Lower Price, Higher Cost: A Real-Life Case Study

Published April 26, 2013

In a recently conducted study of total MRO costs and consumption for a manufacturing company, a comparison was made of pricing and service response (on-time delivery, etc.) from local suppliers vs. pricing and service response from LTAs (Long-Term Agreements). MRO stands for Maintenance, Repair, Operations–the goods and services that keep a facility up and running.

The supplier of pipe, valves, and fittings (PVF) had been chosen via a market basket competitive quote procedure, the goals of which were to provide the lowest price with agreed service response levels.

When PVF requisitions are processed and orders placed by the company, they are done so periodically to fill stock bins and optimize freight costs. Orders are also placed for parts needed for capital projects. In both cases, this results in orders that are two- and three-pages long containing 25 to 30 line SKUs (Stock Keeping Units). Since the supplier is the low price bidder, their margin is squeezed so that they will rely on their manufacturer/source for supply rather than supplying orders from stock which is reserved for their higher margin clients.

Orders are shipped to the company when the product arrives at the supplier’s dock. This effects a sporadic supply situation; an average PO with 30 line items has at least 12 shipments to complete the order. This means that there are 12 receipts created which generate 12 invoices to be processed for payment which constitutes excessive paper costs.

BUT WAIT, there is far more to be added to the total cost of the situation:

  • All shipments were made via a delivery service.
  • The service has a minimum charge, which, in this case, is $8.40 per shipment.
  • 12 shipments for 30 lines resulted in a shipping cost that sometimes exceeded the value of the parts shipped.

In addition, since many of the orders were for projects with deadlines, the sporadic delivery performance of the low-price supplier caused the company to go to the local distributor to fill their needs and to do so at a higher price. When the order finally was shipped completely, it was put into stock which constituted an increase in inventory that was not needed.

Why does this condition continue to exist? The supplier did not live up to the service agreement; therefore, should they be replaced???

The cost of replacement (another market basket scenario) plus admitting that the original supplier selection was in error was determined to have a negative ROI; the situation was allowed to continue and was covered by cost reduction projects in other areas.

Although unit pricing from the local supplier was higher, the total cost at point of consumption for the user would have been considerably lower, with projects completed on time, if all costs were considered when the supplier was selected.