ADR’s Development Needs Analysis skills assessment shows that the biggest skills gap in procurement professionals globally is supplier cost analysis.
This article explains how this skills insight links to recent events at Carillion.
What is is required to ensure the suppliers we select are stable?
There has been much media commentary this week about the failure of the 2nd largest construction firm in the UK, Carillion. Much of this has focused on the government purchasing team who selected Carillion. Some have criticized the buyers’ lack of rigor in the supplier selection process that allowed Carillion to be chosen as a vendor despite them not having the financial strength to support the investment.
However, most major organizations have the appropriate processes and procedures to ensure prospective suppliers are evaluated in a manner that is appropriate to the scope and scale of the project that they are being considered for. Such processes include:
1. Evaluation against customer technical requirements
The extent to which the suppliers’ proposals meet the specification / statement of work.
2. Evaluation against customer business requirements
A review of the extent to which the suppliers’ proposals meet the business requirements of the buyer in terms of availability, service, quality, cost and legal / corporate social responsibly.
3. Evaluation against customer budget requirements
A review of the suppliers’ proposed prices and actual input costs.
4. Evaluation against customer financial sustainability requirements
A review of the suppliers’ financial performance is done for risk management purposes (does the supplier have adequate cash, liquidity and solvency to initiate and sustain the work?) It is also done to seek opportunities for improvement (does the supplier have profit in line with the industry norm, does it manage its operation efficiently, according to the financial data?)
5. Evaluation against customer business values
Many organizations also attempt to assess whether their suppliers meet their business values that could include areas such as social impact, ethical behavior or problem-solving practices.
Given these well-established processes that help ensure that the suppliers we select meet our needs now and in the longer term, why does supplier evaluation and selection often go so wrong? How can it result in a supplier being selected that subsequently cannot perform according to your needs and the contractual agreement?
With over 30,000 online evaluations ADR’s online skills assessment tool has shown that while tender procedures are often applied well, what is often lacking is the right cost analysis skills to support supplier evaluation and selection.
What cost analysis skills are required to support reliable supplier selection?
1. Collecting the right cost analysis data
Every supplier proposal should include a breakdown of the actual input costs that the supplier will invest in order to implement and manage their solution. This includes:
- Direct and Indirect Labor: Wages and social costs of the number of people with the varying qualifications and skills required to perform the work. Indirect labor refers to the people performing services that are required for the project to be effected, but are not directly working on it.
- Materials: Actual prices paid for the quantities of bought-in materials, consumables, tools, supporting equipment.
- Overheads: The premises required to perform the work, and the premises of people, equipment and items that support the work. In addition, software and other enablers like licenses and maintenance to support the work. Finally come overheads, which are business costs like rent, tax and energy. Overhead costs are allocated proportionately across all the suppliers’ customers.
2. Analyzing cost analysis data
Analysis goes wrong when the correct information is:
- Uncollected – either because suppliers haven’t been asked, or asked for the right thing. Or suppliers refuse to provide the data, and this is tolerated.
- Untested – the information is given to buyers but there is no sensitivity analysis to determine what would happen if any of the conditions changed from the time of contracting to later in the agreement life. For example, market environment, currency, volume of work, political change could all impact the input costs of the supplier.
- Unchallenged – the information is given to buyers but it is not questioned. In particular, there is a lack of interrogation of the source of funding for supplier investment, inadequate review of the efficacy of the suppliers’ own procurement approach, and a failure to question the assumptions behind the costs.
- Unsustainable – the supplier has put forward a solution that will win them work but it is not possible to maintain the agreement without additional funding. They may attempt to get this money from buyers in the form of a price increase later on in the agreement life.
- Invalidated – the information is given to buyers, who fail to check its veracity. The data can be checked a variety of ways including using third party sources, site visits, and benchmarking.
3. Creating a business continuity plan
Business continuity planning involves creating options for if the supplier does not fulfil their contract through interrupted or ceased operation, unavailable or late goods or services or any other form of performance failure. To address this, the buyer should prepare the following:
a. Account cost plan
Buyers should expect that all prospective supplier bids include an account plan that details the financial investment at all stages of the proposed contract. This may include recruitment and training costs, ongoing maintenance costs, costs to replace equipment that is end-of-life, and plans to mitigate adverse cost conditions in the market. The implications to the buyer should be clear, for example the associated support and resourcing costs that the buyer will have to pay for as part of their internal business costs. This demonstrates that suppliers are considering the whole life cost of a proposal, not just the element that relates to their part of the supply chain.
b. Risk plan
Buyers should create business continuity plans with the help of their prospective suppliers. This is a plan that details what will happen in the event of supplier failure for any reason, to ensure that the operation is maintained. Typically this is included in a sourcing strategy and could include options such as additional qualified sources or temporary insourcing.
Buyers should also concern themselves with the customer / service user side of the project, if the purchase is being used for external stakeholders rather maintenance, repair and operations (MRO) items for internal use. Suppliers need good visibility of upcoming requirements, volumes and changing needs. This helps them to plan their business, resourcing and procurement plan. Buyers who are able to give suppliers stable forecast information help their suppliers to give cost and financial data that is reliable, with suitable caveats included.
d. Supplier Performance management plan
Buyers and suppliers work together throughout the bid and contracting stage to jointly develop performance measures that will do several things:
- Provide an early warning system, to ensure rapid detection and mitigation of risk elements. Such a system would highlight incidences such as suppliers extending their payment terms to their own supply chain (which is often an indication of cash flow difficulties).
- Give an indicator of whether current performance is on track to deliver the future performance required (hence, key performance indicators, or KPIs).
- Ensure the buyer is getting earned value. In other words, the supplier is doing what they promised to do, at the cost levels that were agreed.
- Be adaptable in the event of variation in requirements, market conditions or input costs.
- Motivate both buyers and suppliers to feel committed to achieving continued good performance.
Effective supplier selection and management requires an expert understanding of price and cost analysis combined with a robust supplier evaluation process. Organizations that train and develop their procurement people and business stakeholders in understanding price and cost will be more effective in supplier management, and are more likely to deliver sustainable, reliable supply agreements.