Measuring the total cost of ownership in customer/supplier relations is crucial in evaluating the performance of a procurement organization.
Pharmaceutical companies face ongoing cost pressures and the need to optimize all business functions, including procurement and sourcing activities for raw materials, intermediates, and active pharmaceutical ingredients (APIs). Eric Evans, vice-president and general manager of the global API division at Covidien (Dublin, Ireland), offered a commercial perspective on sourcing and ways in which companies can take a more holistic and fuller view of procurement activities. Evans spoke at the DCAT–ISM Sourcing Summit: Forward Thinking Sourcing, an educational program presented by the Drug, Chemical, and Associated Technologies Association (DCAT), along with its partner, the Pharma Forum and Chemical Group of the Institute of Supply Management (ISM). The program was held Nov. 3–4, 2010, in New Brunswick, New Jersey.
APIs account for approximately $400 million of the roughly $2 billion of Covidien’s annual pharmaceutical group sales. Covidien’s API business centers around three primary businesses: controlled substances, acetaminophen, and pharmaceutical stearates. As a seller of APIs to many different types of organizations worldwide, Evans has developed a broad perspective on how purchasing decisions are made. He explained his views on how sourcing and procurement are generally measured, the limitations of traditional metrics used in measuring the success of sourcing and procurement activities, and how these metrics and related functions can be improved.
In a bottom-line approach, procurement success is typically measured by lowering the cost for materials purchased for the next year, said Evans. The total cost of ownership, which involves factors such as security of supply, quality, and sustainable and flexible partnerships with suppliers, is considered, but often is not a prominent piece of measuring procurement success. “The disconnect in how procurement success is measured is due to several factors,” he said. Part of the disconnect results from the difficulty in quantifying factors in the total cost of ownership. “For example, risk is difficult to measure. How do you quantify the costs needed to secure supply and maintain a flexible relationship to guarantee supply?” he said. “There is also the balancing act between short-term financial goals, which are tied into short-term financial metrics and longer-term objectives. Generally, short-term financial goals have a greater emphasis. Individual performance metrics are tied into these short-term goals. In short, measuring and rewarding procurement success holistically is a challenge.”
Evans pointed out that there are many reasons to address this challenge. “Forward-thinking sourcing demands diagnosing issues before improvement can be made and therefore facilitates the likelihood those improvements can be made,” he said. “Ancillary considerations beyond cost are important. People need to have their incentives measured and rewarded properly in order to achieve these other goals. Shareholder value is created by having this balance,” he said.
The cost of a material. To illustrate his point, Evans offered several examples of situations that come up in procurement activities. A fundamental question is: What is the true cost of a material? “Typically, most companies use a volume-adjusted measurement of purchase-price variance in examining cost. It generally boils down to ‘units times price,’” he said. Evans pointed out, however, that the components of cost could be much greater. Cost can entail “obvious additional elements” such as freight and distribution costs, but also can include “important, yet less obvious elements” such as inventory carrying cost, support organization transaction costs, time, and effort, he said. Also, “critical, yet often obscure elements” such as performance and quality are crucial components of determining cost. It is also important to take into consideration that cost is not a one-year occurrence. “Cost is longitudinal, meaning how can future savings be captured,” he added.
Risk-mitigation. “All companies talk about the need to mitigate risk in purchasing decisions, meaning ensuring security of supply,” said Evans. Simple ways of minimizing risk can be through the use of active market intelligence, multisource procurement, long-term supply agreements, and quality audits, inclusive of inventory requirements. Although risk mitigation is important, it typically is not measured, or if it is measured, it is more on a subjective basis. “The risk discussion must have meaning beyond purchasing and go beyond a theoretical concept,” said Evans. “If risk mitigation is not measured and rewarded, it will be underemphasized.”
Incorporation of broader objectives. Evans said most companies have global initiatives with broader goals such as minimizing environmental impact, having sustainable business relationships, long-term perspective on growth, and assurance of quality to customers and shareholders. “Yet again, how is this typically incorporated into the measured and rewarded objectives of the purchasing organization?” said Evans. “Suppliers need to encourage purchasers to help ‘tell the story’ of how their global objectives are being supported. Suppliers and purchasers need to quantify impact where possible and have high-level internal dialogue that goes beyond the negotiation table about these objectives and their importance,” he said. The key takeaway is that suppliers need to take joint responsibility by going beyond cost per unit when defining value, he emphasized.
Influence of the broader market. A final consideration is to consider the effect an individual firm may have on the broader market, particularly over time. “The bigger picture needs to be incorporated by individual players, both suppliers and purchasers,” said Evans. For example, suppliers have to consider long-term interests and not engage in risky short-term behavior such as cutting costs unrealistically, lowering quality, or engaging in anticompetitive behavior. Similarly for purchasers, a key question is: How can the health of the overall supply picture be built into the decision-making process of the firm? “It is important for industry purchasers to have rules to play by to ensure a healthy marketplace,” said Evans. “Trade associations are also crucial to maintaining a broader perspective. ”
Given the need to redefine how procurement success should be measured, Evans outlined some improvements that companies might explore to get better results. These improvements involve the metrics themselves as well as organizational and attitudinal approaches as follows:
• Perform an active and holistic review of purchasing decisions, which also include other functional areas of the organization such as general management and finance
• Modify the incentive structure to incorporate the intangible goals of the organization
• Use risk-adjusted financial models versus one-dimension cost-variance reports
• Create evergreen, multidisciplinary teams that assess the true cost of purchasing decisions across the organization
• Become actively involved within industry groups to ensure a healthy operating environment
• Maintain genuine concern over the health of one’s suppliers.