Mini-Case Study: One of the major drivers of total cost of ownership is price. How does a company ensure that it is receiving the most competitive prices in market? For components or subassemblies where market pricing is not available due to the nature of the product, how can one determine what a component should cost? What steps can be taken to drive cost down throughout a product's life cycle?
Problem: Company C, a $1B division of a large OEM, was in various market segments, most of which were faced with intense price competition. Price reductions were generally reactive and were triggered by price wars for the final product in the market. In other words, Marketing was under pressure to reduce the price of the final product, which eroded profitability and forced Finance to put pressure on Materials to negotiate price reductions to improve profitability. By the time the negotiations were complete, the vicious cycle would continue, leading to poor profitability results as well as frustrated suppliers.
Solution: In analyzing the problem, we found two fundamental root causes to this problem. First, we realized that cost reductions were approached tactically and mostly through quotation activity. Cost drivers upstream in the supply chain were not understood and component market pricing was unknown. Second, the company missed its greatest opportunity to leverage its position and negotiate pricing (as well as terms) during the design phase. Once the design was frozen, suppliers were less compelled to offer more favorable pricing.
Before proceeding, it was important to understand that all components and subassemblies could not be treated in the same manner. The classification of custom, semi-custom, and standard was used to differentiate the approach to negotiating more favorable pricing.
| Category | Definition | Strategy |
|---|---|---|
| Custom | One customer, specific application (custom ASIC's, custom crystals & oscillators) |
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| Semi-custom | More than one customer, limited market and application (e.g. wireless semiconductors) |
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| Standard | Various customers and market segments (e.g. memory products, passives) |
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For custom components, we realized that a solid understanding of the mfg. process paid off. Through this understanding, we were able to gain visibility to supplier's capacity expansion plans, migration of mfg. activity from one location to another, yields at each process step, and how improvements in manufacturing could impact pricing. Furthermore, by being part of a collective team focusing on reducing price, the suppliers often suggested changes that could reduce the cost of mfg., and therefore the price to the company. The engineering team would then evaluate whether or not the change could be accommodated, and usually, the changes were acceptable.
The semi-custom components followed a similar plan to the custom parts, however, since alternate sources were available for these components, changing suppliers was not as difficult as custom parts. The company was able to benchmark several suppliers based on product functionality, understanding that these parts were not interchangeable. Suppliers realized that although there was no drop-in replacement for their product, the OEM had the option of designing an alternate supplier's part in future designs.
Finally, market intelligence was the key factor in the ability to negotiate the best price for standard components. Since the source of supply could be switched much more easily on these products, suppliers knew that loss of price leadership meant loss of business. Industry reports on pricing and quotations were used to drive price reductions with suppliers. For most standard parts, the OEM relied on the contract manufacturer to leverage its volumes to negotiate the best deals, and only used its own market intelligence to provide direction and validation.
Results: With a new process institutionalized in the company, chasing after price as a result of pressure from Marketing was no longer the case. Proactive pursuit of material price reductions now created an opportunity for Marketing to establish price leadership in the market. The price reduction realized in the first year was 18%, at a time when prices were actually rising in the market due to capacity constraints. Suppliers in the "leverage" segment were consolidated by 50%. Fewer suppliers were now enjoying a larger portion of the company's purchases and offering lower prices in return. Interestingly, once the supplier consolidation took place, the sources of supply remained relatively stable. Suppliers knew the expectations and many of them were proactive in initiating the quarterly discussions ahead of schedule.