Having a purchasing or procurement department has many benefits and we will review them one by one. If you are unsure about the value of the procurement department .. read on.
This guide is also meant for owners of small companies who are thinking about setting up a procurement department but unsure about the benefits of the procurement department.
Just to clarify the terminology, when we say procurement it means the all-encompassing process of negotiating cost with vendors, setting up contracts, and issuing purchase orders to vendors. Now you might call it purchasing, strategic sourcing or procurement.
Procurement is a well-established function at large companies but if you are a small to mid-market company then chances are that you don’t have a procurement team. We categorize small to mid-market as less than $150M annual revenue.
When you are a small company or a company in the growth mode, it doesn’t mean that you don’t purchase product or services. Of course, you are still doing purchasing in the company, it just that it is not a formal function or a centralized function.
Purchasing might be done by the office manager or the production department. So how do you know that it is time to hire someone to formalize the procurement process?
In this post, we will cover why you need a procurement department and signs that you need to formalize the purchasing process under the procurement team
If you are already convinced that you need a procurement team, you probably want to read
How to build your procurement team.
Also, we highly recommend that you have a purchasing policy so that you can standardize the purchasing process for your employees. We covered this topic in
We use procurement and purchasing interchangeably. They are not the same but there is no standardization of language across companies.
So a good question is to ask is – when do you need a procurement team – if you don’t have one already.
The short answer is it depends upon the nature of the product or services you are performing. If you are manufacturing a product which needs raw materials, then chances are that you already have the function from day one.
That function might be managed by the person or department responsible for inventory management. It could also be managed by someone in the production department.
However, if your company offer services, let’ say you are a software provider then it is most likely that the purchasing activity is performed within individual functions. For example, the IT department is responsible for purchasing hardware and software.
A key function of the procurement department is to centralize the purchasing operations for efficiency and compliance.
So let’s look at some key signals that indicate that it is time for you to hire a procurement professional to start building the dream procurement team.
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A common sign that you need a procurement team is that your company is experiencing year on year growth in revenue.
If your company is in growth mode and experiencing double-digit growth YOY, you are also spending more money to generate revenue.
Now the above statement only makes sense when you have significant revenue, to begin with.
What is a significant revenue?
If you are just starting, experiencing 100% growth year on year is not unrealistic. Let’s say you are a startup and your annual revenue is $100,000 and you doubled it next year, of course, we are not saying you hire a specialized procurement function for such a small spend.
In our humble opinion, The magic number is $15 M and above.
As per Bain’s research, on an average in any industry, 43% of the spend can be managed by procurement.
So far $15M, annual revenue 43% is $6.45M.
That is not an insignificant amount of purchase every year.
A procurement department can help drive the cost down and increasing purchasing efficiency.
Along with revenue, the other sign is the number of locations and number of revenue.
If you are in a business where you need physical locations to expand, then it makes sense to have a centralized procurement department to manage that.
Also once you cross 100 employees, your employee-related expenses also increase. Once you cross this threshold, it would be helpful to review your employee-related expenses and negotiate better deals on such expenses.
If your expenses are rising then it might be time to look at the review of spending and finding opportunities to reduce cost.
The common practice for finance teams to provide cost reduction targets for individual departments without looking at the impact of such reductions.
The issue with this approach is you might see a short-term cost reduction but these costs come back as your revenue grows.
By looking at the expenses strategically, you can identify opportunities for better cost allocation. That would drive increased EBITDA margins and improved cash flow for your company.
And it is not just the procurement or the finance team responsibility to review those expenses. You should try to build a cost-conscious culture so that all budget owners are continuously reviewing the expenses and ensuring that it is the best use of the available capital.
Every company has cost reduction goals, some have more formal goals and some have informal goals.
Having a procurement team can help in having centralized responsibility and accountability for driving the cost reduction efforts.
By conducting a spend analysis exercise, your procurement team should be able to identify opportunities for cost reduction.
If you are not familiar with spend analysis, here is a quick brief
Spend analysis is the process of collecting spend data, cleansing, categorizing the data and analyzing it to understand spending trends and identifying saving opportunities.
You can read more about how to conduct a spend analysis at your company.
By analyzing the spend patterns, the procurement team can identify cost reduction opportunities in the following areas
• Reduce cost through consolidation of vendors. For example, you are purchasing office supplies from different vendors and you can get a better rate by consolidating your purchases.
• Reduce cost by adopting a low-cost country sourcing strategy.
•Reduce cost by standardizing product specifications across different locations. If you don’t have a centralized procurement function, you would be surprised to see that different locations are purchasing the same functional product or service at a very different price point.
•Reduce overall demand by controlling the spending behavior. If there is wasteful spending happening in your company, spend analysis can help you identify that.
•Increase cash flow by managing the payment terms. Your procurement team can easily identify opportunities for increasing cash flow by extending the payment terms. Now the realization of that opportunity might depend on the creditworthiness of your company.
• If your suppliers accept credit cards, then you might be able to extend the cash flow by paying with purchasing cards. The trick is to use the card as another payment vehicle (ACH, Check). If you can convince your vendors to keep the same payment terms but take payment through purchasing cards, you just extended the terms by 30 days!
Most of the support functions are cost centers and not profit centers. You might consider procurement to be a cost center similar to other functions like payroll, HR etc. These functions are critical for running operations but they don’t increase revenue.
We agree that procurement doesn’t generate revenue but it can help you do something better than that.
Increase EBITDA without investing capital to generate revenue.
You can calculate the impact of procurement cost savings as follows
Let’s look at a hypothetical income statement for a software company with an operating margin of 16.67%. Assume that you don’t have a procurement department.
Now let’s look at the same income statement but let’s assume that procurement is able to reduce 10% across the board for COGS, Sales & Marketing and General administration.
Total savings added = COGS ($50,000) + Sales and Marketing ($50,000) + General and Administration ($50,000) = $150,000
The same income statement now looks like this
The operating margin jumped from 16.67% to 21.67% which is approx 30% increase without increasing revenue.
The question you should ask is – is it worth to gain an increase in EBITDA by adding the cost of the procurement department?
Another sign that you need a procurement department is if you are losing money on unwanted contract renewals.
As we mentioned earlier, even though you don’t have the procurement department, you are still purchasing product or services.
Let’s take a case where a contract is negotiated by the IT manager for certain software and let’s assume the annual renewal cost is $100,000.
If you are not tracking your renewals at a central place, chances are that contract is with an individual. To make the matter worst, sometimes the person has already left the organization and you don’t even have a copy of the contract.
Now let’s assume you don’t use that software anymore, but since nobody is tracking the renewals, you only come to know about the renewal when the vendor sends you the invoice for the annual subscription renewal.
Every contract has a clause for advance notice for either renewing or terminating the service and in most case, it is 30 – 60 days.
Chances are that by the time you are seeing the invoice, it is already too late to cancel the subscription and you are obligated to pay for the service which you don’t even use anymore.
This is not an exaggeration of truth as many of you would be able to relate to such occurrences.
Having procurement centrally manage procurement contracts ensures that you are tracking the renewals and you have sufficient time to send termination or renewal notices based on the needs of your business.
Centralized purchasing teams are not just for large companies but a company of any size can benefit from having a centralized purchasing function.
Let’s look at some of them
Having a purchasing team can help you streamline the purchasing process for your company.
Once you have ownership of the purchasing process, the process owner can then start looking at tracking the performance of the process.
The process owner can also look at areas where improvements can be made.
There is a direct relationship between your purchasing process and adoption of your purchasing policy. The simpler it is, the better it is for adoption.
Let’s do a simple exercise – Ask 5- 10 employees across different departments to explain what is the purchasing process.
If the answer is same across the board, then you at least have a common process.
However, you shouldn’t be surprised if the answer is – I don’t know or every person has a very different understanding of the purchasing process.
It reduces ambiguity on how to purchase a particular item or service. The more informed the employees, the better the chances that they would purchase the products from your preferred vendors.
To give an example – should you purchase office supplies from Amazon.com or should you use contracted prices from Staples.com.
Many companies complain that their employees don’t follow their purchasing policy, assuming you have one.
When it comes to the purchasing process, you need to have empathy for your end users experience. This is not the only thing they do in their day so simpler the experience the better it is.
Having clarity on how to purchase product or services can greatly simplify the experience for your employees. Having a purchasing system definitely simplify the experience for your employees
The acid test is if they don’t have to look up a policy manual to understand the purchasing process, then you are on the right track.
B) Reduce cost
Reducing cost is critical for any business so that you can free up the capital and invest it in revenue growth.
Having a centralized procurement team can help you reduce cost. Let’s look at some ways on how procurement can help with cost reduction.
By reviewing the purchasing data, also called as Spend analysis, the purchasing team can combine the volume leverage to discount better terms.
For commodity items, it is possible to leverage the volume to gain discounts.
But what if you don’t purchase a lot of certain commodities then you might have limited leverage.
For example – if you a small to a mid-market company, you are probably spending $50,000 to $100,000 annually on office supplies. That might not be enough to get a good price from companies like Staples or Office Depot.
So what you should do in such case?
You can leverage the power of cooperating purchasing whereby you can combine your purchasing power with other companies to get a better rate. This concept is not new and is widely used in healthcare companies to reduce cost.
If you already working through such an arrangement, then that is great. If not, ProcureDesk can help with that. Our marketplace offers the same benefits of cooperating purchasing and we leverage the volume for our customers to get better pricing on products like MRO, office supplies and IT accessories.
Now let’s look at how procurement helps reduce cost in case of non-commodity items. For example, facility cleaning services.
Given that the scope of services is different for different customers, there might not be a standard price which can be offered.
So your procurement team can ask for proposals from different companies and that can help drive the cost down. Of course, your team should know what is the average cost paid for such services so that they can effectively negotiate the price down.
Companies who don’t have a procurement department often think that procurement can only help with material items.
It is not uncommon to hear – “We are not buying widgets here”. An experienced procurement team should be able to handle all your categories and put it through a strategic sourcing process.
Once you have negotiated the savings, you need to have a control mechanism in place to ensure that your employees are purchasing from the negotiated that contract.
Just negotiating a great price doesn’t mean that you are going to realize the savings.
There are a couple of ways the purchasing team can help avoid savings leakage
• By ensuring that every purchase order is reviewed to ensure that the items are purchased from the right vendor at the correct price. Of course, this process is highly inefficient as the team has to review each and every order to ensure that savings are realized.
• The other option is to build these prices in some form of a catalog or item master so that users can select predefined items at predefined pricing schedule.
• The third alternative would be to use an intelligent system which can guide the users to the right suppliers based on the information provided by the user. Such a system can automatically take care of ensuring compliance with negotiated contracts.
Increasing revenue is much harder than reducing cost. Your procurement team, of course, reduce cost which increases cash flow. But if the team is heavily focused on operating expenses or Opex spend, then that can help you dive significant changes to the EBITDA.
See how procurement cost savings can help you drive EBITDA growth.
So how do you quantify the impact of procurement cost savings?
The above research by CAPS and Bain provides interesting statistics based on your industry.
As per this Bain and CAPS research, on average companies spend 43% of their revenue with external vendors.
So for example, if you are a $100M annual revenue company, then you are spending $43M with external vendors.
In certain industries, the number is pretty high. For example, in semiconductor, 63% of revenue is spent with external vendors.
Computer hardware and software companies spend around 42% of their revenue with external vendors.
That is the spend which your procurement team can control and impact.
Now your next obvious question is what is the ROI of the procurement team and how do you measure it.
The obvious output of the procurement team is the cost savings delivered by the team.
As per Bain, the average savings delivered by procurement teams is in the range of 8-12% across different spend categories.
Direct materials have the lowest potential, in the range of 1-2%.
But categories like HR services, travel and facilities can go as high as 15%.
We think this is a good start to estimate the value or cost savings procurement can team can deliver but then you need to adjust these numbers based on the following factors
• If you don’t have a procurement department today, it will take some time for them to get to up to speed and start contributing results.
• It takes time to understand and increase stakeholder management. So we have to discount the time it takes from the initial estimate of cost savings.
• Even if your company has a high procurement maturity, the team will not be able to address the entire spend in one year.
So with that in mind, let’s look at a more realistic model.
Annual Revenue: $100M
Spend with external vendors: $42 M ( Using the industry average)
Spend which can be addressed in a year: 40%
We are discounting this to factor in procurement maturity as well as the fact that certain spend might not be addressable in a given year.
So that brings us to $16.8M [$42 * 40%]
The average cost savings is 8-10%.
That means the team has the potential to deliver $1.3 M [$16.8 * 8%] to ~$1.7M [$16.8 * 10%] in savings every year.
Assume you have a team of 3 people and at an average cost of $100,000 loaded cost.
So you have $300,000 in annual cost and return of $1.3M – $1.7 M
That is a return of 400% +
Fraud is prevalent in all companies, and procurement can’t help with each one of them. However, your procurement team can help you increase compliance with purchasing policies and prevent procurement fraud
We looked at a recent survey conducted by PWC and across three industries, there is a varying level of procurement fraud.
For example in the technology industry – 23% reported procurement fraud as an issue.
However, in professional services, the number is close to 26% and in Industrial products, the number is as high as 28.
The problem with fraud is that you might feel there is no fraud until the time fraud is detected. To avoid a scenario like this, companies must invest in controls to ensure that policies are followed and fraud is controlled.
Let’s briefly look at some examples of procurement fraud. We covered this subject in details in another blog post. Here is the link
Conflict of interest.
Whether you call a conflict of interest fraud or not it is up to how your corporate spend policy is defined. Here is a classic example of conflict of interest.
Bob is responsible for purchasing a product for the company, let’s say raw materials. He purchases the product from a company where his wife is part owner. That means he is directly benefiting from the transaction.
Personal gains are different from conflict of interest. Personal gains could be int he form of bribery or some other benefit which is provided to the buyer to influence the purchasing decision.
For example, the buyer is taking a bribe to award the business in favor of the the vendor. In some countries, the personal gains might be in the form of personal trips especially to Vegas or expensive watches.
This kind of fraud can happen if the person who is making the payments to the vendors also have access to set up new vendors.
If that is the case, they can set them up themselves as a vendor and keep on issuing fraudulent payments to themselves without being detected.
This kind of fraud generally goes undetected becuase the amounts are generally small and the payments are done over a period of few years
Segregation of duties
By only having procurement issue purchase orders limits the potential of fraud.
First of all define a corporate purchasing policy, so that everyone has a clear guideline about how your company purchase products and how the spend needs to be authorized before the purchase order can be issued.
Second, procurement needs to review the orders going out of the door to ensure that are with the preferred vendors so that you can control rogue or maverick spend.
Define an ethics policy for procurement
Yes, the person who is responsible for watching also needs to be policed. You need have a ethics policy for procurement so that you can define what is ethical purchasing,
This doesn’t need to a separate policy but could easily be a part of your purchasing policy.
The idea here is to define guidelines for purchasing and clear directions on what is acceptable behavior, for example – accepting gifts from vendors or going out for lunch or dinner with the vendor.
You should clearly define what people can or can’t do during an RFP process.
Thought it is important to have guidelines for your employees, it is even more critical that you have stricter guidelines for your purchasing team.
Vendor escalations are part of the day to day purchasing activities, especially for material purchases.
Vendor escalations can happen because of the following
– The vendor has not delivered the products on time.
– You need products urgently so you need the vendor to ship the product ASAP.
Let’s look at the root cause of these problems and see how a purchasing team can do to avoid it.
In the first case, the common reason we hear from vendors is that they never received the order or the order was delivered to someone email’s box and they are no more with the company.
This can be easily resolved by ensuring that you have a vendor acknowledgment process whereby it is mandatory for vendors to acknowledge that they have received the order and they can deliver what is requested and by the requested date.
A purchasing system can streamline this process and ensure the deliverability of the orders.
The purchasing team can review the vendor contacts on a regular basis and keep the vendor contacts current so that the order is delivered to the correct person.
The second case where escalations are required because you need the product sooner can be avoided by having clearly defined lead times with the vendors.
And then finding a way to communicate that to the stakeholders. The idea is to have the orders automatically default the dates based on the lead times.
The procurement or purchasing team should work with the stakeholder to understand why an escalation is required in first place.
And what could have been done to avoid it?
After doing some investigation, you might find that
Vendor escalations are generally a sign of poor supplier performance or inefficient purchasing processes.
Whatever the case, the purchasing team should be able to look at the root cause and work on fixing it.
Before the purchase order can be sent to the vendor, it needs to be entered in your systems, approved by stakeholders etc.
And on top of it, you have to sometimes to vendor escalations to ensure timely delivery.
All this is the cost of the purchase order.
Do you know how much does it cost for you to issue a purchase order to the supplier?
There are multiple benchmarks out there, for example
As per APQC (American Productivity & Quality Center)– Cost per purchase order varies from $35.88 to whopping $506.52
As per CAPS research, the cost varies from $53 to $ 741
All this is the cost of the purchasing process, from the time the requisition is created until the vendor is issued the purchase order.
If you are interested in understanding what is costing your company to issue a purchase order, you can conduct your own cost analysis exercise. We covered this in depth in Purchase order cost benchmarks
If you don’t have time to read that, the following is a quick analysis of different activities involved in the purchasing process and the average time it can take. Of Course, this is an example
If you have a purchasing team, they can look at why it takes so long to create a purchase order and what can be done to reduce the cost.
In the above example, the cost per PO is $62.7, So assuming that the team can reduce the cost by 50% and for the annual count of 10,000 PO’s – you can save around $313,500 on an annual basis.
We highly recommend you to look at the cost of a purchase order and what can the team do to reduce the cost.
There are two main ways the purchasing team can reduce the cost of the purchasing process
1. Automate the purchasing processing so that the end to end process is completely automated. You can enable self-service and catalogs so that users can easily find what they are looking for. The system can drive the compliance to your purchasing policies and you can focus your time on negotiating better pricing with your vendors.
2. The second way is to look at your purchasing process and see if it can be simplified. For example, what step in the process takes the most time and what can be done to reduce the time.
Both these approaches go hand in hand to support your cost reduction initiatives.
For example, you realize that approvals take a long time. So you can look at how many people are approving the requisition.
Let’s say each requisition goes through at least three approvals.
Do you really need three approval levels?
Now once you have identified the appropriate approval levels, you can further reduce the time by automating approvals and enabling approvals through a mobile app.
The above is a good example of how technology combined with process reengineering can help you reduce purchasing cost.
Procurement or Purchasing team can not only help drive cost savings but can also help in increasing the EBITDA (Earnings before interest, tax, depreciation and amortization).
If you are a business owner and looking to reduce cost, you should first start with analyzing your cost and that is where detailed Spend visibility can help. Procurement teams can use that data to find opportunities to drive down cost.
We hope that the examples provided above have helped you to quantify the procurement value add.
Interested to see how ProcureDesk can help you automate end to end purchasing process?
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