Regardless of the industry, the scale of the business, the size of the procurement team, or the maturity of the procurement discipline, cost savings was and will always be a vital objective of the procurement department. This is no news. More or less, an average enterprise spends about 50 to 70 percent on procurement.
Now, the primary reason behind the drastic growth is the continuing trend of outsourcing activities which the enterprise used to do on its own. One more reason for the growth is the fact that the procurement division is being responsible for activities that one considered outside of their responsibility such as marketing & communication, insurance, business travel, etc.
Irrespective of the procurement activities, cost savings should be the top priority. However, numerous enterprises find it challenging to identify an efficient and effective approach for reporting savings and measuring the real cost savings.
There is no doubt that measuring procurement performance is a tad complicated and quite challenging, but successfully executing the best and most effective reporting system is also essential to accomplish those strategic savings. Therefore, procurement has an immense effect on the revenue and profitability of the enterprise. For large enterprises, even a small reduction, as small as 5 percent, can easily save your company millions of dollars. Cost control is one of the crucial shared responsibilities of the procurement and accounts departments.
Significance of cost savings
Procurement cost savings are what define how the procurement function is performing. And quite understandably, procurement teams mainly focus on this single performance indicator.
Right from day one, procurement has always been focusing on savings. Having said that, procurement cost savings alone is not a great strategy in the long term. The secret to procurement success is good stakeholder engagement. Procurement savings can be achieved if your stakeholders are engaged.
There are a handful of reasons why cost savings is and should be the primary goal and objective of the procurement function.
- Effortless tracking
This is one of the easiest ways, provided it is done right, to measure your procurement performance. In addition, this is the main goal of the procurement team in most enterprises. So it can be said that this is a pretty obvious and easily tracked procurement performance indicator.
No matter how small or big, cost savings will always have a huge impact on the bottom line when compared to other metrics such as risk mitigation.
Of course, risk mitigation is equally important, however, businesses only see the value when the risk indeed occurs. For instance, take a car or health insurance. You will only understand its true value when you need it.
Cost savings effect could vary depending on business to business. Sometimes, cost savings could hold high stakes that senior management utilizes to boost higher EBITDA margins.
- Enhance credibility
Procurement is primarily based on relationships with vendors, suppliers, and other 3rd parties within and outside the organization. A good track record in cost savings helps in enhancing the credibility of procurement and also assists the team to get involved early in new initiatives that could result in new spending.
Cost Savings vs. Cost Avoidance
Before we dig any deeper into this topic, let’s learn the difference between cost savings and cost avoidance.
Even though cost savings and cost avoidance are related, they are different concepts in terms of procurement savings tracking, and enterprises should track both to get a good understanding of the total value delivered by procurement.
By the books, the definition of cost avoidance is: “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.”
Let’s take an example. You are currently paying $5,000 annually for a BI tool. This year, the price was hiked to 10%. What would you do? You utilize your negotiation skills to avoid paying that extra 10% by signing a long-term contract or introducing a new customer from your network to your vendor.
On the other hand, cost savings is something more visible. In other words, cost savings is the money that is saved as the company policy is changed and hence the cost of operation is reduced. When a company realizes cost savings, it is nothing but pure profits and both the staff and company are accountable for planning and executing the effective strategies.
Not just once or twice, but the enterprise should be responsible for making sure that the practices and policies are thoroughly followed so that the cost savings measures are properly executed. Apart from the enterprise, the procurement team also shares equal responsibility for ensuring that they strictly follow the said standards.
For instance, you can negotiate the rate with your suppliers and bring down the per-unit price of an item so that your sourcing becomes a bit cheaper, resulting in cost savings.
What are the types of cost savings in procurement?
There is no doubt that cost savings will result in profits even if you don’t know the different types of cost savings.
Basically, there are two types of budgets in every enterprise. One is Capex and the other is Opex. Let’s take a look at each one in detail.
First of all, Capex is Capital Expenditure. Why? A capital budget is to buy assets. For instance, the enterprise has to purchase a piece of new machinery for some activity. Purchases like these usually come under below-the-line expenses. They surely affect the business’s cash flow but not enough impact on EBITDA.
Opex is an Operating Expense. These are the expenses that occur during an enterprise’s day-to-day operations. For instance, basic supplies, purchasing software, system maintenance, etc. Now, these costs come above-the-line expenses and they surely impact EBITDA.
Now that we understand the types of budgets, let’s see how they are related to savings.
1. Capital cost savings
An enterprise negotiates these savings for the capital budget. The effect of these savings primarily lies in cash flow, however, even small amounts of savings in the capital budget will help the enterprise with additional investment in capital assets as a long-term investment.
2. Opex Cost Savings
Savings that come under these are reported toward the Operating Expenses budget. Enterprises usually pay more attention to Opex cost savings due to its high impact on EBITDA.
3. Cash flow savings
Savings in this category generate due to favorable payment terms. For instance, the enterprise moved payment terms for $150 million in spend from Net 70 to Net 100. You will see a profit for 30 days and you get a pretty good one-time increase in cash flow depending on the timing of the change.
How to achieve cost savings?
There are numerous ways for procurement teams to accomplish cost savings. The very first step is to design a savings framework.
Let’s take a look at a model that was created by Capgemini.
Primarily, there are 3 focus areas that are discussed in this model.
A. Purchasing demand management
This is one of the straightforward ways to achieve cost savings. Now, this can be done in 3 ways.
- Reduce consumption
Have you ever thought “Do I really need this?” while purchasing or after purchasing? We all do this. But every enterprise at least once had purchased items or goods that they could survive or manage without. Situations like these occur especially in times of economic growth and completely disappear when the situation gets less positive. For better understanding, prohibiting business class flights or the avoidance of air travel completely and using a video conference instead.
- Consolidation of spend
This is another commonly utilized cost reduction strategy. Let’s say your procurement team wants to buy3 laptops of different configurations and brands. One is for executives, one for middle management, and one for junior staff.
Now, instead of going for 3 different brands, you can significantly reduce the cost by choosing one standard model and then using volume to get discounts to reduce the cost.
- Enhance product specifications
Enhancing product specifications can greatly help you minimize the cost and most organizations leave money on the table.
For a clear understanding, let’s take the same laptop example again. Your procurement team wants to buy a laptop that has the best software, specifications, and configuration, including ports, warranty, and other related things.
Once all these things are added, your cost is certainly going to go up. Provided, this is the best laptop you can possibly get, however, do you really need the additional items that you added to the bill?
Once you figure out what you really want, apart from getting a cheaper product, it also makes your item a basic commodity.
B. Supply Based Management
Supply management is mainly about vendors and suppliers. There are 3 strategies in this category.
- Increase competition
When you increase competition, you are going to get more leads on suppliers which will help you with cost reduction.
However, if your specifications are not standard, then you might have fewer suppliers bidding for your project. For instance, if you want to buy a particular brand product whether it is a smartphone or a laptop, then you might have limited suppliers who are willing to provide the goods you want but if you widen your specifications then you will have more suppliers. Hence, more competition. Ensure whatever your requirement is, suppliers are competent and can meet your standard specifications.
- Restructure supplier relationship
This strategy will help you enhance your collaboration and communication with your existing suppliers, resulting in a reduced cost. If your enterprise doesn’t have a supplier development program, then you have to start one.
Let’s say you have to buy a widget from a regular supplier who sends in standard packaging. But now you want to minimize the cost as much as possible. In that case, you might want to work with your supplier to opt for cheaper packaging but still meet your quality requirements.
This is a classic win-win scenario for both of you as it is cost reduction for you and your supplier.
- Restructuring the supply chain
When compared to the above strategies, this one requires a deeper and better engagement with the enterprise in order to evaluate the supply chain for cost savings.
Businesses mostly are able to achieve a low-cost country sourcing strategy. You can also consider shifting from a distributor model to a direct purchase from the manufacturer.
C. Total Cost Management
The strategies in this group will help the enterprise in minimizing the total cost of ownership. Let’s take a look at some of them.
- TCO analysis
In this technique, the procurement team will consider the total supply chain cost including the inventory carrying cost. Based on the sector and industry, the inventory carrying cost would be somewhere between 20 to 30 percent. A robust supply chain is capable of increasing flexibility in meeting internal stakeholders’ demands along with JIT (Just in Time) programs which can result in significant inventory reduction.
- Vendor managed inventory
Shifting to a vendor-managed inventory can take a lot of responsibilities off your shoulders as forecasting and demand management tasks are now handled by the vendor. Having said that, the only downside of this approach is that your supplier should be able to get his/her hands on demand forecast. From a basic market condition changes to internal factors such as sales promotions can potentially result in a hike or could slow down inventory consumption.
- Minimizing transaction costs
When your procurement team assesses the total cost of management, ensure they consider transaction costs as well. One classic example of this is there is a transaction cost for issuing a couple of purchase orders and processing a handful of invoices. But if your procurement team is buying items from a trusted vendor regularly and on a fixed schedule, then is there a need for purchase orders.
- Cash flow savings
The savings in this category are based on how you work with your suppliers to manage the cash flow. Here are some of the key strategies.
- Modifying payments to meet the cash flow requirement
Procurement teams can create the contracts in such a way that they assist the enterprise in effortlessly meeting the cash flow obligations. For instance, you could choose between a one-time annual payment and quarterly payments for maintenance contracts, whichever is easy for you.
- Extending payment terms
This is another widely utilized strategy to extend payment terms. If you are new in the market or to the industry, try to onboard with high spend suppliers as it will provide you a free hand in the cash flow. Once it is done, you can then overtime to extend your payment terms for the rest of your supply base.
How to measure cost savings in procurement?
Honestly, there is no simple single formula that can help you seamlessly measure your cost savings in procurement. This is mainly because procurement is not a standalone process. Regardless of the business or industry you are into, procurement is majorly dependent on other disciplines. Hence, measuring cost savings in procurement is complex.
Without proper prior cost references or cost history, calculating savings is a complicated task. Then is there no way to calculate cost savings?
There is one way. The average price of all quotes you received from the vendors is subtracted from the negotiated contract price. How many ever goods or products you purchase during this period of calculation is multiplied by this value.
For enterprises that are serious about cost savings, it is recommended to invest in a procurement savings tracker. The solution will offer real-time insights into actual realized savings. Through the solution, it will be easier for the procurement team to conduct savings initiatives that affect not only the bottom line of the enterprise but also streamline and automate the entire procurement process and enable collaboration between teams.