Imagine you’re a purchasing manager at a company in a high-wage country and you’re tasked with sourcing an important component. You have one quote from an offshore supplier and one from a domestic supplier, which has a higher per-unit price. What’s your best option?
So often in business, decision-makers are focused solely on cost and would therefore pick the offshore supplier. But perhaps this purchasing professional has a sophisticated understanding of logistics and international trade compliance costs. They might build a detailed total landed cost (TLC) model that adds in shipping and warehousing; customs, tariffs and taxes; carbon footprint; and other overt and hidden expenses. Maybe they would even perform a total cost of ownership (TCO) analysis to find the sum of all costs associated with this particular sourcing activity — taking into account dozens of factors, such as increased disruption risk as supply chains get longer.
Yet even if such a thorough analysis is conducted, focusing on costs alone is problematic. As companies continue to outsource important activities, purchasing managers are responsible for all kinds of things that affect a product’s sale price or volume. With offshoring, purchasing managers encounter more risk and ambiguity when operating in or sourcing from disparate locations. When broader factors are considered — not to mention the drawbacks of long, complex supply chains — high-cost domestic suppliers may turn out to be the better choice.
A new way of thinking
Companies should adopt purchasing methods that are closely tied to their overall value proposition. One way to do this is with a new approach to procurement: total value contribution (TVC). This is a structured method for sourcing decisions designed to maximize an organization’s long-term value. The name of the approach itself anchors the discussion around value, not cost, and replaces the idea of ownership with contribution. In addition, TVC is designed to counteract common biases through careful incorporation of individual and group decision-making best practices.
The approach is broken down into five steps:
1. Set the objectives: To truly break the habit of focusing on easily measured costs, TVC starts with two questions:
- What do our customers — current and future — value about our products?
- How can this sourcing decision affect those values?
Decision-makers must find out what customers value about the good or service in question. Then, they need to link the sourcing decision to these value drivers. Answering these questions well requires cross-functional expertise. Generally, the decision should involve people with a strong understanding of customer expectations, technical requirements and supplier capabilities. For example, in a manufacturing context, the marketing, engineering, operations, procurement and even new product development teams should be included in the discussion.
In some cases, value creation can be almost entirely based on obtaining the item for a low price, making the TVC choice the same as that obtained by employing TCO, TLC or per-unit cost logic. In these cases, the TVC analysis can be concluded quickly, but it still should be performed in order to ensure that the team agrees that the price-minimizing objective is appropriate.
In other cases, the answers to the opening questions could include factors such as consistent quality, protection of intellectual property, corporate social responsibility or a specific technological capability. For example, a customer may value having a partner with the capability to co-develop new products. In these situations, alternatives need to be explored at the supplier or relationship level and product level.
2. Determine the alternatives: Now, decision-makers have to ask themselves a third question: What alternative sources exist? As decision-makers refocus on what customers value, they likely will need to search for different sources that are more closely aligned with those priorities. Further, decision-makers should also think about issues regarding the specific activity or product under consideration; related activities; and how sourcing multiple components from the same supplier can unlock advantages, particularly in cases when two components work together to deliver the value customers appreciate.
This is a good time in the process to prequalify potential suppliers to be considered in the next step. The prequalification process also should be driven by customer values. Keep in mind that some prequalifying factors might be non-compensatory. For example, if a supplier fails to achieve a certain level of performance for one critical key performance indicator, such as workplace safety, it should be disqualified from your consideration regardless of how well it performs in other areas.
3. Evaluate the differences: This step is the most difficult of the whole process. Decision-makers need to assign a rough monetary value to the value-related differences between the alternatives. It often is impossible to be accurate in determining value differences, so rough estimates have to suffice. TVC allows for any method of calculating value differences. You could even have a wide range for some values, if that makes the most sense for the analysis. This estimation process might be more challenging for teams that are sourcing components or backend services rather than finished goods. To simplify this step, focus only on value drivers with significant differences in customer value.
As a preliminary step, the TVC team should agree on the categories of revenue and profit that the sourcing decision may affect. After this, the goal is to reach some agreement about the rough magnitude and likelihood of value differences among sources. In some cases, the decision-makers may have the in-depth knowledge needed to define a distribution of potential value differences for each value driver, allowing a formal assessment of risk differences using Monte Carlo or similar analyses. More often, they will not. In this case, one shortcut is to consider best-case, worst-case and most likely scenarios. In this analysis, the TVC team should pay attention to the interrelatedness of potential outcomes and trigger events. For example, as a result of greener business practices, sales might improve while the risk of coming under fire for unethical business practices decreases.
In some cases, decision-makers may find it helpful to think about the value generated by one of the alternatives both with and without a particular feature, such as an option for future expansion, in order to arrive at an estimated value for that value driver.
Beyond value drivers that affect revenue or risk, this discussion also forces the team to decide how much, if at all, it truly values social issues, such as supplier pollution levels and compliance with rigorous safety or worker-protection programs.
As value differences are uncovered, the TVC approach can lead decision-makers to identify safeguards
that the organization can implement to reduce differences among options. For example, the team may see that one potential source has a higher disruption risk and realize that a disruption at a peak time may result in millions of dollars of lost revenue and goodwill. One option is to roughly quantify that lost value — for example, an X-Y% higher chance of complete disruption, which would result in $A-$B lost sales and lost goodwill valued at $C-$D — but a better approach might be to implement safeguards, such as higher inventory or flexible capacity buffers during the peak season to reduce or eliminate this issue.
The TVC team should note the need for these safeguards, which must then be included as adjustments to the cost model associated with the suppliers for which they are required. Often, estimating the costs of implementing these safeguards requires knowing the supplier's unit costs. However, such calculations should not be performed until the value differences have been fully determined so that knowledge of unit costs cannot unduly influence value estimates.
4. Reveal the costs: Measurable cost differences enter the equation only after hard-to-measure value differences between options have been articulated. These cost differences are roughly the same as those captured in a TLC model. The person in charge of the cost model should add the costs of any safeguards identified during the estimation of value differences, such as the cost of carrying additional inventory to offset increased disruption risk. (See Step 3.) However, don’t count these in both the cost model and the value model.
When both value differences and cost differences are revealed, decision-makers can finally see the full picture. We expect that, in general, the cost differences revealed in this step will not seem as large as they would have if introduced at the beginning of the analysis. This leads to more decisions based on value.
Previous experiments have shown that purchasing managers do not treat value and price as equivalent, even when value is monetarily quantified. Instead, managers doubt whether the benefits of higher-value, higher-cost purchases that their suppliers promise will be truly realized. TVC partially addresses this potential bias because the values analyzed come from internal assessment of what the firm’s customers value, rather than from suppliers. Other researchers have shown that confirmatory data from reference customers and pilot programs can be effective for reducing ambiguity about superior value. When appropriate, TVC users should incorporate these techniques to improve the precision of their estimates.
5. Learn from experience: Rational heuristics, or simple rules, are part of what organizations learn from experience. Organizations that consistently follow the TVC approach will find themselves developing heuristics for how much their customers really value speed, reliability, innovation, reputation, environmental impacts and other factors. In strategic decision-making contexts, heuristics can provide direction and enable group coordination. Just as TCO promotes learning about costs, experience with TVC promotes learning about value drivers, making the TVC approach easier over time.
To speed this learning, after a decision has been made and implemented, organizations should take one final step: As forecasters assess the accuracy and bias of their forecasts, decision-makers using TVC document the values they quantified and later attempt to compare the outcomes of their decisions to their original expectations. In so doing, they will learn to improve their estimates of value differences in future decisions. However, this will clearly be difficult for two core reasons: Realized value will be difficult to measure, and information about the performance of discarded options will be unavailable. Nonetheless, decision-makers should ask themselves: Did we identify the most important hidden costs and risks? Did we realize the expected revenue? Were our estimates reasonable? Why did we miss the things we missed? Better sourcing decisions, and better firm performance, will result.
Guidance for potential challenges
One of the biggest hurdles is that purchasing managers’ incentives typically are aligned with cost savings. For TVC to work, organizations need to restructure this approach and reward purchasing managers for adhering to the TVC approach. This, of course, is a completely different mindset from objective, numbers-based evaluations or more subjective reviews, but a focus on adherence to procedures does eliminate the difficulty of trying to put a number value on the work of purchasing managers. However, it is important to have clear steps and expectations for purchasing managers so that these professionals know what is expected of them.
Another challenge is that the approach of putting customer values first may underemphasize the concerns of other stakeholders, such as employees, as well as the company’s corporate social responsibility values if those issues are not priorities to customers. Organizations therefore will be challenged to balance these concerns, possibly by making concessions in other areas to create the best situation for all stakeholders.
The TVC approach also can change the supplier-customer relationship — but in a good way. This approach can increase supplier loyalty because the emphasis will no longer be on negotiating the lowest possible per-unit price, but on positive-sum attributes such as innovation or quality.
Again, the benefits of TVC may be difficult to measure, but they will make a difference. It is time for the purchasing function to be managed like the strategic function that it is. TVC’s benefit is that it factors in both cost and value. In fact, this approach is powerful enough that simply changing the language of sourcing will provide some benefit. Most importantly, TVC puts the values of customers first and thereby enables companies to deliver and receive value.
A more in-depth version of this article originally appeared in the Journal of Operations Management.
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