Chapter 2 covers markets:
2.1: Markets and industries
2.2: Competitive Forces
2.3: Costs and prices
2.1: Markets and industries
Industries
The Standard Industrial Classification (SIC) system
is a famous way of grouping companies into sectors e.g. mining, construction,
services etc.
·
These sectors then break down into segments underneath.
Manufacturing
Manufacturing companies convert materials and components into finished goods. These goods could be:
- Finished consumer goods
- Intermediate goods e.g. components
- Capital equipment
- The specification could be given by the buyer, if it is highly complex e.g. defence technologies
- There could be a recognised industry standard specification
- Some items are standard in and of themselves e.g. chemicals
Manufacturing companies can have quite complex supply chains, involving various materials and components.
- Some sectors have adopted world-class practices, such as the just-in-time (JIT) methodology of procuring and producing, and Materials Requirements Planning (MRP)
- Logistics is an important consideration in manufacturing supply chains, particularly as companies would have global suppliers
- Advanced technologies, such as RPA and AI, have been integrated into manufacturing and supply chain processes
- ESG and Net Zero are important considerations in manufacturing supply chains
Key implications for procurement teams:
- Production needs ongoing resources feeding into it: resource inputs need to be available at the right time to avoid machinery down time
- Warehousing can be a big driver of costs in manufacturing supply chains; JIT aims to avoid this by minimising storage
- Quality is important, as defects are costly. Total Quality Management (TQM) is a methodology for rigorously adhering to standards
- There are some unique categories to manufacturing: MROs and capital equipment are needed to enable manufacturing
Fast-moving consumer goods (FMCG) is a sector falling underneath manufacturing.
- There are short product lifecycles (think of ‘fast fashion’), so procurement needs to be agile
- Defects can be costly, so quality will need to be rigorously adhered to
- FMCG works on volume rather than margin, so keeping costs down is important
Construction
There are different types of construction: it could
be for housing, manufacturing or large-scale infrastructure, for example.
The level of construction work required can also vary: it
could be simply a refurbishment of existing works, or a new project entirely.
The construction supply chain
·
The various aspects of construction are highly
specialised (e.g. engineering, equipment, trades and project management).
This means there will be a lot of subcontractors
· It’s usual for construction projects to be competed, because there will generally be a plurality of big construction firms interested
- Contracts will go to the large Tier 1 supplier, who will then subcontract the specialist parts down to their supply chains
- Tier 3 suppliers will often be sole traders, doing trades work (e.g. plumbing). They will provide services to the Tier 2 suppliers
·
Again, ESG and Net Zero is becoming important!
Types of construction contracts
- Design and build contracts: supplier will take on both aspects of the construction
- Traditional contracts: the design is handed to the supplier to then build
- Construction management approach: the buyer directly procures from a range of suppliers and then gets a manager to oversee the project
What is the construction procurement process?
Business case -> Requirements -> Design ->
Competition -> Award
After the customer takes control of the building, they’ll
usually have a defect liability period where the contractor will have to
address defects.
Key implications for procurement teams:
- Many heavy supplies e.g. bricks and steel, are low value so transportation costs can be disproportionate to the value of the materials
- JIT might be used to minimise storage costs and concerns around theft of supplies
- Having a complex supply chain: might make use of ‘collateral warranties’ to ensure subcontractors deliver
- The quantity surveyor will provide a ‘bill of quantities’ (BOQ) setting out the requirements, which will then go into tenders
Retail
- Retail is quite a catch-all term: it can capture FMCG (discussed earlier) and also high-margin specialist retail e.g. art shops.
- Retail stores could prioritise either breadth (more product categories) or depth (fewer product categories, but more options within them)
- Online stores aren’t restricted by physical space and a localised customer base, so could have both breadth and depth
The traditional retail supply chain is as follows:
Manufacturers
-> Wholesale -> Retail -> Customers
Implications for procurement:
- The products that are bought need match customers’ interests; the procurement function needs to understand the end user
- There isn’t much differentiation between what is bought from wholesalers and what’s ultimately sold by retail
- I.e. they buy from wholesalers and sell for a small margin onto consumers
- Minimising cost is important
- The speed of online retail is disrupting the physical retail industry, with faster deliveries and greater choice; how can procurement teams facilitate this?
- The retail buyers will select and order products: they have a big role. They may focus on a particular category, or work across categories
Agriculture
- Procurements could include machinery, feed for livestock, breeding animals and chemicals
- There isn’t much product differentiation between agricultural produce and meat, except for some quality standards
- Prices can vary dramatically depending on seasons, weather events and tariffs placed on agricultural products.
Hygiene and ethical standards are important in agriculture:
- Disease can wipe out livestock
- The EU bans chlorinated chicken from the US due to hygiene concerns
- Ethical standards such as Fairtrade products, are geared towards ensuring that people in agricultural supply chains are treated fairly
- ESG is also becoming increasingly important e.g. with reference to packaging
Implications for procurement
- Uncertainty in the supply chain due to unpredictable events, and nature of a global supply chain
- Low market power sellers, so the big customers are able to dominate
- Procurement needs to be cognisant of environmental and hygiene regulations
Financial services
Banks are heavily regulated. However, procurement is relatively less important due to lower complexity spend. Most spend is indirect spend:
- Facilities management
- Any use of outsourced corporate services or advisory
- IT infrastructure
Implication for procurement: low complexity
activities, but may be emphasis on keeping costs low due to tight profit
margins.
Service
industries
Differentiate between equipment-based and people-based:
- Equipment-based: services delivered using equipment e.g. transport (will require more upfront investment)
- People-based: services delivered mainly through people e.g. tourism
Firms might choose to outsource services that aren’t core to
its offering e.g. HR, accounting.
2.2: Competitive
forces in markets
Porter’s 5 forces model
- Competitive rivalry
- Threat of new entrants
- Bargaining power of suppliers
- Bargaining power of buyers
- Threat of substitute products
Competitive rivalry
- In the case of commodities and primary products, product differentiation is limited, so competition is intense
- More commonly, there might be competition where each provider offers similar, but not the same, service
- High competition will lead to lower profitability and prices
- Market concentration
- Product differentiation
- Switching costs
- If fixed costs are high, it induces firms to compete for achieving a high enough volume of sales to cover their costs. This will make profit margins low
Threat of new entrants
Keeps profits low, as a higher profit margin can tempt new
entrants into the market. This depends on if there are barriers to entry
into the market (i.e. is it challenging to be able to set up, scale and sell
that product?).
Bargaining power of suppliers
Can be affected by a number of things, such as the supply
market concentration, switching costs, how important the product is to
customers.
Bargaining power of buyers
If buyers have strong bargaining power, prices will be lower.
This can be affected by a number of things such as buyer market concentration,
switching costs and importance of the product.
Threat of substitutes
A substitute is something that is different from the seller’s product, but can
derive a similar benefit for the buyer (the extent of the similarity is
crucial, as this affects the threat level). A higher availability of
substitutes will make the market more competitive, decreasing prices.
2.3: Costs
and prices
‘Spending map’: a calculation showing how much the organisation has spent on a particular product over a period.
- It might be split across different departments, potentially showing where departments are buying the same things
- It might segment spending by direct materials, and various indirect costs
Procurement professionals can also try to estimate suppliers’ costs.
- You might use raw material estimates and prices to feed into the model
- You might use RFIs from suppliers to gather information
- You’ll need to estimate labour costs as well, using various open-source data and technical estimates
- Finally, you need to measure supplier’s indirect costs and profit margin: this could be a % markup that you estimate is on top of the other costs
Should costing: estimating that a supplier’s costs
should be for selling a product. It’s built in a bottom-up way, following the
approach above.
‘Negotiating the gap’: trying to reduce the gap
between the seller’s price, and what the buyer thinks the seller’s price should
be. The should-cost assumptions and model might be explored in this, and used
to drive the price down.
Another way of estimating costs and prices is market data.
- This could be through market research firms, industry benchmarks and government departments
- A market research firm could be asked to do a purchase price cost analysis (PPCA): i.e. analysing and estimating direct and indirect costs of a supplier
Whole-life costing is important for capital items
e.g. maintenance costs and training for operating the equipment.
Open book accounting could be used as a transparent way of negotiating on price. The supplier openly reports on their costs and profits for a contract; this is relatively common in large government defence contracts.
The head of procurement will make the budget for
- Direct materials that need to be purchased
- The direct costs of the procurement function
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