One of the primary elements for sourcing a supply partner is cost and a solid practice to have is receiving at least three quotes from highly qualified suppliers. However, there is more to an RFQ (Request for Quote) than just a financial breakdown of requested parts and/or services.
The use of multi-round competitive bidding ultimately results in a pricing war between suppliers; a war that reduces their costs, but also reduces profit margins. This is always beneficial for the buyer, but what if all parties in the equation could reduce their costs, yet keep their profit margins? Implementing a strategic partnership when sourcing in this instance, which produces mutual value to the end customer by reducing suppliers’ costs, can achieve just that. As a result, we recommend moving toward a single bidding round method for RFQs and taking this strategic approach to identify cost savings opportunities for sourcing decisions.
To help illustrate what this sourcing strategy looks like, we have provided a sample situational analysis below.
Assume a potential supplier provides a buyer with the following costs on an RFQ:
Costs of Direct Materials: $12,000.00
Cost of Direct Labor: $3,000.00
Cost of Overhead: $4,500.00
Total Costs: $19,500.00
What is the minimum price a supplier might be willing to quote if the amounts mentioned above are their costs provided?
$15,000.00 because it covers the direct costs.
Suppliers would lose money on this business if they took it for less than $15,000.00 because it would not cover the direct costs involved, which are directly tied to taking on this business. Every company has overhead and suppliers want to spread out these overhead costs to customers since they are paying for a product or service that incur costs to produce. Remember, there are three types of costs: direct material (costs going into what is being built), direct labor (necessary people to build what is being built), and overhead (everything else – engineers, salaried employees, facility maintenance, etc.).
Often times there is excess capacity built into a given supplier’s business resulting in additional overhead, whether they win the bid or not. These overhead costs are inevitable and the lowest the supplier would be willing to accept the project for in this instance is $15,000.00. However, long-term, the customer must begin to cover some supplier overhead because they cannot expect some customers to pay for overhead while others do not. This circumstance will lead to the supplier not competitively pricing their products or services and will eventually lose future business when other customers discover that. A seasoned sourcing professional will always determine if they are paying too much.
Why would a supplier take on business for less than the $15,000.00 quoted and lose money?
Perhaps the supplier is thinking long-term and wants to get a foot in the door of a given market. Sometimes this practice is necessary for a smaller supplier, or even a supplier new to a given sector, to build their reputation for producing a quality product or service. Tread with caution though, as buyers engaging in this kind of business where they know the supplier is losing money may not be the best companies to partner with in the future.
Why would a buyer accept a bid from a supplier knowing the supplier will be losing money?
It is possible that the buyer is promising this supplier something in return later on down the road, like an introduction to another firm that could use the supplier’s product or service. Or maybe the buyer recognizes that the supplier’s direct material costs are not competitive. A buyer thinking collaboratively would then communicate this fact to the supplier to try and help them reduce these costs to ensure that this supplier is making enough profit to deliver promised products or services.
The largest component of costs when purchasing from a supplier will be in direct material, so focus on this element of the cost structure. Be vigilant of a suppler who’s majority of costs are determined to be overhead expenses, as this is typically an indicator of inefficiency within the organization’s operations.
From the information provided in the quote above, why would a supplier consider a price of $17,000.00?
Because it covers the supplier’s direct costs and leaves some funds to appropriate for overhead costs.
What is the formula for Profit Margin?
(Sales – Cost of Sales) / Sales
Keep this simple, take a supplier’s total annual sales revenue and subtract its costs (direct materials, direct labor, and overhead). Then, take that number and divide it by the total annual sales revenue.
How can a company increase this margin?
By cutting costs. Where do most of a supplier’s costs come from? Direct material purchases. Why do you want to increase profit margins? To increase ROI (Return on Investment). ROI is PM multiplied by Asset Turnover Rate (ATR). What is ATR? Doing more with less (i.e., reducing inventory, getting customers to pay sooner, outsourcing, buying less expensive materials). When ROI goes up, the company’s stock goes up.
What is the formula for Net Income?
Sales – Cost of Sales
Net income is equal to the profit or loss balance remaining after all costs and expenses have been covered for a given time period. Simply put, net income is the money left over after a company sells its products or services, pays for the costs of producing their products or services, and pays for all remaining organizational expenses. Understanding the profit margin and net income are vital for suppliers to determine if the products or services being delivered are profitable after expenses are accounted for. Regular evaluation of an organization’s net income and profitability enables opportunities for suppliers to see patterns, therefore providing the decision makers with valuable information they can use to implement changes when quoting new projects or when re-prioritizing funds set aside for facility maintenance, for example.
Breaking down the above sample situational analysis should begin to reveal some benefits of a strategic partnership approach to sourcing and supply base building; working with supply partners to identify cost savings for all parties helps suppliers improve their cost structures, develop and maintain strong supply partner relationships, and subsequently, increase end customer supply chain value.