Sourcing has won a reputation over the past decade as a powerful tool for improving profitability. It is easy to see why. In a survey of electronics companies,¹ we identified a 19 percentage point gap in profitability between the most and least successful companies, a full 13 percentage points of which was accounted for by the lower cost of goods sold (COGS) (Exhibit 1). A closer look at the structure of COGS showed that 40 to 70 percent was accounted for by the cost of purchased goods and services (Exhibit 2).

Most companies have tried in recent decades to reduce the cost of purchases by distinguishing between strategically vital goods and those that are in ample supply or easy to substitute, and between critical and non-critical suppliers. In the case of essential goods that might hitherto have come from a single supplier, buyers cultivated a second source in order to introduce a degree of price competition. In the case of less essential goods, companies played suppliers off against each other.

Much of the (single-digit) cost-reduction potential in this method seems to have been realized. But that does not mean purchasing costs cannot be cut further. The world’s more successful companies have found additional ways of doing so, and simultaneously improved their performance.

Reducing the cost of goods sold

Successful companies use three main levers to reduce the cost of goods sold. First, they simplify their products. Reducing the number of parts or the number of variants or models of a product can save significantly on material costs and thus increase profitability (Exhibit 3). Our research shows that most of the complexity in a product is generated not by customer demand, but by its design, and is usually neither seen nor valued by customers. In fact, they see only what they regard as an unwarranted higher price.

Complexity can, therefore, often be reduced without customers noticing much difference in the finished item. For instance, by standardizing parts and subassemblies. Second, successful companies redesign their products to reduce unit costs. Depending on the industry, best-practice companies have made savings of 7 to close to 20 percent through redesign (and in extreme cases, of up to 35 percent)—although this is possible only if development, purchasing, production, and suppliers are involved (Exhibit 4).

Third, successful companies reduce the cost of goods sold by increasing outsourcing. The more competitive the industry, the more important it is to outsource any in-house activity that falls short of world standards. Our research also shows that in successful companies, decisions about whether to make or buy a product are more often taken by a neutral party—the board or a special committee; average companies, on the other hand, frequently fail to define whose responsibility it is or leave it with the production department (Exhibit 5).

An implicit part of cutting the cost of goods is improving relationships with suppliers. A third to a half of the difference in cost structures between a world-class supplier and the average supplier of an item is accounted for by differences in design or product-line complexity; a further third is the result of operational inefficiency. Factor cost differentials such as labor or capital costs are usually less significant. The most important way for a manufacturer to reduce purchase costs therefore is to collaborate with suppliers to improve their design and operational efficiency.

Collaboration is possible only if manufacturers have close relationships with suppliers. These are achieved by having fewer suppliers to get close to. Our survey indicates that successful companies have half the number of suppliers per DM100 million purchasing volume that their less successful counterparts have, and are usually keen to have only one supplier per part, with the exception of the few most vital parts (Exhibit 6 and Exhibit 7). We believe purchasers should be able to devote at least 50 to 100 hours a year to each supplier—clearly an impossible task if they have to deal with purchasers have a great many of them. Most manufacturers fail to dedicate this amount of time even to core suppliers.

The benefits of closer relationships are that suppliers improve their global competitiveness and become partners in the effort to reach cost and performance targets. Successful companies have more direct-to-stock shipments, for example, because the high quality standards achieved by their suppliers mean that costly quality inspections are unnecessary. The ultimate goal is "virtual vertical integration," whereby the manufacturer enjoys the advantages of an integrated company without the disadvantages of high capital exposure and the probably inferior performance of areas of the business outside the core expertise.

The more intense the competition, the more necessary it will be for companies to reduce the cost of goods sold. Companies should therefore heed the experience of those who have already discovered that dramatic cost reductions can be achieved by working with fewer but better suppliers. World-class companies rely on world-class suppliers.