Risk & Value Mapping – Pt. 1

This is part one of a two-part post on risk and value mapping.  In part one, we provide some historical perspective on how procurement has evolved over the past century and how value-based procurement has become increasingly important.  In part two we discuss the mechanics of applying risk and value mapping and how it relates to supplier relationship management.

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Risk and value mapping –

Then and Now: A Brief History of Procurement

Today we are going to briefly discuss the idea of risk and value mapping, what it is, how it works in procurement, and how it helps protect your organization. But in order to really get a sense of context, let’s start by looking back at the evolution of procurement in modern business and how its role in the organization has evolved.

If we were to step back in time about 90 years ago and find ourselves in Dearborn, Michigan, we would likely see a scene like this.

This is the Ford Motor Company River Rouge Complex. “The Rouge” as it was called, was huge by any standard. It occupies a massive 1.5 square mile footprint along the banks of the River Rouge. And within the complex lie ore docks, sixteen million square feet of manufacturing floor across 93 buildings, and 100 miles of train tracks with 16 locomotives. There were steel furnaces, coke ovens, rolling mills, glass furnaces, and plate-glass rollers. There was a tire manufacturing plant, a stamping plant, an engine casting plant, a transmission plant, a radiator plant, and a tool and die plant. And, oh by the way, they assembled cars here, too.

But there wasn’t much of a procurement operation here.  Why? Because Ford owned virtually EVERYTHING.  The Rouge was one of the most vertically integrated operations of all time.  Ford owned everything from the raw material production – such as ore mining – through final assembly and sales. There was very little bought from outside. Consequently, the procurement operation added very little value to Ford in those days.

But times change and with them how markets work. While vertical integration provides a company ultimate control over its material suppliers, there are drawbacks. Here are two obvious ones. First, it is expensive.  Second, it induces brittleness in the supply chain.

It takes a lot of time and money to be great in one industry, be it automobile, glass, plastics, or steel manufacturing. This fact is exacerbated by the complexity of today’s products. Compare Henry Ford’s Model T to even the simplest car rolling off today’s production line.  I imagine there are more components in a car’s cruise control than there were in the entire Model T. And this complexity brings with it greater barriers to entry at each level of a company’s supply chain.  

Then there is the lack of flexibility.  If a company owns its source of supply in any given area, it is unlikely to have a substantial relationship with alternative suppliers.  That means, when a disruption occurs within a company-owned supply chain, there is little opportunity for mitigation beyond their stockpile.

Henry Ford even saw this in 1927. The one raw material he did not control was rubber.  That was produced in Southeast Asia and managed exclusively by British agents. So, Ford bought a huge swath of land in the Brazilian Amazon to build his own rubber plantation. The effort, however, was a colossal failure costing Ford a fortune and many workers their lives. Ford, in the end, was forced to return to the British rubber agents.

Over time, most businesses have moved further and further away from the vertical integration model and adopted a much more nimble, flexible and less asset-intensive approach – “We do what we do best and buy the rest.”

And with this change, the locus of cost to the operation moved steadily from wages, salaries and overhead toward goods and services expense. And just as early automation was an attempt to minimize the cost of labor per unit of production, this transition brought with it attention on reducing the cost of materials and services purchased.

This was the birth of Procurement as a critical business function.

And it is a critical function. In their book “The LIVING Supply Chain”[i], Handfield and Linton describe a concept the biologist Sean Carroll termed Serengeti Rule 1. “(S)ome species exert effects on the stability and diversity of their community that are disproportionate to their numbers or biomass. These are termed ‘keystone species’”.  Applying this definition to the departments within an organization, we can certainly say that Procurement is a keystone department.  Let me illustrate.

In the example above we are looking at a hypothetical company with $500M in annual revenue. The Baseline column shows its current fiscal performance. Each column to the right shows what happens when the cost of goods and services procured is reduced in 5% increments.  All other expenses remain the same.  As you can see, each 5% step down in cost results in about 11 ½% increase in Net Income Before Taxes in this example. Clearly, this is a case where a department exerts a disproportionate effect on the performance of the enterprise.

And therefore, we have traditionally pushed Procurement organizations to reduce costs, reduce costs, reduce costs!

But there are a lot of other factors that remain unseen, hidden under the waterline of the “Price Iceberg”. Factors like delivery performance, quality of material handling, production delays, inspection costs, pre- and post-sales service and support, product training, supplier financial health, and a host of other risks and opportunities.

While the impact of price negotiation is immediately apparent on the bottom line, focusing exclusively on price often leaves other potential risks and values on the table, unaddressed. There are many other questions we need to be asking beyond, “What is the total landed cost of this item?”.  Questions like:

• What other assets/capabilities the supplier can offer in addition to the product/service procured?
• Is the supplier better with existing activities (e.g., inventory management; after sales support; product development…)?
• Can the supplier decrease our risk (e.g., reducing bottlenecks/critical parts purchasing; disruption response; exchange rates)?
• Can the supplier provide some other competitive advantage (e.g., differentiating factor; new product variant)?
• Can the supplier help expand the product portfolio to address new customer needs?

With value-based sourcing, you seek not only to leverage price, but to leverage the skills and assets of your suppliers to develop and expand competitive advantage in the marketplace. This means at times you may pay a somewhat greater per unit total landed cost in order to reap a larger value for your organization.

In shifting from a solely price-based focus to a value-based one, we need to take into consideration not only the total cost of ownership (TCO), but the additional value provided by the supplier. But this requires a bit of a shift in viewpoint and the broadening of a couple of skillsets. The procurement group needs to maintain as lean a purchasing process as possible for low-value items while developing a strategic perspective, both with internal customers and suppliers, to understand where supplier assets and skills can be leveraged to the organization’s advantage.

Value-based sourcing also means that cross-industry benchmarks have a different purpose.  Instead of seeking to be as good as the benchmarks, with value-based procurement we seek to be better.  Better and different through using the value the suppliers bring to the table. This is done, in part, by moving the purchasing position in the organization from one of tactical and operational specification and delivery to one of strategically coordinating vendor resources and assets to meet the business’ goals. This requires the procurement professional to expand his or her skills to encompass greater general business and finance competencies.

Finally, value-based procurement lends itself to a center-led format. In this particular model, the central procurement organization coordinates enterprise-wide, strategic procurement in direct coordination with the business unit level purchasing organizations which, in turn, provides tactical and operational support to the individual operating units and stakeholders.

Next week in part two of this series we will look at the mechanics of risk and value mapping as well as how you can use risk and value mapping to guide your supplier relationship management strategy.

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[i] Robert Handfield & Tom Linton, “The LIVING Supply Chain”, Wiley, 2017, pg. 11