The following article was prepared by Mike Taylor, C.P.M., for distribution to ISM affiliate newsletters. January  2007

100 or Not?

January 2007

Q: When is an equipment order for 100 items not really an order for 100?

A: Whenever we ordering items with unique production requirements, items made with castings or forgings, delicate or fragile items and items with a shelf life. Surprisingly, 100, is not an exact number to many manufacturers, producers and even distributors. An order for 100 8-inch gate valves could easily generate production, testing, transportation and storage of 110 gate valves.

These 10 extra valves are ghosts in the supply chain created to accommodate a variety of potential problems. The problems and the number of resulting ‘ghosts’ vary based on the types of products, manufacturing techniques and risks associated with handling, transportation and storage. Here are a few examples why ghost items are created

• To cover production process risks: Not all castings come out perfect, and the casting process can be very expensive. So, when casting large, complex or time-consuming items, casting producers will regularly “pour 2 – so that they can be assured of getting one good one”.
  • Why? Because if one casting fails, they have a backup instead of having to start from scratch.
  • How does the producer pay for the extra work involved in making two castings? Include it in the price.
  • What happens to the extra casting if both are good? It could end up on the shelf waiting for the casting producer's next order – and if you are not careful you will pay for it again – just like new.
• To cover shop scrap rates: Mistakes happen in the shop.  In machining processes, working on a group of parts is much less costly than doing them one at a time. If, on the average, our machinist makes a mistake on 1 part in every 100, then by starting with 101 or more parts, machine shops can allow for the scrap and still get 100 good parts.
• Handling and storage loss. Are these items delicate or subject to high theft rates? If so, suppliers produce and ship some extra, just to cover the ones which might get broken or lost
• Inventory shrinkage. Over time, many items being stored in warehouses end up lost, broken or stolen.  Ask anyone in the retail business about the cost of shoplifting. So retailers and distributors stock extra items o make up the difference.

In all of these examples the supply chain will, at some point, contain more items than we have ordered.

Q: What happens to the extras?

A: They might get scrapped, recycled, sold for a discount or end up on the shelf waiting for the supplier's next order.

Q: Who pays for the extra items?

A: We do. The extra cost is added to supply chain either as a direct “allowance for overages” or an indirect cost of supply and distribution.

The principle: An order for 100 items – may actually generate production, storage & handling costs for more than 100 items. The extra cost of creating and handling these extra ‘ghost’ items, gets passed along to the buyer. Interesting to note, the more complex the supply chain the more likely that these costs get compounded as each supply chain process generates its own risks and adds ‘ghosts’ to cover those risks.

Corollary: One of the ways that suppliers can be more competitive is to be more efficient and reduce the need for ghost items – thus lowering the cost of doing business.

Q: Does this principle apply to contracts for services?

A: Yes, in many service industries contractors employ or retain additional workers beyond the bare minimum needed to do the job. Contractors employ contingency staff to maintain continuity of service. Examples:

• The general contractor who has to worry about members of his crew calling in sick or being injured. While he may not have to pay the sick worker, the contractor has to have other workers on call and has already incurred costs associated with recruiting, hiring, equipping, training, etc..
• A training organization has substitute instructors on call, who have been recruited, interviewed and retained.
• A delivery company has extra truck drivers, delivery persons and warehouse operators on call or available. They can’t just put anyone in the truck, they have to use trustworthy drivers who meet DOT licensing regulations.
• A security service has to have guards on duty at all times. They can’t just bring someone in off the street. Extra guards have to be vetted, trained and equipped.

Q: Who pays for the contingency staff? If I only want one truck driver who pays for the extra person?

A: You pay. The cost for the extra staff ends up in every contract, even if we don't use the extra people.

Can you see the trend? In delivering products or services, quantities are often not exact. The costs of those variances in quantity and maintaining contingency staff are passed along to buyers. The extra costs might be hidden, where a production operation starts with 110 parts to cover production losses or the extra cost might be much more direct; where a contractor adds an extra charge to give our job priority over another customer.

Q: What can we do to reduce or mitigate the extra costs?

A: a) Understand the hidden costs which might be included in the price and try to negotiate agreements which reduce or eliminate the need for those hidden costs.   b) Assist suppliers in finding ways to be more cost-efficient.  c) Increase efficiencies and reduce complexity in the supply chain.  d) Communicate with the supplier to mitigate the need for contingencies.

How do we proceed?

The most important part of reducing cost is detailed information. The Fed calls it fact finding, I call it supply chain professionals taking the time to add value:

1. Learn everything we can about the product or service we will be procuring. Go on a plant tour, ask questions about the processes and explore production costs. Example: Ask the production manager what his shop failure or rework rate is – he’ll know and be proud to tell us how low it is, while the salesman may not have a clue. True confession: On a plant tour, we walked into a shop production office just after their weekly production meeting. All the information we wanted to know (and the salesman wasn’t telling us) about order status, rework rates, etc. was still on the chalk board.
2. Look at each part of the process in an analytical way to determine how we might accomplish the same task or what expenses suppliers have in performing the service. Example: "I see that you have to bring in all of the raw material via truck – what’s the contingency in case of snow?"
3. Visualize supply problems in terms of the cost – then follow the money. Example: We all have experienced a substitute teacher. But have we ever considered how schools manage that extra cost? Where does it end up in the budget? Now consider how suppliers of security services or truck drivers might manager the same costs? Someone has to pay for it – who and how?
4. Investigate and map out the entire supply chain. Then start noting where ‘ghosts’ might be hiding. Look for risks of loss or failure and ask how those risks are addressed. Example: “how do you accommodate days when one driver is sick?” or “Knowing that the part could be rejected during machining, how do you keep from having to start over?”
5. Visit other suppliers of the same product or service. We might learn new facts about the process or gain insight into alternatives. Example: We might see an order being prepared for another customer – where the buyer had specified a less expensive testing or packaging process.
6. In the solicitation phase of the action, ask for a detailed breakdown of everything. Examples:
   a. An initial compliment of spare filters might be included in the purchase, but how much will they cost when I reorder them? I want to know before I buy the equipment. My total cost of ownership might be very high when I consider the long-term cost of filters. Accordingly, I might want to negotiate a long term agreement for replacement filters as part of the original purchase.
   b. The manufacturer ships unfinished products to a testing company on the east coast before assembly. Wow! what a high extra cost (risk of loss, handling, storage, time, freight, and volatility in the testing subcontract). If I can find a way to avoid the testing or have it performed elsewhere, we can save money.

Now assemble the negotiating team and include experts from the supplier, producer, etc. We are a team negotiating together to create the best and most cost effective agreement.  First Question for the team: What are the facts? Is this really what happens? Are these really part of the costs that we will be paying for, in this agreement?  Now discuss how to eliminate, reduce or mitigate those costs. Here are some ideas based on our examples above.

1. If the supplier's shop failure rate is really 8%, then let’s include a variance in the order of plus or minus 8%. Anything over 100 – I get at ½ price and anything down to 92 completes the order. This reduces manufacturing risk and I should get a better base price with an opportunity to get a few more at a lower price.
2. If you are really going to pour an extra casting or two, I’ll purchase any extra raw castings from you (if they are good and if I know what a good price should be for the castings). Then I can supply the raw castings to you when I order this item again. In exchange for reduced risk, I’ll get a lower purchase cost this time and a contingency which might greatly reduce lead time or cost on my next purchase. True confession: I once purchased the mold for a large specialty casting so that it wouldn’t get lost and become an extra charge item on future purchases. It also came in handy when the manufacturer went out of business and I had someone else make the part.
3. If you really have to buy a 20 foot piece of material (and of course charge me for all 20 ft) to cut my 12 foot order, then I’d like to take the 8 foot drop instead of letting you keep it. I can sell it for scrap or use it for something else.
4. If you really have a problem with inventory shrinkage, then let’s put the inventory in my secure warehouse and just charge me for what I use.
5. Instead of a firm date for cleaning our AC ducts, how about we agree to a open window in the schedule? We should get a discount for reducing the supplier's need for contingency staff by accepting flexibility in performing the work.
6. Instead of delivery required on Tuesday – we can accommodate delivery anytime that week.
7. We have a person who can fill-in as instructor for a few hours on this class, in exchange for a discounted price and reduced charge during the time the supplier's instructor is unavailable.
8. We have a testing contractor here in this state. We’ll negotiate a way to handle the testing for you since we get a better price and can control the schedule. This will reduce the need for “ghost” schedule days in my delivery.

There are many more ways to creatively spot and mitigate the costs of ghosts in the supply chain. But what about the other direct costs which aren’t hidden at all? Can those be reduced or eliminated? The basic answer is YES! An effective buyer will consider each and every cost in the supply chain a target for reduction or elimination. We’ll talk more about this next time.

Mt

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