Do you really know what your operational costs are and what the exact nature is of the products or services that you are purchasing?
Many manufacturing companies know what they’ve spent in direct material and direct labor.
But when it comes to indirect expenditures, the clarity is just not there.
Ironically, a company can grow substantially and be spending tens to hundreds of millions of dollars on indirect expenses and not have the right process or program in place to analyze or manage it.
To properly analyze this type of spend, it is necessary to,
- Define the company’s indirect categories of spend
- Answer questions about ‘agency’
- Create, publish and support a ‘company-wide’ Procurement program
Defining the Company’s Operational / Indirect Spend
The first step in understanding a company’s ‘operational spend’ requires categorizing, coding and documenting the spend, i.e., the company must have a way of grouping and associating multiple transactions.
This allows the firm to document, tally and analyze dollar amounts and transactions in each category.
The next step, creating an agency doctrine, is more complex but perhaps more important and must be addressed for a company to manage the indirect spend.
The important questions senior executives must ask themselves about agency is,
- Where, for what categories and amounts, and whom should have the responsibility for the stewardship of purchases on behalf of the company?
- What are the reasons that the control has been specified this manner?
Creating, Publishing and Supporting an Agency Doctrine and Procurement Policy
For a company to control spend, there needs to be an agency doctrine, i.e., a written policy that specifically authorizes individuals to act as ‘agents’ for the company when expending company assets.
Likewise, the company will need to create a procurement program so that personnel know what needs to be done to obtain the necessary products and services needed to support the company operation.
Senior Management Support
Understandably, the agency doctrine and procurement program must be thorough working as intended (and should be tested before release).
However, unless executive management supports all facets of this program, it will not be followed and in that case not provide the information required to properly manage this spend.
The Bottom Line. Knowing what the company’s operational costs are is the first step that is needed to manage these costs. To properly analyze spend, companies must categorize what is being purchased. Likewise, the company must develop and publish an agency doctrine and procurement policy. Finally, executive management must completely support these programs.
As businesses grow, entrepreneurs and the companies they’ve started must cope with changes in their business model and adapt their management style. In addition, they must confront the change in objectives, strategy, measurements and control.
Businesses at Stage One Growth
Stage One companies are typified by an entrepreneur who launched the company to promote an idea, product or service. The company’s main goal is survival and growth.
Likewise, the objectives are personal or subjective and strategy is implicit with exploitation of immediate opportunities. Measurement and control are accomplished by simple accounting and daily observation and communication.
Companies at Stage Two Growth
Companies have gotten larger and resources have expanded providing much needed help. One of the biggest changes, and challenges for stage two companies, is that the entrepreneur has hired functional managers. This transformation can be very difficult for some entrepreneurs, since they typically need to and should (with well-formed guidelines) relinquish decision making responsibilities (but many times do not).
At this stage objectives are focused on profits, meeting budgets and basic performance targets. The strategy typically is on one product or one service. Here, control grows beyond the solopreneur and structured control systems are developed.
Stage Three Companies
A Stage Three business has changed significantly from the early days. It is typically much larger in sales, personnel and products. The change in size also creates a challenge to increase profitability.
There is now a trusted management team as the company’s diversity and complexion has increased significantly. It is necessary to manage the overall business at the strategic and operational levels.
Growth has created the opportunity to be in more than one type of industry and geographical area. This means multiple divisions, product lines and product mixes.
Objectives have changed and take the form of Return on Investment, profits, and earnings per share. Control is performance measurement.
The strategy also changes as the company wants to increase sales of its product lines, both organic or non-organic in nature. This enables the company to exploit more business opportunities.
The Bottom Line. As companies are successful, their businesses grow and must adapt to changes in objectives, strategy, measurement and control. Early stage entrepreneurs make all the decisions and their objectives are personal and subjective. However, as companies grow changes take place. At the other end of the spectrum are larger stage three companies. Growth has taken off and products are diverse and complex. There is a need to have a management team overseeing a much larger organization that focuses on the Return on Investment, profits and earnings. The strategy is to grow the company’s sales, and this can take the form of organic growth or acquisitions.
Can a company, in the lower middle market, really save money using a digital procurement process?
Let’s take a closer look …
The First Step
The first step towards digitizing the procurement process can only begin if a company already has a procurement program in place, i.e., process, templates and a submission network.
This being the case, let’s stipulate that management has decided to examine which process is better for the company, a manual or digital purchasing requisition program.
To simplify this example, we will only look at the first part of the process and that is creating and submitting a purchasing requisition to the Purchasing department.
To begin, it is necessary to benchmark the company’s current manual process. The time for processing and submitting requests for operational supplies needs to be measured.
Below are the results, using a random sampling of purchasing requisitions, extrapolated to equal one year’s worth of requests.
The next step involved processing the same requisition(s), but this time the requests were processed and submitted electronically. Here are the results. Again, the same sampling of requisitions was used and extrapolated as in the first case.
When comparing these two studies, it is easy to see there is a significant reduction in costs when using the digital creation and submission process. In addition, requisition accuracy increases by eliminating repeated data entry that is an integral part of the manual process.
More Reduction in Costs When Digitizing Other Processes
The reduction in costs achieved by a company can be even greater, once the entire process is digitized. This can be seen when the entire purchasing and administrative processes of the company are digitized (i.e., purchase orders and Accounts Payable).
The Bottom Line. Once a procurement program is in place, a company can analyze the idea of migrating from a manual to a digital requisition process. The first step is a time study to benchmark manual processes. Likewise, the digitizing of the purchase requisition creation and submission process must be measured. The time saved by a requestor in processing and submission of a requisition was approximately 50%. More opportunity for cost reductions exists when considering digitizing the purchase order and Accounts Payable processes.
The Challenge. Many production systems today contain ‘bottlenecks’ or constraints costing a company money. Do you still have significant bottlenecks in production at your facility?
The APICS dictionary defines a bottleneck as “a facility, function, department or resource whose capacity is less than the demand placed upon it.”
In other words, a constraint is an element or process in a system that prevents the overall output from reaching higher levels.
Theory of Constraints. Dr. Eliyahu M. Goldratt developed a philosophy that ‘all’ systems at any one time have only a small number of variables or constraints (perhaps as few as one) that effectively limit the output of a system.
With this in mind, there are ways to optimize a manufacturing system’s output. Likewise, once constraints are removed, a company can reduce its overall costs since more product will be moving through the production process in a shorter amount of time.
It follows that the company’s challenge is to see (and understand) the current state of the production system and then envision the future state allowing for higher output of the system.
Removing Constraints. The APICS dictionary defines ‘five focusing steps’ to help identify and remove bottlenecks or constraints in a system. They include,
- Identify the constraint – determine the throughput rate and the demand rate
- Exploit the constraint – maximize use of the constraint
- Subordinate the constraint – make effective use of the constraint the top priority
- Elevate the constraint – increase capacity of the constraint
- Once resolved, identify the new constraint.
One of the most difficult steps, in more complex processes, is identifying the initial constraint in the system.
‘Product flow’ diagrams, that pictorially describe the product and flow rate, can be of help in finding the point or points of constraint in a system.
The Bottom Line. Many production systems exhibit ‘bottlenecks,’ i.e., those elements whose capacity is less than the demand placed upon them. Dr. Goldratt’s theory of constraints stipulates that a system can have only one or, at most, several constraints limiting the systems output. Identifying and removing constraints increases the output of a system and helps reduce costs. APICS defines five steps that assist in removing constraints. Product flow diagrams help identify constraints in a system.
In the last few years there’s been a lot of discussion about ‘category management.’ So, what is category management and do we need to worry about it?
Category Management Defined
Category Management is the deliberate grouping of products, that have similar physical attributes and/or manufacturing processes, into a single category.
This is done so the company can better analyze and understand the supply and demand of these products. Ultimately, this action leads to consolidation and leveraging of the supply. And this usually translates into significant cost reductions.
As an example, a company may have different Planner-Buyers purchasing many different machined parts from different suppliers. Furthermore, this could be the case across more than one division of the same corporation. The company would find it very beneficial to create a Category titled Machined Parts and work to organize and manage these parts both at the division and corporate levels.
Due to limited resources, the importance of a category to the company must be defined. This allows the supply chain group to focus on the most important Categories. Ranking of the Categories can be determined by dollar value and/or how critical the product(s) or service(s) are to generating revenue for the business.
A good example of a critical product is powdered Tungsten, an ingredient used when manufacturing a shape charge (shape charges are used in the perforation of an oil or gas well). There aren’t any substitutions for this ingredient so without Tungsten production stops and the company experiences ‘lost time.’ This could also mean ‘missed’ customer shipments.
An appraisal is a ‘status report,’ i.e., how well is a Category performing when supporting the objectives of the company. The report should include usage, projected demand, production issues, cost savings, non-conforming products, etc.
The Category Scorecard is composed of important elements from the Category Appraisal, and weighted to provide an overall score. Using the example above, the company should have a way to track and score deliveries, cost, usage, non-conformances, etc.
Category Strategies are developed to ensure that the category is properly organized and supporting the objectives of the company.
Let’s use the shape charge example above. Suppose the manufacturer has a customer service level goal of 98%. In this case one of the strategies should be to eliminate (as much as possible) production downtime.
Tactics, for a category, refer to specific actions the company will take to support its strategy for that category.
In the example above, an action to be taken to eliminate stockouts of powdered Tungsten is for the customer and supplier to exchange all necessary information ensuring the continuity of supply. This would include forecasts, current production schedules, inventory levels, consumption figures, etc.
Another tactic could be the creation of safety stocks, both for the supply of raw material and the demand of finished goods. This would attempt to account for any forecasting error(s), backlog changes, etc.
Review, Evaluation and Control
The final step is to review and evaluate the Category Management process to determine if the company is reaching its objectives. If the company is meeting its goals, further action may not be needed.
However, if the objectives are not being met, corrective action should be taken at the corresponding level in the category management process where issues have developed.
The Bottom Line.
The category management process is the careful and deliberate consolidation of products or services to allow for better control and management. This process, depending on the spend, can provide significant cost reductions. The Category Management Process has specific steps to ensure its success. When the Category Management Process is managed properly, it supports the company in reaching its objectives.
The Cash Conversion Cycle (CCC) is one of the tools that can help manage the company’s assets and liabilities. Is your company’s CCC number good, bad, or really ugly?
The Meaning of a CCC Number.
The CCC is reported in days. The formula for the Cash Conversion Cycle is,
CCC = DIO + DSO – DPO
DIO = Days Inventory Outstanding (selling or turning over the entire inventory),
DSO = Days Sales Outstanding (number of days needed to collect the Account Receivables), and
DPO = Days Payable Outstanding (number of days, as agreed with suppliers, to pay the company’s bills)
The CCC metric measures the efficiency (performance) of the company when managing short-term assets and liabilities. The lower the CCC value is, the faster the company is converting cash to goods and back to cash again.
The CCC also is a measurement for liquidity, and how much risk exists should the company choose to invest in additional resources over the ‘short-term.’
Calculating the CCC Number.
Company ABC has an Inventory Turnover of 6.8 times per year. Currently ABC has 53 days of production inventory. ABC has ‘aged’ receivables of 40 days. The company has negotiated Accounts Payable terms of N55. Using the formula,
CCC = DIO + DSO – DPO
= 53 + 40 – 55
This measurement indicates overall performance, but it must be taken in context. The result should be compared to other companies and their CCC numbers in the same industry.
Interpreting the CCC Number.
Let’s say that the business in the above example is using raw materials in production that are commodities. This means their purchasing lead times should be short (let’s say five days). Let’s also state that the company’s manufacturing lead time is ten days.
With these two premises in mind, the company should have a very low CCC number (if they have also managed their DSO and DPO numbers).
Conversely, if the same company above has two months of production inventory on-hand, then the company will probably have a higher CCC number meaning that its Cash Conversion Cycle is too long.
It is important to realize that there can be other reasons for a higher DIO or CCC numbers, e.g., the company may not be meeting customer order ship dates due to planning and/or execution issues.
The Bottom Line. The Cash Conversion Cycle number is just one of the tools available to review company management of assets and liabilities. The number is used to measure how fast the company converts cash to goods and back to cash again. A lower CCC number, if found to be comparatively equal to other businesses in the same industry, can indicate effective management of the company’s Cash Conversion Cycle.
For many companies, and their supply chain, the ‘Cost of Goods Sold’ averages between 40 – 65% of sales revenue.
Each year companies face and accept price increases for their materials based on their supplier’s notifications of increased labor and material costs. In turn, these companies simply pass these additional costs on to their end customers.
But, is this good business to regularly pass along these kinds of price increases? Probably not …
First, it’s not always clear what drives these increases. Secondly, by allowing regular increases, it can appear to end customers that your company lacks control over its supply chain.
By developing the ‘right’ supply chain, the company will find many opportunities to optimize performance leading to a reduction in total costs, so it may not be necessary to increase prices.
To serve customers at the right time, with the right product, for the right price, companies must build advanced supply chains. This means evaluating and selecting suppliers based upon,
1. A shared vision
2. ‘Trust’ (once developed)
3. Specific criteria (ranging from technical capabilities to issues like ‘supply chain maturity’
4. Collaboration, i.e., the ability to operate together as one organization, and;
5. Long-term contracts (with critical suppliers)
The Bottom Line. Companies spend over half of their sales revenue for the cost of goods sold. Each year there are pressures to increase costs. Businesses do not always have to increase prices. Companies can, through their evaluation and selection process, build the ‘right’ supply chains that optimize performance, reduce total costs and increase gross profits.
The manufacturing evolution began from entirely manual operations and spanned to the incredible sophistication of today. This evolution was accelerated in the past several decades as US manufactured goods increased in demand across the globe.
Successful companies conduct categorical review of their manufacturing processes to remain competitive. They modernize and refine their manufacturing methods to fully exploit efficiencies, without losing the quality their customers expect.
Process automation has grown to be one of the most prevalent considerations to achieve this goal. Automating processes within fabrication, assembly, and packaging will translate to a reduction in overall cost of the final product; in effect, widening the profit margin.
The Bottom Line. For successful manufacturers, automation is a viable solution to significantly reduce costs in this highly competitive environment. Implementation can be a costly investment, so it’s imperative that a comprehensive analysis is conducted on current processes to determine maximum impact.
Arguably, one of the most unknown and under-appreciated programs that helps organize a company’s sales, production and customer deliveries is the Manufacturing Planning and Control (MPC) system.
This topic is so important that APICS devotes many chapters in its publications and certification classes covering how Manufacturing Planning and Control (MPC) works.
In a testament to MPC, many software companies including Oracle and SAP use ‘very similar’ algorithms to the MPC program when designing their manufacturing programs.
Why is this important?
The heartbeat of MPC is a process called Priority Planning. Priority Planning is much like the operating system for a personal computer in that it integrates the company’s sales and manufacturing plans by organizing and controlling Sales & Operations Planning (S&OP), Master Scheduling (MS) and Material Requirements Planning (MRP).
MPC enables companies to manage orders, prioritize and re-prioritize manufacturing, and balance the demand side of the business with the supply side of the operation. This enables greater focus on the customer ensuring on-time deliveries and high levels of customer satisfaction.
The Bottom Line. Manufacturing Planning and Control (MPC) is well known for its process of integrating critical segments of a business. MPC is so important that many of the world’s software companies use the process when developing manufacturing programs. MPC’s benefits include integrating the S&OP, MS and MRP processes that enable on-time customer deliveries and higher levels of customer satisfaction.
Over the years, many studies have been commissioned by ISM, Industry Week and private companies to determine the ‘cost’ to process purchase orders.
The same argument includes Account Payables and Receivables. It costs money to manually process these transactions.
The numbers range from $25 an order, to hundreds of dollars per order (depending on type of purchase and size of the company).
Isn’t it about time to ask a tougher question, i.e., “Isn’t there a better way to handle these kinds of transactions?”
Fortunately, even for the smallest of companies, the answer is “yes.’
From simple Microsoft Office programs to personal computers, with the latest in Enterprise Resource Planning (ERP) programs, there are better and faster ways to process these transactions (many automatically).
And that is what it is all about, right? Spending time on the ‘value add’ activities while eliminating those elements that cost you money.
The Bottom Line. It costs the company money to process purchase orders, accounts payable and accounts receivable. Today’s computer and software technology allow companies to streamline these processes saving time and money.