The MRO cost profile

The potential to dramatically reduce MRO procurement costs is greatly enhanced by a proper understanding of the profile of such costs

by Joel Roth

Most purchasers think of MRO costs in terms of supplier-invoiced amounts or hard-dollar spend. However, in most organizations, the merchandise cost shown on the invoice is no more than 40 percent of the total cost structure.

Moreover, hard-dollar costs are both variable and elastic. They vary based upon levels of operating activity or production. Even at a given activity level, they can be dramatically altered by changes in purchasing criteria such as brand selection, standardization and consolidation, and other characteristics. Soft-dollar costs, on the other hand, tend to be fixed and are mostly comprised of labor, overhead, administrative and financial costs associated with buying, receiving, storing, moving and paying for MRO materials.

A proper understanding and appreciation of the nature of these cost elements, and how they behave, is essential to impacting them favorably. Without this insight, the buyer is limited to driving down prices by negotiating with vendors, or competitive bidding, and eking out reductions in the range of 3 percent, 4 percent or 10 percent at best. By thoroughly reviewing and attacking all of the cost elements, the savings potential immediately grows to 35 percent or more.

How many ways can you reduce the price paid? A few. How many ways can you reduce total operating costs? Hundreds.

Let’s examine these MRO cost elements more specifically. First, it is important to understand that MRO procurement activities reflect a mirror image between the customer and supplier. You place an order, the vendor enters the order. He delivers, you receive. He bills, you pay (hopefully). Therefore, each partner’s costs are directly affected by the other. For instance, a purchaser who places many small orders instead of less frequent large orders is more costly (and less attractive) to the supplier. A supplier who creates too many back-orders will multiply the costs of his customer in receiving, expediting, stock-outs, bill paying and other areas.

For the end-user, the majority of MRO material procurement expenses are hidden. Typically, more than 60 percent of the total costs are buried in departmental budgets and accounts, rather than shown on an invoice. For the supplier, operating costs are paramount, since the merchandise cost from the manufacturer is, for the most part, fixed and he makes his profit from how well he manages his operating expenses. That is why there may often be conflict between the demands of the customer – such as 100 percent service level, frequent deliveries, extended payment terms or substantial sales and technical support – and the willingness of the supplier to comply.

The typical MRO distributor earns about 2 percent before taxes on sales. Therefore, if you seek price reductions from such suppliers, without allowing any other changes, they cannot make such cuts without losing money. That is why the major portion of MRO cost reduction has to come from other methods than price reduction. To the sophisticated supplier, the argument that your large volume of business makes up for his price cuts simply means that he will lose money at a faster rate.

Goal setting
An old axiom states, “If you don’t know where you are going, any path will take you there.” Most organizations have no specific objectives for MRO activities. When asked for their MRO goals, many procurement managers offer vague statements like “lower costs, better service, higher quality.” Or, “I’d like to cut prices by 10 percent.” Goals that are general are useless; they must be specific and measurable. Objectives pulled out of thin air, with no realistic basis, may be counterproductive. Moreover, goals must be related to activity levels; it is probably unrealistic to expect a 20 percent cost reduction if production volume is increasing by 20 percent.

An important first step in setting objectives for MRO purchasing is to identify the key unit of activity that affects MRO spending. In a steel company, it might be tons of metal processed; in a brick works, number of bricks produced; in an insurance company, number of policies written.

The second step is to approximate the cost levels that might be achieved using best practices. This benchmark might be obtained from industry trade associations, reviewing competitors’ financial statements, or a comparing costs among your own operations. You can also obtain valuable input from your key suppliers regarding cost reduction potentials.

A large southern electric utility asked six major MRO suppliers to estimate potential cost savings they could achieve within their functional area if they were free of constraints. Their estimates ranged from 8 percent to 30 percent, and averaged 19 percent. As a result, a key objective for the power company’s program was to achieve a reduction of 19 percent in MRO costs, per million KWH produced, over 3 years. (Note: Utilizing suppliers in this manner not only provides valuable planning data and cost reduction ideas, but also yields excellent insight into the caliber of your suppliers and their capabilities.)

Many other suitable objectives might be considered besides reduction in MRO procurement costs per unit of production. Here are some typical examples:

• Reduce the number of SKUs by 35 percent over 18 months through product and brand consolidation.

• Reduce the number of purchase orders by 35 percent over 24 months by vendor and product consolidation.

• Reduce the number of invoices by 70 percent within six months through consolidated billing.

• Reduce MRO inventory investment by 75 percent over three years with vendor-consigned stock.

• Streamline the MRO transaction cycle by eliminating nonproductive tasks and automating remaining tasks to reduce cycle time by 50 percent within 12 months.

Leadership responsibility
It is said that “A great plan poorly executed is much inferior to a mediocre plan that is well executed.” Execution – that is, analysis, planning, implementation, measurement and control – does not happen by chance. It requires strong leadership.

The leadership of an MRO cost reduction program is an excellent vehicle for the growth and development of an individual(s) who are deemed to have potential for greater responsibilities. The qualities required are not necessarily technical or product knowledge but rather intelligence, resourcefulness, intellectual curiosity, persistence and persuasiveness. Such an individual might come from purchasing, accounting, maintenance, engineering or even production.

The assigned program leader should be given clear goals and a firm timetable. He may choose to form an inter-functional team within the organization, rely heavily on outside vendors, or employ a mix of both.

A large contractor operated a major nuclear facility for the U.S. Department of Energy. The contract was coming up for renewal and an important criterion was the ability to reduce operating costs per kilogram of fuel produced. The contractor formed an MRO team composed of eight vendors (non-competitors) representing about 40 percent of its $24 million annual MRO spend, under the leadership of an impressive young procurement analyst. The team was given very specific and aggressive cost reduction goals and a one-year time frame. While the suppliers were offered no financial inducements, the assignment to the team was considered prestigious and would help to cement their position should the contract be renewed. Within the time frame, the team identified $2.5 million of potential cost reductions and implemented $1.8 million of that total. So successful was the approach that another group of vendors was assigned to the program each year to continue the program, with continued impressive results. The cost to the contractor – zero. As a bonus, a number of strong managers were developed through the program.

Closing the loop
It is an academic exercise to start an MRO cost improvement program without the means to measure and control its progress. It is essential to measure progress periodically and make course corrections as necessary. Part of the process is learning what works, what does not, and why. To accomplish this requires clear objectives, a database and a management information system.

The measurement and reporting can be derived from your internal and operating reports, compared against your objectives and database. Alternatively, progress reports containing quantitative data may be requested from key MRO suppliers involved in the program.

This article originally appeared in the July/August 2008 issue of Progressive Distributor. Copyright 2008.

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