Risk-Adjusted Accounting and Assembly Costs (or: A Tale of Two Supply Chains)
Whether a company uses the relationship or auction supply chain model can influence the competitiveness of businesses: in other words, the way purchases are made — and how vendors are held accountable — are strategic decisions.
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
In my last post, I discussed differences between auction-based and relationship-based supply-chain management models. Where a company lands along this managerial spectrum can influence the competitiveness of businesses: in other words, the way purchases are made — and how vendors are held accountable — are strategic decisions.
The One-Handed Economist witnessed this firsthand during two conversations, displaying very different perspectives on supply chains, with automotive OEMs. The first was with an American automobile assembler with headquarters located in Japan. This non-Detroit domestic (I cannot call this company’s cars “foreign,” because they have among the highest domestic content of any in the United States) was deeply involved with all of its Tier 1 suppliers on production discipline, had some degree of engineering-level relationship with what was termed a “few” of its critical Tier 2 suppliers, and said that its lack of relationships with the rest of its Tier 2 and nearly all of its Tier 3 suppliers was a nagging worry that kept them up at night. They asked for help in spreading the gospel of Lean and continuous improvement down the supply chain.
The other company had its headquarters in Southeast Michigan, and the conversation was very different. I asked if they worked with their supply chain on quality issues and manufacturing practices. As I recall, the answer was to the effect of, “Our relationships are limited to the Tier 1 suppliers.” The view was that they had contracts with their Tier 1s and that was the limit of their responsibility. If the parts or subassemblies were defective, or did not meet quality standards, that was a contract issue between the OEM and the Tier 1. If the problem came from the Tier 1’s supply chain, that was a business problem between the Tier 1 and its supplier. I was told that the OEM did not want to interfere with business and contractual relationships between the Tier 1 and its suppliers. Legal risk mitigation was more important than mitigating risks to the quality of the final product.
Sadly, this view is all too common. Most cost accounting begins and ends with the delivered price of the part to the plant (the Free on Board (FOB) price plus delivery costs). However, in a risk-adjusted accounting framework, consideration is given to:
- The ability of a supply disruption to stop production and the cost of expediting a renewed flow of parts. The disruption could come from the loss of a single supplier due to fire or natural disaster at the point of production, or from a financial meltdown. The offset would be the cost of dual tooling and managing two sets of supplier relationships, as well as the consistency of the part.
- The probability of a supply chain disruption in the logistics system due to weather, natural disaster, strike, seasonality, or equipment shortage.
- The currency risk inherent in any long-term international contract. (An International Letter of Credit is a currency bet, and most manufacturers do not want to be players in currency markets.)
- The demands of a just-in-time system that values quality and competitive sourcing.
The just-in-time risks result from the system’s key strength: the ability to time deliveries on a cycle that minimizes inventory at the plant. Long, slender supply chains need to buffer inventory somewhere in the system, and some company is paying the inventory costs. Long-distance supply chains also make it difficult to rework or fix parts that are defective or out of specification.
OEMs with complicated products that compete in competitive global markets have to make difficult sourcing decisions. While it would be nice to gold-plate or armor every part so that it’s fail-proof, the final cost of the product does not allow that choice. As soon as the retail price gets too high, the product has to be “value-engineered” to remove cost from the product. The trade-off usually appears to be between cost and reliability, which often pushes companies toward the auction model, rather than the relationship one.
When the relationship model works, though, it really works. As an example: before the Great Recession, an automobile manufacturer’s best-selling passenger car went through a major redesign. Everyone was delighted until the manufacturing cost was fully estimated; the resulting car would end up being the most expensive vehicle in its peer group — by a wide margin. This was a problem that could not be solved by beating up suppliers on margin; it also could not be solved by lowering the quality of the car, because competing products were just too good.
It could be only solved by making the car cheaper to build.
The OEM brought its Tier 1 and 2 suppliers and a few critical Tier 3s to its R&D center and formed integrated teams with its own engineers, tackling the process of how the car was to be manufactured. Every assembly and subassembly was examined, the number of parts was reduced, and new ways of assembling components were agreed on. A supply-chain leader told the One-Handed Economist that the savings actually beat their targets — and that the manufacturing changes positively affected the company’s assembly practices for years afterward. This only happened because the solution was built on existing shared culture, trust, and partnership. It also required an OEM with a culture willing to acknowledge that it does not have a monopoly on wisdom.
Frankly, I thought that this story was apocryphal until it was verified by a Tier 2 vendor who participated; the vendor said that all involved had a shared interest in the success of the car. He added that the shared benefits came from everyone staying on the team, and sharing in the success of the product.
The good news is that this model is taking hold in surprising places. I was in Elyria, Ohio on Monday of this week to interview leaders of entrepreneurial companies. Upon arrival at my hotel the night before, I ran into a two-person team of engineers from the reborn GM. They were there to work with a supplier on a production issue the next morning. I did not let the engineers know I that I was delighted to hear this, but I was: it’s possible that in the new GM, legal risk no longer outweighs the risk to customers. Good for them: Way to go, Mary Barra!
Follow Ned Hill on Twitter at @AOneHandedEcon