Demand management proves equally valuable for nonproduction spending. Many companies have dramatically reduced travel costs by imposing more restrictive travel policies, such as enforcing advanced ticket purchases, mandating economy class on all but the longest flights, and tightening constraints on the use of nonpreferred airlines.
Insight into specifications employed by competitors or “best practice” policies often provides a clear road map to potential tools for managing demand. In addition, deep cost understanding ensures that the customer captures its full share of the benefits.
The create value phase of the cycle logically comes after the other three phases. Once the company has proven its capabilities in capturing margin, reducing cost, and managing demand, creating value becomes a priority. Ideas, such as supplier-recommended features intended to increase margins, create value for the company even if the costs of the materials go up. Convincing the organization — especially the CEO — to accept these recommendations, however, proves far tougher than in the other three phases, in which the results can be immediately measured in lower purchasing costs. The credibility developed through rigorous quantification of the bottom-line impact from the prior three phases makes the organization more willing to accept such ideas on faith — further underscoring the logic for approaching this phase only after successfully completing the prior three.
Blockbuster Inc. offers an excellent example of creating value through a creative pricing agreement with its suppliers. Prior to 1997, Blockbuster paid movie studios up to $80 per videotape — though the marginal cost of making a copy was a mere fraction of that total. Such pricing made it cost prohibitive for Blockbuster to adequately serve the initial surge of demand for new releases because it would have been left with a huge inventory of expensive tapes once the initial demand tapered off. However, the studios producing the tapes worked with Blockbuster to develop a creative pricing arrangement, reducing the up-front cost to only $7 to $8 per tape and sharing the revenue stream that followed. This pricing structure aligned incentives for Blockbuster and the studios to flood the stores with copies of newly released videos to tap the demand surge, resulting in far more video rentals, which helped drive Blockbuster’s market share from 26 percent in 1997 to 36 percent in 2000. More important, revenues increased 62 percent and EBITDA rocketed 180 percent during the same time period.
Such effective value-creation strategies build on cost understanding — in this case, for example, the true production cost of a videotape — as well as competitive insight into overall demand patterns. But value creation requires even more: an understanding of the overall business economics, the creativity to envision new paradigms, and the credibility to convince others to accept the risk.
Though this conceptual model may be intellectually appealing, a hardened purchasing executive may remain dubious. Most find themselves trapped in the corporate equivalent of Lewis Carroll’s “Wonderland” — facing a CEO and lamenting, like the Queen of Hearts in Through the Looking-Glass, “it takes all the running you can do, to keep in the same place.” Others might cite Rita Mae Brown, the American writer and playwright who observed, “Insanity is doing the same thing over and over again, but expecting different results.”
Through our frontline experience with many purchasing executives, we’ve heard mandates from CEOs who expect miracles. Though it may feel like a fantasy, expectations for ongoing improvement have unfortunately become a corporate norm not likely to go away. For those arguing against the insanity of doing the same thing over and over again — frankly, we agree.
In fact, those observations spurred our development of the Continuous Sourcing Cycle. Companies must continuously drive performance improvement but recognize that doing the same thing over and over again won’t work. We are not proposing the mythical perpetual-motion machine that runs forever after an initial charge of energy. The Continuous Sourcing Cycle, like a generator in a hydroelectric plant, requires sustained effort and a dynamic environment: Take either away and the generator fails.