Don’t confuse price with total cost

The following cautionary tale, which shows the pitfalls of confusing price with cost, is a fairly accurate example of what we have been seeing in customers’ buying practices. What this story shows is that the true cost of wire includes so much more than the material cost. Those looking for true bargains need to consider a variety of factors such as rebates, product guarantees and return policies, and value-add features that may end up saving money in the long run. The calculation of costs must also consider lead time, fill rates, number of shipments to complete an order, as well as payment terms. All play a role in determining the true cost.

John Jeppson is the owner of Jeppson Electric Supply. John’s buyer, Joe Peterson, is retiring after 20 years of service. Joe’s buying approach was to purchase all his wire from tier one suppliers, who provide quick deliveries, high fill rates and enhanced product features.

John views the retirement of his buyer as a golden opportunity to get better pricing for the products that he sells and immediately begins looking for a tough negotiator who can get the lowest-priced products. After months of searching, John finds what he thinks is the perfect buyer in Eddie Phillips. Eddie is proud of being a tough negotiator, who hammers the lowest price out of suppliers. He even frequently refers to himself as ‘The Hammer.’

Joe agrees to spend a week before his retirement helping Eddie transition into his new buying role. During the week, Joe introduces Eddie to each supplier and walks him through how to get things done at Jeppson Electric Supply.

After the week is over, Eddie meets with John and tells him that he knows for a fact that he can get better prices. Eddie immediately begins by reaching out to his contacts at low-price suppliers. Eddie is very excited about the responses that he gets from his contacts. Eddie meets with John and shows him the most recent quotes, in which the new supplier’s price is 3% below the existing supplier. John is excited about the prospects of improving the company’s profitability and tells Eddie to go full steam ahead.

Six months after the buyer change, George Tyler, the company’s CFO, tells John that he is concerned about the direction in which the company’s finances are moving. John is puzzled, saying, “What do you mean? We are getting much better pricing than we have ever gotten.” George replies, “John, price and cost are not the same thing.” He adds, “To illustrate the point, I had the accountants put together financial data comparing the last six months Joe was buying wire versus the first six months that Eddie has been buying wire. This demonstrates what is happening across the entire company.”

Table 1 shows the figures.

Table 1: Financial data comparison of new buyer vs former buyer.

John looks at the numbers and replies, “This cannot be right. If Eddie is getting a 3% lower price than Joe on building wire, how can he be making less money?” At this point, George begins to show John the difference between price and cost.

Looking at material costs on Table 1, you can see that Eddie is indeed getting a better price than Joe did. However, there are several important costs that both Eddie and John were not considering: vendor rebates, product guarantees, product value-add features, lead time, fill rates, number of shipments to complete an order and payment terms. Each of these factors had a definite impact to the business, and together they added up to a situation that increased long-term costs.

Rebates add up

Table 2 breaks down the rebate situation, which George (patiently) explained must be factored in. By overlooking rebates, they had missed the boat on $40,275.

Table 2: Rebate comparison.

Product guarantee and return policies differ among manufacturers

Next up was product guarantees and return policies, which are vastly different and can have an impact on a company’s profitability. George used Cerrowire’s footage guarantee as an example when explaining this to John. Since switching from tier one suppliers to low-price suppliers, the company’s inventory shrinkage increased dramatically. Table 3 shows how this shrinkage affected the results.

Table 3: Shrinkage comparison.

John had been upset with Chad Roberts, his operations guy, about losing control of inventory. George’s approach was to meet with operations and try to identify what changed in their operation. Upon seeing Cerrowire’s footage guarantee, George had the warehouse pull some of the other newly purchased master reels down and measure them, which proved to be time consuming and tedious.

George told John that Chad measured 10 reels, of which seven were short and three were at or slightly above the correct length. One of the reels was even 6 m (about 4%) shorter than it was supposed to be. “Since anything unanticipated, long or short, creates costs associated with scrap, labour, inventory or other issues, it is no wonder that we are having a shrinkage problem in our cutting operation when most of the reels are coming to us short,” George said.

George also pointed out that Eddie had not gotten the new vendors to list them as additional names on the supplier’s liability insurance policies. Luckily nothing had happened yet but they were exposed to potential liability. By not considering product guarantees, they had overlooked $37,853 in value.

Product value-add features

Not taking into account product value-add features also had a negative impact on Jeppson Electric Supply. George showed John that some of their wire products were slippery and had sequential marks on them while others did not. This presented them with several new operational problems that did not previously exist.

When they filled orders, some of the products would be slippery and some would not. This irritated several contractors who would only use the slippery product. As a result, they found themselves having a more difficult time filling orders and had to make unanticipated orders for slippery products.

Another factor that came into play was how true sequential markings assisted them in their cutting operation. In the past, the employee cutting the wire would use the gauge (footage counter) to get in the area and slow down and make the cut on the manufacturer’s mark. The low-price suppliers did not have this feature, so they had to solely rely on the machine’s gauge (footage counter). George sampled several cuts and found that every cut gave extra wire. On the slippery wire, he found that they could be giving away tens of feet rather than inches due to slippage. This was another factor that was contributing to the increase in shrinkage and on-hand inventory.

Lead time, fill rates and number of shipments to complete an order

George explained that the company had to tie up a lot of its cash increasing inventory to support the lower-priced vendors. The increase in inventory required was due to the supplier’s performance in fulfilling orders. Joe’s vendors’ first shipment arrived five to seven days after the order was placed and was 95-99% complete. The goods were split into 2-3 shipments, typically taking 10-14 days. As against this, Eddie’s vendors’ first shipment arrived 14-20 days after the placement of the order and was 75-85% complete. The goods were split into 5-7 shipments, taking a total of 30-45 days. This difference required the company to maintain a higher inventory balance to support the company’s customer service level requirements. It also required overtime to process the added receipts, invoices and payments. In addition to the labour expenses, the internal damage of inventory increased due to having to handle the inventory more frequently.

Table 4 shows that, by not considering these factors, the company had to spend $783,098 more cash for inventory and incurred $29,680 more expenses.

Table 4: Inventory and operating expenses comparison.

Payment terms can also affect the bottom line

George also pointed out that John had failed to consider how the difference in payment terms among vendors could affect the overall picture. Table 5 shows how the difference in payment terms cost the company $142,248 in available cash.

Table 5: Payment terms.

This tale is told

George concluded by saying, “John, what I have shown you in the wire department is occurring throughout the company. If we do not change how we purchase, I will have to seek out new bank loans to support our added working capital requirements so we can make less money. Something has to change.”

George proposed developing a vendor scorecard, shown below in Table 6, which provides each vendor with an overall rating rather than focusing solely on price. Those who use such a tool are definitely on the road to success.

Table 6: Vendor comparison tool.

Cerrowire

http://www.cerrowire.com/