Like it or not, most Procurement organisations are still primarily measured on cost savings.
Despite the movement towards a broader value-driven view of how procurement contributes to the wider business, the reality is that even though there is a tacit, new-found appreciation that buyers deliver more than just bottom-line savings, it doesn’t usually get reflected in their annual objectives.
For indirect procurement, this is especially frustrating. Unlike on direct materials, it’s much trickier to measure hard (P&L visible) savings, and there is certainly less visible impact of being able to outperform general market pricing on indirect commodities.
Financial controllers looking for visible results often have rather inflexible, rigid definitions of what they recognise as savings.
The most common example is companies who only measure savings based on Purchase Price Variance, or PPV, usually based on last price paid or moving average price.
Great for repeatable spend. But what about items that are only purchased once, or at best infrequently.
How do you measure the added value?
Acknowledging cost avoidance: Why you can’t measure (indirect) procurement just on hard savings
Controllers, manufacturing managers and professional services stakeholders often don’t understand or appreciate the hidden champions they have working on indirect commodities within their procurement organisation.
A direct materials buyer can deliver a $1 million saving after the conclusion of 1 major supplier negotiation.
Now, I’m not saying they have an easy ride. But such a large chunk of money from one vendor negotiation or tender is virtually unheard of in many indirect categories.
With indirect spend, many purchases are one-time buys.
Whether it be IT infrastructure or machinery & equipment capex, or even something much more mundane such as one-time spends on building maintenance, fabricated spare parts or promotional goods.
While a category manager on direct commodities may be expected to deliver all of his / her savings target through PPV-measurable savings, this is simply unrealistic on indirect commodities.
So, why do so many organisations use this soul-crushing method of measuring value for their indirect procurement staff?
How organisations should recognise the “invisible” benefits
The contribution indirect buyers make to the business often comes through cost avoidance.
This is a pretty widely accepted concept for capex purchases, and yet it seems to be brushed under the carpet for smaller, less strategic areas of spend, both for goods and services.
It’s demotivating and often drives buyers down the wrong route of trying to take cost out of contracts or reduce the spec, as opposed to working to a more win-win deliverable to both the vendor and internal business partner who procurement is negotiating on behalf of.
Simple one-time buys, as well as long-term service contracts which deliver additional value beyond price, are both great examples of how cost avoidance can be measured.
Activity undertaken by category managers to avoid cost can manifest itself in many different forms:
1) Difference between original quote and final negotiated price
2) Driving compliance through competitive tendering on a one-time spend item where the stakeholder would otherwise have just requested a PO
3) Bonuses or additional goods / services provided at no extra cost
4) White space savings (freeing up someone’s time or eliminating non-value added work)
5) Process savings
6) Personnel savings
Which brings us to the next logical question:
What’s the best way to measure this invisible value?
The simple answer is there is no 100% fool proof way.
Such a system can theoretically always be abused or can leave itself open to the accusation that these soft savings are somehow not being measured fairly.
A sense of trust and acknowledgement that there is no perfect model
In spite of these savings never being as clear cut or transparent to measure as hard savings versus prior year or last price paid, it’s about the only reasonably fair way to measure the weighted contribution of indirect procurement professionals.
Recognition of cost avoidance in some form acknowledges that much of indirect procurement’s spend, workload and value that they deliver simply can’t be measured in the same way as it is for repeatable purchases of raw materials and component parts.
To have a successful model, there has to be an acknowledgement of 3 major components:
1. An element of trust that procurement will not manipulate the “savings” being reported
Risk of getting artificially high-ball offers. This can happen when a site buyer has a close relationship with some of his or her stakeholders.
There’s nothing stopping them going to a vendor who they know is expensive for the initial quote, knowing full well that they will not source with this vendor. Then to claim that they’ve made massive savings through getting 2 or 3 alternative offers which come in at considerably less.
2. An acknowledgement by all parties that the savings validation model will never be perfect.
One of my former employers had plants in Switzerland and Italy. The results when measuring cost avoidance between original quote and final negotiated price were vastly different in those 2 locations.
The Swiss buyer would look like he was failing, whereas the Italian buyer would look like a superstar.
In Switzerland, a quoted price is usually the price you’ll pay, except for perhaps a couple of percent the salesperson is able to give away if the buyer comes knocking. It’s pretty black and white.
Just a couple of hours over the border in Italy, culture is very different. It’s expected that quotes will get negotiated and there will be a certain degree of wrangling. It’s not unusual to negotiate 10% out of an offer, especially if there is some labour cost in there and it’s not just a simple purchased part.
3. A top-down approach to implementation, with a senior member of the Finance team sponsoring the initiative.
The only way that cost avoidance will gain credibility and indirect procurement will be recognised for the value they provide throughout the business is by procurement and finance leaders working together to come up with the optimum model of recognising this, and then introducing this from the top down.
Bottom-up local attempts to agree on a system are usually doomed to fail because the procurement professional typically does not have the weight or the influence to drive the acknowledgement and acceptance of this.
Only if the directive is coming from Finance or Controlling will it carry the necessary authority to gain recognition and be adopted across all plants and country HQs.
So, the final question: How much of indirect procurement’s total target should come from cost avoidance?
Again, this is difficult to apply a one-size-fits-all solution to all industries and categories of spend.
Anything up to 60-70% of an indirect buyer’s total spend could be made up of non-repeatable items, based on my own previous experience as an MRO Category Manager.
There is no hard and fast rule.
That’s why it’s always best to look at the spend first and put together a fairly accurate estimate of:
- How much of their spend is actually sourceable i.e. not under contract or only available from a single OEM or distributor?
- How much of their spend is repeatable and as such can be measured on a hard savings model?
I cover this in more detail in my other article on spend analysis.
It’s essential that to keep the morale high and recognise contributions made by indirect procurement that some sort of cost avoidance target is built into their objectives.
Year-on-year hard savings are harder to realise in indirect areas of spend.
There is no perfect reporting model.
Nonetheless, having a mechanism, even an imperfect one, is better than not recognising this contribution at all.
Any system must be sponsored at a senior level by Finance or Controlling to have the best chance of success and acceptance.
Setting the appropriate targets and establishing the optimum model to measure cost avoidance is highly dependent upon a number of key factors:
- the industry;
- the category of spend;
- and, most importantly, how much of an individual buyer’s category spend is repeatable vs. one-time purchases.
I can help you! Let’s work together to put in place a strong, fair, savings recognition process for indirect procurement in your organisation, which has the all-important blessing of your financial controllers.
Please contact me and I would be delighted to discuss how I can help you on a phone or Skype call.