Supply Chain

Looking for Raw Deals

E-procurement is hot, but the goods you need most are the hardest to buy online.
Tim ReasonJanuary 1, 2001

By the time Elvis had left the building at United Technology Cos. headquarters last winter, it was clear that the Hartford-based company’s new E-procurement system could procure just about anything. The system didn’t actually bring the King back from the grave, but it did manage to engage an Elvis impersonator for a company event, without getting all shook up.

That was something of a personal triumph for Kent Brittan, vice president of supply management at UTC. In 1996, Brittan left his job as CFO of Otis Elevator Co., a UTC business unit, to accept a challenge laid down by the parent company’s CEO: shave $750 million off UTC’s $14 billion annual purchasing tab by the end of 2000. With 26 years of experience in finance, Brittan knew UTC would need new technology to meet that goal.

“When you have a huge target like $750 million, that isn’t incremental stuff,” says Brittan. Fortunately, he says, “it was clear that the new Internet procurement tools opened vistas that were very exciting.” In late 1996, Brittan began a pilot project with FreeMarkets, a Pittsburgh-based online reverse auction site, to purchase a variety of direct goods (raw materials used by UTC business units to manufacture products). By 1999, UTC was such a devoted user that it bought a 5 percent stake in the online company. To date, says Brittan, UTC has run more than 1,000 reverse auctions (in which suppliers underbid one another), representing more than $1 billion in contracts, on FreeMarkets, with an estimated $180 million in identified savings in the process.

Also in 1996, Brittan started visiting other companies to see how they bought indirect goods ranging from office equipment and phone service to maintenance, repair, and operations (MRO) supplies. He was impressed with a system IBM Corp. had developed for internal use, and pressed the company to sell it to UTC. “IBM had the same issues as UTC — they were worldwide and had large volumes,” he says. Most important to the former CFO was the fact that the system could handle — and therefore record and track — any type of purchase, including the occasional celebrity impersonator. In 1998, UTC began using IBM’s Global Purchasing Services at its Carrier business unit, and is now rolling the IBM-hosted system out to its other business units.

It’s ironic that it was the need for a system to handle indirect purchases that led Brittan to IBM. Before he bought any technology, he had calculated that 60 percent of UTC’s purchases — $8.5 billion worth — went directly into product manufacturing, while the remainder were nonproduct or indirect purchases. That’s a fairly typical ratio, says Pierre Mitchell of Boston-based AMR Research, with direct material purchases outweighing indirect spending by anywhere from 10 percent to 30 percent, depending on the industry. UTC was unusual because Brittan tackled both kinds of spending simultaneously, and the company made its first online purchases in direct materials. Despite the extraordinary hype surrounding E-procurement today, most companies tackle the smaller expenditure — indirect purchases — first. In fact, the larger prize, direct goods, remains elusive for many.

Why? One reason is that administrative cost reductions show up in the income statement sooner than manufacturing savings. “The real low-hanging fruit is indirect,” explains Brittan. “When you do a leveraged deal for photocopiers or cafeteria providers, that starts hitting the P&L right away.”

Another reason is the greater opportunity for cost control, which appealed to Brittan’s CFO instincts. “If you cut the price of sheet steel, you aren’t going to put more sheet steel into the product,” notes Brittan. “But in indirects, usage is as important as price. If you cut 30 percent off the price of an airline ticket and people start flying first class, you won’t save anything. If you cut the price, cut the budget. The biggest savings is stuff that never gets bought at all.”

Strategic purchasing of direct materials offers greater long-term returns, says AMR’s Mitchell, but he agrees with Brittan that indirect materials provide an attractive quick fix. “People are getting ROI paybacks in four to eight months,” he says. “They’ve picked their battles wisely, choosing fragmented spending areas with suppliers that are more tech savvy.”

Indirect purchasing, Brittan explains, is diffuse. As he puts it, “It is managed by absolutely everybody. The cafeteria is run by HR. Advertising and brochures are run by Communications. The president buys books and flowers. Nobody owns it.” Direct purchases are usually handled by one or two specific departments with precise roles. “Direct purchases are covered by standard cost rules and annual inventory valuations, and are helped by MRP [material requirements planning] systems and an annual physical count,” he says.

While the fragmented nature of direct purchasing is complex, large suppliers of indirect materials have been quick to help companies gain control of their spending through online catalogs and preferred-supplier agreements. “The Web is a natural for us,” claims Jim Ryan, president of MRO provider, who rattles off the names of Ariba, CommerceOne, Intelysis, Oracle, and SAP as examples of E-procurement solutions providers with which the company has alliances.

Mitchell says that by consolidating suppliers, negotiating aggregated contracts, reducing maverick spending, and reducing transaction costs, “a lot of companies use indirect purchasing as a good way to get their feet wet in buy-side E-commerce without shutting down a plant or creating a project that is unmanageable,” he says. But, he adds, the key question may be, “Can indirect procurement vendors help you get into direct procurement?”

An Exponential Expansion

The rewards are tempting, but moving direct purchasing online is often more challenging — and risky — than indirect E-procurement, and it can take a substantial effort before systems that support the purchase of office supplies can handle the additional complexity of raw manufacturing goods.

Woodcliff Lake, New Jersey­based IR Co. (formerly Ingersoll-Rand), which plans to begin procuring direct materials this month at one of its manufacturing sites, already has 40 nonmanufacturing sites using Oracle’s E-procurement system to purchase indirect materials, and hosts catalogs from preferred suppliers, such as Grainger and Boise Cascade Corp., on its intranet.

“Using Oracle E-procurement for direct purchasing is just an expansion of our indirect system,” says Donald Janson, vice president and director of shared services, Global Business Services, “but it is a major expansion.” Before the first site can procure items used to manufacture a product, every active item must be included on an item master list so the Oracle system can generate the order and bills of materials. For a company with as many divisions and products as IR, that will ultimately mean including thousands of items for each division. That’s an “exponential expansion” from indirect purchasing, he says, where relatively few items–those with both direct and indirect uses–were included in the item master lists.

Direct material purchases will also cause the number of suppliers listed in the Oracle system to grow dramatically, says Janson. That wasn’t the case with indirect goods: IR’s E-procurement effort allowed the company to select preferred suppliers of indirect and MRO materials. But with six major divisions manufacturing a wide range of equipment — and using many different and specialized suppliers — the move to direct will have the opposite effect.

Another complication: integrating Oracle’s E-procurement system with an older MRP system supplied by another vendor. “We had to build a lot of interfaces between Oracle and our legacy system,” notes Janson, including scheduling, inventory, and translations between dissimilar charts of accounts. Direct materials also require bar codes for inventory control, automatic ordering when stocks run low (kanban), interfaces with suppliers that store inventory in their own warehouses, and forecasting ability — all elements that indirect systems do not have to handle.

Indeed, the primary transaction efficiency to be gained in indirect purchasing is the so-called procure-to-pay, in which the supplier’s system receives an order and automatically sends a shipment notice to the purchasing company, which in turn automatically generates a payment. This can eliminate mountains of expensive paperwork and earn additional discounts for prompt payment. When it comes to direct goods, however, the focus shifts from payment to making sure the raw materials get delivered.

Direct Dangers

That’s one reason many companies are loath to try E-procurement of direct materials until they have practiced with indirect. “Buying indirect materials doesn’t directly affect my customers,” explains Doug Grimm, vice president of global strategic sourcing at Toledo, Ohio-based automotive-parts supplier Dana Corp. Grimm is responsible for the company’s $8 billion in annual purchases — both indirect and direct. He plans to cut the company’s supply base by 50 percent and reduce total acquisition costs by $1 billion over the next four years.

To do that, Grimm has already rolled out four systems: i2’s eSource for drawing up content management and decision support, FreeMarkets for online auctions and quote requests, Ariba for transactions, and Lotus Notes to handle workflow and communications. Ultimately, he says, all four systems will work together to handle most facets of both direct and indirect purchasing. To date, however, the differences between the two types of purchasing have forced him to apply the technology selectively.

For example, Dana uses eSource and FreeMarkets to compile bid proposals and conduct online reverse auctions for direct materials. Auctions work well for direct purchases, says Grimm, because “direct tends to be more blanket purchase orders, while indirect tends to be more spot buys.”

Ariba, meanwhile, is up and running at 105 of 320 manufacturing sites worldwide, but handles transactions only for indirect purchases — which account for just $1.5 billion of Dana’s $8 billion total spend. That’s because Grimm wants to make sure there are no glitches in the Ariba system that would disrupt service to Dana’s customers. “We want to refine the process before we move to direct,” he explains.

Indeed, Dana straddles something of an E-procurement chasm. The company is a direct supplier to Ford, DaimlerChrysler, NAPA, Mack Truck, and other customers that have robust supply chain communications. “We have excellent EDI connections with them — globally — for sequence parts delivery and just-in-time delivery,” says Grimm.

But Dana’s own varied mix of suppliers helps explain why the company still uses Ariba primarily for indirect purchase transactions. “For indirects, we deal with large national accounts like Boise Cascade, Dell, or Grainger,” notes Grimm — companies whose own systems can interface with an Ariba system. “But on the direct side, most of our suppliers are privately held businesses. We may be dealing with a machine shop in Indiana” that lacks the technology infrastructure.

Ultimately, Grimm hopes that the combination of the Internet and E-procurement systems such as Ariba will provide “a great opportunity to get that same connectivity. If someone at the machine shop in Indiana has an America Online account, we’ll be able to connect.”

Suspicious Minds

Not every distinction between direct and indirect purchasing is a technical one. Companies usually have many options when choosing indirect suppliers, but direct materials may offer less latitude. Buyers must know that their suppliers can hit delivery windows in this age of just-in-time and kanban manufacturing, and rely on them to maintain quality and manufacturing capacity. Such considerations are often as important as price. And buyers of rare direct materials must maintain a delicate balance of power among suppliers — favor one, and you may help create a monopoly.

“You may not be worried if you alienate a bunch of paper-clip suppliers,” notes Deva Hazarika, founder and chief strategy officer of San Francisco­based E-procurement software provider Moai Technologies Inc. “But if you are buying chemicals and there are only six major suppliers, you can’t afford to alienate anyone.”

Alienation and ill feelings are a genuine danger in E-procurement, particularly in the high-pressure world of reverse auctions. Research conducted by Sandy D. Jap, assistant professor of marketing at the Sloan School of Management at the Massachusetts Institute of Technology, provides a case study in ruffled feathers. She looked at six online reverse auctions conducted by a major manufacturer of automotive parts to procure approximately $200 million worth of production materials. Three of the six auctions were open, meaning suppliers could see their competitors’ bids as they were posted.

The result? “Suppliers felt the process was exploitative, that the competition wasn’t viable, or that the buyer was ‘shilling the bids’ by taking part in the bidding itself,” says Jap. Some suppliers thought the buyer was testing the market with no intention of actually awarding a contract, although Jap, who monitored the entire process, insists these concerns were groundless.

Although Jap expected higher levels of mistrust in an online environment, other results came as a surprise. “You’d think suspicion would be higher among incumbent suppliers,” she says. “In fact, it was higher among new suppliers. It may be that new suppliers weigh their initial experiences very heavily, whereas incumbent suppliers” in the dog-eat-dog world of automotive supply “expect to be beaten up” by buyers, she reasons.

While incumbents shared some of the doubts of the newer suppliers, they also rose to the challenge. “Paradoxically, they were more willing to make dedicated investments to improve their cost-competitiveness,” she says. But at the same time, distaste for the electronic bidding process also spurred a determination to avoid a vicious cycle of cost competition. “They believe that by dedicating resources such as people, equipment, and machinery to the buyer, they can differentiate themselves,” or even avoid the auction process altogether by becoming a preferred supplier, she says.

Jap suggests that online auctions can be a way to deliver a wake-up call to incumbents, or they can serve as an initial screening process for long-term partnerships. “An initial auction may be a way to see who is price-competitive,” she says.

Reverse auctions can be used for indirect materials, too. Of course, when the product is simple and the suppliers plentiful, subtle psychological distinctions go right out the window. “The psychology of a reverse auction is [simply] that it drives suppliers to a lower price,” says Angelo Brisimitzakis, vice president of global supply chain for Indianapolis-based Great Lakes Chemical Corp.

To prove his theory, Brisimitzakis conducted an experiment. He held individual meetings with six suppliers and asked them for their best bid on fasteners — “a mundane item we use at our plants,” he explains. “Supposedly, we got their ‘final’ price. Then we asked them to participate in an online reverse auction on, and got an additional 11 percent discount. When they saw they were going to lose the business, they had a change of heart.” Technology has changed the rules, but it’s left human nature intact.

Tim Reason is a staff writer at CFO.

Steel (and) Magnolias

Sometimes the distinction between direct and indirect goods can be moot. Consider Lisa Catanzano, purchasing manager for Montague Co., a Hayward, California-based manufacturer of commercial cooking equipment. Her company belongs to Chicago-based buying consortium Prime Advantage Corp. — a sort of industrial-strength buyer’s club, formed in 1998, in which members get discounts or rebates from participating suppliers of everything from stainless steel to flowers. Although technology was not its raison d’être, Prime Advantage had to find a way to solve integration issues as the numbers of members and suppliers grew. The answer? Become a data clearinghouse.

Purchase orders, invoices, shipping documents, even project specs are sent from buyer to supplier and vice versa through Prime Advantage’s system, which automatically translates the data into the format each participant needs. A data-mapping process, usually involving no more than a one-day site visit, prepares Prime Advantage to pass data back and forth between participants’ widely varied systems (including ERP, MRP, accounting, and others) with nary a glitch, according to president Louise O’Sullivan.

At first, admits Catanzano, she was skeptical, and tested the system by simply ordering MRO supplies. “If a box of pencils doesn’t arrive in time, it doesn’t shut my plant down.” She held her breath when she placed her first order for stainless steel, but, she says, “the order showed up in full on the day I requested. I’m a true believer now.” Indeed, in just a year’s time, Catanzano has moved 45 percent of the company’s $5 million in annual spending to participating suppliers, and that number will grow, she says, as more suppliers join the club.

“The technology side isn’t what’s driving our ability to work with more suppliers,” explains Catanzano. “The technology side just allows us to streamline our purchasing process with those suppliers.” —T.R

4 Powerful Communication Strategies for Your Next Board Meeting