You heard me right. They’re bloody ridiculous.
You might think you’re saving money, but in reality, you’re losing a small fortune. And if you take the time to read this post in its entirely, I’ll show you why.
One of the good things about the lingering recession, which is the third significant recession in less than a decade, is that it’s finally convinced many companies that they need a long-term plan for spend control. However, this is also one of the bad things because many companies have made a knee-jerk reaction of just imposing across-the-board year-over-year savings targets without thinking of the ramifications of this ridiculously stupid idea.
When you impose a blanket “savings target” instead of a single “cost reduction goal”, one of two things generally happens.
- Quality Plummets
From a pure spend perspective, your purchases fall into three buckets, you’re spending way too much, you’re spending more than you need to, and you’re spending about the right amount. If you impose an across-the-board cost reduction on a category that your spending the right amount on (because an A-team completed a very successful strategic sourcing event in the last year and raw material costs increased), the only way you’re going to lower prices further is to change the specs, which you usually can’t do, or lower your quality thresholds. As a result, after a few years of squeezing a supplier’s margins too thin, you’re going to get pure junk and lose a fortune in warranty, repair, and return costs.
- You Leave a Small Fortune on the Table
At the other end of the spectrum, if you impose an across-the-board cost reduction target on a category that you’re spending way too much on, your team is going to leave a lot of money on the table. They’re going to say “I have to save 5% year over year for the next 3 years. If I take the 15% savings I’ve identified now, and raw material prices increase, I won’t be able to meet my numbers next year. I won’t get my bonus, and I might even be next in line for layoffs if things get even worse. So I’m going to negotiate a 5% year-over-year cost reduction for three years now, because they’re going to “innovate”, or just take a 5% and then re-source next year, armed with all the research I did this year.” Trust me. I hear this story time and time again from consultancies who join me in shaking their heads in disbelief.
And you lose in the third case, where there are savings to be had, but not much, because once a sourcing professional realizes there isn’t a lot of wiggle room, the sourcing professional will spend as little time on the category as possible so he can move on to the next category in hopes it will be one with a lot of savings potential and the possibility to negotiate a year-over-year savings contract. (And in doing so might miss an opportunity to redefine the sourcing event or raw need and find savings by innovating design or delivery.)
And any way you look at it, you’re losing a fortune.
Scenario 1: Quality drops through the floor.
Let’s say that instead of having 2% of products defective, you now have 10%. Your warranty-related costs have quintupled. If we’re talking 1 M products worth $20, with a total warranty cost of replacement and return equal to $30 off of your bottom line, your warranty costs have increased from $600,000 to $3,000,000. That’s a 2.4M loss on a 20M category, or over 10% of revenues down the drain.
Scenario 2: You Leave a small fortune on the table.
Let’s say that you have a 10M category that has never been strategically sourced before, a 15% savings opportunity, and a 5% year-over-year across-the-board savings target. Your average purchaser who wants his bonus and his job is going to try to negotiate a 5% year-over-year cost reduction with his preferred supplier. That sounds great until you realize that means you leave 10% on the table this year, at least 5% on the table next year, and who knows how much on the table after that (when the supplier gets more efficient and/or volumes increase and/or raw material prices go down again). Even leaving just 10% on the table this year and 5% on the table next year will cost you 1.5M over the next 2 years!
If you must create a “target”, make a sourcing department wide goal of XM for this year only, where X is a small, reasonable, percentage of total corporate spend, and let sourcing decide the best way to try and meet that goal. Furthermore, have an incentive plan that pays a bigger bonus for every dollar of savings realized above the goal. Better yet, focus on “cost avoidance”, where Sourcing focusses on controlling costs in categories where raw material costs have skyrocketed. That way, sourcing won’t leave any money on the table and you’ll stay ahead of your competition.