Want to reduce procurement costs? & How to negotiate with Chinese suppliers?

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Buyers should always keep one thing in mind, that is “cost”. 

That is because the procurement staff always face cost pressure. The main objective of a company’s operation is to create maximum wealth for shareholders. Thus, annual performance and return on investment are 2 key figures when making annual review. Cost control is the working responsibility of procurement staff.

 

The impact of costs on the business 

Although ROI sometimes is calculated in different ways, the most common way to indicate it is as follows:

 

Profit margins represents a company’s revenue condition and cost control performance. The turnover of assets reflects management ability to use available assets of the company. Therefore, there are three ways for management team to achieve an increase in ROI:

(1) reduce the cost;

(2) Using existing assets to increase sales performance;

(3) Synthesis of the above two items.

 

According to statistics, for manufacturing company, purchase amount for raw materials and spare parts accounts an average of 50% sales revenue. In other words, any savings made through procurement are a direct contribution to profits.

 

Let's look at the following example:

Supposing a company spends 50% of its total revenue on purchasing materials with a net pre-tax profit of 10%. For every CNY100 sales amount, a profit of CNY10, a material cost of 50 CNY, with other expenses account for CNY40. Furthermore, assuming that all costs and expenses change together with sales figure, the profit is as follows:

Sales amount: CNY100

Production cost: CNY50(Purchase amount) + CNY40(Other fees) 

Pre-tax profit: CNY10

 

If the company wants to earn additional money, e.g. increase 10% profit margin, its sales amount must be increased to CNY110. Purchases and other expenses are raised to CNY55 and CNY44 respectively. Then new profit and expense situation is as follows:

Sales amount: CNY110

Production cost: CNY55(Purchase amount) + CNY44(Other fees)

Pre-tax profit: CNY11

 

If the company adopts the method of reducing the purchase cost from CNY50 to CNY49, then only 2% of the purchase cost savings can achieve the goal of increasing the profit margin by 10% also. In this example, a 2% reduction in procurement costs and a 10% increase in sales amount have an equal impact on net pre-tax profits. Generally speaking, to increase sales amount takes much more effort than reducing procurement costs, let alone 5 times difference. And the higher the proportion of procurement costs to total sales amount, the more significant the ratio of both:

Sales: CNY100.

Production cost: CNY49(Purchase)/CNY40(Others)

Pre-tax profit: CNY11 

 

How to calculate the cost reduction

By analyzing current products, services, contracts, manufacturing procedures and etc. to find out any possible changes to fulfill cost reduction. Any expense related is lower than the previous one can be considered as cost reduction.

 

There are several simple calculating methods: 

1. Difference between previous unit price & current unit price.

2. Cost reductions (original unit price - new unit price) x quantity per purchase(or annual purchase quantity)

3. Difference between cost reduction & projected target = actual cost reduction amount (per unit or year) - Estimated cost reduction amount (per unit or year)

 

For instance, a certain type of screw purchased by company A cost CNY6.0/KPCs * 10 million in previous year , while it gets the price of CNY5.8/KPCs for same purchase volume for current year, so it could get CNY0.2/ KPCs savings with total cost reduction amount of CNY2,000/year. 

 

Another concept, which is more confusing than cost reduction, is Cost Avoidance. Sometimes, the price increase is not controlled by the purchaser. Taking the increase of material cost or price adjustment of supplier into consideration, procurement staff can take some measures, such as signing a price protection contract to reduce the impact caused by price increase.

 

Different companies have different practices and views on whether to take this approach in the scope of cost reductions or not. 

 

Ways to reduce procurement cost 

“Cost reduction can be implemented in many ways, but it must be understood that the primary purpose of cost reduction is to identify and reduce unnecessary cost and to make the most efficient allocation of costs without compromising product quality." Any decision that is contrary to this principle deserves careful consideration.

 

Central purchasing is one of the most effective ways to reduce cost. 

By centralizing the needs of various business unit, purchasing department can use a larger purchase amount as a valuable chip to get a better discount price in number. After standardization of the specification, preferential price of supplier's standard products can be obtained, inventory can be reduced relatively as well. Then, procurement of unified operations could result in administrative cost expenditure reduction. And it makes procurement department focus more time and resources on developing new suppliers.


However, centralized procurement might give the impression of rigidity and inflexibleness.


Thus, another more compromise approach is that the business unit, which requires one certain part most, help consolidate all demand of this part of company and be responsible for leading procurement bargaining.


In addition to having the same quantitative advantages as central procurement, it also promotes close cooperation relationship between the procurement department and user departments so as to fully grasp the real needs. Other product committees, such as product committees composed by representatives from related departments, joint procurement, long-term contracts, as well as total demand contracts required for the life cycle of the purchased product, are interactive.

 

Using value analysis method is also one of the most important ways to reduce cost.

To simplify product design to reduce production cost; adopt different bargaining techniques, choose logistics companies who could provide reasonable charges or consider to use various transportation modes to fulfill cost reduction purpose. Of course, other influences, such as sufficient lead time, which must be confirmed in advance and a comprehensive decision needs to be made.  

 

Activity Based Costing is another way to control cost. 

This has been prevalent in Xerus and Hewlett-Packard in the United States for years. Indirect costs can be configured rightly according to time spending on supporting a product, which differs from average allocation of indirect costs in traditional accounting operations. It shows management team a clear picture of indirect cost allocation and makes it easy to judge if it is reasonable. However, the excessive details of the analysis may also result in complex situation. Therefore, it is absolutely necessary to do some appropriate analysis to identify the key costs.

 

In addition, high-risk procurement strategies, such as commodity futures operations, could be used to purchase materials that exceed current demand or future demand for speculative procurement with price advantage.

 

Basically, any cost-saving means is well worth considering for procurement, provided that it must be reasonable, legitimate and in favor of supplier partnerships. As for which method above  should be taken, the procurement staff need use their professional skills and working experience to make a comprehensive judgment and use it flexibly. 

 

How to make correct RFQ 

Request for Quotation is a necessary stage in the operating flow for buyers.

 

After receiving internal sourcing request, buyers should understand the current inventory status , procurement budget, then contact the supplier immediately. If this is a normal procurement, a standard part, it will not be a problem.

 

However, in the process of developing new products, for those parts that are not standard, when asking for quotations, procurement staff must make sure the information provided to suppliers is enough. In order to avoid future argument between procurement (or quality or R&D) department and the suppliers, the complete information needs to be provided at the time of inquiry. Because intact and correct RFQ documents help suppliers make correct and valid quotations in the shortest possible time.

 

A complete RFQ file should consist of following major sections at least, 

1, the inquiry item's "product name" and "material number"

Some large companies have more than ten digits and letters when naming product& material. A single digit difference in the number of materials might be a difference in material version, or it may even be another product. The characteristics and types of the product should be easily recognized literally when naming. 

 

2, the "quantity" of the RFQ item

Usually suppliers need know the buyer's quantity demand when quoting because the final purchase amount affects the price calculation. Quantity information is usually provided in the form of "annual demand", "quarterly demand" or even "monthly demand"; In addition to keeping suppliers understood of purchasing demand and the pattern of procurement, the buyer could also ask suppliers to inform whether their own capacity can meet the buyer's needs or not.


At the time of inquiry, the buyers usually has a common errors of recognization, that is, they can not get a good purchasing price with a small purchasing amount. Then they would exaggerate the demand or purchase amount. At this point, the procurement might obtain short-term benefits since they get the price of mass production. While once the supplier found that the real purchase amount is much smaller than the procurement informed when making quotation, the supplier might either raise the purchasing price or provide unsatisfied  customer service in other ways, or even stop supplying sometimes. All of these possibilities might be risks in the end. Therefore, the information on demand should be true while procurement staff could also come up with market forecasts to convince suppliers so as to achieve long-term cooperation purposes.

 

3, the inquiry item's "spec book"

A specification book is a tool that describes the quality of a purchased product and it should include the latest version of the engineering drawings, test specifications, material specifications, samples and etc. to help the suppliers to quote. The drawings must be up-to-date. For international procurement, if the original engineering drawing is in local language rather than English, such as German, French, Japanese and etc., it should also be accompanied by English version. Bilingual communication will be better in international business. Whether the engineering drawing could be provided by means of electronic archives or not, it’s up to supplier’s willingness. But be remember to send the file in formats, such as DWG, IGES, DXF, PRO/E and etc., which are widely accepted.   

 

4, "quality" requirements in the inquiry

There are many ways to express the quality specification requirements for RFQ items and often could be presented in the following ways. It is difficult for purchasing personnel to express the quality requirements of a product or service in a single way, and a combination of several methods according to the different characteristics of the product or service should be used also .

1. Brand

2. Or the same class Brand

3. Business standard

4. Materials and manufacturing method specifications

5. Performance or functional specifications

6. Engineering drawing

7. Market grade

8. Samples

9. Statement of work

 

5, the "quote basis" requirements of the RFQ project

The "quote basis" usually includes the "currency value" and "trade terms" of the quote. Domestic trading is relatively simple, usually in CNY transactions and the terms of trade are either “ex-factory price" or "DDP price”. However, international trade is much more complex, the quotation currency are mostly based on USD. As to whether to purchase local currency value or not, it depends on the stability of the exchange rate. It is a flexible practice.


The conventional delivery terms for international trade include Ex-Work (factory delivery), FOB (on-board delivery), FAS (ship-side delivery) or CIF (in-ship delivery), and under different conditions, the risk of liability to buyers and sellers is different. Under FOB conditions, the seller bears duty to have the goods loaded on board. Therefore, the seller must bear the risk of loading the ship while the buyer is responsible for freight cost, insurance and other costs. Under CIF conditions, the seller must bear the freight and insurance costs required for the shipment of the goods to the designated port of destination, as well as the risk of loading. Therefore, in the transaction of the same goods, the price quoted on CIF terms is naturally higher than the quotation on FOB terms, and the buyer must indicate the request for quotation.

 

6, payment terms

Regarding the terms of payment, although both buyers and sellers have their own corporate policies, the buyer always favors longer payment time. On the contrary, the seller certainly expects shorter payment time, the sooner the better. The buyer is obliged to make the seller aware of the standard terms of payment within the company (in the procurement of the mold, there is usually a "phased payment" method, such as a deposit of 30%, the first test mold 30%, acceptance 40%), the seller can also make a different request at the time of the offer, the final payment terms needs to be agreed by the buyer and seller in the agreement. In a situation where supply exceeds demand in a competitive market, goods and/or services can be easily obtained, the economic forces of the business tend to lead to prices close to the estimated value of the purchase, and buyers are often able to require the seller's cooperation on better terms of payment, such as "accounting methods (O/A)", T/T 60 days or even 90 days. "In the seller's market, since the demand exceeds the supply, sellers generally require shorter payment periods, such as Cash on Delivery, C.O.D. or Pre-paid payment terms (T/T in advance).


In addition, in international trade, domestic suppliers typically calculate the due date of payment based on Shipping Date, Invoice Date or On Board Date for payment terms that need to be clearly stated in their time calculation. At this point, in case an overseas buyer identifies Arrival Date or even The Receiving Date as the starting date, there might be a one-month time difference between buyers and sellers.

 

7, "delivery period" requirements

The delivery requirements should contain the information, like how long the seller needs to prepare samples and the first small quantities of production, the lead time of the product. Although the supplier may cooperate according to the buyer's request, the length of the delivery period depends on the price of the purchased product sometimes. Thus the buyer should make a request according to his actual needs rather than pursuing "just in Time, JIT".

 

8, "packaging" requirements

Packaging methods accounts for partial proportion in product price calculation. In addition to special shape of product or large volume of customer orders, packaging suppliers have to customize packing cartons, pallets as well as other packaging materials. If there is no special packaging requirement, the supplier will evaluate it and use their own standard packaging method. Sometimes, detailed description of standard packaging method will not be shown on the quotation. At this time, if it is not defined clear, it might lead to additional cost or even influence timely delivery. In addition, after understanding the buyer's packaging requirements, suppliers can also provide suggestions on whether to consider standard packaging or reduce shipping costs by less than container load.

 

9, "shipping place" and "delivery mode" 

Detailed information, e.g. country, city, street, house number, attn, contact number and etc. about the shipping location must be clearly provided to the supplier. The place of delivery and mode of delivery in international procurement have a major influence on price accounting. If the seller is required to quote at CIF, whether by sea or air, shipping and insurance premiums are of course borne by the seller. There will be different billing methods depending on the distance of shipment, unless the buyer specifies air freight, suppliers usually quote on the basis of sea freight, which is the most economical mode of delivery.

 

10, "after-sales service" and "guarantee period" requirements

In the procurement of some machinery and equipment, such as punches, plastic ejaculation machines, test instruments, semiconductor packaging equipment, generally speaking suppliers will provide basic after-sales service and guarantee period. If there are special requirements at this time, like request for an extension of the guarantee period, or a change in the content of after-sales service and etc., as it is a part of the purchase of "Total Cost of Owndership, TCO".

 

11, the supplier's "quote due date"

Quote due date is a very important part in quotation process. The expiration date of the quotation should be made understood by the supplier, and the supplier should be given sufficient time to evaluate the more complex products.

 

12, "Non-Disclosure Agreement" 

In some new product developing inquiries, since it involves business secrets, in order to make inquiries without letting competitors know and missing business opportunities, the sellers will further let suppliers sign "non-disclosure agreement (Non Disclosure Agreement, NDA)", requiring suppliers treat the name of the new product plan, purchasing forecast, technical requirements, specifications, drawings and other information in the strictest confidence in a standardized number of years. 


Price Negotiations with Chinese suppliers  

Price should be cost-centric rather than price-centric 

Cost-based negotiations help lead to good agreements. Pre-negotiation preparation is the key to negotiation success. Price negotiations are not only about reaching a cost consensus with suppliers but also about whether both parties are satisfied with profits or not. If an agreement is to be reached in cost-based negotiations, several things must be done:

First: a thorough understanding of the composition of supplier costs

Second: there is a good faith and a desire to share these costs

Third: understand the norms of the industry

Fourth: set the target price

 

Understand and explore key elements 

To understand cost composition of suppliers, cost classification and cost analysis should be done to help supply managers set fair prices. Costs include direct costs, indirect costs and overall administrative costs. Direct cost contains direct labor cost and direct material cost while indirect cost can be divided into daily expenses of the project, daily expenses of materials, and daily costs of production. Sometimes cost can be divided into fixed costs and variable costs.

 

Trust and loyalty are important  

Complete trust and cooperation is the second important factor in understanding supplier costs and prices. If this is possible, suppliers are often willing to present the accounts to the purchaser, which requires a prior confidentiality agreement for sure. Another benefit of mutual trust is that there is a discussion about the possibility of cost reductions, which can be achieved through product modification or production process modification, also known as value engineering.

 

Set a target price 

"Finally, it is important that the purchaser understands the supplier's industry and the cost information about related products and services so that other similar party's costs and possible prices can be estimated prior to negotiation." Understanding competitiveness in the supplier industry is also critical. How many businesses can offer similar products? Only a very small number of suppliers could provide the product? These factors have a direct impact on suppliers' profit margins.

 

Adequate preparation is the key to the success of the negotiations 

All of these elements can help supply managers set a target price before negotiations. If the relationship is open and honest, the target price will soon lead to a win-win agreement because the buyer is able to estimate the cost in advance. It should be noted that the target price must be supported by data and that supply managers need collect it in the preparation phase of the negotiations.

 

Actual negotiations 

The time and place should be predetermined, the venue should not be hostile and do remember that both parties should be the winners. The negotiations begin with guidelines, which help to establish the boundaries of the negotiations. For example, "Before we start, I would like to review the current situation and give an overview of our purpose...". Such kind of opening remarks is conducive to mutual understanding between the two parties at the beginning. Once the points above are done, your negotiation is half done. Understanding the cost factors and minor information are critical to the success of the negotiation, and each step of the preparation process increases the chances of success by 10%.


Author:steven.zhou

Email:steven.zhou@pintuu.com