Originally posted on on the e-Sourcing Forum [WayBackMachine] on Sunday, 9 July 2006

In our first post we tried to characterize the two types of cost reduction, “hard” cost savings and “soft” cost avoidance, introduced you to some of the challenges in defining and measuring savings, and indicated that a proper incentive structure was key to success. In our second post, we defined some starting metrics to address the challenges in measuring savings. Today we elaborate on the topic of incentives.

In our first post we noted that a sourcing professional is more likely to engage in behaviors rewarded by the company and that this is the basis for a serious problem if only “hard” cost savings are rewarded. Thus, we stated, in full agreement with the CAPS report “Defining Cost Reduction and Avoidance” that inspired this short series of posts, that a successful company must count cost reductions as savings. In addition, a company must clearly define recognized cost reduction efforts, tie them to goals, define their relative importance or weighting, and define the share of the credit that will go to sourcing team in a cross-functional initiative.

However, in our initial post we made no mention of what these cost reduction efforts might be, how they could be quantified and measured against overall goals, and how credit should be doled out to your sourcing group in cross-functional initiatives.

Yesterday, we tackled five of the challenges in defining cost reduction metrics and defined hard metrics that captured the cost reduction savings associated with:

• sourcing a pre-existing product for which there was prior year spend and the market index of the associated raw materials remained stable or dropped,
• sourcing a pre-existing product for which there was prior year spend and the market index of the associated raw materials increased (significantly),
• sourcing a new product or service, and
• multi-year contracts and cost reduction efforts

and indicated how to effectively include TCO in these calculations.

These metrics provide a solid foundation for quantifying cost reduction efforts, and, as mentioned in yesterday’s post, crediting the sourcing group in a cross-functional initiative is as simple as determining a split percentage up front before the project begins. This just leaves us with the issue of determining what constitutes a cost avoidance and how to incentivize your team based upon these efforts, associated metrics, and percentage splits.

The CAPS report provided a number of definitions for cost avoidance, which can be succinctly summarized as follows:

Cost avoidance is a cost reduction that results from a spend that is lower then the spend that would have otherwise been required if the cost avoidance exercise had not been undertaken.

This accounts for the situations where spend is higher due to higher demand but overall cost per unit is lower, where up-front investments reduce overall spend in one or more categories over a multi-year initiative, and where a process improvement or product replacement resulted in a lower operating cost or cost per unit compared to what the company would have spent had the company not improved the process or replaced the product.

(Note that the cost reduction enabled by a process is easily calculable by comparing the average operating cost for a fixed period before the process change with the average operating cost for a fixed period after the process change, and everything we have mentioned is measurable and calculable.)

Thus, if you adopt this open definition of cost avoidance, and maintain a document of common examples and their associated metrics, which is updated each time a new type of project is encountered that could result in a cost avoidance, you can fully quantify the “hard” and “soft” savings delivered by you to your management team.

By doing this, you will have clearly defined cost reduction efforts, tied them to savings, defined their relative importance, and defined the share of the credit that will go to supply management in a cross-functional initiative. You will also have avoided the problem where your team over concentrates on finding “hard” dollar savings, which is a serious problem if raw material and energy costs keep rising significantly and your largest savings potential is in the “soft” savings realized by long-term process and product improvements.

Now the only question you have to answer is how to structure your incentive plan? As I stated in my first post, I firmly believe that a sourcing professional’s compensation should include a variable compensation component based on meeting or exceeding various savings goals. These types of bonus plans are already common for senior management, marketing/sales, and production and have been shown to yield significant positive benefits when an individual’s earning potential is limited only by her own efforts. 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, or even triple, her salary if she hits a recognized savings target of 5M or more?

I am also in favor of an uncapped compensation packages. This might sound crazy to a manager, like a CFO, who’s job it is to reign in expenses, but I would point out that it is not expenditures that ultimately determine a company’s success, but profit, and when procurement is involved, this depends soundly on ROI. In my view, it’s not at all crazy to pay a sourcing professional 500K a year if that sourcing professional generated 10M in savings that the company would not otherwise have seen. Why? Let’s say instead of $100K / yr + 4% on all recognized savings the sourcing professional had a fixed compensation structure of $100K + 20K bonus for hitting a 2.5M savings target or a 40K bonus if he hit a 5M savings target. Given that he can’t earn more then 140K, how hard is he likely to work once he hits 5M?

Back to our ROI perspective, it makes much more sense to offer him a limitless bonus plan. With the fixed plan, you spend 140K and save 5M for a ROI of $4.86M. But with the variable plan, you spend 500K and save 10M for a ROI of $9.5M. I don’t know about you, but I’ll take the second option. Successful companies have known for years that the best performing sales people are those with the potential to make more then anyone else in the company. And when you consider that each dollar saved is worth five to ten dollars in sales revenue, doesn’t it just make sense to incentivize sourcing at least as much as you incentivize sales, especially considering what they can do? Look at HP’s first quarter results for the year – earnings went up 51% despite the fact that revenue increased only 5.5%! Why, because “procurement across the board at HP made a substantial contribution to the results”.

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].