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Lean Purchasing and What It Can Mean to You and Your Company

August 16th, 2009 · No Comments · Uncategorized


As a national average, 60% of the cost to manufacture is attributable to purchased materials.  If the purchasing function controls over 60% of the costs in a product, then resources and talent must be focused on this function if the business is to stay healthy.

What should be emphasized is the establishment of business relationships and arrangements with suppliers as a primary task and satisfaction as a primary measurement.  Emphasis on placing purchase orders and on expediting delivery should be minimized.

  • Can today’s suppliers grow with us and supply the technologies and capacity required for our future needs?
  • What strategic alliances with suppliers will be required in the future?
  • What roles will price and quality play in the product sourcing decisions of the future?

Purchasing establishes and maintains the supplier base, seeing to it that adequate capacity and quality are available and that the level of service and price are optimal.  To accomplish that requires purchasing to develop your suppliers.  You need suppliers who are dependent upon your company’s success and are willing to work closely with you.

Lean and Inventory Management

The only good reason for maintaining inventory is that conditions exist that make it less costly to have it than not to have it.  If a supplier doesn’t deliver on time, extra inventory compensates for the problem and allows operations to continue.  It also makes us an enabler and sends a wrong signal to the supplier.  Inventory is a RESULT and very expensive.  Inventory simply hides problems.  Drain the inventory and expose the problems.  Now you can deal with them.

Problems covered by inventory:

  • Unpredictable customer demand
  • Inaccurate forecasts
  • Low process yields, scrap, rework
  • Incoming materials rejects
  • Unreliable supplier deliveries
  • Equipment availability
  • Missed production schedules
  • Field failures, customer returns

Fact:  The longer the lead-time the greater the need for more inventory and the greater the costs.

Fact:  The longer inventory sits, the harder it is to move.

Fact:  The cost of carrying inventory has been looked upon by accounting as strictly a dollar item based upon what you paid for it.  The TRUTH is, you are looking at roughly 75%/year of the purchase price, or 1.5% per week.

We keep trying to solve problems with increased inventory.  And price increases are only an enabler for the habit.  The only way to reduce inventory is reduce the lead-time.  The only way to reduce the lead-time is to reduce your process cycle time.  The way to do that is to reduce your set up time.

The Problem with Inventory:

  • When the market or technology changes, all you have is worthless inventory.
  • It is expensive to hold on to
  • It requires support resources of people, systems, equipment and transactions
  • It is difficult to work around
  • Eventually it becomes not worth what you paid for it
  • It can be a coping mechanism that hides the real problems

The Cost of Carrying Inventory

Recognized Costs Approximate % per Year

Interest rate of money                                                                                    5 – 10%

Taxes                                                                                                             2 – 5%

Insurance                                                                                                2 – 3%

Space (occupancy + utilities)                                                                             5%

Obsolescence reserve                                                                                    7 – 20%

Total                                                                                                            20 – 30%

Unrecognized Costs

Personnel                                                                                                10 – 15%

Capital equipment                                                                                     5 – 10%

Computation Costs (hardware + transactions)                                                3%

Secondary quality costs (reinspection)                                                5 – 10%

Rework, handling damage, additional costs                                                5 – 10%

Total:                                                                                                            50 – 75%

References:  The Supply Management Handbook, 7th ed., McGraw Hill, The Institute of Supply Management; and Profitable Purchasing, Leading Manufacturing Excellence, John Wiley & Sons.

The hidden cost of inventory is massive.

Factors included in determining Inventory Carrying Costs:

  • Cost of money
  • Obsolescence or Scrap
  • Space
  • Taxes
  • Insurance
  • Personnel
  • Handling
  • Storage
  • Overhead Allocations
  • Equipment
  • Lost Opportunity
  • Inflation
  • Rework
  • Service Costs
  • Currency Devaluation
  • Packaging Materials

We need to move from Supplier Managed Inventories to

Supplier Managed Deliveries

  • Identify the demand
  • Produce and deliver to that demand
  • Deliver to point of use
  • Monitor and adjust to usage

Let our suppliers become Bread or Milk Men restocking as they see fit.

LOOK AT THE PRODUCTS YOU PURCHASE NOT BY PRICE BUT BY PRIORITY.

You have A, B, and C Items.  An A item is one that is extremely critical and will shut you down.  Price does not matter.  It’s the criticality of the item.

Sell what your are producing at the time you produce it.  Get rid of inventory by eliminating lead times.

If it cost 1.5% per week to hold something, the very same number applies to the manufacturer, the distributor and the customer.

It all comes down to the supplier’s lead time versus when you need it, versus the price of inventory.

The point is that the item may appear to be less expensive than the competition, but their lead time can really cost you.

In working with a supplier, why not have them ship to you out of inventory for the first 4 months.  Afterward, they have to ship directly off their manufacturing line.

Elements of Lean Purchasing

  • Collapsed cycle times
  • Speed replaces inventories
  • Direct links to top suppliers
  • Appropriate quality for the particular application is a given
  • Direct user/provider interface
  • The deeper the supply chain, the better

Elements of a Good Supplier

  • Has minimized cycle times
  • Quality is appropriate – Cpk 2-4 (process capability)
  • Owns logistics – transport & POU deliveries
  • Assists in the design of components/products
  • Knows your business/customers
  • Knows why they are profitable
  • Is a technology leader in their field
  • Prices based on a superior process
  • Personnel turnover <5% per year

Example:

Let’s say you have a product that takes 12 minutes to produce, but it has an 8-week lead time.  To determine the Velocity ratio you would do the following:

60 (minutes) x 8 (hours) x 5 (days) x 8 (weeks) = 19,200 minutes ÷ 12 minutes = 1:1600

The question becomes, if it takes 12 minutes to produce a part, why is there an 8 week lead time?

Just as we took a look at our OMC, our suppliers need to do the same.  They have to get their Process Cycle Time reduced.  To do that means reducing WIP while increasing output.  Furthermore, by making everything happen faster, you also improve cash flow.  Because the faster it all happens, the faster you get paid.

Exercise:

The Gazorp Manufacturing Company is a 15 year old, publicly traded company.  It manufactures smoke and carbon monoxide detectors for homes, offices, institutions, and public buildings.  It sells to retail outlets, electrical distributors, and construction contractors.  Gordon has no sales staff.  They sell solely through independent sales agents.

Last year sales: $176MM

Last year costs:

Direct Labor                                                            $11MM

Material                                                            $80MM

Overhead                                                            $40MM

Sales & Commissions                                                $20MM

Taxes                                                                        $14MM

Net Profit                                                            $11MM

The year’s beginning inventory was $23MM and the ending inventory was $19MM.  The quoted lead time for new production is eight weeks.  Actual process cycle time is 6 hours (the plant works five days per week with one eight hour shift per day).  The company is ISO 9000-2004 compliant.  Their cost of all quality activities is $8MM of the $40MM overhead and $6MM of the Sales and Commissions.

  • What is their manufacturing velocity?
  • What are the inventory turns at year end?
  • What is their PONC (as a percent of sales)?
  • What is their PAT percentage?

We need to stop doing business on the terms of our suppliers:

  • Their lead times
  • Their costs
  • Their quality
  • Their policies
    • You cannot afford it
    • You are dealing with hundreds of different commercial terms
    • You are the customer

It is time we made some demands and issue orders with our terms:

  • Affordable prices at any volume
  • Required lead times  (Mr. Supplier, I can no longer afford the lead times you’ve given me.)
  • Process capability  (Does it match our needs?  What do we say about quality on our purchase order.  How good does the product being delivered by the supplier need to be?  How often does it have to look like the print?  And what happens if it doesn’t?
  • Technical assistance
  • Service, returns, response times  (How long can we afford to give them to rectify a situation?  Minutes, hours, days?  What is our policy?  Do we state right on our purchase order that if the product is bad, you have exactly 24 hours to deal with it, replace it, or we dump it and don’t pay you for it?)
  • Packaging, standard counts (Why are we doing things the supplier should already be doing for us?  What do we consider a standard container and a standard count?)
  • Transportation/delivery terms  (When is delivery actually completed?)
  • Payment terms

Perhaps it’s time to challenge your own purchasing department by asking them:

  • Do we know the level of quality we require in specific terms?  How good does it have to be?  How good is good?
  • Are our blueprints and spec a reflection of our true needs?
  • Do we know what a process in control looks like?  Can we fairly evaluate a supplier’s process?
  • Is there a correlation between the supplier’s quality system and ours?
  • Are we willing and able to assist the supplier?
  • Is the certification looked upon as the beginning of the quality process or the end?
  • Do we have the sustaining power to make quality a life long process?
  • What are the quality targets WE have set for the products we buy and sell?  Cpk 1?  Cpk2?  Or, Mil Std. 105?
  • What is our supplier’s plan to improve the quality of his product line and reduce his lead times to meet our needs?
  • What is the supplier’s cost of non-conformance?  Remember that it can be as much as 25% of the cost to produce.
  • What is their manufacturing cycle time and ratio?  What’s their plan to improve upon it?  Remember:  The right product delivered at the wrong time is a wrong product.
  • When will the supplier eliminate the need for our incoming inspection of his product?
  • When will we have the confidence to do that?
  • When will we begin introducing more errors by inspecting than by accepting the goods without inspection?
  • When can we begin reducing the unnecessary inspection overhead?
  • When will we begin using inspection only to correlate data?

We must demand from each of our suppliers that they inform us whenever they:

  • Change their manufacturing processes or equipment
  • Change ownership or make significant management changes
  • Change their raw material suppliers
  • Change their technology

Things to consider:

  • Lead time should only be incurred on an initial order
  • Repeat orders should utilize
    • Requirements Contracts for Direct Material
    • Systems Contracts for MRO
  • Minimum orders are the suppliers’ set up time problem
  • Lead time is a choice the supplier makes

The time has come for us to be thinking in terms of Contribution to Profit instead of Controlling Costs.

If Purchasing Wants to Become Lean:

  • Buy from lean suppliers
  • Key suppliers must have lead times no greater than your needs
  • Each week of lead time costs you 1.5% per week of the price
  • Suppliers cannot hide behind inventory
  • Suppliers’ quality system must match your product needs
  • Purchasing must buy affordable cost
  • Contribution to profit- not PPV (Purchase Price Variance), cost reduction

Recommendation:

Invite the OWNERS of your top 20 suppliers, or the highest official person you can, to your company for lunch.  Explain to them what your company is all about and where your company is going.  Explain to them what we need from them to help us get from where we are now to where it is we need to be.  Educate them on Lean if they aren’t already.  Ask them to declare who wants to come with us right then, there and now.

Explain to them that you are seeking a business partner.  That you want a business strategy not an individual package with each supplier.  Then hold a one day seminar at the suppliers site talking to their employees about LEAN.

A key role of purchasing is to build roads of communication between your company and your suppliers.  In doing so, you must:

–  Define Quality.  What is it?

–  Listen to suppliers’ issues

–  Resolve historic issues – engineering, personnel, broken promises, singed fingers, etc.

–  Establish lines of communications – people systems

–  Agree on quality definitions

Should the concept of Lean Purchasing interest you, contact SME to attend the next Lean Purchasing Course in nearest you.  Or, if you would like the concept of Lean Manufacturing explained and introduced to your employees, contact Jim Altfeld at jaltfeld@altfeldinc.com or call 1 800 397 0010 for his introduction to Lean.

Answers to the Gazorp Manufacturing Exercise:

What is their manufacturing velocity:

60 x 8 x 5 x 6 = 19,200 ÷ 6 hours (360 minutes) = 53.3

(Amount of time the plant works per week) 60 minutes x 8 hours x 5 days x 6 weeks lead time ÷ time to produce = Velocity

What are the inventory turns at year end: 131 ÷ 19 = 6.9

IT = Annual Cost of Sales ÷ Dollar Value of Inventory

(Direct Labor + Material + Overhead) ÷ Ending Inventory

Annual Cost of Sales = Standard Cost x Total Forecast or Total Units Sold ÷ Total Invested Inventory

What is their PONC (as a percent of sales): 176 ÷ (6 + 8) = 8%

Sales ÷ Quality Activity Costs  = PONC

What is their PAT percentage: 176 ÷ 11 = 6.25%

Sales ÷ Net Profit = PAT

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