Wednesday 4 July 2012

Economies of scale: Customers Looking For Savings From Suppliers

Yesterday’s NamNews’ item on Morrisons’ alleged demands for £500k savings from some suppliers produced our top visitor-count for the day.  
However, the issue is not whether larger quantities mean greater savings, but whether the discount demanded by the buyer matches the savings made by the supplier.

'Economies of Scale'
As you know, there are many potential sources of economies of scale, depending on the company and category in question, including:
- spreading administrative overheads over a bigger operation/quantities
- purchasing power to get better deals from suppliers of raw materials, packaging, etc
- lower costs in manufacturing - e.g. if longer runs result in lower costs per unit produced
- greater delivery quantities leading to lower distribution costs
- cross selling synergies
Any such savings will obviously depend upon your category and factory capacity/asset-utilisation levels.
The incremental sales route to fair-share negotiation
However, either way, the ‘incremental sale’ calculation allows suppliers to approach the problem from a more productive angle…
In other words, if a customer demands £500k cost-price reduction from a supplier netting 7% on the business with that customer, a ‘back-of-envelope’ calculation says the supplier needs incremental sales of £7.1m to cover the cost (i.e. £500k/7 x 100), unless you can identify and measure some real scale savings, and reduce the incremental sales requirement appropriately.
The basis of your costing-model
Any credible negotiation stance means that you will need to reveal the basis of your costing-model ( i.e. even tougher negotiation with your colleagues?) in order to be able to quantify and argue with the buyer that there is a shortfall between the actual savings and the discount demanded, an additional discount that will not realistically be covered by the anticipated incremental sales. 
Quantifying in this way may result in something approaching a fair-share solution..
Simply saying no is not an option

Q1. Why not substitute your figures and see how much extra you need to sell in order to break-even on the new deal?
Q2. Some might argue that explaining scale economies to a customer is not the job of a NAM/KAM. If so, please explain to us mere earthlings why the global financial crisis is diminishing, rather than enriching, the scope of the job…

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