As the frenzy escalates to junk old systems or transform software into Internet-based e-commerce applications, who will benefit from an enormous opportunity to cut previously untouchable information costs now embedded within the existing value chain? Costs will be cut when the dynamics of purchasing decisions shift from supplier-to-supplier bargaining to centralized management of the entire procurement process through e-commerce applications that link the production systems of millions of suppliers without intervention by brokers, dealers, wholesalers and promotion agents.
Nevertheless, whenever predictions of huge savings call for a CFO to write a multimillion-dollar check, an IT executive may boost his standing by offering clues for where the profits may end up after the business-to-business e-commerce revolution settles down in the near future.
It's difficult to find authoritative estimates that quantify the cost savings that e-commerce generates. I was intrigued to read (Fortune, March 20) that Delphi Automotive, Owens Corning and United Technologies saved $60 million, $9 million and $32 million, respectively, by purchasing components, packaging materials and circuit boards on the Internet. Such savings -- ranging from 9% to 43% -- are difficult to conceive if one considers that suppliers of industrial goods already suffer from very slim profit margins. The huge savings must come from something else!
An Examination
Looking for clues, I examined the financial databases of more than 10,000 U.S. industrial suppliers and analyzed their cost structures. Since suppliers of finished goods, in turn, depend on other suppliers, I was able to construct a simplified financial model of the median costs of the supply pipeline. It offers an explanation of where the money is spent:
In the chart, 100% of the value-chain contribution equals the price charged by a typical manufacturer. At each step in the chain, each supplier spends money for materials, labor and logistics. Then, each succeeding supplier adds overhead (information costs) then tags on profit. Therefore, for example, the "other suppliers" contribute 15% to the value chain and "secondary suppliers" contribute the difference between 33% and 15%, until it all adds up to 100%.
At each stage, a firm adds information expenses for sales, marketing, administration, research and development and IT. These costs, averaging 15.9%, are included in the manufacturer's sales price, thus taking a big chunk out of the manufacturer's value added of 44% of revenue (the difference between its 100% and the 56% paid to "prime suppliers").
The suppliers also contribute their shares of information costs to a product's final sales price. All told, the information costs at each of the four stages add up to 34.5% of a product's price, which sticks out as the largest cost-cutting target for boosting profits.
What does this mean for the CIO? It's imperative that he begin to analyze the total costs of delivering information within the entire value chain before launching an e-commerce project. Remember that whomever has the power to extract value chain savings and add to profits will see the greatest benefits.
Strassmann can be reached at paul@strassmann.com. This is the first in a series of articles in which he will analyze the costs of processing information from a raw materials supplier to the consumer.