Using TCO to rate suppliers
As more electronics companies outsource, they are using total cost of ownership criteria to measure supplier performance.
By James Carbone -- Purchasing, 2/19/2004 2:00:00 AM
Reducing cost is the name of the game for electronics companies. It's the reason why so many OEMs have outsourced manufacturing to electronics manufacturing service (EMS) providers. It is also the reason why many EMS providers have transitioned manufacturing from North America to Asia.
So, it should come as no surprise that many electronics OEMs and EMS providers are using a total cost of ownership (TCO) model to evaluate suppliers. While TCO is not new, many providers are embracing it because the potential cost savings is huge. While a buyer may be able to negotiate a 5-10% price decrease for a part, measuring a supplier's performance based on TCO can identify much larger savings.
However, measuring TCO can be an inexact science and some would say it is an art. While measuring on-time delivery and parts per million (ppm) defect levels of parts can be objective, determining the dollar impacts of late deliveries or defective parts can be subject to interpretation.
Nevertheless, many companies are using TCO to measure suppliers and many suppliers think it's a good idea because it shows suppliers' true value to OEMs and EMS providers.
One company that has used TCO to evaluate suppliers over the past five years is EMS provider Manufacturers' Services Ltd. of Concord, Mass. MSL has used TCO to rationalize its supplier base. "Several years back we were fragmented in our supply base," says John Boucher, corporate vice president, supply chain at MSL. "As we brought on additional OEM customers, they had their own approved vendor lists (AVLs) and our supply became more fragmented and our challenge was to defrag it."
Wanted: Lowest TCO
MSL developed a supplier performance measurement process, which was used to determine which suppliers provide the lowest TCO. After determining supplier TCO ratings, MSL moved business to suppliers who provided MSL with the lowest total cost of ownership. In addition, MSL tried to convince its OEM customers to use those suppliers.
Each quarter, MSL measures about 125 suppliers on quality, delivery, responsiveness, technology and cost. MSL has a Web portal where each one of its sites rates suppliers on those criteria. Suppliers can achieve a maximum of 20 points for each criteria.
While the criteria is typical of most supplier evaluation scorecards, MSL has developed a system that attaches a monetary cost for a late delivery, a defective part or lack of response to an MSL request.
For example if a supplier provides a part for a $1.00, but the part is delivered two days late or is defective, MSL's TCO system can attach a cost for a late delivery or a quality problem. "There is an actual lookup table that says a late delivery for a particular part costs five cents, a quality problem with a part costs eight cents per part," says Boucher. "The system will come back and say that $1.00 part actual costs $1.20 because there was a late delivery or the supplier did not have a strategic initiative in place."
During reviews with suppliers, MSL will tell a supplier how much a part actually costs. A semiconductor from one supplier may have a TCO cost of $1.30, but another supplier total cost may be $1.20. "I can tell them where they are losing ground with us and it isn't on the invoice price," says Boucher. "We can tell them where their total cost problem is geographically and at which site."
That detailed information is often presented at executive reviews that MSL has with suppliers. "I'll show them a TCO scorecard, their score for each operating unit, a score for similar commodities and scores of other suppliers of similar commodities without naming the suppliers."
MSL then migrates business to suppliers who have the lowest TCO scores even if the invoice price is higher than suppliers with higher TCO costs. MSL factors in the TCO cost benefits of programs such as vendor-managed inventory (VMI), in-plant stores and extended payment terms. "All that adds up to a total value proposition, which is the way we score our suppliers. Sometimes a supplier may have a higher price for a part, but may have a VMI program with MSL, which reduces MSL's total cost and raises the supplier's rating.
All of MSL's sites have access to the TCO data via a Web portal.
TCO criteria are very useful when measuring distributor performance because typically a distributor's price is higher than a component manufacturer's price, but the distributor offers many materials management programs that often mean a lower total cost of ownership. "I expect distributors to be high in price and well positioned on performance, vendor-managed inventory, payment terms and flexibility," says Boucher. "If I am buying the same commodities from three distributors and I see a significant difference among the distributors, I start talking to the distributor executives and tell them they are losing ground and risk losing my business," says Boucher. "I can do that because I am not changing the approved manufacturers list (AML), just the AVL."
Dive deep
To measure TCO, MSL takes a deep dive into supplier performance criteria. For instance, with quality, MSL measures several parameters. "We measure how many lots are rejected," says Boucher. "What is the total loss during the time period? Do they require on-site inspection? How many times was product cited for a line stop? What is their corrective action response? How long does it take them to get back to us for corrective action? There are times when labeling is an issue so lots are rejected," he says.
With delivery, MSL measures both on time to committed ship date and to MSL's request date. However, the latter is measured under responsiveness. "If there is one measurement that is subjective it is that one because the systems we have in place are only good to committed ship dates," says Boucher "Unless we have very strong disciplines from a process standpoint within our factories, sometimes the site changes the ship date based on supplier commit date."
In recent months, delivery has become more of an issue because suppliers took out capacity during the downturn. "I have been astonished that several times I couldn't get deliveries because they have taken out capacity," says Boucher. Suppliers are also measured on flexibility, which is the ability to deliver the correct amount of parts if there is a surprise upside or downside with orders.
While MSL's focus is on TCO, it also measures suppliers' ability to reduce the prices of parts. "Cost reductions are done by site material directors who sometimes set specific targets with suppliers, says Boucher. "Material directors at the sites score the suppliers on that. They are the ones who place the POs and see the cost trend over a three-month period."
But getting lower prices is difficult because "in some commodities there is not a lot of margin left," he adds. "There is also the question of how much investment we want to put in place to drive down pricing. I don't want to add 10% of investment cost to get 5% out of margin."
Be strategic
Suppliers are also rated on strategic initiatives, which can vary from supplier to supplier depending on MSL's need. "This year some of MSL's strategic initiatives involve getting component data from suppliers. "I want end-of-life data for the commodities I buy. I don't want the data delivered to me per se, but I want my suppliers to participate in end-of-life programs run by companies like iSuppli," says Boucher.
Another example of strategic initiatives is a program that would provide MSL with a 30% upside flexibility program through virtual VMI. "In other words, they [suppliers] don't have to have inventory deposited across all my sites, but as long as I get access to it within 24 hours, they have a virtual VMI program. They would get points for that," he adds.
The idea of MSL's TCO supplier rating system is not to make life difficult for suppliers but to make sure suppliers understand what MSL's needs are for its customers. "This is not about beating them up on price," says Boucher. It is about the total business proposition that we are engaged in and what is important to MSL, based on what our customers are driving us for."
He says suppliers appreciate the rating system. "I have never had a negative reception from a supplier on this scorecard. They look at me and say 'You're putting a value on my performance in total versus rather than just my invoice price,'" says Boucher.
TCO expectations
Handheld computer company palmOne uses TCO criteria with suppliers because TCO is integral to the company's overall business model. "We're a cost targeting machine here," says Jon Adee, senior director, strategic sourcing. "We make sure every supplier knows exactly where we expect them to be."
PalmOne's product development times and lifecycles are short, typically less than a year. Early in product development, palmOne determines what the average selling price of a new product should be and what revenue the product is expected to generate.
"We determine what we need for investment in terms of overhead and support structure, our cost of goods sold, shipping, warranty, technical service and repair," says Adee. "Those targets are established for the life of the program and we put in forward cost routines at the very beginning before we kick off the supplier relationship." Suppliers are given cost targets for their products that must not be exceeded. Cost targets decline during the time of palmOne's product.
Suppliers are measured on how well they improve on total cost. "It is not just cost target for materials. There are logistics issues, freight issues, engineering and development issues, says Adee. "There's more to the cost equation than materials cost. It's total cost of ownership."
A supplier may have the lowest price for a part. "But if I am getting hit with a service repair cost in the back end, that doesn't help me out," says Adee. palmOne also measures the impact of time to market, engineering and development inventory management programs.
Suppliers who have supplier managed inventory (SMI) programs with palmOne get higher scores because such programs keep the [inventory carrying] cost of parts off the company's books so there is lower total cost ownership. "Not all suppliers are executing out of SMI, but obviously it comes into play because depending where the SMI is, freight and duty structures, those are costs that can be incurred. It affects their scoring," says Adee.
PalmOne gathers suppliers' performance data from the factories building its handheld products. "We ask these factories to give us their view of quality, delivery, responsiveness. If they have cost issues relative to execution in the chain, those will come up too," says Adee.
PalmOne rates suppliers on:
Quality. It includes parts per million (ppm) defect levels, lot acceptance rates, incoming inspection reports in yield rates at factories. "To get 100%, they have to be flawless, no rejections, no line rejects, no incoming quality rejections. They have to have a ppm that is zero, operating with a Six Sigma quality limit," says Adee. There also need to be no outstanding issues or any unforeseen field problems.
Delivery. On-time delivery means one day early and no days later to the supplier's commit date. "We measure if suppliers did what they said they would do on the day they said they would. We have another line on responsiveness, which measures how quickly they change relative to our request," says Adee.
Responsiveness. "This is the ability to move commitment dates to our request dates as our forecasts change," says Adee." If my forecast decreases I need the parts not to be delivered. Occasionally in materials management you have to be a magician and make the stuff go away."
Technology. How well does a supplier's technology roadmap align with palmOne's? "We try to find out how quickly is a supplier bringing new technology into our roadmap and are our suppliers giving us first-to-market opportunities with new technology," says Adee. Technology advances that palmOne is concerned about can include higher memory IC densities, die shrinks, and increased brightness in display technology.
True colors
PalmOne uses a color-coded system to rank suppliers: Green, yellow, or red. Suppliers who score the highest are in the green category. 'These are our go-to guys. They are automatically included in RFQs on new programs. They have the opportunity for the next piece of business and the follow-up piece of business," says Adee.
Suppliers in the yellow category have had some problems and must give palmOne documented plans on how they are going to provide corrective action plans to get back to green status.
A red rating means the supplier will not get an RFQ from palmOne. "You will not have an opportunity to bid on new business and we need an extremely detailed corrective action plan that makes everyone happy," says Adee. A supplier with a red rating for any length of time loses business.
Because palmOne and other OEMs outsource, they need to measure the performance of their EMS providers, who in many instances, have become the de facto manufacturing arms of OEMs.
Measuring EMS providers on TCO is a little different than measuring component suppliers. Besides basic quality and delivery, measuring EMS pro-viders includes criteria such as new product introduction yield, production yield, field returns, and repair intervals. OEMs also often measure EMS providers' abilities to manage inventory.
For instance Lucent Technologies measures its EMS providers on how long it takes them to deliver prototypes for a new product and the initial quality of the products, says Gary Timlin, director of supplier management. When the product goes into production, Lucent measures the product yield rate that is, how many units pass system tests. Lucent monitors number of returns and measures how long it takes an EMS partner to repair a product and how many products are unrepairable.
For each of those categories, Lucent sets targets for suppliers, says Timlin. The supplier rating is based on if the supplier meets those targets. Lucent also measures inventory levels and how much buffer inventory the EMS partner will carry for Lucent, says Timlin. He adds suppliers are becoming risk averse and don't want to build capacity or hold inventory. "That's why measuring things around materials buffers is critical," says Timlin.
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