Value sourcing – buy cheaper, better, faster
Elsevier Food International Vol.9, Number 4, November 2006 Peter Breuer and Robert Klingler
Despite the strategic value of their positions, purchasers commonly spend a lot of time on administrative activities, even though much more profitable activities are possible. Treated as a strategic function influencing the entire value chain in harmony with overall strategy, purchasing can offer a real competitive advantage and take on a completely new role in the organisation. A new generation of buyers is realising the value potential of radically redesigning purchasing to meet the very different requirements of "cheaper", "better", and "faster" – value sourcing.
"Cheaper"
The Swedish furnishings company IKEA takes a holistic approach to optimising the value chain. It purchases inexpensively, following four steps. First, the company defines target costs for most products based on profit margins and final prices derived from market research. Then it develops a vision for product development and explores optimisation options for every part of the value chain. Third, the furnishings company requires complete financial transparency from its strategic suppliers. Finally, IKEA negotiates long-term contracts with suppliers including clauses on annual production increases or changes in raw materials prices. By holistically scrutinising the value chain in this manner, IKEA positions itself to offer often incredibly low prices, such as vodka glasses for the equivalent of EUR 0.08 in their Moscow store.
"Better"
The British grocery retailer Tesco cooperates closely with its suppliers to introduce innovations into the market. One complete success was to cultivate and grow a type of green apple in England that had never been grown there before. The company entered a strategic partnership with a fruit grower for this purpose, underwriting the joint product development with a long-term guarantee to purchase the harvest. Tesco describes its approach as a departure from negotiations based purely on pressure and a shift toward increasingly partnership-based and strategic cooperation. The approach has been a success. Over 35,000 apple trees were planted in 2002 for Tesco, and the harvest is expected to exceed 350 tonnes.
"Faster"
The Spanish clothing retailer Zara manages purchasing and production in a highly flexible way. Only a week or two go by between a decision to change the design of an existing item and store delivery. The Spanish fashion company achieves this speed by breaking down the value chain into its components to create the highest possible level of freedom to act flexibly. For example, Zara buys half of the fabric for a season undyed. If colour preferences change mid-season, the company modifies its production in a flash. Zara also waits until after the beginning of the season to produce 30 to 40 per cent of their collection, leaving the door open to adapting its purchasing and production in response to feedback from their stores.
In all three of these very different case studies, sourcing plays an influential role in each company's strategic orientation and gives them a competitive advantage.
Value sourcing – the concept
The retailers described above think strategically right from the outset of the sourcing phase. Current market developments indicate that this makes sense for other retailers as well:
• Retailers operate in an increasingly deflationary environment with limited leeway to raise prices.
• Retailers with a growing international presence find it necessary to consolidate their purchasing power.
• Macroeconomic developments are opening up new opportunities to purchase globally.
• Retailers are under increasing pressure to differentiate themselves from the competition by leveraging store brands.
These trends have required leading retailers to develop new approaches to their purchasing strategy including three key elements of value sourcing.
• Pull-principle: Retailers first need to align their purchasing function along customer needs and with their own corporate philosophy. Retailers such as ALDI, Wal-Mart, Schlecker, or IKEA focus their purchasing on "cheaper”. In addition to reducing purchasing costs, H&M and Zara concentrate on speed. Tesco and Marks & Spencer add a further purchasing focus on quality and innovation.
• Aspiration level: Retailers need to radically modify their purchasing aspirations to match their fundamental strategic orientation. For example, if a company's strategy is to lower final sales prices, their strategic aspiration may be to reduce total direct and indirect purchasing cost by 30 per cent over the medium term, forcing the purchasing organisation to reconsider all existing practices. Replacing typical short-term tactical purchasing negotiation by longer-term planning can help retailers define supplier management improvements for a longer, perhaps five-year period and implement them incrementally year by year.
• Holistic optimisation: Lastly, retailers should optimise the value chain holistically, evaluating each individual step from raw materials on for latent improvement potential. This new approach breaks with traditional purchasing for brand articles focused on product selection, purchase price, and negotiating conditions. Best practice companies enter traditional manufacturers' domains, targeting not only negotiations, assortment streamlining, volume bundling, and global direct purchasing, but also optimising material purchasing, production, and packaging.
"Cheaper sourcing" in practice
These examples from the food service industry illustrate how value sourcing focused on "cheaper sourcing" can be applied in practice.
• Shrimp: A holistic analysis of the value chain reveals that purchase price and indirect in-store handling costs are the main cost drivers of purchasing cost of shrimp. Lowering these costs requires linking the purchase price to a price index, purchasing flexibly at advantageous times, rigorously removing agents from the value chain, and/or capturing new purchasing sources with lower prices. In-store handling costs can be reduced by purchasing pre-treated or individually frozen shrimps or by increasing automation or machine utilisation levels.
• Sliced ham: The cost of sliced ham can be reduced by buying the entire rump rather than more costly technical parts, such as the leg. Retailers can also break down the value chain and have the individual value-creation steps realised in the most economical location. For example, pork breeding, feeding, slaughtering, and butchering are 18-20 per cent less expensive in eastern Europe than in western Europe. However, eastern Europe's price advantage for ham processing and packing is only three per cent, making a high-performing domestic partner a viable alternative for these value-creation steps. Further optimisation possibilities include entering long-term, index-based contracts to reduce risk, varying sales pricing to manage demand oriented toward purchase price, and minimising in-store handling.
One successfully implemented instrument to help companies identify potential levers is called the upstream opportunity heat map. This matrix helps companies scrutinise every cost block for potential process optimisation, product design/specification adaptation possibilities, and utilisation of factor cost advantages.
Using the matrix, one company leveraged significant potential to improve the timing and volume coordination of receiving and delivery activities and reducing variants to nearly eliminated storage facility costs. The map helped another company identify cost-reduction potential by reducing package variants, allowing 50 per cent higher production run times for the remaining variants. The results: an eight per cent reduction in cost.
Strategic purchasing requires investment in organisational conditions. One best practice company dedicates ten times as many employees to purchasing than an average company with approximately the same purchasing volume. Equipped with sufficient personnel, the best practice company was able to reduce its purchasing costs by 35 per cent within five years.
However, purchasing organisations also need employees with new skills, such as:
• Industry experts providing industry-specific knowledge about production processes, raw materials markets, or value chains.
• Functional specialists familiar with design-to-cost approaches and lean manufacturing.
• Analysts able to collect and interpret relevant data proficiently to give purchasing a detailed overview of the cost situation along the value chain.
• Project managers with the requisite conceptual know-how to lead change programmes systematically.
In summary, the trend for retail companies is to redesign their purchasing functions in three steps. They start off following the pull principle, aligning levers along customer needs and the company's corporate philosophy to achieve "cheaper," "better," and/or "faster" purchasing. They then adjust their purchasing aspiration level, putting up to 30 per cent reductions in long-term operating costs within reach. Finally, they optimise holistically to set all possible levers along the entire value chain in motion, from raw material purchasing to indirect in-house product handling costs. It is a complex challenge, but the effort will pay off in the end.
Dr Peter Breuer is a partner in McKinsey&Company's Cologne office and leads McKinsey's German Consumer Goods Industry and Trade Sector. His main focus is on strategies in global sourcing and supplier management.
Robert Klingler is a partner in McKinsey&Company's London office and a co-leader of McKinsey's Global Sourcing & Supplier Management functional area.
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