Lowest Cost Sourcing May End Up Being A Company-Killer
Purchasing managers and companies guided by lowest delivered costs, rather than life-cycle costs, can kill their companies. A purchasing culture that does not live by the principles of Lean, and depends on long, thin supply chains, can kill a business.
By Ned Hill, A One-Handed Economist, and Professor of Public Administration and City & Regional Planning at The Ohio State University’s John Glenn College of Public Affairs, powered by The MPI Group
Touring Delphi’s Dayton brake assembly plant, now closed, in the spring of 2007, showed me how purchasing managers can kill companies.
Walking a disc brake assembly line with the plant’s manager, we noticed brake rotors running through with warps so bad, even a one-handed economist could notice the defect. The plant manager looked pained, explaining that Delphi had sent the rotors to the “Quality Assurance” lab of the original equipment manufacturer (OEM), who approved the part for two reasons. First, the part was expected to outlast the OEM’s warranty period, but eventually fail. In other words, the part was good enough for customers. Second, not using the part would disrupt the OEM’s production because tooling had to be corrected at the supplier, which was located in Europe (I also thought that there would be a trickle of cash going to the OEM as honked-off drivers paid for new rotors).
The plant manger bluntly and colorfully said that the OEM’s purchasing department considered nothing but the delivered price of the part — issues of manufacturability, quality, or customer satisfaction after the warranty ended were absent from the “Quality Assurance” decision.
Two thoughts came to me that day. First: Never buy anything from the OEM. Second: Purchasing managers and companies guided by lowest delivered costs, rather than life-cycle costs, can kill their companies. A purchasing culture that does not live by the principles of Lean, and depends on long, thin supply chains, can kill a business.
My visit to Delphi was part of an in-depth examination of manufacturers in Ohio’s automotive supply chain on the eve of the Great Recession — from 2007 to 2008. Driving Ohio’s Prosperity covered a lot of ground; what remains relevant are our observations on the often under-appreciated link between risk-based cost accounting and supply-chain management.
The manufacturers interviewed were quick to point out that an overriding focus by OEMs on finding the lowest delivered cost of parts failed to factor in the hidden risks and related costs of sourcing: the requirement to hold extra inventory in the supply chain triggered by long shipping distances, the potential disruptions caused by defects, and the cataclysm that can result when a good part goes bad — just ask Takata or Cuisinart.
Two examples came out of Japan after the Fukushima earthquake and the resulting catastrophic tsunami that killed over 14,000 people. Only one factory in the world manufactured a specific kind of deep, lustrous, black auto paint; it disappeared under the tsunami, affecting luxury auto sales by all of the automotive OEMs. The second was more specific. One OEM classified an engine controller as a Tier 3 part — after all, it was put into the engine block that was part of the propulsion system that was a component of the automobile. As the OEM was smart and risk-averse, the chip was dual-sourced. What was missed? One supplier purchased the other, and the OEM failed to notice. When this one source went underwater, engine plants had to be shut down until another source was found. That was a bad, bad, quarter.
In a just-in-time system, manufacturers, or their suppliers, who buy parts from halfway around the world, need to keep a larger inventory on hand than would be needed if buying parts from a supplier an hour’s drive down the highway. Responding to design flaws or manufacturing defects is more challenging the farther away the supplier is from the final customer. “There are a huge amount of hidden costs,” one manufacturer said. “In general, you have to have high-volume, low-value products to be competitive if [your customer is considering] purchasing from overseas. There has to be a lot of labor involved in order to beat the cost [of producing] here [in the United States]. If it’s a design-generated product, we can probably produce it here.” Another parts supplier, feeling the squeeze of low-cost parts, echoed: “The advantage of low-cost countries is a lower labor base and lower standard of living. The disadvantages, and there are many, are lead time, problems in shipments . . . If you have a defect or a design problem, you have a hard time fixing [it] with so much product in the stream.”
One supplier shared his experience with the pricing demands of working with certain automakers: “You hear that sourcing parts is based on lots of factors – that’s BS. Cost is more like 98 percent and everything else [quality, inventory, risk] is 2 percent,” he said. “The hidden cost of overseas production is an absolute nightmare – a $40 part becomes a $15 part moved to China. But that doesn’t count the hidden costs, losses, etc. Then there is the organizational drain on people: they have to track down parts, it’s a holiday . . . . Quality is a main part of the risk: there can be a 6-month lag on correcting the quality of a low-cost-country-sourced part. In a pinch, you have to charter [an airplane to ship] the parts [and fly them] over, and they often require payments upfront when the parts leave the plant. You have to really understand the risk profile of overseas suppliers.”
Many of the suppliers interviewed spoke of efforts to compete on quality and added product value, but said it continues to be an uphill struggle to get many companies to look at issues beyond per-unit price. “If a competitor turns in a bid using overseas parts, we may lose the bid,” one supplier explained. “The quality may not be there [in the part]…” He continued that “it may [take] another two to three years to regain the business…” after the OEM discovers the quality problems and rebids the part considering both “cost and quality.”
Domestic auto assemblers, and other OEMs, need to think carefully about the fully accounted, risk-adjusted, cost of sourcing. In plant visits to Tier 1 suppliers and conversations with OEMs and consultants who work with OEMs in a number of industries, we ran into cases of supply-chain breakdowns that imposed significant costs and risks to the purchasing company. It is clear that there are serious cost-accounting and strategic issues involved in determining the economic costs of sourced components and parts. OEMs need to examine their supply chains in terms of the risk they pose to the business, and the location of that risk: cost, quality, delivery, and the ability to shut down operations. It is also important to keep track of all parts of the supply chain that can shut down production — no matter if they are Tier 1, 2, or 3.
As for the story about the warped discrotors? The Detroit-based OEM went bankrupt and took Delphi down with it. So much for Quality Assurance.
 Driving Ohio’s Prosperity is posted on ResearchGate: https://www.researchgate.net/publication/254582067_Driving_Ohio%27s_Prosperity_Auto_supply_chain
 When a Tier 2 or 3 company sources a part internationally they often pay with an International Letter of Credit (ILC), cashed when the part ships. The US supplier is not paid until sometime after their final assembly is received by a customer — which can be net 30, 60, or 90 days. This can result in up to a half-year of financing from the day the ILC was cashed.