Originally posted on on the e-Sourcing Forum [WayBackMachine] on Friday, 7 July 2006

A couple of months ago, CAPS released a critical issues report entitled
“Defining Cost Reduction and Avoidance” that is definitely worth a (second) read. In this report, they note seven major points that I would like to stress:

1. critical to the sourcing professional’s mission of reducing costs and delivering savings is the proper categorization of the various types of cost reduction and their application to the company’s operating budgets and profit and loss measures;
2. cost reductions come in two different categories: “hard” cost savings and “soft” cost avoidance;
3. a great deal of supply management’s efforts results in cost avoidance, yet this category is more intangible then cost savings;
4. even though many people might find it easy to discount cost avoidance as “phantom” or lesser savings to the company, these are “real” savings nonetheless and, despite the challenge, these savings must be properly quantified;
5. flexible and comprehensive IT systems are crucial, as they are the medium that will provide the visibility needed to accurately assess costs and expenditures;
6. metrics to track cost savings and cost avoidance should be standardized throughout the company, should be clearly defined, and should be available to all personnel; and
7. the key to success is to create a proper incentive structure for supply management personnel.
   In today’s post, I am going to elaborate further on each of these points, primarily with material from the CAPS study. In follow up posts, I will delve deeper into the types of metrics that could be used to measure savings and reductions and describe how one could structure a fair and comprehensive incentive-based compensation plan based on these metrics that could be used to drive success in your sourcing organization.

(1) Proper Categorization is Critical

Remember the old adage – “what can’t be measured, can’t be managed”. You need to measure, using standardized metrics, your cost reduction efforts, but before you can apply metrics, you need to have normalized data. This involves properly categorizing each type of cost reduction. Thus, your first step is to define each type of cost reduction and how it relates, directly or indirectly, to your company’s budgets and / or profit and loss measures. Some categories will be obvious, such as material cost reduction or freight reduction, some will be less obvious, such as decreases in process cycle times.

(2) Cost Reductions may be “Hard” or “Soft”
“Hard” cost savings, understood as tangible bottom line reductions, are easily defined as/characterized by:

• year-on-year saving over the constant volume of purchased product/service,
• actions that can be traced directly to the P&L,
• direct reduction of expense or a change in process/technology/policy that directly reduces expenses,
• process improvements that result in real and measurable cost or asset reductions,
• examination of existing products or services, contractual agreements, or processes to determine potential changes that reduce cost, and
• net reductions in prices paid for items procured when compared to prices in place for the

prior 12 months or a change to lower cost alternatives.
On the other hand, “soft” cost avoidance is much more difficult to define. Suggested definitions include:

• avoidance is a cost reduction that does not lower the cost of products/services when compared against historical results, but rather minimizes or avoids entirely the negative impact to the bottom line that a price increase would have caused,
• when there is an increase in output/capacity without increasing resource expenditure, in general, the cost avoidance savings are the amount that would have been spent to handle the increased volume/output, and
• avoidances include process improvements that do not immediately reduce cost or assets but provide benefits through improved process efficiency, employee productivity, improved customer satisfaction, improved competitiveness, etc.; over time, cost avoidance often becomes cost savings.

(3) Cost Avoidance is More Intangible

Some examples of cost avoidance that are given include:

• resisting or delaying a supplier’s price increase,
• purchase price that is lower than the original quoted price,
• value of additional services at no cost, e.g. free training,
• long-term contracts with price-protection provisions, and
• introduction of a new product or part number requiring a new material purchase; spend is

lower, but savings classified as avoidance due to a lack of historical comparison.

(4) Quantifying Cost Avoidance is Challenging

Some of the challenges faced by a company as they seek to properly assess cost reduction include:

• “cancellation” of net savings due to an overall increase in the business unit’s cost structure,
• supply management’s role in the cost savings allocation decision,
• chronology of supply management’s involvement and the need for budget cuts,
• visibility, in terms of systems, people, and metrics,
• Total Cost of Ownership (TCO) concept for purchases items/services,
• multi-year issues in cost savings, and
• creating a proper incentive structure for supply management personnel.

(5) Flexible IT Systems are Required

Systems, understood as both IT infrastructure and company policies, need to be in place to allow managers to get a realistic handle on what costs actually are, what areas might benefit from cost reduction efforts, and how company policies are designed to track and execute these savings. Also, processes for executing and tracking cost reduction projects should be in place and available to all personnel.

(6) Metrics need to be Standardized across the Company

The establishment of clear metrics and definitions helps avoid the accusations of “fuzzy math” or the arguments over what amount has been saved by a particular initiative. [Side note: despite common usage, fuzzy math is actually well defined and has solid foundations in centuries-old set theory and calculus, but, as per the implication in the CAPS paper, generally not your best choice for financial metrics.]

(7) The Key to Success is a Proper Incentive Structure

Like all employees, a supply manager will engage in behaviors rewarded by the company. This will create a problem if cost avoidance or cost reduction efforts beyond hard savings do not count toward a supply manager’s compensation and performance.

A successful company must count cost reduction as savings, clearly laying out how different cost reduction efforts count towards goals, and what their relative weighting or importance is. The share of credit that goes to supply management in cross-functional initiatives needs to be clearly defined and supply managers need to be recognized for their contribution to improvement projects with “soft” short-term benefits but “hard” long-term savings.

One idea is to provide supply managers with variable compensation as part of their incentive for meeting various savings goals. Such bonus plans are common for senior management, marketing/sales, and production. Such (uncapped) bonus plans could have an overall positive effect on the company’s overall cost reduction goals.

And all things considered, who is likely to work harder: a supply manager who makes $100K a year regardless of his performance, or a supply manager with the potential to double her salary if she hits a savings target of 5M?

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For more information on cost reduction and avoidance, see the “Cost Reduction and Avoidance: Best Practice Principles of Corporate Procurement” wiki-paper over on the eSourcing Wiki [WayBackMachine].