Whenever we meet with potential clients regarding our services, some of their initial reactions include: “we have already squeezed our suppliers to the limit” or “we don’t believe there is any more room for cost reduction in this category!” What comes as a surprise to many of these professionals is the fact that there are still untapped pockets of efficiency that can be harnessed using the Total Delivered Cost (TDC) model.
While many companies have put in place long term initiatives to reduce procurement costs – strategic sourcing, low cost country sourcing, procurement outsourcing – shorter term solutions can be more elusive through these approaches. To capture more immediate results, we recommend the use of TDC to identify areas of opportunities in purchased goods and services.
The TDC model shifts the focus from the ‘cost’ of purchased goods and services to the ‘value’ provided by them with respect to the finished products. By closely linking the purchased materials to the finished products, we are able to directly influence the cost inputs where it matters the most – the net profits of the company. Let me illustrate this with a simple example. One of the clients in the paper industry that we worked with used to source Coal that was used as fuel for their boilers. Paper is an energy intensive commodity, and thus coal contributed substantially to the company’s monthly purchase bills! The company used to buy locally available coal and preferred not to purchase imported coal because of its higher price, as well as the additional costs in import duties, customs clearances and the freight to get it into the factory site. The table below shows the pricing (indexed, to maintain confidentiality) to illustrate the price difference.
|Annual requirement of coal (in Metric Tonnes - MT)||100,000|
|Indexed landed cost of local coal ($ / MT)||20|
|Indexed landed cost of imported coal ($ / MT)||30|
Now, let us look at these two options using the TDC model. As a first step, we look at the annual energy requirement of the company – this is measured in Kcal. Let us say that the annual energy requirement from the boiler is 5,000,000 Kcal. This would mean that the 100,000 MT of purchased coal should be able to deliver this energy – translating to 50 Kcal per MT of coal. This is termed as the calorific value of the coal. We compared the calorific value of the coal from the two sources and the results are shown in the table below
|Source||Calorific value (Kcal / MT)|
So, essentially the price of local coal to generate 1 Kcal of energy = 20 / 50 = 0.40 $ / Kcal. If we do the same analysis for imported coal, the price works out to be = 30 / 90 = 0.33 $ / Kcal! In other words, if we use the higher priced imported coal, we will be cutting down on the quantity of coal purchased and thereby reducing our coal procurement costs! (The above example has been significantly simplified for the purpose of this blog. The actual analysis also had to consider other issues such as sulphur and ash contents in the coal, regulatory restrictions, inventory costs etc) So, in the above example, we shifted the focus from price of coal to the value provided by the coal and were able to identify an opportunity in optimizing the final energy costs.
The TDC model can be used for any purchased category – it is important to determine the impact it will have on the bottom-line or the top-line of the company. Also, implementing solutions based on TDC will more often than not, require the involvement of the user functions such as manufacturing or marketing. TDC approach can be used to identify and reduce the delivered costs across categories – however, it is not just a one-time exercise. Nimble companies that include this approach in their day-to-day operations will definitely retain the competitive advantage.