It is one thing to have external buyer-seller relationship where parties are virtually free to walk away if contract terms are breached, and it is totally another thing to source direct materials from an inhouse production facility, where relationship seems obligatory and permanent. In fact parties are “married” in an internal customer relationship! So how could procurement function make the best out of this “marriage”? What are major issues and takeaways?
There may be various reasons driving companies to get production inhouse, such as cost savings (by eliminating profit margin of suppliers), long-term supply security (especially if particular production input is critical to operations), utilizing idle production capacity, protecting proprietary technology and know-how, having more tracability and better control on quality, etc. Whatever reason there is, inhouse production/internal supplier should strive for competency at market level. As one of my friends once told me in a joking manner, “having worn the wedding ring does not guarantee that my spouse and I will spend the rest of our lifes together. Each and every day we have to prove each other that it was the right choice.”
Technical and quality
A structured methodology with quality audits, incident management, regular performance reviews will help to close the gap with market within a short time.
There are many instances where internal supplier or inhouse production facility is not up to market quality standards, and this may cause additional challenges for procurement.
So what do we call “inhouse production” anyway? It is production other than core operations. It can sometimes be tricky to judge what is the core business of a company and what is not. An approach could be defining core business as the process that brings largest value to company. Another definition could be what a company cannot source from the market, but nowadays it is possible to buy or outsource virtually everything. My personal experience is as follows: The management would almost certainly call a production step “inhouse production” or “internal supplier”, when they believe their technical capability is not up to market level, and it is clear that semi-finished good or compontent can be easily sourced from market. On the other hand, if the management considers itself competent in a certain production process or component, they do not call this line “inhouse production” even when that particular semi-finished good or component could theoretically be purchased from market too.
Here are some ways how procurement can tackle with quality issues with “internal suppliers”:
- Do not hesitate to include your inhouse production facilities to supplier partnership program if you have one for external suppliers. Such programs increase supplier competency and reliability. A structured methodology with quality audits, incident management, regular performance reviews will help to close the gap with market within a short time.
- Benchmark performance, if you have both internal and external suppliers for the same material. Identify best practices at external suppliers which can be applied to internal suppliers and drive this process with technical team. Consider connecting your inhouse production team to directly technical teams external suppliers to share expert opinion.
- Ensure core production and internal supplier negotiates and gets aligned on specification of semi-finished good or component on an official document. Mediate for interim targets if it is impossible to get ideal specs immediately.
- Involve responsibles from core production to issues regarding production and procurement processes for inhouse production facility. Ensure transparency about risks and action plans.
- Balance discussions by pointing out to technical advantages of having inhouse production, such as more tracability on processes and higher control on quality.
- Focus on problems and processes, not on people.
Planning and delivery
Streamlining processes will bring cost optimizations and higher quality of work in most cases.
Some companies adopt different processes for their core production and internal supplier/inhouse production. These differences could be in planning and delivery management processes too. For example, material requisition planning and delivery scheduling may be done by planning department for core production, and by procurement department for internal supplier/inhouse production.
Material requirement for inhouse production should be calculated manually if product recipes on ERP include materials only for core production. These manual calculations may take long time and are subject to errors. In my experience, there is frequently an error with stock quantity while calculating purchase requirement for inhouse production for next period. This is because the planner takes only finished good quantity or raw material quantity instead of taking them together. Or he makes a mistake while translating one to another.
The companies should avoid different processes for core production and internal supplier/inhouse production unless there are good reasons. Streamlining processes will bring cost optimizations and higher quality of work in most cases.
Finally, whether directly or indirectly involved in logistics planning, procurement has a serious potential in optimizing transport grid and other operating costs of the internal supplier/inhouse production.
So here are some tips
- ensure there are valid reasons for the differences and current processes are optimum
- have access to necessary resources to carry out such responsibilities (such as access to weekly rolling estimates, etc.)
- constantly look for opportunities in value chain of internal supplier/inhouse production.
Contracts
It is to the best interest of procurement to have a written document regulating responsibilities and obligations.
Business has become increasingly complex in last few decades. Corporate strategies involve a lot of M&A activity, partnerships, strategic alliances, vertical and horizontal integration to value chains. Inhouse production of components for core production could take place at your main plant for core production. However it could as well take place at another legal entity, which your company acquired, or at a plant of one of your minor shareholders. In latter cases, buyers need to conclude a contract from legal point of view, although it is an intercompany transaction in commercial sense.
There is not necessarily a single management for core production and for inhouse production for components. In fact business goals and interests of two production teams are sometimes not totally aligned. Procurement function mediates between these two teams and sometimes could be scapegoat. So it is to the best interest of procurement to have a written document regulating responsibilities and obligations. This would be a regular supply contract when it is inhouse production is organized at a separate legal entity. If inhouse production is at an autonomous department in same legal entity, then an internal document, such as SLA (Service Level Agreement), should be signed in order to clarify responsibilities, metrics and expectations.
It is always a potential stratetgic option for top management to outsource such production by selling to a third party in future. So this is just another reason why to document better.
Key learnings on contracting;
- Work out inhouse supply contracts as diligently as third party supply contracts
- Coordinate with legal and accounting departments as usual.
Finance and tax
When striking a contract with a legal entity serving as internal supplier, it is not procurement, but finance and tax departments that have a final say on pricing.
There is a specific term for commercial transactions between two companies under common ownership or control – this is called “Transfer Pricing”. Transfer pricing is not, in itself, illegal or necessarily abusive. What is illegal or abusive is transfer pricing manipulations. For example, a parent company, controlling both buyer and seller companies, may set a price artifically higher or lower than market in order to allocate more profit to the subsidiary which will have less tax payables.
Arm’s-length principle is that intragroup transfer prices should be the same with what would have been charged by unrelated enterprises dealing at arm’s length.
Buyer should be especially alert if the commercial transaction is with a related party which is at loss in current period, or with large carry-forward losses from previous years, or with large carry-forward deductible VAT, or enjoying tax privilages, or located in a tax haven, such as Cyprus, Cayman Island, etc.
Besides tax regulations, finance department may have some other concerns, such as representation of financial information, currency regulations in certain countries, cash flow management, minority shareholders, etc.
So here are some tips:
- Give final say to finance and tax departments on pricing when concluding a contract with an internal supplier/related party that has separate legal entity
- Provide finance department with market insights and offers from external suppliers in order to support them setting prices at arm’s length.
FINAL WORDS
Procurement has a significant role and responsibility in growing and maintaining inhouse production/internal supplier to a more competitive level in both commercial and technical terms. On the other hand, inhouse production/internal supplier should not rely on the wedding ring, but prove its competency each and every day. With good coordination between all stakeholders, inhouse production may grow to be one of the most strategic advantages in a competitive market.
I dedicate this post to my dear wife Anna. Today is the 3rd anniversary of our wedding! I am happy, grateful, and trying to do my best each and every day!