Supply management: the next competitive advantage for utilities

Stephen Budd and Frank Heard co-direct Theodore Barry &

Associates’supply management

practice. TB&A is a general management consulting firm

specializing in energy and telecommunications.

Supply Management: The Next Competitive Advantage for Utilities

Almost three-quarters of the cost of operating a typical utility is attributable to supply management activities-planning, acquisition, handling, disposition, and payment for materials, services, and fkel. Reducing their costs can substantially improve one2 competitive position.

Stephen Budd and Frank Heard

I. Effects of Deregulation

While the new rules spawned

by deregulation are not yet fully

defined, what is known is causing

concern within utilities. Conduct-

ing “business as usual” will prob-

ably result in a business that

“used to be.”

The new business environment

will dramatically affect the way

utility companies are managed

and evaluated. No longer will profitability be governed-indeed

protected-through rates of re-

turn negotiated with a state regu-

latory commission. Instead, the

marketplace will decide which

companies survive and thrive, and which do not. Three perform-

ance indicators will be paramount:

l Price. Energy is a commodity

As such, the principal driver of

market penetration in the new era

of wholesale and retail wheeling

will be price. Therefore, the deter-

minant of success will be the abil-

ity to provide products and services to the marketplace at the

lowest possible price. l Service quality. Beyond price,

the most meaningful differentia-

tion among energy delivery com-

August/September 1996 39

panies is in the perceived quality

of services provided. Customer

service and reliability will be the

key means by which a provider

differentiates itself, positively or

negatively, from the competition.

l Earnings growth. With the ap-

plication of incentive regulation,

earnings will be governed by a

company’s ability to compete suc-

cessfully in the market. This will

place extreme pressure on utilities

to enhance revenues-which is

difficult in a mature market-

and/or to reduce costs through productivity gains and process

changes.

II. The Case for Supply Management

The pressure to increase earn-

ings is forcing utilities to reduce

costs and, to the extent possible,

differentiate products and serv-

ices. Since tangible points of differ-

entiation in electric power deliv-

ery have been slow to emerge

(service excellence being the most

prominent), cost reduction is the

major driver in the industry for the time being. Improving the per-

formance of supply management provides perhaps the best opportunity for substantial and sustain-

able reduction in the cost of opera-

tiOIlS.

The primary area in which utili-

ties (and companies in many other industries) have attempted

to reduce costs is labor. The result has been substantial downsizing in recent years. While a focus on reducing labor costs may provide

some financial benefits, as a cost reduction strategy it is becoming

less viable. In fact, the downsizing

of supply functions may actually

increase the total cost of opera-

tions through diminished supply

management effectiveness. In

some instances, an increase in the

cost of labor associated with man-

aging supply may be required to

improve the overall performance

of all supply-related activities. In

essence, focusing on reducing per-

sonnel costs may undermine the

utility’s ability to attract and re-

tain the appropriate talent and

skill sets to manage the supply function effectively.

Contrary to conventional wis-

dom, in most utilities the cost of operations is driven less by pay-

roll than by purchased materials

and services. Supply management accounts for approximately

75 percent of total costs in a typical utility (45 percent for materials

and services, 30 percent for fuel and purchased power, and the re- maining 25 percent for payroll

and taxes). Supply management (including

materials management, purchas-

ing, contract administration, and

accounts payable) cuts across

most departments within a utility

such as generation, transmission, and distribution. Traditionally, the

lines of communication between

these organization units has been limited. By streamlining the sup-

ply management process, a utility can dramatically improve the us-

age, availability, and reliability of

necessary materials and services,

thereby improving the perform-

ance of the operations departments.

P urchasing departments are

often perceived as merely a control function, while operating

departments are viewed as per-

forming the “real work.” It is not

surprising that purchasing departments are viewed as reactive or-

ganizations that do not add sig-

nificant value, given that they are

rarely involved in the business

unit planning cycle, are rarely pro-

vided sufficient information or

time to conduct research or negotiations, and are rarely rewarded

appropriately for saving the com-

pany money. Moreover, many utilities keep incomplete records

about items purchased, the total cost of purchases, and supplier

performance. Consequently,

many companies pay too much for purchased materials and serv-

ices, store substantially larger

quantities than necessary, and are able to exercise only limited over- sight of service contractors.

For example, it has been re- ported that nuclear plant owners

may be paying many times too much for such parts as bearings, controls, fasteners, and electronic

equipment.’ The author of that ar-

40 The Electricity Journal

title priced a single two-watt resis-

tor at $112 through original equip-

ment manufacturer (OEM) for nu-

clear grade parts; $24 through a

third-party vendor; $19 through

another source; and $2.50 under standard military specifications.

Opportunities for savings

through improved supply man-

agement are numerous. In only

four years Detroit Edison has

documented over $200 million in

savings, achieved primarily by im-

plementing an improved supply

management program focused on

better purchasing, planning, supplier relations, and training. Duke

Power has saved between 15 per-

cent and 30 percent on its pur-

chased materials and services.

Meanwhile, another article re-

ports that 196 projects using simi-

lar initiatives saved an average of 15 percent of total installed costs.’

ln fact, Belcan Engineering Group

of Cincinnati saved more than $140 million over six years by es-

tablishing strategic partnering relationships. Several other major utilities also have begun to imple-

ment supply management initia-

tives, which they expect to gain up to 30 percent in sustainable an-

nual supply savings.

III. Areas of Maximum Return

Conceptually, effective supply

management is not difficult to

comprehend. By simply improv-

ing the way it acquires and man-

ages its purchases, a company can substantially improve its profit

potential and competitive position. Nevertheless, implementing

best practices in supply management is a challenging task and re-

quires that supply management

activities be fully integrated into

the core operations planning cy-

cle. This can be facilitated by ele- vating supply management

within the organization, prefer-

ably to the vice president level, to

ensure adequate corporate atten- tion and scrutiny

Improved supply management

processes do not necessarily re-

quire new or complex informa-

tion systems but, rather, sound in-

itial planning and the integration of supply management with op-

erations. Ultimately, it is the effec-

tiveness of the philosophies and the application of the tools of sup-

ply management that makes the

difference in reducing supply

costs. We have found that the highest

returns in supply management

are attributable to:

l Improved sourcing strategies; l Better supplier relationships;

and

l Enhanced performance accountability

IV Sourcing Strategies

Strategic sourcing refers to the

acquisition and management of

services in a well-planned and integrated manner. This includes

identifying and defining the busi-

ness requirements, collecting and analyzing business intelligence on

suppliers and markets, formulat-

ing an overall buying strategy

and executing a strategy The goal

in applying a sourcing strategy is

to find the optimal method to

achieve the lowest total cost and

the appropriate service level for availability delivery, and reliabil-

ity Total cost includes:

0 Initial purchase price;

l Cost of storage, handling, de-

livery, and disposal;

l Cost of reliability; and

l Cost of managing or adminis-

tering the contract.

Ultimately, the intent is to trans- form purchasing from a reaction-

ary function into a proactive, highly valued activity that is

closely aligned with the com-

pany’s core business processes. To develop an effective strategy

for sourcing a class of materials or

services, sourcing personnel must understand and assess both the

external market and internal com-

pany needs. Assessing the exter-

nal market requires identifying

the primary cost drivers of the ma- terial or service itself, and analyz-

ing the competitive position and

relative strengths and weaknesses

of the major suppliers within that market. Understanding internal

needs requires investigation of the purchase’s characteristics and end

use. Additionally, sourcing per-


sonnel must pursue leverage that can be applied to improve the

terms of the final contract.

Leverage can be strengthened

by either increasing the sales vol-

ume to a supplier or decreasing

the supplier’s risk. Increasing the

volume of materials and services

purchased from a supplier can result in volume discounts, and the

supplier can often be encouraged

to grant additional price conces-

sions and/or to increase the value-

added benefits. Purchase volume

leverage is increased by:

0 Using fewer suppliers; l Consolidating buying across

organizations;

l Standardizing specifications

and/or use of materials and serv-

ices; and l Optimizing the mix of materi-

als and services in the commodity

class being sourced.

Decreasing the supplier’s risk

offers additional savings opportu-

nities. Suppliers typically are more willing to enhance benefits

or reduce costs if they anticipate a

longer-term or more stable rela-

tionship. Developing long-term commitments requires informed

and focused negotiations with qualified potential suppliers. Spe-

cific risk-reducing activities in-

clude:

0 Longer-term planning cycles; l Enhanced planning and fore-

casting techniques; and 0 Closer supplier relationships.

Supplier Relationships

Effective sourcing strategies re-

quire close interaction with sup-

pliers. It is now generally ac-

cepted in most industries that

42 The Electricifu lournal

strict adherence to arm’s length

and adversarial supplier relationships will result in less than opti-

mal sourcing. For the most part,

however, utilities still rely on this

type of relationship, frequently as

a result of miscommunication on

purchasing practices between util-

ity companies and their regula-

tors. We have observed, however,

that regulators generally are open

to any type of agreement that can

be shown to both benefit ratepay-

ers and adhere to sound manage-

ment control principles.

There are numerous types of relationships that utilities can pur-

sue with suppliers. A useful

framework for establishing and

evaluating such relationships is to

consider a continuum of potential

supplier relationships-from

arm’s length/competitive, to pre-

ferred, to aligned, to partner rela-

tionships-as shown in Figure 1.

Contributing Factors: 4 LOW

Within this framework, the com-

pany is encouraged to analyze the materials and services being pur-

chased to determine the appropri-

ate type of supplier relationship.

At least four factors should be

considered in this analysis:

l Puoductlseuvice uniqueness

and potential for improvement. If

the product or service is unique

and offers an opportunity to en-

hance a competitive advantage, or

is common but offers significant

potential for improvement, a

close supplier relationship may be

warranted. l Risk of potential product1

service stock-out. Availability-re-

lated risk and the expected cost of

a stock-out may require a close

working relationship with a sup-

plier. Currently the typical utility

response to minimize the risk of a

stock-out is to increase inventory

levels. However, most suppliers

High I),

Product/Service Negligible

Uniqueness and Potential opportunity for

for Improvement improvement

Some degr+ze*f: unique&w .I’

(vendor to vendor)

Risk of Potential Product/ Productlsewlce Various suppliers LImited number Potentla Service Stock-Out plentiful of SupplIers non-avallabillty

Supplier Expertise Required

Negligible assistance required

Some assistance required

Some Highly specialized speclailzed skill sklll required required

4 Competitive Preferred

Figure 1: A Guide to Selecting Relationships

are willing to hold inventory for customers in return for increased

business or longer-term contracts.

0 Strategic importance. The

more important a product or serv-

ice is to the strategic business

needs of the company, the closer

the relationship with the supplier

should be.

the organization. Companies that

have demonstrated best practices

in supply management have

clearly defined performance ac-

countability. They track perfonn-

ante measures monthly, and re-

view and update the measures

annually.

l Level of supplier expertise re-

quired. More complex products

and services generally require a

higher level of expertise, often

available only from selected sup-

pliers. A close working relation-

ship is required to ensure that an

acceptable level of integration and

performance is maintained.

Performance objectives should

be established for both providers

and users of materials and services and should include invest-

ment as well as service level meas-

ures. A useful framework is

depicted in Figure 2.

VI. Implementation Issues

V. Performance Accountability

Implementing a new supply

management strategy is a signifi-

cant challenge for several reasons:

Implementing performance ac- 0 Supply management organi-

countability in the supply man- zations that are primarily func-

agement process often requires a tional and organizational silos

change in managerial approach. often inhibit communication with

Performance accountability re- the operating and maintenance or-

quires the integration of clearly ganizations. Integrating supply

defined performance indicators management into the operating

that are closely tied to the core and maintenance organizations

business processes and that track usually requires substantial corpo-

supply performance throughout 1 rate change-management efforts.

l Commitment l Fill Rate l Dates Met l Commitment

% Dates Met l Lead Time l Performance Dates Met ._ L l Use of P.0.s Variances 8

l Planning l Lead Time Targets

l Cost Savings/ Avoidance

l Purchase Price

l Inventory Balance l Change l Inventory l Handling Charges Orders Investment l Investment l Claims l Value

Recovery Engineering

Figure 2: A Useful Framework for Evaluating Performance Measures.

l Traditional purchasing activi-

ties that have been primarily reac-

tionary and transaction-oriented

must be transformed, and staff

equipped with new skill sets. Sig- nificant training and recruiting of

experienced supply professionals

may well be required.

l During the past few years

most utilities have undertaken

substantial improvement initia-

tives, such as process reengineer-

ing, downsizing, core business

process redesign, total quality im-

provement, and information tech-

nology assessment. Successful

implementation of supply man-

agement initiatives usually re-

quires thorough integration with

these initiatives.

* * *

Many utilities are now realizing

that heightened emphasis on sup-

ply management is vital to im-

proving a company’s competitive position. Improving supply man-

agement approaches is a rela-

tively low-risk strategy that can

be implemented effectively with minimal investment in new tech-

nology Effective leverage in sup-

ply management is gained primar-

ily from sound initial planning

and analysis, and from the inte-

gration of supply management

with operations, rather than from

the application of sophisticated

transaction processing systems. n

Endnotes:

1. Robert L. Beard, ELECTRIC LIGHT &

POWER, Dec. 1994, at 10.

2. Rob McManamy, Cl1 Benchmark Sav- ingS,ENGINEERINGNEWSRECORD, Aug.

15,1994, at 15.


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Supply management: the next competitive advantage for utilities