SOURCE SELECTION STRATEGY

Learning Objectives
To understand:
 the concept and relevance of strategic cost management;
 the basis of price management;
 the leveraging of supplier costs of production and delivery;
 the concept of the total cost of ownership over the product life cycle;
 the scope for collaborative strategic cost management (target pricing and cost
sharing) along the supply chain; and
 the relative advantages and disadvantages of different approaches to supplier
selection.

To select the appropriate source of supply the buyer must first consider the specification,
quality and quantity of the requirement, the price to be paid per unit of the deliverable
and the delivery schedule. All these elements are interrelated and, in particular, the cost
and quality of the deliverable are likely to depend on the number of potential suppliers
and how they are engaged by the buyer in sourcing the requirement. When two or more
suppliers vigorously compete for the supply, the quality of the deliverable could easily be
assessed by the buyer, and the latter may switch costlessly between the sources of supply,
it is reasonable to expect that the forces of in- and for-the-market competition between
suppliers will ensure that the buyer gets a good deal, i.e., the supplier tasked with the
delivery has a strong incentive to minimize the unit cost of production, keep profit
margin at the minimum and avoid the temptation to chisel at the quality or let the delivery
schedule slip. But, the sourcing strategy cannot simply rely on the efficiency of market
forces when the choice of suppliers is limited, perhaps restricted to one, the quality of the
product cannot be easily determined and is not immediately visible to the buyer, and
there is no direct visibility of the cost of production and the drives of delivery schedule.

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Thus, the development of an efficient sourcing strategy must start with an investment in
better understanding of the cost of supply, the development of Should-Cost approaches,
and the analysis of factors that could induce the supplier to take advantage of the
asymmetric knowledge between the parties and market forces that would not be able to
ensure that the forces of active competition and contestability (potential/latent
competition) deliver a reasonably efficient deal for the buyer. Thus, the first part of this
Topic (sections 7.1-7.5) draws on MHGP, ch. 11. Section 7.6 refers to other readings in
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the context of source selection strategy and tactics. Students are also asked to re-read
MHGP, ch. 10, which deals with worldwide sourcing of supplies. For another perspective
see L&F chs. 11, 14 and Baily et al (2008), ch. 9: 225-239.
7.1 Strategic Cost Management

Strategic cost management involves the scoping of opportunities for reducing the
cost/price of procured items while securing the desirable quality, timeliness and
dependability of supplies. How this is done varies along the supply chain depending on
the positioning of the firm of interest (focal firm) in the sequence of value-adding
activities, the firm’s market power relative to that of its suppliers and the competitiveness
of various segment of the chain, particularly its final (end product) segment. The focal
firm may be positioned downstream in the supply chain, in which case it is likely to
source intermediate products that are already quite complex (elaborately transformed), or
it may be an upstream producer that buys relatively simple inputs from its suppliers.
Inter-firm supply chain
Upstream direction of flow Downstream
Primary
Inputs
Support Activities (HRM, IT, Technology, Administration)
Inbound and Outbound Transport and Storage
Firm A
End Customer
Firm B Firm C Firm D
Procurement, R&D, Design, Production, Waste Disposal,
Marketing, Sales, Distribution
Figure 7.1 Inter-firm supply chain
Focal
Firm
ACSC 2006

Figure 7.1 was first shown in Week 1 as Figure 1.2. It is now used as a framework for
the discussion of different approaches to strategic cost management. For example, if the
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Final
Outputs
After-sale
Product
Support
and
Disposal
focal firm in the Figure is Firm D, it may try to influence the cost of sourcing its inputs
from its upstream supplier C. If it has the market power to influence prices charged by C,
it may use it aggressively to demand deep price discounts. Alternatively, D may decide to
collaborate with C to reduce the latter’s cost of production and to share the cost savings
between the two firms. If Firm D has the market power to influence prices, schedules and
product specification upstream in the supply chain, it may also try to ‘lean on’ upstream
producers such as Firm B and force them to lower their prices. Alternatively, D may
initiate cross-company collaboration with C and B, in which case strategic cost
management may become a collaborative effort between the three companies. This is
discussed in more detail in Exhibits 11.1-11.4 in MHGP: 413-415.
The collaborative cost management will be revisited later in this topic. First, consider the
scope for non-collaborative management of supply prices and costs by the focal firm. As
MHGP observe, “Evaluation of a supplier’s actual cost to provide the product or service,
versus the actual purchase price paid, is an ongoing challenge within all industries” (p.
411). Thus, procurement specialists must understand and take advantage of the principles
of price and cost analysis. To facilitate this understanding, the authors distinguish
between:
 price analysis – “the processes of comparing supplier prices against external price
benchmarks, without (our italics) direct knowledge of the supplier’s costs”;
 cost analysis – “the process of analyzing each individual cost element” to
determine the actual production cost; and
 total cost analysis – the analysis of the total cost of the end product by focusing
on all costs incurred by different organisations that add value to the product along
the supply chain (op. cit.: 411-412).

Sections 7.2-7.4 briefly discuss these concepts. First, a health warning: the procurement
department should not apply these analytic approaches indiscriminately. It should be
selective in its use of analytic resources, in particular its scarce management time. The
Pareto Principle suggests that the time and effort devoted to price and cost analysis
should be proportional to the importance of different procurement items. For example,
suppose that all items purchased are stratified into three categories, A, B and C, where
 category A acquisitions comprise items which are most valuable or critical for the
focal company but relatively small in number, that is, they account for a large share
of the total value of the acquisition but a small share of the total number of items.
This category may also include items that are cheap to buy but critical for the success
of in-house production activity. To procure these items effectively, the procurement
department should use tight control and detailed analysis of supply costs and prices,
detailed price forecasting, continuous monitoring of quantities, prices and costs;
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 at the other end of the spectrum, category C acquisitions include items that are
standard, widely available, cheap to buy but which account for a large percentage of
the volume (as opposed to the cost) of all acquisitions. These items tend to be
purchased in bulk and there are usually many alternative sources of supply. As they
tend to be supplied competitively, the market ensures that prices tend to be close to
the cost of production and supplier profit margins are small. The purchasing of these
items should best be kept simple and automated. There is not much point in using
detailed pricing and costing analyses as competitive markets ensure that suppliers
provide value for money. However, it may be useful to analyse samples of products to
confirm that sources of supply are competitive and that markets are effective in
delivering value for money. The procurement department should also use simple
demand extrapolation (rather than detailed price forecasting) and maintain reasonable
safety stocks to avoid supply disruptions; and …………………………………………….