Buying means arithmetic calculation. And that should be done very accurately. So let's start right away:
Profit contribution = (material intensity multiplied by material cost reduction) divided by yield on sales
It's getting too complicated? Don't give up; it will be worth it. Let's assume we are presenting a classical machinery manufacturer – after all, by workforce figures, it's the largest industrial sector in Germany. Here, the material intensity (material expenditure in relation to sales) is 51 percent on average; yield on sales is four percent. What would be the impact on the balance sheet (profit contribution) if we were successful in squeezing purchase prices further by a measly two percent? That should be doable.
That yield leverage is some feat and hard to top. What's obvious with this small calculation is that a sales department, for instance, would have to increase sales by a fantastic 25.5 percent to achieve the same effect.
The López trick
Yet, purchasing departments rarely are the talk of the day. And it's lawyers who are on the management board – not buyers. Only in the last few years, universities have begun to offer a pertinent study course within their business administration study programs. There is just about a handful of professorships for these studies; yet, the purchasing task would actually need special academic training and education: According to a query by Penning Consulting among 500 companies, only 20 to 30 percent of current applicants have the qualifications required in strategic purchasing.
But who would be surprised – when one is faced with the cliché according to which the purchasing department is only good for pushing prices down? Buyers like José Ignacio López de Arriortúa at Volkswagen provided this image in the 1990s. Even in the most recent cost reduction programs of many DAX-listed corporate groups, it was above all a matter of kicking free by specifically stomping towards suppliers – for instance with regard to BASF ("Next", minus one billion euros until 2012); BMW ("Number One", minus six billion euros until 2012) or Linde ("High Performance Organisation", minus 800 million euros until 2012). Pushing prices down is the core competence in purchasing – yet, calculations may also be fast very far off.
Savings – no matter what the cost
Getting back to 'calculations' – Do you have 40 million euros? If so, you would be able to afford the new ICE in its basic version. If not, just put yourself in the shoes of Jörg Manegold. He buys long-distance trains –it's his job – for Deutsche Bahn.
From his office in Frankfurt, Manegold, who is in his mid-forties, can see his employer's train tracks for regional and long-distance trains. Manegold is responsible for technical purchasing – about ten billion euros and thus nearly half of the train company's purchasing volume which, at more than 24 billion euros, is among the largest in Europe – more than three times the budget of the German Federal Ministry for Energy and the Economy. Dealings with the Head of Procurement – which is Jörg Manegold's job title – should be very friendly in the local industry.
His savings potentials are gigantic. For the new ICE, a two percent cost reduction could fast add up to one million euros that would remain in the coffers of Deutsche Bahn. That's what it takes to transport more than 7,000 passengers at full price from the far north to the far south of Germany – from Rostock to Konstanz – and until 2023, Manegold will be buying up to 100 new trains.
However, it might cost Deutsche Bahn dearly if it squeezes down on the acquisition price. "For trains, the purchase price often makes up only 20 percent of the actual costs over their life cycle", says Manegold. A far greater percentage will go to operating and maintenance costs – thus, if you are tight with the money when you are buying, you will pay for it dearly years later.
Deutsche Bahn had to make that painful experience – and its paying customers as well: In trains with failed air conditioning, or in trains not moving at all due to defective wheel set axles. All that the results of trying to buy trains as cheaply as possible – costs increased enormously due to that. Manegold has a clean conscience when he tells us about it: he has been managing procurement only since 2010. Before that, he was, as head of production, a member of the management board of DB Fernverkehr [Deutsche Bahn long-distance traffic division]; for heads of purchasing, there is no room on the management board.
According to Manegold, putting the squeeze on prices started in 1994: After Germany's rail reform, the former state-owned enterprise wanted to present itself as a genuine company. Instead of continuing their development of new trains and subcontracting only design and manufacture to the outside, Deutsche Bahn relinquished control over the complete field of development – as cheaply as possible. "Today, we know that the industry initially had an extremely hard time to supply the required quality virtually from the start", says Jörg Manegold. Expensive maintenance, failures and repairs – this is how Deutsche Bahn is paying today the true price for the trains it had acquired at that time for a seemingly low price.
Price pressure is increasing
In the meantime, many buyers have learnt that procurement prices say little about the costs of a purchase and a successfully reduced price can become really expensive – yet, paradoxically, the price pressure is massively increasing across all sectors of the industry. Gerd Kerkhoff has a simple explanation for it: Today, buyers are significantly better informed than in the past.
Kerkhoff is the CEO of a consultancy specialized in purchasing and procurement with headquarters in Düsseldorf and 150 employees in eight countries; and he has that touch of brash directness typical for people in the Ruhr Valley when he says: "It used to be that a buyer was largely in the dark about the way a machinery manufacturer, for example, calculated its machine. Today, a buyer is able to trace back from which materials and by means of which processes or methods the machine has been built, and also how much time, brains and margin have been calculated." Such detailed analyses can be purchased, accessed and propagated in no time for virtually any product worldwide.
Buyers thus have the opportunity to efficiently compare different providers and sellers: Prices and margins will inevitably decrease thereby. That's good for purchasing and bad for the supplier: Now, he will also have to check his supply chain for savings potentials and put downward pressure on his business partners' prices. "There are times when a supplier has already lost a few millions the instant he signs a contract for delivery with a purchasing company", says Kerkhoff. To be able to still account for this contract order at a profit, his purchasing department, in turn, must tenaciously work against the loss. Accordingly, prices will develop today by the so-called top-down approach: Essential for pricing is not what the costs of a product are, but rather what the maximum price to be paid will be.
Railroad car with 12,000 parts
In detail, this will become complex rather quickly. For example, a middle coach car of an ICE 1 consists of more than 12,000 individual parts – from carpet fabric all the way to complicated electronics components. A purchasing manager like Jörg Manegold should have at least heard of each of these parts; he should also know who manufactures them where in the world, how he will calculate, and how these products and suppliers might possibly fare in 30 years. Because that's the time period of the so-called life cycle of a long-distance train. Whether two percent of the purchase price can be saved will no longer be the most pressing question in view of this constellation.
Much more important is whether Manegold's purchases still pay off when he himself has long gone into retirement. And that's also why the first major maintenance date of an ICE in its seventh year of service is vitally important. For the supplier, Siemens AG, it will be decided in 2021 only – for any currently purchased trains – whether the negotiated purchase price will be paid in full. "We have the manufacturer guarantee us the life cycle costs of trains up to the trains' first major inspection", explains Manegold. Only if these costs are valid, Deutsche Bahn will pay the final ten percent of the purchase price. If expenditures are lower, Siemens will be paid a bonus. If they are higher, there will be renegotiations at Siemens' expense.
In his current purchasing decisions, Manegold must take now already into account a second milestone: the year 2029. He will celebrate his 64th birthday then, and the trains he had purchased in 2014 are due for their general technical overhaul. In railroaders jargon, a train is done for or had it after 15 years. It will then be gutted, completely refurbished and its interior design redecorated. "At that time, we also want to have no unpleasant surprises", says Manegold. After that, the train is to run for another 15 years. Thus, at the earliest at age 79, Jörg Manegold will know how expensive the trains purchased today really are – because that's when his ICEs will go into retirement.
Knowing – not assuming
A product's unit price would not be the basis but rather, at best, the starting point for a purchasing decision, says Stefan Wolff who has provided consulting for 15 years already – with his firm 4flow – to the purchasing and logistics departments of major corporate groups, such as General Motors for instance. He knows the method – which had been a standard for a long time even in internationally operating enterprises – of simply adding a flat rate of ten percent for logistics; and that's how one felt sure to know how much a purchase would cost. "Of course, that's just nonsense", says Wolff. There is only one valid way to ascertain purchase prices: by precise calculations.
But that's easier said than done in such companies as General Motors, which buys from more than 10,000 suppliers a yet much greater number of different components from all over the world. With regard to every one of these suppliers, one would have to obtain the unit prices, calculate the resulting costs of delivery, quantify risks of all kinds, review the evaluation of the supplier and a delivery history – that's the package 4flow offers its clients.
Consultants like Stefan Wolff utilize huge databases to determine worldwide transportation prices or customs charges; also, to convert risks such as fires in factories, natural disasters or unforeseeable price hikes into calculable probabilities. When you have 50 potential sellers, even a simple item like a curved or bent sheet of steel can turn into a complex arithmetical problem.
Company 4flow offers its clients software solutions to simplify such calculations. But the real challenge is that calculations are often based on assumptions, not facts. "Purchasing always decides on the basis of costs which one feels sure to know", says Wolff. But nobody knows, at the time of contract signature, whether a volcano will erupt or whether the costs of logistics will increase as had been assumed. Wolff calls it "spurious accuracy", which will require permanent readjustments and which results in purchasing decisions being made on ever shorter notice and such decisions being valid for ever shorter periods of time. For consultants, that's definitely lucrative – instead of being called in sporadically for concrete projects, they are now more and more frequently booked as permanent supports.
Despite their spurious accuracy, all those figures by now have gained absolute control and power. In the areas of controlling and purchasing – for which Wolff supplies his analyses – empirical knowledge is hardly important anymore. According to Wolff, it is no longer relevant that a company had collaborated for years with a supplier on a basis of trust. At ever shorter intervals, entire groups of suppliers would be replaced. And since it has become possible to quantify, in concrete terms, all possible probabilities of occurrences, potential risks would also be an important element in price calculations.
Lately also the center of attention: innovative capacity – a factor difficult to measure. Buyers calculate their suppliers' supply chains, participate in planning their products and, in turn, want their suppliers to think proactively. Aside from the price, an ever more important factor is the question as to which supplier can be expected, in the future, to come up with innovations decisive on the market, or which supplier is actively engaged in the most interesting networks. Purchasing departments are no longer merely looking for low priced products but also for innovative partners.
This is where another dilemma comes up: When you talk about being in a partnership, partners should be nice to one another – yet, purchasing departments hardly have any likeable instruments and tools: Purchasing departments will tighten the screws on prices, push terms of payment back more and more to a later date. The interests of buyers and sellers are simply too divergent. What might be helpful in that case? Required will be the toolboxes of impartial and non-involved third parties:
Allowing later payment, getting money earlier
For instance, the corporate group of Siemens – purchasing volume in the prior business year: 38 billion euros – is aiming for future payment terms of up to 200 days with its suppliers. Since then, many suppliers in Germany know that there is a small town named Scharnebeck, close to the area of the heath land in northern Germany called Lüneburger Heide.
This is where the German branch of a company is located that had been founded by Citibank and SAP in 1999. They had wanted to combine the conflicting interests of purchasing departments and suppliers into one financial product for their mutual benefit. Yet, especially the interests of the major bank and those of the software company differed fast, which is why company Orbian with registered offices in Norwalk (USA), London and Scharnebeck was sold to private investors in 2003.
At the edge of the Lüneburger Heide, Jens Weiner now provides support for global players like Siemens in the implementation of their strategic objectives – called "optimization of working capital", for example – and which might mean, for suppliers, payment terms of up to 200 days.
As a non-involved party, one might even understand Siemens: If Deutsche Bahn takes seven years to pay completely for a train, why shouldn't its suppliers be kept waiting for some months? Jens Weiner poses the question differently: Which one of these business partners would still be economically 'alive' or viable after such deferred payments?
Selling and selling
In order to keep them all alive and well, if necessary, and have Siemens keep them not only alive but also in good spirits, the company offers its suppliers to sell, together with the products, the corresponding receivables at the same time. And so we are now in the realm of financial 'wizards'. Their concept or construct, also offered by major banks like Deutsche Bank, works as follows:
The purchasing department of Siemens signs a contract with supplier A. At the time of delivery, the supplier presents an invoice with terms of payment of, let's say, 120 days. After Siemens has checked and audited the invoice, Orbian will buy the receivable from the supplier; approx. 10 days after invoicing, the supplier will receive its money. Siemens, in turn, will ensure Orbian payment for the due date, and since the corporate group has a first-class credit rating, Orbian is able to get interim financing for the total amount at very low interest rates on the financial market. The supplier will bear the costs, he has to accept a discount on his receivables in the amount of the Euribor/Libor interest rate plus the Orbian margin. Currently, this comes to a total amount of between 1.8 and 2.5 percent per year; calculated with regard to the term of payment, this results in a deduction of 0.5 to 0.9 percent. About 1,500 Siemens suppliers are using this financing offer at present.
Since the margin is small, this business will only be worth it for Orbian starting at a certain purchasing volume; traded receivables add up to several billion euros per year. The company handles transactions of this kind worldwide and in any tradable currency. The most important argument for this so-called supply chain financing is the optimization of working capital for both buyers and suppliers. A longer term of payment will increase liquidity and thus also the credit standing with financial institutions.
Boosting financial strength
Entirely without tightening the pricing screws, the purchasing department can thus simply buy yields. Experts talk about "boosting the financial strength" in the supply chain which means nothing less than one may earn money by spending money. This will work because low purchase prices result in inventories, for instance, being valued lower on the balance sheet. So the costs for their financing will also drop. Accordingly, some buyers are considering whether purchased goods need to be transferred to corporate assets at all.
Joachim Getto, logistics expert at Camelot Management Consultants in Munich, thinks that those who only process goods could surely leave their ownership to a service provider. Camelot is a specialist for financing supply chains by logistics providers. The purchasing department not only lets the currently used logistics partner deliver the goods, but also assigns to it the company's own competences and responsibilities: Order processing, inventories, reserving storage areas, simple installation steps will pass over into the responsibility of the logistician – and especially into his balance sheet. The purchasing department will sell itself, so to speak.
In English-speaking countries, this has long been standard practice; in Germany, it's still rare. For Joachim Getto, the greatest obstacle is the "internal silo mentality. The step to logistics services provider concerns several corporate areas, for example production, logistics, purchasing and controlling." According to his experience, purchasing departments are in favor of these considerations; controlling or production departments are rather against it. Especially the middle management does not like to give up responsibilities, i.e. potential influences. Joachim Getto believes that– in its increasing importance for the balance sheet, for production and logistics – purchasing will need strategic decisions across the group and across the divisions. He says that a lot is still patchwork: Purchasing would negotiate prices; the financial department would take care of the balance sheet; logistics would reduce freight costs or inventories – hardly any company would develop any joint objectives for the departments. "So far, the few attempts of creating at least responsibilities across departments have mostly failed in a grand way", says Getto. "But if you want to release financial strength and liquidity in the supply chain, you must declare it to be a joint internal goal."
Getto is convinced that this makes good economic sense. Just too bad that it will probably be proven only when all participants in this matter have long gone into retirement. Only then will it be known what purchasing had really cost.