In the context of the manufacturing industry, as the relationship between an OEM and their downstream suppliers mature, it is a supply chain best practice to seek continuous cost reduction opportunities by leveraging economies of scale, streamlining transnational and manufacturing processes, and developing cost conscious product and design improvements. There are other tactics that contribute to reducing the true cost of a product, however the three aforementioned practices from my experience are the most commonly pursued by best in class companies and have the largest correlation to achieving cost savings over time.
Way too often I hear of annual price increases that are “published” by downstream OEMs at the start of each fiscal year. These cost increases are often justified with standard language that many just take at face value. Common reasons I’ve been given range from “we have received general labor and overhead increases” to “vendor costs have gone up”. Whenever I hear this I think to myself: Shouldn’t costs be going in the opposite direction over time? Don’t get me wrong, sometimes price increases are justified and the supplier is merely passing through the cost to the customer or passing through inflation. Material prices go up, labor prices go up, and indexes take hits. This is normal in a day in the life of a procurement professional -- though as a procurement professional you should always be asking for official letters or publications detailing pass-through increases.
However best in class organizations don’t think this way. And as a procurement professional myself, I don’t think this way. Over the life of a supplier relationship a continuous joint effort should be taking place to work on reducing costs. Even if costs do go up for a supplier these cost increases should be offset and/or exceeded by leveraging economies of scale, streamlining processes, and continually looking for product and component improvements that result in lower costs.
To leverage economies of scale, downstream OEMs should be constantly evaluating optimum production schedules (or shipment schedules/order quantities in the context of distributors) to reduce the variable unit cost of the goods they are producing. This results in operational efficiencies due to larger run sizes and more precise delivery schedules. The supplier should be able to achieve this by better predicting the trends in demand and usage as they become more familiar with their customer’s business over time. Over time, synergies should be developed between the supplier and the customer’s forecasting/planning team which allows the supplier leverage economies of scale where possible and pass those savings on to the customer.
Suppliers should also be able to reduce unit costs over time by developing more efficient manufacturing processes. As time goes on, suppliers should be leveraging their tribal knowledge to optimize the manufacturing process. This can come in the form of purchasing machinery and equipment that reduces labor and overhead costs, or coming up with other lean manufacturing processes to reduce the total production time. It is all too often that suppliers are instead using this best practice to pad their margins instead of passing on cost savings to their customer.
Lastly, customers should always be evaluating new opportunities to pursue cost efficient design or part changes. Design and development costs to the customer are either charged up front as an NRE (non-recurring expense) or amortized into the unit cost of the products being sold. The latter is a dangerous proposition from the customer’s point of view since the incremental design costs cannot be easily tracked and therefor a break-even point for the supplier cannot be easily determined. As an industry best practice and something to push for with your suppliers, the unit costs of a product should eventually go down after the supplier has had a chance to recoup their costs from the design project if an NRE was not charged up front. The time to elapse before the supplier recoups their engineering resources costs all depends on the scope of the design or development project and should be collaboratively determined between supplier and customer. If an NRE was not charged up front and a supplier claims that a design project was free of charge or a value added service, this is more times than not simply not true. Engineering resources are extremely expensive. There is no such thing as a free lunch. Weather evaluating a completely new, cost efficient design of a product or component, or analyzing a swap-out of a custom component with a more cost efficient OTS part, engineering and development costs need to be decoupled from the unit price charged by the supplier. This industry best practice will take away the suppliers ability to continually cash-in over time on historical development projects and will also give increased visibility to the customer to the true cost of a product.