Irrespective of the industry sector, the size of an enterprise or the maturity of the procurement discipline, realizing cost savings will always be one of the most important objectives of the procurement function. This is hardly a surprise. In most organizations the percentage of revenue that is spent on procurement has grown to 50-70%, depending on the type of business. The most important reason for this growth is the continuing trend of outsourcing tasks that were formerly performed within the organization. Another lasting trend is the procurement function becoming responsible for commodities that were traditionally outside of its compass of responsibility, like business travel, insurances, marketing and communication, professional services, etc. Hence, procurement has a huge impact on the profitability of a company. For large organizations a reduction of maverick buying between 5-10% can easily generate millions of dollars of savings. Cost control is an important shared responsibility of both procurement and finance. Especially in this area, both disciplines must be aware of each other’s frame of reference. Finance professionals are more often than not focused on costs and assume that reported savings translate immediately into a decrease of costs. That may seem like a logical conclusion, but we will see below that this will not always be the case. With procurement savings it is sometimes difficult to distinguish apples from oranges.
Next to helping to improve profitability there are other reasons for measuring and reporting procurement savings.
- Continuous improvement. Measuring is knowing. Insight into price trends and the extent to which procurement knows how to deal with them throws light on deviations from the planned results and makes it easier to take measures to deal with undesired consequences.
- Demonstrate added value. Given the impact of procurement on the profitability of an organization and ,therefore, on its right to exist, it is only logical that proving the contribution to effective cost control is important in showing the added value of the procurement function.
- Improve credibility. Procurement is characterized by relationships with all disciplines within an organization and can only be successful when it cooperates appropriately with these disciplines. A good track record in cost savings improves the credibility of procurement and helps procurement get involved early in new initiatives that will lead to new spending.
- Motivation. Provided that an organization is capable of linking realization of cost savings to the right KPIs, it can be a good way to motivate buyers.
Types of savings
From a procurement perspective there are three areas to look for cost savings. These are represented by the three sides of the triangle shown in figure 1: the demand side, supply side and total cost side.
Figure 1. The sourcing triangle (© Capgemini)
Purchase Demand Management
The easiest way to achieve cost savings is to decrease the demand. This can be done in three ways.
- Reduce consumption. An obvious though seldom asked question: “Do we really need this?” Every organization has purchased goods that they could do without. This often arises in times of economic growth and stops when the situation becomes less positive. Good examples are forbidding business class flights and the reduction of air travel by deployment of video conferencing.
- Consolidation of spend. A widespread cause of hidden costs is needless specification, where a harmonization of specifications (one size fits all) could lead to attractive savings. Well-known examples of this are mobile phones, laptops and lease cars.
- Improvement of specification. Technicians are a particular group who is often striving for perfection and thus, look for the most beautiful, but often most expensive solution, while another less expensive option would be suitable (fit for purpose).
Supply Base Management
The supply side is traditionally associated with procurement. This is all about how to use suppliers to save costs.
- Restructuring supplier relationships. How can we get more value from our relationships with suppliers? It is possible to gain additional cost advantages by intensifying the collaboration with suppliers, starting up partnerships and striving for a sustained cooperation.
- Increase competition. This is the opposite of restructuring supplier relationships. The competition between potential suppliers is stirred up in order to achieve favorable conditions.
- Restructure supplier relationships. Depending on the characteristics of a commodity, cost advantages can be obtained by sourcing from low cost countries or by spreading the total demand for a certain product over multiple suppliers, causing continuous competition.
Total cost management
Decrease of demand or reduction of direct purchase expenses are obvious ways to realize savings. It is also possible to assess the total costs related to the acquisition of products or services (Total cost of ownership, TCO). This might offer different opportunities such as the following:
- Optimization of total supply chain costs. This is an area that has expanded enormously over the last 30 years, led by the Japanese, with the introduction of methods like JIT, Kanban and Kaizen.
- Reduction of total life cycle ownerships costs. This involves the assessment of additional costs next to the product price. Examples of this are special tooling that must be developed like moulds. Is there a possibility to buy a standard product instead of developing a unique part. Would it be better to lease a product rather than buy it? Can we share ownership of an installation with other parties?
- Reduction or elimination of transaction costs. Costs that may easily be overlooked are the costs related to the process of ordering, receiving and paying for purchases. Examples of ways to limit these costs are vendor managed inventory, electronic ordering and invoicing and the usage of P-cards.
From the presented overview of types of savings it is clear that cost savings cannot be measured using one standard formula. A related issue is that procurement is not an isolated discipline but, instead, operates in cooperation with other disciplines on which it is partially dependent. This complicates both measuring and gauging the value of savings. A third issue is the definition of ‘saving.’ When is it fair to claim a procurement saving? Here are some examples to illustrate why discussion may arise between procurement and finance about the legitimacy of reported savings.
- Procurement has been able to negotiate lower prices for a specific commodity. However, in the next period there is a higher demand for this commodity. Despite the lower unit price the overall expenses for this commodity rise. (The opposite situation is also possible: a price increase combined with an easing of demand leads to a reduction of expenditures).
- There is a need for new products or services. A buyer starts a tender process based on business requirements. Through negotiations with the supplier with the most attractive offer economically, the buyer is able to obtain an additional discount of 10 %%. The formula applied to calculate the procurement saving is the average price of all received quotes minus the negotiated contract price multiplied by the real number of items bought in a certain period. This is a common practice, but expenses will increase despite a reported saving.
- A buyer is responsible for a volatile commodity. In a specific period there is a price rise for this category of 25 %. Through excellent negotiation the buyer is able to limit the price increase to 15 %. He reports a saving of 10 %, being the difference between the two %, although the real expenses rises by 15 %.
- A sourcing project leads to an adequate savings number. This is counterbalanced by the disproportional usage of hours and other means to achieve the savings number.
- A sourcing project delivers an adequate savings number. At the same time, an increase in costs is detected as a consequence of late deliveries, bad quality of goods delivered, etc.
Effectively measuring and reporting
Based on the information above, some may believe that it is impossible to register savings in a proper way. This is not correct, but it does require a proper approach and clear choices. This approach consists of three parts.
Determine method and framework
There must be agreement on the types of savings that can be claimed (see figure 1). Since these types are very different, it is important to determine how savings will be calculated. This concerns both the formula for calculation and the starting-points that are applicable. For example, the index figures or benchmark data that may be used, the starting-point for savings to followe or the level on which calculations are measured. Do we measure per product or category of products? Are savings realized per month, quarter, calendar year or contract period? It must also be clear how savings will be documented and validated. Since sourcing projects are often executed by interdisciplinary teams, there must be an answer to the question of which party is allowed to claim savings. If R&D proposes a simplification in the specification of a component which leads to a saving, can this then be claimed by procurement? It does not really matter if the answer to this question is yes or no, as long as it is clear which choice has been made.
Identifying and quantifying saving opportunities
Cost savings initiatives must be based on a solid spend analysis. This serves as a starting-point for identifying saving opportunities and as a benchmark to verify claimed savings. In this analysis different kinds of data are gathered:
- Number of suppliers
- Spend per supplier
- Spend per cost center and G/L account
- Comparison of measured values with benchmarks
The identification of saving options is done per commodity and preferably in interdisciplinary teams to ensure involvement of the different stakeholders. Identified alternatives are analyzed to determine the savings potential (quantitative) and impact (qualitative). The outcome of the analysis is used to set priorities and to decide on the implementation of saving initiatives.
Implementing and securing savings
It is impossible to describe a uniform method for the implementation of a saving, because it is dependent on the type of saving. What matters is that a savings opportunity is really turned into a reduction of expenses. After all, good intentions alone will not bring results. It will only be significant if intentions are converted into concrete action. A last attention point is the relevance of evaluating a savings initiative to determine if the objective has really been achieved. This can best be done by conducting a new spend analysis, an analysis that can also bring new saving options to light.
To conclude, it is important for the sake of credibility to report the good as well as the bad. We consistently speak about savings, but unfortunately it is not always possible to avoid price-rises. A correct, complete report which gives a clear insight into the performance of the procurement function will enhance the esteem and trust of the management.