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Sourcing Reloaded:Targeting Procurement’s NewStrategic Agenda

A strategy+business Reader

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Sourcing Reloaded:Targeting Procurement’s New Strategic AgendaA strategy+business Reader

Edited by Jeffrey Rothfeder and Georgina GrenonWith an introduction by Patrick W. Houston, Detlef Schwarting,Robert Spieker, and Martha D. Turner

In today’s risky global business environment, supplier networks are the ulti-mate lifeline for many companies — delivering the far-flung materials,goods, and services that drive worldwide commerce. The sourcing functionhas thus become an indispensable contributor to strategic goals and competi-tiveness in every industry. But charting a course that positions the corporatepurchasing department as a catalyst for growth is no easy matter.

This strategy+business Reader, Sourcing Reloaded: Targeting Procurement’sNew Strategic Agenda, is packed with insights and prescriptive advice thatsenior leaders and purchasing executives can use to navigate today’s mostvexing sourcing problems. Its main theme: how to balance traditionalsourcing strategies with the new, collaborative approaches needed to drivesourcing’s effectiveness and help it attain its full potential in the face of thedemands of globalization, resilience, sustainability, complexity, andcustomization.

The Reader’s 14 chapters, written by Booz & Company’s foremost sourcingexperts, cover the latest ideas and trends, including the next wave of sourcingexcellence, the new role of the CPO, green sourcing, collaborative supplierrelationships, improved strategies for commodities procurement and supplychain resilience, and global and low-cost-country sourcing.

Sourcing Reloaded is aimed directly at companies that are determined to buildfresh purchasing capabilities that leave behind old, unprofitable sourcingroutines forever. For them, this Reader will be a helpful guide to arevolution in the making.

Sourcing Reloaded



Edited by Jeffrey Rothfeder and Georgina Grenon

With an introduction by Patrick W. Houston,Detlef Schwarting, Robert Spieker, and Martha D. Turner

A strategy+business ReaderPublished by strategy+business Books

Copyright © 2008 by Booz & Company Inc.All rights reserved.

No reproduction is permitted in whole orpart without written permission from Booz& Company. For permission requests,contact Virginia Brosnan by e-mail [email protected].

Visit Booz & Company online atwww.booz.com

Visit strategy+business online atwww.strategy-business.com

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Design: Opto DesignCover art: Pelato, Duarte, Lopez Pereyra

strategy+business BooksPublisher: Jonathan GageEditor-in-Chief: Art KleinerExecutive Editor: Rob NortonManaging Editor: Elizabeth JohnsonDeputy Managing Editors: Laura W. Geller,Debaney ShepardSenior Editors: Theodore Kinni,Melissa Master Cavanaugh

7 Introduction: Sourcing Transformationby Patrick W. Houston, Detlef Schwarting, Robert Spieker,and Martha D. Turner

Sourcing’s New Frontier18 Reinventing Procurement to Drive Growth and Profitability

by Harald Dutzler, Peter-John Liberoth, Detlef Schwarting,and Robert Spieker

27 Win-Win Sourcingby Bill Jackson and Michael Pfitzmann

40 The New CPOby Simon Harper and Fabrice Saporito

48 Getting Creative: Efficient Sourcing in Marketingby Harald Dutzler and Martha D. Turner

59 Green Sourcing: Seeking the Payoff in Environmentalismby Patrick W. Houston and Martha D. Turner

The Building Blocks of a New Sourcing Approach78 The Collaboration Game: Building Value in the Retail Supply Chain

by Simon Harper, Pertti Heinonen, Amit Kapoor,and Marco Kesteloo

86 Procurement’s New Operating Modelby Patrick W. Houston, Robert Hutchens, and Alan S. Pincus

Contents

96 Coping with Record-setting Commodity Prices and Volatilityby Patrick W. Houston, Matthias Mueller, and Martha D. Turner

109 Be Prepared to Bounce Backby Rich Kauffeld, Dermot Shorten, and Robert Spieker

Sourcing Basics That Enable Success122 Smoothing the Path for Procure-to-Pay: A New IT Approach

by Jeffrey Barta, Bernhard Rieder, and James Weinberg

132 Make or Buy: Three Pillars of Sound Decision Makingby Simon Harper, Michael Pfitzmann, and Dermot Shorten

145 Buy Globally, Think Globallyby Simon Harper and Laura Thompson

150 Lessons from China: The Importance of Knowledge-basedSourcing in Low-cost Countriesby Ronald Haddock, Michael Pfitzmann, and Reid Wilk

162 Off the Table, Into the Pocket: Capturing Procurement Savingsby Harry Hawkes, Patrick W. Houston, and Martha D. Turner

172 About the Authors

Contents, continued

IN TODAY’S RISKY global business environment, supplier networksare the ultimate lifeline for many companies — delivering the far-flung materials, goods, and services that drive worldwide commerce.The sourcing function has thus become an indispensable contribu-tor to the strategic goals and overall competitiveness of companiesin every industry.

This is quite a turnabout. Not long ago, procurement waslittle more than a back-office function, responsible for the down-stream process of negotiating price-based contracts and extractingscale benefits from increasingly unyielding groups of suppliers. Year-over-year price improvements and day-to-day supply assuranceoften represented the extent of purchasing executives’ involvementin corporate activities.

Today that antiquated notion of sourcing is scarcely recogniz-able in leading purchasing departments. Inexorably, these depart-ments and their leaders have extended their sphere of influencewithin the organization by proving that, given the opportunity, theycan generate substantial value.

This value comes in many forms. For instance, procurementdepartments have taken a leading role in driving cross-functionalcollaboration at several large companies. They are breaking down thesilos that have isolated R&D, marketing, sales, and other corporate

Introduction:Sourcing Transformationby Patrick W. Houston, Detlef Schwarting,Robert Spieker, and Martha D. Turner

Introduction 7

departments from suppliers, because such isolation significantlyinhibits cost savings and other performance improvements. Theyare using their newfound muscle to great effect — facilitating inte-grated sourcing processes, acting as liaisons between internal depart-ments and suppliers, and coordinating projects that are aimed atdeveloping innovative products and minimizing sourcing and life-cycle costs.

Leading purchasing departments have also demonstrated theirimportance by elevating their activities to new heights, to a strategiclevel far above mere cost cutting. Procurement executives can befound at the center of critical aspects of organizational performance,such as maximizing supply chain efficiency, reducing product devel-opment and manufacturing cycles from design to delivery, buildingoperational resilience, enhancing marketing effectiveness and effi-ciency, and collaborating with suppliers to leverage capabilitiesthroughout the supply chain.

Given this wide-ranging set of activities, it is scant surprise thatin many industries, purchasing departments now influence half ofthe annual operational budget. And that figure rises to 80 percent insuch sectors as manufacturing and retail.

Sourcing’s ChallengeDespite sourcing’s promise and power, many companies have notyet successfully charted a course that positions their purchasingdepartments to become a catalyst for creating and capturing value,including profitability and growth. Even as chief procurement offi-cers (CPOs) relish the notion that they may finally earn spots on thesenior leadership teams of their companies, they must also under-stand that only superlative performers will retain this privilegedposition. Indeed, in a recent Booz & Company survey, 46 percentof senior purchasing executives recognized that a high level of lead-ership ability, a strong business sense, and strategic savvy are the

8 strategy+business Reader

Introduction 9

most important traits CPOs need for the future. Conversely — andclearly representing a sign of the times — the more traditional skillsof purchasing executives, such as tactical supply management andcategory experience, did not rank as priorities in the eyes of 95 per-cent of the respondents.

The opportunity to raise purchasing to the level of other criticalcorporate functions also means that its leaders must shoulder theirshare of the responsibility for addressing the increasingly challeng-ing business landscape. When purchasing is managed well, compa-nies can gain a competitive edge because they are able to overcomethe obstacles on which their competitors founder, such as:

Globalization. Rich opportunities for profitability and productand service supply lie in the expanding economies and growingmarkets of India, China, and many other emerging nations; thevast new supply alternatives driven by low-cost labor pools and newfactories opening in these countries; and the rising demand foressential commodities. But so do difficult challenges. The com-panies that most adeptly develop, manage, and optimize their sup-ply networks to serve end markets around the world will have aclear advantage.

Resilience. As supply chains extend ever further into regions thatwere nearly untouched just a few decades ago, their exposure to nat-ural disasters, computer network attacks and failures, and politicalupheaval is increasing. There are many ways that companies canprotect their supply chains from disruption, but few companies haveactually done so. In fact, a recent Booz & Company survey of lead-ing supply chain executives found that 68 percent believe the great-est risks they face are interruptions in the flow of products andservices from key suppliers, but only 46 percent of their companieshave developed well-thought-out plans to avoid such calamities.

Complexity/Customization. The proliferation of products and ser-vices that has been enabled by digital and other innovations has


been a boon to growth for most companies. This is an era ofmass customization in which marketing efforts as well as productsand services can be tailored to individual customers. However, asany good operations leader knows, this level of variation comes at acost — increased complexity. Those companies that can balance thevalue of variety with the incremental costs of supply will be bestpositioned for significant profitability. The trick for sourcing isto work collaboratively across the company and with suppliersto provide what customers truly value in a way that minimizes sup-ply costs.

Sustainability.Concerns among all stakeholders — from custom-ers to investors to governments and increasingly to end consumers— about global warming, large carbon footprints, and increasedwaste are compelling companies to link green initiatives closely tooverall strategy. Much like quality, sustainability is evolving into anintegral part of the supply equation, and its dictates must be recog-nized in the way companies produce and design their products andservices. Sourcing’s role in facing this challenge is especially impor-tant because, for most companies, nearly two-thirds of green oppor-tunities reside externally, in the supply chain.

Four Rules for Approaching Sourcing ExcellenceSimply put, in no other period has sourcing had so much power tomake a significant impact in support of a company’s strategic direc-tion and overall competitiveness. And those organizations that arestriving to achieve sourcing excellence will enjoy the competitiveadvantages it yields. For example:

Honda Motor Company has developed a no-nonsense way toeliminate the enmity that typically paralyzes purchasing’s relation-ships with suppliers, replacing strident negotiations with opencollaboration. Ideas for collaboration are often displayed openly onwhiteboards during joint meetings, and then agreed upon by the

Introduction 11

end of the session. In the process, the automaker has lowered itscosts and raised overall performance.

Procter & Gamble Company has begun a comprehensive analysis todetermine how its supply chain must be transformed in the nextdecade. Through this study, the company plans to develop ways toreduce product size, create green packaging, and predict consumerdemand so that it can place its factories and distribution pointsnearer its key sales markets.

Vodafone Group PLC has shifted from purely transactional procure-ment to a much more strategic approach that includes a comprehen-sive range of demand-side and supply-side levers and that is focusedon creating value and optimizing the total cost of equipment own-ership in its global mobile telephony business. This transformationhas enabled the company to better utilize supplier capabilities, todevelop systematic measurement and insight into supplier perfor-mance, and to create extensive cross-functional collaboration inter-nally and with suppliers.

These three examples are leading companies in the sourcingarena, but in our view, no single organization has yet achieved all thebenefits of sourcing transformation. And no matter the stage ofdevelopment at which its sourcing function stands, any companycan gain in the short and long term by “reloading” its sourcing func-tion if it closely aligns procurement with the overall businessagenda and continuously challenges the function to enhance itscapabilities. Further, more companies should do what the best do:improve their sourcing skills in those areas that are organizationalpriorities — a tactic that begins, of course, with precisely identify-ing those areas. From there, the path to purchasing improvement isan incremental activity that ultimately creates a full-fledged and fun-damental transformation.

As sourcing leaders undertake this transformational process,they can benefit from these four rules of the road:

1. Pick your spots. Companies should start their sourcing trans-formation by redesigning procurement procedures in simple, con-crete ways that can produce measurable and significant value. Theseinitial successes will build momentum within the organization forgreater levels of change.

2. Create total transparency in purchasing costs and trade-offs.

Whether it be the costs, savings, and benefits of environmentallyfriendly product options; the weighing of whether to buy or makea product; or the design of a more resilient manufacturing foot-print, the issues, implications, and ramifications of sourcing changesshould be clearly articulated and openly shared throughout theorganization.

3. Collaborate fully with internal and external stakeholders. A morerobust sourcing process depends on participation throughout theproduct life cycle, from the concept stage in R&D to the disposal orsalvage of spent products by a recycler. This requires the combinedefforts of key company departments and suppliers in the quest todeliver innovation, reduced costs, supply chain efficiency, improvedproduct launches, and the reduction of silos.

4. Become an influential corporate leader. Successful CPOs buildtheir confidence and power by leveraging their position in the exec-utive suite. They ensure that purchasing plays a greater role in devel-oping and defining the company’s strategic direction. And theycreate a road map for sourcing transformation, as well as buildingthe skills and capabilities required to support business partners.

A Source of Best PracticesTo help your company chart a winning course through today’ssourcing demands, priorities, and opportunities, this strategy+business Reader, Sourcing Reloaded, offers a compendium of bestpractices culled from our experiences with purchasing executivesin companies that have successfully undertaken this work. Sourcing


Introduction 13

Reloaded shows that businesses have many ways to achieve thehighest level of procurement excellence. Whether companies areconcerned with getting the basics right or elevating the sourcingfunction to new heights, this Reader includes the perspectivesand insights they need to begin the difficult but ultimately lucrativeeffort to transform sourcing into a wellspring of significantadded value.

Toward that goal, this Reader is divided into three sections:Sourcing’s New Frontier. The five chapters in this section are

devoted to exploring the newest sourcing ideas and trends. In “Re-inventing Procurement to Drive Growth and Profitability,” the freshchallenges and responsibilities of purchasing departments areplumbed through descriptions of some of the best companies’ strate-gies for staying ahead of the revolution in procurement’s potential toadd value.

“Win-Win Sourcing” explains how the conventional rules ofprocurement are being rewritten by a knowledge-based sourcingapproach that allows manufacturers and suppliers to establish along-term commitment aimed at improving each other’s capabilitiesand performance.

“The New CPO” examines the job of today’s chief procurementofficer and finds that, far from being a career backwater, sourcingleadership now involves delivering significant strategic and finan-cial value.

“Getting Creative: Efficient Sourcing in Marketing” exploressourcing’s often neglected role in the purchase of marketing prod-ucts and services, often a very sizable portion of a company’s spend-ing that should be managed with the same rigor as other criticalfunctions. Indeed, all strategic services in a company, including legalcounsel, back-office operations, and retail partnerships, can applythe lessons in this chapter.

The final chapter in this section, “Green Sourcing: Seeking the


Payoff in Environmentalism,” describes how sourcing, supported byits growing credibility in the C-suite and the ability to encouragecollaboration among corporate functions and business units, is in aperfect position to enable a holistic, multifunctional strategy forreducing environmental impact while cutting costs and buildingbetter relationships with suppliers and communities.

The Building Blocks of a New Sourcing Approach.The four chapters ofthe second section of this Reader examine the tools and techniquesthat enable a strategic sourcing program.

“The Collaboration Game: Building Value in the Retail SupplyChain” details how building holistic, cross-functional, and collabo-rative relationships with selected suppliers across the value chainhelps drive benefits in both revenue and cost far beyond theoutdated and ineffective tradition of haggling over the terms of sup-ply contracts.

“Procurement’s New Operating Model” points out the ways inwhich flawed and otherwise incomplete operating models cost mostcompanies 5 to 10 percent of their total purchasing spend in unre-alized savings. The primary causes: End-users do not have the toolsand processes to optimize procurement strategy, decision-makingroles are not clearly delineated, and information systems fail to pro-vide the data needed to ensure compliance with procurement poli-cies and objectives.

“Coping with Record-setting Commodity Prices and Volatility”examines how to reduce the tremendous pressure that escalatingcommodity and material costs are bringing to bear on companiesand on traditional procurement strategies. It offers fresh approachesto older methods that create more transparency and a detailedunderstanding of key cost drivers that can help reduce near-termcost variability as well as achieve supply, price, quality, and sustain-ability objectives.

“Be Prepared to Bounce Back” explores how to combat the new

Introduction 15

fragility of supply chains caused by the rapid growth in outsourcingto geographically remote partners, the increase in sole sourcing, andthe potential loss of data integrity due to the outsourcing of noncoreservices such as IT.

Sourcing Basics That Enable Success. The third section of thisReader revisits perennial sourcing issues, offering insights and pre-scriptions that CPOs can use to reload in their efforts to deal with aglobalized procurement landscape and ensure that a company’sextended supply chain and its technology dovetail perfectly with theneeds and strategies of the organization.

“Smoothing the Path for Procure-to-Pay: A New IT Approach”introduces procure-to-pay, an IT strategy that eliminates the needfor one-size-fits-all purchasing systems and replaces them withhighly efficient individual modular applications, each of whichaddresses a specific area of the procurement process.

“Make or Buy: Three Pillars of Sound Decision Making” revis-its a classic sourcing decision and offers CPOs a rigorous processfor making more objective and informed “in-house or outsource”decisions.

“Buy Globally, Think Globally” explores how a more robustunderstanding of the economic and geopolitical dynamics of themarkets in which their companies participate enables CPOs to helptheir organizations take advantage of opportunities that have beenoverlooked by their competitors as well as create a competitive edgewhere it seemed none was available.

“Lessons from China: The Importance of Knowledge-basedSourcing in Low-cost Countries” examines the fast-changing con-siderations in dealing with suppliers in low-cost nations. This chap-ter describes how companies can use knowledge-based sourcingto develop strong relationships with such suppliers that extendbeyond supplier costs into a careful assessment of manufacturingand transportation economics, lead-time requirements, schedule sta-

bility, product design changes, and the technical skills of suppliers.Finally, “Off the Table, Into the Pocket: Capturing Procurement

Savings” offers companies a way to identify and capture a large por-tion of procurement initiative savings and drive these savings to thebottom line.

Sourcing Reloaded is intended to provide foresight and insightinto how companies can tackle some of today’s most vexing sourc-ing problems. It emphasizes that successful sourcing transformationsdepend on carefully balancing traditional sourcing approaches withnew approaches, earmarking a portion of the gains from new pro-curement strategies for building fresh capabilities that can driveprofit and growth in the future, and building superior purchasingcapabilities over time, in much the same way that Toyota, Honda,and Procter & Gamble developed their sourcing functions. Toachieve similar levels of success, companies must encourage substan-tially more proactive and radical behavior in their CPOs and ensurethat their organizations leave behind old, unprofitable sourcing rou-tines. We hope that Sourcing Reloaded will serve as a helpful guide tothis revolution in the making. +


Sourcing’s New Frontier

OVER THE PAST 10 years, company procurement departments havedone well, on the whole, in meeting a series of new challenges.Whether it meant working with an increasingly global vendor baseor managing partnerships with back-office service providers, pro-curement generally accomplished the task at hand. With each suc-cess, the visibility and importance of the function in the overallorganization grew — so much so that procurement now controlshalf of the annual budget in many industries and up to 80 percentin sectors such as manufacturing and retail.

As confidence in procurement departments soared, companiescounted on them to take on even more challenging projects. Now,procurement chiefs are being asked to undertake a host of newresponsibilities: decrease supply chain complexity, speed products tomarket, stimulate supplier innovation, enhance operational security,and even consider the social and environmental impact of the sup-plier in sourcing decisions.

Addressing issues like these requires a higher level of talent andcommercial acumen than anything procurement departments havetackled before. Indeed, these aims demand a reach beyond thatof the organizational supply nexus: They require a transformationin the way we traditionally think of sourcing. In leading companies,sourcing is evolving from a stand-alone function that ensures

Reinventing Procurement toDrive Growth and Profitabilityby Harald Dutzler, Peter-John Liberoth, Detlef Schwarting,and Robert Spieker

Also contributing to this article were Simon Harperand Marco Kesteloo


Reinventing Procurement to Drive Growth and Profitability 19

that materials move through the supply chain at the lowest possiblecost to a nerve center that monitors, anticipates, and responds to avariety of needs throughout the company — and even those ofits suppliers.

Many companies covet the potential rewards of this kind ofholistic, integrated approach to sourcing, but few are prepared toimplement the organizational changes such an approach demands.Often, the sheer scope of the challenge can overwhelm manage-ment’s ability to visualize the steps necessary to tackle it.

To learn how some leading companies plan to meet this trans-formational sourcing challenge, Booz & Company interviewed chiefprocurement officers at more than 100 global companies with areputation for procurement excellence. Through these conversa-tions, we discovered that companies will need to make four keyorganizational adjustments to stay in front of the next wave ofchange in sourcing:

• More cross-functional integration• Better supply networks• More collaborative supplier relationships• Greater supply chain resilience and risk management

More cross-functional integration. At present, the silos and bordersthat separate functions often limit opportunities for cost savings andvalue achievement. For example, the walls that separate R&D, mar-keting, and suppliers inhibit jointly executed and coordinated proj-ects aimed at such goals as developing new products and services ordriving down sourcing and life-cycle costs. Breaking down thesebarriers can have a substantial impact.

Two-thirds of the survey’s respondents told us they believethat procurement has a crucial role to play in integratingdepartments within their organizations. And 73 percent saw a needfor similar procurement-led, cross-functional integration with


external suppliers and partners.The procurement function is well positioned to serve as the cat-

alyst for bringing internal departments and external suppliers closerto each other: After all, the function often serves as the communica-tion link between them. Many procurement leaders point to bettermanagement of specifications as a key catalytic mechanism in thiseffort. One CPO told us he wanted his department to learn to takean “active role in challenging the core value” by questioning engi-neers on their product specifications. This, the CPO believed,would encourage the procurement team to move from simply iden-tifying unnecessary design elements to better defining the product’sabsolute needs.

The advantages of this kind of dialogue are not limited to theCPO’s organization. Large global retailers, such as Wal-Martand Gap, have discovered that closer contact with their suppliersallows the suppliers themselves to integrate logistics and returns-management solutions, as well as to adopt new supply chain tech-nologies such as RFID more rapidly.

Greater integration, and the looser boundaries that may comewith it, should not be confused with less discipline. On the contrary,many CPOs complain that buying procedures must become bothmore rigorous and more widely applied. “There is still too muchmaverick buying,” declared one CPO. A vast majority of respon-dents — 86 percent — believe that creating global purchasingprocesses and systems will be increasingly important over the nextfive to 10 years.

Better supply networks. Today, most supplier interaction happenswithin a point-to-point relationship — procurement to supplier.This relationship has evolved in some industries, such as theautomotive sector, where it is standard practice for companies tomanage deeper into their supply chains, down to Tier Two andTier Three suppliers. But soon, even this extended management


will not be enough.As we interview leading executives, increasing numbers are

telling us that the ability to orchestrate a vast network of supplyrelationships will become more important. Such networks will lookat the supplier not just as a source of a material or a component,but as a partner that will help improve delivery systems and designproducts.

These executives anticipate using a variety of strategies toimprove their ability to manage supply networks. Fully three-quarters of respondents believe supplier cost modeling will becomemore important over the next five to 10 years, as buyers seek agreater understanding of their suppliers’ underlying expenses. And81 percent of respondents see low-cost-country source modelingas a crucial emerging skill. Another important opportunity, CPOsbelieve, is joint action with suppliers in the continuous reductionof waste: 47 percent see the challenge to reduce waste as a top pri-ority, and an additional 30 percent say they will be focusing moreintently on waste reduction in the future.

All these tools speak to the growing need of companies to gaina deeper, more differentiated understanding of their supply net-works. “How to manage strategic partnerships will become key,”one CPO told us. Another agreed, but warned that, at present,“there is a lack of clear approach and tools to manage this.”

More collaborative supplier relationships. Many unrealized opportu-nities for value arise within a company’s supplier network in areasthat neither the buyer nor individual suppliers can identify on theirown. Collaboration is needed to optimize cost, to drive top-linegrowth, and, sometimes, to develop breakthrough concepts.

CPOs still see a tremendous untapped potential in collabora-tion. Although 86 percent of the procurement leaders we surveyedsaid they have worked hard to develop collaborative partnershipsover the last three to five years, most believe their work is nowhere

near complete. In fact, 44 percent still see the development of thesepartnerships as a top priority over the next five to 10 years, and eventhose who don’t see such partnerships as a top priority say theyintend to pursue a greater level of collaboration (38 percent).

Typically, collaboration with suppliers occurs in the areas of newproduct development, order delivery and fulfillment, and manufac-turing. In a recent example, a northern European airline uncoveredvaluable synergies while working with a private airport to improveits luggage handling and check-in facilities. By ignoring organiza-tional boundaries, the two were able to design a jointly executedcheck-in process that was much more cost-effective for each partner— and more convenient for passengers.

In this new collaborative world, competitiveness will be basedon a detailed understanding of the suppliers’ costs, not the back-


The experiences of a global toy companydemonstrate the potential inherent incross-functional process improvements.Over time, this maker of constructionkits had evolved from making a relativelylimited product line requiring parts ina few primary colors and basic shapesto offering an extended line of kitsrequiring parts in hundreds of colors andshapes. In the process, a low-cost productbased on molded resin blocks had growninto something complex and expensiveto produce.

This had occurred because the compa-ny’s engineers were encouraged to createinnovative products without regard tocost of supply. As a result, few engineersthought much about the real price ofmaterials or the additional costs — suchas inventory expense and the capitalrequired to maintain it — that their

requirements generated, a practice exac-erbated by lax procurement compliancerules. Over years of incremental “scopecreep,” the company lost its scale advan-tage as a major resin buyer and added atremendous amount of waste and ineffi-ciency to the supply chain.

The solution to the problem wasfound in rewriting the purchasingroad map and adding a step that ensuredregular communication between theengineers and procurement. This cross-functional link led to a reduction inthe number of unique resins andcolors needed by manufacturing, lower-ing the costs of materials and alsosimplifying production. Interestingly,reducing the number of resins also stim-ulated innovation, as engineers discov-ered new ways to make do with fewermaterial options.

Linking Functions for Improved Results

and-forth of negotiations. Companies will gain an advantage overtheir competitors not by squeezing an extra nickel out of theirsuppliers’ margins, but by working with suppliers to boost the levelof efficiency in the supply network or to develop new cutting-edge products.

The benefits of supplier collaboration are becoming well recog-nized. One study by the Toyota Motor Corporation found thatwhereas negotiations can reduce costs by about 5 percent, collabo-rative practices can yield as much as a 38 percent cost reduction.Toyota analysts estimate that the benefits of collaboration stack upthis way: 5 to 10 percent in cost reduction from engineeringimprovements, 5 to 8 percent in lower inventory levels through just-in-time shipping, and, most productive of all, 15 to 20 percent insourcing raw materials and finding low-cost sourcing strategies forthe supplier.

Greater supply chain resilience and risk management. Many CPOsbelieve they will need to focus more on risk and resilience than theyhave in the past, because they fear that today’s extended supplychains have made their companies vulnerable to new kinds ofdangers. A total of 68 percent of respondents believe their greatestrisk is the interruption of deliveries from key suppliers. (By compar-ison, less than half as many, 31 percent, fear physical damage tocompany-owned facilities or breakdowns in information security.)

“Risk management becomes more important as a larger part ofproduction and development is done by partners,” said one CPO.In fact, this heightened dependence on external partners hasexposed companies to new problems that are falling under thepurview of procurement. Issues such as a contractor’s level of socialresponsibility in its labor practices are fast becoming an importantpart of due diligence.

One new kind of resilience many CPOs say they must developis the ability to work with their suppliers to create products that are


manufactured and distributed with less carbon. And as environmen-tal sustainability or “green” business practices become more andmore popular with customers and even become a regulatory neces-sity in some markets, such an ability will become a greater priority.

To build resilience and manage risk, one CPO told us, “we needto be broader in our understanding and have people working in dif-ferent functions across the disciplines.” Consequently, nearly half ofrespondents — 45 percent — say they will be hiring professionalswith the strategic knowledge and business sense that would enablethem to tackle as-yet-unidentified social, regulatory, and environ-mental roadblocks. Risk management is a much-needed capabilityas well, according to 18 percent of the CPOs.

(For a detailed examination of green practices, see “GreenSourcing: Seeking the Payoff in Environmentalism,” by Patrick W.Houston and Martha D. Turner, page 59. For more on supply chainresilience and risk management, including how to protect the sup-ply chain, see “Be Prepared to Bounce Back,” by Rich Kauffeld,Dermot Shorten, and Robert Spieker, page 109.)

Meeting the Next Wave ChallengeThe last wave in sourcing’s evolution was based on disaggregation —that is, evaluating the potential value of each supplier and then mak-ing sourcing choices based on that more granular understanding.The next wave of sourcing will build on that foundation and extendit in a holistic sense, propelling companies still further beyond theold zero-sum approach to purchasing.

First, the purchasing department will encourage cross-functionalintegration to develop greater insight into the needs of the business.Next, it will work more closely with suppliers to help them addressthese insights in ways that go beyond simple price cutting. To dothis, procurement will build networks of suppliers who work togeth-er to optimize the efficiency of the entire supply chain and engineer


innovative new ways to create value. Finally, purchasing will applythese new capabilities to find ways to better manage the businessrisks their companies face and to boost resilience. (See Exhibit 1.)

Better knowledge management will be essential in meeting thenext wave challenge. At minimum, purchasing needs to understandthe cost drivers of its suppliers. But that’s just the beginning. In thefuture, a much deeper understanding will be necessary in all direc-tions — among suppliers, between suppliers and procurement, andbetween procurement and other departments within the company.This requires a complex and systematic web of cross-reporting andcontinual dialogue to ensure that the supply network learns andkeeps on learning as needs continue to evolve.

Finally, an elevated organizational commitment will be required.For example, to release sourcing’s potential to drive growth andprofitability, the procurement department will need a strong board-level presence: This will ensure that the company’s purchasingstrategy incorporates and is aligned with its long-term goals.More critically, it will help the company realize important changes,such as arranging the sourcing footprint in a way that reflects


Exhibit 1: “Next Wave Sourcing” Key Themes

Source: Booz & Company

Value Creation(From price to cost and value focus, i.e.,

growth, profit, return on capital employed)

Institutionalize Knowledge and Learning

People

Cross-functionalintegration

From silo tocross-functionalvalue perspective

Supply networks

From one-to-onesupplier manage-ment to managingsupply networks

Collaborativesupplier

relationships

From transactionto collaboration andcapability leverage

Business riskand resilience

From risk toresilience

management andsustainability

Supplier OrganizationChan

ging

busi

ness

envi

ronm

ent

Succ

essf

ulle

ader

ship

stra

tegi

es

the expected growth of the market or anticipates future require-ments for limiting carbon output.

But board support — or, for that matter, senior managementsupport — should not be a blank check. It must be given only ifprocurement’s values, processes, and key performance indicators arealigned with corporate projections and tactical plans. To accomplishthis, CPOs will need to develop a culture of continuous learningwithin their departments, ensuring that the procurement team isable to adapt to changing business conditions. At the same time,they will need to build an infrastructure to continually raise the levelof performance management and controls. As one CPO told us,“We need to professionalize the total procurement organization.”

Sourcing is at an important juncture. Many companies are readyfor a procurement transformation; others are not. But simple aware-ness is a first step. Companies that recognize the importance ofholistic sourcing practices are on their way toward implementing thenext wave of procurement strategies and opportunities. +


IT’S AN INTRIGUING way to create a contract. At Honda MotorCompany, during meetings with suppliers, the executives write theirproposed actions and agreements on a whiteboard. When all theitems have been discussed, the meeting is over. The contents of thewhiteboard are then typed up, two copies are printed, the supplierand the automaker sign them, and the contract is complete.Thereafter, both sides focus on executing the plan. Honda and itssuppliers thus avoid the drawn-out, querulous negotiation processthat is common at other automakers, a process that can last monthsand even then sometimes blows up without a resolution.

This is one of many methods by which innovative manufac-turers like Honda and the Toyota Motor Corporation rewrite theconventional rules of procurement. Their unorthodox techniquesadd up to a form of procurement based on shared information andinsight: We call it knowledge-based sourcing. In this approach,manufacturers and suppliers share a long-term commitment toimproving each other’s capabilities, starting by working togetherto eliminate wasted effort and other inefficiencies. Instead of beingat odds, the two sides collaborate openly to lower costs and raiseoverall performance, with the expectation that this mutual effortwill continue over many years and benefit both companies.Businesses pursuing knowledge-based sourcing use sophisticated

Win-Win Sourcingby Bill Jackson and Michael Pfitzmann

Win-Win Sourcing 27


costing tools and industry data, as well as discussions with othersuppliers, equipment manufacturers, and competitors, to producerealistic cost targets that change over time. They set prices thatreflect the supplier’s true economics for each process, part, compo-nent, and system. These prices include a reasonable profit marginfor the supplier as well as incentives for lowering costs, improvingquality, expanding innovation, and making design changes in subse-quent years.

Contrast this with the alternative ingrained in many purchasingdepartments: price-based sourcing. Essentially, this approach pitsthe interests of the supplier against those of the manufacturer. Eachside reveals as little information as possible, for fear of giving theopposing side an edge. Components, parts, raw materials, and fin-ished goods are purchased through a competitive bidding process,with specific volumes and deadlines spelled out in advance (hencethose agonizing negotiations).

The primary cost-cutting option available to manufacturers ina price-based sourcing approach is squeezing every possible cent outof procurement contracts. Purchasing managers focus exclusivelyon attaining cost savings greater than those of the previous year;their compensation hinges on it. Suppliers, in turn, focus on calcu-lating bids that will win them the jobs. Once they have made a suc-cessful bid, suppliers are stuck with its terms. They have no reasonto speak openly about their true costs, because they believe thattheir customers won’t pay a penny more. They have no incentive toimprove their product, its design, or its manufacturing processes.They often feel they have no recourse except to game the systemby overstating their expenses or charging exorbitantly for designchanges. Both sides lose, and mutual suspicion and resentmentare rooted so deeply in the system that they are almost impossibleto overcome. This all-too-common story ends with rising costs,increased time-to-market, a loss of any shared innovation practice,

and, in the worst of cases, supplier bankruptcies.Indeed, many suppliers today are in serious trouble. With raw

material prices rising, margins cut to the bone, and purchasingdepartments struggling to meet corporate expectations for costreductions, suppliers are under pressure from all directions. In themotor vehicle industry, many suppliers, including Collins &Aikman, Dana, Delphi, Dura, Federal Mogul, and TowerAutomotive, have filed for bankruptcy. Even suppliers with a longrecord of success have been squeezed, with profit margins oftenfalling below the cost of capital. These financial crises, in turn, arepresenting a huge cost to buyers. The expenses associated with thebankruptcy of major suppliers can easily swamp contract savings.

No wonder knowledge-based procurement models, and themanagement philosophy underlying them, are becoming moreattractive to many manufacturers. (See Exhibit 1.) Although they

Win-Win Sourcing 29


A market of competitive, independentproviders bidding against one another

An integral part of the business network,essential for competitive advantage

Cost management

The relationshipwith suppliers

View of thesupply base

Price-Based Customer Knowledge-Based Customer

Exhibit 1: Sourcing PhilosophiesThe perspective associated with each type of sourcing can be deeply ingrained. Managers may takethem for granted — until they switch their approach.

• Sets targets with suppliers that are based oncost and performance

• Increases efficiency through sharing knowledgeand making a long-term commitment tosuppliers

• Encourages suppliers to achieve anadvantage over the market through continuousimprovement

• Promotes competition through dual sourcingand being the buyer of choice

• Seeks leverage on suppliers for price andproduct improvements

• Will switch suppliers to gain improvementor a slightly lower price

• Constantly monitors market for new suppliersto drive competition primarily on price

• High level of mistrust — relationship hingeson leverage

• Customer does not want to be too dependenton one supplier (for fear of losing leverage)

• Often ends up combative or antagonistic

• High level of cooperation — relationship isfocused on improvement

• Creates integrated relationships based onmutual learning, teaching, and quality-relatedefforts

• Demands operational excellence and relentlessimprovement

are not perfect, the Toyota and Honda sourcing models consis-tently earn high marks from suppliers — along with favorable terms.As one automobile manufacturing executive put it recently, “Hondacost estimators can tell suppliers their own costs within 1 percentaccuracy.” That’s meaningful because suppliers are often unable toidentify their own manufacturing expenses with anything near thisdegree of certainty and, thus, often suffer cost overruns. Backed byaccurate cost information, automakers and suppliers can jointlydevelop a performance improvement plan to reach their cost goals.

Manufacturers are equally rewarded. For companies that adoptthe Toyota/Honda approach, the acquisition costs for parts such aspistons, exhaust manifolds, and cylinder heads are 35 to 55 percentlower than for those using traditional procurement models. Severalfactors account for this. First, product and part designs can be deliv-ered at lower costs. Second, productivity and quality improve assuppliers practice joint process coordination and improvement.Third, manufacturers’ purchasing departments can be quite smallbecause they work with fewer, more strategically chosen suppliers.Fourth, warranty costs drop as much as 3 percentage points. Finally,fewer components need to be reengineered after launch, and as aresult, both the manufacturer and the supplier avoid the addedcosts of changing product designs at the most expensive time —during production.

For all these reasons, in everyday practice, knowledge-basedsourcing consistently outperforms the traditional bid-based model.This is true for companies in a variety of industries, and particular-ly for repeat purchases of anything that is not a true commodity.

In most cases, even taking into account annual price cuts ofapproximately 5 percent, the quoted price under competitive bid-ding doesn’t approach the agreed-to cost under knowledge-basedsourcing for the life of the contract. (See Exhibit 2.) More impor-tant, this form of win-win sourcing ensures that the knowledge


gained and improvements made on one program or product will betransferred to the next. Meanwhile, the improvement plan contin-ues to achieve new levels of success each year, until productivitygains draw the supplier ever nearer to ideal cost expectations, whichreflect more closely the supply and demand realities.

Yet as advantageous — and profitably innovative — asknowledge-based sourcing can be, many companies, particularlyWestern ones, have had a hard time adopting it. Some executivesfind it difficult to accept the idea that knowledge-based purchasingsavings of 3 percent per year could be more profitable than the 5percent annual savings mandated under the price-based system.“Impossible,” one chief financial officer protested. But it’s not im-possible. It merely requires a company to overcome its ingrainedhabits and internal obstacles. The path to knowledge-based sourcingincludes reframing supplier relationships, building and sharingknowledge along the supply chain, and instituting new employeetraining in factory processes, product development, and industryoperations so that employees can accurately gauge ideal costs andpotential cost improvements.

Win-Win Sourcing 31


Exhibit 2: Two Pricing Models

Price-Based Sourcing:A Recipe for MediocrityCustomers pressure suppliers to reduce prices, oftendemanding annual price cuts of, say, 5 percent. Althoughthis approach appears advantaged because of the significantyear-over-year savings, customers actually pay more assuppliers inflate their initial price in expectation of futuredemands for price cuts.

Knowledge-Based Sourcing:A Win-Win ApproachCustomer and supplier work together to achieve the lowestcost design up front. They agree on a price that is close tobut higher than ideal cost; this price reflects the supplier’strue costs plus a reasonable margin for the supplier. Overtime, the price is further reduced to reflect productivityimprovements. This approach consistently outperformstraditional price-based sourcing on an absolute basis.

–5%

–5%

–5%

Agreed-tocost

Supplierquote

Supplierimprovement

program

Updatecost

standards

Time

Idealcost

Agreed-to cost

Agreed-to cost

Pri

ce


Don’t Copy ToyotaFor executives and procurement managers who want to adoptknowledge-based sourcing, but who have not grown up with Asianpurchasing techniques, a framework can translate these techniquesinto more familiar Western-style rubrics. American and Europeanbusinesses that adopt knowledge-based sourcing often need a newset of formal cost and performance metrics and new employeeincentives. These standards replace old price-based sourcing metrics,which were most likely aimed at attaining those old-fashioned an-nual procurement cost savings. The new metrics are designed tohelp managers work closely with suppliers, in an atmosphere ofmutual trust, to achieve the ideal cost for each item. They incorpo-rate improved supplier measurement techniques, worker evaluationprograms, and a system of salaries and bonuses geared to meetingperformance goals — not to meeting narrowly defined purchaseprice or cost objectives.

Such metrics should not be direct copies of the Toyota or Hondametrics. Indeed, the best knowledge-based sourcing practices are tai-lored to each company’s situation. For example, Toyota typicallyfavors suppliers whose factories are in close proximity to theautomaker’s plants, and so does Honda; the automakers frequentlyacquire an ownership stake in the businesses. Although at times thisleads to somewhat higher costs because suppliers are located in moredeveloped and expensive regions, both Toyota and Honda prefer thissystem because it minimizes product lead times, eliminates qualityand disruption risks, affords them more control, and dovetails wellwith just-in-time, lean manufacturing philosophies.

But this approach overlooks the favorable economics found inlow-labor-cost nations like China, India, Vietnam, and thePhilippines, benefits that should be strongly considered — thoughnot necessarily as the dominant factor — in a procurement pro-gram. Through carefully constructed strategic relationships with key

Win-Win Sourcing 33

suppliers elsewhere around the world, Western companies can coun-terbalance the advantages that Japanese companies gain from prox-imity and ownership.

Every company has internal strengths that can allow it to changemodels. But for an organization to fully make the transition toknowledge-based sourcing, it must take four critical actions:

1. Establish suppliers as strategic long-term partners. Toyota investsdirectly in its suppliers — using a keiretsu model of interlockingownership — to manage its alliances. But that isn’t necessary. Moreimportant is an alignment of goals and cultures.

In fact, one of Toyota’s preferred suppliers is not part of itskeiretsu. Johnson Controls Inc., a U.S.-based company that makesautomotive interior and battery products, has been cited by Toyotafor perfectly matching the automaker’s standards of quality, on-timedelivery, diversity, and performance excellence. By sharing opera-tions, knowledge, and expertise, Toyota and Johnson Controls havedeveloped a mutual learning and development pact buoyed by asteady rate of manufacturing improvement.

The same is true for most other Toyota suppliers. They oftendescribe the automaker as both their best customer (providing pre-dictable volumes and profitable margins) and their most demandingcustomer (requiring excellence in performance, continuousimprovement, and the highest quality at the lowest total cost).

For suppliers to become willing partners, they must be con-vinced that the new knowledge-based practices — setting cost,quality, and delivery targets, and then more ambitious ideal cost andperformance levels — will not be used against them. It must be clearthat suppliers who meet the required standards and consistentlyimprove performance will benefit from more consistent business,which in turn will allow them to operate more efficiently and enjoyhigher profit margins in the future.

Long-term partnership does not mean exclusivity. At times,


when these relationships are not producing the expected returns,manufacturers choose a second supply source as a backup. Chiefly,this creates competition that encourages the original supplier tomeet its targets and protects the manufacturer from receiving partsthat are lower in quality, more expensive, or delayed. If a supplier iscontinually unable to raise its performance to agreed-on levels, man-ufacturers should transfer some volume to the secondary source,always in hopes of eventually improving the initial supplier’s opera-tions so that it can take on more business again.

2. Set up an ongoing system to eliminate waste through collaboration

across the supply chain. One facet of knowledge-based sourcing thatmany manufacturers readily embrace is the drive for transparency incosts. Suppliers are asked to reveal their ideal cost performance, orthe cost to produce components under perfect circumstances. In atrue collaboration, this knowledge would then lead to a mutualeffort between suppliers and manufacturers to improve productionthroughput, quality, and delivery, with the ideal cost performance


Exhibit 3: Supplier Support Model

SUPPLIERSTAGE

Novice suppliers

Stable suppliers

Mature suppliers

Focus Reactive; addressquality issues andcapability gaps

Proactive; concentrateon continuousimprovement

Forward looking;seek even greatersophistication

Teaching, training,problem solving

Customer role Teaching, training,facilitating, strategicpartnering

Networking, showcasebenchmarking

Objective Achieve stability Improve production Operate in a leannetwork

Hands-onLevel of customerinvolvement

Facilitation Very little; suppliersare self-directed

Manufacturers who follow a knowledge-based sourcing model must often educate their suppliers.As suppliers gain proficiency, their role changes — from novice to full-fledged partner in a leanproduction network.

Win-Win Sourcing 35

demonstrating the potential savings that suppliers could achieve. Inmany current cases, however, the ideal cost performance becomesyet another target, a new form of leverage that manufacturers useto press suppliers to cut their margins. This defeats the entireknowledge-based effort; rather than providing incentives to collabo-rate, it gives suppliers every reason to obfuscate their true costs.

Instead, deliberately design the costing approach as a self-reinforcing learning process for both buyer and supplier. Establishup front that the ideal performance levels in cost, quality, delivery,and innovation are expected to continually change. For each compo-nent, suppliers should submit a cost breakdown — that is, what theybelieve it would cost at their current level of productivity to producethe item. Working with suppliers, manufacturers then reset thisprice on the basis of industry data, productivity benchmarks, and acompetitive analysis. Ultimately, this process is meant to produce an“agreed-to cost” that is acceptable to both the manufacturer and thesupplier, providing competitive cost and performance for the manu-facturer and profit margins and stable volume for the supplier.

As they collaborate to achieve these continually changing per-formance goals, manufacturer and supplier develop a manufacturingimprovement plan together. This plan lowers the supplier’s cost fur-ther over time while improving the quality of the output and theperformance of the factory. The extent of the manufacturer’sinvolvement depends on the supplier’s capabilities and processsophistication. (See Exhibit 3.) Although more hands-on assistancemay be required to address quality issues and build capabilities atsome suppliers, the most mature suppliers are largely self-directed intheir continuous improvement efforts. Even with the most sophisti-cated suppliers, a consistent focus on open communication andmutual assistance helps reduce waste along the supply chain.

One fascinating example of this virtuous learning circle occurredin the late 1990s, when Toyota asked the Exxon Mobil Corporation


to produce motor oil at 30 percent below its bid. At first, the oil giantwas convinced that this was impossible and told Toyota managementso, adding a few choice words about what the automaker knew — ordidn’t know — about motor oil. But six months later, after exploringToyota’s offer more closely, ExxonMobil had a change of heart. Itturned out that Toyota’s assignment was possible, and ExxonMobilagreed to the deal and used the knowledge gained to improve its coststructure for all its jobs. ExxonMobil likely would never have realizedthis performance reward without the benefit of Toyota’s sourcingmodel. It helped that Toyota’s executives were willing to challengeestablished attitudes. Indeed, a capability for constructive challengewill make more of a difference to a knowledge-based sourcing initia-tive than any number of borrowed best practices.

3. Get it right the first time. Because the price-based system favorscost reduction over quality, it often leads companies to launch prod-ucts on deadline but with unresolved flaws — which must then becorrected in subsequent releases, recalls, and updates. Engineersoften end up tinkering with aspects of the post-release product,sometimes for months, trying to justify the additional retoolingcosts by arguing that the changes will add product value. Somemanufacturers even demand from suppliers the option of reengi-neering products after launch, billing the requirement as a costreduction measure.

But no matter how it is justified, the net effect of the price-basedsystem is to raise design and engineering costs — for three reasons.First, it sanctions sloppy engineering; if suppliers know thatredesigns are likely, they may feel less pressure to insist on flawlessengineering the first time. Second, and more pragmatically, suppli-ers figure out the game very quickly; they build in features that willthen be removed to give the appearance of saving costs. In amoment of candor, one designer at an automotive company said, “Ialways overdesign the product so I can hit my cost reduction targets

Win-Win Sourcing 37

after launch.” Third, when overhead and marketing costs are fac-tored in, engineers working on an already launched program createonly a third of the value of those involved in a new effort.

With knowledge-based sourcing, a short time after productlaunch, the engineers are pulled from the project and redirectedtoward developing new products or new versions of existing prod-ucts. The manufacturing function, meanwhile, can focus attentionon in-plant productivity improvements, not on retooling for prod-uct redesigns. In other words, by creating a well-managed up-frontphase, manufacturers gain a long-term, significant, and often unex-pected benefit. Suppliers are equally enthusiastic. “U.S. automakersreinvent for each program,” said one supplier. “They make eight to10 design changes for each program, while Toyota makes maybetwo. What’s more, [the Detroit manufacturers] continue to changeup to the last minute but don’t want to pay for the changes.”

4. Respect and develop human capabilities. Underpinning knowl-edge-based sourcing is a significant degree of people development.Toyota and Honda, as well as many other Japanese companies, workto instill in their employees a profound sense of cooperation. Theyalso build a deep and company-specific well of product and processknowledge, identifying and codifying their best practices andpursuing ideal performance levels with their supply base. FewWestern companies can claim this type of educated workforce, soa major training effort is needed to improve overall procurementperformance.

In companies that pursue knowledge-based sourcing successful-ly, we see the following skills present among a wide range of employ-ees, whether on the shop floor or in the purchasing department:

• They can map the underlying processes, materials, and tech-nologies that lead to or promote competitive performance.

• They can produce cost models that accurately reflect supplierand industry economics.


• They can identify world-class factory output.• They can help suppliers reach recognized top-of-the-line

standards.

Shifting from a traditional manufacturing model to this newknowledge paradigm is culturally difficult. Managers at many com-panies change jobs often; this makes it virtually impossible toacquire the depth of experience and information needed to workclosely with suppliers on continuous cost and performance improve-ment. Moreover, compensation is usually based on straightforwardcost and revenue benchmarks, not on quality and performanceimprovements. That is why one of the first steps for a company totake is to design creative incentives that reward employees for suc-cessful long-term supplier relationships and for improved commu-nication among purchasing, engineering, and the executive suite.These incentives can alter old-fashioned perceptions quickly. Otherforms of support include focused training — on topics such as sup-plier relationship management and development, cost modeling,and industry economics — and career tracks that allow people togrow and develop without shifting positions. Some companies havesuccessfully developed and implemented a training and certificationprogram for cost management that encompasses much of the engi-neering organization and all of purchasing.

The Path to a New ModelThe practice of knowledge-based sourcing is still evolving; a “next-generation” approach is emerging now as more companies in a vari-ety of industries adopt Japanese techniques and incorporate theminto their own corporate cultures. The most effective manufacturerswill build up supply chain management teams with differentiatedcapabilities, balancing commercial, technological, and managerialskills. They will align their values, incentives, and key performance

Win-Win Sourcing 39

indicators with the relationship-based system, focusing on perfor-mance management and support instead of by-the-book cost reduc-tions. They will build networks of suppliers who will work togethermore regularly and effectively across the value chain, ensuring com-patibility among components and seamlessness among their pro-cesses. Finally, they will adopt more modular approaches, in whichcomponents are distinctive when necessary but standardized whendistinction matters little to customers. In short, careful attention tosourcing quality and logic will finally be seen as the strategic capa-bility it deserves to be, positioned with a top management mandate.

To be sure, a knowledge-based sourcing model is not appropri-ate for every situation. If a company is buying a part or componentjust once and is unlikely to require the supplier in the future, thereis little need to spend resources on improving operational and sys-temic output. However, any company’s most important supplieragreements involve the most essential components. In those cases,manufacturing productivity improvements are critical in maintain-ing high quality, reliability, and a continuously advantageous costbase. The move to knowledge-based sourcing may not be easy, butby implementing the four steps outlined here, most companies willfind themselves on the road to making the transition, relatively cer-tain of reaching the end. +

Editor’s Note

First published in strategy+business, Summer 2007.

PURCHASING USED TO be a boring function that most companies tookfor granted; it involved a lot of transactional work and tedious rep-etition — important activities for day-to-day or even moment-to-moment operations, but not critical to the organization’s overallplanning and financial performance.

Anyone with basic negotiating skills could manage procure-ment, it was often said; deeper strategic thinking and serious dealmaking took place elsewhere. For a nine-to-fiver, it wasn’t a bad wayto eke out a living. For an ambitious businessperson, however, pur-chasing was nothing but a dead end.

But that’s all changed. The growth in outsourcing, the drive forefficiency, and the dramatic cost savings that can be delivered bywell-managed supply chains and pricing analytics have transformedpurchasing into a strategic function in many companies. The best ofthem now view procurement as a potential asset, one that is asimportant as research, product design, finance, and marketing.These companies realize that many of the questions that executivesmust answer correctly to succeed in today’s commercial environ-ment are intimately and directly linked to purchasing: What workshould we farm out? What work should we keep? With what com-panies should we partner? How many suppliers should we have?What should our relationship be with our suppliers? All of these

The New CPOby Simon Harper and Fabrice Saporito


The New CPO 41

strategic questions now fall squarely on the desk of the chief pro-curement officer.

Of course, recognizing that the procurement department is notthe career backwater it was once considered and capturing the sig-nificant strategic and financial value embedded in this function aretwo different things. Indeed, to profit from an elevated respect forprocurement, many companies will have to undo decades of badhabits in the recruitment, training, and development of their pur-chasing professionals. No longer can they afford to place competentbut unimaginative people in these jobs. Nor can they afford toignore their current procurement staffers by offering them fewchances of advancement and neglecting their skills.

Hiring the merely good is not enough for organizations thatwant to build world-class purchasing departments. Instead, theymust make stellar appointments — filling the senior procurementjobs with people who can become tomorrow’s top corporate leaders.Managerial talent of this caliber doesn’t develop by accident.Businesses hone executive abilities by identifying and encouragingpromising individuals and providing them with the right opportu-nities over years, even decades.

Slowly but inexorably, the programs that are needed to developtop purchasing executives are being implemented at more and moreorganizations. In fact, procurement managers themselves evince abudding sense of optimism about their prospects, a sharp changefrom prior, gloomier assessments. In a recent Booz & Companysurvey of 100 CPOs and supply chain management leaders, 66 per-cent of respondents said the CPO will play a larger role in settingbusiness strategy in the next five to 10 years, and 44 percent ofrespondents said activities in the purchasing department will be atop priority. (See Exhibit 1.) The general conviction in the executivesuite seems to be, as one respondent put it, “Procurement needs tobe more strategic — closer to the CEO agenda.”


This suggests that although it will continue to be important forthe purchasing professional to have functional expertise enablinghim or her to get the best deal on paper clips (as well as to leveragemore value from the entire supply base), strategic capabilities, polit-ical savvy, and leadership talent are increasingly important prioritiesand prerequisites for CPOs. In fact, our survey revealed that 46 per-cent of senior purchasing executives believe that strategic under-standing and overall business sense will be the most important traitsfor purchasing managers in the future. Meanwhile, two traditionalmeasures of purchasing professionals’ functional expertise — theirability to manage supplier networks and their understanding of theproducts or services they are buying — weren’t rated as the top pri-ority by even 5 percent of respondents. (See Exhibit 2.) The chal-lenge for tomorrow’s procurement officers, noted one CPO, will be“setting the strategic agenda through growth and innovation.”

Companies determined to develop a new generation of corpo-rate procurement leaders — while maintaining a competitive supplychain — should take five steps in particular:

1. Recruit from top schools. The bad news is that, by and large,

Source: Booz & Company survey

Exhibit 1: CPO Role in Business Strategy

Major role

Important role

Limited role

No role

Top priority

More

Same

Less

N/A

44%

22%

29%

3%

2%

7%

27%

27%

39%

What is the role of the CPO in defining thebusiness strategy of the company?

How important will CPO involvement indefining business strategy be in 5–10 years?

The New CPO 43

companies have not bothered to seek out the best and the brightestfor purchasing; most recruiting has historically been internal. Theresult, of course, was a self-fulfilling prophecy: Second-tier candi-dates couldn’t raise purchasing to a strategic competence, and theirunderperformance seemed to justify the function’s relegation to asupporting role. If procurement is to achieve its promise, companiesmust seek out top performers to fill these jobs.

The good news is that the level and quality of purchasing talentis rising. Responding to the new demand, some top business andindustrial management schools have added purchasing to their cur-riculum. For example, Helsinki University of Technology, a for-ward-thinking business school whose students consistently beattheir European and American peers in international business casecompetitions, recently added a purchasing and supply managementcurriculum within its industrial management major. The universitydeveloped the innovative course of study with the support of lead-ing Finnish corporations.

2. Pay a competitive salary. The growing corporate realization ofthe enormous business impact that procurement can create has stim-


Exhibit 2: The Importance of Future Capabilities

Which two of the following capabilities do you believe will be mostimportant for purchasing professionals in the future?

Strategic understanding and overall business sense

Cross-functional supply and value chain understanding

Supplier cost modeling

Risk management

Ability to manage supplier relationships

Deep technical understanding of category

Ability to manage network supplier

0% 20% 40% 60%

46%

15%

4%

18%

9%

3%

3%

13%

21%

24%

4%

10%

13%

10%

Most important

Second most important


ulated healthy increases in the earnings of procurement and supplychain professionals. The magazine Purchasing reported in December2007 that on average, U.S. purchasing professionals earnedUS$84,611, up from $64,300 in 2002 — a 30 percent increase infive years. In the United Kingdom, purchasing directors’ compensa-tion rose steeply as well — to £76,000 ($157,000) in 2007, up a full14 percent from the year before, according to a survey conducted bythe Chartered Institute of Purchasing and Supply and compensationexperts the Croner Company.

Underpaying for purchasing executives in such an environmentis a penny-wise, pound-foolish strategy. Worse, an insistence onclinging to old pay scales — that is, not paying purchasing execu-tives on par with other top managers — will simply ensure that thecompany hires the same old kinds of individuals, only worse.

3. Rotate functional assignments. It is essential to the developmentof future purchasing leaders that they obtain the widest possibletraining and experience within the organization. Leading corpora-tions already routinely move executive candidates from one job toanother to broaden their knowledge of overall operations. At IBM,for example, the most promising purchasing employees may spenda few years in finance, market intelligence, or even global servicesbefore being shifted back to supplier management. Similarly,Nokia’s procurement rotation plan gives its purchasing staff a tasteof what it’s like to deal with different types of expenditures or cate-gories of supplies and services.

Rotation programs not only create new opportunities for theindividual procurement executives but also benefit the company.Two- to three-year rotations infuse fresh blood and new ideas intothe top purchasing ranks, prevent the development of counterpro-ductive personal relationships between buyers and suppliers, andreduce the risk that bottlenecks will arise from relying on a limitednumber of experts who specialize in buying an even smaller number

The New CPO 45

of products and services.4. Revise and expand training. The training required to function

effectively as a purchasing officer is much more complex than it wasjust a few years ago, because it must include both traditional pur-chasing expertise and broader financial and managerial skills.

Procurement professionals still need such core skills as negotia-tion techniques, supplier market analysis, and cost modeling, buttraining programs involving these once-basic skills often require revi-sion as the field of purchasing becomes more advanced and challeng-ing. For example, traditional cost modeling involved little more thanshort-term analysis of commodities markets to lock in prices overperhaps a three- to 12-month period. But these days that’s only thebeginning. CPOs now must be adept at macroeconomics and havewider corporate finance skills to manage futures, puts and calls, fixedcontracts, and other strategies and instruments that are designed tocover purchases over many years. CPOs increasingly need the finan-cial acuity to accurately forecast supplier prices 24 months out ormore so they can make better decisions about long-term contractsfor oil and other commodities or the raw materials that should beused in their company’s manufacturing processes and products.

In some industries, such as the airline industry, the last few yearshave demonstrated that the cost management of a key commoditylike fuel oil can sometimes be the key not just to profitability butalso to corporate survival. For example, with long-term hedgingof more than 80 percent of its energy costs, Southwest Airlinesavoided the turbulence many airlines suffered when jet fuel pricesnearly tripled between 2002 and 2005.

To help develop the broad areas of expertise that procurementofficers need to thrive in the new purchasing environment, compa-nies should turn again to top business schools for general manage-ment training.

5. Create career paths for purchasing talent. Ironically, although


capabilities training is an investment that yields a higher return inthe short term, it’s also one that carries a greater risk to the depart-ment. Equipped with a wider array of skills and more expertise,purchasing professionals will find it easier than ever to leave theircompanies for better opportunities — and high industry turnoverrates suggest that these budding executives aren’t shy about takingadvantage of new offers.

To prevent such a brain drain and ensure that companies andindividuals are capturing the full potential of their purchasing tal-ent, it is essential that companies offer concrete and compellingcareer paths for procurement professionals. To determine whichprocurement executives deserve special treatment, human resourcesdepartments should build into performance appraisals and measure-ment the new set of skills needed by purchasing managers, such as ahigher degree of financial acumen and finely honed strategic think-ing. Moreover, the company must reward procurement officers whomeet certain cost and delivery targets with greater compensation.

The purchasing department should be viewed as a trainingground for senior corporate positions. If the anecdotal evidence isany indication, the best senior purchasing officers are fully capableof filling those spots. For instance, Richard Purcell, formerMicrosoft CPO, is now chief executive officer of the Corporate Pri-vacy Group, a consultancy on business privacy practices. And PekkaOjanpää, after only a year as CPO at Kemira Oyj, the leading chem-ical supplier to the pulp and paper industry, was named president ofits Kemira Specialty division. In February 2008, he was named pres-ident of Kemira Water.

Some might argue that thinking of well-trained and innovativepurchasing managers as indispensable talent assets is a short-termphenomenon that will generate only a modicum of real changewithin most organizations before it disappears. But we see the risingneed and desire for highly skilled purchasing professionals as a lag-

The New CPO 47

ging indicator in the long-term trend of supply chain revolution.Over the past 30 years, business thinkers have become increasinglyaware of the crucial role that the supply chain plays in corporate suc-cess. Yet even as they realized that the supply chain was a profitengine, executives and purchasing professionals alike remainedoddly unaware of the purchasing department’s contribution to theefficiency of that engine. It is time for both smart companies andsmart purchasing professionals to adopt a new perspective. +


Getting Creative:Efficient Sourcing in Marketingby Harald Dutzler and Martha D. Turner

THE LARGE RETAIL bank’s approach to buying marketing-related ser-vices and materials was typical. On direct marketing efforts, decen-tralized business units worked with advertising agencies of theirchoice — agencies usually chosen on the basis of demonstratedcapabilities, their understanding of the nuances of the individualbusinesses, and the personal relationships they had built over time.The relative cost was hard to compare, as each of the bank’s businessunits negotiated its own agreements with its marketing partners.Pricing was usually project-based, with no standardization from onebusiness unit to another, even when it involved universally useditems, such as envelopes, mailing inserts, and postcards, or whenunits shared the same vendors.

This sadly common scenario speaks volumes about the sourcingside of marketing at large companies. Although creative develop-ment is met with great attention to detail — no marketer would letpoorly written direct mail copy or artwork go out to half a millioncustomers or approve a point-of-sale placard that was off-message —the sourcing of marketing materials or services rarely gets the samescrutiny.

In a way, this is understandable. A marketer’s first currency isimage — what people see, hear, or touch that draws them to a prod-uct or service. But to focus on marketing’s end product at the

Getting Creative 49

expense of the sourcing process is to miss a very large opportunityboth corporation-wide and for marketers themselves. After all, mar-keting materials and services can represent upwards of a quarter ofmany companies’ total purchasing costs.

Leaving Money on the TableIf marketing provides such a tangible opportunity for cost savings,why have so few companies found a way to increase the function’spurchasing efficiency? For one thing, when companies give theirlocal marketing departments an undue amount of autonomy towork their magic, including allowing them to select vendors andmake buying decisions independently, the result is a wide anduncontrolled proliferation of specification and service levels, alongwith a fragmented vendor base.

One consequence is a lack of consistency in the bidding process.A provider to one business unit may get the job because it offers thelowest price, but a similar supplier to another business unit may wina contract simply because it has been the go-to vendor for manyyears and the local marketing manager can’t imagine switching sup-pliers. The results of narrow, relationship-based vendor selection canbe extremely damaging, both to the company and to the suppliersthat are ostensibly benefiting. For example, a restaurant chain wasrecently forced to end its relationship with a fulfillment vendorbecause the growth of the chain’s footprint and associated marketingneeds outstripped the vendor’s capacity and capabilities. With theoverwhelming majority of its revenue gone, the fulfillment houseunfortunately went out of business.

Another reason that marketing spending lacks controls and isoften wasteful lies in the limited interaction, at least historically,between marketing and purchasing departments. Even at companiesthat are trying to change that dynamic, purchasing directors oftendo not have enough direct experience working with creative agencies


and media buyers — marketing’s primary cost centers — to knowhow to implement more advantageous contracts.

The results of companies with which we have worked demon-strate that the benefits of addressing this disconnect can be substan-tial. The cost savings from bringing marketing and procurementtogether in a dedicated program to raise the efficiency of marketingprocurement start at 5 percent and can climb as high as 40 percentacross spending categories. That can mean tens of millions of dollarsin savings at companies that depend heavily on marketing, such asthose in the consumer packaged goods, pharmaceutical, and autoindustries. And although some marketers have harbored concernsthat any efficiency gains would be achieved at the expense of mar-keting creativity, those fears, by and large, have not been justified.

On the contrary, what chief marketing officers (CMOs) of someleading-edge companies have discovered is that more efficient sourc-ing actually leads to greater marketing effectiveness and a strongeremphasis on creativity. This is true because one by-product ofgreater procurement efficiency — say, in the form of designatingcertain suppliers as strategic vendors — is less time spent on man-aging processes and more time spent on developing core marketingprograms and activities. Further, when the CMO allows marketersto reinvest a portion of the savings generated from sourcing, theycan use the money to fund new creative efforts and invest more insuccessful campaigns. In short, in this era of cost cutting, efficientsourcing can enable marketing to do more with less.

To gain the maximum benefit to their bottom lines and market-ing efforts, companies will have to ensure that marketing and pro-curement departments collaborate to an unprecedented degree. Thisis not an indirect way of saying that marketing should be preparedto relinquish control of its budget. Rather, it’s a prescription for anew paradigm, in which purchasing can bring a fresh rigor to theeffectiveness of marketing expenditures.

Getting Creative 51

This tighter collaboration between marketing and procurementwon’t come naturally; it is a change that requires careful planningand oversight. And although there is no silver bullet for achievingthis task, there are steps that companies can take to begin the processof managing their marketing dollars more efficiently.

1. Analyze Marketing Spending in DetailIt is hard to buy marketing products and services efficiently withoutknowing where and how the money is currently being spent. Yet thisis precisely the situation in which most CMOs of large companiesfind themselves: They don’t have a detailed understanding of thecomposition of their marketing expenditures or a comprehensiveprofile of their supply base.

This is because most marketing budgets are complicated, di-vided between “above the line” items such as advertising and creativeservices, meant to build brand awareness, and “below the line”spending in targeted areas such as promotion, direct mail, andpoint-of-sale, as well as prepress, printing, and fulfillment services.Further, most marketers manage against budgets and campaignsrather than focusing on the compliance of individual vendors tocontractual terms. Also, because brands tend to operate in silos,many CMOs cannot get a clear picture of spending across brands.No wonder it’s so hard to keep it all straight: Marketing spendingisn’t a line item; it’s a scattergram.

Nevertheless, setting a clear baseline by establishing where themoney is being spent is crucial to a CMO’s ability to identifyopportunities and develop insights for improvement. In the largeretail bank described above, the CMO was able to gain criticalknowledge of variations in prices and service-level agreements, aswell as the financial institution’s multiple internal points of contactwith suppliers, by conducting a thorough baseline diagnostic thatencompassed all of the bank’s marketing activities. That, in turn,


allowed the CMO to drive toward more efficient sourcing by delin-eating points of synergy and opportunities for greater collaborationacross brands.

2. Adopt a More Rigorous Approach to SpendingMarketing can become more disciplined about controlling costs intwo ways. The first is attacking supply levers by rebidding and con-solidating the vendor base, a process that marketing and procure-ment can and should undertake together. The second is through themanipulation of demand and process levers, the requirementsplaced on suppliers by the marketing staffers themselves.

Supply levers. Supply levers offer a broad opportunity to becomemore efficient. This is partly because upwards of 70 percent of themarketing budget lends itself to definition by a standard set of spec-ifications — e.g., trim size, paper weight, color, finish, and bindingfor printed materials. Companies that want to become efficientabout marketing sourcing must be willing to adhere to rigorouspricing levels for standard products and services. They should alsoestablish and maintain enterprise-wide rate cards or pricing gridsfor services such as graphics work, so that an individual businessunit knows what it can expect to pay for different design elementsand for agency resources, such as the services of a copywriter or cre-ative director.

This discipline should extend to special situations in which themarketing concept requires unusual purchases (think of a totempole, or a branded mobile that might hang in a store), creatingunique specifications so complex that it is not possible or does notmake sense to establish a rate card. In such cases, it is best to use a“market basket” approach, meaning that the company asks for pricesfor a representative set of services and uses those estimates to deter-mine a preferred set of vendors. As the need for special items arises,only these preferred vendors are asked to bid on the work.

Getting Creative 53

For companies in which print runs are a major component ofmarketing costs, disaggregating fixed print costs from variable onesis a good approach. Here, the relatively high fixed costs of printsetup are amortized over longer print runs. So if a marketer knowsshe needs 200,000 print pieces in August and another 100,000 inNovember, she orders a whole print run of 300,000 at once. Or, ifthis is impossible, marketers might identify suppliers that are inher-ently better — and hence less expensive — at running jobs of theparticular sizes needed.

Demand and process levers. On the creative side, demand andprocess levers — which include the job’s complexity and deadlines;the composition in terms of number of colors, trim size, papergrade, and use of colors; the number of revisions and changes;the extent of quality control; and the type of technology employed— can be even more fruitful than pricing levers when broughtunder control.

Marketing should take the lead in managing the company’sdemand levers, with purchasing playing a facilitating role. As is thecase with the supply levers, improvements won’t happen until mar-keting managers clearly understand the specifications of each job.Only then can marketing take steps — harmonizing the size ofposters, ruling out special colors that require the interruption of aprint run, and the like — to address what it buys, and how.

On the process side, one change that marketing and procure-ment may jointly pursue is handling more creative and productionwork either in-house or offshore. This is the classic make-versus-buyquestion, made more relevant in an era of cost-effective digital tech-nology, which enables companies to do high-quality, low-cost pro-duction work internally, possibly through independent contractors.Another increasingly common tactic is to use one vendor to overseea larger fragmented supplier base, as part of an effort to minimizeinternal administrative work.


3. Deploy Decision Support Tools to End-UsersCompanies that are most serious about controlling demand-sidemarketing expenditures are equipping marketing managers withdecision support tools for day-to-day procurement. These softwaretools can serve many purposes. They can alert marketers when theircurrent suppliers are overly expensive, less experienced, or less capa-ble compared with others. They can automate price comparisonsamong multiple vendors, for instance, for doing an initial order of aprint and fulfillment project and for handling repeat orders, andhelp marketers after they have selected a vendor, by highlighting thecost trade-offs of, say, opting for nonstandard dimensions, customcolors, or services, such as campaign planning. They can also be use-ful in compliance analysis, offering tangible metrics that quantifythe results of marketing’s efforts.

These tools come in a variety of forms — from simple Excelspreadsheets based on vendor pricing grids to more robust workflowmanagement systems, such as Aprimo or NewlineNoosh — butthey have the same purpose: to create greater transparency into costsof decisions that marketers make on a day-to-day basis while simul-taneously enhancing their creativity and agility.

4. Create a Clear Delineation of Roles and ResponsibilitiesCost savings from marketing sourcing won’t happen at a companywhere decision rights and lines of responsibility aren’t clearly delin-eated both within marketing and between marketing and purchas-ing. Within marketing, categories of spending that span businessunits, such as media buying, should be centrally managed, withmarketing executives taking the lead in directly selecting the vendorsand executing the marketing strategy. In categories such as localsponsorships and other regional and business unit events, central-ized execution is often not feasible. In those cases, corporate market-ing’s role should be to ensure that a vendor selection process is in

Getting Creative 55

place and the individual business units know how to execute theprocess and adhere to corporate or brand standards.

There also needs to be clear cross-functional delineation of rolesbetween marketing and procurement. Typically, final decision rightsremain with marketing, while procurement works to facilitate andcontinually improve the effectiveness of sourcing strategies. But inall cases, leaders in the functions must determine for themselves theproper roles of the two functions across the full procurement lifecycle — from defining the category strategy to structuring the bidand negotiating the contract to performing ongoing vendor man-agement and measurement and tracking. They must also decidewho will play the lead and supporting roles at each stage of thesourcing cycle. When this collaboration is properly positioned withmutually agreed-upon goals, marketers often become enthusiasticabout working with procurement.

5. Define an Operating ModelIn order to purchase marketing products and services more effi-ciently on a sustained basis, a company needs to develop an operat-ing model to manage the effort. This structure is governed by theroles and responsibilities described above, but it will vary dependingon the nature of the company’s marketing activities.

In companies where marketing is relatively standardized acrossbusiness units, a centralized department that all the business unitsuse as an interface in their dealings with external creative agenciesand vendors may be the best model. This group’s responsibilitiescould also include purchases that span the marketing organization,such as market research, brochures and other collateral, direct mail,and the development of novelties or giveaways.

Where there is more differentiation — whether in product orcustomer type — multiple sourcing centers located in and sharedacross major business units or regions are more effective. For in-


stance, a large consumer packaged goods company with major inde-pendent business units may establish a sourcing center in each. Inthis distributed model, coordinating mechanisms will be needed toensure that different business units and brands can take advantageof one another’s efforts.

6. Use Change Management to Implement the New ParadigmThe previous steps require companies to change established strate-gies and practices and implement new ones. Some of these changescan be as basic as making an ironclad commitment to adhere to anew price schedule for incumbent vendors; others can be complex,such as a shift to a streamlined set of preferred vendors that must beused regardless of local preferences.

Irrespective of the scale of the marketing sourcing agenda,the appropriate application of change management must be an-ticipated and provided if these initiatives are to succeed. And,although it’s true that higher levels of change and gains in effi-ciency are positively correlated, this does not imply that every com-pany should aim for a maximum amount of change in a minimumamount of time. Many companies need to approach change care-fully, with an accurate sense of their own change capacity andwith an eye toward building the capabilities needed to sustain thechange effort.

To build support and avoid surprises, the transformation tomore efficient sourcing of marketing requires comprehensive com-munication about the initiative’s objectives and approaches. It alsorequires a well-defined project structure that includes detailed workplans, clear direction, and frequent reviews to keep the projecton track.

When the marketing sourcing initiative is ambitious, theinvolvement of senior executives is critical. It can be as simpleas making sure that influential leaders in marketing conspicuously

Getting Creative 57

use the new processes and tools and, thus, drive adoption by ex-ample. Or it can be a more formal kind of leadership in which theCMO and CPO sponsor the initiative directly, participating inthe plan design, communicating its benefits, and even calling onother senior executives, such as the CEO, CFO, and COO, for theoccasional show-of-force pep talk to midlevel managers and the rankand file.

The Fruits of Optimized SourcingAn encouraging aspect of sourcing marketing more efficiently is thatthe payoff can materialize relatively quickly. Often, merely creatingmore visibility into a supplier’s relationships across a firm and dis-cussing the level of business with the supplier can elicit more favor-able pricing. It is a good idea to look for this low-hanging fruit andharvest it with tightly controlled, guaranteed-to-succeed pilot proj-ects. The quick wins that come out of such projects naturally relievesome of the organization’s resistance to change and create momen-tum for wider adoption.

For the longer term, much higher benefits should be targetedand pursued. One consumer products company was able to targetup to 8 percent in savings on creative services by developing a morecompetitive bidding process for choosing agencies. It targeted 16percent savings by utilizing lower-cost resources, including internalgraphic designers, for less complicated work. And it targeted 18percent savings by adopting a preferred set of enterprise-wide ven-dors. Overall, the company’s cost reduction target reached 42 per-cent: a US$10 million savings in a firm spending $25 million oncreative services!

In short, a company that undertakes a marketing sourcing ini-tiative can expect extensive return on its investment. Improved eco-nomics provides more money for other marketing initiatives — orhigher profits for shareholders. New analytical tools and data result


in better-trained marketing personnel capable of making moreinformed decisions about project specifications, job allocation, andpurchasing. Deeper insight into supplier activities and more carefuldevelopment of supplier relationships produce better price, service,and quality, as well as more reliable deliveries. And all of this can beachieved without interfering with creative goals or treading on themarketer’s fundamental decision-making autonomy. +

WHEN THE SENIOR vice president of supply chain management andsourcing at a global consumer packaged goods (CPG) companydecided to look into procuring more environmentally responsiblematerials and packaging, he knew what he didn’t want: a “green-washing” program with no strategic objective except the right to saythe company was reducing its carbon footprint. As with any othermajor initiative, he had a mandate from his executive team to createsubstantial benefit for the business, with a connection to a targetmarket and a fundamental link to the brand proposition. Beyondthat mandate, however, he was less certain. Having identified greensourcing as the right goal to pursue, what should he do next?

Today, organizations around the world are being compelled —by their employees, their customers, their products’ end consumers,and their supply chain partners — to undertake green initiatives.But although they are caught in a deluge of information and opin-ions about the importance of being green, they find much less reli-able information and advice about the mechanics of beginning, letalone maintaining, an effective green shift in operations.

Although this particular senior vice president didn’t know whereto go, he was starting in a good place. Sourcing, having gained itscredibility in the C-suite, lies at the nexus of a number of functionsand business units, and is therefore in a position to influence action

Green Sourcing: Seeking thePayoff in Environmentalismby Patrick W. Houston and Martha D. Turner

Green Sourcing 59


across an organization; it can be a strong leverage point for startinga green initiative. By working with senior leaders in other func-tions, sourcing executives enable a successful, holistic, multifunc-tional strategy for reducing environmental impact while cuttingcosts and building better relationships with suppliers and commu-nities. They can do so by instituting gradual improvements andcontinually making the green initiative more relevant to the com-pany’s overall strategy.

A Clear Look at GreenGreen sourcing is not a departure from the way sourcing is cur-rently being practiced; it’s an augmentation. When considering thetrade-offs between one material, service, or supplier and another, thesourcing function has traditionally measured the value of each byanalyzing either the economics of the deal or the deal’s impact on thecustomer. Green sourcing starts with the same considerations, but italso takes into account the environmental impact of a particularchoice, be it transportation, materials, energy source, or packagingdesign, on the ecological footprint made by a product or service.

It’s essential for a company to have a rigorous and carefullystructured sourcing program in place before attempting a greensourcing initiative. Such a program requires even deeper insightthan does a traditional strategic sourcing program because thechoices among environmentally friendly products and services canbe extremely complex; thus, it is also essential to have a network ofsuppliers that can provide the necessary transparency. To fullyunderstand the trade-offs inherent in their choices, sourcing execu-tives must be able to analyze the entire value chain of a product orservice in terms of cost, customer benefit, and environmentalimpact. In doing so, they can make certain that various componentsin that chain interact in a way that benefits the whole system.

The classic example of these value chain interdependencies is a

32-watt, energy-efficient lightbulb that costs US$6. It may appearmore expensive than a 100-watt bulb that’s available for 75 cents,but the green bulb actually has a lower cost of ownership once otherfactors are taken into account. Its 10,000-hour life is 10 timeslonger than the life of the cheaper bulb — and it will burn only$48 worth of electricity, compared with $150 worth for the conven-tional bulb. A shift in lightbulb supplies, however, may be worthmaking only when multiplied across a company’s dozens of facilitiesaround the world.

Today, such analysis can go far beyond lightbulbs; similar trade-offs exist among a wide range of materials and services, includingrenewable energy, janitorial supplies, packaging, and many aspectsof building construction. Although not all choices will yield theclear value proposition of the lightbulb example, they are worthy ofcloser examination.

This kind of careful scrutiny yields a significant advantage.When a company learns more about the impact of various choicesthroughout its value chain, it is better able to control and poten-tially reduce costs. Green sourcing has a number of other benefits aswell. At an obvious level, it allows companies to capitalize on thegrowing awareness of green issues, helping them to attract cus-tomers, motivate current employees, and recruit new employees. Itenables companies to respond more effectively to regulation, or evento anticipate it. Finally, green sourcing allows companies to deliveron the promises made in corporate social responsibility (CSR)reports: According to the “Green Purchasing Report,” a 2007 studyfrom the research firm eyeforprocurement, fulfilling the CSR mis-sion was the primary reason that survey respondents pursued greensourcing initiatives.

Beyond those benefits, green sourcing encourages the same kindof in-depth, widespread awareness of practices and processes thatcompanies have gained from adopting Lean Six Sigma, process opti-

Green Sourcing 61


mization, collaborative decision making, and other quality-orientedmethods. Indeed, the potential of green sourcing today is reminis-cent of the quality movement in the late 1980s, when that idea hadjust begun to mature. That was the era in which, following the lec-tures of W. Edwards Deming and the examples of the Toyota MotorCorporation and other Japanese manufacturers, companies began tosystematically focus on eliminating waste and making operationsmore reliable. To accomplish these goals, they had to give up theidea that improving product quality was “overengineering,” and thatbetter products cost more to produce. Instead, when productionprocesses were understood and continuously improved, costs con-tinually dropped. As an additional benefit, companies were able totout the quality of their products to customers and back up theclaims with hard evidence. Within a few years, in many companies,quality took its place alongside price and service to become the thirdfull-fledged element of strategic sourcing. Today, thanks to changingcircumstances and new enablers, environmental sustainability ispoised to become an important fourth element.

Pressures and EnablersPublic opinion, government regulation, the competitive landscape,and investor interest are making it necessary for companies to takea stand on green sourcing. The idea that the natural environment isdeclining at a dangerous rate is far more commonly accepted nowthan it was 10 or 15 years ago, and society at large is becoming morecommitted to sustainability — pushing individual consumers to fac-tor environmental considerations into their buying decisions.

Governments are also becoming more aggressive in requiringcompanies to make changes to their manufacturing processes. First,there are more regulations than ever, addressing such issues as man-dated carbon trading schemes and cap and trade programs.Multinational companies, especially, are under pressure to somehow

Green Sourcing 63

reconcile the varying standards among different countries and evenamong different regions in the same country. For instance, manycountries in Europe are pushing companies to reduce carbon emis-sions and use more recyclable materials in their products. This leavesmanagement with the conundrum of whether to align the wholecompany’s policies with the highest common denominator and bearthe costs of setting stringent standards worldwide, or to deal withthe complexity of a patchwork of standards in operations aroundthe globe.

Second, governments are promoting green materials and servicesas buyers in their own right: Both the U.S. federal government andlocal governments have been leaders in the use of hybrid vehicles,the adoption of paper with a high percentage of postconsumerwaste, and the construction of buildings certified by the U.S. GreenBuilding Council’s Leadership in Energy and Environmental Design(LEED) program. The U.S. federal government, for example, hasundertaken a multiyear renovation of the Pentagon that uses manyrecycled products, including more than 59,000 square feet of carpettiles made from recycled material and 53,500 linear feet of recycledsteel wall studs.

With the demand for green products on the rise, many investorsare more attracted to green companies, as evidenced by the creationof the Dow Jones Sustainability Indexes and their U.K. counterpart,the FTSE4Good Index Series, which track the performance of,respectively, sustainability-driven companies and companies meet-ing global CSR standards. Institutional funds that invest alongsocial guidelines in Europe and the U.S. also appear to be encourag-ing more businesses to think about sustainability: In recent years,these funds have reached $4 trillion in assets — enough to buy 91percent of all outstanding Nasdaq stocks and more than enough toensure that green stays at the top of every corporate agenda.

Meanwhile, as both internal and external pressures drive the

need for change in sourcing practices, a number of elements aremaking such change more feasible. Foremost among these elementsis the increasingly collaborative nature of supplier relationships. Thisallows more visibility into sourcing decisions and makes it easier todefine mutually beneficial goals. For instance, DuPont Packagingand Industrial Polymers announced in 2007 that it was collaborat-ing with Plantic Technologies Ltd., an Australian bioplastics com-pany, to develop polymers based on corn starches that could be usedfor cosmetics and food packaging and to market them under theDuPont Biomax brand. The partnership offered advantages to bothcompanies: It broadened Plantic’s market reach, and it broughtDuPont closer to its goal of growing revenues from nondepletableresources to $8 billion by 2015 — a goal that the company clearlystates it can achieve only by supplementing its own research anddevelopment with that of strategic partners.

Another element making green sourcing more feasible is anincrease in requests from the top. Procurement officers have beentasked by the C-suite with investigating alternatives and weighingtrade-offs among price, service, quality, and sustainability. Forinstance, they might be asked to determine whether the companycan save money by substituting tools and supplies that use energyand water more efficiently, have more recycled fiber, are built to lastlonger, or can be sourced somewhere nearer to where they are need-ed. Furthermore, because sourcing influences 40 to 45 percent ofthe cost base of most companies — a percentage that is growing —it is recognized as a strong potential agent of change. Sourcing’s con-trol over those expenditures today tends to be more comprehensivethan it once was, since the sourcing function extends more andmore to operations that touch every part of the company, includingthose areas not traditionally under the influence of procurement,such as marketing and professional services like the legal depart-ment. Sourcing is now recognized as a competitive tool for manag-


ing costs, services, and supplier relationships.Finally, green sourcing is enabled by new technologies —

including more efficient energy options, brighter LEDs, and trans-portation designed to burn cleaner fuels — and by new processes,thanks to computer models that help companies analyze optionsand trade-offs.

Justifying the InvestmentDespite the pressing need for greener practices and the recentadvances discussed above, good practices (let alone best practices) ingreen sourcing are not yet clearly defined, and there are still hurdlesto overcome in creating those definitions. At one large CPG com-pany, for instance, a number of executives stated that they werecommitted to green initiatives and sustainable sourcing — but theyhad trouble defining what that meant in terms of their day-to-daydecision making. Green sourcing is still treated as an incrementalpart of the procurement function, rather than as a full-fledgeddimension of strategic sourcing. According to the Green PurchasingReport, only 31 percent of 188 companies surveyed in a variety ofindustries were actively practicing green purchasing. Even somecompanies that have launched green sourcing initiatives have nottied them to one another, to goals at the business unit or brand lev-els, or to the company’s overall strategy.

Ultimately, no green initiative will succeed unless it has aproven value: better economics for the company, benefits to the cus-tomer, or a marketing advantage. To date, articulating this value hasproven difficult. In terms of the bottom line, the costs and benefitsof green sourcing have been diffuse and hard to quantify. As withquality, it has taken some time for green sourcing to move past itsreputation as an expensive add-on valuable only to companies thatare willing to pay more to assuage their ecological concerns.Customers, for their part, will buy green products or services in

Green Sourcing 65

numbers that justify the investment only when the seller can con-clusively show the benefits — that fuel costs are lower, that theproducts will last longer, or that the use of the service will be morepleasant and less wasteful than any alternatives.

The fundamentals of green sourcing are similar to those of qual-ity in three ways: approach to costs, brand appeal, and cross-functional insights into processes.

Approach to costs. Traditionally, the sourcing function has beenpressured to cut costs rather than to consider the sustainability ofmaterials and services. But the underlying goal of both quality andgreen sourcing is the same: to eliminate waste. In eliminating waste,sourcing organizations gain a way to look at value rather than costs,by taking into account the total cost of ownership. The quest forquality required companies to give up the idea that better productscost more to manufacture and thus raise prices for consumers; greensourcing means giving up the idea that environmental quality costsmore. Take, for example, the trade-off between petroleum-based andsoy-based lubricants used for manufacturing. At first glance, petro-leum seems the cheaper choice, at $1,500 for an annual purchase of300 gallons, compared with $3,195 for soy. But petroleum has coststhat are not immediately obvious: $300 per year in waste, $2,400 inspill administration, $1,000 to minimize the waste from spills.When these factors are taken into account, the monetary cost ofusing petroleum-based lubricant for a year is $5,200 — and that’snot considering the less quantifiable environmental cost of using anonrenewable resource. With no such add-ons, soy is clearly themore cost-effective choice, in addition to being more environmen-tally friendly.

Furthermore, green sourcing leads to holistic efficiencies byforcing companies to pay continual attention to the whole supplychain and their overall carbon footprint. (See Exhibit 1.) The pitfallsof focusing on just one area were borne out by a study conducted


for Trinity Mirror PLC, a U.K. newspaper publisher, by the CarbonTrust, a U.K.-based research and advisory group, on how to reducethe ecological impact of Trinity Mirror’s publications. The easyassumption would be to move from virgin paper to recycled, but theCarbon Trust found it was not that simple. Looking at the entirevalue chain, the group determined that 80 percent of the total car-bon emissions come from paper production. If the supplier thatmakes the paper uses a carbon energy source to make 50 percentrecycled paper, it actually creates greater carbon emissions than itwould by using a hydraulic energy source to make 100 percentvirgin paper. As a result, the Carbon Trust indicated that the idealsolution would be to buy paper with high recycled content from asupplier using low-carbon energy sources.

Brand appeal. Just as Ford Motor Company became indeliblyassociated with quality during the years of its “Quality Is Job One”ad campaign, a few forward-looking brands today are making greenlook both functional and cool. For companies that want to do the

Green Sourcing 67


Exhibit 1: Simplified Life-Cycle Analysis in Paper Production

Reuse

Disposal

Conducting a life-cycle analysis with a value chain perspective uncovers greenersourcing alternatives.

Raw Material Procurement• Use more recycled paper fiber, a thinner

grade, or a smaller trim size• Use alternative fuels• Use paper from a sustainably managed source• Minimize colors and coatings or use soy-based ink

Recycle• Use bleaching that is totally chlorine

free or free of processed chlorine• Use alternative energy sources for

purification and removing ink

Processing/Manufacturing• Use alternative energy sources for production

such as renewable energy (wind, solar, andhydropower) and biomass (combustion of woodfuel and paper sludge)

Use• Use alternative-fuel or hybrid vehicles• Print double-sided pages• Reduce consumption

Distributionand Retail

• Use alternative-fuelor hybrid vehicles

• Minimize packaging


same, it’s important for green sourcing initiatives to be tied to thebrand’s identity. Clif Bar & Company, for instance, makes energybars from organic ingredients and promotes a healthy, outdoorsyimage; given that background, the company’s espoused five aspira-tions (to support its planet, community, people, business, andbrands) make sense, as do the measures that support these aspira-tions, such as purchasing all of its energy from NativeEnergy, arenewable-energy wind farm owned by Native Americans and farm-ers; running its fleet on biodiesel; substituting fractionated palmkernel oil for the more frequently used, chemically processed par-tially hydrogenated oil; and using recycled materials for packaging.

Even companies whose products don’t evoke hikes in the SierraNevada can build a green brand, supported by the right initiatives.Look at the Starbucks Corporation. There is nothing intrinsicallygreen about coffee, which had a successful run for many years with-out being tied to environmental sustainability. But from its incep-tion, Starbucks has worked to minimize its environmental impact,whether in store design or in the sourcing of its coffee beans, and itis always looking for new ways to do so. Recently, the companyswitched to thinner trash bags, which reduced the amount of plas-tic it sent to landfills by 750,000 pounds per year and producedannual savings of $500,000. Starbucks has not been shy about shar-ing news of these efforts with consumers; support for the environ-ment is a key part of the company’s brand proposition.

Cross-functional insights into processes. In evaluating the environ-mental impact of the value chain from end to end, the procurementfunction cannot act alone. It must develop a strong sourcing organ-ization that ties together the supply chain, marketing, innovation,and research and development, as well as an operating model thatsustains and supports ongoing collaboration with all these internalstakeholders and with external partners, such as suppliers.

An isolated sourcing organization that has not developed these

Green Sourcing 69

links will be limited to small ventures into green sourcing, such asordering recycled paper or reconditioned toner cartridges, ratherthan comprehensive changes such as those made by Trinity Mirror.Anheuser-Busch Companies Inc. provides a good example of howsuch partnerships can offer advantages that cannot be developed ina vacuum. In conjunction with its suppliers, Anheuser-Buschreduced the lid diameter for four types of cans, saving 17.5 millionpounds of aluminum in 2006 — which not only reduced theamount of energy needed to produce, transport, and recycle thecans, but saved money as well.

Elements of an InitiativeTo reap the benefits of green sourcing, companies must tackle theissue at a number of levels, from the visionary down to the tactical.(See Exhibit 2.)

Setting a vision. Appropriately conceived, a green sourcing initia-tive allows a company to create an internal and external identity foritself, as opposed to having its identity defined by outsiders. In

Exhibit 2: A Framework for Building Green Sourcing Capability

A variety of capabilities come together in a green sourcing strategy, with decision rights andinformation flows aligned holistically. The broader the section of the triangle, the more peoplewho are directly involved; arrows represent directly designed information flows, trackingresults in cost savings and waste reduction and tying all the parts of the supply chain together.

Set“green”

direction

Reduction Reuse Recycling

Life-cycle analysis, trade-off evaluation,demand management, procurement, contract negotiation

Policies and procedures,innovation, staff development,

investment in eco-technology, suppliercollaboration, adoption of targets and metrics

VisionCEO and top team

StrategicBusiness unit leaders andchief procurement officers

TacticalDay-to-day operations

OperationalLine management

Operationalmeasures

is, tra

Business metrics

Insight



devising an overall green vision, a company should consider itsbrand image, mission, and history; companies with a portfolio ofbrands should look at each one to understand how its image can belinked to green initiatives. 3M Company, for example, has a 32-yearhistory of building its green identity. It has defined its vision as a

At Kaiser Permanente, green sourcing isjust one part of an overall corporatestrategy that reflects the deep roots thatenvironmental awareness has in the orga-nization’s culture.

“Rachel Carson, who is still recognizedas one of the people who kicked offthe environmental movement, came toaddress a number of Kaiser Permanentephysicians back in 1963,” says RobertGotto, senior sourcing director for KaiserPermanente, an integrated health planand provider based in Oakland, Calif.,that provides care to members througha network of hospitals and clinics. “Shewas a pretty controversial figure at thetime, and Kaiser Permanente reached outto her because the physicians wanted tounderstand her ideas and how they wererelevant to the health-care industry.”

Nearly a half century later, care forthe environment is almost as firmlyembedded in the organization’s culture asis care for patients. In 2001, KaiserPermanente formed an environmentalstewardship council that chose threemajor areas of focus: green buildings,environmentally responsible purchasing,and environmentally sustainable opera-tions. The decision to make purchasinga major part of the strategy stemmedfrom the fact that Kaiser Permanentespends about US$14 billion per yearon various products and services, and it

wanted that money to be spent in a waythat supported the company’s values. Itturned out that making purchasing deci-sions based in part on environmentalcriteria didn’t just “save the earth” — italso saved money.

“One of the myths you have to addressright up front is that cost-cutting initia-tives and environmentally responsibleinitiatives are in any way in conflict,” saysGotto. “We have a list of more than 30initiatives, delivered through the greensourcing program, in which we made en-vironmentally preferable choices. Most ofthose initiatives have been cost-neutral,but there have been a significant numberthat have delivered cost savings — about$9 million annually. None of them haveinvolved a cost increase.”

Some savings have come from meas-ures unique to the health-care industry,such as replacing some single-use medicaldevices (such as trocars, which are portsthat introduce instruments into bloodvessels) with those that can be re-processed by suppliers and safely usedagain; this initiative represents savingsof about $2 million annually for KaiserPermanente. Others are more widelyapplicable, such as the organization’s pol-icy that all desktop and laptop computersbe purchased according to ElectronicProduct Environmental Assessment Toolguidelines, which ensures that the level

A Permanente State of Green

Green Sourcing 71

commitment “to actively contribute to sustainable developmentthrough environmental protection, social responsibility, and eco-nomic progress.” To pursue this commitment, the company decid-ed, among other things, to use life-cycle management across itsbroad product portfolio to continuously lighten the burden of its

of energy consumption and the extent oftoxic materials used are factors in thepurchasing decision. Thanks to the re-duction in energy consumption in theuse of these computers, the U.S. En-vironmental Protection Agency (EPA) es-timated that Kaiser Permanente wouldsave about $4 million per year.

These examples underscore the keyrole that Kaiser Permanente’s suppliersplay as external partners in its greensourcing program. The relationshipswere a challenge in the early stages ofthe program: Suppliers were slow torespond or were even resistant to thecompany’s environmental goals, whetherbecause they were concerned that reveal-ing the chemicals in their products wouldmake them vulnerable to litigation orbecause they felt there was not enoughdemand for environmentally friendlyproducts from the rest of the health-careindustry.

In response, Kaiser Permanente estab-lished a strategic program in which itworks with key suppliers to identifyenvironmental opportunities and findmutually acceptable solutions. The com-pany’s sourcing department also makesa point of seeking out other businessesin the health-care industry that haveenvironmentally sustainable cultures,such as Johnson & Johnson and BaxterInternational Inc. Its aim is to learn from

its peers’ programs, exchange ideas, andconsult with the others about customerpriorities — all with the objective ofencouraging change. Finally, the com-pany has recently begun using an auto-mated sourcing tool that measuresenvironmental criteria in weighing sup-pliers’ proposals.

The organization’s holistic approachto developing a green sourcing programled it to the conclusion that it couldaccelerate the impact through partneringwith others. Therefore, in 2007, KaiserPermanente launched a global healthand safety initiative that brought to-gether supply chain leaders from morethan 20 U.S. health-care systems, aswell as government agencies, includingthe EPA; nonprofit organizations, suchas Health Care Without Harm; andgroup purchasing organizations, whichdo the contracting for 90 percent ofmedical expenditures in the U.S. Themembers of this informal consortiumrecognized that a united approach togreen purchasing would acceleratechange within the supply chain. To thatend, Gotto now meets monthly with anumber of U.S. health-care supplychain colleagues. One of the group’s firstgoals is to identify the products in theindustry that have the most environmen-tal impact and to find more sustainablealternatives.

products on the environment, to set and achieve aggressive pollutionprevention goals, and to make such prevention profitable by devel-oping new technologies and products to serve that market. Thisstrategy has led to the reformulation of many of 3M’s products andprocesses, reducing the amount of pollutants it would otherwisehave emitted over the last 32 years by 2.6 billion pounds and savinga total of $1 billion.

Other companies are in earlier stages of this process. CadburySchweppes PLC, for example, launched its “Purple Goes Green” ini-tiative, so named for the distinctive hue of its candy packaging, in2007 with the goal of combating climate change by reducing itsuse of energy, packaging, and water. The company is backing upits vision by setting concrete goals to achieve by 2020: It aims to cutits carbon emissions in half; reduce its packaging by 10 percentper ton of product; introduce water-reduction programs in water-scarce sites; and use more environmentally sustainable forms ofpackaging, including 60 percent biodegradable and 100 percentrecyclable packaging.

Determining action.With a vision in place, a company must definethe activities that will make its vision a reality. These fall loosely intotwo categories. First (identified as “strategic” in Exhibit 2) are thebroad, all-encompassing activities that support the execution andbranding of greenness at the company level. These are the measuresthat allow the company to meet the objectives outlined in its vision— to take the Cadbury example, using alternative energy sourceswould be one of the activities underscoring the company’s vision ofreducing carbon emissions. Marketing efforts, such as the creationof the Purple Goes Green program and its dissemination to thepublic, are also included in this category. The marketing of greenefforts should generate recognition and goodwill among consumers,employees, and other stakeholders.

The second category is made up of more narrowly targeted oper-


Green Sourcing 73

ational and tactical activities that are specifically intended to drivebusiness and increase revenue and profit for a particular brand,product, or service. An example is promoting a newly repackagedproduct to consumers on the basis of its reduced material content orits new biodegradable packaging.

Managing demand. In strategic sourcing, demand managementtypically entails specifying the right product with the right charac-teristics and the right price point to provide the best value to thecustomer without creating a disadvantage for the company — forinstance, by adding unnecessary cost complexity. Green sourcing hasthe same goals, but seeks to meet customers’ needs while adheringto an even more stringent set of specifications, such as tryingto identify opportunities to reduce emissions. Companies need tounderstand their customers’ needs and develop their green strategyaround those needs, providing visibility into customers’ habits ver-sus the value and cost associated with options in, for example, prod-uct design or packaging specifications. With this information on thetable, a company can work to serve its customers while crafting solu-tions in line with its overall green strategy.

Building collaborative supplier relationships. Suppliers can be keypartners in helping companies develop green sourcing strategies,offering ideas about product innovation and how to reduce environ-mental harm throughout the supply chain. For instance, a companysourcing a particular kind of produce would need suppliers’ input todetermine which would have more of an effect on the overall carbonfootprint — sourcing produce grown locally that requires a hot-house or sourcing it at a distance with the associated transportationimpact. This was the trade-off that the U.K.’s Marks & SpencerPLC studied in early 2007, when the retailer announced that itwould double its regional food sourcing, minimize the amount offood transported by air, and mark all food that did travel by airfreight with the label “flown” to make consumers aware of the


carbon impact of that purchase. A company can also help its suppli-ers develop their own green sourcing initiatives, as integrated healthplan and provider Kaiser Permanente is doing with its partners.

Conducting cradle-to-cradle analysis. Such analysis examines theentire life cycle of a product or service with the goal of producing it,distributing it, and disposing of it (or, in the case of a service, dis-posing of the materials and by-products associated with it) in a waythat renders its total impact environmentally neutral. As one canimagine, it’s an intensive exercise and may not be realistic in everycase. However, even a focus on a few high-leverage areas can uncov-er significant savings. For example, Sonoco Products Company, asupplier of industrial and consumer packaging, found that usingcomposite materials instead of steel in its cans would reduce thecans’ weight by 27 percent, the energy their production required by34 percent, and greenhouse gas emitted in the process by 20 percent.

Implementing material, technology, and process innovation. Sourcinglooks at using the right kinds of materials, technology, and process-es supported by the right kind of organization. In traditional strate-gic sourcing, this may entail finding low-cost, high-value sourcingmaterials, making technology more efficient, or developing newinventory control techniques. In green sourcing, it may mean work-ing with suppliers to purchase materials with a higher percentage ofrecycled content, to implement technology that is more energy effi-cient, or to develop more paperless transactions. In all cases, imple-mentation demands an end-to-end perspective on production andservice costs, including key cost drivers.

Measuring a set of the gains. All of these elements must be support-ed by appropriate metrics (shown as arrows to the right of the trian-gle in Exhibit 2). Measurement is a critical element, yet one that fewcompanies have tackled; those that have waded in are using a vari-ety of standards as they attempt to certify and audit their green prac-tices and those of their suppliers. A number of industries have heard

Green Sourcing 75

calls for standardization, which must be heeded as soon as possible.Difficulty in measuring results is a major reason that green ini-

tiatives fail. As with traditional strategic sourcing, the final (andongoing) step in a green sourcing plan is to set specific targets andmeasure the results. One groundbreaking program involving suppli-ers has been implemented by Wal-Mart Stores Inc., which requiresits suppliers to respond to questions about their packaging, provid-ing such details as the amount of recycled content used and the ratioof product to package. Wal-Mart assigns each supplier a score basedon its answers. The company will use this data to reduce the amountof packaging it uses by 5 percent by 2013. About 97,000 productsare currently being evaluated in this way; the company aims to put160,000 through the process.

Hewlett-Packard Company also uses a sophisticated audit pro-cess; it evaluates its suppliers’ environmental permits and reporting,pollution prevention and resource reduction, hazardous substances,wastewater and solid waste, air emissions, and product content. Thecompany further recognizes that its effect on the environmentstretches beyond its own processes and those of its suppliers, andthus trains suppliers to audit their own partners.

Developing metrics is challenging. It is difficult to measure thebenefits of green sourcing because they cut across so many dimen-sions. Whereas the value of reduced errors could be easily quantifiedduring the early days of the quality movement, the positive resultsof, for instance, cleaning up a manufacturing process may beharder to measure because they involve so many parameters, includ-ing customer goodwill, political regulation, and operational costs.However, leading companies have already begun measuring them-selves on such elements as greenhouse gas emissions, energyefficiency, the use of environmentally sustainable raw materials, thecarbon footprint of facilities, and water efficiency. Setting concretegoals along these lines — as Cadbury and others have done — and


communicating explicit targets to suppliers are highly motivatingways to make sure that the vision set at the highest level is realizedin practice.

In attempting to quantify the benefits of green sourcing, it’simportant to remember that it is a long-term effort and to strategizeaccordingly. The quality movement, for instance, took severaldecades to achieve sustainable results, and there was a further lagbefore its reputation caught up. Companies should aspire to earlyvictories to build support but recognize that green sourcing is not aquick fix.

Pushing through UncertaintyAlthough many companies have undertaken some steps towardgreen sourcing, most have yet to take a holistic approach that pro-vides a comprehensive view of its benefits or ties it to overall corpo-rate strategy. Companies need to better assess their efforts at greensourcing and improve its impact on growth and the bottom line.

Just as the current state of green sourcing reminds senior man-agers of the excitement of the early days of the quality movement, ithas also spurred other emotions. The dawn of any change move-ment in operations and practices is marked by uncertainty, concern,and even fear. But green sourcing has amassed enough evidence ofits value to prove that it, like quality, is no flash in the pan. For thosewho persevered with quality initiatives, the rewards were substantialin cost savings, more effective operations, and a stronger connectionwith customers. Those companies that fully engage today in greensourcing can look for comparable results. +

Editor’s Note:

First published as “Start with Sourcing” in strategy+business, Summer 2008.

The Building Blocks of aNew Sourcing Approach

RETAILERS HAVE HISTORICALLY maintained an adversarial relationshipwith consumer packaged goods (CPG) companies, their primarysuppliers. Negotiations over price, promotional support, and mar-keting budgets, among other persistent areas of disagreement, oftenresult in damaged relationships and minor gains — only to have thefights resume the following year. For some buyers, this annual wran-gling is seen as an important part of the job — and even fun. Tothem, facing down suppliers is a kind of sport.

But if their goal is to maximize profitability, buyers would bewise to take up tennis instead. As good as old-fashioned hagglingmay feel, it generally results in very little actual good, as retailers andsuppliers overlook the many ways that they could gain from theirpartnership.

Changing these old habits is not a particularly new aspiration.For more than a decade, retailers and suppliers have tried to learn tocollaborate more and move beyond the old zero-sum games. Theirinitiatives have included assigning “captains” to work with eachother on ways to drive category growth and forming industry groups(such as Efficient Consumer Response and Collaborative Planning,Forecasting, and Replenishment) that pursue supply chain opti-mization. Yet despite all the hard work, only partial success hasbeen achieved. A recent Booz & Company survey of European

The Collaboration Game: BuildingValue in the Retail Supply Chainby Simon Harper, Pertti Heinonen, Amit Kapoor, and Marco Kesteloo


The Collaboration Game 79

retailers and manufacturers found that less than 20 percent ofrespondents were “very satisfied” with the results of their currentcollaborative initiatives.

Even now, the most successful collaborative relationships aremostly pilot projects involving a retailer and a single supplierfocused on fixing a particular problem in a particular category. Onlyabout 30 percent of the projects involve multiple partners and mul-tiple categories, according to Booz & Company research. Broad-based strategic collaboration remains a rarity, and most retailers stilldo not consider building collaborative value a core activity.

Watch Value, Not PriceRetailer–supplier partnerships have failed primarily because buyerstend to view their value in a limited way: purely as a means ofextracting lower prices or extra promotional dollars from CPG sup-pliers in their yearly negotiations. Buyers often walk away from anegotiation feeling successful, unaware that their victory may wellhave been compromised by the failure to address issues that couldhave much more impact on retailer and supplier profits, such as in-store availability. The shelves are still not fully stocked, and whatseemed like a highly profitable day’s work is actually only a slightlylarger share of a smaller pie.

These negotiations overlook proven opportunities for enhanc-ing revenues and profits simply because the annual dialogue aboutproducts and prices traditionally includes only retail buyers andthe suppliers’ field sales teams. This restricted dialogue eliminatesthe possibility of external and internal partnerships that can raisethe level of the negotiation and add value to the annual supplyplan. Having the buyer be the sole point of communication withthe supplier also encourages a silo mentality within retail compa-nies, in which buyers are separated from their peers in marketing,supply chain, planning, and store operations — and that results


in much less creativity in dealing with suppliers.Companies that want to build holistic relationships with select-

ed suppliers across the value chain that can result in higher revenueand lower costs than the old haggling habits must pursue collabora-tion and cross-functional participation. More cooperation at annu-al purchasing meetings and during the year could improve returnsfor those on both sides of the negotiating table. For example, aretailer can provide more advantageous shelf availability to a CPGcompany if the two parties agree on joint programs for replenish-ment merchandising and promotion. Programs like these requirethe up-front participation of store operations and supply chain plan-ning managers. And this is not a unique example. A wide spectrumof possible collaborative measures can raise revenue, improve effi-ciency, and cut costs for both retailers and their suppliers. (SeeExhibit 1.)

Revenue/margin enhancement.Working jointly to harness comple-mentary skills and apply the knowledge needed to grow a categorycan be a win-win proposition. This effort can be as simple as link-ing the supplier’s consumer insight to the retailer’s promotionalcapabilities. For example, Migros Türk Ticaret Anonim Sirketi, oneof Turkey’s largest supermarket chains, worked with Unilever to useconsumer response and store layout data to increase sales of hairconditioner. Beginning with a survey conducted at an interactive in-


Revenue/Margin Enhancement Process Improvement

Exhibit 1: Collaborative Levers for Enhanced Profitability

• Increasing penetration ofcore products

• Building multiyear strategies togrow/build the category

• Managing/reallocating shelf spaceand products

• Driving consumer convenience andimpulse shopping

• Collaborating more closely withprivate labels

Cost Reduction

• Launching new productscollaboratively

• Improving effectiveness of marketingefforts

• Jointly improving promotion planningand management

• Practicing life-cycle management• Utilizing POS data and improving

on-shelf availability• Improving demand forecasting

• Decreasing shortage• Enhancing distribution efficiency• Redesigning display operating model• Optimizing the role of merchandisers• Reducing returns• Improving efficiency through supply

chain improvements


store coupon kiosk, Unilever and Migros discovered that shopperswere not buying hair conditioner for a variety of reasons, includingsimply feeling that they didn’t need to (18 percent) and believingthat it was too expensive (12 percent). With that new knowledge,Migros and Unilever tweaked their sales program, increasing pricepromotions and reallocating shelf space so that conditioner andshampoo were sold together in hopes of establishing conditioner asa necessity in the shoppers’ minds. As a result of this campaign,Migros’s overall conditioner revenue increased by 25 percent, andthe chain’s sales of Unilever conditioner grew by 36 percent.

Process improvement. A wide range of supplier-related processescan be improved by more collaborative retailer–supplier relation-ships, including promotion planning and execution, demand fore-casting, and stock replenishment. One of the best sources of in-formation for improving these processes is the retailer’s point-of-sale(POS) data. For instance, by examining POS data to identify pur-chasing patterns at certain Tesco supermarkets, Kellogg Companyfound that most of its out-of-stocks at the United Kingdom retail-er’s stores occurred midweek, in the afternoon. Consequently,Kellogg’s adjusted its shipping schedules — and in the processhelped Tesco recapture more than £2 million (US$4 million) in lostsales and improve customer satisfaction. In a similar initiative, KraftFoods Inc. used U.K. food retailer J Sainsbury PLC’s POS data toimprove in-store availability of cheeses during promotional periods.The accuracy of forecasted returns from promotions increased by 20percent, reducing the risk of both understocking and overstocking.

Cost reduction. Supply chain improvements such as more efficientdistribution, streamlined inventory, increased product availability,and improved merchandising operations are all within reach of col-laborative retailer–supplier relationships as well. For example, largeU.K. health and beauty retailer Boots, working with a leading sup-plier of hair accessories, came up with a system to cut labor costs and


improve the supplier’s displays at the same time. By designing anintuitive, color-coded product display system, the retailer cut setuptimes from 60 minutes to about 15 and reduced overall storerebuilds from eight weeks to two; this faster path to installing andchanging promotional campaigns helped Boots increase sales of hairaccessories by double digits in the first year alone.

From Supplier to PartnerDespite the promise of collaboration, few retailers have succeeded increating such partnerships with their suppliers. It is not difficult tofind pockets of excellence within a given retailer–supplier relation-ship, such as buyers who work diligently on promotional planning,but these tend to be isolated successes — more like pilot programsthan established partnerships. Most retailers have found it difficultto expand successful pilot programs into a broad, strategic agendafor deeper supplier collaboration, largely because of the challengeinvolved in learning to work cross-functionally.

Nevertheless, this challenge can be met. Broad-based collabora-tion between retailers and suppliers is possible if careful attention ispaid to how the relationship is structured. A few key guidelines canmake all the difference in undertaking this task:

Generate a full basket of possibilities, but home in on a few prioritized

opportunities that are most important to both businesses. Think holisti-cally about revenue and cost, and challenge current ways of workand operating procedures in order to identify as many potentialavenues to improvement as possible. Although some of these oppor-tunities can be pursued unilaterally, the best opportunities for col-laborative sourcing improvement are typically those where the data,skills, and insights of the supplier and retailer intersect.

Establish an open dialogue, but make sure that the terms of all agree-

ments are explicitly defined up front. Specific agreements on targets,responsibilities, and accountabilities should be locked in as early


as possible, along with explicit expectations.Create transparency by sharing benefits, costs, and information openly,

but build in appropriate confidentiality measures. Collaborative partner-ships require parties to move “beyond the gut” to a more fact-basedrelationship. This cannot succeed without trust and transparency.An up-front agreement on how to share data across the value chainis essential — as is a clear understanding of how the companies willshare the benefits and costs of their joint initiatives. Perhaps evenmore important for building trust is a clear understanding of theareas that each party wants to keep off-limits.

Set both short- and long-term agendas with supply partners to capture

value quickly but still pursue the big ideas. Find a mutually beneficialimprovement idea that will provide each partner with a quick gain.This will help build momentum for tackling more complex, andoften more lucrative, opportunities down the road.

Gain top-level support, but stay focused on the execution. Col-laboration is less a matter of what is agreed on in the boardroomthan what is actually done in the warehouse and on the shelf. Onlyby managing and monitoring progress with adequate tracking pro-cedures and metrics is it possible to drive success.

Be more open with all suppliers, but choose collaboration partners

wisely.Given that a collaborative approach is more resource intensiveand requires more cross-functional engagement than other ap-proaches, supplier partners should be selected on a broad set of cri-teria that go far beyond their share of the supply spend. The chosencandidates should reflect the retailer’s strategic aspirations anddemonstrate a serious interest in building a deeper relationship. Theselection should also reflect where a collaborative effort can yield themost value creation, such as taking aim at low-margin categories orpoor supply chain performance.

One northern European retailer followed these guidelines tovery good effect. This retailer had been playing the same old price-


based game as competitors whittled away at its once dominant shareof a stagnant national market. Then, a major global retailer, whichenjoyed a significant cost advantage, announced its intention toenter the retailer’s home market — a move that was expected to cre-ate a much more severe and sudden decline in the retailer’s results.Faced with this grim news, the company’s executive team decided torevamp its strategy.

One of the most daring changes the executives undertook camein the form of an offer to the company’s biggest suppliers: “Workwith us to review the entire value chain, from production all the wayto the shelf, to look for opportunities to improve performance andrevenue,” they said. “Afterward, we’ll make those improvements andshare the gains equally.”

More than 10 top suppliers agreed, and all the players set towork. The partners agreed to a three-year commitment, which gavethe retailer and its suppliers ample time to understand and improvecomplex processes for mutual gain. The commitment also encour-aged the retailer to invest in the process of building a strong individ-ual relationship with each strategic supplier, as well as developingthe internal capabilities needed to ensure sustainability, includingcoaching and skills transfer. At the same time, the partners stayedfocused by agreeing to identify improvements and establish plansnot in months or quarters, but in just eight weeks, making it easierfor both sides to dedicate the staff needed to improve their systems.

Further, the retailer made a genuine commitment to openness.All partners shared data to gain a more complete sense of the valuechain. When the data was sensitive, to help reassure suppliers that itwould not be used against them, it was routed through a third party(in this case, Booz & Company), which acted as a neutral broker toprotect the data from misuse.

After the opportunities were identified, plans were drawn updetailing a new operating model capable of capturing the potential


gains. At the same time, the retailer’s executive team worked to insti-tutionalize the tools and techniques needed to make the changeshappen. And even as immediate gains were achieved, many long-term changes were undertaken to ensure that the forward momen-tum was maintained.

This collaborative effort has already added 5 to 10 percent invalue to overall profitability across all 10 suppliers. Two-thirds of thegains were generated by incremental sales, and one-third came fromcost reduction. Value was added in many ways, including increaseduse of private labels, improved shipping and logistics, and bettercooperation between suppliers. The biggest single source of value:better category management, which was responsible for roughlyone-third of the overall gains.

After so many false starts, it is tempting to dismiss retailer–supplier collaboration as an idea that looks good on paper but isnearly impossible in practice. In fact, as the retailer described abovediscovered, collaboration can work. Trust is a key ingredient: Oncesuppliers feel certain that strategic partnership proposals aren’t justanother negotiating trick, many of them are keen to drive such part-nerships forward. As with any successful commercial partnership, itall comes down to ensuring that both sides gain from the venture. +

BY NOW, MOST companies have ridden one or more strategic sourcingwaves that have collectively saved their organizations billions of dol-lars. Yet even after having benefited from these initiatives, the aver-age company still leaves on the table unrealized savings equaling 5to 10 percent of its total spending. These savings are not lost becauseof ill-conceived strategies or organizational incompetence; rather,their loss is inherent in flawed or incomplete procurement operat-ing models.

There are many reasons that the operating models constructedto procure and pay for goods and services prove inadequate. Theymay not include the processes, tools, or resources needed to fullyexecute the sourcing strategy. They may not be properly connectedto organizational decision making or sufficiently integrated into keycorporate planning processes. Decision-making authority and ac-countability may not be clearly defined. Or the IT systems thatenable them may be fragmented, impeding efficiency and cloudingthe visibility necessary to ensure compliance with overall purchasingpolicies and objectives.

In order to mitigate these problems and deliver on purchasing’scost, quality, and service commitments, companies must evaluateand design their procurement operating models along four fun-damental dimensions: organization, processes, technology, and per-

Procurement’s New Operating Modelby Patrick W. Houston, Robert Hutchens, and Alan S. Pincus


Procurement’s New Operating Model 87

formance management. (See Exhibit 1.) Together, these four ele-ments determine an operating model’s effectiveness at executing acompany’s sourcing strategies. And because any model is only asstrong as its weakest link, each element must be developed fully andaligned properly. A company may develop a series of nearly perfectprocurement processes, but without clearly defined mechanisms formanaging and measuring performance, procurement will struggle toensure compliance and achieve its overall strategic goals. Similarly,procurement technology may provide all the information needed forexecutives to make well-informed purchasing decisions, but thatcapability is largely meaningless if the procurement organization hasnot also clarified the decision rights that identify who will makethose decisions and be accountable for their outcomes.

Most procurement organizations excel along one, two, or eventhree of the operating model dimensions, but very few have fullydeveloped and aligned all four of them. Some companies need to

Exhibit 1: Today’s Procurement Operating Model


• Capabilities• Structure/alignment• Roles and responsibilities• Decision rights

• Strategic• Tactical• Executional• Client relations• Supplier management

• Systems functionality• Decision support tools• Accessibility/usability

1. Organization

3. Technology 2. Processes

4. PerformanceManagement

• Metrics• Management process


travel only a short distance to properly integrate the four dimen-sions; others face a more arduous journey. But no matter how longor difficult the road ahead, the best way to begin is to view the pur-chasing function as a broad, cross-enterprise activity incorporatingall elements of the procurement process, from sourcing throughcontract negotiation, demand management, procure-to-pay, sup-plier relationship management, and measurement and tracking.Such a view enables companies to better see the gaps in their oper-ating models and address each of the four dimensions.

OrganizationThe top priority in putting together a powerful operating model isnot the issue of overall centralization or decentralization; it is deter-mining how best to structure procurement’s various roles in corpo-rate, business unit, and functional-level purchasing. Should theprocurement function own, control, and manage the entire processfor every corporate stakeholder? Should it participate actively in thepurchasing decisions and processes of the individual business units,

Exhibit 2: Procurement Organization


• Creative services• Specialized production equipment• Customized finished parts

• Printed products• Temporary labor• Maintenance, repair, and

operational (MRO) needs

• Travel agency• Office supplies• Utilities

High Degree of Business Typical ExamplesUnit/User Involvement

• Item is complex,nonstandardized, and criticalto business success

Support Model

Procurement teamprovides support to

users of item

Facilitate Model

Procurement teamfacilitates effort acrossmultiple users of item

Manage Model

Procurement teammanages process on

behalf of users of item

Low Degree of BusinessUnit/User Involvement

• Item is standardized and notcritical to business success


functions, and geographic regions in which the company operates?Or should it merely carry out those purchasing decisions?

Deciding where to land on this spectrum of options, from man-aging to facilitating to supporting, involves sorting out a complexmix of issues: How will the decision affect a company’s ability to getthe most bang for its buck? How will it affect the choice of suppli-ers, their degree of engagement in the procurement process, and thenature of the company’s relationships with them? Would completeownership of the function allow for greater process efficiency, orwould the potential resulting inflexibility make the process less effi-cient? Would purchasing’s alignment with overall strategic goals suf-fer if procurement were to take on the role of passive supporter?

In our view, the ideal procurement organization must balancethe desire to leverage purchasing power through complete owner-ship with the need to maintain the flexibility of the individual busi-ness units, functions, and regions. That balance is struck not onlyin the way procurement — and its accompanying processes andtechnologies — is structured, but in how the various roles, respon-sibilities, and decision rights are allocated between the corporateprocurement organization and the various procurement functionsattached to the business unit, functional, and regional stakeholders.

As Exhibit 2 illustrates, the amount of influence exercised bycorporate procurement should vary depending on what is being pur-chased and by whom. When specific business units or functionsmust purchase complex, business-critical, nonstandardized itemssuch as specialized production equipment and materials or cus-tomized finished parts, the business units and functions should con-duct most of the sourcing and procurement activity because theeffective purchase of such goods and services depends on the knowl-edge of the user. Central procurement could play a “support” role,performing cost modeling or providing industry and market re-search, but the business unit or function would make the actual sup-


ply decisions and structure its own implementation strategies.For products or services that are less business specific but still

must be somewhat tailored — such as temporary labor or mainte-nance, repair, and operational needs — procurement might play afacilitating role on behalf of a wider variety of business units or func-tions. It might establish, for example, the guidelines for evaluatingand scoring requests for proposals, while the business unit deter-mines the exact specifications for the products or services it needs.

Finally, for purely standardized purchases that are not critical tobusiness success, such as travel, office supplies, and utilities, procure-ment should completely manage the process from start to finish.

Every purchasing department must identify where and how toexert its influence and leverage its knowledge of process and tech-nology, managing where necessary, facilitating where desirable, andsupporting where most helpful. Doing so will allow it to determinethe structure best suited to its various roles and the processes, tools,and capabilities needed to ensure that it has the maximum impacton overall spending.

ProcessesEvery purchasing organization that stands out from the pack main-tains carefully defined and disciplined processes at every level, fromstrategic to transactional, across the entire procurement life cycle.Just as important, end-users across enterprises that manage the pro-curement process successfully understand those processes and will-ingly adhere to them — even when purchasing does not “own” theprocurement decision. Well-structured, widely understood process-es enhance transparency and ensure compliance with procurementguidelines, thus enabling companies to capture even more savings.

Purchasing processes break down into three categories: sourcingstrategy, execution, and ongoing supplier and customer manage-ment. Sourcing strategy processes typically harbor a great deal of


value, because they determine spending patterns, define require-ments for products and services to be purchased, structure rela-tionships with suppliers, and develop supporting contractualarrangements and internal policies. The challenge in optimizingsourcing processes lies in clearly defining and implementing them insuch a way that they consistently drive fact-based, cross-functionaldecision making. Ultimately, these processes must generate theinsights into economic and market conditions and internal demandneeded to select the right supply structure and supplier pool for thecompany as a whole.

Procurement execution processes encompass activities such asrequisitioning, purchase orders, goods receipt, and invoicing. Here,procurement should seek to establish clearly structured, easilyunderstood, and easily used systems and tools to streamline execu-tion and manage compliance on the part of end-users. Often over-looked, procure-to-pay processes generally deserve close attention,as the benefits of consolidating and streamlining them can reduce acompany’s total spending by 1 to 5 percent. Still, many companieshave yet to holistically review the processes (many of which are frag-mented legacy structures) that support procure-to-pay activities.This inattention can undermine compliance, weaken adherence tofavorable pricing terms, and encourage maverick buying amongend-users.

Finally, the processes for ongoing supplier and customer man-agement are vital to the success of any procurement operation. Thenew paradigm in dealing with suppliers is collaborative relation-ships, which allow companies to work closely with vendors to bestmeet both parties’ needs. However, the cooperative nature of suchrelationships demands far greater participation on the part of pro-curement professionals in order to capture the hoped-for gains incost savings, service, quality, and innovation.

At the same time, procurement must design clear processes


for actively managing its relationships with business unit and func-tional end-users, as well as internal demand. This will, in turn, allowprocurement to play a greater role in the improvement of end-users’ decision making. To do this, procurement needs to be inte-grated both at the front end — aiding end-users in developing theirsourcing strategies and processes — and at the back end, assessingwhether end-users are complying with procurement policies andcontract terms.

TechnologyUltimately, procurement processes are only as good as the systemsand tools that support them. There are multiple approaches to pro-curement IT, but the objective is invariably twofold: to enable thewide variety of purchasing transactions on which every companydepends, and to arm decision makers at every level with meaningfuland actionable information in a predictable, easily accessible manner.

Minimally, procurement IT systems must ensure that all trans-actions — both internal and external — are carried out consistent-ly, and that decision makers have a clear view of all elements of thecompany’s purchasing. Surprisingly, many highly sophisticated pro-curement systems cannot boast either of these attributes, typicallybecause they were built for financial reporting and budgeting pur-poses and are not set up to furnish sufficient data about procure-ment performance or to facilitate procurement transactions.

Fortunately, the solution to the technology challenge in procure-ment, discussed at greater length in “Smoothing the Path forProcure-to-Pay,” page 122, is not as sweeping or cost prohibitive asmany procurement executives might fear. Companies do not need astate-of-the-art, end-to-end ERP system to effectively support theirprocurement objectives. Instead, they can use the company’s exist-ing IT infrastructure in combination with various bolt-on systems.

The advent of powerful, best-of-breed Web-based applications


allows for easy integration of any number of functions into the pro-curement system: supplier portals that let end-users source productsand services on their own; end-user interfaces that manage the actu-al procurement process through purchase order and payment; evenperformance management systems that provide increased trans-parency throughout the entire process. Through a combination ofpolicy and systems adjustments, supplements to existing IT archi-tecture, and improved data management techniques, these reno-vated systems can boost transaction accuracy and compliance whilegenerating more accurate and timely spending analyses to supportboth supply and demand management decisions.

Performance MeasurementThe final dimension of a successful procurement operating model ismeasurement and assessment of performance. Although specificprocurement metrics vary, top companies typically adopt a commonmanagement process and framework to assess not only the cost sav-ings generated through procurement programs but also how muchvalue procurement is generating on an ongoing basis.

Aided by the technology infrastructure described above, a com-mon framework is typically designed to illuminate a company’sprocurement performance against specific objectives. To be effec-tive, however, performance management systems must providestakeholders with the transparency needed to see and interpret theresults, conveying sufficient information to generate confidenceand buy-in among decision makers. The systems must enable thesekey constituencies to provide feedback regarding methods andresults. The goal is to stimulate a dialogue with business units andfunctions concerning realistic goal setting, joint accountability,and continuous improvement.

A combination of procurement dashboards, budget data, andcontinuing assessment against global benchmarks can help in mea-

suring, setting, and refining overall performance goals. The secret tosuccess in performance management, however, can be captured inthree words: Less is more. Metrics should be focused, practical, andactionable. They should furnish insight into both procurement effi-ciency (such as spending per full-time employee and procurementorganizational costs as a percentage of spending) and effectiveness(including savings and cost avoidance, cost index performance, per-centage of spend under purchase orders, and percentage of spendwith procurement influence). Dashboards dedicated to individualspending categories should highlight not only absolute spendingand savings but, more important, the state of and trends in cost andperformance drivers for that category.

Tracking performance is an integral component of procure-ment’s new operating model if for no other reason than that it helpsprocurement establish credibility with its business unit and func-tional clients.

Procuring Competitive AdvantageThe benefits of adopting the right procurement model for yourorganization are substantial, not only in terms of cost reduction butalso in the ability to better focus resources, enhance value from sup-plier collaboration and innovation, and more fully capture contrac-tual promises.

However, despite having launched successful procurement ini-tiatives, too many companies, in too many industries, find that theyhave yet to complete the journey. They may have made many of theright moves in implementing the latest capabilities across the pro-curement life cycle, yet they rightly suspect there is still significantvalue to be realized. That value, we believe, will come not through abetter or brighter strategy, but through more consistent executionof existing strategies.

Companies that successfully execute a “procurement agenda”



can deliver a great deal of value, but only if they have the right oper-ating model, one that integrates organization structure with best-practice processes supported by appropriate information technologyand performance measurement systems. Of course, the “right” oper-ating model will vary from company to company. It depends on theorganization’s existing structure and culture, as well as the role thatprocurement plays in managing the purchase of goods and servicesacross categories, business units, functions, and geographies. Howmuch a new operating model will affect overall spending varies bybusiness strategy and the broader corporate agenda, but the impactis invariably positive and significant. +

IN THE PAST few years, the price of many commodities has risensharply — jumping precipitously in early 2008 to record or near-record levels. Add in the weakening dollar, weather-related cropshortfalls, increasing market speculation, and general margin pres-sure, and it comes as no surprise that commodity prices are now afront-and-center issue for every company.

Since 2006, oil prices have risen 100 percent, and corn is up 300percent. The turmoil isn’t affecting only agriculture and energy.

Coping with Record-settingCommodity Prices and Volatilityby Patrick W. Houston, Matthias Mueller, and Martha D. Turner


Note: Food commodities index is a composite of corn, soybean, wheat, and rice price indexes.

Source: U.S. Department of Agriculture, International Monetary Fund

Exhibit 1: Commodity Price Increases, 1992–2008

0

100

200

300

400

500

600

200820062004200220001998199619941992

Inde

xVa

lue

Monthly

AllCommodities

Oil

FoodCommodities

(Index: January 1992)

As shown in Exhibit 1, the costs of all key commodities, includingbasic and precious metals and energy derivatives like resin, have bal-looned as well. Price volatility is also rising. In March 2008, aChicago Board of Trade index of price volatility showed that tradersexpected wheat prices to rise or fall by more than 72 percent in thesubsequent 12 months, the highest level of volatility since 1980.Soybean and corn volatility also surpassed historical monthly aver-ages. (See Exhibit 2.)

The degree to which companies depend on any particular com-modity varies across industries, and among individual companiesand products. Yet few sectors have been immune from the recentrun-up in prices. Whether because of the price of steel for cars, resinfor household product packaging, aluminum for soda cans, grain forbreakfast cereals, or jet fuel for airlines, the distress has scarred manybalance sheets. Tyson Foods Inc. reported a loss of US$5 million inthe second quarter of 2008, compared with a profit of $68 millionin the same period a year before, due in part to higher commoditycosts. Procter & Gamble Company reported that higher commod-ity and energy costs reduced its gross margins by more than 220basis points in the first quarter of 2008. And it’s likely that there will

Coping with Record-setting Commodity Prices and Volatility 97

Source: CME Group

Exhibit 2: Historical Volatility Trends in Three Agricultural Commodities

Jan. ’92 Oct. ’94 Jul. ’97 Apr. ’00 Jan. ’03 Oct. ’05 Jul. ’08

%C

hang

e

Monthly

Corn

Wheat

Soybean

(January 1992–July 2008)100%

80%

60%

40%

20%

0%


be much more bad news in the coming years: Although it’s difficultto foretell the length or severity of any given price cycle, mostexperts predict that commodity prices will experience upward pres-sure and volatility through 2012 at least.

Some companies try to soften the impact of rising commodityprices on margins by squeezing efficiency gains out of their supplychains and manufacturing functions, substituting less expensiveitems for costly material components, and streamlining selling,general, and administrative costs. Other companies have succeededin passing along increased commodity prices to customers orconsumers. In 2007, Nestlé SA, the world’s largest food company,increased prices across its strong portfolio of products by 3 percent,compared with increases of 1.5 percent, 2 percent, and 1.6 percent,respectively, in the three previous years. Dow Chemical Company,facing a 42 percent jump in energy costs in the first quarter of2008, imposed an unprecedented 20 percent price increase — thebiggest one-time hike in the company’s 111-year history. Still othercompanies are making more dramatic structural changes to copewith escalating costs. For example, P&G announced that it wasshifting manufacturing sites closer to consumers to decrease trans-portation costs.

But such efforts are one-off, or at least finite, measures — notan enduring plan for dealing with ballooning commodity costs.They are not sufficient in an environment in which a company’ssuccess will be measured by how it buys as much as how it sells. Toprofit in such an environment, a company must create a fine-tunedapproach to handling commodity price shocks that integrates deepinsight into underlying cost drivers with improved pricing trans-parency and strategic foresight. Such an approach cannot preventprices from rising, of course, but it can delay the impact of higherprices, opening a window of time to adjust operational processes tonew conditions in the supply markets and occasionally even creat-


ing a competitive advantage. A strategic approach can also limit thedamage that commodity price volatility and supply disruptions caninflict on quarterly earnings targets, and leave the company betterpositioned for the turbulent years to come.

Traditional Commodities StrategiesThe goal of a successful commodities strategy is threefold: to securesupply, mitigate risk, and minimize pricing volatility. Historically,proactive companies have relied on a range of commodity manage-ment options to meet these objectives. (See Exhibit 3.) The suitabil-ity of each approach differs by commodity and market — asdo the unique circumstances that impact commodity prices. Theutility of each approach is also dictated by a company’s time hori-zon: Some strategies will not change the price a company paystoday — and may even require near-term investment — but could


Option Description

Exhibit 3: Risk Management Options

Characteristics

• Let commodity pricing swing fully with themarket through either a direct or indirectmarket index (e.g., no position)

• Let commodity pricing swing within agreed-onlimits, as contracted directly with supplier(s)

• Fix commodity pricing directly with supplier

• Arrange pricing directly with supplier (1 or 2above), then transact a financial hedge to lockin pricing

• In conjunction with 1, 2, or 4 above, purchase andinventory material in attempt to “buy low”

• Own/take a position in the direct, producingassets of the commodity (e.g., buy the farm/manufacturing plant)

• Lowest cost• Highest volatility• Risk borne by purchaser

• Low cost• Bound volatility• Element of risk shared between buyer and

supplier

• Low cost• No volatility (short term)• Risk borne by purchaser who takes a position

vs. market

• Some cost• Can eliminate volatility• Risk borne by purchaser, who takes a position

vs. market

• Some cost• Managed volatility• Risk of taking wrong bet vs. market

• High fixed costs• Low volatility (usually)• Can be very risky and requires an understanding

of running the new business and an explicitstrategic need

1.Market-basedPricing

2.Collar Pricing

3.Fixed Pricing

4.Financial Hedge

5.OperationalHedge

6.BackwardIntegration


have positive long-term results.Fixed pricing was a commonplace strategy in the past, but it no

longer works. With commodity prices extremely volatile and inmany cases trending nowhere but up, few suppliers are willing tolock in a long-term price, whether it be firm-discounted or evenat-market. A more likely arrangement is market-based pricing,which typically relies on transparent and available barometers suchas market indexes to monitor and set prices. The General MotorsCorporation has an agreement with suppliers to adjust pricesmonthly for parts made from aluminum on the basis of the spotprice of the commodity on the New York Mercantile Exchange. Ahybrid strategy that incorporates a bit of market-based and fixedpricing is collar pricing, which lets the commodity price swingbetween a minimum and maximum. If the cost of the commoditydrops below expectations, the supplier profits because the buyer isbound to purchase it at above-market rates; if the price rises aboveforecasts, the buyer pays less than market rates.

When commodity prices are wavering, companies that are con-fident they have gauged the marketplace well often turn to hedging,which entails using futures or options contracts to minimize adverseprice swings prior to an anticipated sale or purchase of a commod-ity. Consider Southwest Airlines Company. More than 15 years ago,Southwest locked in an aggressive hedging strategy that allowed it tobuy oil at $32 a barrel for 65 percent of its fuel needs in 2006, $31a barrel for 45 percent of its needs in 2007, $33 a barrel for 30 per-cent of its needs in 2008, and $35 a barrel for one-fourth of its needsin 2009. Given current prices of over $100 a barrel, the airline’sseemingly uncanny strategy has given it a significant leg up on itscompetitors, few of which matched the accuracy of Southwest’slong-range reading of the oil market.

For companies that can afford to buy and hold the commoditiesthey need, an operational hedge may be a more viable alternative.


Using this approach, a company anticipating a price increase buys alarge amount of a commodity — enough to cover its needs for thenext few years, for example — at current market prices and puts itin inventory, thus protecting the company from paying more for thecommodity if its price indeed rises. This is a fairly aggressive strat-egy in terms of cost; expenses, such as the use of operating capitaland storage of the commodity, must be weighed against the poten-tial savings of advance purchases.

An even more aggressive strategy favored by some companies isbackward integration. In this process, a buyer simply acquires itscommodity supplier or parts maker — or takes a stake in the com-pany — so that it has a ready amount of the commodity available atthe lowest possible cost. This is a high-risk approach: Besides havingto lay out significant amounts of cash to complete the deal, thebuyer must weave the supplier’s operations into its overall organiza-tional structure and successfully run the new business. Nevertheless,some businesses find that backward integration is the only compet-itive option at their disposal. For example, a major clothing maker,facing a growing demand for products made from organic cotton,was concerned that a shortage of the much-needed commoditywould force it to limit the large volume runs that allowed it to offerretailers apparel at lower prices than its rivals could. Consequently,the company acquired a stake in an Indian organic cotton farm,securing a long-term supply and giving the farmer enough new cap-ital to cultivate more cotton and gain organic certification for addi-tional farms.

Although traditional strategies such as these can still be quiteuseful, many companies have been caught short by the recent pricerun-ups and increased volatility of commodities markets — and arestymied by sharply changing micro- and macroeconomic conditionsthat have led to supply shortages as well as price escalation. They’vefound that many of the old rules no longer apply and that more and


deeper insight into the reasons behind commodity price instabilityis needed. In the past, for example, companies that relied primarilyon indexes and hedging focused on managing price volatility, butassumed a nearly unlimited supply market with some modest levelof seasonal or climatic supply–demand perturbations. As a conse-quence, they have found themselves unprepared to foresee, or han-dle, severe price and supply disturbances occurring simultaneouslyin commodities markets.

One example: A consumer packaged goods (CPG) company wascaught unawares by a sudden spike in synthetic urea (fertilizer)prices, despite its diligence in tracking the price of important feed-stock commodities used in producing it, such as natural gas.Looking more closely — something the company now wishes it haddone sooner — it found that urea prices had recently “broken away”from the underlying feedstock index (as seen in Exhibit 4), a changedriven by lagging capacity in urea plants and supplier consolidation.Furthermore, the CPG company learned that because of urea short-ages, it would face smaller allocations in the upcoming year.

Meanwhile, some of the company’s weaker but more prescient

Source: U.S. Department of Energy, U.S. Department of Agriculture

Exhibit 4: Urea Prices vs. Natural Gas Prices, 1988–2008

$0

$100

$200

$300

$400

$500

$600

1988 1993 1998 2003 2008

Fertilizer

(Urea)

Natural Gas

(Feedstock)

$/S

hort

Ton


competitors, which had taken long-term positions in urea duringdepressed spot markets, realized significant earnings gains and madeinroads into the larger company’s core markets. Faced with thiscompetitive threat, the CPG company had to fight the temptationto embrace rash, short-term steps, such as backward integrationwith a urea provider. Instead, the company undertook a comprehen-sive examination of the market drivers affecting urea prices, whichallowed it to buy a sufficient quantity of the fertilizer to cover short-term needs and mitigate the damage of imminent price escalation.The company also identified several capacity expansion projectsunder way that in the next two to three years would not only easeurea pricing but also provide a short window when supply wouldovershoot demand, offering an opportunity to lock in low prices forthe long run.

Our experience suggests that no matter what the current eco-nomic environment looks like or which strategy is selected to man-age unstable commodity prices, a company must take three steps toensure that its commodity procurement efforts are properly man-aged in terms of cost, risk, and supply and to support the continuedprofitability of its goods or services.

1. Profile commodities risks. Assess the extent of your company’ssourcing risks — whether the concern is price, physical availability,or both — by mapping the corporate-wide commodities needs andthe organization’s price exposure by commodity, business unit, andlocation. Analyze the flow of materials through the entire supplychain, going as far back as second- and third-tier suppliers. Eachcommodity can then be ranked in terms of the degree to whicha sudden increase in price or decrease in supply might affect thebusiness. In performing this exercise, companies typically find thatthey face supply risks they had not previously considered, and thatthey are more exposed to price movements in a commodity thanthey had realized.


Take the case of a manufacturer of private-label detergents thatcompletely missed its annual profit target after being caught offguard by rising oil prices. Although oil-based materials are key com-ponents of the company’s product line, the manufacturer hadunderestimated the risk until it was too late; it simply didn’t under-stand the extent of its exposure. Most of its petroleum-relatedpurchases were in derivatives such as tensides, an ingredient in deter-gent, and packaged materials such as plastic bottles, whose priceswere linked to ethylene, a petroleum offshoot. A simple hedgingstrategy might have shielded the company from 85 percent of theprice run-up.

With commodity prices in flux, piecingtogether a successful commodities sourc-ing strategy requires more market insightand a deeper well of knowledge aboutcommodity cost drivers than ever before.These are difficult to attain, but theprocess is made easier with a tool we call“fair return sourcing.” Simply put, this

approach provides transparency intocommodity pricing trends as well asglobal, regional, and local supply–demand dynamics. Based on an in-depthexamination of market conditions —current and past — fair return sourcingproduces a detailed pricing analysis tohelp companies create a commodities

Fair Return Sourcing


Exhibit A: A Fair Return Sourcing Example

Spike

Average High

Fair ReturnAverage LowUndervalued PriceIn

dex

Valu

e

Calendar Quarters

200

180

160

140

120

100

80

60

40

20

0

Market MakerLock in price that providesa fair market return overthe long run

Price TakerLock in price that isundervalued by market onthe basis of fair returnvalue


Companies can also underestimate their exposure to commod-ity pricing if they purchase materials from another part of the world,where fluctuations in exchange rates affect prices. For instance, theweak U.S. dollar has helped reduce the impact of rising commodityprices, many of which are priced in dollars, on some European com-panies. However, that advantage, held since 2002, could easily turninto a disadvantage if the dollar bounces back.

2. Understand commodities market dynamics. Gain a better under-standing of external economics and internal demand by addressingthese critical questions: What are the most important cost drivers ofthe commodities we purchase? How is the business environment

purchasing strategy that reduces the im-pact of price variability.

Implemention of fair return sourcingbegins with an exploration of cost param-eters for a given commodity. Included arethe factors that most influence the priceof the commodity, such as transporta-tion, labor, and raw material costs; thecommodity’s relative price sensitivity tochanges in each of its underlying costdrivers; and historical and geographicprice trends for these drivers. This costanalysis is combined with marketplaceinsights — among them, production bycountry, supply and demand trends, andpricing data. What emerges is a “fair pric-ing” estimate — a likely range of scenar-ios for how much the commodity and itsby-products will cost over a period oftime, depending on real and potentialchanges in market conditions.

Armed with this analysis, companiescan use fair return sourcing to determinenear- and long-term commodities pur-chasing opportunities, depending on themarket power of the buyer and the sup-

plier. For example, market makers, com-panies that have significant leverage oversuppliers because of the sheer volume oftheir purchases, may seek to lock in a fairreturn, which will maintain security andcertainty of supply at a price that will pro-vide a balanced and sustainable return forboth buyer and seller over the long term.On the other hand, price takers — small-er companies with no influence over sup-pliers or commodity prices — could relyon the fair return model to chart when acommodity is underpriced, pinpointingthe best time to buy. (See Exhibit A.)

Perhaps most important, fair returnsourcing can facilitate collaboration be-tween a company and its suppliers, creat-ing partnerships that use the model as abasis for purchasing agreements. Amongmany other benefits, coping with marketchanges together can prevent the supplierfrom amplifying a shift in the market,such as labor rate increases or currencydevaluations, and can protect the buyerfrom being put at risk by an unexpectedprice spike.

changing for suppliers? What external influences have an impact ondemand and price volatility? What is the suppliers’ competitivelandscape? How much buying (and selling) power do we have?Thoughtful answers should lead to the deep insights needed to cre-ate a tailored sourcing strategy. In many cases, companies will findthat building this overall understanding of the market is a fairlystraightforward, yet enlightening, endeavor.

More complex products, such as those based on several rawmaterials and dynamic markets — among them are citrus products,which are affected by local conditions, and resin-based productsclosely linked to oil volatility — frequently require deeper analysis.In these cases, it is often helpful for a company to develop a multi-variable cost model for each component commodity included in itsproducts. Such analytics can be used to maintain a dashboard ofcritical market factors that provides continuous data about thedirection of commodity prices. That, in turn, will allow companiesto set well-chosen maximum and minimum commodity pricing col-lars, to enter into contracts of suitable length that minimize expo-sure to commodity price shocks, and to price their own productsmore carefully, keeping an informed eye on shifts in the cost of theirunderlying commodities.

3. Address supply, price, and risk goals.Build on the insights gainedfrom studying risks and commodities market dynamics to craftcommodity-specific strategies that address the near- and long-termgoals needed to ensure cost stability and manage both supply andrisk. This process includes examining supply chain resilience —identifying which links in the company’s global supplier footprintare most vulnerable to disruption because of political or climaticinstability. How a company designs its strategy will often depend onits time horizon and its relative buying power. For example, opera-tional hedging may be appropriate for some commodities, such ascorn-based products that could be disrupted by natural disasters,



but securing supply through long-term contracts may be moreimportant for commodities with limited sources, such as preciousmetals. Even in cases in which a company has significant marketleverage by dint of the sheer volume of its purchases, market insightsmay enable it to time its purchases better to take advantage ofswings or dips in pricing.

An effective and winning commodities strategy must be builtwith expertise from across the company — product development,marketing, sourcing, finance, manufacturing. Changing productspecifications to reduce internal demand for a commoditywhose price is rising rapidly, for example, can be a powerful solutionto higher costs, but it requires significant internal cross-functionalcoordination. In 2004, Florida suffered an unprecedented fourhurricanes in one season, which wiped out two-thirds of thestate’s grapefruit crop. Consequently, the cost of grapefruit oilshot from $10 a pound up to $70, forcing beverage and fragranceproducers that relied on grapefruit oil as a key ingredient tofind alternatives. Many of them tapped the knowledge of theirdesign and development teams to reformulate their recipes usingother natural ingredients. The grapefruit oil market has sincerebounded, but companies that changed their specifications gainednew knowledge of substances that mimicked grapefruit oil, mitigat-ing the risk from future crop shortfalls and reducing overall ingredi-ent costs.

Companies that successfully leverage greater insight into com-modities markets to improve their approach to commoditiesmanagement can gain significant competitive advantage. Donewell, taking such an approach ensures mutually beneficial and sus-tainable solutions with suppliers that not only mitigate price volatil-ity but also reflect the true economic cost of production — andlead to both decreased procurement spending and increased share-holder value when compared with a “sit and wait/do nothing”


approach. Although no strategy can provide perfect foresight, adiligent approach to commodities purchasing can yield the knowl-edge needed to make better-informed decisions and trade-offs, andprepare a company better for the future while managing opportu-nities today. +

IN OCTOBER 1998, Hurricane Mitch blew through Central America,destroying roads, bridges, railroad tracks, factories, and fields uponfields of crops. Two major banana producers lost much of theirCentral American capacity, but the two fared quite differently.

Dole Food Company suffered devastation to 70 percent of its40,000 acres in Honduras, Guatemala, and Nicaragua, or roughlyone-quarter of its worldwide production. Because the company hadno strategy for alternative sources of bananas in the region, itsCentral American inventories were interrupted for more than a year.

By contrast, Chiquita Brands International Inc. was able tomaintain a steady supply of bananas from the hurricane-ravagedregion, despite significant damage to its plantations, by tappingthose among its network of partners whose land was undamagedand by improving productivity at other locations, such as Panama.

In the fourth quarter of 1998, Dole’s revenue declined some 4percent, while Chiquita’s grew by the same amount.

This tale of two companies aptly captures the challenges pro-curement chiefs face in managing supply chains that have becomeincreasingly fragmented and brittle, thanks to the combination ofrapid growth in outsourcing to geographically distant partners andsuppliers, a developing focus on sole sourcing to better capitalize onprice advantages, and the hesitancy of company executives to set up

Be Prepared to Bounce Backby Rich Kauffeld, Dermot Shorten, and Robert Spieker

Be Prepared to Bounce Back 109


shockproof supplier networks. Indeed, the notion of supply chainresilience has been raised and dropped repeatedly at most companiesin recent years as disastrous events elevated the visibility of the issueand relatively calm periods relegated it to the back burner again,usually with few fail-safe mechanisms implemented. In the end,considering the dangerous business environment that exists today— one in which a supply chain can be disrupted by bad weather,political upheaval in emerging nations, supplier incompetence,environmental disasters, or terrorism — it’s no surprise that com-pany executives are frequently left muttering statements that startwith, “We should have….”

A recent Booz & Company survey asked leading supply chainexecutives in various industries about their understanding of supplychain risks. (See Exhibits 1 and 2.) The survey revealed that mostcompanies, regardless of industry, perceive the greatest risk to theirsupply chain to be interruptions in deliveries from key suppliers, arisk exacerbated by the tendency to sole source. Survey results alsorevealed that the majority of respondents did not have detailed mit-igation plans for such an event.

In recent years, most companies have sought to maximize theefficiency of their supply chain, emphasizing speed, agility, andespecially cost. In fact, cost justification is the biggest impedimentto truly dedicating the time and resources needed to build in resil-


Exhibit 1: Greatest Supply Chain Risks to Organizations

68%

35%

31%

30%

17%

13%

Interruption in supplies from key suppliers

Physical damage to owned facility

IT breakdown/information security breach

Large-scale natural catastrophe in area of operations

Loss of key people

Nonphysical disruptions to owned facility


ience. Whereas designing for efficiency emphasizes flexible supplychains that minimize costs, supply chain resilience planning bal-ances this view by ensuring that these supply networks are notso flimsy that they crack under the pressure of unforeseen cir-cumstances. The trouble is that activities that make the supplychain more resilient — buffer inventory, redundant sourcing, mul-timodal logistics contingencies, and continuity planning — areoften labeled unnecessary expenses and equated to over-insuringbusiness operations.

This emphasis on efficiency is also borne out in most organi-zations’ metrics. While many companies have explicit objectivesand initiatives related to efficiency, such as cost and inventoryreduction or the implementation of just-in-time production,resilience often remains an implicit concern. Such a discrepancy ishardly surprising, as it is difficult to define a set of metrics thatmeasure protection against supply chain risk. Ultimately, the


Exhibit 2: Survey Respondents’ Level of Preparedness for Various Risks

46%

38%

13%

1% 2%

60%

30%

7%9%

1%2% 2% 2%

71%

18% 19%

5%3% 3% 3%

33% 34% 34%

26%

21%

17%

6%

15%

36%

Detailed, well-thought-out plansHigh-level plansNo specific plansNot prepared at allDon’t know

43%

Loss of key peopleInterruptionin supplies from

key suppliers

Physical damageto owned facility

IT breakdown/information

security breach

Large-scale naturalcatastrophe in

area of operations

Nonphysicaldisruptions

to owned facility

absence of disruption is the most important measure of success.However, there are metrics that can indicate a supply chain’s overallresilience, such as safety stock levels, supplier lead times, and thenumber of relationships with sole sourcers. And if companies workat it diligently enough, they can achieve a high level of both effi-ciency and resilience.

Moving toward ResilienceA successful supply chain resilience framework begins with a robustidentification of risks. This process involves taking a holistic view ofthe supply chain operating units and functions to uncover sharedrisks in the supply chain and also to ensure that risk managementstrategies are consistent throughout. Along the way, risks are accu-rately prioritized and measured to provide the basis for effective riskmanagement strategies. The process culminates in a program thatwill inject supply chain resilience into the corporation.

Step 1: Anticipate risks. Disruptions in today’s supply chain canbe caused by events as diverse as the failure of sole source suppliers,labor disputes, and earthquakes. To establish a comprehensive riskinventory, stakeholders from every point along the supply chain —procurement, manufacturing, distribution, marketing — needto be engaged and brought together to understand the risks inher-ent in their functions and in the links between their functions. Theirvaried perspectives help to ensure that each of the critical risk areasis uncovered.

An effective approach to this step includes the use of wargamesto identify supply chain risks. More advanced than typical inter-views, wargames allow stakeholders to interact and uncover deeperrisks within the supply chain. (See Exhibit 3.) Participants’ reactionsto certain scenarios help to uncover hidden risks and also identifyespecially challenging risks, such as those that require complexresponses with little warning and those that require collaboration


among functions or business units. In a recent wargame, an automo-tive manufacturer discovered that the recovery from certain supplychain disruptions would require the collaboration of multiple func-tions. The company’s ignorance of the number of stakeholdersinvolved and the level of collaboration across organizational bound-aries necessary to manage such a disruption was a major blind spot,indicating significant risk exposure.

Step 2: Assess risks. Once identified, risks should be analyzed ormodeled so that companies can understand their potential impact



Exhibit 3: A SampleWargame

Teams communicate tomake alliances and learn

what is happening

ActionReactions

MarketImpact

BusinessImpact

Scenarios

CorporateManufacturingDistributionProcurementCompetitors

Competitor andStakeholder Teams

Customer/Market Teams Control Teams

Modern TradeRegulators

Control

• Identify objectives and priorities• Develop strategy• Take action to achieve strategy and find common ground• Brief decisions and rationale to all other teams after each move

May represent competitors’ internal or external stakeholders

• Agree on criteria for success• Assess stakeholder action against

criteria• Provide feedback from customer point of view

Stakeholder wargames sometimesinclude a customer team, but not

always

• Oversee wargame play• Reaction from all others (e.g.

regulators, suppliers)• Update scenario, introduce external shocks

A financial model may be used to capturethe implications of team actions


on the supply chain and business in terms of both the likelihood ofthe event and the magnitude of the disruption. Mathematical mod-els drive much supply chain planning, but physical topology mod-els and dynamic supply chain simulations can provide fresh insightsinto the potential impact of important risks. For example, a physi-cal topology model depicts the links between critical supply chainsystems, processes, and infrastructure to illuminate interdependen-cies that may not be obvious. An understanding of how this com-plex web of systems and processes supports the supply chain canprovide a more robust analysis and is often a critical element in abroad-based review.

Recently, a Fortune 50 global pharmaceutical company set outto develop an enterprise-wide risk management and business conti-nuity program that could reveal the interdependencies among peo-ple, processes, and technologies across the organization. The com-pany began by developing a model to depict the relationships in itsbusiness and operating environments. The model highlights sharedresources, such as key personnel, infrastructure, and suppliers, show-ing these concentration points across the enterprise, including thosein the logistics and supply chain. By understanding these relation-ships, the company could evaluate the complete impact of anypotential disruption.

After developing an accurate depiction of the supply chain,companies should prioritize potential supply chain disruptions bycharacterizing the likelihood and magnitude of the outcomes theywould cause. In comparing risks, it is important to distinguishbetween events and their outcomes. For example, a shipping facilitycan become inoperable in many ways: hurricanes, chemical spills,and strikes, to name a few. But for analytical tractability, it isbetter to focus on the outcome — in this case, the inoperability ofthe facility — regardless of the cause.

The likelihood of a given outcome is driven by both the nature


of the threat itself and the vulnerabilities of the supply chain beingaffected. Both qualitative and quantitative assessments can beused to estimate the likelihood of different outcomes, employingrelative rather than absolute metrics. The magnitude of a particularoutcome is the (potentially) negative effect, or effects, that a com-pany can expect if some aspect of the supply chain is damaged,destroyed, or disrupted. These effects can include stakeholder con-cerns such as lost revenue, increased costs, compromised ethics, ordiminished brands.

Exhibit 4 shows a representative mapping of risks to a supplychain, using both likelihood and relative consequence as metrics.Risks mapped in the upper right quadrant are of a higher severitythan the other risks and should be the highest management priori-ty. This is not to say that risks in the other quadrants are unimpor-tant. All of the risks should be considered, whether or not they riseto a level that warrants immediate action or senior managementattention, because depending on a company’s circumstances or busi-


Exhibit 4: Weighing Key Risks to the Supply Chain

Supply Chain Risk List

Loss of sole parts supplier

Raw materials shipment delay

Material price fluctuations

Labor shortage

Negative actions of supplypartner (e.g., abuse of childlabor laws)

Prolonged loss of electricalpower to manufacturing plant

Critical Risks

Relative Consequences 50

05

Like

lihoo

d

High-Consequence/Low-Likelihood Risks

High-Consequence/High-Likelihood Risks

Low-Consequence/Low-Likelihood Risks

Low-Consequence/High-Likelihood Risks

Note: The likelihood and relative consequence of each identified risk were rated on a scaleof 1 to 5 and placed accordingly in the matrix.


ness environment, even risks that are a bit under the radar mayrequire a response now or sometime in the future.

Step 3: Act against the risks. By offering a holistic view of thesupply chain and a common understanding of the greatest risks forall stakeholders, risk identification and measurement provide a base-line for the development of mitigation strategies. Additionally, theyprovide a basis for informed decision making about risk manage-ment initiatives.

Addressing supply chain risks will likely require several tacticalrisk management activities, such as holding more inventory stock.In our experience, though, effective long-term risk management isthe result of a broad consideration of risk management goals ratherthan a narrow focus on specific risk management activities.

As a pragmatic illustration of how a risk management plan canbe established, consider the efforts of a leading consumer packagedgoods firm examining the dangers it faced in sole sourcing of rawmaterials. (See Exhibit 5.) To determine how best to address thisrisk, management explored the impact of its immediate and long-term actions on supply, price, quality, and corporate social responsi-bility. The company found it needed to rethink the structure of its


Exhibit 5: Sample Actionable Risk Mitigation Plan

S: SupplyP: PriceQ: QualityCSR: Corporate

SocialResponsibility

Risk Mitigations Horizon

Short-termmitigations

Raw material issole sourced

Review current contractual arrangementsto ensure contracts adequately protectcompany interests

Determine if a 2- to 3-year contractis required

In the absence of a reasonable substitute,work with the finance department to builda business case to seek an equity stakein supplier

Long-termresiliencestrategies

Impact

S

S P Q

P Q CSR

CSR

Major impact

Some impact


existing contractual terms and conditions and to evaluate the pur-chase of a stake in the supplier for longer-term risk mitigation.

Workshops and modeling exercises of the sort used to anticipaterisks can also be valuable in providing insight into the best risk man-agement goals and activities. For example, a wargame can facilitatea discussion among supply chain stakeholders to plan potential riskmanagement activities. Similarly, risk management plans can be ver-ified using simulation tools that can show the potential effects, inkey metrics, of a change in supply chain strategy or activities. Theoutput of a successful risk management exercise will produce bothactionable risk management plans for curbing immediate threatsand a game plan detailing the long-term changes needed to increasethe supply chain’s resilience.

Step 4: Designate a coordinator. The implementation of risk man-agement activities and strategies requires rigorous adherence toprocesses, roles and responsibilities, and governance structure sothat the risk management program doesn’t become stale and ineffec-tive. Companies can create a new position, such as that of coordina-tor of business continuity management, to supervise the riskmanagement plan or assign the responsibility to an existing role.The coordinator should be responsible for maintaining all docu-ments and electronic files related to the program, conducting aperiodic review to ensure accuracy (e.g., confirming that the rightphone numbers are listed), scheduling and overseeing regular exer-cises, and alerting senior management when the plan needs to beupdated because of significant changes in the supply chain or sub-stantial new threats.

A Resilient EnvironmentThe mechanics of implementing a resilience plan vary significantlyand depend heavily on an individual organization’s circumstances.However, since the goal of business continuity is universal, there are


undoubtedly common characteristics among all companies thatoffer good examples of resilience. Our research has led us to identifyseveral elements of successful risk-conscious supply chains.

Make risk management ongoing. It’s important to note that identi-fying risk is not a one-off exercise. Building and maintaining supplychain resilience requires a company to be continually aware of therisks it faces. An organization should consider not only recent fail-ures and mishaps, but also internal circumstances with the potentialto cause disruption and impair its ability to operate.

Often, companies fail to update their risk management docu-ments when new supply chain initiatives or external threats (e.g., anavian flu pandemic) appear. As new risks crop up, they need to beworked into existing risk management strategies or added as newinitiatives. The success of such a change initiative requires regularreview and adequate resources.

The General Motors Corporation has proactively increased itsrisk awareness through sophisticated tracking of its Tier One andsole source suppliers in close to real time, constantly monitoring thepossible disruptions that could occur in their geographic locations.In moments of crisis, such as an impending hurricane or a laborthreat, GM can ship parts to other supplier locations to avoid hic-cups in its manufacturing operations.

Similarly, one Fortune 50 consumer products company createdsuch a comprehensive and constantly updated assessment programthat it was able to produce a heat map demonstrating the relativeposition of each raw material it purchased on two dimensions: riskrating and brand impact. In this way, the company learned that,for example, its orange drink unit was highly susceptible to disrup-tion by crop failures and operational slowdowns at its blendingoperations. With this knowledge, more energetic surveillance effortscould be directed at the company’s orange drink line, which wasa critical source of revenue.


Develop a partnership approach. For years, people have been boast-ing about the benefits of partnership with key suppliers. However,in most instances, the partnership ends with public formalities. Fortrue resilience, a culture of information sharing with key suppliers isa must, incorporating joint teams, regular tests of the supply chainthat include all relevant parties, and frequent conversations withsuppliers to understand their concerns.

Cisco offers a good example of how sharing information canminimize supply chain risks. The company mandates that its sup-pliers allow it to examine their processes for adequate businesscontinuity plans and second-source suppliers that could fill in if adisruption occurs. It’s a sound policy, and it signals that Cisco, likeany savvy company striving for resilience, realizes that supply chainsare only as good as their weakest link.

Understand the culture. As management teams design and embracea supply chain resilience plan, it is important to remain cognizantof the role corporate culture plays in the organization’s dailyoperations. For instance, while a plan may show the need for aninventory buffer, the simple suggestion of creating such a bufferwould be counterintuitive to any organization using the Toyotaproduction system, which touts the importance of just-in-time prin-ciples. In such cases, it’s important to find a balance between devel-oping the right plan for the culture and convincing the culture thatsome changes are necessary.

Companies that want to embrace a resiliency plan must have theculture in place to propagate success. Although the actual balancemay differ by organization, the ingredients are often the same. First,there must be organizational acceptance, which starts at the top.Localized buy-in and subsequent activity then become catalysts todeveloping a workable structure that is inculcated into the dailyoperations. It is also important to ensure that previously establishedincentives are not at odds with any resilience initiatives; for instance,


if teams are rewarded for running a lean operation, it may be diffi-cult to build in the redundancies necessary for a resilient operation.

Creating supply chain resilience requires more than utilizing theframework to identify, assess, and mitigate enterprise risks. Thelong-term success of a resilient supply chain also depends heavily onthe organization’s ability to foster a culture of reliability that stretch-es across departmental borders. The constant drive to lower supplychain costs will continue to increase any company’s risk exposure,but with some forethought, risk need not threaten extinction. +

Editor’s Note

Adapted from “Prepare to Bounce Back,” 2008.

Sourcing BasicsThat Enable Success

THE IT SYSTEMS that support purchasing are a critical determinant ofprocurement effectiveness. Consider the example of a large utilitycompany — let’s call it Acme Power — that was created out of awave of mergers and struggled for almost a year to integrate its pur-chasing function. The effort was in many ways a fool’s errand:Procurement, like the company at large, was riddled with overlycomplex and redundant IT systems that created structural barriersto integration and improvement.

Nowhere was this more obvious than in Acme’s indirect pur-chasing efforts. Through a tightly run, centralized procurementorganization, the company was able to control its direct spending,including the large-scale purchases of commodities and materialsthat fed its power plants, but its indirect spending — for itemsneeded less regularly, such as computers, furnishings, and office sup-plies — was another story. Despite Acme’s efforts to centralize indi-rect spending through its company-wide procurement group, thefunction remained fragmented. The company had identified goalsand adopted policies for controlling indirect spending. But it hadn’tput into place the standards, processes, and IT systems needed tomanage these purchases. The result: Costs remained high, and com-pliance with the new policies remained low.

This situation was exacerbated by the company’s overall IT

Smoothing the Path forProcure-to-Pay: A New IT Approachby Jeffrey Barta, Bernhard Rieder, and James Weinberg


infrastructure, which was adequate to support procurement’s directspending function but was in no shape to support the effort torationalize its indirect spending — which was fragmented through-out the organization and marked by highly decentralized end-userbuying. Numerous acquisitions had left a legacy of several ERPsystems and incompatible data standards and processes, whichresulted in a slow and sporadic flow of information across the com-pany. Consequently, purchasing was unable to track and controlindirect spending.

Many companies find themselves in a position similar to that ofAcme Power: They have their direct spending under control, buttheir indirect spending is far less disciplined and much too costly.Despite their best efforts, neither their processes nor their IT sys-tems are up to the task of controlling this spending.

A common solution to this problem is to make a significantinvestment in a one-size-fits-all purchasing system that promises tocompletely automate the sourcing, requisition, and buying process-es. Theoretically, the structure and processes provided by these sys-tems lower the cost of each purchasing transaction. Unfortunately,such systems have not, for the most part, earned the return oninvestment that companies have hoped for. They are very expensiveto license, implement, and maintain; too inflexible, not providingthe adaptability needed to make future improvements in purchasingprocesses; and difficult to integrate with large ERP systems.

In order to reform procure-to-pay — essentially, the second halfof the procurement process, in which employees actually purchasethe items or services negotiated with vendors during the first half ofthe process — companies need to have a holistic understanding ofthe IT systems that support it. Replacing procurement’s existing ITinfrastructure with an end-to-end solution is not the answer. Thebest approach avoids the inefficiencies and integration problems oflarge systems by blending together individual modular applications,

Smoothing the Path for Procure-to-Pay 123


each meant to address a specific area of the procurement process.Many of these applications are Web-based, allowing them to beswiftly integrated with other applications in the purchasing system,and easily modified as processes change. These modular applicationscan fill the gaps in a company’s purchasing system as needed, whileusing the applications already in place to the extent possible. In thisway, they can fulfill virtually all the goals of end-to-end procure-ment suites, at lower cost and with faster implementation.

Ambitious GoalsThe primary operational goal of every purchasing department is tomake sure the company is supplied — in a timely and cost-effectivefashion — with the equipment, supplies, materials, and services itneeds to operate. Achieving this aim is a highly complex endeavor.It involves a concerted effort to automate as much of the procure-ment process as possible, in hopes that the technology will enablecloser monitoring of costs and thus help to maximize savings.Strong purchasing departments are always on the lookout for moreways to capture savings and limit year-over-year incremental in-creases from suppliers, while minimizing transaction costs.

At the operational level, well-tuned purchasing departmentsseek to standardize the procurement and sourcing processesthroughout their companies by broadening the reach of procure-ment controls without increasing head count. In an ideal world,there would be visible, consistent, and coordinated processes acrossthe enterprise. To accomplish this, purchasing teams must haveaccess to the information necessary to evaluate their own perfor-mance, including savings benchmarks and metrics, supplier per-formance, and pricing histories.

An integrated IT system supporting procure-to-pay processescan help accomplish these goals in several ways. It can limit transac-tion costs by reducing paper-based processes to a minimum, poten-


tially lowering the cost of creating purchase orders 10-fold, and byestablishing a procurement model based on user self-service. It canalso increase compliance with purchasing rules and supplier con-tracts by slashing maverick spending — that is, purchases made out-side the purchasing system — through a purchase order preapprovalprocess and by enforcing the use of preferred suppliers. Using cus-tomized budgetary reporting analyses and category-level views ofexpenditures, the technology can also identify significant savingsopportunities by increasing visibility into purchasing spend. This, inturn, allows companies to move to a strategic approach to sourcing.And because the modular technology can be implemented in a low-cost, step-by-step fashion, it affords a significantly faster return oninvestment without massive up-front capital expenditures or evenextensive time devoted to training workers.

The Process ProblemBefore Acme Power could embark on designing the IT system sup-porting procure-to-pay, it needed to rationalize its overall purchas-ing processes. In its efforts to instill some discipline into the indirectspend effort, Acme’s procurement department had instituted poli-cies involving suppliers, decision rights, and approval processesdesigned to reduce maverick spending and increase compliance. Yetthe process — or rather, processes — still varied from department todepartment, and requests for similar items could take a variety ofroutes through the system. Although some supplies and materialswere under strategic contract, or were bid for competitively, manyothers were not. Some charges were paid through paper invoices,others through the ERP system, still others via the electronic datainterchange system. Fully 55 percent of indirect spend transactions,representing 62 percent of the value of all indirect purchasing trans-actions, were conducted without any purchase order at all.

The solution to Acme’s procurement processes began with an


analysis of a typical end-user’s view of the purchasing function.Confronted with the need to buy materials, supplies, or services, theend-user had a choice between contract buying and spot buying.Buying against an existing contract (or open contract buying) ischeaper, faster, and easier to use, and can be automated with theproper technology. On the other hand, one-off (or spot) buying istypically slower, in part because it requires human interaction withsomeone in the purchasing department, and thus is ultimately moreexpensive. Unfortunately, end-users at Acme were choosing spotbuying far too often.

Further analysis revealed that Acme’s end-users had a choiceof seven purchasing channels, or ways to purchase items. Un-fortunately, procurement’s processes overlooked some channelsentirely and supported others in a fragmented, hit-or-miss mannerthat allowed plenty of exceptions.

To remedy these conditions, procurement defined a new processmodel that eliminated many of the spot-buying options andreduced the seven purchasing channels to three, while leaving roomfor (very occasional) exceptions, typically involving verbal orders.

The first channel was a fully automated procure-to-pay processfor purchases made under existing strategic contracts. Between thetime the end-user places the order — on a Web-based interface —and the order is received and checked and a receipt is generated,there is no human intervention of any kind; the order proceedsthrough sourcing, procuring, and then payment untouched byhuman hands.

The second channel involves low-value indirect purchases,made primarily with a procurement card held by the end-user.Here, the end-user is involved in sourcing the item, but then pro-curement, receiving, and payment are again entirely automated.This method drastically reduces transaction costs for low-cost itemsand bypasses the procurement department, while capturing the


details of the transaction in a single data warehouse.The third channel, designed for so-called structured buys —

major items that are not under any strategic contract — is the mostcomplex. Here, the end-user works with the procurement depart-ment to source the item, the purchase order is faxed to the supplier,a goods receipt is issued when the item arrives, and a paper invoiceis generated for payment. Although expensive and time-consuming,such transactions do allow the purchasing department to identifyopportunities to negotiate new strategic contracts with suppliers. Inother words, even for less-than-routine purchases, a well-definedwork cadence is created. This is particularly useful when adding sup-porting systems, technology or otherwise.

The Solution for Procure-to-PayAlthough this was clearly a much streamlined procurement model,it needed an equally agile IT system to run it, and Acme’s existingsoftware was not up to the task. Consequently, the company revisedits architecture from end to end, using modular technology to fillin the gaps without ripping out the entire procurement infrastruc-ture. In addition, Acme management decided to alter the interfacesbetween different parts of the procurement system, making surethat they shared a common backbone. These included a supplierportal that would allow end-users to source items on their own, anew sourcing tool kit, a new accounts payable system, an enhancedmanagement reporting tool for tracking performance of the newsystem and providing greater visibility into overall expenditures, anda new contractor tracking tool for improved insight into servicesprocurement.

The resulting system provides all the tools necessary to automateAcme’s entire end-to-end procurement process. It offers end-userswho are sourcing items the maximum use of supply and materialscatalogs and identifies materials and services already under


contract, as well as the preferred vendors and contract pricingfor every item. It also tracks detailed item-level data and spendingdata against preferred supplier agreements and loads informationabout contracts, supplies, and services into real-time suppliercatalogs. At the procurement stage, the system generates purchaseorders and sends them electronically to suppliers via their preferredroute: XML, EDI, auto-fax, or e-mail. Then, when the items arereceived or the contractor services completed, it generates receiptsand feeds them to the accounts payable system, all the while track-ing critical contractor spend data. Finally, when it comes time forpayment, the system feeds supplier invoices into the accountspayable system, matches and reconciles purchase orders and receipts,captures and tracks payment data, and sends the data back into therequisitioning system.

Ultimately, of course, Acme’s success in transforming its pro-curement function depended on making sure the entire companycomplied with the new processes and channeled the greatest num-ber of purchases into the procure-to-pay system. Ensuring compli-ance with supplier contracts dramatically reduced the number ofsuppliers Acme dealt with, and that smaller supply base made thecompany’s strategic sourcing efforts more efficient, while simplify-ing the payment process and producing more accurate and completedata on how much was being spent.

As is often the case, the success of the new initiative required thebuy-in of top executives. The company also worked hard to educateemployees not just about the new procurement processes but alsoabout the benefits to the entire company of the changes being made.

Two years after Acme Power undertook the restructuring of itsprocurement function, it was saving US$30 million annually in pur-chasing operations. Given that the total spend had been $1.2 billionper year, the initiative resulted in annual savings of 2.5 percent —not a bad return.


Pay as You GoAmong the many virtues of implementing a modular system forprocure-to-pay processes is the ability to get started quickly, thanksto the use of Web-based applications. The initial savings can then beearmarked for building out the longer-term, more complex parts ofthe project. This approach also provides a faster return on invest-ment, with considerably less project risk. It begins with developing aclear and complete road map, from baselining to project completion.

Baselining. The first step is to gain a clear understanding of thekey elements of spending and to do it quickly: What policies are inplace to control and manage spending? How much money is actu-ally being spent, and what is it being spent on? Which suppliers areused most regularly, and which ones only occasionally? Which sup-pliers are operating under long-term, strategic contracts, and whichare not? How exactly do the purchasing processes work, and howvariable are they?

At this time, it is also critical to identify the company’s purchas-ing needs and define the objectives of the new system. That meansdeveloping an understanding of the company’s purchasing require-ments, as well as the drivers of cost in the current system andexisting service or quality problems that the new system will haveto address.

Once these two baselining steps are taken, the goal is to use theinformation gained to form a hypothesis about how and where costscan be taken out of the system. Begin by estimating the potentialsavings from each source — whether process or spending itself.Categorize and prioritize the savings opportunities. Then developthose opportunities into actionable ideas.

During this stage, it is also crucial to review the current IT sys-tems supporting procurement, define the gaps where processes thatcould be automated have not been, and begin to develop an imple-mentation plan for the project stages required to complete the


transformation. Work to gain executive buy-in at the earliest stagesof the project in order to ensure a smooth transition and high lev-els of compliance.

The baselining exercise itself should take no more than 12weeks. Companies that tackle this stage aggressively can identifysome easy wins that will create momentum and provide funding forthe more intense technology build-out to follow.

Easy wins. The second stage of the process involves implement-ing and achieving the easy wins. These often include Web-based,externally hosted purchasing applications that are easily implement-ed and managed, and can quickly bring significant savings. Suchapplications typically feature supply catalogs with pricing informa-tion, technology for managing the approval process, and transactionsystems for automating much of the actual purchasing. These sys-tems can track and analyze how much is being spent, allowing man-agers to quickly understand the cost savings being captured. Thatinformation can in turn be used to gain further buy-in for the later,more complex stages of the project.

At the same time, companies should launch the change manage-ment effort to gain buy-in from users and increase compliance. Thisinvolves expanding the communications program regarding the newsystems, training employees in the new processes and systems, andworking to maintain executive buy-in. The centralization of the pur-chasing organization should also begin at this stage; that will providea head start on promoting the implementation of the more difficultsteps to come.

Longer-term planning.The final stage of the project involves push-ing the process gains already accomplished deeper into the corpora-tion and extending the procure-to-pay IT systems to produce anend-to-end technology footprint. At this stage, much of what waslearned from the earlier effort to put in place the easy wins will comeinto play. Processes can be adjusted to capture further savings.

Pushing policies throughout all divisions of the organization willfurther the effort to gain compliance. And the information capturedwill assist in narrowing the supplier field and structuring strategiccontracts with the most frequently used suppliers.

The fuller understanding of the purchasing process gained ear-lier will help guide the filling of technology gaps over the longterm. This usually involves further automation of the purchasingprocess, from beginning to end. Closer links to the ERP systemallow purchase authorization without human intervention, and pur-chase orders can be generated automatically. The more completethe system, the better the information generated, which in turn willaid the organization in continuous adjustment and refinement ofthe processes. +


AS WESTERN COMPANIES come under increasing pressure to cutexpenses and improve their return on assets, the dilemma of whetherto keep key functions in-house or outsource them has taken centerstage. Manufacturing units are identified most often with “make orbuy” decisions because third-party suppliers in eastern Europe,China, and other low-cost regions hold out the promise of signifi-cant advantages that many brownfield plants in developed nationscan’t offer. But other critical activities — such as human resources,information technology, maintenance, and customer relations —can gain (or lose) just as much from outsourcing and shouldn’t beneglected when the options are considered.

What does this mean for chief procurement officers? CPOs canand should lead business units in conducting detailed analyses thatthoroughly evaluate the costs, benefits, risks, and rewards of out-sourcing and the implications of keeping the activity in-house.

Before giving up on in-house operations, a company mustobjectively assess its core competencies and measure them againstworld-class standards. CPOs, with their proficiency in overseeingand managing third-party suppliers to generate the highest possiblelevel of quality and productivity, know the right questions to ask tomake these determinations. Among them: If our manufacturing orHR capabilities are below global benchmarks, can they be improved

Make or Buy:Three Pillars of Sound Decision Makingby Simon Harper, Michael Pfitzmann, and Dermot Shorten


Make or Buy 133

to reach maximum performance and efficiency, and would the ben-efits of those capabilities surpass the benefits that we would obtainfrom outsourcing? If so, what resources are required, and how longwould it take to reach noticeably improved performance? Are tech-nology innovation and alignment necessary for us to have a compet-itive edge? Do our customers expect a high level of service andresponse, much greater than we could offer if we outsourced callcenters to, say, India?

If, after these questions are answered, outsourcing is chosen,CPOs can work with the business unit to find the right partner.Pivotal indicators such as business strategies, manufacturing andengineering capabilities, design and innovation skills, labor costs,staff skills, employee training programs, the ability to scale, capacityutilization, and the social policies of the potential partner must beassessed. In addition, the risks in outsourcing must be accuratelygauged, whether they relate to the supply chain or to proprietarytechnology and intellectual property.

CPOs can also help structure outsourcing deals to protect theircompanies from quality, delivery, and other material failures.Lessons learned from procurement — for example, the importanceof maintaining the right balance between collaboration and compe-tition — are similar to those that must be applied to outsourcingarrangements, in which the perceived value of the relationship maycloud people’s initial judgment and lead to serious problems a fewyears later.

Because they have no direct management responsibility overdepartments that may be considering outsourcing, CPOs can pro-duce an unbiased “right-sourcing” evaluation that takes into accountall the possible consequences — economic, human, and technolog-ical — of outsourcing or maintaining internal operations. This is anextremely important task because too often these choices are basedon precedent and poor or incomplete analysis. Keeping the process


in-house is typically preferred only because the capability and capac-ity already exists internally. And outsourcing is frequently an emo-tional response, a way to avoid fixing processes that have becomeinefficient and flabby but whose true potential is not completelyunderstood. In other words, outsourcing may be a poor alternativeto confronting internal inefficiencies and, in the process, improvingcompany performance.

Faced with this level of inertia, CPOs must challenge theirorganizations to make more objective and informed make-or-buydecisions. Indeed, it is the responsibility of CPOs to ensure that allthe right trade-offs have been evaluated and all the possibilities havebeen considered. This is far from their typical position: Procurementofficers, if they are involved in these choices at all, are usuallybrought in after high-level deliberations, not during them.

Booz & Company has developed a framework to help simplifythe decision. It is built on three key pillars: business strategy, risks,and economic factors. (See Exhibit 1.)

Pillar 1: Business StrategyBusiness strategy includes the strategic importance to the companyof the product or service that is being considered for outsourcing,as well as the process, technologies, or skills required to makethe product or deliver the service. These factors must be considerednot merely in light of the current competitive environment butalso in anticipation of how that environment might change inthe future.

As a rule, it’s desirable to choose in-house capabilities when aproduct or a function is critical to a company’s performance or isconsidered a core operation. For instance, if a product is time-sensi-tive or prone to frequent design changes, third-party manufacturingwould likely be a mistake. Conversely, outsourcing tends to be agood choice when companies are seeking to:

Make or Buy 135

• Eliminate the burden of capital- or labor-intensive processes onthe balance sheet

• Reduce costs• Gain flexibility to adjust output in response to changing

demand• Phase out management of paperwork or training• Supervise fewer workers• Gain access to new process or network technologies• Leverage external expertise

Milwaukee-based Harley-Davidson Inc. illustrates the impor-tance of business strategy in determining whether to make a prod-uct or buy it from a third party. The motorcycle company continues


Make (In-House) Pillars

Exhibit 1: Weighing the Make–Buy Decision

• In-house process differentiates theproduct or service

• Capability has synergies acrossthe business

• Supply market is hostile orcontrolled by competitors

• Need to “push the technology orcapability envelope”

Buy (Outsource)

• Attractiveness of the process/business• Criticality for overall business success

– Proprietary processes– Product differentiation

• Industry dynamics and competitivepositioning

• Dynamics of the technology orcapability– Rate of change– Risk to core capabilities

• Process/business is unattractive(e.g., hard to find workers, strictregulatory environment)

• Materials or processes are not criticalto end products or marketing efforts

• Supply market is suitable for buildingclose partnerships

• Suppliers are willing and able tomeet innovation needs

• Few or no alternative sourcesof supply

• High supply market risks• Imperative to couple supply and

usage (real-time/short lead time)for quick response or quality

• Sensitive intellectual propertyinvolved in process/product

• Holdup risks• Availability of alternative sources and

switching costs• Supply market risks (if foreign-sourced)

– Political stability– Exchange rate volatility

• Transportation risks– Lead times– Supply disruptions

• Intellectual property protection

• Holdup risk is low or sufficientlymanaged through contract of broaderbusiness relationship

• Low switching costs and easily access-ible alternative sources of supply

• Uncoupling the supply chain haslittle impact

• No sensitive intellectual propertyinvolved

• Internal cost advantage or cost parity,high quality

• Significant recent investment inprocess technology that cannot berecovered

• Investments meet required returnon invested capital

• Company has strong, defensibleskills base

• Relative economic and operatingperformance advantage– Scale and utilization– Efficiency– Reliability– Factor costs– Quality

• Capital requirements and financialreturns

• Level of skills and expertise

• Suppliers have lower costs or betterquality

• Major new investments are required• Suppliers have lower ROI targets• Insufficient or weak in-house skills/

capabilities; skills are difficult toacquire

Bus

ines

sSt

rate

gyR

isks

Econ

omic

Fact

ors


to thrive, in part because of its decision to manufacture mostly in-house in the United States. Harley-Davidson’s “Made in America”brand image is so strong today that consumers don’t care if the com-pany’s motorcycle accessories and ancillary merchandise such asclothing are produced overseas by outsourcers; those operations areperipheral to the brand image of Harley-Davidson’s primary prod-ucts. (Ironically, when the German beer maker Löwenbräu licensedNorth American production to another Milwaukee-based business— Miller Brewing Company — in the mid-1970s, Löwenbräu’sattractiveness to U.S. customers fell because the product no longerhad the cachet of a genuine German beer.)

The CPO could lead the discussion among senior managementaimed at resolving which aspects of the organization rise to such alevel of strategic importance that they must not be outsourced.Strategic value can be a subtle thing. For instance, if a product isbased on proprietary technology or hard-won and coveted intellec-tual property, outsourcing is probably not a good idea. Ethicalconcerns also merit consideration. A company’s reputation canbe seriously harmed if the company is connected to unsavoryactivities such as sweatshop production, child labor, or environmen-tally damaging manufacturing techniques — all of which areroutine at some outsourcers. Exhibit 2 outlines the beginning of


Exhibit 2: Identifying Strategic, Core, and Outsourcing Potential

Process

Preexisting commitments?Low

High

Yes

Yes

No

NoRenegotiate

Future competitiveadvantage and/oremerging technology?

Core criticalityranking

STRATEGICEnsure adequate

investment

COREEnsure world-class

capability

OUTSOURCINGUnwind/manage

investment

the process in which the strategic value of the services and manufac-turing processes under consideration for outsourcing can besorted into their respective categories: strategic, core, and outsourc-ing candidates.

Of course, outsourcing is worth considering under certain con-ditions. If a product or function has essentially become a commod-ity or is derived from factors other than unique or differentiatingcapabilities, and the possibility of moving production or manage-ment to a third party does not give rise to significant risk to thecompany’s strategy, outsourcing could be the perfect solution.

Moreover, when outsourcing is called for, CPOs can use theirknowledge of the supply base to compare potential outsourcers’technologies, product development and supply chain managementcapabilities, and ability to work in partnership. And a CPO canevaluate whether his or her own company has the skills andresources needed to manage outsourcers so they make continuousquality and cost improvements over the life of the contract. Withoutthat, the outsourcing arrangement will probably deliver disappoint-ing results.

Pillar 2: RisksRisks include lower quality, reliability, and predictability of out-sourced solutions as compared with in-house manufacturing orservices, as well as risks inherent in the process of identifying andselecting the right supplier and structuring a workable ongoingrelationship.

The CPO has multiple roles to play in managing risk. He or sheshould encourage the organization to view the supply chain or ser-vice providers as partners that deliver an entire product or managean entire function. The CPO must also oversee risk assessment dur-ing a make-or-buy evaluation with much more diligence than wouldbe necessary in traditional sourcing. Also, the CPO should supervise

Make or Buy 137


the writing of the contract so that it protects the organization fromthe outsourcer’s deficiencies.

When there are multiple suppliers, a single failure in the chainmay not be fatal. And when suppliers are making components ratherthan finished products, manufacturing errors will likely be caughtduring assembly and not be passed on to the consumer directly. Butbecause outsourcing introduces such a wide array of new risks,CPOs must be keenly aware of any potential pitfalls with suppliers,and evaluate outsourcing partners on the basis of their importanceto the organization. Failure of service could be devastating in an out-sourced critical operation, such as an IT network, a payroll process-ing system, or component manufacturing, whereas a glitch in atraining program or a long-term product development plan wouldbe much less of a problem.

It is rare for companies to hire multiple outsourcers for thesame service, but the General Motors Corporation did just that in2006 in a highly publicized decision, primarily to minimize risk.Though some critics warned that it would be a managementheadache, the automaker split its US$15 billion contract for ITservices among Capgemini, Covisint, EDS, Hewlett-Packard, IBM,and Wipro.

As it turns out, GM has benefited from the strategy in a num-ber of ways. First, multiple suppliers encourage competition, mini-mizing the chances that the contract’s cost competitiveness willdecrease over time. Second, system failures at any of the companieswill not harm GM’s entire IT infrastructure. Third, as opposed tothe 10-year term of GM’s prior IT arrangements, the contracts arefor only five years, which limits the automaker’s long-term financialrisk and ensures accountability from the outsourcers.

In addition, GM and the IT suppliers jointly developed stan-dardized approaches for all five companies to follow — involvingmatters as varied as systems delivery and supplier interactions with

Make or Buy 139

the automaker — aimed at producing greater efficiency in the ITservices provided.

Crucial to the mitigation of risk is the supplier selection process.It must be based on a clear understanding of the supplier’s strategy,operations, and cost structure. Choosing the lowest bid is not suffi-cient. Only a supplier that has a compatible business strategy andwill maintain an advantaged cost position over time can offer com-petitive prices in the long term.

Outsourcing a broken process — for instance, a humanresources benefits call center that is not equipped with the rightanswers to the most prevalent questions — will end up costingmuch more than it would if the function were fixed before beinghanded off to a third-party provider. The outsourcer will likelycharge a significant amount to repair the process, and as an outsideoperation it will probably not know enough about the organization’sneeds to repair it properly.

The financial health of the outsourcer must be considered aswell. Will the company still be in business in a year? In five years?And is the company too dependent on this outsourcing contractfor its survival? CPOs regularly assess all these issues in puttingtogether contracts.

Understanding the risks associated with the location of anexternal supplier is equally important. Besides gauging the sourcecountry’s political stability, companies need to assess the safety andlead times of transport arrangements. They must also identify andevaluate potential secondary carriers or routes, or find backupsuppliers in a different region that can provide incremental volumeduring peaks in demand or disruptions of the primary sourceof supply.

Supply chain management is a highly complex function, espe-cially when combined with outsourced manufacturing of productsor outsourced processes that require unique capabilities or assets


and thus are difficult or expensive to re-source. But even these“holdup” risks — that is, risks that a supplier will exploit a cus-tomer’s highly dependent relationship by raising prices or demand-ing better terms — can often be managed with external solutions.It is critical, however, to consider the options and determine thebest alternatives before any commitments are made with a supplier,because outsourcing contracts can be difficult to amend or break.(See Exhibit 3.)

Pillar 3: Economic FactorsThe economic factors include the impact of outsourcing on capitalexpenditures, return on invested capital, and return on assets, as wellas the possible savings achieved through outsourcing.

The CPO’s primary focus should be to shift the discussion fromthe price of a finished product to the overall cost of providing theproduct or service. To do that, he or she must identify the supplier’scost drivers and design a pricing mechanism that reflects the currentunderlying costs and how the costs might change in the future. The


Option Advantages

Exhibit 3: Managing Holdup Risks

Control production through directownership or joint venture

Have multiple suppliers for eachproduct or service with significantholdup potential

Select only one supplier for eachproduct or service, but split overallvolume among suppliers to stimulatecompetition

Create situation with similar incentivesfor customer, original equipmentmanufacturer, and supplier

Disadvantages

• Highest level of control over operations

• Potential backup for contingencies• Strong competition• Easy supplier assessment/comparison

• No capital requirements• Competition through prospects of

gaining future/additional business

• No capital requirements• Truly strategic partnership• Partner’s interest in long-term

success keeps total costs low

• Capital requirements• Management efforts

• Higher cost through redundantoperations, lower volume witheach supplier

• Potential for inconsistent quality• More supplier coordination/

management required

• Need enough products or serviceswith similar capability requirements tosplit total volume among suppliers

• Potential loss of economies of scale ifvolume is small and suppliers cannotleverage additional volume

• No alternatives/backup forcontingencies

• May require close-to-exclusiverelationship and thus loss of scale

• Supplier may charge premium forpossible exclusivity agreement

Make or Buy 141

goal is to make sure that ongoing improvements in cost are coveredin the contract and are shared between the outsourcer and theCPO’s organization. It is important to find an effective gain-sharingmechanism that properly rewards the supplier for taking action butpasses the ongoing improvements on to the buyer. Sometimes thisrequires placing staff at the outsourcer’s headquarters to encourageand monitor continuous improvement.

To understand how critical appropriate pricing mechanisms are,consider that most companies base the decision on whether to out-source solely on estimates of the in-house versus the external costsassociated with the outsourced operation — that is, the price of eachpiece made or the cost of running an HR department or an IT net-work — rather than on the total costs.

Among the total costs that must be considered are the outlaysfor managing the outsource provider, especially as the outsourcedprocess changes. These can be significant. For example, softwarecustomization on a third-party information technology network canadd a huge surcharge to the outsourcing deal. Handling the cus-tomization in-house, where the IT department can work closely andmore productively with end-users to meet their needs, might bemuch less costly.

In addition, when outsourcing partners are not chosen properly,organizations frequently attempt to protect themselves from failuresor delays by duplicating in-house some of the effort that was origi-nally farmed out. This results in multiple costs for the same project,potential expenses that are often not considered when the outsourc-ing deal is made. The costs that are most frequently ignored in out-sourcing manufacturing operations:• Shipping and handling• Expanded inventories• Administrative expenses, such as supplier management

and quality control


• Added complexity and its impact on lean flows• Lower return on invested capital• Production reliability and quality control

Considering all this, relying on a one-time quote to gauge thecompetitiveness of an external supplier is generally not sufficient.Chief procurement officers can save their companies from this mis-take by factoring into the outsourcing equation the economic effectsof relative wage rates, labor productivity, equipment and staffutilization, the leanness of both the labor base and functionalprocesses, the capacity for process and product innovation, and rel-ative purchasing power.

Possible top-line gains from keeping production in-house mustbe calculated as well. In choosing not to outsource, some companieshave enjoyed significant revenue growth by taking advantage ofthe speed and quality of internal innovation cycles, the ability todeliver customized products to nearby consumers quickly and withlittle advance planning, and the possibility of leveraging new lines ofbusiness from a favored supplier’s proposal.

Expectations must be clearly articulated so the company canavoid unpleasant surprises once the supplier feels the businessis locked in or thinks that its current performance will be sufficientin the future. It is vital to provide up front the appropriate specifi-cations and current and future deadlines, to the extent that they areknown. Any misunderstanding about the scope of the outsourcingprogram will surely be costly and damaging to an organization.

The contract must reflect how the business will unfold ratherthan its state at the signing of the agreement. In outsourcing, CPOsmust be vigilant about creating a customized contract rather thansimply offering the standard terms and conditions.

A successful outsourcing relationship often includes the sharingof savings from productivity improvements, so that both parties

Make or Buy 143

have an incentive to collaborate. During the course of the relation-ship, it is also important to find the right balance between fullytransparent supplier operations and micromanagement, or the per-ception of it.

Once the outsourcing decision has been made and suppliershave been selected, it is essential to agree up front on a fair and bal-anced pricing mechanism, productivity improvement and costreduction expectations, and the required degree of responsivenessto design, service, or delivery changes.

Outsourcing contract terms span multiple years; five- and10-year agreements are not uncommon. During that term, howev-er, business conditions frequently change, resulting in significantmodifications in what is required from the outsourcer. For example,production rates may need to be increased or decreased dependingon the market performance of the products. A hike in volume isapt to reduce production costs because it allows the outsourcer toput excess capacity to work. Unless this benefit is shared fairlybetween outsourcing partners, the venture often deteriorates; afterall, why should the outsourcer alone gain from improved marketconditions? Similarly, should volume requirements fall, the out-sourcer’s production costs are likely to rise; that increase, too, shouldbe shared. In the short term, outsourcing relationships can normal-ly survive imbalances, but for the partnership to endure for a longtime, the contract must provide a fair mechanism for consideringthe cost implications of any major changes.

As demonstrated by the variety of factors and risks that needto be taken into account in the three pillars, the decision of in-houseversus outsource should not be made without careful analysis.The CPO is essential to making sure that this analysis is initiatedand conducted diligently and objectively. This will put some strainon CPOs and their organizations, and new capabilities will berequired. But by viewing the process as a logical extension of the


procurement role, both the CPO and the purchasing departmentwill be able to handle the new responsibilities with a high levelof skill.

Although the choice to keep an activity in-house or use anoutsourcer may be cross-functional and strategic, it is the role of theCPO and the procurement function to make any outsourcing deci-sion work. Consequently, purchasing executives should not be pas-sive about making sure that their input is clearly articulated. +

Editor’s Note

Adapted from “Make Versus Buy: A Decision Framework” in Manufacturing Realities(strategy+business Books, 2006)

IT’S NOT UNUSUAL for procurement teams to react sluggishly tomacroeconomic changes. A case in point: Purchasing departmentsof many European apparel retailers were apparently caught off guardin 2005 by the “bra wars,” during which Chinese-made textilespiled up in E.U. warehouses, barred from sale as a trade dispute sim-mered. Claiming to be innocent victims of an intergovernmentalsquabble, retailers moaned that millions of euros in lost sales were atstake because of the unexpected turn of events. But in fact, theretailers should have been more prepared; the saber rattling overimporting inexpensive Chinese apparel into the E.U. had beengoing on for some time.

The problem is that many procurement officers are runningtheir long, complex 21st-century supply chains with a parochial20th-century outlook. Often, they don’t stop to think about how anevent such as a war or a change in tax policy in a distant part of theworld can have an impact on the availability of a commodity orservice their company needs.

In truth, these blind spots are good news for any procurementofficer who is willing to do a bit of homework. An understandingof the economic and geopolitical dynamics of the markets inwhich a company participates can lead to many opportunities over-looked by its competitors and can create a competitive edge where

Buy Globally, Think Globallyby Simon Harper and Laura Thompson

Buy Globally, Think Globally 145


seemingly none was available.For some commodities, a procurement manager can profit from

knowledge of regular cyclical price swings by locking in prices at thebottom of a cycle. For others, an understanding of the market canhelp procurement officers see when a permanent shift has occurred.The price of sugar, for example, is set not merely by the demand forsugar as a food ingredient, but also by the growing need for sugar asa raw material for ethanol, thanks largely to Brazil’s ambitiousethanol fuel program. As a result, whereas sugar once hewed to itsown seasonal supply-and-demand cycles, it now also tracks the priceof oil — a fact that a company could use to gain an advantage overcompetitors who monitor only seasonal cycles.

In addition to overall commodity price movements, currencyfluctuations can provide a source of savings. Although currencymanagement has been simplified by the introduction of the euro,it is still an important factor to keep an eye on. Does the U.S. dol-lar seem to be heading down? Maybe it makes sense to lock in adollar price on Christmas stock early. Japanese yen seem too un-certain? A company could hedge now, and prevent an unexpectedlyhigh price tag later on, or make sure a contract is denominatedin the company’s currency. Sometimes, a currency-related op-portunity may exist even when one’s direct purchases are made in asingle currency. For example, if a company pays in euros but oneof the key commodities used by an upstream supplier is priced inU.S. dollars, it’s possible to disaggregate the dollar-denominatedcosts and negotiate a discount if the dollar has declined againstthe euro.

The same divide-and-conquer gambit can work well for uncov-ering other kinds of cost drivers. By separating the value of under-lying commodities in a product, one can more easily see what thetrue cost should be. Vendors are all too quick to demand higherprices when some of their cost factors go up, but are understand-


ably less than eager to point out when those same prices go downagain. A knowledgeable procurement manager with access to a bitof price data might call the vendor and say, “Hang on, why am Istill paying the same as I did last month, now that sugar is down 3cents per pound?”

As well as monitoring daily, weekly, or monthly fluctuations inprices, it’s also crucial to understand trends in macroeconomic fac-tors over the long haul. For example, a company that spots risinglabor costs in a low-cost country where it is outsourcing, such asChina, could gain enough time to scout out partners in less costlylocations before its existing agreement becomes uncompetitive.

A little global foresight also allows a company to create a signif-icant competitive advantage by anticipating a price spike or a com-modity shortage better than its rivals can. For example, in 2005,some businesses were surprised by China’s cardboard shortage, real-izing the problem only when orders started to arrive in weak, bulkyboxes made of wheat or rice straw. Sourcing managers who wereaware that China faced a serious shortage of harvestable trees, andthat non-wood fibers accounted for nearly 85 percent of the pulpChina produced, had already planned for suitable alternative pack-aging — or sought to specify the grade of shipping material in con-tracts. But those who failed to foresee the problem found themselvescoping with damaged cargo.

Anticipating all the possible permutations that can affect sourc-ing appears to require a highly sophisticated level of foresight, butanswering four simple questions can make it relatively easy to takeadvantage of (or at least not be harmed by) global conditions:1. Which categories within our procurement expenditures are

strategic enough to warrant close attention?2. What are the economic, regulatory, and political cost factors

behind these key categories?3. How would changes in those factors affect the overall perfor-

mance of our current sourcing arrangements?4. How can our team best monitor these potential changes?

The first question requires little more than diligent self-analysis;the second and third can be addressed by sending out an all-pointsbulletin throughout the organization for, say, legal, finance, and taxexperts to flag relevant changes in economic and geopolitical condi-tions pertaining to the purchases that the company has determinedare strategic. In addition, procurement staffers can be directed toread articles in newspapers and trade journals involving these itemsor, in the case of a commodity, to closely monitor the sector via Websites that cover it. Also, blogs are becoming increasingly valuablesources of industry information. And even casual conversations withsuppliers can be useful. If a vendor is moving its manufacturingfrom country X to country Y, a simple “why?” may uncover deeperchanges in the market.

As for the fourth question, once the most important cost factorsare identified, they can often be tracked relatively easily by creatinga simple online dashboard of commodity prices or even by subscrib-ing to online news alert services such as those offered by Google. Formajor commodities, price quotes only a few minutes old are oftenavailable online at no cost, and most industries have newsletters andother publications that track price trends. And this kind of data isnot confined to raw materials. For almost any product manufac-tured in large quantities, even such high-tech goods as flat-screendisplays and computer memory chips, it is almost certain that some-one somewhere monitors its price.

Of course, it’s one thing to subscribe to a report or install awidget on a procurement manager’s screen. It’s another to make surethe manager and the department make good use of the information.One way to embed awareness of economic factors into the procure-ment team’s day-to-day operations is to set key performance indica-



tors for expenditure categories that incorporate appropriatemacroeconomic factors. For example, if a particular metal is 30percent of a part’s cost and the entire product is priced in U.S. dol-lars, assessing the procurement manager’s contract prices againstcurrency fluctuations will provide a good litmus test of the manag-er’s performance. It might sound great that a buyer was able to avoida price increase on a part over the past year, but if the dollar is down5 percent, that accomplishment begins to look less impressive.

In most cases, global sourcing analysis primarily identifiesopportunities for cost savings by making pricing more transparent,trends more obvious, and negotiations less prone to deception. Butsmart procurement can also create value and increase profits when itis used to develop consumer insight and anticipate changing buyingpatterns. For example, Whole Foods, one of the few profitable gro-cery chains in the U.S., has employed a deep analysis of consumerpurchasing trends to fill its stores with organic foods, tapping into agrowing and well-heeled customer base that is willing to pay morefor items without additives and other unnatural ingredients. Thoseand similar eco-friendly preferences seem likely to proliferate in thefuture, so why wouldn’t a savvy food buyer be proactive and lead hiscompany in capitalizing on the geopolitical hot topic of climatechange by sourcing “carbon-neutral” food?

Indeed, for the globally savvy CPO, the opportunities may be asunlimited as the challenges. +

Editor’s Note

First published as “All the World’s Your Stage” in European Leaders in Procurement (Spring 2007).

Lessons from China:The Importance of Knowledge-basedSourcing in Low-cost Countriesby Ronald Haddock, Michael Pfitzmann, and Reid Wilk


ONE MAJOR AUTO-RELATED manufacturer based in the United Statesrecently learned a painful lesson in China. Top management was ina hurry to drive down the cost of parts, which was no surprise inlight of the problems hampering the U.S. automotive industry. Butthe company went about finding Chinese suppliers in a decidedlyold-fashioned way: It sent out requests for proposals (RFPs) todozens of parts suppliers that it did not know. Many suppliers sub-mitted bids for the work, but as is typically the case with such bids,they did not include essential information, such as a supplier’scapacity to fill the company’s orders on a timely basis, its ability todeliver high-quality parts, or its cost basis for making the parts.Without this information, it was impossible for the company tomake sound selection decisions, and the effort eventually failed.

Compare that with the experience of a top U.S. retailer, whichover the years had built a broad supply base in China, doing busi-ness with hundreds of companies. To seize an advantage over its U.S.competitors, the retailer decided to narrow this supply base — lim-iting the companies from which it purchased items to those that itmost trusted and sharing more extensive information with the cho-sen companies to ensure deeper relationships. In so doing, the retail-er was able to benefit from supplier expertise, and it achieved a 33to 50 percent advantage over its competitors in terms of the time

needed to introduce new products to the American market.For years, it has been clear to practitioners that sourcing from

China and other low-cost countries (LCCs) requires a rigorous andthorough approach, particularly when companies are seeking morehighly engineered or otherwise complex products, for which theability to understand nuances in suppliers’ capabilities or to influ-ence design or production is required. Nevertheless, the myth thatbids from Chinese or other suppliers can be fully understood bysmart analysts in a back room a continent away still persists in somequarters. Many U.S. and European manufacturers still send RFPs toChinese suppliers without ever setting foot on the mainland.

China’s Changing RealitiesSuch practices will no longer work, partly because of importantstructural shifts under way in China’s economy and its competitive-ness compared with other LCCs. According to a new survey by Booz& Company and the American Chamber of Commerce inShanghai, some 50 percent of multinational companies doing busi-ness in China think the nation’s competitiveness in low-cost manu-facturing is eroding. Almost a fifth, or 17 percent, are considering— and in some cases already pursuing — a shift of operations toeven lower-cost countries such as India, Vietnam, and Thailand. Atthe same time, the vast majority of these companies find China tobe highly attractive as a growth market, thanks to its expandingeconomy and a middle class that continues to grow by tens of mil-lions of people every year.

The primary reasons for China’s declining competitiveness inmanufacturing are commodity and wage inflation, the rising valueof the Chinese currency, high real costs of talent due to low em-ployee retention, and the failure of many manufacturers to imple-ment efficient and lean operational systems in their plants.

As a result of these pressures, companies will find it increasing-

Lessons from China 151

ly necessary to pursue a dual strategy of using the Chinese platformfor making more sophisticated product components for export andsimultaneously seeking to penetrate the domestic market. Thismeans taking a more holistic view of how sourcing fits into a com-pany’s overall activities in China, and it requires a deeper level ofmanagement engagement.

Other pressures are mounting as well. The problems in supplychains in China — particularly the use of low-quality, dangerousmaterials and the prevalence of shoddy workmanship — that haveaffected manufacturers of products as varied as toys, pet food, andmedicines have demonstrated that Western companies must havedeeper footprints on the mainland. And it is becoming increasinglyevident that the best techniques for protecting one’s intellectualproperty in China, in the absence of effective governmental agree-ments, center on having one’s own employees monitoring the com-petitive landscape. Companies including the General MotorsCorporation and Cisco Systems Inc. have been stung by the emer-gence of copycat products from rivals operating seemingly rightunder their noses.

The Knowledge-based Sourcing ChoiceFor all these reasons, multinationals should consider adopting thenew approach to working with LCC suppliers that we call knowledge-based sourcing, which significantly increases companies’ insight intotheir supply bases. In addition to understanding their suppliers’ pro-duction costs, companies that practice knowledge-based sourcingcarefully assess manufacturing and transportation economics, lead-time requirements, schedule stability, the likely degree of productdesign changes, and the technical skills of the suppliers.

The use of knowledge-based sourcing in China is a controversialidea for some Western CEOs and chief procurement officers. Intheir minds, an investment of this magnitude, which can require


maintaining a staff of dozens or hundreds of people in China, couldoffset any possible gains from sourcing there. Wal-Mart seems toadhere to this view. It requires its suppliers to participate in an an-nual bidding process that consistently awards contracts to the low-est bidder (even as, critics allege, the quality of its productsdeclines). That serves the purpose of driving the price down witheach passing year, and that, not developing strategic supplier rela-tionships, is Wal-Mart’s primary motivation.

But it’s a different game entirely for companies interested inlong-term, innovation-based relationships and for retailers seekingto improve product design and quality or to secure access to uniquecapabilities. If top Western executives need to change their productdesigns in response to new tastes or market demands anywherein the world, to what extent can they count on Chinese suppliersto understand those realities and to accommodate them if they


Agree on the mind-set you will employ. IsChina a new center of global competitiveadvantage or is it merely a low-value-added low-cost country?•Develop a vision for how the supply

base will evolve over time, recognizingthat your company may well need to playa central role in shaping this supply baserather than simply segmenting it anddeveloping approaches to suppliers.• Segment your supply-side needs and

develop a supply base strategy thatdefines roles, relationships, and commit-ments by commodity category, supplierrelationship, and other factors. Whichcommodities and suppliers are trulystrategic? Which are or should be purelytransactional?•Develop a forward-looking knowl-

edge development strategy across com-modities and suppliers, defining whichknowledge should be developed internal-ly, which should be outsourced tothird parties such as Li & Fung, andwhich should be developed by yoursuppliers.•Recruit a team (using as many locals

as possible) that has the mind-set, ex-perience, and commitment to implementyour tailored approach. This typicallyinvolves people with specific technicalskills as well as business developmentskills. In some cases, significant effortsmay have to be put toward buildingsupplier capabilities, including jointinvestments and the insertion of profes-sionals who can think across this rangeof requirements.

Practical Steps toward Implementing Knowledge-basedSourcing in China


do not have a close partnership?Moreover, consider the costs that companies can incur if they

fail to pay close attention to their suppliers. Mattel Inc., forinstance, was forced to recall more than 20 million toys — mostlybecause of lead paint — that had been sold from November 2006through August 2007. What Mattel and other companies learnedfrom this experience was the importance of having the right peopleand processes in place from the outset; in other words, a greater up-front investment in supplier relationships diminishes the risk of hav-ing to pay far more to put out the fire after a problem has erupted.

Of course, a company contemplating sourcing in China couldconclude that the nature and scope of its buying is so limited that itdoes not make economic sense to build a knowledge-based sourcingsystem. For a company that sources such a low volume of productsfrom China that the cost benefit of “better sourcing” is not offset bythe cost of a team that can manage it, the answer may be outsourc-ing to one of the many Chinese sourcing and logistics companiesthat essentially help businesses gain the insight to better manageknowledge-based sourcing. Li & Fung Ltd., a Hong Kong–basedcompany, has been one of the pioneers in this area.

Implementation of a knowledge-based sourcing strategy is madea bit more complicated by local conditions in China that managersmust take into account as they determine how deeply to embed thisapproach into their companies’ operations. One variable is supplierbase maturity. Some industries today have very sophisticated suppli-ers and supply bases in China, while others are still quite primitive.The maturity level is driven by historical factors, such as how long aspecific industry has been using Chinese suppliers and the magni-tude of the cost advantage that Chinese suppliers have offered overthe industry’s previously established or domestic supply base.

One of the earliest industries that set up shop in China was elec-tronics, and today much of that sector’s global supply chain resides


there, driven by outsourcing from Hong Kong, Taiwan, the UnitedStates, Europe, Japan, and South Korea. The auto industry made itsfirst major foray into China in the 1980s and 1990s, when Japanesemanufacturers extended their supply base into the country wellahead of U.S. and European vehicle manufacturers. As a result ofthese early activities, Chinese electronics suppliers are in fact worldclass, and auto suppliers are rapidly moving in this direction. Bycontrast, major oil and gas companies have only recently begun toestablish bona fide sourcing teams in China.

A second key variable in a company’s decision of how deeply toembed a knowledge-based sourcing strategy is China’s importanceto the company globally. Different CEOs view China from differentperspectives. Some see it as a center of gravity for their global sup-ply base; others perceive it, correctly in some cases, as just anothersourcing location. Companies that consider China to be a new loca-tion for developing global competitive advantage across operations— for example, in product development as well as in marketing,sales, and aftermarket services — experience the role of the supplybase in one way; companies that are sourcing limited, low-value-added, semi-processed materials or components experience it in asubstantially different way. Where China is central to global strate-gy and involved in potentially highly profitable activities, the expec-tations for the supply base and supplier capabilities will necessarilybe elevated.

Three Knowledge-based Sourcing ImperativesWhen companies decide that a knowledge-based sourcing approachin China (or another LCC) is right for them, they must invest indeveloping strong relationships with potential and existing suppli-ers. Knowledge-based sourcing is more resource intensive at theoutset, but its ability to drive down costs and improve quality overthe long run repays that investment many times over. Particularly


in China and other LCCs, there is wisdom, and profit, in theknowledge gained. In the changing Chinese environment, threeimperatives are essential to implementation of a knowledge-basedsourcing strategy:

1. Know your suppliers inside out. Understand current and potentialsuppliers’ true cost positions. We have heard of many cases in whicha supplier in China or another LCC did not understand its owncosts. It won work from major manufacturers and retailers only todiscover that it was losing money by fulfilling its contracts. Not sur-prisingly, these relationships fell into crisis.

Visit suppliers and see their technical capabilities and capacitywith your own eyes. This includes their machinery and equipment,their process technologies, the number and qualifications of theiremployees, and the like. A bid is no guarantee of a supplier’s willing-ness and ability to meet current volume and quality requirements orits future competitiveness.

Assess supplier performance against major cost drivers (includ-ing wages and benefits, productivity, facility and process/equipmentscale and utilization, logistics, and access to raw materials). Lowlabor costs and the ability to obtain cheap raw materials and com-ponents are just two possible elements of cost structure. To gain trueadvantage, it is important to establish the ideal combination ofworld-class performance with location, scale, process technologiesand automation, and success in execution. It will then be possible torate potential suppliers against that ideal and determine how close asupplier from an LCC can come to meeting it. In some cases, itmight be more advantageous to select a supplier closer to home.

2. Develop strong relationships with fewer suppliers. Identify a fewsuppliers that are willing to commit to a long-term relationship andto jointly creating a competitive advantage. Offer an enduring andprofitable business relationship to each supplier and, in turn, de-mand its commitment to meeting cost, delivery, quality, and, if


applicable, innovation targets. This will likely require local resourcesdedicated to supplier development, which means working with thesupplier to achieve ambitious jointly established targets.

To avoid fragmentation of the supply base, stop bidding outeach part and dropping suppliers anytime another company offers abetter deal. It is difficult for suppliers to develop the right capabili-ties, make customer-specific investments, and work together well ifthey’re not confident of continuity.

Beware of the risks of a large supply base into which you havelittle insight and over which you have little control. The dangersinclude divisive conflicts within the supplier’s leadership team,financial problems, shifts in the supplier’s strategy or customer base,and deteriorating performance. These problems could go unnoticeduntil crucial shipments are missed, costs mysteriously escalate, orquality suddenly nose-dives.

Avoid the transactional costs associated with managing manysuppliers. Each supplier, particularly one far away from a customer’slocations, requires valuable and often expensive resources in pur-chasing, engineering, and other functions to manage purchasingorders and financial transactions, to review and discuss quality anddelivery performance, and to work on innovation and productdesign changes. The larger the supply base, the more resources arerequired to manage transactions, control supplier performance, andaddress issues in the relationships. These resources could be betterspent on valuable activities such as working on an innovative orlower-cost product design.

3. Work jointly with your suppliers on continuous improvement. Focuson developing suppliers’ capabilities and advancing their competi-tiveness over time. Set ambitious but realistic targets for better per-formance in cost, quality, delivery, or innovation, and work withyour suppliers, not against them, in achieving those goals. Successfulcontinuous improvement requires agreed-on objectives, transpar-


ency of current and anticipated costs and processes, and the sharingof improvement ideas.

Large customers often have internal knowledge about advancedconcepts such as lean manufacturing that many low-cost suppliershave not yet developed. Improving low-cost suppliers’ capabilities inthat regard can create a big payoff for both parties. If you have asmaller, more dedicated supply base, you can afford to invest in rela-tionships and ensure a higher level of coordination in the entiresupply chain.

General Motors’ sourcing program in China reflects both thedemands and the benefits of knowledge-based sourcing. GM is veryactive in China; the company has a joint venture in Shanghai withthe SAIC Motor Corporation and sells a million vehicles a year inChina, making it the number one player in the market. GM alsopurchases US$2 billion worth of parts each year from Chinese man-ufacturers to ship to its plants in Asia and North America. In 2007,the automaker bought many different types of components inChina to fill its North American assembly needs, led by aluminumwheels, chromed parts, and electronics such as radios, according toBo Andersson, GM’s group vice president of global purchasing andsupply chain.

In addition to staff assigned to the joint venture withSAIC, Andersson has put in place a veritable knowledge-basedsourcing blitz, with 250 GM purchasing professionals in Chinaworking with suppliers to monitor and upgrade their capabilities,as well as to build strong relationships that can redound to GM’sadvantage. “We now have a third of our people in Beijing, a thirdin Shanghai, and a third in Guangzhou,” Andersson says. “Butwe’re moving much, much more into the countryside.” This movedeeper into China’s mainland is part of an effort to seek newChinese suppliers and reduce GM’s dependence on large multina-tional suppliers, which charge standardized global prices that are

higher than China-based prices.Andersson and his purchasing team are trying to find

more people like Jiang Yintai, president and owner of ShanghaiDaimay Automotive Interior Company. Currently, GM buys morethan 5 million sun visors a year from Daimay. “It’s a privatelyheld company, and Jiang loves our business,” says Andersson. “Hehelped us to go from 100-plus sun visor families to just four. He’snow making steering wheels for us, and he’s doing the same type oftransformation.”

GM’s goal is to find more of these local entrepreneurs and takean active hand in the evolution of their businesses. “It may take us10 years to develop them, but we’d rather do that and have loyalsuppliers forever,” Andersson explains. “Our strategy is based on thefact that we are willing to do a lot of work with people who have theright mind-set and the right culture and the right cost structure, ver-sus just sourcing from China. What we’re doing is much more dif-ficult, but the payoff is much better and the loyalty from thesesuppliers is very different.”

Other Western companies have also shifted their focus in Chinafrom traditional practices to knowledge-based sourcing. Like GM,one Tier One automotive supplier based in Europe began its effortto cultivate a robust Chinese supply base by establishing a strongsupplier development team in that nation. This team assists newChinese suppliers as they develop their capabilities to meet contractrequirements, and helps existing preferred suppliers evolve into full-fledged partners.

The Tier One supplier also invested in several development cen-ters in China. These centers support both the company’s own localproduction and its supply base to optimize designs to suit the localmarket. One surprising gain: The centers have helped suppliersreduce costs by replacing raw materials formerly imported from theU.S., Europe, and Japan with domestically sourced raw materials.



A Mind-set of Long-term CommitmentAs GM and the Tier One supplier have discovered, knowledge-based sourcing places a high premium on identifying the rightsupplier and building an enduring relationship. It’s not quite ascomplex or as time-consuming as finding a full-fledged joint ven-ture partner, but it does take more time than simply calling for bids.There are no shortcuts in this kind of relationship building.

The mind-set of knowledge-based sourcing is also different fromthe shotgun RFP approach in this respect: Companies should workclosely with suppliers, so closely that they might even jointly acceptresponsibility for a supplier meeting its cost and delivery per-formance targets. There should be no uncertainty and absolutelyno surprises. The old mentality was simply to tell LCC suppliers,“Just meet your deadlines. We don’t care how you do it or whatkinds of parts and materials you use.” That approach, of course, isno longer wise.

A crucial aspect of a positive supplier relationship is mutualcommitment. As GM found with Daimay, it is important for pur-chasing managers to educate suppliers about how they want to dobusiness and to spend time with suppliers to gear them up. If thetwo parties can achieve a mutuality of purpose, over time, the com-pany can truly leverage the relationship and help the supplier devel-op and expand its business. If a company doesn’t demonstrate thistype of deep commitment, the supplier’s inclination is to do the bareminimum necessary to get the business.

The ability to adopt and use a knowledge-based sourcingapproach takes on particular urgency in view of the rising currencyand cost structure in China. Companies that want to hold theirmargins and maintain access to that fast-growing economy mustincrease the efficiency of their Chinese supply base. Even those man-ufacturers and retailers that choose to simply shift their supply baseto a lower-cost country, such as India, Vietnam, or Thailand, would


do well to observe the essential truths of knowledge-based sourcing.As these emerging economies prosper, it is very likely that they willgo through the same evolution that China is now. When that hap-pens, the winning multinationals in those countries will be thosethat learned from their experience in China and implemented bestpractices in sourcing from the start. +

IF YOUR COMPANY is striving to capture procurement savings, you’veno doubt heard complaints like these:

My head of procurement is claiming €250 million in savings a year.I’ve asked him why I cannot see this in the profitability of the divi-sions. He says he doesn’t know. He assumes the divisions are compro-mising his savings with spending increases and unauthorized “mav-erick buys” from local suppliers. — CEO, global logistics provider

We made significant strides in reducing our costs for procured mar-keting materials and services — reaching up to 50 percent in costreductions in some cases and achieving an almost 10-fold increaseversus our target. Unfortunately, we had no mechanism to affect thealready established budget, so all the incremental savings werequickly spent. — Head of purchasing, North American con-sumer products company

In this frugal business environment, many companies are refocusingtheir purchasing efforts to be as thrifty as possible. For example,Johnson & Johnson plans to cut as much as US$1.6 billion incosts out of its $6.8 billion procurement budget in FY08, andCitigroup announced a major overhaul and centralization of its pro-

Off the Table, Into the Pocket:Capturing Procurement Savingsby Harry Hawkes, Patrick W. Houston, and Martha D. Turner


Off the Table, Into the Pocket 163

curement programs, aimed at cutting $4.6 billion from $22.2 bil-lion in costs by 2009.

But as attested by the perplexed tone of the quotes above, it isvery common to find big gaps between planned savings, actual sav-ings on the table, and actual savings in pocket and applied to thebottom line. Despite their best intentions, too many companies dis-cover that a large proportion of the savings their procurement exec-utives promised seems to leak away. In fact, our experience indicatesthat most companies realize no more than 50 percent of the procure-ment savings they plan for. Others see an even more dire situation:According to a 2008 report by the Center for Advanced PurchasingStudies, even though 46 percent of U.S. corporations’ revenue is ear-marked for the purchase of goods and services, and corporate pro-curement departments manage more than 80 percent of those expen-ditures, the typical corporate-wide savings program is able to realizecost savings of only 4 percent. Moreover, one-third of those savingsrepresent cost avoidance, which never drops to the bottom line.

Clearly, the impact from savings leakage in procurement effortscan be significant — so significant that finding a way to plug theholes and minimize the leakage is just as important as identifyingand capturing procurement savings in the first place. The good newsis that the problem of leakage can be fixed. The fix takes a numberof cues from the way leading companies approach cross-functionalcost reduction initiatives; they achieve success by using a set ofexplicit execution, decision-making, and tracking mechanisms.Without such structural rigor, no focused savings program —whether a one-off savings initiative or an ongoing procurementeffort — will fully produce its intended results.

Why Leakage OccursEssentially, leakage is the result of four factors (the first three areclosely related to a lack of buy-in between procurement and the

affected functions or divisions):1. Overestimating.Too often, the assumptions used to project pro-

curement savings are simply too optimistic or too aggressive. Suchassumptions typically arise because of poor benchmarks, an incom-plete understanding of current and forecasted spending, or miscon-ceptions about the cost drivers that affect savings, such as suppliereconomics. Ultimately, these problems result from a lack of rigorand departmental input into the underlying assumptions.

2. Dubious budgeting.Once a particular department determines itsexpected savings, those expectations may be intentionally watereddown when they are incorporated into departmental budgets — thegoal being to provide a budgetary cushion to make sure budgetingexpectations are met. Again, lack of organizational buy-in typicallyleads to this behavior. The result: The full amount of the expectedsavings never appears.

A corollary to this tactic involves the lack of a mechanism for


Consider the typical, yet challengingexample of achieving savings in the area ofmarketing, specifically media buying. Let’sassume that through supplier interactionsand economic analysis, procurement iden-tifies significant savings opportunitiesalong several fronts, including switchingto a lower-cost but higher-value mediabuying agency and instituting specificdemand-side savings opportunities, suchas volume commitments, regional splits,and lower-cost designs. If you think thesavings will make it to the bottom line inthe absence of the six elements for mini-mizing leakage described in this chapter,think again.

First, the agendas of the marketing andprocurement departments are inherently

at odds, and no savings will be achievedwithout aligning their incentives andobjectives. Therefore, step one is to securemanagement commitment and establish across-functional marketing/procurementteam for the initiative.

But even though marketing is part ofthe project team, the department is likelyto seek to minimize the savings opportu-nities; after all, its argument will be thatany such savings will adversely affect thecreative product. Here is where the bro-kering process comes into play: Someoneneeds to break the tie, either by commit-tee or through explicit decision-makingauthority.

Media buying is a budget-driven spend-ing category in which savings typically

Saving the Savings


capturing the additional savings created if the savings initiative ex-ceeds expectations. In this case, the exact target savings are achieved,but any additional savings — which were not budgeted for — aresimply spent elsewhere.

3. Poor demand management and compliance. Savings evaporatewhen companies start buying products from vendors other thanthose identified by the procurement process. So, for example,instead of a 20 x 20 inch poster in black and white, marketing maypurchase a 31.5 x 43 inch full-color, embossed poster from a vendorthat does not have the best negotiated prices and isn’t on theapproved list. Unless these “off-plan” decisions are made with a clearpicture of the business trade-offs and the impact on targeted savings,functional and divisional budget owners may seek solutions that areless than optimal for the company as a whole.

4. Changes in baseline assumptions.Despite the best intentions, theeffect of inflationary pressures can be impossible to avoid; for exam-

mean that you get more to spend tohit the budget, so $5 million in savingsusually translates to $5 million more tospend. Therefore, unless the budget isadjusted to compensate for the moneysaved — unless strong-form budgeting ispracticed — the savings will simply evap-orate. Again, senior management broker-ing and cross-functional teaming will helpto avoid this problem.

Then comes the argument that a chang-ing media buying environment requiresadditional spending or requires that sav-ings be allocated differently: “What wasthe basis of savings measurement? Well,we’re operating under different conditionsnow, so we can’t possibly save what we saidwe would.” Here is where initiative defini-

tion — including savings targets, projectmilestones, and baseline assumptions —must be clearly articulated. If not, preparefor slippage in both execution and theability to measure performance.

Finally, even if all else goes well, to trulyidentify the savings you have captured,you need to be able to clearly measureyour results against the original plans andassumptions. That’s certainly more easilysaid than done, but if you don’t figure outhow to measure the variance, you’ll neverfully understand why the savings were orwere not achieved. Was it a change in thespend assumptions? Did you buy whatyou said you would, and from the suppli-ers you said you would use?


ple, when increases in raw material costs and wage rates generatehigher prices for vendors, the increases are often passed along tocompanies. To further complicate matters, a company may changewhat it is buying and from whom it buys. In either case, it is criti-cal to have a well-documented baseline that enables the company toexplain the impact of such shifts and account for them in the calcu-lation of procurement savings.

Plugging the Holes in Savings InitiativesSix elements must be in place for an organization to minimize leak-age and maximize the delivery of savings from procurement pro-grams to the bottom line. Three of these elements — initiativedefinition, “strong-form” budgeting, and well-defined measurementand tracking — are tactical and require hard-wiring, as well as somemodifications to existing processes. The other three — senior man-agement commitment, cross-functional engagement, and the bro-kering process — are “softer,” company-wide elements, but they areno less critical to maximizing the savings potential and makingsavings stick.

“Hard” Tactical ChallengesThe tactical, business-process challenges inherent in savings initia-tives can be intractable for many companies, particularly those with-out a culture of intensive cost management. Here are some ways toaddress these critical elements:

1. Initiative definition.Transparency is necessary to ensure adequaterecognition of expenditures and savings and is an important basisfor internal brokering and future negotiations, whether for ongoingprocurement savings efforts or as part of a one-off cost-cutting ini-tiative. Structured tools, such as the “project sheet,” can be a hugehelp in making sure that the savings process is sufficiently articu-lated so that clear responsibilities, targets, milestones, and baseline



Exhibit 1: Sample Procurement Savings Initiative Project Sheet

Commodity ProjectTitle SavingsLevers

April 1

April 21

May 15June 7July 15July 31

September 1

• 30 percent response rate on RFP requiringextension of time line to allow more responses

Jay Doc (procurement), Pat Dodd (maintenance),Jane Jones (manufacturing), Pete Franklin (finance)

Year 1$0.6

Year 2 Year 3$1.1 $1.3

$0.3 $1.4 $1.5

$0.3 $1.0 $1.2

Target

Achieved

Budgeted

• Baseline unit pricing from sample invoices• Forecast volume based on baseline volume adjusted for

percent sales forecast increase• Scope covers all six facilities in U.S. (five plants and HQ)

Industrial supplies

Spend consolidationDevelopment of preferred vendor

Milestone Activity Planned Date of Completion Savings Summary ($ millions)

Baseline Assumptions Issues

Notes/Comments

• Many products in category (paint, plastics, lubricants,etc.) are petroleum-based and therefore subject tosignificant price increases in the short run, potentiallyminimizing or eliminating “cash” savings

Risks

• Need to respond to questions submitted by RFP respondents• Draft responses to supplier questions and get input from

functional team members before sending

KickoffBaseline approvalRFP development/issueRFP analysisNegotiationsSupplier selection

Savings start

Team Members

assumptions are understood by all — including procurement,finance, and individual departments. (See Exhibit 1.) Key activitiesin initiative definition include:• Documenting who is responsible for what and defining the

cross-functional teams• Clarifying spending assumptions from which savings expecta-

tions can be explicitly measured• Committing to a schedule, including specific milestones, for

execution• Establishing savings targets to be tracked against savings achieved• Setting up a system in finance to monitor whether procure-

ment’s targets for project costs and savings are being met2. Strong-form budgeting. Rigorous budgeting is fundamental to

the procurement savings process. As a rule, budgeted savings willguide maximum savings. If you set the budgeted amount of savingstoo low, you are apt to end up with this artificially reduced amount.


The budgeting process sets the commitment early on and allows forvisibility into realized savings. It also provides the framework inwhich all departments and functions must work with procurementto achieve the targeted savings. Two additional elements are criticalif the budgeting process is to be effective:• Finance must clearly link the savings initiative to the functional/

divisional budgets.• Adjustments to the budgets must also include changes in the sav-

ings targets to create a true measure of actual versus expectedspend. Thus, if savings exceed the originally budgeted amount,the plan would be adjusted accordingly. For example, if the finaloutcome of a rigorous RFP and negotiation process yields savingsthat are higher than originally estimated, this upside needs to becaptured in the budget or the savings will “fall off the table.”3.Well-defined measurement and tracking. Poor measurement and

tracking of current spending and future savings is the bane of mostprocurement savings efforts. It is always difficult to isolate and “see”the savings that have actually fallen to the bottom line even whenyou have cross-functional teaming, a clearly documented baseline, awell-defined savings initiative, and a tightly crafted budgetingprocess. Savings can disappear for many reasons: some manageable,such as maverick buying or specification changes; some unmanage-able, such as inflation or changes in demand. Critical to knowingyou have captured the anticipated savings is creating visibility intothe savings identification process and successfully managing thelink between finance and procurement. (See Exhibit 2.) There areseveral requirements that need to be in place for this to happen:• The procurement function must accurately track the overall

progress of the project. The project sheet used to help definethe initiative can also be used for monitoring. Such a tool cap-tures procurement’s progress and compares it with establishedmilestones.


• All budgetary adjustments must be linked to departmentalbudgets. This process allows for savings to be built into everybudget. Adjustments are made for changes in baseline assump-tions as well as for the impact of increased savings, and then aretied back to individual procurement project tracking sheets.

• Actual savings must be tracked against budgeted savings on anexception basis. Broad variances from planned savings and theirsubsequent effect on budgets should be highlighted; price andvolume variances should be normalized as appropriate to checkfor true procurement impacts.

• Commodity dashboards must be monitored. Drivers of devia-tion from expected savings results can be explained — e.g., vol-ume, specifications of the product mix, vendor changes fromoriginal plan and baseline — and reconciled with the exception-based tracking by finance.

“Soft” Organizational ChallengesNo enterprise-wide savings initiative has much chance of succeedingif certain organizational issues have not been dealt with. Such issuesinvariably involve top management leadership, interdepartmentalbuy-in, and consensus on decision rights.

Exhibit 2: Savings Measurement Tracking

OngoingReconciliation

of MajorVariances

Develop SavingsOpportunities

CreateProjectSheet

Procurement and Function

Finance

MapSavings

Estimates toBudget

Build Savingsinto Budget

Track BudgetVariance vs.

Expected Impact

Develop andMonitorMetrics

Track Projects andUpdate Status

(Savings, Timing)

Procurement Support ServicesLiaison


1. Senior management commitment. Nearly every significant pur-chasing initiative works across organizational and functional bound-aries to drive savings within budgets that purchasing does not own.And because it is often difficult to get cooperation among diversedepartments, these initiatives must have executive sponsorship atthe highest level of the organization in order to manage the processthrough any potential organizational friction and provide the neces-sary incentive for change.

2. Cross-functional engagement. Similarly, because procurementitself does not own a budget and has limited decision-makingauthority, cross-functional engagement is a key element for success.Indeed, it is required throughout the specific savings initiative —from the early identification of potential savings (baselining, savingsidentification and estimation, RFP development, and negotiations)to the embedding of the expected savings in the appropriate budgetsto measurement and tracking of the results.

3. Brokering process.Given the divergent views that procurementand the other functions hold about purchasing savings — for exam-ple, marketing may have a natural allergy to standard materialsbecause it believes they inhibit creativity, while procurement mayseek to streamline the SKU portfolio to gain better leverage andeconomies of scale — it is critical to have a process for resolvingstalemates that arise during decision making, and to arrive at theright business decisions without stumbling. Often an executive bodyor committee is necessary to oversee this process and establish orclarify decision rights. Decisions that require brokering come inmany forms: Is the savings initiative worth pursuing? Whatresources should we dedicate to the effort? How much of the ex-pected savings should we budget? Should we budget for greatersavings than are likely achievable in order to provide more of anincentive to save? What should we do with excess savings: reinvestthem or bring them to the bottom line?



Getting money into your company’s pocket is just as difficult asputting money on the table — and in our experience worth just asmuch. No matter how skillful your procurement organization is atfinding and negotiating savings, a flawed process for defining andcapturing those savings can significantly hamper your ability to real-ize those benefits and may negate any sourcing advantages youmight have negotiated.

It’s more than likely that any company that has successfully leda cross-functional cost reduction program in any area has experi-enced the elements required for procurement savings success. Thechallenge, however, lies in instituting the elements of the savingsprocess as a matter of ongoing business practice — hard-wiring theprocess and changing the organizational approach.

Instituting these changes can lead to significant increases in theamount of money that makes it to the bottom line of the company.With many companies experiencing a near 50 percent leakage ofsavings identification and capture, even a slight improvementwill translate into big benefits — benefits that justify overcomingthe organization’s initial resistance to change. In the end, it’s notmagic but a whole lot of process discipline and organizational buy-in that is required to move the money off the table and into yourcompany’s pocket. +

Editor’s Note:

First published, 2005.

JEFFREY BARTA([email protected]) is an associate withBooz & Company based in Chicago. He special-izes in sourcing and procurement operations,with a particular focus on procurement technol-ogy and strategic sourcing programs across abroad range of industries.

HARALD DUTZLER([email protected]) is a principal withBooz & Company based in Vienna. His areas ofexpertise include performance improvementprograms through strategic sourcing and supplychain management, particularly in the con-sumer goods and retail industries.

GEORGINA GRENON([email protected]), based in Paris, isdirector of Booz & Company’s global businessdevelopment and intellectual capital efforts inoperations, manufacturing, sourcing, and logis-tics. She recently led an ongoing initiative inenergy-efficient and sustainable supply chainmanagement and sourcing.

RONALD HADDOCK([email protected]) is a Booz &Company partner based in Zurich. He has beenwith the firm since 1994, including 10 years inAsia in the China, India, and Korea offices. Duringhis recent assignment in Shanghai, he led theauto and industrials practice in greater China.

SIMON HARPER([email protected]) is a partner in Booz& Company’s London office. He advises clientsin the retail, consumer, and telecommunica-tions industries on operations strategy, pro-curement, and supply chain transformation.

HARRY HAWKES([email protected]) has 19 years of expe-rience with Booz & Company and is a partner inNew York and Cleveland. The global leader ofthe firm’s operations practice for media andentertainment clients, he focuses on performanceimprovement, operations restructuring, andmajor organizational change programs.

PERTTI HEINONEN([email protected]) is a principal inBooz & Company’s Helsinki office. He advisesclients in the retail, consumer, and health-careindustries on strategy, procurement, and valuechain collaboration.

PATRICK W. HOUSTON([email protected]) is a partner with Booz &Company based in New Jersey who has over 13years of global consulting experience. The leaderof the firm’s strategic sourcing practice in NorthAmerica, he specializes in operational and orga-nizational transformation with particular empha-sis on sourcing and supply chain initiatives.

ROBERT HUTCHENS([email protected]) is a partner withBooz & Company based in New York. He workswith companies in the pharmaceutical, medicalsupply, and consumer products industries on arange of operational and strategic issues.

BILL JACKSON([email protected]) is a senior partner withBooz & Company based in Chicago. He works onmajor organizational change programs, includ-ing restructurings, postmerger integrations, andgrowth, for a variety of industrial clients, espe-cially those in the global automotive industry.


About the Authors

About the Authors 173

AMIT KAPOOR([email protected]) is a senior associate inBooz & Company’s London office. He specializesin the optimization of sourcing, supply chain, andvalue chain collaboration strategies for retailand consumer packaged goods companies.

RICH KAUFFELD([email protected]) is a Booz &Company partner based in New York. He focus-es on corporate and business unit strategy, sup-ply chain management, and transformationalimprovement programs for consumer productscompanies and retailers.

MARCO KESTELOO([email protected]) is a partner withBooz & Company based in Amsterdam. He focus-es on assignments in the areas of strategy, oper-ations, and organizational management, and hasextensive value chain experience with companiesin the retail, consumer goods, and automotiveindustries in Europe and North America.

PETER-JOHN LIBEROTH([email protected]) is a partner withBooz & Company based in Copenhagen. He hasover 16 years of experience, specializing in sup-ply chain management, strategy and transforma-tion, and strategic sourcing, and has worked withconsumer goods, energy, utility, construction,and manufacturing and packaging companies.

MATTHIAS MUELLER([email protected]) is an associatein Booz & Company’s Berlin office. He special-izes in procurement across a broad range ofindustries, with particular emphasis on automo-tive and other industrial clients, and he has spe-cific expertise in raw material hedging, supplychain finance, and working capital optimization.

MICHAEL PFITZMANN([email protected]) is a principal withBooz & Company in Chicago. He serves automo-tive and other industrial clients and specializes insourcing, competitive cost analysis, manufactur-ing strategy, and operations management.

ALAN S. PINCUS([email protected]) is a principal with Booz &Company based in New Jersey. He has over 15years of experience assisting clients with keyissues pertaining to sourcing and procurementtransformation, and he has specific expertise instrategic sourcing, procurement-related organiza-tion design and performance management, ande-sourcing and procurement technology.

BERNHARD RIEDER([email protected]) is a partner withBooz & Company based in the Munich office.He is a member of the global information tech-nology practice and focuses on the interactionbetween organization/process design and sys-tems implementation.

JEFFREY ROTHFEDER([email protected]) is a senior editorof strategy+business and writes frequently aboutmanufacturing, technology, environment, privacy,and security. His latest book is McIlhenny’s Gold:How a Louisiana Family Built the Tabasco Empire.

FABRICE SAPORITO([email protected]) is a principal withBooz & Company in Dubai. He focuses on oper-ations strategy and major transformationalefforts, and has specific expertise in businessstrategy, strategic sourcing, complexity reduc-tion, and supply chain management in theenergy, heavy industrial, consumer goods, andtelecom sectors.

DETLEF SCHWARTING([email protected]) is a partner withBooz & Company in Düsseldorf. He focuseson the procurement process: building best-practice sourcing organizations and capabilities,realizing short-term and long-term results,and implementing cross-functional processes,mainly in the high-tech, health-care, and auto-motive industries.

DERMOT SHORTENformerly was a partner with Booz & Company inNew York.

ROBERT SPIEKER([email protected]) is a principal withBooz & Company based in Amsterdam. Hefocuses on leveraging sourcing, supply chain,and logistics to drive performance improvementand build capabilities, and has extensive experi-ence with logistics, consumer products, andretail companies.

LAURA THOMPSON([email protected]) is an associate inBooz & Company’s London office. She special-izes in procurement across a broad range ofindustries with particular emphasis on retailand consumer businesses.

MARTHA D. TURNER([email protected]) is a principal in Booz& Company’s New York office and co-leader ofthe North American sourcing practice. She spe-cializes in driving operational and sourcingtransformation efforts for a variety of industries,with a particular focus on consumer-mediacompanies and specific expertise in marketingand green sourcing.

JAMES WEINBERG([email protected]) is a partner with Booz& Company based in McLean, Va. An officer inthe global information technology practice, hefocuses on strategic transformation programsand building IT-enabled capabilities for automo-tive, aerospace, and industrial companies.

REID WILK([email protected]) is a senior executive advi-sor with Booz & Company based in Detroit. Heleads the firm’s sourcing business in the auto-motive/industrial market and works with a vari-ety of automotive, industrial, and consumerproducts clients. He has nearly 20 years ofexperience in sourcing and business strategy inthe automotive industry.


About the Authors, continued

About the Authors 175

BOOZ & COMPANY is a leading global management consulting firm,helping the world’s top businesses, governments, and organizations.

Our founder, Edwin Booz, defined the profession when he estab-lished the first management consulting firm in 1914.

Today, with more than 3,300 people in 58 offices around the world,we bring foresight and knowledge, deep functional expertise, anda practical approach to building capabilities and delivering realimpact. We work closely with our clients to create and deliver essen-tial advantage.

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Sourcing Reloaded:Targeting Procurement’s New Strategic AgendaA strategy+business Reader

Edited by Jeffrey Rothfeder and Georgina GrenonWith an introduction by Patrick W. Houston, Detlef Schwarting,Robert Spieker, and Martha D. Turner

In today’s risky global business environment, supplier networks are the ulti-mate lifeline for many companies — delivering the far-flung materials,goods, and services that drive worldwide commerce. The sourcing functionhas thus become an indispensable contributor to strategic goals and competi-tiveness in every industry. But charting a course that positions the corporatepurchasing department as a catalyst for growth is no easy matter.

This strategy+business Reader, Sourcing Reloaded: Targeting Procurement’sNew Strategic Agenda, is packed with insights and prescriptive advice thatsenior leaders and purchasing executives can use to navigate today’s mostvexing sourcing problems. Its main theme: how to balance traditionalsourcing strategies with the new, collaborative approaches needed to drivesourcing’s effectiveness and help it attain its full potential in the face of thedemands of globalization, resilience, sustainability, complexity, andcustomization.

The Reader’s 14 chapters, written by Booz & Company’s foremost sourcingexperts, cover the latest ideas and trends, including the next wave of sourcingexcellence, the new role of the CPO, green sourcing, collaborative supplierrelationships, improved strategies for commodities procurement and supplychain resilience, and global and low-cost-country sourcing.

Sourcing Reloaded is aimed directly at companies that are determined to buildfresh purchasing capabilities that leave behind old, unprofitable sourcingroutines forever. For them, this Reader will be a helpful guide to arevolution in the making.

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