Several of my friends and clients are directors or managers of indirect sourcing divisions at foreign capitalized firms in Japan. They are part of a clear trend among these companies to establish such divisions and assign high profile managers with consulting background or business school education.
Shortly after taking over, they’re all motivated and proud of their significant cost reduction achievements. Typically they rack up savings of 20 to 30 percent or sometimes even up to more than 50 percent for some spend categories.
But three to five years later, they appear less happy. Cost reduction opportunities have started to decrease as larger spend categories have already been reviewed and negotiated. Some of them face being laid off. In fact, I know some people who already had to leave their companies.
If you are a CFO or a CEO of a foreign firm in Japan, you might be familiar with the story.
Is this sort of cost reduction degression an unavoidable fate that you just have to accept?
Is the shelf life of indirect sourcing managers limited to about five years?
My answer to these questions is a resounding “No, you don’t, and no, it isn’t.” In fact, substantial efficiency gains are on the table if management better understands the nature of indirect sourcing and the difference between direct and indirect sourcing.
Why direct sourcing can continuously generate cost reductions
In many industry sectors, direct sourcing divisions have been setting and achieving aggressive cost reduction targets every year for over 30 years. How is this possible? What are the differences between direct and indirect sourcing?
Let’s consider a simple thought experiment. If the annual cost reduction is 5 percent, what would be the direct spend be in 30 years? Assuming $100 million of direct spend back in 1985, it would be $100 million x 0.95^30 = $21 million in 2015!
Have you ever seen companies that have reduced their Cost of Goods Sold by 80 percent over the last 30 years?
I don’t think this is what is happening in the real world. And the key to understand that mystery is technological innovation.
Photo credit: Innovation by thinkpublic via Flickr
In the direct sourcing world, different kinds of innovations usually take place within several years. Companies have to invest in these innovations so that they can maintain competitiveness in the market lest they lose their market share.
Because of these investments, costs tentatively increase. The direct sourcing divisions then start cost reduction activities again. Due to this investment and cost reduction cycle, direct sourcing divisions can – and have to – continuously generate savings and help improving their product or service added values.
If you look at the automotive sector, you can imagine what has changed over the last 50 years. Air-bags, computer controls of power steering and engines, all the integrated sensors including keys, hybrid system, electricity driven and autonomous cars, you name it.
Indirect sourcing 3.0: Bringing innovation to your company
Why are investment cycles longer than cost reduction degression cycles in case of indirect sourcing? Do innovations happen more slowly in indirect spend categories?
I believe the primary reason is psychological hesitation at management level to make investment decisions in these categories. This hesitation is rooted in the fact that measuring return on investment on indirect spend categories is often difficult and vague.
Many of you have probably experienced personally that the return on investment on advertisement can cause everlasting arguments, especially in B2B settings. Another example is the impact of new IT systems on revenue, which is almost impossible to define quantitatively.
The impact of indirect spend categories on the profit and loss statement is literally indirect or difficult to measure.
On the other hand, in the direct sourcing world, managers are dealing with what is being sold. Investment failures directly influence revenue or profit which often happens to be the strongest performance indicators for management incentive systems.
As a result, investing in new technologies in the indirect spend categories tends to be less prioritized.
But, even if investment decision are more difficult to make in indirect sourcing, management should spend more time getting it right rather than putting them off as lower priority.
Keep in mind that “the impact is indirect” doesn’t necessarily mean that “the impact is small.”
Also, industry leaders or high performers tend to be positive about investing in employees’ working environment to recruit excellent people, creating a virtuous cycle. Low performers are in many cases suffering from less motivated employees.
And what is more, the issue is even more important for the majority of foreign companies in Japan. Their primary scope of investment tends to be on indirect spend categories as many of them have their production capabilities not in but outside of Japan.
Then what should foreign firms in Japan do?
To me, the best way is to exploit the market investigation capabilities of the indirect sourcing division to make management decisions easier.
There are three things I recommend to consider:
First, management has to redefine the mission of indirect sourcing. It should include not only cost reduction but also value creation by bringing new technologies into your company.
Second, set up new key performance indicators. For instance, they should include employee productivity, working environment improvement or something that suits internal stakeholder requirements.
Lastly, develop buyer capabilities to monitor trends of new technologies and to understand the concept of “product lifecycle,” so that it is possible to figure out the best timing to invest and later to put them in competition again to reduce price.
I personally define this advanced stage of indirect sourcing as “Indirect Sourcing 3.0.”
Let me conclude this article by briefly summarizing the indirect sourcing models from 1.0 to 3.0.
Indirect Sourcing 1.0
Procurement is carried out by non-professional buyers like marketers, sales personnel, administrators and others. There are a lot of cost reduction opportunities untouched. This is the most primitive shape of organizational setup.
Indirect Sourcing 2.0
The primary mission is focused on cost reduction. The sourcing function is separated from requirement-defining functions such as marketing, sales, IT, or administration. Cost reduction achievements are significant right after establishment, but start to decrease after three to five years.
Indirect Sourcing 3.0
The mission does not only focus on cost reduction but includes value creation for internal stakeholders. The sourcing function possesses the ability to monitor trends of new technologies or innovations to help management making informed decisions and goes back and forth between bringing innovations into your company and putting them into competition to reduce costs.
Is your indirect sourcing division already 3.0?