The should-cost analysis — determining how much it really costs a supplier to produce and deliver products — is common in procurement, but like any skill, it benefits from diligence and practice. A case study presented at ProcureCon, which runs through today in St. Louis, shows how vital this exercise is to a company’s bottom line.
The customer in this case was Siemens Healthcare Diagnostics Inc., of East Walpole, Mass. Peter Manni, vice president of strategic sourcing, told an audience how Siemens won a 22 percent reduction in contract price from a long-time supplier, which was referred to anonymously as “Vendor X,” by diligently reviewing the company’s financial data (including materials cost, machine time and labor, depreciation, and other expenses) and extrapolating what its operational costs were.
Based on the data, Manni and his team concluded that Vendor X, a film converter, was earning a 53 percent margin on its contract with Siemens. The supplier’s initial discount offer of 6 percent was pulled off the table, and eventually Siemens and Vendor X agreed to a 22 percent discount, which still gave the supplier a healthy 43 percent margin.
“Every day is a good day to ask for a discount,” Manni remarked. “You can always negotiate inside the terms and duration of a contract.”
Here’s how it went down.
Vendor X converts two specialty films into 15 discrete parts for a Siemens blood-testing kit that is shipped for distribution to Europe and North America. Vendor X produces 350,000 units annually, and has been working with Siemens as a sole source for 30 years. Siemens, in turn, is Vendor X’s only customer.
The status of Vendor X as a sole supply source might seem to be a powerful bargaining chip for Siemens. If the supplier refuses to offer a discount in the contract, it could lose the business. But as Manni said in his presentation, it would be a long and expensive process for Siemens to validate another vendor. And Siemens has over the years encouraged Vendor X to upgrade its capabilities.
So a good, productive relationship exists — something that wasn’t taken for granted by either side. Negotiation was thus key to achieving the discount.
Siemens wanted the discount after a business review suggested it was in order. The company began negotiating with the plant manager of Vendor X, whose initial offer was 6 percent. This was way too low but clearly in the plant manager’s interest, as a higher offer could affect his status within the vendor’s organization.
Manni and his team created a pro forma P&L statement for Vendor X, figuring out the supplier’s costs and overhead. Since all of the supplier’s equipment was paid for, depreciation wasn’t a factor.
“We figured the supplier was making a big profit off our business,” Manni said, possibly as much as 62 percent.
Siemens brought in senior executives, who insisted on meeting with the president of Vendor X to present the P&L statement — the “should cost” analysis. The supplier’s president, incredulous at the detail of the cost analysis Siemens assembled, upped his discount offer to 18 percent. Siemens countered with 27 percent but finally accepted 22 percent.
From the initial profit margin estimate of 62 percent for Vendor X, Siemens settled on around 53 percent as the more realistic figure during negotiations. Even with the discount, the supplier is making a 43 percent margin on the contract, which is still generous. Siemens had benchmarked the supplier’s ROI and concluded that 25 to 30 percent was a fair margin range.
“Using financial data is a very good tool” for negotiations, Manni said.
He stressed the importance of negotiating with people who are high up in the corporate structure. “The plant manager would never have made concessions. Our team had to keep pushing until we found the right person,” Manni said.
Also, taking a win/win approach to negotiations, where both sides emerge with benefits, is vital to maintaining good relations. “Treating vendors right is important in procurement,” he remarked.
Manni admitted that the case was unusual. Siemens was dealing with a sole-source supplier and would have had little leverage if the vendor refused to budge on its initial offer, owing to the difficulty of replacing it. But because relations between the companies are good, and Siemens developed accurate “should cost” numbers and showed flexibility, a deal that both sides could accept was possible.
It has been 18 months since the negotiations and there has been no degradation of services, Manni said.
He concluded by saying that this experience, which Siemens now uses for its corporate training, shows how important procurement has become to a company’s bottom line.
“Procurement was a back-room function for most companies,” Manni remarked. “Now it’s different. We have a voice.”