1. Importance of Cost Savings
I am sure that you would agree with me that procurement cost savings is the main KPI (Key Performance Indicator) for any procurement department. Understandably, procurement professionals focus on this one main performance indicator.
There is a lot of evidence of procurement focus on savings
As per the recent survey conducted by Deloitte, 79% of CPO’s (Chief Procurement Officer) indicated that procurement saving is their top priority. 57% said that managing risk is their key KPI. The results make sense because priorities are very dependent on the industry and the maturity of procurement in the company. However, all CPO’s must focus on all the four areas mentioned below.
I would argue that a sole focus on procurement cost savings is not a good strategy in the long-term. The key to procurement success is the ability for procurement to better stakeholder engagement. If the stakeholders are engaged, procurement savings will follow.
There are multiple reasons procurement cost savings is the main focus of the department
Easy to track
This is the most objective and easy way (if done right) of measuring procurement performance. Also, this is the primary mission of the procurement department in most companies. So no doubt this is a highly visible and tracked procurement performance indicator.
It has a direct impact on the bottom line as compared to other metrics like risk mitigation. I am not saying risk mitigation is not important, but most people only understand the value when the risk really occurs. It is like car insurance, you only understand the value when you need it.
Depending upon the industry, cost savings could be a major lever that senior management can use to drive higher EBITDA margins.
2. Cost Savings and Cost Avoidance
No discussion about cost savings is complete unless you differentiate between cost savings and cost avoidance. Procurement should be tracking both cost savings and cost avoidance to better understand the total value delivered by procurement.
As per CIPS.org (The Chartered Institute of Procurement and Supply
“Cost avoidance is a reduction in cost resulting in a spend that is lower than would otherwise have been if the cost avoidance exercise had not been undertaken.”
Cost avoidance is also called “Soft savings”
Let’s take an example: You are currently paying $10,000 for a BI tool yearly subscription. The vendor sends you a renewal contract which includes a 10% increase from the previous year. You use your negotiation prowess to avoid the 10% increase in the cost, maybe by signing a long-term renewal contract.
So you avoided an increase in cost and that is an example of cost avoidance.
Cost savings, on the other hand, is tangible or also called ‘hard dollars’. CIPS refers to this as cash releasing benefits.
Let’s take an example.
You currently purchase printing paper from a supplier at $30 per case and you purchase 1000 cases annually. Assume nothing else changes, print volume etc. So the total annual cost in this case is $30 *1000 = $30,000
As a result of a sourcing event, you were able to reduce the cost from $30 to $28 a case, a 6.6% reduction in cost.
Now the total annual spend is $28*1000 = $28,000, resulting in savings of $2000 per year.
A common argument is why cost avoidance shouldn’t be measured as savings. There are two views on this
Before I get into how the finance department views procurement cost savings, let’s look at how finance departments prepare their budgets.
There are generally two common approaches for preparing the budget, Zero cost budgeting, and Incremental budgeting
If the finance department is using incremental budgets, they generally take last year’s budget and add increments wherever they have visibility. For example, yearly merit increases and benefits cost increase.
So in most cases, they might not include an increase in the cost of a product or service in the budget unless it is pre-negotiated in the contract.
Zero cost budgeting essentially needs the justification of each line in the budget and that might force the stakeholders to review whether an item is required or not.
In both cases, you have a yearly budget and in most companies, the budget is very granular and in some cases at a vendor level.
Now let’s take an example of the BI tool example where the vendor proposed a 10% price increase.
Finance has $10,000 in its annual budget for the BI tool so even though you negotiated the cost down, the budget is cost neutral. So it has no impact on the budget and hence it doesn’t impact the bottom line.
In contrast to that a scenario where you reduced the BI tool cost to $9,000 a year. This is a $1000 reduction as compared to the $10,000 annual budget and hence has a direct impact on the bottom line and this is considered “Cost Savings” or “Hard dollar savings”
Procurement stakeholders, on the other hand, have a different view of the value delivered by procurement.
Let’s take an example of the BI tool, if procurement was not able to negotiate the contract to be cost-neutral, the budget owner would have to either ask for a budget increase or cut cost in the discretionary spend to meet the budget targets.
So your stakeholders would appreciate the value-added whether it is cost savings or cost avoidance.
Should we measure and report Cost avoidance?
So the big question is whether procurement should report cost avoidance or not. The answer is, it depends. A CPO should consult with the CFO of the company on this and then decide whether to report to finance or not. In my view, you should track and at least report to your stakeholders on the value-add. Why should you still do it?
- It improves procurement team morale. No matter why the cost increase was not factored into the budget, the sourcing team is spending time on these initiatives. If the cost avoidance is not considered a value-add, it is demoralizing to the team because they feel that their works add no value.
No matter how proactive the procurement team is, you will have scenarios where the result of a sourcing event is cost avoidance.
- It helps to better summarize the total value delivered by the procurement team, especially when you are presenting procurement value-add to your stakeholders.
A tool like ProcureDesk can help you track Year on Year savings and track spend against the budgets.
No discussion about savings is complete without looking at different types of cost savings. The different type of cost savings is mostly from a finance view, the difference in how finance looks at savings. Also, these savings are cost savings and not cost avoidance.
There are two types of budgets in an organization
Simply put, a capital budget is to purchase assets. For example, the purchase of new machinery or a server. This is generally a below the line expense, it impacts company’s cash flow but it doesn’t impact EBITDA.
And the official definition as per Investopedia is “A capital expenditure is incurred when a business spends money, uses collateral or takes on debt to either buy a new asset or add to the value of an existing asset with the expectation of receiving benefits for longer than a single tax year”
This is the cost which a company incurs during the course of its day to day operations. For example, software maintenance, supplies etc. This is also called above the line expense and it impacts EBITDA or in others words, Company’s operating margins.
The official definition as per Investopedia is “Operating expenses, on the other hand, are expenses incurred during the course of regular business, such as general and administrative expenses, research and development, and the cost of goods sold.”
Here is a good comparison between Capex and Opex
Now since we understand the different type of budgets, let’s see how they relate to savings.
Capital cost savings
These are the savings negotiated towards the capital budget. The impact of these savings is generally on cash-flow but savings in the capital will help drive additional investment in capital assets which is a good long-term investment.
Opex Cost savings
There are saving reported towards Opex budget. Companies pay more attention to Opex cost savings because of its impact on EBITDA.
These are generally driven by favorable payment terms. For example, you Company moved payments terms for $100M in spend from NEt 60 to Net 90. That is a net gain of 30 days and you pick up a nice one time increase in cash flow depending on the timing of the change.
4. Cost Savings Framework – Different Techniques For Cost Savings
There are multiple ways for procurement professionals to approach cost savings. The first step is to create a savings framework. We will discuss a model proposed by Capgemini
There are 3 focus areas discussed in this model
A) Purchasing Demand Management
Purchasing demand management is focused on internal stakeholders and looks into better demand management and cost reduction. Let’s look at some examples
1. Consumption reduction
This is the most common case where operations can find out a way to reduce the consumption of the product. This could be because of
- Cost avoidance – why do we need this product?
- Demand reduction – overall demand reduction because of market conditions. Procurement has little influence over this.
- Efficiency – Operations is more efficient and waste is reduced.
2. Spend Consolidation
This is the most commonly used strategy for cost reduction. Let’s say you are purchasing 3 different type of laptops, one for executives, one for middle management for one for junior employees. This could be 3 different models.
You can reduce the cost significantly by standardizing to a common model and then leveraging volume discounts to reduce cost. Look for item standardization and savings will follow.
3. Improve product specifications
Improving product specifications can significantly reduce cost and often companies leave money on the table. Let continue with the example of the laptop.
Your IT team currently purchase a laptop which has the best specifications possible, including different types of ports, 5-year warranty, a longer battery life etc. With all these specifications, the cost increases. Granted, this is the best laptop you can get but do you really need 5 – 10 different ports on your laptop, do you really need 5 years warranty?
Asking these questions can lead to getting rid of unwanted specifications. With that, you not only get a cheaper product, it also makes the product a commodity. The simpler the specifications, more suppliers able to supply that.
B) Supply based management
Supply management is focussed on external stakeholders – suppliers. Let’s look at some strategies under this group
1. Increase competition
This is straightforward, find opportunities to increase competition which helps drive cost reduction. This goes hand in hand with an internal focus on standardizing the specifications.
If you have non-industry standard specifications, you have fewer suppliers. For example, if your stakeholder only wants to purchase a specific brand of laptop, then you have limited leverage but if that is not the case then you have more suppliers who can provide the product. More competition, better pricing. Make sure though that the vendor is qualified and meet your standard specifications.
2. Restructure relationship
This approach is focussed on increasing collaboration with existing suppliers to find opportunities for cost reduction. If your company has a strong vendor development program, then you are already doing this
Let’s say you purchase a widget from a vendor that is shipped in vendor standard packaging. You want to reduce the cost, so you work with your vendor to go to a cheaper packaging which still meets your key requirements.
This is a cost reduction for the vendor and cost reduction for you, a win-win scenario.
3. Restructuring the Supply chain
This approach needs a deeper engagement with the business to evaluate the supply chain for cost savings.
A common result of this approach is a low-cost country sourcing strategy
You might also decide that you probably want to move to a distributor model vs direct purchase from the manufacturer. Yes, you do have an additional cost but the cost savings come in the form of lower logistics cost and lower internal headcount.
All the above-mentioned strategies need a deeper engagement with your stakeholders.
C) Total Cost management
Techniques under this group are focused on reducing the total cost of ownership. Some of the techniques are
1. TCO Analysis
This includes looking at the total supply chain cost including the inventory carrying cost. The carrying cost could vary from 20 – 30% depending on the industry. An agile supply chain can not only lead to enhanced flexibility in meeting internal stakeholder demands but initiatives like Just in time (JIT) can lead to significant inventory reduction. JIT might not be for all companies but is worth an assessment.
2. Vendor Managed Inventory
Moving to a vendor managed inventory can free up your internal resources because forecasting and demand management functions are transferred to the supplier. The only caveat with this approach is that a vendor must have visibility into the demand forecast. That includes market condition changes or internal factors like sales promotions which could lead to a spike or slow down of inventory consumption.
3. Reducing Transaction Cost
Transaction costs are another factor to consider while assessing the total cost of management. For example, there is a transaction cost for issuing purchase orders and processing invoices. If you are purchasing materials from the supplier based on a fixed schedule, do you really need purchase orders or could this be handled more efficiently?
D) Cash Flow Savings
The savings in this area is primarily focused on working with your suppliers to manage the cash flow. Key techniques
1. Structuring payments to meet the cash flow requirements
Procurement can help structure the contract in a way that it helps companies meets its cash flow requirements. For example, quarterly payments vs a single annual payment for maintenance contracts. Another example is to structure the payments based on different milestones.
2. Extending payment terms
Another common technique is to extend payment terms. If you are just getting started, focus on your high spend vendors because that will give you the most boost in the cash flow. You can then work overtime to extend payment terms for the rest of your supply base.
5. Measuring and Tracking Procurement Cost Savings
Now let’s look at the most important aspect of cost savings, tracking it!
Few aspects to consider
Tools vs Excel approach
Whether you use a tool or Microsoft Excel to track savings, the important aspect is a discipline to track savings as and when they are realized.
If you already have procurement technology like spend analysis tools, you can add an additional module to savings tracking. The benefit of using a tool is that your team gets an integrated experience from saving opportunity identification to execution. Savings tracking becomes automated and you can be assured that all your savings are captured.
If you don’t have a spend analysis tool, you can create a simple Excel template. If you are looking for a simple tracker, you can download the procurement cost savings excel template.
Whether you use an excel template or an automated system, ensure that all team members have access to that.
What to track
There are a few important aspects of what you should always capture
- Department – So that you can report on savings by the stakeholder department.
- Spend type (Capex/Opex) – So that you can report on savings by spend type.
- Type of savings – so that you can report on the different types of savings. That typically includes Cost Savings, Cost avoidance, and Cash Flow (payment terms extension) savings.
The discipline of updating saving numbers
The procurement team should have the discipline to update the savings numbers every week or every other two weeks. Here is why
- When the CPO is looking for savings achieved to date, you are not scrambling to gather numbers. The number is always updated and readily available.
- The team can easily track how they are doing as compared to the savings target.
- As the department owner, you can be proactive if the team is not close to meeting the savings target.
- If a team member leaves, you are assured that their savings are captured in the tracker.
Reporting Procurement Savings
This is the most important aspect of procurement value add if management doesn’t see the impact of savings, the conversation may be similar to something like this
So needless to say that procurement should report savings in a way that it can be traced backed to the income statement. In this section, we will cover everything you need to know about procurement savings reporting
Whom to report
So the obvious question is to whom should procurement report the savings. First of all, it depends upon on procurement reporting structure in the organization and second the engagement level with the stakeholders. With that said, the following are the 3 most common stakeholders for reporting savings
1) Savings report for Stakeholder
Procurement should report cost savings to the individual stakeholders they support. This report, of course, is specific for each stakeholder. The key difference with this report is that it is focused on both cost savings and cost avoidance. Cost avoidance might not be a significant value-add for finance but this is definitely important in this report. In all, you want to want to show the value add by procurement and there is no better way to do this way then showing cost savings (both hard savings and cost avoidance).
2) Savings report for CFO
This is probably the fastest way to elevate procurement value add. CFO, of course, care about cost savings, so make sure you are presenting savings in a way so that it can be related to the Income statement. In this report, you might want to just focus on Hard Savings because that what finance cares about.
3) Savings report for COO/ Head of Department
If procurement is not reporting to the CFO office, then the savings report should also be presented to the COO or head of a department. In smaller organizations, COO might be more involved in operational savings and hence the need for spend reporting.
What to Report
Depending on the stakeholder, your reporting requirements might change, but the following are the common reporting metrics
1)Addressable spend and Savings
In this report, you are showing the impact of procurement on the total spend. Addressable spend refers to a portion of total spend a procurement team can address. The reason to show it this way is that most organizations measure procurement value-add on the total spend and that is not true.
Let me explain with an example
Company A has a total spend of $500M, procurement savings was $5M
So as % of total spend, procurement savings is 1 %. But is this a true picture?
In reality, it looks something like this
Of course, this is a hypothetical example but as you can see the impact varies based on what you consider as addressable spend.
2) Capex vs Opex
This is the most common view required from a Finance perspective. You should break up your savings report into Capex vs Opex.
The simplest way to do this is to maintain your savings by the type of project. Capex vs Opex and then it should be simple to report on this. For more on this see the reporting format section.
If you don’t know whether it is Capex or Opex, read the section above about type of cost savings. You can always ask your stakeholder or your finance team. Opex reporting is especially critical because it impacts EBITDA.
3) Savings by department: The title is self-explanatory. However, this report is important from two perspectives
Stakeholder view: From a stakeholder perspective, it is important for them to see the impact of sourcing on their individual department. So definitely sourcing should be reporting department savings.
Sourcing view: From Procurement/Sourcing team perspective, it is important to track savings by departments. Since savings is still a major indicator of performance, it is an easy way to see which departments are contributing to the total cost savings. It might not be a bad idea to do a Pareto analysis to understand effort and results. It is not uncommon to see that 20% of effort in a certain department is generating 80% of cost savings. You may also realize that in spite of your best efforts, certain departments are not generating any savings. Understand why that is happening and take corrective action.
A sample report is as follows
I am not saying that you should stop engaging with department/s with no savings, but that would help you with proper resource allocation. For example, you don’t want your top performer to be focussed on a department which doesn’t generate any savings.
How often should you report the savings? It is, of course, dependent on the stakeholder. Here are some recommendations
Your stakeholders are the different departments you interact with on a frequent basis. In this case, you might want to share the data every month. Some of you might have a concern that it might come off as bragging if you show up every month to talk about how much money you are saving. On the other hand, if savings are not significant, there is nothing to talk about.
That is why it is important that you don’t just talk about savings. You should be meeting key stakeholders to do an operations review. Things which should be covered in operations review
Inflight projects status and next actions.
Savings delivered to date- this should just be a quick update, but it is important to provide a snapshot of value-add. Keep in mind that you are reporting cost avoidance in this report. This is the total value add.
What are the key challenges at this time and how to address them?
Review of project pipeline so that you can align your resources.
2) Senior Management
It depends on company to company and how deep procurement is engaged in operations.
There should be a quarterly update of savings or every 6 months depending upon the management need.
Here the focus is on cost savings delivered vs. target and the type of savings. The other focus area is savings pipeline and the forecast for savings.
6. Reporting Format
Now since we have decided on what to report, let’s look at some most common reporting formats. There are mainly two different views in which management reports can be provided
A) Planned vs. actual
As the title suggests, this is planned vs actual savings. The planned comes from your annual savings planning exercise and the actual is the savings achieved to date.
To achieve this report, the savings pipeline should be broken down into quarters. For example, if your annual savings plan is $1,000,000 then your quarterly pipeline could be Q1: $300,000, Q2: 100,000, Q3: 250,000 and Q4: 350,000. The quarterly plan would like very different from industry to industry based on the spending cycle.
Having a savings pipeline not only helps to have a better visibility, but it also helps with better resource planning.
B) Different budget type
A very common senior management requirement is to see the savings impact by Capex and Opex. A simple reason for that is Opex impact EBITDA and Capex impacts cash flow. So management wants a pulse on the savings impact on the EBITDA quarter by quarter
Download the Savings Excel Template
C) Income statement view
Procurement is viewed as a cost center is most of the organizations and in many organizations, procurement is part of shared services organization, the reason for that grouping is that it a service required to run operations, for example, HR.
This reporting view presents procurement as profit center vs a cost center. Let me explain what that means.
A typical Income statement sheet looks like this,
Warning: Apologies to my accounting friends, I have simplified the statement just to explain the concept, So please don’t check this for accuracy!
Let’s assume there is no procurement department at this time and there is a potential to reduce the cost by having a strategic focus on cost reduction.
Now, in this case, let’s assume there is procurement department and procurement value add in this case is savings delivered. Assume that procurement was able to deliver 10% savings across the board. The cells highlighted in green means procurement was able to impact the spend. As research and development is mostly headcount in software companies, there is no impact on the savings.
Total savings added = Subscription ($50,000) + Sales and Marketing ($50,000) + General and Administration ($50,000) = $150,000
Now there are two ways of presenting these results
1. Increase in operating margin
As you can see in the example above, due to the cost savings, the operating margin increased from 16.67& to 21.67%. In this case, operating margins increased by 5%.
2. Increase in revenue:
This is little complicated, so let’s break this down
Assume there were no cost savings and the only way to increase the operating margin is to increase revenue. So you may argue that is this is not mutually exclusive, for increasing the operating margins companies look at increasing revenue and reducing cost.
You are absolutely true, I am just assuming that if the only way to increase margins was to increase revenue then what the case would look like.
So to increase operating margins from 16.67% to 21.67%, the company have to increase revenue and with that, the costs would also increase. Let’s assume that the company decides to sell more software subscription so assumptions are as follows
- The cost of research and development remains the same. The assumption here is that you can maintain the same development headcount and still sell more subscription services.
- The other costs increase with the revenue as a fixed percentage of revenue. So as revenue increase the COGS cost, sales and marketing and General & Administrative costs increase.
So the revised view is a follows
So to roughly have the same amount of operating margin (21.43% as compared to 21.67% in the previous example), Acme software company has to increase subscription revenue from $1,000,000 to $1,500,000 – an increase of 50%
So essentially the savings delivered by procurement is equivalent to a 50% increase in revenue.
I am not sure if any procurement organization is using this view for reporting but it is worth having a discussion with your finance team to see if you can use this view. To operationalize this reporting view, you need to understand your cost structure and your finance friends can help you with that. Don’t do this alone!
It is not uncommon to see situations like this
So as head of purchasing, what can you do to avoid such scenarios
1) Define the Scope
The scope of the project should be clearly defined and procurement should get a sign off on the scope before starting the project. For example – The goal of the project is to purchase 3 laptops with the agreed specs. Common things which lead to scope creep are
- Different specifications – the stakeholder might want a better specification then what was defined on the RFP. The common argument is that we can buy a better product at the same price. That is why your specifications should be part of your RFP requirement template.
- Increased quantity: Since we have reduced the price, let’s buy 2 more widgets in the same budget. Again, if you have sign off on the requirements, you can go back to that.
2) Work with Finance
When it comes to realizing savings, finance is your best friend. Work closely with your finance team to define a cadence for capturing savings and adjusting the budgets. If your finance team is adjusting the budget after savings are negotiated, there is a less chance of scope creep.
If you have read so far, congratulations!. You are among very few who want to fully understand the integration of procurement and finance and impact of your day to day work on the organization finance. When it comes to savings, there is no one size fits all. There might be different reporting format out there.
So I will end this with a request, Leave a comment if you find this article useful and also what other formats are being used out there. I look forward to your comments.