Procurement impact from bottom line to top line: importance of offset
Procurement originally focused on cost reduction to improve the bottom line (i.e. EBIT – Earning before tax). This is the foundation of procurement which enabled the function to start to be recognised as strategic function. Now the function is evolving to bring more value to the company to improve the top line (i.e. revenues). Offset could bring a decisive edge to secure winning proposal. Offset or industrial compensation are side deals which impose on the reseller to redistribute benefits to a certain level of value to the country of the buyer. As the Economist pointed out, there are some risks involved like corruption and market distortion effect. Nevertheless, it is a customer requirement which must be addressed to secure large contract, indeed, in accordance with the law. In 2008, Bell Helicopter withdrew from a 1billion$ Indian contract due to risk on offset requirement losing a large business opportunity. Dassault, negotiating a $20 billion Rafale deal with India, found its greatest challenge in offsetting. The Rafales will be manufactured by Hindustan Aeronautics Limited (HAL) with transfers of technologies. Such large market cannot be dismissed; Boeing forecast that India commercial airplane market worth more than $200Billions within the next 20years…
Which offset strategy to choose?
While offset is a classical in government contract for defence, it tends to be more and more frequent in the commercial world as well. For example, India adds in 2011 offset requirement for commercial airplane. In order to redistribute part of the business in a given country, different strategies are possible.
The creation of a factory is a possible way forward like Airbus did in the USA to have a better access to American Department of Defence contracts at the time of the tanker bid. Indirect offset can be implemented like Raytheon set up a shrimp farm in Saudi Arabia. This offset programme has been a showcase for its benefit to the population but it is too far away from their core business and the farm eventually went bust.
To access the Chinese market, Airbus accepted to enter a joint venture with Chinese consortium of Tianjin Free Trade Zone (TJFTZ) and China Aviation Industry Corporation (AVIC) as part of the commercial aircraft deal which required know-how transfer. The clear advantage is a strong control but the drawback is that a large amount of investment is required. Nevertheless, procurement might be a smarter way to deploy an offset strategy while minimizing the required investment and associated risk.
As those countries develop, they will create undoubtedly create low cost offer for airplane as in China for single aisle aircraft but the technological lead will preserve the western manufacturer.
Challenges are on the way…
It all starts with procurement alignment of Business development function to identify top target countries to focus the sourcing effort. It require a long term view on critical country which might be sometime challenging if the business development is too focused on tactical business winning on incumbent customer and lack anticipation for future area of growth. The list of target countries needs to be revisited on a yearly basis to refocus on changes growth area. For example, as Time magazine suggest, the growth is moving from the BRICS (Brazil, Russia, India, China, South Africa) to PINES (Philippines, Indonesia, Nigeria and Ethiopia) so should be moving the sourcing focus. While a proactive approach is always desired, a reactive and agile mechanism might need to happen when game changer occurs. Such game changers can be geopolitical like Ukraine recent issue or simply natural catastrophe like the Japan’s tsunami.
Supplier relationship and supplier development at the heart of offset strategy
On its side, Procurement needs also to secure resource to fund and allow sourcing manager and multifunctional team to visit and assess it first tiers suppliers.
Secondly, procurement needs to have the right skills in term of supplier development to mitigate risk to go beyond the classical quality audit and preform proper industrial assessment. While quality audit are pass or fail oriented, an assessment stems from a different philosophy where the supplier is treated as a partner to set up a clear action plan. Assessment need to adopt holistic methodology to review not only procedures and process but also people skills and organisation.
Supplier relationship is key, supplier top management need to be fully on board and support a successful completion of the action plan. To strengthen the relationship a local presence is mandatory to overcome the cultural difference like in China where business practices and culture are different or to protect production like for the impact of employee exodus for the Chinese New Year. In some case, this might involve some funding to develop key supplier capability for long term benefit like non quality cost reduction.
Procurement needs also to take on board its first tier supplier in order to flow down to their second and third tiers suppliers. Procurement would create opportunity by influencing rather than imposing, the supplier relationship is a key asset there. The supplier would benefit in this through cost reduction opportunities and compliance to its customer offset requirement improving its competitive advantage. This flow down process is important toward low cost country or hedging country and the same goes for offset.
Supplier might be competitive and offset appealing but not at an operational level. Indeed, as difficulties arise along the project, offset might ruins saving benefits or compliance to offset requirement might disappear. As projects typically have tight schedule, the Procurement Manager could be faced with challenging… Nevertheless, as offset is a typical requirement in the aerospace and defense sector, Procurement Managers have an excellent opportunity to partner with business development to demonstrate its impact on the company long term top line.