Is It All About Price, II

PurchTips edition #46


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How To Incorporate The Cost of Poor Performance

In the last resource, I said that well-trained purchasers base supplier choices on not just price, but performance also. I promised that I would teach you how to consider the cost of poor performance in supplier selections.

This approach works best when you have done business with two or more competing suppliers and you wish to consolidate your supply base. Here's a 6-step process...

  1. Define "events" that constitute poor service, poor delivery, and poor quality. For example, a poor quality event may be receiving an incorrect invoice.
  2. For each event, determine its average cost to your organization. For example, an incorrect invoice may require your accounts payable and purchasing staff to dedicate 3 man-hours at a rate of $30 per hour to resolve the problem. Thus, the average cost is $90. Apply the same average event cost to all suppliers.
  3. For each event, determine the percentage rate of occurrence using historical information. For example, if 10 of the last 1,000 invoices that a supplier provided were inaccurate, the percentage rate of occurrence for that supplier is 1%. Express the rate of occurrence in a decimal format (e.g., 0.01). Each supplier will have a different rate.
  4. For each event, determine the number of opportunities for the event to occur. If suppliers will invoice you weekly over a two-year deal, there will be 104 opportunities for an event. The number of opportunities will be the same for each supplier.
  5. To estimate the cost of poor performance for each event, multiply these three things together: the number of opportunities, the rate of occurrence, and the average cost per occurrence. Cost of poor performance per event will differ by supplier.
  6. For each supplier, add the cost of poor performance per event for all events to the corresponding supplier's price. The supplier with the lowest total cost after factoring in the cost of poor performance will generally be the ideal choice, considering price and performance.

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