Every company that sources products and has the need to identify, qualify, and engage the right supply partner should focus on the total opportunity and its associated costs, not just the lowest cost. This isn’t a new concept, though it’s one that’s often overlooked when evaluating a supply partner that fits a company’s needs. The concept we’re referring to is Total Cost of Ownership (TCO). Not only will TCO give you better overall cost in the long-run, but it’ll also give you a trusted supply partner to do business with.
Creating a plan and process with your team on day one will be the key to sustaining a successful supply partner relationship. Our main goal as procurement leaders should be to ensure our teams have a “supply partner”, not “supplier”, mindset, incentivizing them to carry out plans based on the supply partner developed. Focusing on TCO, amongst other aspects – supplier performance and developing partnerships – will ensure the proper development of qualified supply partners. These are key cost areas that each procurement team should be well-versed in and understand.
Sourcing the right supply partner is challenging due to both internal and external factors; suppliers aren’t developed properly and are chosen based on lowest piece cost alone, the result of corporate procurement teams’ severely outdated practices. These initiatives only focus on, and reward, the lowest cost. Rarely are costs like the following considered:
- Supply partner development costs
- Shipping costs & time
- Inventory costs
- Quality costs
- Payment terms
- Potential cost fluctuations
The concept behind TCO has a more holistic approach, examining all costs (like the above) as they relate to the supply chain, and not just the lowest total piece or tooling costs. So, before your procurement team selects its next supply partner, implement a well though-out TCO process that ensures the below cost considerations are met and the results meet your organizational goals.
6 Total Cost of Ownership Considerations When Choosing a Supply Partner
1. Supply Partner Development Costs
A supply partner development program is critical to the success of TCO. Knowing exactly where a potential supply partner can add value is key and can affect costs both positively and negatively. For example, if you’re sourcing a casted-aluminum part that requires post-machining and heat-treat, then you’ll want to strive for a supply partner that can take on all or most of these processes.
Even if the supply partner can manage the entire process from raw casting to finished goods, you should be cognizant of what they can do in-house versus what they must outsource. Depending on the outsourcing needs of your potential supply partner, it’ll only add costs to the finished good the more they need outsource. Keep this in mind when sourcing all components as this early supply partner development will lower your TCO.
2. Shipping Costs & Time
Understanding the location of your supply partners and shipping costs and time should be at the top of any procurement professional’s mind. While piece cost and tooling may be low, ask yourself where they’re shipping from and how long it’ll take, in order to account for total cost.
China and Mexico are very favorable options for manufacturing due to lower labor costs, however they can add time to shipping and other shipping-related costs like tariffs, customs, warehousing, product damage, etc. Longer distance, more-spread-out supply chains introduce the need to safeguard against potential disruptions like transportation cost fluctuations, currency exchange rates, logistic uncertainties, and other risks, so you’ll need to account for these costs prior to making any sourcing decision.
3. Inventory Costs
Inventory costs aren’t typically taken into consideration when sourcing a potential supply partner, especially the cost of buffer inventory. These costs involve not only the dollar value of the inventory itself, but also the financing cost of the investment and carrying costs related to storing excess inventory. Depending on the contract terms, a supply partner may require minimum order quantities or runs. Ask yourself, “Do we have the space to hold this inventory?” and “What’ll my full costs look like for doing so?”.
Longer-distance supply chains, again, introduce issues, and with inventory costs, these often lead to securing greater inventories. Understanding this critical cost as it relates to the TCO won’t just you’re your management more confidence in the supply partner choice, but it’ll also give confidence that your team is accounting for such an important overall program factor.
4. Quality Costs
Ensuring a quality supply partner and product is vital. The “unforeseen” that may arise from a decision process that’s not thoroughly thought out may lead to many problems, which include, but aren’t limited to:
- Lower quality product
- Leads to greater inspections on your end and ultimately leading to unhappy customers and strained relationships
- Increased costs due to returns or shortages
- Leads to shut-down situations
- Potential legal issues
- Leads to added company costs and strained relationships
- Safety issues
- Leads to added costs and potential larger implications
- Added travel and quality costs
- Due to constant supply partner hand-holding and oversight
Understanding the possibility of these types of problems from the onset will lead to a better supply partner decision process that could mitigate the above quality concerns and costs.
5. Payment Terms
Payment terms should always be weighed as part of a sourcing decision because they significantly impact your company from a financial perspective. Payments in advance are never recommended and will hurt cash flow, compared to terms of Net 30, 45, 60 or 120. A procurement professional should strive to set up Net X terms to allow for cash flow strength. Ensure you work with a supply partner that understands your payment requirements and can compromise to a point where they aren’t hindered financially either.
6. Potential Cost Fluctuations
Cost fluctuations are another important area that need to be accounted for before making any decision with a supply partner. Understanding the history of currency fluctuation for items like raw materials must be taken into consideration. Protection against material fluctuations could be a clause in a supply agreement that puts a ceiling on a percentage of fluctuation where costs aren’t manipulated, either up or down, based on a certain percentage.
To protect against currency fluctuation, your procurement team should choose to purchase a position on the foreign currency for the price at that point in time. Ensuring your team understands how potential cost fluctuations mitigate the risks of additional future costs will lead to a better TCO strategy for your company.
Understanding the TCO concept is a must for any procurement professional making a sourcing decision. As opposed to the mindset where suppliers are decided on by lowest cost, we must move to a TCO/supply partner mindset. Considering all types of costs within the supply chain for a given program including supply partner development costs, shipping costs and time, inventory costs, quality costs, payment terms and potential cost fluctuations, will set your company up for long-term sourcing success.