Purchase capacity, not products

Although the classic model for manufacturing firms relied on vertical integration, modern industrial organizations are built on their supply chains. Take Ford Motor Company, for example. Ford used to bring raw rubber and iron ore in one end of its River Rouge, Michigan, USA, manufacturing plant and push completed vehicles out the other end. Today, however, Ford procures more than 60 percent of the value of an automobile from suppliers.

Ford is hardly alone in doing so; most global manufacturers obtain a significant percentage of their products' components from external suppliers. There are many reasons for this change. Many companies have shed production assets in favor of supplier relationships in order to support geography-based revenue growth, control profit margins, and maximize their return on assets. Moreover, manufacturers' focus on core competencies, enabled by information technology and plenty of capital, led them to shift their emphasis from internal production operations to external supply chain coordination.

Article Figures

[Figure 1] Manufacturing financial performance (2002-2007)Enlarge this image

[Figure 2] Simple bill of materialEnlarge this image

[Figure 3] Simple bill of capabilitiesEnlarge this image

This shift in focus is one reason why manufacturing firms enjoyed a period of robust growth after the "tech bubble" burst in 2001. Figure 1 summarizes information from IDC Manufacturing Insights' global performance index, which is based on data for 850 of the largest global manufacturers. The chart shows that, in the five-year period that includes 2003 through 2007, revenue improved cumulatively by more than 40 percent, and profit margins doubled from just above 2 percent in 2002 to 4.5 percent in 2007.

Now the good times are over. Last year started with a great deal of uncertainty that was largely fueled by the rising costs of resources such as petroleum, chemicals, and metals. The worldwide economic expansion had created inflationary raw material markets, and supply chain captains worried about their effect on growth and profitability. By the end of the year, raw material costs were off their peaks?—but for the wrong reasons. A global credit crunch had slammed the door on consumer spending in mature markets and had dried up business borrowing everywhere.

The 850 companies tracked by the IDC Manufacturing Insights index are, for the most part, well-positioned to weather the storm. Their strong financial performance between 2003 and 2007 allowed them to build up large cash reserves, and these war chests will help them survive. However, many manufacturers worry about key suppliers that have been unable to build a cash buffer and are very dependent on short-term borrowing facilities, which now are hard to come by, or at least are much more expensive than they were. Those supply chain captains know that they will have to become more involved in financing the commercial activity in their supply chains, and they are trying to find ways to mitigate their financial and supply risks. This need to change the way they interact with suppliers has created interest in a different approach to procurement?—capabilities-based sourcing (CBS).

What is capabilities-based sourcing?
Capabilities-based sourcing is not a concept that was born of the current economic troubles; it actually has been discussed for some time. But it has not been widely implemented because few companies have been able to justify the tremendous effort that would be required to change from traditional practices to CBS.

Traditional sourcing and procurement is based on a familiar path. An engineering parts list is translated to a bill of material. Since many of the items are not standard (that is, they can't simply be bought out of a vendor's catalog), the procurement organization sends out drawings to a group of potential vendors, who then bid on producing the specific stock-keeping unit (SKU). The lowest bid from a qualified vendor usually gets the production job.

With the CBS approach, the buying company reserves capacity for specific capabilities?—precision machining, welding, or injection molding, for example. It then issues new requirements to those vendors, consuming that capacity. The capacity reservation may be in the form of a cash payment, or it may be in the form of a binding guarantee that the supplier can use as collateral when it borrows money. The process may be extended such that the supply chain captain furnishes those vendors with raw materials (such as steel, plastic, or even energy), allowing it to utilize its buying power and better hedge price volatility. The CBS approach is attractive in this capital-constrained environment because suppliers that receive contract guarantees have some level of assured capacity consumption and therefore can better finance their operations.

Consider this example. Figure 2 shows a very simple bill of material (BOM) for three end products. All of the parts that comprise those products (assumed to be nonstandard) must be produced by suppliers. Each of the parts would be sent out for bid to qualified suppliers, and the contracts would be awarded to the lowest bidders. If the customer orders two of product 123, one of product 456, and three of product 789, then new purchase orders would be let to those vendors for seven of part A, two of part B, two of part C, four of part D, one of part E, nine of part F, and three of part G, using a simple BOM explosion. (A BOM explosion breaks down each assembly or subassembly into its component parts.)

Figure 3 examines the same set of parts but considers the number of hours needed for certain production capabilities. In this scenario, the capabilities of the vendors are understood and capacity has been purchased in advance. For the same order discussed in the previous paragraph, purchasing would release the following consumption of hours: 23 hours of precision machining (7 x 3 = 21 for Part A, plus 1 x 2 = 2 for Part E); 29 hours of robotic welding; and 29 hours of injection molding.

In this example, capacity that has been reserved is assigned to produce a specific part. The buyer gets greater flexibility in meeting customer demand, and the suppliers finance their working capital needs with the buyer's balance sheet.

The business benefits of CBS
The most prominent reason for supply chain captains to adopt capabilities-based sourcing is to mitigate supply risk. By reserving capacity in advance, buyers can provide suppliers the working capital they need without having to become their lender of record.

CBS offers manufacturers a number of other key benefits, including:

• Flexibility. Because they no longer have a one-to-one relationship between supplier and purchased part (that is, they are not buying a single part from a single supplier), companies using CBS can adjust and calibrate their supply capabilities to demand. Using "lean" parlance, the traditional inventory kanban (buffer inventory) with suppliers becomes a capacity kanban. Hence the whole supply network, not just the factory, can be balanced to demand. In addition, CBS's ability to match supply capabilities with demand ensures a high order-fill rate and thus allows supply chain captains to raise the level of service they provide to their customers.
• Cost control. Hourly rates for capacity consumption typically differ depending on the level of factory automation. The higher the level of automation, the more costly the labor, but those plants operate more efficiently. Conversely, less automated plants may take longer to produce parts but will carry lower hourly rates. Supply chain captains who recognize these differences can better understand their suppliers' cost structures and ultimately exert more control over the profitability of their product portfolios.
• Raw materials. Supply chain captains can also take on the sourcing of key base materials like metals, plastics, and chemicals. By assuming control of sourcing, buying organizations can further mitigate the working capital needs of their suppliers and allow the buying organizations to leverage their buying power.
• Quality. Not only does buying capacity in advance give supply chain captains more responsibility for monitoring production yields, it also gets them involved in quality improvement from the start. This is true, for example, in the semiconductor industry, where prebuying capacity at foundries is a common practice. While it requires additional investment on the part of the buying organization, such diligence should translate to higher overall product quality.

Through these benefits, capacity-based sourcing can enhance the overall effectiveness of the supply network, resulting in higher service levels, lower costs, and improved quality.

Effecting the transformation
CBS offers significant benefits, but companies that shift to this approach will have to overcome some noteworthy challenges. For one thing, there is always the risk that reserved capacity will go unused and that the need for costly, nonrecurring tooling?—a special mold for a specific part, for instance?—will further complicate the situation.

The biggest challenge for companies that are considering this sourcing approach remains the considerable effort required to transform an organization from individual part sourcing to CBS. Organizations are structured around commodity buying, processes are geared to event-based contract awards (requests for proposals and requests for quotations), and information technology is based on conventional material planning. To implement CBS, companies will have to completely re-examine their supply organizations, processes, and supporting information technology.

Let's look first at reorganization. Traditional procurement organizations are structured around commodity managers or teams. These purchasing professionals are responsible for negotiating contracts for items that share attributes such as raw material or function. Commodity managers have an understanding of the item's functional engineering (what it is intended to do) so that they can evaluate alternative sources for those items.

In a CBS approach, the key title is not commodity manager but "capability manager." The role is very similar to that of the commodity manager, except the most important piece of knowledge isn't the functional requirement of the part being purchased. Rather, it is a process-oriented understanding of how the part is produced. There will be some overlap between the two. Just as the commodity manager will have some understanding of the production process, the capability manager will also understand the part's function. Such organizational changes will be the easiest part of the transformation; changing the purchasing mindset from a primary focus on function to a focus on process could prove more difficult.

Along with a new way of thinking, the implementation of CBS will necessitate substantial changes to all aspects of the procurement function, including:

• Planning. Strategic sourcing?—the aggregation of spending based on common attributes?—will transition to sourcing that is based on the aggregation of capabilities that are needed in the supply network. Thanks to the benefits of CBS discussed earlier, this change should lead to more effective network design, more accurate advanced planning, and more effective sales and operations coordination. The planning process will develop recommendations for what percentage of the estimated required capacity should be reserved and how far in advance this should be done. IDC Manufacturing Insights expects most companies will reserve 60 to 70 percent of their estimated required capacity in the longer term (six months to a year), adjust with additional buys in the middle term (one or two quarters), and spot-buy in the near term. This approach will help to mitigate the aforementioned risk of failing to consume reserved capacity.
• Buying. The traditional process of sending drawings and requests for quotes to approved vendors will also change. Instead, complex capacity-reservation contracts will have to be signed and executed before a company receives a bid for production of a part. Instead of calculating pricing for specified quantities of those items, vendors will estimate the amount of capacity hours that will be consumed per unit. The current process is only loosely coupled with planning (the strategic sourcing function works with a list of approved vendors, from which a bid list is composed), but CBS will require tighter coordination between the required-capacity forecast and the actual consumption queue (what is currently in line for production). Purchase order releases will reflect hours, not dollars.
• Execution. Material planners will move from managing on the basis of shipment dates within specified time windows to managing based on near real-time status of production at the supplier. Throughput, yield, and shipment information will be closely tied. Planners will work with the supplier's production personnel to determine lot quantities and sequences based on current need. Kanbans for capacity, not inventory, will be established.

For companies moving toward CBS, making the necessary process changes will be the most complex undertaking. They must develop process blueprints that reflect the state they desire to achieve, and they must devise a transformation plan. It is widely recommended that they engage consulting firms that are well-versed in process re-engineering to assist them in this critical transition.

Information technology considerations
Unfortunately, data models and process applications in the procurement area are built for the traditional approach rather than for CBS. However, this doesn't mean that companies will be required to create new, custom applications. Rather, they will have to build tighter connections between existing product lifecycle management (PLM) and supply chain management (SCM) applications.

In some industries, as much as 80 percent of the product cost is locked in the initial design stages, when critical decisions are made about key components and how they should be produced. This makes the design stage an ideal time to identify what capabilities will be needed to manufacture those components and to estimate the "should take" time (as opposed to "should cost" pricing). These estimates can then be vetted with suppliers where the supply chain captain has reserved capacity.

Because the vendors in essence are providing manufacturing services, not parts, companies using the CBS approach should apply procurement software that is adept at services purchasing to the actual orders. Resource planning software should consider vendors' work centers as if they were their own and run capacity planning (rather than material planning) against the requirements. Thus, instead of being vertically integrated, the supply chain captain becomes "virtually integrated."

The new reality
Although capacity-based sourcing has long been discussed in theory, the concept has always seemed too daunting to put into practice. The new realities presented by the current global recession, however, have generated renewed interest in CBS because of the compelling benefits it offers in the areas of flexibility, cost control, and risk mitigation.

If you believe this purchasing approach would benefit your company, start the transition with a single spend category (for example, metals processing, plastic parts, Application-Specific Integrated Circuits [ASICs], and so forth) to test the process. Be sure to take advantage of the sourcing capabilities offered by your product lifecycle management software vendors, and work with consulting firms that are versed in the purchasing process, risk analysis, and process re-engineering.

The impetus for the transformation from a traditional purchasing model to capacity-based sourcing may be the current economic malaise. But a CBS approach will continue to yield substantial long-term benefits long after the inevitable recovery begins.