After the first part of this series “Value levers part 1: The 1×1 of purchasing optimization, but what are they exactly?” explained what value levers are and what they have in common, this article addresses the question of which lever is suitable in which situation. At the same time, it gives examples of the four additional levers and details the most misunderstood lever “price”.

Which lever to use when in which category

Not every lever should be applied without a risk assessment and an analysis of possible effects on the company and its supply chain. One way of categorizing the goods or services is to display the categories in a “kraljic matrix”. This classification enables to develop a specific strategy for each category and derive appropriate value levers.

The effects of the usage of a lever depend heavily on the strategic importance of the purchased goods for one’s own company. In the case of strategic or bottleneck goods less confrontational levers should be chosen in order not to unnecessarily endanger the security of the companies supply chain. On the other hand, the full negotiating power can be used in the case of non-critical or leverage goods and services.

The four remaining levers of the SCP value levers “make or buy”, “sourcing”, “price” and “contracts” will be outlined in greater detail.

Make-or-Buy –
„Is it cheaper to produce certain products internally or to buy them from external providers?“

The goal of this lever is to find and use the most cost-effective way (internal vs. external) for the provision of services in the production process. In the category “negative molds (plastic)”, which are parts that have to be replaced regularly in a new production machine, the question can be raised before purchasing the machine, whether these negative molds are manufactured in the company’s own injection molding department or should be purchased from external partners. In-house production usually has sustainable cost advantages if two core requirements are met:

  1. The negative mold is a strategically important component, so secrets in the production process would be disclosed if outsourced
  2. Internal manufacturing is more cost efficient compared to external purchasing

These requirements should be clarified with engineering, purchasing and production departments. Two factors are of special importance for the assessment of which variant is “cheaper”. First of all, the calculation of the business case must include all relevant aspects in a cross-functional manner and thus prevent internal conflicts of interest. For example, internal process costs that arise from the effort involved in coordinating internal production should be considered, as well as positive effects when using free internal production capacities. It is always important to consider the total costs for the company so that the lever does not result in a cost shift between departments.

The second important factor is that strategic decisions need to be included in the business case and a monetary value must be assigned to them. This is the only way to identify a positive business case for the company, which would otherwise appear negative locally (for individual company areas/functions/departments).

In addition, a distinction should be made between strategic and operational make-or-buy (MoB) decisions. The strategic MoB develops the set of rules on how to react in certain situations for certain products/services. For example, the decision to utilize internal production capacities with products that would be bought externally at lower cost if the internal production runs at nearly full capacity. This makes it possible to retain know-how and human capital in the company in times when the production is not fully utilized. The reduction of production capacities would be a decision, that would be difficult to correct in the event of short-term changes in the outlook in selected sectors.

At the same time, general conditions must be met for strategic MoB decision. For example, the throughput times between orders and the actual deliveries must be relatively short. At the same time, internal production planning must be able to react flexibly, and the adjustments must be systemically mappable. If the rules and conditions are clearly defined, an operative MoB decision can be made in the respective situation.

„How can the maximum competition be created?“

If the category is a commodity (or close to being one), such as in the sub-category “LED strips”, the lever “sourcing” and thus the use of existing competition can lead to success. The goal is to use the entire market to find the best value for money for a good or service. At the end of this lever, the continuation of an existing supplier relationship can still stand – but normally with better commercial terms. Critical to success is an openness to new suppliers, even if this usually involves additional procedural effort in the initial phase for the buying company.

Competition can be generated, for example, by expanding the supplier base regionally to other countries or continents. The selection of new suppliers should always be carried out in close cooperation between purchasing and the department that orders the respective goods or services. This way, providers with the best price-performance ratio can be identified.

This lever showed great potential for savings, especially in very long, historically grown supplier relationships. Before using it, however, it is important to take into account the overall market environment (e.g. recession, boom phases…), since the establishment of new customer relationships usually also means effort on the supplier side and significantly influences the willingness to submit an offer. Tender documents should therefore be designed as easy as possible to ensure the greatest possible response rate.

Contracts –
„Are conditions with suppliers written down and are they known to all those involved in the process?“

This lever seems to be a requirement in a professional business relationship – in practice, unfortunately, it is often not. Written conditions in a contract not only give the companies (mutually) greater legal certainty but can also generate savings. In the category “logistics (freight)” a longer total contract could guarantee the supplier a basic utilization of his vehicles for a given time, which means that he could reduce risk premiums in his calculations. Lawyers or the legal department should be involved when working on this lever, so that not contractually disadvantageous or untenable agreements are made. Afterwards it is fundamental that contracts are easily accessible for users and contractors if actual savings should be generated. After all, what use are conditions and contracts that nobody knows about, and a different service might be ordered than agreed on?

„Is the price reasonable?“

This lever is often misunderstood, but this lever is not about forcing the supplier to reduce the price without any further analysis and information. The aim is to gain almost complete transparency about the price and its components to be paid for a good or a service. The real challenge is therefore to change the perspective and to think as if you are your supplier, thus, to quantify individual cost factors of the product or service.

In the category “temporary labor”, for example, this would be the analysis of which collective agreement group the leased workers are employed in and what additional overhead costs (e.g. administrative, procedural…) arise for the supplier. This way, a “fair” price can be determined, and the current margin of the supplier can be estimated. (For more information check out this article “The illusion of the best purchase price”) Which stakeholders should be involved in the processing largely depends on which service or which product is to be “broken down” into its cost components. In the example given, purchasing should carry out the cost breakdown together with representatives from the HR department and the ordering department.

If no reliable “disassembly” is possible within the company, it can pay off to involve an expert in the respective category. The greatest savings are possible in non-transparent or previously unprocessed categories. The specialist knowledge of the ordering department is important when breaking down the costs. That ensures that the quantification is realistic in terms of its amount and no “apples-and-oranges” comparison is carried out in terms of quality. This lever can be a worthwhile approach in the case of low competition and low bargaining power (monopolistic suppliers).

How does the theoretical value lever become a measurable saving?

The application of value levers provides a good theoretical basis for achieving savings. However, they are only an analytical and conceptual method. Deriving concrete measures from levers and implementing them successfully is a central task of successful category management. Classic management virtues such as communication, time management, frustration tolerance, leadership or project management are essential in order to successfully integrate the entire company. Good category management is not just about expertise in one or more category, but above all good management. This will be a topic in one of our the next articles…