How to Inform Price Changes to Business

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Do raw materials have a major impact on your company costs?  If so, any of your business colleagues worth their salt will want to know ASAP when their raw materials undergo a price increase.

Of course, for raw materials with big spend dollars and high variable-cost impact, purchasing usually informs its internal clients about changes in price.

Now, imagine that you are able to show, on a monthly basis, the overall price increase or decrease of all raw materials!  Moreover, that you are able to show the price impact over the following three months in the future, serving as a purchasing alert for what is happening in the marketplace, allowing business colleagues to take proactive measures and prevent margin erosion.

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This is possible without additional software, just using your company data along with Purchasing Alerta™, an Excel spreadsheet developed specifically for this purpose. 

Before I explain the Purchasing AlertaTM tool, let me go over with you some crucial terminology: timing, prices, business structure, and three economic terms.

TIMING

In any supply chain we have inventories of Raw Materials (RM), Work in Process, semi Finish Goods and Finished Goods (FG).  Those inventories serve as buffers to meet uncertainties in demand, supply, and movement of goods.  Every industry adapts these for the timing needed to avoid specific uncertainties.

According to a study from Hackett Group (SupplyChainDigest), the 2010 average days of inventory outstanding for hundreds of public U.S. companies was around 51 days.  To that we must add the manufacturing time, Work in Process and movement of goods.  Even for very efficient companies, these factors move the timing to an average of 90 days.

Based on accounting rules, RM prices register in the books or ERP systems the moment the product arrives at the plant, or more precisely, register the quantity received and total amount to be paid.  Under the same rules, sales are registered the moment the FG leaves the plant to the customer.  With a lag time between RM and FG around 90 days, a RM purchased in January is part of the FG sold in April.

PRICES

Unit price in purchasing is defined as the total amount to be paid divided by the total quantity received.  The Unit of Measure (UOM) used to define the quantity is used in a unit price like $/pound, kilogram, metric ton, square meter, etc.

Purchasing departments deal with variability all the time because the same product is purchased in different UOMs according to the geographic region.  The USA, United Kingdom, and former British colonies use English units of pounds, ounces, tons (long and short), gallons, and cubic feet.  Most other countries use metric units of kilograms, metric ton (1000 kg), and liters.  The same mix of UOM is used on the sell side by the company.

UOM.jpgThe problem of comparing sales unit price with RM unit price is that both must be in the same UOM for accurate comparison.  In order to meet this need, Purchasing AlertaTMwas developed to translate almost all UOMs, from sales and purchasing, into one measurement, allowing users to compare apples with apples.

 

BUSINESS STRUCTURE

Each organization has its design based on business type and structure.  The most common structure has at the highest level the global business unit (GBU), where it is divided into business groups, business units, value centers, and performance centers.  The names used in the organization may differ, but the structures follow the same rational: aggregation of products.  Each product sold belongs to a performance center, which belongs to a value center, and so on.

Once the corporation defines its structure, finance and business develop the sales structure accordingly, and controllers (as a part of finance) develop cost accounts accordingly.  For example: Product A is manufactured using RM “X” and “Y.”  On the sell side, Product A is registered into the system in the appropriate performance center, value center, and so on.  The RM “X” and “Y” are registered on the cost side following the same business structure.

GBU.jpgFollowing accounting rules in any country, any sale of a product is registered into the system in the correct business.  Likewise, any raw material used to manufacture that product is also registered in the same business. Purchasing AlertaTM was developed to link both sales and purchasing in the same manner, at any level desired. 

 

ECONOMIC TERMS

Margins are terms used in economics to define the amount of money remaining after deduction of certain items and normally used in the income statement analysis.  The income statement starts with revenue and then shows all possible costs reaching profitability.  Three important margin terms are:

  • Contribution Margin: This is the revenue less the variable costs.  Variable costs are composed of all input costs which vary according to the quantity of products sold (raw materials, packaging, utilities, etc.).
  • Gross Margin: This is the contribution margin less the fixed costs.  Fixed cost is composed of plant labor, maintenance, depreciation, and all other costs in the plant (which do not change with produced volume).
  • Operating Margin: This is the gross margin less expenses.  Expenses are composed of R&D, administration, sales, marketing, etc.

Purchasing AlertaTM shows the difference between sales unit price (SUP) and raw material unit price (RMP).  This is a margin close to the contribution margin because it contains all raw materials but not packaging or utilities; for this reason, we call this the Delta margin.

PUCHASING ALERTATM

Any company where raw materials have a high impact on cost can use this tool.  The software gives an alert to business colleagues on what is happening in the marketplace related to all raw materials purchased by the company compared to their sales unit price (SUP).

More important, it alerts users as to what will happen in the coming three months, so colleagues can take proactive actions to avoid margin erosion.

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Scales

  • Both Y-axes are, in this case, in $/pound, the unit of measure (UOM) common to sales unit price (SUP) and raw materials price (RMP).  All UOM, from sales and purchasing, were translated into just one UOM.  The blue line represents SUP, andred line represents RMP.
  • The X-axis presents two time scales, one for SUP (top) and another one for RMP (bottom).  The scale for RMP is staggered three months ahead. As explained in the paragraph above Timing, there are around ninety days of lag time, so a raw material purchased in January will comprise part of the cost of a sold product in April.
  • The delta margin is the difference between SUP and RMP in $/pound represented in the bars.

Forecast

As we have a lag time of ninety days between the raw materials and sold products, we can forecast the cost impact in future sales.  In reality, we are using actual RM data from the ERP system which will be part of the cost of products to be sold in the future.

As purchasing professionals are not expert in predicting sales prices for the future, we assume the sales price (SUP) from the ERP system will remain flat in the next three months based on last price available.  This is, at least, the conservative view.

With this SUP “forecast” we are able to calculate the delta margin (gray bars), showing the improvement or erosion of margin in the next three months, and our business colleagues can take proactive measures accordingly.

Business Structure

business_structure.pngThrough a drop-down tool, you can select any business level, according to the existing business structure, and the graph will display the data accordingly.

  

Relevant Information

relevant_information.pngThis tool also calculates other relevant information: Impact on sales (total purchasing costs divided by the total sales, for each selected business) and Percentage of products translated to the same unit from all UOM in the ERP system.

 

HOW THIS FITS YOUR COMPANY

The Purchasing AlertaTM tool can be adapted to your company and you will be able, on monthly basis, to alert your business colleagues about what is happening in the marketplace.

  • You define the business structure you want to show
  • We prepare the tool with all your sales and purchasing data
  • We coach you on defining the process of monthly data collection
  • We coach you how to do the monthly updates, while you manage the tool internally
  • You need no software, just a person to collect the data, manipulate it in the tool, and publish in your Intranet for access by your business colleagues

To request a free demonstration, email paulomoretti@pm2consult.com.

To download a PDF of this white paper, please click here–How to Inform Price Changes to Business

Spend Management: A Necessary Evil?

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Several articles and white papers have been written about spend management and spend analytics. Let’s use Wikipedia to define each one:

  • Spend analysis is the process of collecting, cleansing, classifying and analyzing expenditure data.
  • Spend management is the way in which companies control and optimize the money they spend.

Companies have invested money and resources in spend management with two main objectives: Aggregate spends so you can leverage your purchasing power; and decrease “maverick” spending (buy from non- preferred suppliers).

Around 10 years ago, companies defined spend management as one of their key priorities. Last December, Aberdeen published its survey in the 2012 CPO Submit, which shows that spend management is the second biggest technology investment and the third critical need in their organization. So, I was wondering why this issue has not been addressed through the years? Why has spend management targeted mainly indirect spend?

IT Investment

Most of the companies have primarily invested in IT (Information Technology) for sell side and Finance. In the Sell side the goal is to manage each product sold to generate the total revenue of the company. In order to do that, a product code structure was created, so it is well known where and when the product was sold, it is possible to aggregate each product into families, sub-groups, and groups, and by business structure. So, the code structure gives the transparency needed in sales.

In Finance, the goal is to aggregate all the costs, expenses and capital, so it is possible to attend the accountant rules to generate the income statement, balance sheet and cash flow. To build the cost, it is first necessary to calculate the variable cost which is the unit ratio of each raw material, utilities and packaging times the unit cost of each one. It is clear that a product code structure is needed in the ERP (Enterprise Resource Planning) or an IT system to accomplish this calculation, so from the purchasing perspective, we are able to do spend management of direct materials once we have the code structure in place.

The issue arises with indirect spend because most ERPs or IT systems, do not “force” a code structure for indirect spend like MRO (Maintenance, Repair, Operation), Logistics (Freight), and other corporate expenditures (HR, Marketing, IT, TE). Accountants, following the rules of credit and debit, define into which cost center each expenditure can be placed to attend income statement needs, but not Purchasing needs in terms of spend aggregation.

Spend Management Software

Because of a lack of code structure for indirect spend, more than 15 companies listed by Gartner, including the biggest ones SAP (acquired Frictionless and Ariba) and IBM (acquired Emptoris), are offering software solutions for spend management. They understand Purchasing needs in terms of spend aggregation (and lack of code structure) and provide a solution for collecting, cleansing and classifying the spend data.

The principle is relatively simple: 1. they collect all spend data from different IT systems in a structure form; 2. the cleansing process detects and corrects corrupt or inaccurate data; and 3. by “reading” what was written in the purchase order and/or invoice, it classifies the spend under a code structure. The code structure can be the one defined by your company, or commonly used UNPSC developed by United Nations with help from several different companies.

The UNSPSC for a given item is composed of five two-digit identifiers, which together categorize the item into a four-level hierarchy. The four levels are: “Segment”, “Family”, “Class”, and “Commodity”. For example:

  • Segment – 40.00.00.00 = Distribution and Conditioning Systems and Equipment and Components
  • Family – 40.15.00.00 = Industrial pumps and compressors
  • Class – 40.15.15.00 = Pumps
  • Commodity – 40.15.15.21 = Rotary pumps

Having your spend under a code structure is better than nothing. However the given hierarchy does not match with how the Purchasing function is organized, so there is a need to learn and “translate” that to your organization. Also the granularity is not deep enough. For the given example, rotary pumps from different materials and dimensions were aggregated into one “commodity”. Moreover, most software companies claim that they are able to classify a minimum of 80% of the spend: The key question is, how much was classified under the lowest level? Because it is at this level where Purchasing can make a difference.

Solution

There is no doubt that the long term solution is to have a code structure for everything purchased from third parties, products and services in the ERP or IT system. Also it is a good practice to have a code structure for suppliers so you can have just one name for all the suppliers under the same organization and subsidiaries. The most advanced systems now can provide the code at the moment the requisition is typed into the system. The system containing the code structure, can “suggest” alternative codes at the moment it is written so all the processes after that contain the correct code, and so Purchasing, later on, is able to aggregate the spend accordingly.

The down-side of this approach is the cost. It is a big IT project demanding specific resources from Purchasing and IT; your company cannot stop the systems just to change the codes.

An intermediary approach is to use spend management software and the code structure developed specifically for your company. Spend management software can be “on-demand” or in the “cloud”, so at a relatively lower cost and will not “touch” your IT system. So, at short-term, you have the spend aggregation as needed, with codes you developed, and later when your company decides to improve or change the ERP or IT system, you will already have the code structure and the historical spend with the same codes.

Purchasing Strategic Planning: CPOs, Have You Done Your Homework?

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Every single year all companies face the budget planning cycle. At company level, this is defined as the revenue target, the costs and expenses to run the company, and, the profitability for the following year. In a perfect world this process should be two-way street where the corporate leadership defines the targets with functions and businesses giving their input. In the end, all functions and businesses must follow the corporate guidelines.

Short Term Planning

Once the company’s targets are defined, the CPO or Vice President of Purchasing should define the Purchasing targets for the following year.

There are several Purchasing metrics available in the function that should be part of planning cycle. However I’ll mention a minimum of four targets the function head should define: Total Spend, Addressable Spend, Savings and Resources (FTE).

Total Spend can be calculated using the company’s revenue and CAPEX  (capital expenditures) plan.

Addressable Spend can be estimated based on the previous year’s sourced spend; contracts which will expire in the following year as well as major spend needs based on Revenue and CAPEX.

Savings can be defined based on improvement from the previous year’s savings in percentages (Savings/Addressable Spend), market economic cycle and relative position to market savings based on benchmarks.

Resources (FTE) can be calculated based on a budget defined by the corporation and previous year’s capacity (Spend/FTE) for each commodity.

With these four targets, as VP of Purchasing or CPO, you are covering Efficiency (Addressable Spend / FTE) showing how much you can handle with existing resources and Effectiveness (Savings/Addressable Spend) showing the quality of your sourcing projects.

Based on these targets, each Commodity Director can start defining the projects to be sourced next year, using the same metrics, and, the Sourcing Managers (buyers) can define their personal goals using the same metrics.

Long Term Planning

Strategic Planning is more elaborate and time consuming. The CPO or VP of Purchasing should lead the Strategic Planning exercise every three years covering the next five years. The objective is to define: Vision and Mission for the Purchasing function, as well as the Objectives and Goals for the next five years.

There are several methodologies to define this roadmap; however my preference is get grounded in facts; externally and internally. Let me elaborate about it.

Externally: Generate data from Global Economy Trends, Your Industry Trend and External Purchasing Trends.

Internally: Get data from Your Company (Business) Strategy and Your Purchasing Function.

Once you get all the information and data, through several sessions with the purchasing leadership, cluster and affinitize the ideas and trends into five to seven themes related to the Purchasing function. For each theme, define the strategic objective. Now you have enough material to define the Vision and Mission for Purchasing.

For each strategic objective, you need to define the goals for the next five years. Define as many goals as you think appropriate, then prioritize them by using value and impact to the company, also defining the completion date. It is recommended that for each strategic objective, the CPO defines a person from leadership as “owner” of the objective.

Once you complete the Long Term Planning, it is much easier to do the Short Term Planning because now you understand the “roadmap” and each year you refine the goals aligned with the business strategy.

As strategic planning is complex and time consuming, it can be worthwhile to have an outside consultant to help with the development of this process, at least for the first time. The consultant is unbiased and has an outside perspective helping to challenge the goals.

Now that you have done your homework, I wish you Happy Holidays and a very efficient and effective 2013.

Benchmark in Purchasing: Are You Worst-In-Class?

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Wikipedia explains that the term benchmarking was first used by shoemakers to measure people’s feet. They would place someone’s foot on a “bench” and mark it out to make the pattern for the shoes. Today’s definition of benchmarking: “It is the process of comparing one’s business processes and performance metrics to industry’s best practices”.

In my last article Metrics for Purchasing: A Framework that Works I described most of performance metrics for purchasing function to drive behavior with the objective to improve performance. You can improve your own performance; however, what is the most important is to check if your organization is performing above average in comparison to the market / industry. Only the benchmark can give you this picture.

By performing a benchmark you are able to answer: Do you have a competitive advantage? What are your strengths and weaknesses in the purchasing function and where should you direct your efforts to improve?

Framework

Either doing benchmark one-to-one (your company with another company) or one-to-many using third party entities, you need to define the benchmark framework. A good example of framework of benchmarking for procurement performance was given by Professor Andrew Cox from International Institute for Advanced Purchasing & Supply where he also explains the difference between World-Class and Best-in-Class.

Another alternative is to use the existing or part of the framework defined by third party entities performing the benchmark. Either way, you need to define your objectives very clearly, what and why you want to benchmark.

Third Party Entities

My personal preference is for using third party entities to do benchmark because: they have experience in doing it, unbiased; they have historical data so you can see the evolution, and you can compare your company to the same industry or cross industries. There are several entities doing benchmarking, but I’ll mention the ones with whom I have worked and who have given me permission to write about them. The comments below are related to some of their benchmark activities, and not all the services they can provide.

AT Kearney – A recognized consulting company offers two benchmark assessments: “Assessment of Excellence in Procurement (AEP)”* and “A.T. Kearney’s House of Procurement and Supply”*.

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The last AEP was titled “Follow the Procurement Leaders” and was published in 2011. The next edition of the AEP is scheduled for 2014. Participant companies should have annual revenues in excess of $3B. The 2011 AEP included participation from 500 companies across all continents.

A.T. Kearney’s House of Procurement and Supply is the framework for the AEP survey.  The AEP survey is executed through an online tool and there is no cost for participation. All companies participating in the AEP survey receive a customized benchmark report showing company performance versus best practices across Sourcing and Category Management, Operating Process, Organization Alignment and other “rooms” of the House described above.

CAPS Research – Is a nonprofit research organization dedicated to supply and supply chain issues.

They provide several benchmark reports free of charge: Industry and Cross-industryreports, Focused Benchmarking Reports,  and, Market Basket of Goods (prices paid). Some reports are available only by sponsors.

Some benchmark metrics used are: Organization design, # FTE, Spend Managed, Operating Expenses, Work Processes, Cost Savings & Avoidances, among others. To participate, you just need to send an e-mail. The next Industrial Manufacturing Industry Performance Benchmark Report will be published in January 2013.

Roland Berger – A recognized consulting company which provides a report called “Purchasing Excellence Study”.

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More than 500 respondents worldwide help to identify trends and benchmarks cross-industry. The questionnaire and data are used to build your position in the Performance Cube** composed by three dimensions: Strategy, Performance and Enabler.

The report mentioned above shows trends in each dimension and changes over past years. Companies can participate at no cost and individual results as benchmark can be tailored through their consultants.

The Hackett Group – A recognized consulting company which has done more than 7,500 benchmark studies.

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Benchmark is a paid project where you supply information and data in a pre-formatted fashion and this information populates their database construct through a decade.

The benchmark study is plotted in “The Hackett Value Grid”*** where you are able to determine both performance gaps and capability gaps, and also compare your company to peers, cross-industry and best-in-class in terms of efficiency and effectiveness.

Take away

Efficiency and effectiveness in Purchasing are moving targets and only benchmark can give you the direction to pursue and identify the areas in which you need to improve, however you must define what and why you want to benchmark, and most important, have all performance metrics in place, before starting the benchmark.

ATK 2011 – Procurement Leaders

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AT. Kearney developed a methodology called AEP – Assessment of Excellence in Procurement where 185 leading companies describe lessons learned in search for Effectiveness and Efficiency for Purchasing function. It describes how these companies found Seven Ways to Lasting Results. PM2 Consulting provides the core competencies to achieve these results.

Hackett Group -The CPO Agenda 2012

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CPO Agenda from Hackett Group describes the top key issues Purchasing function is facing in 2012. Again, this study reinforce the need of having Strategic Sourcing, Category Management and SRM in order to have a more effective and efficient organization. PM2 Consulting provides work process and tools and these areas.