Over the last months, I have shared with you a number of concepts HP has implemented in its Supply Chains to reduce costs, improve responsiveness and mitigate risks. In this blog, I'd like to share another one, called buy/sell, that focuses mainly on outsourced Supply Chains, and that HP is not only using for its own purpose, but also offers as a business process outsourcing to selected customers.
Buy/sell, also sometimes referred to as price masking, was initiated in the late 90's as a result of the trend to outsource manufacturing. Indeed, the company used to benefit from interesting price conditions resulting from the aggregation of its buying needs. Unfortunately, when HP started to outsource its manufacturing it could no longer take advantage of such prices as suppliers were reluctant in offering similar conditions to the contract manufacturers. Indeed, if the contract manufacturer would have special price conditions for components to include in HP products, it would try to negotiate similar conditions for other purchases, reducing the margins of the supplier. Obviously, this was something the supplier did not want; resulting in HP paying higher prices for commodities/materials going into the products whose manufacturing was outsourced. As HP had decided to increase manufacturing outsourcing, it required another approach to purchasing its key commodities to maintain its competitive advantage. The approach taken is called Buy/Sell and allows HP to save several percentage points on the purchasing of those key commodities.
In practice, how does it work?
In a nutshell, HP will order the commodities at the best price from the supplier and sell them immediately to the manufacturer at the marketprice. These would then be included in the final product, which is sold back to HP at an agreed upon price. As a result, the contract manufacturer has not view on the original price HP paid for the commodity.
In practice, there are a number of activities that gravitate around this. They cover three areas, Sourcing, transactional buy/sell and financial transactions. Let's look at each of these in a little more details.
From a sourcing perspective, the first step is to understand the spending for a particular commodity. One or multiple suppliers are identified and pricing is negotiated. In this process the use of price masking towards outsourcers is clearly stipulated, ensuring a price agreement, beneficial for both parties, can be reached. When the contract manufacturer is approached, it is clearly stated that he will order the parts from HP.
From a transactional perspective, HP shares its forecasts with its contract manufacturers (CM) and agrees with them the quantities they will manufacture by time period. Resulting from this the manufacturer can deduce the amount of components required and places an order with HP, order that is forwarded to the supplier, with request to ship directly to the CM. In some situations, HP manages the logistics also.
The invoice will be sent by the supplier to HP, while HP will send a second invoice, at market price, to the CM and follows up the payments.
These functions are performed by a shared service that manages those business processes on behalf of the business units.
The buy/sell process has additional benefits. These include the management of parts allocations in times of shortage, as HP requests the supplier to perform the drop shipments, and the masking of price volatility. Indeed, for commodities with high price volatility, HP can take advantage of the best price, while maintaining a stable price to the CM. Combining this approach with other procurement approaches developed by HP, such as Procurement Risk Management, HP can take full advantage of its relation with the supplier.
Using inflated market prices limits the diversion of HP commodities to other channels, while it ensures the adherence to contractual engagements by CM's.
The approach described in this entry has been used for a number of years for a wide range of commodities and materials, resulting in important savings to the company. The use of the buy/sell process has increased by a factor 10 since 2002, and the University of St. Gallen in July 2003 commented that, "HP 3rd party Buy Sell process is almost unique in the industry and represents a huge competitive advantage, enabling vital controls in an outsourced manufacturing environment, controls such as price masking, better assurance of supply, central allocation management, bundled buying power, supplier share management, price volatility mgmt, contractual compliance, etc."
It's been a while since I last spoke about the HP Supply Chain and what we put in place to manage uncertainty and variance in the current economic conditions. Most of the best practices I have been discussing have actually been in place for a number of years now, but have proven very useful in the current volatility. Today I would like to talk about an inventory practice involving supplier relationships with the objective to increase supply chain transparency via a standard and scalable collaboration solution. We call this approach Dynamic Replenishment.
Dynamic Replenishment (DR) is an evolution of standard SMI (Supplier Managed Inventory) and got developed around the year 2000. HP's was having inventory issues with one of its key integrated circuit suppliers in its printing supply division. To address those issues, HP recognized the need to open up the supply chain between themselves and their supplier and to share the inventory responsibility between the two partners. Indeed, up till then the forecast had to be frozen three months in advanced and used to negotiate the demand with the supplier. Misses in forecast were extremely costly as they were leaving HP with excess inventory or the supplier scrambling to catch up with an underestimated demand. A collaborative approach appeared to be the only way the partners could address the needs.
Fundamentally, DR is an e-procurement mechanism using internet applications, services and technologies to automate and streamline purchasing processes and enable new procurement processes and business models. The inventory is managed by the supplier (which is a biggest change) all the way from the manufacturing facilities to the supplier's stocking locations (inventory consignment).
The approach balances the responsibility between the customer and the supplier by putting in place service level agreements and a feedback loop. The service level metric represents the availability of material against planned consumption. If HP's planned-to-actual variability (within the lead time) is higher than expected, the service level shows that the supplier managed the inventory well, while HP's planning was poor. Controversially, if the consumption level matches the plan, but the inventory isn't there, then the service level of the supplier needs to be improved. This creates a true partnership where both parties attempt to manage to a service level.
In practice, HP uses signals from its distributors to establish a realistic consumption plan. This plan is then sent via the internet to the back-end systems from the supplier which responds with the capacity information. It is only if capacity cannot match plan that manual intervention is required. The supplier is then shipping materials based on the manufacturing sites' daily consumption plans. "Advanced shipment notifications" and "goods receipt notifications" are used to close the loop.
This approach replaces discrete order management with blanket purchase orders, avoiding a costly management, provides both parties with full visibility of inventory updated automatically, and it shares the daily updated HP demand automatically. The whole process is automated and alerts are generated only for exceptions.
This approach has allowed us to increase the availability of components drastically while keeping the safety stocks low. At the same time, the management of the interactions with the supplier have been reduced and focused on exceptions, increasing its efficiency. By giving the supplier full visibility of the demand, much tighter relationships have been built, making HP an important client of the supplier.
To continue on my series describing the HP Supply Chain, I'd like to introduce a concept called "Inventory Driven Costs", described for the first time in an Harvard Business Review article with the same name. This concept allowed us to completely change our Supply Chain approach in our PC business, ultimately resulting in increasing our margins drastically while growing our market share.
The development of IDC, as it is being called internally, came from a simple question: "when looking at inventory costs in a traditional way (capital + physical costs), do we obtain a correct view of the true cost of carrying this inventory?". And the question is intriguing. PC's are products with a short shelf life, so when looking deeper into this question, the team came to an astonishing discovery. There were a number of other costs they needed to take into account if they wanted to reflect correctly the holding costs of the inventory.
- Material Devaluation, in the electronics industry, prices mostly go in the same direction, they are going down. Carrying inventory holds with it a risk, and that is that the value paid for the components, or the expected value from the end products can no longer be recovered. As the potential losses here are directly related to holding inventory, the costs associated should be included in the inventory costs.
- Discounts, obviously there is a way to address the first risk, and this is by selling excess inventory in a fire sale. But this often implies deep discounts. In the electronics industry one often sells the remainder stock just before introducing the next product. Here again the magnitude of the cost is directly related to the amount of inventory available.
- Price Protection, which is mainly related to working with a distribution channel. As the distributor acquires the stock with a specific sales price in mind, electronics companies will compensate price drops they initiate in the channel. These costs are directly related to the inventory in the channel. Another element of price protection is related to the cost of hedging currencies as they also have an impact on the valuation of the inventory.
- Returns, it is traditional for the channel to send back unsold products in case of overstocks. There are costs related to taking the product back, refurbishing it etc.
By tracking these costs HP has gained a much better understanding of the true cost of carrying inventory in its supply chain. This has resulted in reviewing some of our networks and to make substantial changes resulting in millions US$ cost reductions. It has also highlighted the true cost of inventory, allowing us to take decisions regarding the safety buffers and rush mechanisms to be used to coop with varying demand.
Commenting to my last post, Mutka asked the question on how HP handles predictability and reliability in its supply chain. I realized that to provide him with a thorough response, I should explain the HP Supply Chain in more details. I have taken the decision to do this in a number of posts, whose title will start with HP Supply Chain. So, look out for those.
Last year, the HP Supply Chain took care of more than 45 million PC's, 30 million printers and 2.5 million servers. This makes it one of the largest electronics supply chains in the world. Knowing that most of the production is outsourced, you can imagine the size of the task. To facilitate the process, HP implemented a couple simple concepts which I would like to highlight here:
The first concept, a Supply Chain Pipe is a specific set of standardized business processes, IT systems, physical and financial flows. Looking at it in a modular approach enables a flexible composition of various elements to meet a wide range of customer needs and the goals of our business.
The second concept, which is well known in the industry, is Postponement. This concept invented by HP in the 90's, consists in keeping a product as generic as possible as late as possible in the supply chain, and only perform the differentiation when an order or demand is available. If you are interested in more details, see "Case Studies of Postponement in the Supply Chain" by Susan M. Rietze.
The components of a Supply Chain Pipe typically include a factory, shipment (most often by boat), a postponement center, a distribution center, logistics (typically truck) and channel partners. Factories are typically off-shore. The positioning of the postponement and distribution centers change to provide the best customer service at the lowest cost. Our volume products typically use one of the following three pipes:
- The Value Added Pipe, where both the postponement and distribution center are in the region, is used when the quantities of products are relatively small and the demand rather unpredictable. Often this occurs at the introduction of the product and during the end-of-life period.
- The Low Touch Pipe, where the postponement is performed off-shore, is used when the demand predictability increases and when products are ordered per pallet for example.
- The No Touch Pipe, where the product is directly shipped to the channel, is used for products that can be shipped in large quantities (e.g. Containers). Both postponement and distribution is performed off-shore.
During the lifecycle of the product, the pipe used may change as demand changes. At regular intervals, the situation is reviewed and a decision is taken which of the pipes will be used for the next period.
In doing so, and in combining this with the management of our channel's inventory levels (which I will discuss further in one of my next posts), we are managing to keep a good handle on inventory and service levels. At the same time this allows us to react rather quickly to opportunities or downturns. It is not the only element that plays, but it definitely helps scaling up and down effectively.