Mathew, a friend of mine, is the procurement head for a major global consumer packaged goods (CPG) firm. And right now he is a much perturbed man. In the last board meeting, his CEO gave him a directive to reduce material costs by 10 percent over the next 18 months. As targets go, this is a pretty steep one, especially considering the fact that most of the spend under Mathew's control is comprised of raw and processed agricultural materials, which have a structured and centralized supply market. Worse still, some of them are highly seasonal in nature, both in time and quantity of marketable surplus.
As my friend summed it up: "Going in and asking for a immediate 10 percent reduction across the board in these sort of markets is a sure shot recipe for supply disruption." All I told him was that he was not alone in his predicament, but there is a way out.
Almost all global CPG firms, particularly those operating out of the Western Hemisphere, are facing the same issue in one form or another. The reasons are not hard to guess: Intense competition from local and foreign firms, ever-rising input costs, the inability to pass on the higher input costs to the consumer, pricing inflexibility and increasing pressure on margins are inveterate truths for CPG firms these days. Organizations, especially those with operating bases in the North America and Western Europe markets, have therefore no recourse but to reduce their input costs, and that, too, on a sustainable basis. This is absolutely critical if they want to maintain a profitable margin level.
For any long-term sustained cost reduction program in a CPG organization, the first port of call is inevitably the direct material spend — spend on raw and processed agricultural inputs, to be specific. This is quite logical since, for an average CPG manufacturer, the direct material cost is approximately 55-60 percent (1) of the total spend (Infosys Research, 2007). Out of this amount, agri inputs account for no less than 55-60 percent (2) (Infosys Research, 2007). Clearly, agricultural raw materials spend form the biggest chunk of the direct material pie and quite logically attract the most focus.
A prima facie analysis reveals several methods that have already been tried out by global CPG companies to curb sourcing costs of agricultural inputs:
- 1. Cost rationalizing by renegotiating fixed contracts, implementation of flexible contracts, collaborative and consortium buying, streamlining and strengthening the vendor base.
2. Alternate mechanisms adopted stretch from implementation of auction-based platforms to backward integration models, which take into account the back-end procurement and processing costs of vendor.
Such methods, however, have not produced sustained benefits. Primary and secondary markets (from where most of the raw and processed agricultural inputs are sourced) have established and rather inflexible systems and procedures for trade. Historical evidence shows that implementation of strategic cost rationalization measures have met with determined and sustained resistance in these markets. A case in point: In spite of its obvious business logic, the reverse auction mechanism took close to decade to be acknowledged as a sustainable model for procurement. For North American- and Western Europe-based CPG companies that are facing such adverse sourcing conditions, low-cost country sourcing (LCCS) of agricultural products is an attractive option.
Low-cost Country Sourcing of Agricultural Inputs
LCCS is defined as a procurement or sourcing strategy in which a company sources materials from countries with lower labor and production costs in order to cut operating costs. Up until now it has been profitably implemented by global firms in the IT and discrete manufacturing space. It is only recently that global CPG companies operating from North America and Western Europe have started using it for sourcing of agricultural inputs. The initial step is to identify the "agri commodity" to be sourced and the "source" country. For most LCCS agricultural sourcing operations, the source countries are pre-dominantly from Southeast Asia, like China and India. This is quite logical, since most of these countries are agricultural economies and have significantly lower processing and labor costs compared to USA and Western Europe.