Vendor Selection Strategies

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We now get into our next section of vendor selection criteria. So, actually selecting a vendor can be daunting but

rewarding if done properly. Organizations depend on vendors not only to fulfill the requirements of their customers,

but also to drive their own profitability. Choosing the right vendor protects the organization from any future risks and

helps them running the business efficiently.

What are the major parts that have to really done in case of doing a vendor selection? There are certain points that

really need to be evaluated. These points include aspects related to analysis of the vendor in terms of:

• Finance

• Insurance

• Production capacities

• Quality

• Health and safety

• Environmental management

• Existing contracts

• Organization structures

• Subcontracting possibilities

• Procurement capability of our role

• The supply chain management with that particular vendor

One of the most important things in that comes first of all is the financial risk assessment. This being the most

important can also provide a peek into the health of a vendor as well as assure the organization of the vendor's

longevity and capability to fulfill business requirements.

So, how do we do a financial assessment of a vendor? In the financial risk assessment, the financial health of the

organization is assessed through the balance sheet and the P&L statements, which is the profit and loss statements.

Transcription

Vendor Selection Strategies


Three parameters are calculated for this.

Financial risk is evaluated based on the bankruptcy test, which is also called as the Altman Z-score. This test predicts

the probability of insolvency for an organization.

How do we calculate the Altman Z-score?

Altman Z-Score formula = (1.2 x A) + (1.4 x B) + (3.3 x C) + (0.6 x D) + (0.999 x E)

The bankruptcy test is one of the most critical tests to analyze a financial health of the vendor. And this can be assessed

by understanding

• The working capital, which is abbreviated as, A, in the coming formula.

• The retained earnings or total assets, defined by B.

• Then earnings before interest in tax, the total assets defined by C.

• The market value of equity, the total liabilities as D.

• The sales, the total assets by E.

Now what is the formula derived? The formula says Altman Z-score is equal to

(1.2 x A) + (1.4 x B) + (3.3 x C) + (0.6 x D) + (0.999 x E)


Now there have been proven facts across that this particular formula ratio calculations actually plays a role in

understanding what is the bankruptcy. The following three zones are defined based on the value of the Z-score.

When the Z is more than 2.99, it's called as the safe zone. Here, there's a negligible probability of filing for bankruptcy.

When the score, the Z-score is falling between 1.81 and 2.99, then this is a gray zone. There is a moderate probability

of filing for bankruptcy out here. However, if the z-score is less than 1.81, then this is a distress zone. Very high

probability of reaching a stage of bankruptcy and business with such type of vendors is a risk. Because the production

continuity of an organization can greatly get impacted by their going into a bankruptcy, whereas we as buyers have

planned our productions based on them.

The second aspect is short term liquidity. This is the interest coverage ratio defined by ICR. For an organization, the

payment of interest on its outstanding debt is a crucial factor in its financial performance. The interest coverage ratio

is a debt and profitability ratio that assesses how easily a company can service their interest. So, what we do is that

the interest coverage ratio is defined as the ratio of earnings before interest in taxes, which is EBIT divided by interest

expenses. So, the interest coverage ratio must be at least two for a company with a solid consistent revenue, although

a preference for a number of three. So, that's the point number two.

Third, long-term solvency. This is a net debt divided by equity ratio. This ratio indicates a companies soundness in

terms of long-term financial policies. So, a good debt to equity ratio must be from 1 to 1.5. For the manufacturing

industry, the target debt to equity ratio must be two.


Now assessing the financial risk of the vendor exempts the organization from the risk caused by the vendors

organization, bad financial health.

Let's look at the factors that influence vendor selection decisions.

1. The first factor is vendor's technical ability. High precision products require vendors with a high level of

technical expertise. For example, the level of expertise expected from a chip producer of a smart phone may

not be the same as the technical expertise required for printing a label for a beverage. Understanding the

products and investing in R&D to keep up with the times is essential for vendors dealing in high-tech

specification domain. So, this is all over and above the financial analysis where we have screened the first level.

2. Similarly, the second factor is manufacturing capability. Does the vendor have equivalent capacity that is

required for us more than that, in terms of required machinery, manpower to deliver the desired goods? A

vendor may be excellent in delivering labels for your favourite soft drink, but asking the same vendor to

produce pouches for chips is really not applicable because the vendor manufacturing lines are going to be

different and it's not asking the same. We cannot do that. Similarly, different processing capabilities exist for

different vendors and this may not yield the best results.

3. The third factor that influences the vendor selection decision is reliability. Having reliable output with a low

rejection percentage is desired. Most organizations have a quality certification program with vendors that

monitors their processes and certifies them for the desired quality standard.


4. Now we come to the fourth factor. This is after sales service. Very, very important. You can form long-term

associations with vendors only when they are not limiting themselves to just delivering the ordered product

or services. They need to extend their services beyond that.

5. The fifth factor is supplier location. As discussed earlier in the boutique example, remember in module one,

which we talked about the Gujarat boutique, the tailoring needs and all. So, in that particular example,

optimizing logistics costs and finding the right capability determines the vendor base. As we discussed, for a

label supplier having a facility near the beverage production plant is desirable. However, this is not essential

for a simple reason that labels are lightweight in nature, and it's more important to have a capability of actually

being able to meet the artwork needs of printing rather than just the location. Now here, labels being

lightweight, it can also be transported by couriers, and hence, it is an important factor but not so important to

have the vendor next to your door.

6. The sixth factor is JIT, which is just in time capability, which means that the vendor should be able to deliver

to you just in time so that you do not have any excess inventory or under inventory. For any assembly

operation, for example, automobile OEMs, a vendor that has a JIT capability provides trust for long term

relationships. As JIT reduces inventory carrying costs for the OEMs, it is preferred trait in the vendor selection.

For example, most beverage makers have a usage for carbon dioxide, which also has a storage constraint. Carbon

dioxide is actually stored in tanks. Hence, it becomes very important that the material arrives, the carbon dioxide

arrives in a tanker which will only be unloaded once the carbon dioxide in the existing tanks actually finishes. In such

a situation, it becomes very important to connect finishing of carbon dioxide of the first time with the start of the

carbon dioxide of the next tank, which has just arrived. That is one of the straight examples for JIT. In a situation, when

we want to take a delivery of carbon dioxide, just imagine what will happen.

See for example, your capacity of your tank within the premises in 9 tons. Also, the arriving tank is of 9 tons. But just

imagine if you have actually finished four tons of carbon dioxide, you're still left with five tons of carbon dioxide within

it. It is not possible to actually unload four tons of carbon dioxide. Then what will happen? The tanker will still stand

because the balance five tons of carbon dioxide, which has come in the arriving truck is still un-utilized. That's one of

the good examples of JIT.


7. Now we come to this next factor, which is the seventh factor, which is price. Finally, it all boils down to the

cost. Price is one of the most important factors in vendor selection, but please remember it is not the only

factor. Most organizations make this mistake.

There are certain methods to selecting vendors. Some of them are competitive bidding, price negotiations, reverse

auctions, etc. So, a balance between long-term strategic vendors and short-term contracts is required depending on

the items in questions and their criticality of nature. For standard non-exclusive items, short term regular buying

contracts may be executed. For high precision exclusive components, finding a strategic long-term partner always

help. There is also certain product which actually lie in between, in which case we have to look at the criticality versus

cost component of the product into the whole thing to understand which portion of the metrics they would lie for.

Now we have understood what sourcing is, what the vendor selection process is. So now let us come into

measurement. We talk about the metrics to measure sourcing performance and purchase performance. It is said that

without data you're just another person with an opinion. The objective of sourcing can now hence be discussed.

The movement of material in the right quantity at the right time to the right location, with the right equipment, using

the shortest lead time and lowest possible costs for both supplier and customer is the target.

In order to achieve the objective of a sourcing process, it is important to identify key measures of performance, also

known as KPI or the key performance indicators. The selection of appropriate KPIs based on the type of sourcing and


desirable outcome ensures that the target sets in these KPIs are achieved, which improves the performance of the

business.

So, the essential elements of defining KPIs should be that they have to be SMART.

• S for specific

• M for measurable

• A for actionable

• R for relevant

• T for time-bound

In general, tracking and maintaining the following KPIs will ensure sourcing performance.

1. The first KPI is loss of production due to shortage of parts. This should not happen. Basically, we do not want

any loss of production due to shortage of parts. This indicator measures the supplier's performance in terms

of delivering parts or products or direct materials as per the given schedule and within the agreed lead time.

Any shortage of the parts will result in the loss of production which can be measured in the number of hours

lost or quantity lost. And it's just supply will also hamper the performance as it will increase the inventory

levels and something else will have to be cut shot.

2. The second KPI is adherence to the procurement pipeline. This KPI tracks the sourcing performance in terms

of the lead time from the business request generation to the purchase order generation. The supplies

adherence to the procurement timeline ensures the faster launch in the market as well as to avoid cost

overruns due to the delays.

The organization can also be flexible in changing the market conditions and perform activities faster than its

competitors. The OTIF, that's the real measurement in a majority of the organization you are going to find this. What

does OTIF mean? OTIF means, on time in full. The performance has to be in alignment, so MRP, so as to ensure that

the planning cycles are adhered to. It is desired that the product arrives on time and at the same time in full quantity

as ordered for the specific date of delivery. Shortfall off either side is a red flag.

3. So, the third KPI is logistics costs per vehicle. You plan on the transport and logistics and optimize it, they can

also plan to use different systems. For example, flexible load configuration in place of bulk load, which means


instead of creating one bulk load of one particular item, they can also plan to have, either smaller loads or they

could have multiple type of materials getting into the same truck. Let me give you an example.

For example, say a beverage manufacturer is producing a Cola and an orange and a lemon and a water-based drink.

Now the caps for each of this drink is coming from the same supplier. It is not essential that only the Cola caps come

in one load and the orange caps come in the other load. Basically, they can also club all the type of caps within the one

load that is coming in the transportation to reduce the logistical costs?

4. We now move to the next scope KPI, which is the premium freight cost incurred due to shortage of parts.

What does that mean? It often happens that suddenly you realize that the vendor has not delivered in time or

suddenly a market demand has come up in a manner where you need immediate supply of goods. That is the

premium for which you at that point of time, you're going to pay. Which means if you have to move from a

road shipment to an air shipment, there is going to be an extra cost. This extra cost is going to be called as the

premium rate that are going to be paid across.

So, you need to measure this parameter, unexpected disruptions in the supply of critical parts. As a result, the

organization will need to bring the part to an alternative faster mode, for example, between road to air. This will result

in extra logistical cost and reduce profitability. However, it's important to understand that at that particular point of

time, you will not just take the air cost, you will actually take the Delta air minus road costs.

All these KPIs help in maintaining minimum inventory levels so that for the identified critical parts in the process, that

is an important aspect. The measurement of these KPIs ensures that the process performance is visible to the

stakeholders and timely actions can be initiated to improve the performance including vendor management.

5. The fifth KPI is adherence to specifications. This is quite important, which is measured in rejection

percentages. This is basically talking about the quality adherence to the whole thing. Suppliers must ensure

defect free parts are supplied to the manufacturer or your vendor.

How do we ensure that we limit these types of rejections? Most of the organizations have a certificate of analysisbased

performance measurement. Normally in the organization, the certificate of analysis is coming along with the shipment.

And later on, looking at the certificate of analysis which is giving the test specifications and the range and the actual

results, this is coming to the quality department for measurement.


Now what I would suggest is that over and above that, it is also important that once the shipment is actually leaving

from that particular supplier, before leaving only if this certificate of analysis is actually sent across to the buyer

company, and the quality department in case of any type of defects seen within the COA, they can be flagged there

itself and the shipment need not actually move. This can actually be a win-win situation for both buyer and the

supplier.

6. The sixth KPI is cost. Sourcing professionals need to implement cost-savings suggestions in the parts and the

process. Both the parts and the process. The technical changes in the parts and/or in the process will reduce

the part costs and improve profitability. The cost can also be saved by agreeing on the suppliers to benchmark

costs defined by the organization. However, it has to be ensured that this should not lead to any type of dilution

in specification. At the same time, you should not ask for a gold when your specifications of silver are good

enough to meet. The procurement of extra services from the suppliers at no extra cost can also be a part of

cost avoidance.

Another example for this is, for example, if generally the market has a warranty of one year. However, if you're able

to negotiate a warranty of two years or three years, basically you're able to save that maintenance cost probability

from the organization and the spare parts that you will need to order for.

The six KPIs that you have learned till now also impact the decision regarding whether to make the product in house

or outsource. A very important decision for the organization. For example, a beverage maker may choose to produce

the preforms or labels in-house or cartoons in-house. However, it can even choose to grow and refine sugar in house.

So, one has to actually understand what are its capabilities and the organization must ask itself what is the area and

efficiencies that it can bring into it.

• The first question will be, will the third party increase the supply chain surplus related to the performing, the

activity in house? Now what is the supply chain surplus? It is a monetary value that is getting created.

• Second, what percentage of the increase in surplus does the organization get to keep?

• Third, to what extent do risk grow on outsourcing? Whether in terms of quality, whether in terms of customer

reliability, whether in terms of logistical aspects, whether in terms of continuity.


So, the economies of scale, regulations and core competencies drive such type of decisions. Since, the preform

maker in a beverage industry can use a similar capacity to service multiple clients with minor tweaking, it may be the

best to leverage economies of scale by the preform maker rather than doing it yourself.

However, if you have specialized products which are actually niche products, which you do not want to come into the

market, either you have an NDA signed with the outsource vendor or you actually ensure that you make it yourself.

So, these challenges that organizations face today in sourcing strategies are completely different from the challenges

they face a decade ago. So, the sourcing function is not only immune to the changes occurring in the world.

As we have entered into the decade of disruption, these challenges will test organizations across the world and only

those organizations that are able to predict and prepare for these challenges will manage to survive. What are the

challenges?

1. Challenge number one, fluctuation and global demand for products. Now this fluctuation and global demand

can actually create a demand supply situation which will affect the prices. The second part is the customer

demand has been the biggest variation in the current time because of the variety of innovations in the market.

These fluctuations in the demand for the products can throw the supply chain of its position, if adequate

flexibility is not built into the system. Adopting the lean supply chain can also prepare organizations to take on

such challenges.


2. Challenge number two, cost reduction and efficiency improvement. Now increase in the cost of raw materials

commodities, energy and labour, and the reduction in the profits generated from the sale of the product have

pressurized the entire value chain to reduce the cost in the existing process, and prevent the cost from

increasing further. Now for this, various methods such as value engineering, consolidations, standardization,

and cost avoidance can provide sufficient ammunition to overcoming the cost problem.

3. Now we come to challenge number three, customer service and quality preferences. Each day with a lot of

innovation, things are changing. The customers are becoming more conscious of the quality and the product

at the same time. They don't want to pay more for a product with a superior performance. In organization,

supply chain needs to deliver a consistent quality of parts and invest in new technologies to satisfy customer

preferences.

4. The concerns about the sustainability and the implementation of various environmental regulations and

restrictions have rendered many parts of the logistics process such as non-biodegradable packaging materials,

polluting transportation methods for goods etc., making them absolutely unusable. Now the organizations

need to innovate and implement initiatives such as returnable packaging to ensure it conforms to the green

supply chain requirement or reusable packaging or recyclable packaging.

5. Challenge number five, transformation of supplier relationship. The supplier and the buyer are no longer just

a shopkeeper and a customer. They have to continuously participate in business activities in order to navigate

current business challenges. Only by having a mutually sound and harmonious relationship, they can deliver

efficiently. Also, they have to actually do engineering together to understand what are the trends in the market

and what are the requirements. It is hence imperative for organizations to upgrade their suppliers so they can

minimize the risks that might originate from changing market conditions.


Let's try and understand what are some of the challenges in sourcing. So, there might be challenges which are under

your control and there might be challenges which are external and not in a company's control. So, let's take an example

of an external challenge. India has been declared as single plastic use ban by 2022 which means that after 2022,

companies will not be allowed to use plastic which cannot be recycled. Now at this moment, India has about 30,000

plastic processing units with about 4 million people employed and with a turnover of about 2.25 crores.

The graphic here shows that what are the breakup of industries which are using these plastics and how the industries

are going to be impacted. Now what it means is that come 2022, all these industries will have to look at an alternate

material as compared to plastic. So, for example, for a company who is selling chips and sending products in the plastic

pack, it will no longer be able to use that product. It will have to use a product which is a substitute of plastic. It

probably cannot use paper because you know, paper will get soggy, etc. So, it will have to come up with some new

solutions. And all of this then ties back to your sourcing. How do you change your sourcing strategy so that the cost

doesn't go up and you're able to meet the same quality requirements as well as adhering to the government

regulations which have come in. So, these kinds of challenges which are external in nature, not in your control, keep

on coming in sourcing and the function needs to solve for these challenges.


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Vendor Selection Strategies