Have you ever sent someone to the grocery store with a list of items to buy along with the money necessary, then had them return home after spending more than you gave them/budgeted? And that they bought flank steak instead of ground beef and both hard and soft shells for your taco dinner?
When asked why they bought and spent what they did, the answer is something like this:
“Your list just said taco shells, so I didn’t know what kind to get (brand or texture) and I prefer to use flank steak when I make tacos as its quality and taste are significantly better than ground beef.”
Essentially, there wasn’t a clearly defined spec that someone other than you could follow when shopping and there wasn’t alignment between you and the shopper on the recipe or quality that was to be followed in preparing the meal, therefore there was no cost management. The net result of these disconnects: an increase in cost and probably longer cooking (processing) time.
The household example above is simplistic and didn’t break the bank or result in dinner being on the table too much later than originally planned, but when similar situations happen in business the impacts can be far greater and include: significant cost overruns and reduced profitability, missed available to ship dates, and angst between functional areas and/or a company and its suppliers, thus the importance of cost management and a well-defined spec.
Proper Use of Cost Management Principles Can Prevent Costly Budget Overruns
We recently encountered a situation with one of our Spend Management clients where there were significant disconnects between functional areas as to the scope of work and specifications that a supplier was working to. The result was a major change in cost from the supplier ($10,000 – $15,000 per production unit) which when combined with budgeted internal expenses, ended up creating a negative impact on margin. To make matters worse, the supplier was still not covering costs with what they were invoicing and decided that each unit they would handle would need to be quoted separately. The cost overrun on the next production unit was expected to be close to $25,000 further impacting margin in the wrong direction.
How did these disconnects occur?
For starters, the initial spec that the supplier bid on was not complete. The client’s Purchasing Organization developed a spec that was used in the bid process without involving other functional areas to make sure that the entire scope was captured and ultimately aligned with internal quality end customer expectations. Since then, things have spiraled out of control with three things driving the cost increase:
- Other functional areas that interfaced with the supplier pushed work from the internal manufacturing process down to the supplier which has a cost impact on the supplier and in turn on our client.
- When quality issues arose, the Quality Control group didn’t work with Purchasing to provide timely feedback to the supplier and work to understand the root cause of the problem so corrective action could be taken. Instead, they developed a tighter quality inspection specification which they provided directly to the supplier without consideration for the impact on cost. Furthermore, they didn’t communicate the new spec to Purchasing.
- Sales didn’t understand the spec that work was being performed to and therefore wasn’t appropriately managing the end customer acceptance process. They also weren’t appropriately pricing what they were selling based on COGS.
The new, even higher quote triggered a lot of anger, frustration, and concern throughout our client’s organization and a request to solve the problem immediately. Likewise, the supplier was very frustrated which was evident in conversations with them as we sought to understand and solve the problem.
When the quotes came back, our supplier had sharpened their pencil overall. (Win #1) We then presented the quotes to Quality and Sales and asked them to make the final decision as to what the inspection criteria would be since this drove the difference in cost between the quotes. Quality deferred to Sales. (Win #2 as Sales has to manage the customer, not our internal Quality Group.) Sales decided to go with the lower cost option and agreed that they would manage the end customer to the correlating inspection criteria or charge more for a tighter spec. (Win #3) Lastly we gained alignment internally and externally that all direction to the supplier would flow through purchasing and that the supplier was not to take direction from any other member of the organization. (Win #4)
After gaining an understanding of the situation through conversations with the supplier and numerous people in the client organization, we pulled together a cross functional team of people (the users) to review the current scope of work and inspection guidelines, make adjustments, and ultimately develop a comprehensive scope of work agreed to by all involved internal parties that could be provided to the supplier for a revised quote. We also asked for quotes on several inspection options so the cost vs. quality trade-off could be weighed appropriately. Lastly, we explained the margin situation to the supplier and asked them to sharpen their pencil as much as possible on this quote while we worked to develop a new bid package for them to respond to.
KEY TAKEAWAY: Everything starts with the specification development process. Without the input of a cross functional team, there is high risk of missing parts of the specification/scope of work leading to unrealistic cost expectations and the potential for frustration and poor supplier relations. Furthermore, if the cost isn’t right, you can’t develop the right selling price and present options to customers that maintain margin.