Improving COGS and Margins With Strategic Sourcing

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In Part 1 of this series, we called out six key challenges retailers need to address to embrace and realize the value from a strategic sourcing exercise. They are:

  1. Inefficient organization design, with merchants often left solely in charge of sourcing
  2. Lack of dedicated and skilled sourcing specialists with authority to engage suppliers
  3. Lack of strategic sourcing process, tools and roadmap linked to margin improvement goals
  4. Lack of clarity and transparency in cost sheets that prevents meaningful comparisons
  5. Ad hoc private label development plan
  6. Strong incumbent bias stemming from a general belief that suppliers hold more leverage and can hurt the retailer if business is taken out to bid

Now we will take a deeper dive into the six elements that are crucial to implementing a sustainable strategic sourcing process.

1. The right organization design and skills

Merchant teams often serve dual roles. They are responsible for generating revenue while also managing product costs for both national brand and private-label goods. While searching for the next big thing to generate revenue growth, they often side-line COGS optimization as a by-product of their category growth strategy. This approach discourages the growth of systematic strategic sourcing skills within merchandising, which in turn generates weaker sourcing decisions and results. Even when merchants do focus on COGS, they often ask suppliers to meet cost objectives based on margin, instead of uncovering the true cost in the market. Sourcing groups then become order-placing and fulfillment professionals with little to no influence on supplier engagement and selection.

Retailers with strong COGS management programs instead share these key features:

  • Focus on total margin management, covering both revenue and COGS independently, setting goals based on true market cost
  • A separate and independent sourcing organization that works collaboratively with merchants on supplier portfolio and business allocation.
  • Sourcing efficiency goals linked to and measured along with corporate margin goals
  • A skilled sourcing team utilizing best-in-class processes and tools, including routine market research and supplier competitive dynamics

2. Knowing true market cost: the holy grail

“Cecil Graham: What is a cynic?

Lord Darlington: A man who knows the price of everything, and the value of nothing.” – Lady Windermere’s Fan, Oscar Wilde

In our experience, retailers generally believe they know the true market cost of their products and that their suppliers have no more room for cost improvement. However, the source of this information is typically the supplier itself. There are many better, more accurate alternatives to a supplier’s word for cost and margin information. The most elegant of these is “should-cost” modeling. This process takes a product, strips it into its component parts, weighs the various raw materials, applies raw material market prices, adds costs to cover all manufacturing inputs, adds supply chain costs, and a fair market margin to arrive at what the product should cost. The gap between the should-cost and current cost represents a theoretical cost reduction opportunity.

The process is not 100 percent accurate, but is almost always directionally correct. An open market competitive bidding process typically recovers half to two thirds of the gap opportunity, based on the authors’ collective experience. Retailers with leading sourcing practices routinely deploy this practice, leading to better costs than traditional negotiations.

3. Do you really know what you pay your suppliers?

“Tyrion Lannister: I don’t even know how much I’m paying you now.

Bronn: Which means you can afford it.” – Game of Thrones

Simply applying a should-cost and open market bidding process, however, is not sufficient. Another challenge that retailers face is identifying the true “dead-net” cost underneath layers of obfuscation added via back-end dollars, promotional dollars, ad hoc funds, and services that suppliers provide. One of the key success factors for a strategic sourcing program is to partner with the retailer’s finance team to obtain an accurate true cost by SKU, adjusted for all back-end dollars.

This true-cost exercise cannot be a one-time process. It must become part of the supplier contract, instead of utilizing individual memory, oral/email communications, and one off addendums as many companies do today. Retailers with leading sourcing functions maintain true dead-net pricing for their SKUs. As prices and promotions change over time, they discontinue and replace SKUs, and they also create a record of costs is to understand true-market pricing. This tracking requires a concerted cross-functional effort between the merchant, sourcing, legal, finance, and infrastructure teams.

4. The right product mix between national- and private-brands

“Grimes: It’s all in the grind, Sizemore. Can’t be too fine, can’t be too coarse. This, my friend, is a science.” – Black Hawk Down

One driving factor for increasing total margin is pursuing private label replacement of national brands. Typically private label products deliver 10 points of additional margin. However, retailers need to conduct thorough research to ensure the private label product will sell as well as the national brand product. The norm, however, is quite the opposite. Typically, retailers:

  • Lack appropriate organization structure (market research, product development, and sourcing) to introduce innovative and price competitive offerings to market
  • Develop private label products ad-hoc, instead of utilizing a core set of materials (e.g., in apparel) to gain efficiencies and increase speed to market
  • Develop private label lines in categories that do not align with the retailer’s brand
  • Source private label products from national brand suppliers, rather than directly from factory, thus losing cost competitiveness

Overcoming the above challenges, instituting the appropriate mix using a customer mind set, and sourcing from the right suppliers, can increase margin by double digits in the authors’ experience.

5. Finally, it is all about the right partnerships

The vast majority of retailers that we have worked with believe they already have strategic partnerships with their suppliers. However, these partnerships are generally not the outcome of an objective and fact-based process, and they are not regularly reviewed as market conditions change. Incumbent bias is rampant. Suppliers often successfully convince merchants that any changes would be devastating for the business. However, retailers that use strategic sourcing practices as a standard operating procedure can improve margins and rationalize vendor portfolios without any accompanying business risks.

The key questions to ask as a retailer setting up a successful supplier portfolio management program include:

  • Does this supplier sell to other renowned retailers and provide top-quality products and services?
  • Is this supplier financially stable and not too dependent on one retailer?
  • Is this supplier willing to be price competitive with other vendors?
  • Is the supplier taking advantage of and sharing benefits from favorable currency and commodity changes and investments and efficiencies in the manufacturing process?
  • Is this supplier located in a favorable manufacturing zone with a low cost of labor and efficient supply chain?
  • Does this supplier have a clear plan to mitigate future cost pressures from commodity and labor price inflation?

Once the supplier satisfies these criteria, the retailer can decide whether to conduct business directly with the supplier, or to act through an intermediary like an agent or a distributor. Although retailers with a smaller footprint may require an intermediary, retailers with sufficient scale generally have a well-functioning, low-cost-country sourcing centers that enable them to work directly with the supplier’s factory.

It’s not a race to the bottom

We would like to emphatically state that sourcing should not be a race to the bottom for the sake of cost reductions alone. That perspective results in poor results and a fragmented supplier base, as well as lost revenue. Strategic sourcing encompasses a well thought-out approach, from understanding manufacturing costs and processes to managing strategic supplier partnerships. Retailers can create an environment for appropriate market costs by regularly executing sourcing processes that foster supplier success and growth. This strategic viewpoint provides a simple, yet effective, competitive advantage for retailers struggling in a stagnant economy.

In our experience, the resulting supplier portfolio after strategic sourcing processes are executed changes marginally, with only about 20 percent to 30 percent of SKU migration from one supplier to another. A strong supplier research process ensures that no low-quality suppliers win business. Incumbents typically end up with a larger share of business, resulting in supplier consolidation and an easing of the supplier management process. The suppliers that remain in the portfolio become stronger partners as a result, delivering benefits for both retailers and suppliers that should last for a long time.

John Bonno, Murali Gokki, and Apratim Sarkar are managing directors at AlixPartners, a business management consultancy, specializing in turnarounds.


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