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03/07/2012

Light in the Dark

Danger looms if technical departments determine conditions for capital goods together with suppliers. That will result in unexpected follow-up costs.

By Michael Dörfler

Alf Schwaten has a sizable budget of EUR 320 million for annual purchasing. He is the head of purchasing of the energy grid operator 50Hertz Transmission which is active in Germany's North and East. He has to spend these amounts together with his 20 specialized buyers for operation, maintenance, planning and expansion. "We are using increasingly regional companies for the realization of contracts", says Schwaten. The largest single project – the South-West tie line from Thuringia to Bayern – uses 22 trades with a budget of EUR 290 million. There is not only the installation on lines, but also road building, material deliveries, electrical installations, civil engineering, or work on transformer substations. Numerous small contracts add up for Schwaten to many millions of expenditures for capital goods.
Such complex procurement procedures would "considerably influence the economic result of enterprises", says Erik Hofmann, Professor of the Department for Logistics Management at the University of St. Gallen. Every year, German companies buy capital goods for nearly EUR 550 billion, as indicated by the Statistische Bundesamt [German Federal Office of Statistics]. A company will spend 5 to 10 percent of its total procurement volume for long-term capital goods.

Purchasing professionals wanted
For many companies, capital goods purchasing is extremely important because of both short- and long-term costs, as well as its effect on competitiveness.

"Nonetheless, the degree of professionalism of capital goods purchasing has not yet reached the required level in many companies", complains Hofmann. Purchasing is here facing major challenges – given the special characteristics of capital goods as well as their procurement process. But according to experiences by Jens Hornstein, Partner at Kerkhoff Consulting in Düsseldorf, the purchasing department will not automatically have a seat at the negotiation table in small and medium-sized companies – even with investment volumes of between EUR 300,000 and one million. "Engineering is prevailing in the producing trade", says Hornstein. The production department will conduct procurement negotiations with the supplier. But that department as well as the developers are shying away from any truly critical examination of the offer.

The result will be that, at first glance, the contracts present a favorable investment in the new acquisition. And the controller will be pleased. But nobody had reckoned in the follow-up costs. "The supplier offers excellent conditions but will get his money back through his service", explains Hornstein. In such a case, the buyer is merely a handler. The procuring enterprise will thus have no financial advantages. Five recommendations by Erik Hofmann and Jens Hornstein will show how capital goods purchasing is done.
Problem of technical specification: Budget determinations in capital goods purchasing are frequently based on empirical values. Technical specifications underlying budget determinations are often established by technical people without involvement of the purchasing department. Thus, supplier dependencies will result at an early stage of the procurement process, and purchasing is no longer able to use its negotiation skills.
Solution: Yet, especially here are great savings potentials. By means of the functioning interaction of purchasing and engineering and by ensuring neutrality in the determination of specifications, the actually required funds can be very much reduced in many instances.

Problem of purchasing instruments: During the stage up to the final contract award, additional potential can be raised by using classical purchasing instruments — such as supplier selection, tender invitations, negotiations.
Solution: Care must be taken that the existing documents are complete to be able to compare the different offers in their commercial and technical aspects. Moreover, the technical staff and the purchasing department need to sit down at one table as early as possible to jointly determine the specifications.

Problem of strict project management: One frequent phenomenon in capital goods purchasing concerns subsequent cost increases and time delays. Especially for production plants, time delays are frequently connected with very high costs.
Solution: At this stage, purchasing can contribute to the success of the project by preventing supplements, by providing expert support, as well as by a functioning project and time management.

Problem of total cost of ownership: In most cases, follow-up costs exceed procurement costs in capital goods purchasing. Frequently, the purchase price of capital goods is merely between 30 and 50 percent of total life cycle costs.
Solution: Follow-up costs such as energy, personnel, maintenance and repair should be taken into account in every purchasing decision and assessed within the scope of the net present value approach.

Problem of compliance management: Compliance security is particularly relevant. For example, if a supplier disregards statutory requirements or social and ecological standards, risks might also result for the purchasing enterprise.
Solution: In conformity with audits, companies should document planning and budgeting processes as well as award decisions in capital goods purchasing. A special compliance audit can help to indicate weak points.

michael.doerfler@marktundmittelstand.de