply chain is expected to happen in various ways. Shell’s practice of cost saving in the 40/40/20 split up is intriguing. In my perspective, the practice of saving cost through price reduction (20%) and demand management (40%) is acceptable. Because, the price reduction strategy is widely used in various industries – eg. grocery and apparel. This strategy helps to increase the revenue of the company by narrow reduction in the profit margin. Companies are trying to increase their competitive advantage and customer satisfaction through various demand management strategies. These strategies change based on the sector and particular company policies.
On contrary, the practice of modifying the specifications to achieve saving should not be a first choice to take into consideration. In few instances, companies can make minor changes in the component specifications, without compromising the functionality, would result in greater cost reduction. But, if the changes were not closely evaluated, then it could lead to bigger problems such as recalls. The communication of specification changes across suppliers is also a problematic situation. Different suppliers in the supply chain adapting to the frequent modification in specifications make them prone to errors.
Supplier should be encouraged to identify the cost saving opportunities. Although, supplier are not required/subjected to find new ways to decrease the total supply chain, some proactive supplier actively involve with OEMs to find opportunities for improvement. These supplier should be awarded by the OEMs. Additionally, OEMs should strive to develop an environment that award incentives and recognition for proactive suppliers.
The answer to if the an effective supply chain management i.e., adjustment of demand and specifications for supply significantly dominate prices in improving cost of goods sold is yes but would involve careful consideration of the relationship with the suppliers and their incentive to discover such savings through activities such as innovation.
The above stated would not work if the company asks supplier to make excessive or late specification changes without considering how reasonable the execution would be and when a company puts pressure on a supplier to reduce prices by situations such as adjustment of demand.
The key lies in the manner companies collaborate with the suppliers.
1. Involve suppliers in company’s processes.
2. Share information with suppliers in timely ways.
3. Work with suppliers to improve competitiveness in both cost and quality.
Increased coordination will make suppliers more involved in company’s businesses and the relationships. As a result of which suppliers become more knowledgeable about company’s plans and strategies and align their plans accordingly.
However, the increased coordination will not happen without proper communication. Companies must share their plans and expectations along with their technology. Suppliers might not have the financial means or technological capabilities to comply with all requests and hence companies should offer help and support. That assistance signals to suppliers that companies have confidence in their long-term capabilities. Suppliers are then motivated to reciprocate and innovate.
This would not only bring about cost savings but also reduce the side effects of continued changes to specification adjustments.
I agree that effective supply chain management can improve costs of goods sold in many ways but historical data analysis should be made carefully to reduce the risks of making the new decisions. Companies should search ways to increase their information accuracy for better forecasting by reducing unknown parameters. For example, Walmart and P&G vendor management supply chain improved the forecasting by Walmart’s point of sale data and P&G’s market data. Walmart and P&G achieved; increased inventory turns, reduced stock outs and unnecessary inventory costs and increased customer service. They increased their competitiveness by building a specific relationship to reduce information asymmetry. Additionally, companies can improve COGS through demand management. Generally grocery stores use Pareto-analysis to improve demand management which helps them to reduce costs.
There could be unintended side effects from continued specification adjustments like information leakage to competitors. In order to prevent such side effects, companies should select their suppliers carefully and should build strong relations by investing their suppliers to improve their costs. Also, companies increasingly want their procurement managers to be on the supplier place to have instant information to be more effective when unexpected problems arise. There is always room for improvement for cost optimization but the challenge is information asymmetry.
Potential cost savings can be reaped by adjusting the part’s specifications. For example, in food industry, water vapor transmission rate and oxygen transmission rate are checked for wrappers to ensure shelf life of the product. If a supplier can maintain the same standard with a different film at a lower cost, procurement department provides samples of new film to marketing and quality control for approvals. As long as key outcomes are satisfied, new specifications would be issued and new low cost film will be procured. Thus, by varying the specification of an incoming material, COGS can be reduced.
Secondly, by committing a consistent demand of a raw material for a longer horizon to a supplier, supplier’s operation can be stable (with better production efficiency, lesser startup and shutdown waste, lesser downtime). Manufacturer can negotiate for longer credit limits or lesser unit price with the supplier and thus working capital requirement can be reduced.
I agree that better cost savings can be achieved by Shell’s practice of probing at a wider angle. Procurement manager should focus not only on price negotiations but on other factors to achieve significant cost savings. Supplier who provides idea to change specifications and achieve cost savings for the company should be recognized and motivated. Thus he can suggest best practices employed by other buying firms in the industry. Also, procurement and quality departments should ensure strict approval process to ensure non compromise of quality standards.
Effective management of supply chains will definitely help in improving the overall efficiency of the process and a decrease in the COGS would actually be a part of this increase in efficiency. Design for manufacturing is a concept which takes into factor the actual manufacturing process while designing the product. Other concepts like demand pooling, postponed production, commonization of parts, supplier consolidation etc help in improving this efficiency as well. The supplier base plays a critical role in the implementation of these concepts by adopting the same at their end as well. If the adoption is not complete then the gaps would result in the maximum efficiency not being achieved. Tweaking the design to achieve cost benefits should be done so much that the product integrity is maintained and after this point a new product should be designed (which would incur an initial cost) else by stretching the thread too far too thin it might end up having a reverse effect of product failure. Another way of incentivizing the suppliers to be a part of this change is to bring them on board and share the profits achieved which would build their confidence in the change and also trigger changes in their own supplier change which would inturn have a positive effect on the overall supply chain.
This article reminds me of the first principles approach often repeated in Elon Musk’s interviews. Most big manufacturing corporations are characterized by unwieldy supply chains, legacy designs, layers of contractors, and “cost-plus” billing. The advance of SpaceX in launching rockets at a much lower cost than its competitors is attributed to the integrated design strategy rather than designing by sourcing sub assembles/components from a variety of suppliers. The pressure of constant price reduction is reaching a point where suppliers are not able to sustain their businesses unless they improve their productivity. Percentage growth of productivity in manufacturing industries has decreased over the past 3 decades because continuous improvement is focused primarily in silos. If companies take a more coordinated approach across all elements of a product by helping their suppliers at every level, the opportunities to decrease overall cost and improve quality are numerous. Sharing information and technological capabilities to accelerate the coordination activities is important to long term success of these companies.
Yes, effective supply chain management dominates prices in improving costs of goods sold. Proper forecasting the demand and reducing inventory in entire supply chain help in reducing significant cost for the whole chain which ultimately brings down product cost. Proper coordination with supplier helps to remove the friction in supply chain. So, suplier should be incentivized to improve supply chain so that win-win situation can be achieved between the manufacturer and supplier.
Effective supply chain management can play a big role in improving COGS, but it is not the only factor which influences it. The optimization of overall operations( procurement, transportation, warehouse, other overheads) and better forecasting and management of demand will reduce costs till a certain point, but final costs will have other costs as well like raw material costs which are a result of various other factors like economic atmosphere, origin of the raw material etc.So After a point, the impact of optimization will be minimum on overall COGS, and hence the figure of 3-5% will be declining one over years.
When it comes to incentivizing the process of continuous improvement, everyone benefits from the process. A company having it as part of their growth strategy, have to carefully choose and partner with the suppliers who align with the strategy or help their current suppliers align with it. This is viable only when all parties in the equation are committed to it, otherwise it will just create a stagnation.
Although, if a company is not realistic about the growth figures they are expecting and expecting a fixed figure of say 3-5% from just improvising their operations and not paying attention to other factors contributing to the costs , it will lead to potential economic holdups and focus on wrong KPIs.
Effective supply chain managements that is adjustment of demand and specification can be really efficient method to improve the COGS of a product and reduced COGS can definitely will have a dominant impact on the price of product and thus its future demand in today’s highly competitive market, but forecasting correct demand is not an easy thing to do and adjustment specifications, if not done correctly can affect relationships with both customers and suppliers, so this efforts of stabilizing demand should be coupled with process innovations or value engineering efforts from supplier side and many industries in manufacturing sector have this VAVE approaches to ensure suppliers are equally involved in supply chain optimization as they are , this also helps suppliers grow their competencies and at the same time develops a trust factor across supply-chain.