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Chemical Sourcing Models for Cost and Risk Optimization
By Omid Ghamami
The biggest challenges facing chemical purchasing professionals are supply line, cost and quality. Because chemicals are typically direct material components, supplier and product selection are subject to rigorous and lengthy approval processes. These processes typically involve both internal manufacturing technology organizations and similar approving bodies in external customer organizations. As a result of the arduous technology qualification process, supply management professionals often find themselves in single-sourcing situations in which supply line risks exist and there is little price performance pressure on the supplier.
To make matters more difficult, most favored-customer contract language typically does not help the supply management professional. The chemical being procured is often unique in some fashion and, therefore, is not subject to contractual price matching requirements which would otherwise apply.
In this situation, the supply management professional should develop a short but influential presentation to share with someone of sufficient authority in the internal manufacturing technology qualification organization. It should outline the inherent supply line and cost risks of the single-sourcing strategy being employed, and the critical need for qualification of one to two additional suppliers. It should be explicitly stated that a multisourcing strategy will not only improve supply line risk, but also set the stage for reverse auctioning methodologies that will reduce total cost over time.
This information can also be shared with a senior customer account manager of influence to bring added visibility to these risk factors. Both managers will likely be far more moved by the supply line risk factors; as such, the risk factors should be the primary area of focus the supply management professional uses when making the case.
Once approved, standard technology protocol should be followed to qualify additional suppliers and their products. A period of two to three months might pass before the new suppliers are formally qualified and approved to supply specific direct material chemical products.
Making the Case for Reverse Auctions
Because chemicals are true commodity products that — once qualified — have pricing as a primary decision criterion, they are ideal candidates for reverse auction practices. Reverse auctioning can be done via application-specific software or a manual process. In either case, all supplier contracts must be identical in terms of total cost components not directly related to price (lead time and inventory management model, for example) such that the demand allocation model may be driven using product price as the sole variable.
Additionally, special contract language must be embedded to release the supply management professional’s firm from any detrimental reliance liability for resultant fluctuations in demand allocation, as the suppliers might experience significant shifts in business over time as they compete for the business.
The suppliers need to be advised of the new business paradigm under which they will operate moving forward. They can be told how many suppliers they will be competing against, but not the names of those firms for confidentiality reasons.
The supply management professional must determine a reverse auction bidding frequency model that is driven by the price volatility of that chemical commodity. Highly price-volatile chemical commodities might necessitate weekly bids, whereas quarterly bids might be more appropriate for those commodities that are relatively stable. A demand allocation algorithm should be developed which reflects distribution levels the supply management professional believes will keep suppliers both motivated and competitive. The initial assumption can be that each supplier is due an equal share of the business, with their allocation modified based on the pricing proposal given for that bidding period.
The following is an example of an algorithm that may be used. Assume a three-supplier situation in which the suppliers respond with the following pricing:
| Supplier A: | $1/unit |
| Supplier B: | $.90/unit |
| Supplier C: | $.80/unit |
In this example, since there are three total suppliers, a figure of 33.3 percent each is the starting point for the demand allocation model. From there, the percentage difference between Supplier A and Supplier B’s respective proposals (25 percent), and that of the lowest bidding supplier (Supplier C), is subtracted from their 33.3-percent allocation and added to that of the lowest bidding supplier, as shown below:
Supplier A: 33.3% – 25% = 8.3% allocation*
Supplier B: 33.3% – 12.5% = 20.8% allocation*
Supplier C: 33.3% + 25% + 12.5% = 70.8% allocation*
To arrive at the figures of 25 percent (Supplier A) and 12.5 percent (Supplier B):
Supplier A is pricing at $1/unit, while supplier C is $.80/unit. $1 divided by $.80 results in a figure of 125 percent, meaning that $1 is 125 percent of $.80. If we want to express that as a measure of how much greater $1 is than $.80 — as a percentage — we would subtract 100 percent to arrive at the difference, which is 25 percent. Mathematically, this would read as: (1/.8) – 1 = .25 = 25 percent.
Supplier B is pricing at $.90/unit, while supplier C is $.80/unit. $.90 divided by $.80 results in a figure of 112.5 percent, meaning that $.90 is 112.5 percent of $.80. If we want to express that as a measure of how much greater $.90 is than $.80 — again, as a percentage — we would subtract 100 percent to arrive at the difference, which is 12.5 percent. Mathematically, this would read: (.9/.8) – 1 = .125 = 12.5 percent.
The algorithm you choose should be very clearly stated to suppliers in advance, with multiple scenarios played out for clarity of process and potential outcomes.
The process for providing bid responses should also be extremely clear. If the supply management professional is using reverse auctioning software, the process will be inherently synchronous — typically over a prescribed time period spanning 15 to 30 minutes — whereby the suppliers bid against one another in a real-time and graphically displayed fashion. If a manual reverse auction model is employed, the process must be kept relatively synchronous, such that all bid responses are received by a particular time and date via a prescribed communication format.
The supplier debriefing process should also be documented and communicated to the supplier in a prescribed manner, with notification of exactly when the demand allocation model will change, what the new demand allocation percentage is for that supplier, and for what period of time.
A critical component of implementation involves ensuring that demand allocation does, in fact, change to the prescribed amounts for each supplier. This might necessitate spreadsheet management and tracking of purchase order volumes by supplier.
While suppliers might initially resist this model, they should be encouraged to view the process very opportunistically. The process is not meant to be punitive nor antagonistic. In fact, the transparency of information between supplier and the supply management group should be greatly improved; where suppliers do not receive the desired amount of business, they should know exactly why, and how far off they were.
If done right, suppliers can leverage the opportunity to continuously streamline their supply chain costs and develop a sustainable model to test their market competitiveness in a far more dynamic method than they would otherwise have been afforded.
The payoffs of this process provide these benefits:
- Suppliers committed to continuous improvement will become more competitive.
- The internal customer will appreciate the reduced supply line risk.
- The supply management professional will reap improved savings.
- The external customer will ultimately benefit as both risk and cost are managed better on its behalf.
In short, this model represents a true win-win for all involved parties.
* Allocation adds up to 99.9 percent due to decimal rounding.
Omid Ghamami has more than a decade of experience negotiating multimillion-dollar contracts and managing regional and global purchasing departments with Intel Corp. He is the president and chief consultant of Purchasing Advantage, a purchasing course and seminar solutions provider.