Supplier Selection And Evaluation Through Activity-Based Costing Approach

Brain Korea 21 Logistics Team Industrial Engineering / Pusan National University

Author : Han Lee

(Economic System Analysis Lab., Industrial Engineering, Pusan National University)

Thesis supervisor : Prof. K.K. Lee

(Economic System Analysis Lab., Industrial Engineering, Pusan National University)

Abstract
Purchasing from supplier involves many kind of significant costs for purchaser. Purchasing decisions related to theses purchases include the selection of supplier, order quantities to be placed and etc. Such decisions are very much complicated due to the fact that various criteria must be considered in decision making process. This paper deals with supplier selection and determination of order quantity by Activity-Based Costing(ABC) and Total Cost of Ownership(TCO) concept, which explain the cost caused by supplier more accurately than traditional cost accounting

Supplier Selection and Evaluation through Activity-Based Costing Approach

Contents
Abstract 2 1 2 2.1 Introduction . ..4 An integrated method for supplier selection . 5 Criteria for supplier selection 5

2.2 Activities and cost drivers and other costs analysis .. . .6 2.3 3 4 A mixed integer programming model . . . 6 Supplier performance evaluation . . 8 s A numerical example . . 9

5 Conclusions ..12 6 Reference . . . .13

BK21 Logistics Team, July 2000

Introduction
In most of manufacturing firm the cot of raw materials and component parts constitutes the main cost of a product, such that in some cases it can account for up 70%. In circumstances the purchasing department can play a key role in cost reduction, and supplier selection is one of the important functions of purchasing management. The Supplier selection decisions determine how many and which suppliers should be selected as supply sources and how order quantities should be allocated among the selected suppliers. These supplier selection decisions are complicated due to the fact that various criteria must be considered in the decision making process. Traditional supplier selection and evaluation methods are all too often based on quoted price, which ignore the significant costs associated with ordering, expediting, receiving, inspecting, and using purchased parts and materials. A number of alternative approaches for traditional supplier selection methods have been suggested to take these other cost of factors into account. The widely used approach is Weighted Point Plan. This approach uses a simple scoring method, which heavily depend on human judgments. The simplest method is the Categorical Method, which assigns either good(+), neutral(0), or unsatisfactory(-) to each defined criteria for all suppliers, then a total rate for each supplier is calculated[Timmerman,1983]. The Analytical Hierarchy Process(AHP) is other method which uses pairwise comparison and it was applied by Narasimhan(1983) Recently Weber and Current(1993), Akinc(1993), Lee and Kasilingam(1996), Ghodsypour and OBrien(1998), and Karpak et al(1999) suggested various mathematical programming approaches as mixed integer programming and goal programming, which used various supplier performances criteria as quality, delivery, flexibility and so on. The above methods use various criteria, but not consider that how much impact poor performance of supplier and supplied components and materials for the purchaser. In this paper we use Activity-Based Costing(ABC) approach and Total Cost of Ownership concept to objectively analyze all costs associated with ordering, expediting, receiving, inspecting, and using purchased parts. And we apply a mixed integer programming, which use the result of the above ABC analysis, to select appropriate suppliers and to determine the order quantities for selected suppliers

Supplier Selection and Evaluation through Activity-Based Costing Approach

An Integrated method for supplier selection

Traditional supplier selection and evaluation methods are all too often based on quoted price, which ignore the significant costs associated with ordering, expediting, receiving, inspecting, and using purchased parts and materials. These added costs are ignored for many reasons, but mainly because of the shortcomings of traditional accounting systems and the performance measures that flow from them[DeRose, 1990]. The costs of acquiring and using the component can also be significant. For example estimates that 50 percent of a firms nonconformance costs are caused by the extra work involved in disposing of repairing, scrapping, or reworking defective purchased materials. These nonconformance costs also include costly schedule change and downtime caused by nonconforming supplies and materials. When all these factors are taken into account, supplier linkages have a greater effect on total cost than the manufacturing process itself. Traditional manufacturing cost systems, however, track only the purchase price associated with a particular part number or supplier : they bury the cots of ordering, expediting, receiving, inspecting, and using purchased goods in factory overhead accounts or general manufacturing expenses by obscuring these additiona l costs, accounting systems encourage purchasing managers to select the lowest bidders to avoid unfavorable purchase-price variance, even though the lowest bids may no represent the best overall value in terms of cost, quality, and delivery. At the same time, management loses valuable information for evaluating supplier performance. ABC is a management accounting methodology that aims to assign costs to the activities that generate the costs. TCO focuses on the true costs associated with the entire purchasing cycle, thus TCO considers all costs associated with the acquisition, usage, maintenance, and follow-up of purchased goods or service, not just the purchasing price.
The model presented in this paper applies the above ABC methodology and TCO concept to suggest a better and more objective method for suppliers selection and evaluation

2.1

Criteria for supplier selection

In this paper we use both financial and non-financial criteria. While financial criterion is the price, non-financial criteria are quality, delivery, quantity, and service & communication. We use performance measures to valuate the performances of supplier for the criteria in following Table 1: Table 1. Criteria and Performance Measures Criteria Financial Price Quality Nonfinancial Delivery Quantity Service & Communication Performance Measure Amount of purchased item Number of trouble due to quality problem Number(Days) of late or early delivery Number of trouble due to quantity problem Service & communication problem

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2.2

Activities and cost drivers and other costs analysis

In this section we analyze activities, cost drivers, and other costs caused by the poor performance of supplier for the above criteria. For example, a delivered part that does not conform with quality standards causes a production stop, return or rework and so on. The inferior part used should be replaced by the supplier when delivering the next order. The results of this analysis are given in Table 2. But, It is possible that each purchaser has different activit ies, cost drivers, and other costs. For this reason we suggest the most general activities, cost drivers and other costs Table 2. Activities, Cost Drivers and Costs caused by Poor Performances of Supplier Performance Criteria Activity / Cost Driver -Return or rework -Rescheduling or planning -Reordering -Repackaging -Re-receiving -Additional inspection -Production stopping(set-up) -Disposing of scrap -Follow-up or expediting activity -Rescheduling or planning -Premium transportation -Production stopping Costs Caused by poor performance -Cost of carrying excess inventory due to their unreliability -Cost of train supplier in quality methods -Lost sales

Quality Problem

Late Delivery Early

-Lost sales -Cost of carrying extra inventory

-Holding & Administrative -Inventory holding cost activity -Additional reception -Additional set-up -Rescheduling and planning -Additional inspection -Reordering -Information exchangeability

Quantity Problem Service & Communication Problem

-Lost sales

-Cost of delays due to slow response to problem

2.3

A mixed integer programming model

Based on the above activity analysis, the supplier selection problem can be formulated as the following mixed integer programming model.

Min z =
s.t
j =1

i =1 j =1

1 2 Pij X ij + n1i1 j1 k1Yij Fnij Anjik + n1i1 m1 j1Yij Fnij Dnijm Anijm + n1 1C nijYij + j1 Z j S j = = = = = = = = = i = j= = 5 I J K 5 I M J 5 I J J

X ij Qi

for i = 1,2,3,...., I for i = 1,2,3,...., I

(2.1) (2.2)

j =1 ij

Y 1

Supplier Selection and Evaluation through Activity-Based Costing Approach

X ij Vij X ij MYij
i =1 ij

for i = 1,2,3,....., I , j = 1,2,3,..., J for i = 1,2,3,....., I , j = 1,2,3,..., J , M is a arbitrary large number for j = 1,2,3,...., J for i = 1,2,3,....., I for j = 1,2,3,..., J for i = 1,2,3,....., I , j = 1,2,3,..., J for i = 1,2,3,....., I , j = 1,2,3,..., J for j = 1,2,3,..., J

(2.3) (2.4) (2.5) (2.6) (2.7) (2.8) (2.9) (2.10)

J j J

Y MZ j Zj W

Yij wi

j =1

X ij 0 Yij = 0 or 1 Z j = 0 or 1

i, j
n k ,m

: i is item index (i = 1,2,3..., I ) and j is supplier index ( j = 1,2,3 ..., J ) : Criteria index (1:quality, 2: late delivery, 3:early delivery, 4:quantity, 5:service) : k & m are Activity 1,2 index ( k = 1,2,3,...K ) , ( m = 1,2,3 ..., M ) : Price of item i from supplier j : The quantity of performance measure of criterion n for the item i from supplier j : Qi is demand for the item i, V ij is Supply capacity of supplier j for the item I : Order quantity of supplier j for the item i : =1 , if supplier j is selected for supplying item i, 0, otherwise : =1 if supplier j is used at all, 0 otherwise : The cost of activity k caused by performance n of supplier j for the item i (Superscript 1 means activity 1 is an activity that uses performance measure as a cost driver) : The cost of activity m caused by performance n of supplier j for the item i (Superscript 2 means activity 2 is an activity that does not use performance measure but others as a cost driver) : The cost driver of activity m caused by performance n of supplier j for the item i : The other cost caused by performance n of supplier j for the item i : Supplier j sustaining cost : The maximum number of supplier for item i : The maximum number of supplier

Pij Fnij
Qi ,Vij

X ij Yij Zj A1 nijk
2 Anijm

Dnijm C nij Sj
wi

The objective is to minimize the sum of purchasing cost and additional activities costs caused by supplier, other costs, and supplier sustaining cost. Additional activities costs consist of two costs term. The first is costs of activities use performance measure as cost driver and the second is not. Supplier sustaining costs are associated with a given supplier that are independent of the quantity and include maintaining files on supplier characteristics and performance, and periodic evaluations of supplier performance.
Equation (2.1) represents the demand constraint for each item. Equation (2.2) requires that all items be supplied. The capacity of items from various suppliers is modeled in equation (2.3). Equation (2.4) represent a supplier is selected before orders are placed, (2.5) require items to be supplied only

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from the selected suppliers. The maximum number of suppliers to be employed for each item i s represented by equation (2.6). Equation (2..7) represents the maximum number of suppliers to be employed. The non-negativity and integrality restrictions are represented by equation (2.8), (2.9) and (2.10).

Supplier Selection and Evaluation through Activity-Based Costing Approach

Suppliers performance evaluation

In the previous sections we use various factors to select appropriate suppliers and order quantities. Because the values of these factors are estimated to compute the degree of impacts from poor performances of supplier, the values of these factors are different from the actual values. In this section we analyze the variances between the estimated and the actual value. There are several advantages to analyze the variances with ABC and TCO concept, not only for the purchaser but also for the supplier. For the purchaser the ABC and TCO allow to identify the relative importance of the different cost components and to give the useful information about cost reduction. That is, the purchaser may attempt to influence estimated units of cost drivers by reducing or eliminating some of the activities. For the supplier it provides an objective indication about the degree of affection that caused by her own poor performances for the various criteria, and the importance of the different criteria involved in the supplying process. For example, in Table 3 we present Cost Driver Rate variance and Cost Driver Frequency variance of quality performance for item i. The Cost Driver Rate variance refers to factors that allow the purchaser to improve its efficiency by reducing its cost driver rates. The purchaser is responsible for this variance. The Cost Driver frequency variance refers to the difference actual and estimated use of cost drivers (performance measure) for which the supplier is responsible since he can potentially affect the cost drivers.

Table 3. The Variances of quality performance for item i Cost Driver Rate Variance : ACD (ACDR- SCDR)
jTi

F1ij

A A ( A11ijk A11ijk ) + jT F1 ijA D1A ( A12ijm A12ijm ) ijm k k m

i

Cost Driver Frequency Variance : SCDR (ACD-SCD)

jTi k

A11ijk ( F1ijA F1ij ) + j A12ijm ( F1ijA D1A F1 ij D1 ijm ) ijm m T

i

(A is actual and S is Estimated standard, CD is a number of cost driver, CDR is cost driver rate) * Ti is a set of suppliers for item i

Together with the above variance analysis, we can evaluate the suppliers performance by calculating the rate of suppliers for each criterion, which can be used to reflect suppliers performance in next purchasing decisions. A Supplier Rating Index(SRI) for the supplier performance is calculated as follow : (Actualactivity cost - Estimated standard activity cost) Estimated standard activity cost for supplier Then we can modify the objective function as follow considering this SRI : SRI = 1 +
i =1 j =1

2 Pij X ij + n1 i1 j1 k1Yij Fnij A1 SRI nij + n1 i1 m=1 1Yij Fij Dnijm Anijm SRI nij + n1 j1C nijYij + 1 Z j S j njik = = = = = = j= = i= = j= 5 I J K 5 I M J 5 I J J

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A numerical example
An example problem with solutions is presented in this section to illustrate the model for supplier selection. The demand for the three items and the selling pric es and capacities of suppliers for the three items, and the supplier sustaining cost for the four suppliers are given in Table 4. The supplier performance associated with the criteria for the three items are given in Table 5. Table 7 represents activities costs. The results are summarized in Table 8 and the variances are summarized in Table 9. Table 4. Price, Capacity, Demand for Item i & Supplier Sustaining Cost Item 1 Supplier 1 Supplier 2 Supplier 3 Supplier 4 Total Demand Item 2 Item 3 Sustaining Cost($) 14 9 14 7 500 550 280 8 500 250 270 300 9 16 16

Price($) Capacity Price($) Capacity Price($) Capacity 10 8 9 300 310 270 8 7 300 230

Table 5. Estimated Standard(Actual) Supplier Performance for Item i

(unit: Frequency)

Supplie r 1 Performance Item1 Item2 F1 F2 F3 F4 F5 3(5*) 17(15) 8(5) 9(10) 12(8) 7(7)

Supplier 2 Item1 Item2 18(15) 2(2) 17(16) 13(13) 4(6) 4 6 9 7 6 Item3 15(12) 16(15) 5(7) 4(6) 6(3)

Supplier 3 Item1 18 3 11 19 3 Item3 4 14 18 9 6

Supplier 4 Item2 5(5) 7(8) 6(4) 13(13) 1(1) Item3 12(12) 13(15) 14(15) 10(10) 3(3)

15(12) 14(13) 2(5) 5(3)

(* is actual) (F1: quality problem, F 2:late delivery, F3:early delivery, F4:quantity problem, F 5:service problem)

Table 6. Other Cost caused by Poor Performance (unit:$) Item 1 C1 C2 C3 15 18 21 Item 2 26 16 14 Item 3 25 17 19

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Supplier Selection and Evaluation through Activity-Based Costing Approach

C4 C5

31 24

26 15

23 29

Table 7. Estimated Standard(Actual) Activities Costs caused by Poor Performance of Supplier for Item i Supplier 1 Activities k=1
1 A1k

Supplier 2

Supplier 3

Supplier 4

Item 1 20(18*) 24(22) 15(19) 19(19) 26(29) 3(5) 12(14) 12(12) 19(20) 12(10) 9(10) 16(15) 15(11) 11(10) 5(10) 8(10) 14(13) 17(20) 22(20) 22(22)

Item 2 Item 1 Item 2 Item 3 Item 1 Item 3 Item 2 Item 3 26(22) 14(14) 15(15) 23(23) 22(20) 7(7) 11(15) 13(13) 17(12) 20(20) 17(17) 13(10) 15(15) 19(19) 13(13) 18(18) 22(20) 20(23) 16(16) 16(16) 27(22) 19(20) 22(20) 12(14) 15(18) 11(10) 14(19) 22(20) 9(10) 12(11) 17(13) 14(13) 21(18) 8(10) 7(11) 15(17) 12(15) 13(15) 18(15) 15(15) 9 19 22 19 26 7 10 15 18 28 24 16 13 19 28 14 12 7 17 17 7(7) 8(8) 8(17) 12(12) 15(15) 11(11) 11(9) 7(7) 5(8) 9(9) 11(10) 14(14) 20(20) 12(12) 4(4) 11(11) 13(13) 21(27) 23(23) 7(7) 12 28 14 18 16 10 8 17 18 7 12 16 11 7 7 8 21 29 24 22 12 13 8 19 28 6 9 8 7 13 13 19 12 7 5 9 15 13 7 11 16(16) 12(12) 21(20) 27(25) 21(21) 7(7) 11(11) 13(13) 8(8) 22(22) 26(30) 11(8) 15(11) 25(29) 14(14) 18(17) 20(20) 17(26) 17(17) 21(21) 10(10) 9(6) 7(7) 5(20) 19(19) 9(11) 10(10) 7(9) 4(6) 13(13) 10(15) 10(10) 10(15) 13(11) 3(3) 11(11) 17(17) 15(15) 20(24) 7(7)

2 3

2 A1m

m=1 2 k=1 2 m=1 2 k=1 2 m=1 2 k=1 2 m=1 2 k=1 2 1

A1 2k

2 A 2m

1 A3k

2 A3m

A1 4k

2 A 4m

1 A5k

2 A5m

(unit:$) (* is actual activity cost)

Table 8. Results of Example Problem Item 1 Item 2 Item 3 Supplier 1 Supplier 2 Supplier 3 Supplier 4 BK21 Logistics Team, July 2000 280 230 11 190 310 270 200

Table 9 . The Variances Item 1 CDR Var. Quality Late Delivery Early 30 77 174 230 1 162 U Total Var. 234 F U U F U F CDF Var. 75 F Item 2 CDR Var. 85 8 33 F F F CDF Var. 123 192 148 94 104 415 F 536 F U F F F F (unit : $) Item 3 CDR Var. 48 135 143 82 30 342 U 191 U
(F: Favorable, U: Unfavorable)

CDF Var. 186 33 F U

F U U U U

116 F 220 F

151 U 4 153 151 F U F

Quantity Service

156 F 171 396 F U

13 F 18 121 F U

Table 10. The SRI of Supplier for Item Supplier 1 Performances F1 F2 F3 F4 F5 I1 I2 Supplier 2 I1 I3 Supplier 4 I2 I3

1.107 1.057 0.841 0.916 0.959 0.863 0.958 0.656 1.013 0.96 1.142 1.403 1.32 0.967

0.552 0.954 0.809 1.374 0.639 0.862 0.889 1.259 1.5 1.03

1.868 0.635 1.107 0.559 1.164 1.095

In Table 9, because of better performances of suppliers the total variance is favorable for item 1 and because of the efforts of cost reduction of purchaser and bette r performances of suppliers the total variance is favorable for item 2 and cost driver rate variance of item 3 is unfavorable by reasons of inefficiency of purchaser. Table 10 represents the SRI of each supplier for item.

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Supplier Selection and Evaluation through Activity-Based Costing Approach

Conclusions
In this paper we proposed an Activity-Based Costing approach and Total Cost of Ownership concept to objectively analyze all costs associated with supplier and supplier components and materials. And we apply a mixed integer programming, which use the result of the above analysis, to select appropriate suppliers and to determine order quantities for selected supplier. The proposed method will help to make better supplier selection decision resulting in decreased overall costs. Own approach will give the purchaser useful information for possible cost reduction and give an objective indication about the degree of affection that caused by own poor performances for the various criteria.

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References
Akinc, U. (1993), Selecting a set of vendors in a manufacturing environment, Journal of Operations Management, 11, pp.107-122 Ghodsypour, S.H, and O Brien, C. (1998), A decision support system for supplier selection using an integrated analytic hierarchy process and linear programming, International Journal of Production Economics, 56-57, pp.199-212 Karpak, B. and et al. (1999), Multi-Objective Decision-Making In Supplier Selection: An Application of Visual Interactive Goal Programming, The journal of Applied Business Research, 15, 2, pp.57-71 Kasilingam, R.G., and Lee, C.P (1996), Selection of vendors-A mixed integer programming approach, Computers & Industrial Engineering, 31,1/2, pp.347-350 Narasimhan, R.(1983), An analytical approach to supplier selection, Journal of Purchasing and Supply Management, winter, pp. 27-32 Timmerman, E.(1986), An approach to vendor performance evaluation, Journal of Purchasing and Supply Management, winter, pp. 2-8 Weber, C.A., and Current, J.R (1993), A multiobjective approach to vendor selection , European Journal of Operational Research, 68, pp.173-184

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Supplier Selection and Evaluation through Activity-Based Costing Approach