Moving from a sourcing process based on minimising cost to one based on maximising value means embracing supplier differences
Strategic sourcing focuses on getting the best deal for a given spend item, be it a good or a service. In the case of a commodity item, the "best deal" could be the lowest price, but could also be about getting the greatest value out of a more broadly defined supplier relationship. It is the latter that is at the heart of value-based sourcing.
For example, when the automotive supplier Hella developed the new ring-shaped headlights with BMW for its new 5 series car, it brought much more than a new headlight to the market: it enabled BMW to strengthen its brand equity and identity. Up until this point, it was very difficult for drivers to distinguish one type of car from another while driving at night on the motorway. With this innovation, car drivers can now easily recognise a BMW coming from behind, thus increasing the brand awareness.
This example underscores the need for procurement professionals, who have traditionally focused on sourcing goods and services, to look at value beyond the immediate scope of purchase to other capabilities and sources of value. This constitutes the next challenge for the supply management community. Value-based sourcing implies figuring out what are the other assets, capabilities or benefits that a supplier can bring to the table, other than just the product or service itself. As figure 1 shows, value-based sourcing clearly defines new boundaries for supply management.
Traditionally, procurement focused on cost. It would take its suppliers to the cleaners by putting them through the company's strategic sourcing process. Of course, there was a sourcing strategy reflecting the levers inherent in supply and demand and reflecting the overall strategic direction of the company. However, when it came to execution, the procurement professional tendered out the goods or services in question, trying to compare like with like, following the apples with apples, oranges with oranges principle. There were ways to take into account the total cost of ownership and other trade-offs, but, at the end of the day, offers were made to the supplier that performed best within this given frame of reference.
Value-based sourcing seeks differentiation, not commonality – comparing apples with oranges – which is different to how most buyers source today. The rationale behind this approach is that value chain partners can often bring more to the table than what is requested from them (in other words, just supplying the goods or services). Suppliers might also have differing capabilities and therefore there is a need for more flexibility in the process than has traditionally been the case.
One such example stems from an engineering company that, as part of a low-cost country initiative, was looking to move as much as possible of its large steel fabrications to cheaper locations, owing to the enormous number of man hours needed for welding.
Using the traditional approach, the company found that, net of additional transportation costs and productivity differences, savings of around 30 per cent could be achieved. Consequently, the optimum decision would be to move as much work as possible to these low-cost countries.
Right? Wrong! The engineering company in question had one particular supplier in its portfolio that was especially good at improving the design of new products. This design capability had an impact several-fold when compared to that of cheap manufacturing.
In the end, this capability was deemed vital and the engineering company gave 20 per cent of the volume to this supplier, which covered new products and some business around lead-time flexibility, as well as volume to fill a base shop capacity. In the usual "make everything equal process", a rigid supplier selection would have driven all the business either to low-cost country suppliers or highly capable and competent design suppliers.
Allowing things to be different does create some issues. Which capabilities should I value? How do I invite suppliers to tell me what they can do differently without losing comparability? How can I design a process that is fair and transparent to everyone, while recognising differences? Clearly, value-based sourcing moves the typical procurement professional out of his or her comfort zone.
First and foremost, value-based sourcing is really a mindset change – not only for the procurement function itself, but also for the other functions within a company. The good news, though, is that CEOs are increasingly looking at value beyond cost, as a survey carried out by AT Kearney in 2004 showed (see figure 2).
Increased CEO attention should make this task more manageable. On the other hand, we still have a long way to go to mobilise the entire organisation to think along these lines. If you thought that measuring savings was tough, try measuring value. Sit down with your marketing department and agree on metrics to measure brand equity or return on marketing invested; meet with your sales department to talk about time-to-market advantage; work out with your distribution/supply chain colleagues metrics to measure increased sales from increased product availability; or ask operations to look at security of supply.
Engage and align
Despite these difficulties, engaging with your functional counterparts is essential to achieving some alignment. They will appreciate seeing that procurement is starting to move away from just looking at the price of a good or service to looking at how to increase the value that the good or service brings. Start on a qualitative basis and move towards a quantitative basis. By doing this, you will win the hearts and minds of your colleagues in other functions.
Introducing a value-based sourcing mindset will necessarily have an impact on the supplier selection process itself. Most companies employ a rather rigid and stringent sourcing process. While there is nothing wrong with professionalising procurement, making it repeatable and less subject to human factors, the problem is that procurement professionals often let the process drive the result, and consequently business often gets allocated to suppliers that most cost-effectively meet technical requirements.
This is fine for less differentiated categories, but can harm business if the technique is used on categories with a more differentiated business impact. Value-based sourcing implies a more strategically driven approach, as opposed to a process driven one. In the strategically driven approach, the procurement professional looks first and foremost at the suppliers' capabilities, then determines if one supplier, or a group of suppliers, can have a differentiated impact on the company's competitive advantage. If this is the case, he or she will use the strategic sourcing process to ensure that these suppliers get selected at a reasonable market price.
Another element that often leads to resistance is that the goal and incentive systems of most companies do not reward procurement professionals for value contributions, but only for cost-related contributions. This is one of the major hindrances to changing their behaviour and needs to be addressed by CPOs in conjunction with other senior executives in their organisations.
Embedded in the DNA
We have seen how value-based sourcing affects supplier selection, but this is not enough. The traditional strategic sourcing process focuses on commodity or spend category and does not look outside what suppliers already deliver. At AT Kearney, we believe that leading companies need to implement a new process, one that focuses on systematically identifying and capturing value opportunities from outside the company's four walls. The value-based sourcing process is illustrated in figure 3.
In the value definition phase, the purpose is to identify:
the value drivers that can be leveraged from outside;
the value chain partners that can make the biggest potential contribution;
how to structure the relationship in such a way that it delivers on its value promise.
In so doing, procurement systematically screens the supply base looking for value-capture opportunities and identifying make-or-buy optimisation opportunities. This is clearly a highly strategic exercise, which should be done as part of the strategic planning rounds, with a high level of input from the different business functions.
To illustrate the importance of this exercise, consider the pharmaceutical industry, where an enormous part of the value chain is now being contributed by external partners. When mapping their capabilities, companies must distinguish between non-crucial and crucial capabilities. In the case of a crucial capability, a company must exert a strong control as this capability will represent a competitive advantage. This does not, however, mean that everything must be done in-house, but rather makes use of so-called "complementors" to build a differentiated ecosystem.
Selling drugs, for example, might be considered a crucial capability, but one might still find a diagnostics, drug or medical device manufacturer with which the company could team up in order to get greater reach (by geography or by doctor specialisation) and a better overall value proposition for a given therapeutic area. This is especially common for chronic diseases such as diabetes. Beneficial capabilities are those that, by themselves, do not build a differentiated competitive advantage, but might make sense to leverage, potentially outside. The pharmaceutical company could be leveraging a contract manufacturer to produce Galenic variants that do not represent key technology know-how (for example, an ointment or an ampoule formulation) for a company with most of its asset base and process know-how in the production of tablets, dragee and capsules formulation.
Given the huge capital required for research-based pharmaceutical companies, it is clear that a leveraged model, relying strongly on capabilities outside the company, is paramount. But we are seeing a trend towards greater leverage of the value chain across almost all industries. The drivers for this mega-industry trend are globalisation, scale, a focus on core competencies and the emergence of new technologies with shorter life cycles. Companies that focus inwards will be at a clear disadvantage.
A good example of external focus is Procter & Gamble. It used to pride itself on its innovation capabilities, with most innovations coming from inside the company. However, recognising that the innovation pool outside the company is between five and 20 times higher than inside the company, P&G embarked on a "Develop and Connect" approach, sponsored by its chief executive, AG Lafley.
Today, more than 50 per cent of innovations come from external sources.
Blurring the lines
In building these ecosystems, the lines between partnerships and supplier relationships begin to blur. Procurement can bring value to the table by using its experience to craft a number of different types of complex relationships: broad-based business alliances and joint ventures, co-making, licensing, collaborative design, carve-out/spin-off, asset outsourcing, tolling/conversion, supply chain pooling, business process outsourcing, or co-branding or selling, to name some of the more common ones.
For companies that are willing to embark on this route, it will mean considerable change, as strategic-minded, business-savvy generalists do not abound in the procurement world. Procurement functions that are unable to enter the strategic part of the value chain will see their sphere of influence in [FIGURE 3] their companies shrink as more and more of the spend moves towards performance-based and value-based relationships and contracts.
After the value definition phase, the value-based sourcing process enters the value delivery phase. Experience shows that forging made-for-purpose relationships to deliver value on its own can only apply to highly strategic relationships. What about all the other relationships, where the suppliers are not contractually incentivised to bring value to the table? Leading companies have implemented a carefully managed idea generation process, to consistently and systematically leverage supplier ideas in various capability areas. When setting up such a process, it is important to manage the following elements:
Focus: idea generation needs to be focused. If not, there will be a flood of ideas, 90 per cent of which are likely to be totally useless but will take valuable time to process.
Governance: establish multi-disciplinary teams and escalation procedures to evaluate the proposals and ensure that difficult trade-offs are made and not avoided.
Discipline: as in all cross-functional teams, discipline during meetings is essential. Executive sponsorship helps here. Also, timely follow-up with suppliers is not always taken seriously, jeopardising the programme's credibility.
Trust: suppliers must know that ideas will not be "stolen" and taken to another supplier. Building this takes time, especially in companies that have a reputation as merciless cost crushers.
Incentives: trust is good, but incentives are sometimes even better. Best-practice companies provide suppliers with the right incentives so that they contribute value. These might vary from structural incentives (based on specially designed contracts) to joint benefit sharing or cash-based incentives.
Process interface: value-based sourcing has important interfaces with many processes within the organisation, such as innovation, product portfolio and strategic planning, but tends to vary by industry. Process interfaces with purchasing are particularly important, as value-based sourcing impacts both strategic sourcing and supplier management. Organisations therefore need a clearly defined process for gathering supplier proposals.
Tools and systems: support the process with web-based tools for capturing, evaluating and tracking supplier proposals. Without a proper collaboration platform, managing the idea generation process can be challenging.
Implications for procurement
Value-based sourcing requires an entirely different mandate for the procurement function. The sourcing of capabilities positions it much more strategically in the organisation. Purchasers step into the role of value chain integrators and this means that the traditional skills need to be augmented to be up to par with the new mandate.
A sharp understanding of key business issues and value drivers, as well as the ability to discuss and challenge internal capability, are critical to value-based sourcing.
Consequently, there is a need for strong cross-functional executive sponsorship. This presents both a challenge and an opportunity for companies that are functionally organised at board level. Nevertheless, value-based sourcing will become a standard practice in the years to come.
Further reading
Thomas Slaight and Jules Goffre, "Strategic sourcing: Where did it come from? What has it accomplished? Where is it going?" in the Supply Management Handbook (ISM/McGraw-Hill, 2006), chapter 6, pp99-119
Jules Goffre (jules.goffre@atkearney.com) is a vice-president and leads the European supply management practice at AT Kearney, www.atkearney.com based in its Munich office
