Introducing Intelligent Sourcing
George E. Danner
June 2, 2022
Now more than ever, sourcing parts and materials is a critical activity. Inflation has given us all a collective headache, especially in industries where it is difficult to pass along higher materials costs to customers. One antidote to this age-old problem: intelligent sourcing.
We’ve all heard about strategic sourcing, a practice that has been around for decades. The short definition: consolidating a commodity spend across fewer suppliers to increase per-supplier volumes and get better pricing. Strategic sourcing is a fairly simple-minded approach and one that has a mixed record of success in the firms I know well who have implemented it. Agility and resilience often suffer in strategic sourcing environments.
On the supplier side, we see companies with relatively complex products and services coming to buyers with “well, not every part/service is the same, this one has different features, etc.”. It is as if suppliers are creating a “fog” of pricing to prevent buyers from understanding the true, comparable price of any part or service. This is why services like Kelley Blue Book and TrueCar are so valuable to car buyers.
Enter intelligent sourcing. This is the means by which buyers really understand the price of a product from the ground up by modeling the price of that item.
Let me illustrate with an example from my own work. The following is a composite of an actual case.
ACME is in the structural cement business. One of the commodities they buy a great deal of is fiberglass. The fibers are mixed with the cement to give it strength and resilience properties. Much of this fiberglass is sourced from countries like Egypt.
ACME’s fiberglass suppliers sell a wide range of products with different physical characteristics, and therefore different pricing. These items are not always perfectly comparable with their second fiberglass supplier, so the procurement team just negotiates the best deal that it can with the starting price set by the supplier. Procurement considers it a victory when they negotiate a few cents per pound off of this artificial price, and in fact, the incentive system for ACME encourages this behavior.
Company leadership grew concerned that they were giving away profits every time they purchased new fiberglass materials, but they had no data to back up their claim—just a feeling. They asked my advice about this, and I started by asking a simple question: “how much should this product cost?”
A moment of embarrassed silence followed. Eventually, we began to discuss the cost elements of fiberglass and the processing needed to produce it. One board member had run a fibers operation and weighed in with a number of key points. We finally reached a conclusion: we must systematically determine how much this product should cost by modeling the supplier’s operations.
Now, this might sound like a daunting task: modeling a company that you don’t even own. You can’t talk to the Subject Matter Experts (SMEs) there, you don’t have expertise in the product, and you can’t have meetings to discuss how things work. But you would be surprised to know how much you can find out in the public domain and from smart employees (and employees’ friends) who may have worked in this industry. In the end, we were able to collect enough information to construct a shadow profit-and-loss statement for the supplier along with a variable cost of manufacture. We knew our model was not perfectly accurate, but it did not need to be—rather, it needed to be close enough to start a conversation.
We all learned so much from the process of constructing the model outside of the findings of the model itself (this is often referred to as double-loop learning). We transitioned from transaction buyers to economic buyers.
We met with the supplier and shared our findings. They of course dismissed parts of our model that they felt were wildly inaccurate but we countered with the knowledgeable sources of our information. In the end, we came to a conclusion on one of the most important invisible pieces of the buyer-supplier relationship, which is: “how much profit should the supplier make with each pound of the product?”. The corollary to this question is: “what defines a fair deal here?”. The supplier must stay in business, produce the product, pay its people a fair wage and provide returns back to its investors. The buyer must keep material costs at bay so that it can in turn realize enough profit to reward its shareholders and so on up the value chain. The flip side of this coin is one side or the other becoming so powerful that they quite literally drive the other out of business. That’s the kind of win-lose that ultimately becomes a lose-lose.
We re-convened the next day. What followed was the most astonishing business strategy to business strategy discussion with both sides openly sharing the challenges and skills required to do business day-to-day. We coached the supplier on the ways they could help us, and, even better, they coached us on how to be a more efficient buyer, even down to the way the buyer insisted on the product being packaged. None of this would have happened if the company had not undertaken this modeling effort.
The two companies set forth a gainsharing agreement where discoveries of cost-saving efforts were shared between buyer and supplier. Both companies engaged in a long-term supply contract that was contingent upon performance conditions on both sides, regularly assessed by the procurement team. The buyer stopped the incentive mechanism for gradual price reductions and instead compensated procurement based on a “whole value” approach. The supplier invested in relationship-specific assets like specialized machinery that improved the slate of products that the buyer preferred. And both companies remain highly profitable today.
These companies learned a valuable lesson: not everything between buyers and suppliers is a zero-sum game—as in a dollar for you means a dollar less for me. Managed intelligently, buyer-supplier relationships can and should be win-win, and in these days of inflationary pricing, good relationships along the value chain are some of the most important assets to have. Are your supplier relationships intelligent?
