10 Elements of the Total Cost Model to Purchasing
Last month, I made what some would consider a radical statement: “The only thing that purchasing on low bid price alone guarantees is that you will never operate by lowest total cost.” I told the story of Ryan, a purchasing director from a national firm who had to not only give up his ideals, but also set aside his knowledge of the facts of purchasing in order to keep his job. He forged ahead with the low-bid-only corporate directive, allowing the company’s senior management to continue deceiving themselves, which, in the process, cost millions.
There is nothing radical whatsoever about the above statement. We are continually confronted by examples of myopic, low-bid tactics (they do not warrant the label “strategies”) that result in greater total cost. The impact is occasionally dramatic and obvious, but more often subtle and may not reveal itself without some passage of time.
You see it in everyday life. Years ago, I was struck that I could not find a single pothole or section of bad pavement anywhere during a week driving around Switzerland, a climate every bit as harsh as my home state of Michigan. Swiss topography is even worse, making road-building a terrific challenge. I was sufficiently intrigued and researched the phenomenon when I came home. I learned that there is little difference between U.S. and Swiss paving materials, but there is a huge difference in the engineering and preparation of the sub-base, where the Swiss spend twice as much time and money as we typically do. More than anything else, it is the quality of the sub-base, especially moisture-control, which determines how long the pavement lasts. Don’t U.S. road engineers understand this? Of course they do, but they are handcuffed by local, state, and federal agencies bound by low-bid mentality. The net result is higher total cost due to premature failure leading to continual repair and rebuilding.
Home building examples are legion. One national builder wrote a low-bid contract with a major supplier to direct-ship plumbing fixtures to job sites. The national purchasing staff got a big bonus that year based, in large part, on the money saved through this deal — on paper. Of course, the field was left to cope with persistent delivery problems, theft of material, wasted trips by plumbers, VPOs for emergency orders, and compounding schedule delays. Many of their best plumbers left when purchasing’s edict to keep labor rates the same — even after giving up their fixture margin — eroded their profits. The inexperienced replacements, desperately trying to “buy the business,” further compromised the builder’s schedule. On top of that, salespeople were unhappy with the fixture selection.
All of this blew up when an internal audit identified the high cost for renting storage trailers parked out behind the field construction offices to inventory plumbing fixtures. The only way the field could manage the UPS deliveries of fixtures was to hold them at the site and have the plumbers pick up what was needed for each job. UPS, tired of wandering job sites in search of nonexistent street names and missing lot numbers, was only too happy to oblige. Bottom line? This low-bid deal increased costs significantly in the field, a net-loss for the company. By the time management figured this out, the bonus money was long since spent.
There are innumerable examples:
- A national drywall deal neglected to include stocking of the board in the houses. That had to be purchased independently. The outcome was damage and delays that exceeded the savings on the material.
- A regional insulation contract came with the lowest price, but material shortages forced local superintendents to rent trucks and drive long distances to Lowe’s or Home Depot in other cities just to get the material needed to stay on schedule. A net loss.
- A cabinet company won the bid with a local builder to do their own installation. Within a month, it was clear that the new “captive” crews could not maintain the schedule the way the trim carpenters had. Yet another net loss.
Despite such losses, it’s not unusual for arrangements like this to continue for years because the builder either does not know how to measure total cost or their employees who do are afraid to bring it up, and for good reason. Those who created these agreements are typically displeased when the folly of them comes to light.
I also stated in part 1 of this article series that if you know how to measure total cost, there is no such thing as a “commodity buy.” Whether purchasing plywood, shower bases, trim carpentry, or cleaning services, “all else being equal” does not exist in the real world. There are always differentiating factors, and to pretend they don’t exist is delusional, financially irresponsible, and just plain lazy.
10 Elements to Get Home Builders Started on Their Own Total-Cost Model for Purchasing
Each home builder must develop its own total-cost model for both purchasing and operations because it saves money. What should be in your model? Here are 10 elements to get you started. Whether you employ all of them, half of them, or make up your own set is up to you, but simply using no other criteria beyond initial price is an unaffordable proposition.
1. Bid price
Putting bid price first is not just homage to tradition. On a practical basis, bid price serves as the anchor against which the value of all other elements is added or subtracted. But here’s the big problem that builders rarely confront. Bid prices between multiple suppliers or trades are virtually never apples to apples — unless you expand the criteria. We hear it from suppliers and trades all the time — they are never sure what each home builder values, and what they do not. Hence, they are guessing. Guessing is not a reliable route to lowest total cost. So start with bid price, but remember, it is only the start.
2. Capability and capacity
It is difficult to find a builder of any size that has not been burned by giving too much work to a supplier or trade — even an otherwise good one — and discovering too late they cannot handle it. In the same vein, we’ve all seen cases where a supplier or trade touted a new capability, such as a drywall firm adding painting to their repertoire, then finding out that they simply didn’t have the new skill-set. Showing loyalty by giving more business to a preferred vendor is a good practice, provided they have both capacity and capability. Adding work adds complexity to a business, and complexity tends to grow exponentially. You have to know the capacity and capability of each supplier and trade, otherwise you are rolling the dice with your own business, along with theirs.
3. Schedule and delivery
In my recent article on 25 essential scheduling practices, I stated, “The best builders are the best schedulers.” It is also true that the best schedulers are the best builders. A tight schedule is the single greatest thing a builder can do to bring order and predictability to a naturally chaotic business. Thus, it goes without saying that having trades that stay on schedule is critical. “Synergistic” is a desperately overused word, but the mutual cooperation required among builders, suppliers, and trades to keep a schedule on track cannot be underestimated. Even the best vendors cannot compensate for a lack of scheduling prowess by the builder. Similarly, no amount of hands-on management or outright cajoling can make up for suppliers or trades that cannot deliver both product and labor on time and complete jobs on schedule. The discipline of schedule drives excellence in virtually every other part of the business. Presuming you want to build a great product at a considerable profit, there is nothing more important.
4. Safety
If you don’t know the state worker’s compensation modification factor for every trade working on your projects, you are costing yourself money and putting your company at risk. You will find with better than 90 percent correlation that your safest trades are your best trades. They hire better people. They train them. They keep them around longer. They provide good supervision. Is it any coincidence that those who care about safety also care about quality, delivery, schedule, and warranty? You’ll have to ask your trades for this information because the state will not give it to you directly. It may scare them at first, and it is up to you to convince them that you are trying to help them become better, not find an excuse to fire them. If you have a trade with a factor over 1.0, your job is to work with them to help them get better. Having said that, if the initial bid price of two trades is very close, but one has a 0.8 mod factor (meaning he is paying 80 percent of premium) and the other has a 1.2, (paying 20 percent over), pick the trade with the lower mod factor every time. Be careful though — use a three-year rolling average, as anyone can have bad luck — or good — in a single-year period.
5. Communication
Whether you use the latest Web portal, a fax machine, or smoke signals, how well do your suppliers and trades communicate with both the office and the field? Presuming you are holding up your end of the deal, suppliers and trades who engage in frequent and timely two-way communication can help you avoid a ton of mistakes, rework, extra purchase orders, wasted materials, and warranty cost. So solicit input from field management, warranty service, purchasing, estimating, and accounting, then develop some measurements and track them.
6. Participation in product development
If you fail to involve your key suppliers and trades upstream in product and plan development, as well as ongoing continuous improvement, you are missing some of the greatest cost savings available anywhere. Some suppliers and trades are far more adept at this than others, and this has to be a differentiating factor in your purchasing decisions. I have been amazed by the variation in performance by like suppliers and trades in our 70 Lean implementations during the past five years, and I’ve watched builders shift business from one to another as a result. Last month, I wrote about two lumberyard managers — one who saw the big picture and helped the builder eliminate unnecessary material to get more total business, even though it cost him in gross dollars initially, and another who was stymied by his fear. The former is getting all the business now, while the latter wonders what happened. In the past year, I have seen the same scenario played out between rival flooring companies, electricians, framers, and a host of others. The consequences for both the builder and the supplier/trade are profound.
7. Process integration
Over the years, I have helped several builders identify all the processes used to run the business, whether or not they had names, as a precursor to a continual-improvement campaign. The number is always surprising and typically exceeds 150 identifiable processes. Whether it is your PO or invoicing process, scheduling system, scopes of work, quality checklists, warranty report form, or a myriad of others, how well a supplier or trade integrates with your systems can be an important factor in managing cost and is frequently a source of hidden cost. First, are they willing? Now, are they capable? If you don’t know or aren’t factoring this in, you are missing a subtle but substantial consideration.
8. Quality
If you are keeping score at home, I relocated “quality” from last month’s preliminary list to go with elements No. 9 and No. 10 here, because they are so closely related. Quality seems obvious, but it is a rare builder who factors it in beyond some global, fuzzy notion of how good a supplier or trade is. When judging quality of work, we tend to either informally judge some “degree of goodness,” which is often hard to put your finger on, or we measure “things gone wrong” through checklists. There is a certain, “I know it when I see it” element, but quantitative measurements are required if you want to help suppliers and trades improve. Output from checklists, job ready, job complete, homeowner walks, and factors No. 9 and No. 10 below are all fair game. Develop a quality measurement system from the best data you have available, begin tracking by supplier and trade, and stick with it.
9. Pre-close rework
Almost no one measures this, and it is an expensive oversight. Most of this cost is never billed, and although that might feel good in the short term, it covers up what is going on out there. The advent of J.D. Power customer satisfaction scores during better times produced two changes in home building. First, knowing they were being measured and compared, builders became more sensitive to customer needs and gave up a lot of the “finish it after they move in” mentality. Second, to get the homes completed to a higher standard, many builders added one or more weeks to the schedule to allow for repairs and rework prior to closing. Sure, it’s better to catch the problems pre-close rather than wait until after closing, but it is a very expensive approach. The genuine, low-cost answer is to build it right the first time. You cannot do this by memo, and it takes time to make the transition. It requires knowledge of how, where, and why the pre-close rework occurs, and it is by no means an easy element to track or measure. But you have figure it out because the old adage still applies, “What gets measured gets managed.”
10. Post-close warranty
I have never found a builder who has used each of the elements above, but tracking warranty incidence and cost in detail and using that information in purchasing decisions is imperative. It is fairly common to see measurements of incidence — “things gone wrong” — such as nail pops, bowed studs, bad carpet seams, wavy siding, scaling of concrete, etc. That must be tracked by trade, and even better, by crew leader. It is every bit as important, though, to measure dollar value. Trade A with only half the number of quality problems but three times the average dollar value as Trade B impacts both your bottom line and customer perception far more. One water leak in the second floor master bath, for example, counts for more than 100 paint touch-ups. So track both, for each supplier and trade, and use the data in your supplier-trade selections and ongoing management.
Many builders report that they use considerations beyond initial bid price in the selection of suppliers and trades, but it often sounds anecdotal. If I challenged you to produce evidence, whether in the form of a printout, marked-up whiteboard, or scribbling on the back of a packing slip, could you? These criteria cannot be “notional” — things you “kinda sorta do.” They have to be systemized and regular, and there has to be a paper trail. It sounds like a lot of work, but once set up it is not a burden. This information allows you to pick great suppliers and trades with confidence and keep them great over time, enabling you to reduce your number of labor and material sources in the not-too-long run. The time saved here more than makes up for the time spent on your expanded total cost selection criteria. This expanded view is one more critical element in the implementation of Lean process and completely destroys the notion that housing components can be purchased intelligently and economically on a pure commodity basis. You have only two choices: choose your suppliers and trades by total cost or stick with the low-bid tactic and leave considerable profit behind. It’s up to you.
