AMR Research recently conducted a study focused on risks within the supply chain with 100 global companies. The top two identified supply chain risks are the volatility of commodity prices and supplier failure. Commodities span fuel and non-fuel product needed for supply chain operations. Risk of supplier failure spans supplier inability to meet capacity and time commitment to financial instability (see "Supplier Failure and Rising Commodity Price Risks Keep Executives Awake at Night" for more information on this study).

Supply management is pulled between risk mitigation on one hand and cost containment on the other. So, what are best-in-class companies doing to successfully navigate through today's uncertain economy? In this article, we share four best practices that are focused on supply management partnering with finance to fully understand and execute on cost reduction and containment.

No. 1--Creating a realistic cost baseline: The baseline or point of measurement from which cost reduction and containment are measured is a critical element across all aspects of the business. Many companies use standard costs as a baseline for a period of time (yearly, quarterly, or monthly), while others use the last purchase price. Once the baseline is known, all purchases made after that point, are the same. This measurement is known as the purchase price variance (PPV), which, for many companies, is an indicator of cost reductions or increases.

Without the knowledge of a realistic baseline, companies don't have a clear indication of their present positions versus their future directions. Direction is critical at all times, but it's especially sensitive in a period of rising prices.

Plotting a future direction that includes plans for current costs and expected increases against an established baseline can help a company navigate the rising tide of prices. Granted, planning for the unexpected is never easy, but knowing the baseline takes the guesswork out of cost containment and allows a company to plot out various contingency plans, from the conservative to the crazy.

Case study: An $8B soft goods retailer established a baseline on the entire purchase price of its new purse. The company discovered that, prior to its review and establishment, it was not capturing the full costs, including transportation. Establishing the baseline allowed the company to readjust its final, sellable product price, providing the required margin to sustain the business. Once the margin was reset, the company could then map out its future cost containment and savings plans. The supply team stated, "With the assistance of our finance partners, the baseline helped us zero in on all the product costs, including manufacturing. We were able to spend more time finding the right suppliers to meet our margin requirements and bring in much needed cost savings."

The bottom line: A baseline is critical for accurate cost reduction and containment measurement and planning. A finance partner enables quicker success.

No. 2--Beating the indices: Only 51% of the companies we surveyed use commodity price indices to gauge the success of their cost reduction and containment programs. Commodity price indices measure one of the following:

1. The price or performance of physical commodities over a period of time
2. The price of commodities as represented by the price of future contracts that are listed on commodity exchanges

The indices are used as a baseline to measure company costs against the commodity market as a measurement of performance, as well as to gauge future cost and inventory requirements.

49% don't have clear indications of how good their current costs are to market indices. Furthermore, we found that most companies didn't even know how to measure themselves. Many we spoke with assumed their costs were good because their company executives saw year-over-year savings.

Real cost containment and reduction success depends on the following:

1. Establishing the baseline
2. Comparing the baseline to the market indices
3. Planning for change

Indices, such as the purchase price index and consumer price index, can be used to establish a level of comparison. One high-tech company we interviewed prided itself on an almost five-year trend of lagging the purchase price index for several critical commodities, while achieving further cost reductions on them during the same time frame.

Case study: A consumer packaged goods (CPG) company we spoke with found it had higher costs that were higher than the market indices. The company took a historical look over the past three years and found it was consistently higher in one critical commodity than the purchase price index. The historical perspective allowed the company to figure out it had left $1.8M on the table over a three-year time frame.

After a few calculations, the company discussed its concerns about paying too much in the three years prior with its top four suppliers. With a guarantee of future business, it secured lower costs that were equal to the pricing of two years ago. This renegotiation gave it a much-needed boost in profits and secured pricing for the next 15 months at just below the index price.

The bottom line: Using market indices to gauge economic conditions provides a key cost indicator of successful cost containment and reduction activity.

No. 3--Hedging your bets: Most companies use hedging strategies to lock in material costs or inventory over a specified time frame. While this is a great strategy to secure pricing and material availability, it can hurt a supplier that doesn't follow through with the same practice of cost management with its own suppliers.

Case study: A discrete manufacturing company we spoke with found that two of its suppliers in its washing machine supply chain went without material because the material hedging strategy was not carried into the next level of suppliers. With its ecosystem in trouble, the manufacturer quickly met with all its suppliers' suppliers to ensure its hedging strategy was understood.

It was discovered that the second level of suppliers was experiencing inventory shortages because the manufacturer's ultimate customer hedging strategies were not carried throughout the supply chain. This forced the brand owner to recognize that inventory liabilities exist at all levels.

To assist its hedging practice, the company used inventory planning tools across the ecosystem. Coupled with monthly forecasts and order time frames, the supply chain has stayed lean while meeting customer commitments.

The bottom line: Multitier hedging practices, coupled with good forecast and ordering practices, can secure pricing and inventory. Still, it's best to understand the risks and tradeoffs as well.

No. 4--Accelerating working capital: While most sourcing and supply chains are focused on quality, reliable supply, and cost containment and reduction, the working capital requirements are often ignored. Cash acceleration is usually the main objective of finance, but not so for procurement, sourcing, or even supply chain management.

However, these three areas are the main stakeholders in the working capital equation. They must jointly understand the interdependencies of key metrics, such as perfect order performance and total costs and inventory, and, based on this, make conscious decisions on tradeoffs.

Calculated as current assets minus current liabilities, working capital is defined as a financial metric that represents the amount of day-by-day operating liquidity available to a business. A company can be asset and profitability rich, but still short on liquidity if these assets cannot readily be converted into cash. This is where sourcing, procurement, and supply chain provide tremendous value, with a focus on the total supplier days payable outstanding (DPO) and the required inventory as it relates to the days sales outstanding (DSO).

Case study: Consider the case of a $2B satellite communications company: its standard commercial customer submits payment within a net 60-day term. But the company prefers to pay its suppliers in a net 75-day term, which gives it 15 extra days of cash float.

However, this can cause havoc for small suppliers that need payment faster. In this case, they have been known to offer discounts on products if they are paid in a shorter time frame, such as 10 to 30 days versus 75 days.

For the communications company, many of its customers require designs and components that are now at the end of life because they were either discontinued or had a product change notice. The company works closely with its customers and develops a three- to four-year forecast for the discontinued part. Its OEM will buy the part and hold it for the future via a distributor. This moves the inventory to the distributor, which has the carrying costs built into the final purchase cost.

This ecosystem approach allows the inventory burden to be shifted in the channel and assists each entity with meeting customer requirements, while also ensuring working capital needs are met.

The bottom line: Supply management and finance can accelerate cash in the supply chain, but this is dependent on an aligned and integrated ecosystem, with benefits for all members of the value chain.

The master plan of contingencies

It's obvious that cost containment and reduction may be derailed, at least in the near term, based on current economic conditions. While guarantees are not available, understanding the baseline, gauging the market, slowing down the arrival of an increase, reducing inventory, and increasing cash can mean the difference between profit and loss.

Successful supply management teams partner with finance to deploy many of these practices in a series of contingency plans, which are put in place and used based on the company's expected performance, future revenue, and profitability requirements. The contingency plans become an enterprise risk mitigation strategy that ensures the success of organizations through even the toughest of times.

What is your company doing to determine your success in cost reduction and containment? We would love to hear from you--mnorthrizza@amrresearch.com and jbarrett@amrresearch.com.
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