Aggressive Sourcing: A Free-Market Approach

The importance of a strong marketing function is universally recognized, and every company invests enormous effort in “out-thinking” the customer. But how much energy is the corporation, as customer, spending to out-think suppliers marketing to it? The answer in many cases is not much. Most companies have historically neglected the “reverse marketing” function (or “purchasing”), and many Fortune 1,000 companies waste several hundred million dollars each year as a result.

In the 1980s, many manufacturers instigated a purchasing overhaul. However, they focused on purchases that typically fall within the purview of purchasing departments, namely, “direct” purchases or “cost of goods sold.” The vast array of expenditures dubbed “indirect” purchases went almost untouched. A model of purchasing excellence emerged that eschewed free-market competition in favor of supplier “partnerships.” In some cases, companies extended the notion of partnership to cover areas in which it had little applicability. As a consequence, they sheltered many large supplier relationships from rigorous competitive scrutiny and seldom realized the potential economic leverage from hard-nosed reverse-marketing.

During the past few years, some firms — particularly in the service sector — have acknowledged the chronic neglect of indirect purchasing and are redefining canonical approaches to the subject. Companies such as American Express, Sears, and Chemical (nowChase Manhattan) Bank have launched campaigns to tackle indirect purchases head on, using various free-market approaches. The results of these campaigns are impressive; they include a greatly improved understanding of and control over what is being purchased and a 10 percent to 15 percent reduction in the expenses reviewed without any changes in quality or functionality. The bottom-line impact of these dollar savings is obviously material. In a case in which indirect purchases represent roughly 33 percent of operating expenses (not atypical for many companies) and net profit is roughly 10 percent of revenues, a 15 percent reduction in indirect purchases translates into a 50 percent improvement in profits.

We base this article on the phenomenal success of such campaigns. First, we review the scope of the rationalization opportunity. Indirect purchases — for example, mainframes, advertising space, health care benefits, and legal services — represent a significant part of any company’s cost structure. Yet, as they have seldom received adequate attention, they will probably survive the current wave of reengineering unscathed.

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References

1. We estimated all figures in the first section using a combination of Department of Commerce and Internal Revenue Service data, figures from a variety of industry associations, and proprietary Mitchell Madison Group databases.

2. This is based on Mitchell Madison Group’s experience in sourcing indirect purchases for many large companies.

3. For example, many purchasing systems use the Dun & Bradstreet industry coding scheme for classifying purchases. This scheme is singularly unsuited to indirect purchases; it has one code for mainframe equipment and fifty for different kinds of furniture, even though purchases of the former are an order of magnitude larger for most companies. Even if a sensible classification scheme can be established and all the relevant users and payables clerks are trained how to use it, this would solve only the problem of classifying the dollar amount of purchases into meaningful categories. This leaves the problem of locating and integrating information on volumes, so that unit costs can be computed, and the company can know that $x million was spent on printing and also that this represented a unit cost of y cents per page. Since existing sources (typically purchase orders and invoices) frequently lack this information, solving this problem itself requires significant additional effort.

4. Based on Mitchell Madison Group databases.

5. P. Milgrom, “Auctions and Bidding: A Primer,” Journal of Economic Perspectives, volume 3, Summer 1989, pp. 3–22.

6. J.P. Womack, D.T. Jones, and D. Roos, The Machine That Changed the World (New York: Rawson Associates, 1990), pp. 167–168.

7. M. Magnet, “The Golden Rule of Business,” Fortune, 21 February 1994, pp. 60–65.

8. F. Bleakley, “Strange Bedfellows: Some Companies Let Suppliers Work on Site and Even Place Orders,” Wall Street Journal, 13 January 1995, p. A1.

9. See, for example, D.N. Burt and M.F. Doyle, The American Keiretsu (Homewood, Illinois: Business One Irwin, 1993);

D.N. Burt and R.L. Pinkerton, A Purchasing Manager’s Guide to Strategic Proactive Procurement (New York, AMACOM, 1996); and

D.W. Dobler and D.N. Burt, Purchasing and Supply Management (New York, McGraw-Hill, 1996).

10. Womack et al. (1990), pp. 158–161.