#Savings numbers: The Emperor's new clothes?
Take an organization with supplier spend of, say, $2 Billion. The Procurement organization delivers 8% year-on-year savings on previous rates, around 80% of spend is recurring spend categories, 20% is new (e.g. capital investments), so bought at rates not comparable to previous years. After 12 years, in this scenario, the supplier spend should be less than half than what is was originally, or around $966 million.
Even though the savings % are something you’d see in reality, the end result seems to never be achieved in that form. So are Procurement savings just “fake” numbers or the Emperor’s new Clothes? While their counterparts in sales can demonstrate numbers black on white, the Procurement function seems to have a gap between the achieved numbers stated and what finally appears in the company’s balance sheet
Well, there are a few elements to answering this. There are questionable ways Procurement could achieve the numbers which overstate the actual savings. There are incentives for Procurement to do so in organizations where the function is seen as a magic wand to beat cost reductions out of suppliers. There are internal behaviours which wipe out savings achieved. There is the difficulty of comparing spend like-for-like. There is the fact that measuring savings realistically for different categories requires a different approach. Or poor savings definition and lack of skills within Procurement in calculating and properly reporting numbers. Shifts between internal and external expenditure. Movements of the external market and change in the competitive landscape. And finally, suppliers’ response to and adverse consequence of rate cuts.
Questionable Procurement savings:
Savings could have been achieved stripping out add ons from a service product. Some of those may have been identified as over-specified extras and are a legit savings. But other elements may still be needed and are then bought in as an add on, often at an even higher cost as when packaged up. So not comparing like-for-like and negotiating a lower cost for a reduced service where add ons then come in is one questionable procurement save. Another is where daily rates are cut or services offshored and it is assumed that the rate saves do not affect volume/role profile distribution or internal cost and savings are calculated straight as the % the rates have been reduced
Procurement as a “Rambo” cost-cutter:
Pushed to deliver aggressive savings targets, Procurement teams can take some very short term, aggressive measures. For example threatening suppliers with exclusion if they don’t cut cost immediately. Or cut internal demand down with temporary measures. These initiatives typically lead to a short-term save and a creep up in cost again shortly thereafter.
Undercutting Procurement rules can take many forms. Stakeholders may engineer project chunks so that they are under the official Procurement threshold. Facing a demand challenge in one category, say management consultancy, they will reclassify the spend to proceed with the project. Or they may stretch suppliers’ goodwill by constantly demanding more service than originally agreed or changing project goals, which lowers the suppliers’ willingness to reduce price over time or not charge extra for elements not clearly listed out upfront. Similarly, if cost is cut, but corresponding budgets are left, they are just redeployed to another cost position (whether sensible or not).
Comparing spend like-for-like:
Comparing supplier spend from one year to the next is difficult. There are some recurring purchases and services with the exact same parameters, say production ingredients or cleaning services for a given premise. Many expenditure types are not easily comparable however and finding the right baseline to compare against requires more thought. IT or Marketing Projects, Capital Investments, Innovation activity and more are examples where negotiation success is not that easily measured. Which doesn’t mean that Procurement is not doing an excellent job here getting the best deal possible!
Category savings characteristics:
Opex, recurring Opex and Capex all have a different logic when looking at savings. But also within those categories, using the same measuring stick does not always make sense. For an engineering services, under a specified service level, reduction in the service cost is probably the sensible savings measure. For Marketing Services, instead of cutting the cost of the service, you may want to focus on reducing cost per desired outcome, e.g. customer acquisition, growth in brand recognition, etc.
Savings definition and Finance skills:
Increasingly, organizations have a clear savings calculation and validation procedure. Still, financial analysis is a skill that needs to be developed more within most Procurement teams as well as understanding of what the different types of savings mean (e.g. with regards to budget adjustments) within Finance teams. Savings reporting needs to become more granular, provide for the different metrics that make sense in each category and take market price developments into account, become less cumbersome internally and be followed up on to ensure that hard savings are truly realized.
Shifts between internal/external expenditure:
As well as shifting budgets between expenditure types, organizations respond to (budget) challenges in one area with substituting through other means. The classic is the spike in contractor/consultant expenditure when internal headcount is cut. Often, the very same people laid off come back as contractors. The inverse happens a bit less. But measures like large-scale offshoring programs are often projected in an overly optimistic way and turn out to cause a lot of additional internal effort or the need to hire contractors to manage the transition.
Procurement performance needs to be measured against the specific market buyers operate in. Achieving a % cost reduction target in a highly inflationary and tight market is a different challenge to a stable market with increasing competition say. Similarly, as savings are typically reported in headquarter currency, FX rate fluctuations need to be factored in.
Faced with demands by large clients to cut cost, most suppliers will look to recover the revenue eventually. Become more stringent on what is included or not to charge extras. Re-grading resources to command a higher rate. Reducing quality within the agreed parameters. So any Procurement exercise looking to cut cost aggressively and unilaterally is not a very strategic exercise. Joint supplier improvement initiatives and negotiating with the other parties agenda in mind and provide incentives to sustainably reduce cost, is.
So, measuring Procurement against financial metrics does make sense. The function does and needs to deliver good deals. But it’s not as simple as many parties internally would like to have it and savings can’t be cut from the budget 1-1. Understanding what the different “buckets” of financial performance improvements mean and how they should be dealt with is key. And the recognition that “hard savings” (with the ability to make a direct budget cut) are not the only useful measure of (financial) Procurement contribution and that making a quick “win” does not translate in permanent financial improvements. As a few companies known for their overly aggressive, unbalanced approach to the supplier market had to learn the hard way
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