Best-In-Class Procurement is About Cost Avoidance, Not Savings!
In a recent post over on his Purchasing Certification Blog, Charles asked why doesn't Procurement save as much on non-traditional categories in response to his review of Aberdeen's latest CPO Agenda research report which found that Best-in-Class Procurement achieves 10% savings on managed spend while laggard Procurement achieves savings of 16% on managed spend. His assumption was that Procurement didn't do as well on non-traditional categories and that dragged the average down.
As far as I'm concerned, the situation is the exact opposite. If the Procurement department is truly a Best-in-Class Procurement department, each time they negotiate a contract they get the best deal possible. Once you've negotiated the best deal possible, there's no more "Savings" to be had until either the indexed market price for the core commodities, components, or labor that makes up the product or service cost decreases or a disruptive innovation comes along that allows the product or service to be produced more cost effectively. Since that doesn't happen every day, or even every year (as commodity and labor costs tend to increase and production efficiencies quickly reach a ceiling on popular products or services), if Procurement did it's job right, there are no "Savings" to be found on the majority of categories sourced in the last year.
The fundamental truth -- which is hard to see with the recent myopic focus on "Savings" -- is that there is no such thing as "Savings" in a perfect Procurement organization. If Procurement did its job perfectly, it negotiated the absolute best deal. This would mean that there are no "Savings" to be had because, if there were, that would mean that Procurement did not do its job perfectly.
A Best-in-Class Procurement organization is all about Cost Avoidance. After all, since most products and services increase in cost over time, a great Procurement department finds a way to contain, and even eliminate, cost increases even when raw material costs go up 10% and labor costs go up 5%. They work with the supplier to find ways to improve supplier efficiencies, or they work with sales to find ways to increase volumes, so that the supplier can commit to the same price and still maintain a reasonable margin even if its costs increase 5% to 10%. And then, if prices happen to drop for a category that comes up for renewal, they renegotiate the renewal to represent the effective cost decrease and never pay a penny above the best price that can be achieved.
Using this definition, and this logic, this tells me that a Best-in-Class company should see diminished "Savings" year after year as they get better and better at getting the best deal each and every time they tackle a category, leaving the only "Savings" opportunities to be those opportunities where product costs (either due to commodity price or labor price decreases or production efficiency increases) have decreased since the last time a contract was cut. And this is much better than finding "Savings" because it means they didn't waste capital in the first place, which they left free for the business to fund operations and growth!
Remember, even Wal-Mart, despite the popular perception, cannot roll-back prices forever, especially in categories where commodity prices rise day after day! (Heck, sometimes they even roll-up by 50%! Case in point, last time I was there I was going to pick up "our" brand of coffee because they advertised, in their flyer from the previous month, that it was 4.99 everyday, which is a price you can only get in the grocery stores on sale. Well, I'm there, and I go to get some on my way out, and it's 7.57 ... a 51% increase.) At some point, until a disruptive innovation comes along, a Best-in-Class Procurement department is going to get the best deal and there will be no more "Savings". The better the department, the sooner they hit the floor. The sooner they hit the floor, the sooner they maximize "cost avoidance", which is what Procurement should be all about.
In other words, I think the numbers are just fine and that Mr. Bartolini did a good job of uncovering numbers that reflect the actual reality of how a good Procurement department really performs!
Categories: Best Practices, Procurement Innovation, Cost Reduction
Tags: Cost Avoidance
Doc,
While I absolutely agree that the more frequently you source a category, the less you save, you did somewhat mischaracterize the position I expressed in the post.
You wrote: "His assumption was that Procurement didn't do as well on non-traditional categories and that dragged the average down."
My assumption was that the difference between the spend that the best-in-class manages (88% of total spend) and the spend that the laggards manage (23% of total spend) was likely related to the fact that the best-in-class manage more indirect spend (insurance, health benefits, fleet, etc.) than the laggards do. Both are likely to be responsible for many of the "traditional" categories managed by Procurement.
In my experience, when Procurement branches into categories that have been unmanaged or undermanaged, there is a lot more savings to be had precisely because of the fact that they haven't been repeatedly sourced the way "traditional" categories have. So as the best-in-class uncover new areas of the business to source, the margins are generally higher and the savings greater.
So, if anything, I am saying that sourcing more indirect, not-previously-sourced categories should pull the average up, not drag the average down. If my assumption that the difference between the best-in-class and the laggards is that the best-in-class manage more indirect categories is true, IT IS THE ABERDEEN REPORT that indicates that the indirect categories drag the average down.
You also said "I think the numbers are just fine and that Mr. Bartolini did a good job of uncovering numbers that reflect the actual reality of how a good Procurement department really performs!"
But wait a second...Aberdeen defines best-in-class by two and only two metrics: spend under management and savings as a percentage of total spend. Aberdeen says more savings = better procurement department. Your post here says says better procurement department = less savings (more cost avoidance).
So it seems that you would disagree with Aberdeen on a few points and agree with me on them...
A good comment - I wish it were that simple.
I feel one can't qualify being best is class simply selecting more indirect spend management over direct spend. Deeper spend analysis and categorization makes one world class. Getting and analyzing true spend information is the key (which I feel to be truly available from accounts payable side). How much money was spent of maintenance services, external resources, HR, IT, R&D ... how many suppliers one actually has for each category and how many invoices they are sending each month. Focusing on limiting the number of suppliers in key categories and identifying the key process and spend savings potential makes one world class. There typically is a lot of room for consolidation outside the top 20% providers in each spend category.
So wanting to become a world-class procurement organization - I feel one needs start with following issues;
- Consolidate the supplier base starting with i.e. office supplies,research & development, training, marketing and travel to quickly gain big annual spend savings potential and concentrating purchasing power.
- Establish centrally negotiated contracts. Ensure that you procurement department has negotiating skills in place. Establish company wide spend management practices and monitoring process
- Ensure contract usage and minimize maverick buying through building & forcing the disciple into the organization through purchase management system.
- Establish company level purchasing processes in detail and ensure - automate as much as possible on purchasing for each key category.
- Ensure process savings in contract based purchases by automating the invoice matching with the contract
- Build the ruling in the purchase management system with matching approval process.
- Ensure company wide transparency and visibility in purchase to pay process through automation of the processes and forcing the set unified policies
- Establish competent procurement organization to ensure optimal procurement management by establishing category management practices
Above all the changes must be implemented across the entire organization so that business cost savings and efficiency targets are to be met.