Category Archives: Cost Reduction

How Do You Find Hidden Costs?

We all know that there is never a fixed arithmetic formula between the cost of producing, and transporting, the goods and services sold to us and the prices charged for them … sellers charge what they can get, and if we don’t do a good job of figuring out the true cost, which can be hard to do, chances are they are building in a hefty margin.

But the margin is only one hidden cost. There’s other hidden costs baked into the COGS by the supplier, some of which even they may not be aware of. But if you want to bring costs down, you have to find them. So where do you look?

Start by investigating each of the main production costs:

  • raw materials — what are your T1 suppliers paying to the T2 suppliers
  • energy — production always requires energy … but there isn’t always one rate
  • labour — if there is temp labour / contract labour involved, is it market rate
  • overhead costs — facilities, financing, etc. — these could be fixed, or they could not … for example, if the supplier has to borrow to fund operations until they get paid, what interest rate are they paying … and how does it compare to your rate? might be cheaper for you to pay them early in exchange for a discount that exceeds your cost of capital

That’s how you them. So what do you do next?

Come up with a plan to address any costs that look high:

  • if material costs are too high, can you buy on behalf of suppliers at a better rate? can you find alternative materials?
  • if the market is deregulated, can you help the supplier identify a better option? are energy requirements so large a supplier would do better off with its own plant? should you invest in it if there are multiple suppliers in the region paying absurdly high energy costs?
  • should you share labour negotiation and management best practices to help your supplier keep labour costs down
  • if suppliers have a high cost of capital, help them out … reduce their cost, reduce yours; maybe you can identify facility upgrades that would save them money

It’s not as easy as it sounds, but it’s not that hard either. Just takes data gathering and analysis.

Right Now, Savings Are Everywhere …

… because you don’t have your costs under control. While there is no such thing as true savings, because finding savings just means that you weren’t spending optimally to begin with, the reality is that you are not spending optimally. Not even in your most strategic categories where you are putting the most of your effort. This is because you are not applying both leading strategic sourcing decision optimization and leading spend analysis to this category across multiple levels on a global category scale. (Even if you own both technologies, chances are you don’t own best of breed in both, and even if you are that one in a thousand company, the doctor has seen the most complex optimization models that are being built by the average company, and they are still elementary compared to what models could, and should, be built.)

So, even if you are given an unrealistic savings target, if it’s 10% or less, it is easy to meet because, until you have applied these two advanced sourcing technologies to every single category, and done so in a three-year time span (as costs always creep back in to a category over time, and that’s why GPOs and niche consultancies find you savings on the same category again and again if sourced three to five years apart), there is overspending everywhere. So, if you can just get your CFO to write the cheque, acquire these technologies, and apply them appropriately, you’re going to find significant savings on the 60% to 80% of your non-tail spend, which hides even higher levels of savings (as we have discussed here on SI in the past).

And then, since the secret to cost control is to source everything, make sure you are buying everything that costs 5 figures or more through an RFX or Auction, and, in many cases, preferably one that is automatically configured and run for you by the platform with little buyer involvement beyond keeping the approved supplier database up to date and verifying the award before the contract or PO is sent to the winning supplier. And if you actually manage to find the majority of savings across your leading spend and tail spend, limiting potential year-over-year cost reductions to 3% in the following year, you’ve still only scratched the surface.

Just because your organization has optimized it’s spend, that doesn’t mean that your strategic / high volume supply base has optimized their spend. This is where supplier development and supplier (relationship) management comes into play. If you help your top x suppliers, where this X constitutes 80% of your strategic spend, and over 50% of your spend, save 10% by optimizing their procurement, you lower your costs on this half of your spend by 10%, and there’s another 5% without doing anything but process improvement. But we always know that savings don’t stop at process improvement, they continue with product improvements that enhance quality, reduce manufacturing costs, and reduce reliance on rare earth metals or non-renewable materials — all of which can be identified with the right innovation.

So, in CFO speak, savings are everywhere, and you should have no problem finding significant savings as long as you acquire, and apply, the right tools for the job. This means if you don’t have appropriate advanced sourcing technologies, you have to go get them. They are worth it.

True Savings Can Only Be Identified through Multi-Factor Optimization

A recent guest post from a vendor-employed guest contributor over on Spend Matters said to Calculate Your True Savings Using Predictive Analytics. While the doctor agrees predictive analytics can often give you a good data point as to projected savings, the reality is that it’s not always as accurate as you would like to believe and typically does not capture your best savings opportunities.

Why? Before we discuss the guest post, which did have some good points, we have to note that most predictive analytics algorithms work on trending and statistics on historical or market data, and while this can be highly accurate (95%+) the majority of the time (95%+), because market data is only historical and typically does not include data points on new (not yet introduced or announced innovations), detailed cost breakdowns on consumer / market prices, or operational insights into hidden inefficiencies whose correction can do more than shaving a few points off the top.

Going back to the post, the author states that if you use a Savings Regression Analysis (SRA) model based on multivariate regression of past-realized savings for a given subcategory to compute the savings potential under current market conditions, the target computed will be realistic, achievable, and likely mirror what you will do (despite the savings targets you set).

And this statistically based model will work if it is the same buyer (group) employing the same strategy on the same market base under similar conditions, but what could happen if a new buyer comes in that totally redefines the demand and the market strategy, or the market conditions have suddenly changed from supply shortage to supply surplus, or new production technologies could revolutionize production and trim overhead 20%? In this situation, this type of model will be significantly off.

Now, anything you can do to better predict savings is a positive, because, as the author points out, this allows for

  • better cash flow management (as you will better know your costs)
  • time to market optimization (as you will know the best time to source if you have leeway)
  • goal setting (as you won’t be trying to achieve the impossible)
  • performance management (as you can track against a realistic goal)

But while predictive analytics give a good data point, the best data point is when you use your market intelligence to build good should cost models, use optimization to minimize transportation and incidental storage and sales (and even taxation) costs (when sourcing globally), and use six sigma analysis to see if there is any opportunity to take cost out of a supplier’s overhead production cost. Going into this level of detail may indicate that while the product cost is likely to increase 1% this year (and explains why the predictive software says only 2% savings should be expected after heavy negotiations), an extensive analysis could show that a transportation network redesign could shave 3% and lean process improvements at your supplier could shave 2%, meaning that a cost reduction of up to 7% could be achieved with the right footwork (which is something the predictive model will never tell you). So use the predictive algorithms to establish a baseline, but never, ever stop there.

Why You Need Mass Adoption Of An Optimization-Backed Sourcing Platform

Last week, in our post on why Higher Adoption is Where the True Value of Optimization Lies, we emphasized the importance on not just having optimization, but an optimization-backed sourcing platform that can be used by the most junior of buyers. We focussed on the efficiency, time savings, and value such a platform would bring, but didn’t give you any hard numbers. While the hard numbers will be hard to come by, SI expects that the savings that hit the bottom line from such a platform will increase by at least 150% over using stand-alone optimization, and more than likely will double what an organization would see if it just used a regular strategic sourcing platform without optimization. We know that 2.5X is not a very impressive number when vendors go around talking about 10X ROI, but the ROI that vendors promise is relative to the cost of the platform, not the ROI relative to the organization’s bottom line, and that’s what really counts.

The reality is that, at the end of the day, after COGS, depreciation, taxes, etc. are factored in, a good Procurement organization might only take 2% off of the bottom line. This doesn’t sound that impressive, unless the organization is a 10B organization where 2% is 200M, in which case it’s knock your socks off impressive. Now imagine if that same Procurement organization could increase the straight to the bottom line savings by 150% and show a bottom line savings of 5.2%. That’s another 320M in annual savings for a total savings of 520M! That’s buy everyone on the Sourcing team a custom made Jaguar savings because no other initiative is going to take that much off the bottom line.

But you don’t have to be a 10B organization to see the impact. Imagine you are a small mid-size organization with only 100M in annual spend. Instead of seeing an average year-over-year impact of 2M, you’d see 5.2M. If a fully burdened FTE is 200K and you had a small Procurement department of 5 people managing your spend, the department’s ROI would go from 2X to 5.2X in a single year, and that is quite significant.

So where are these, quite conservative, numbers coming from?

  • A Best In Class Organization has 80% of spend under management (Hackett, Gartner, etc.)
  • A Best in Class Organization will strategically source approximately 1/3 annually (due to resource restrictions) (Crowd Wisdom approximation used by many vendors)
  • A Best In Class Organization with stand-alone or hard-to-use optimization capability will only put the top third of complex, strategic, or high volume spend through the organization (Generous crowd wisdom approximation based upon SI’s interaction with optimization vendors)

As a result, (at most) one-third of one-third of four-fifths of spend gets optimized on an annual basis, or about 9% gets optimized using strategic sourcing decision optimization and the full extent of its capability.

However, if the organization has an optimization-backed sourcing platform that is configured for one-click evaluations and automatic weighted auction awards for low-cost / standard categories,

  • 98% of spend can be under management (as it can flow through the platform as easy as it can flow through an auction or spot buy RFP),
  • one half of that can be sourced annually due to efficiency gains
  • and all of this spend will be subject to optimization.

This means that about one half of organizational spend, or about 48% of spend, can get at least partially optimized on an annual basis. In other words, an organization can subject 5x its spend to optimization on an annual basis.

The net result is that an organization that adopts an optimization-backed sourcing platform that can be used by every buyer will see at least 150% more savings hit the bottom line every year. Why?

If we look at the numbers:

  • the average return from Procurement at a world class organization is 4.7% (Hackett Group)
  • the average return on tail spend (which is never strategically sourced) is 7.1% (Hackett Group)
  • the average return from SSDO on a strategically sourced category where the full power of the solution is enabled is 12% (Aberdeen)

This leads to the following (where we assume 20% of spend is “tail spend”):

Traditional:
09% using SSDO @ 12.0% savings = 1.0% savings
18% using SS   @ 04.7% savings = 1.0% savings
TOTAL = 2.0% savings
 SSDO Platform
38% using SSDO @ 12.0% savings = 4.5% savings
10% using SSDO @ 07.1% savings = 0.7% savings
TOTAL = 5.2% savings

Now, mileage will vary among organizations, but this example should make it pretty easy to see that optimization is a huge value driver that will have a significant impact on your bottom line when it is widely deployed.

So if you want to know what to look for in an optimization-backed sourcing platform, download Optimization: Higher Adoption is Where True Value Lies (registration required) today and find out what you need to take optimization from a success to a smashing success in your organization.

Buy, Buy, Buy, Once Bitten Twice Shy

Many procurement functions and executives see price negotiation and reduction as the primary element of their role. In doing so, they run the risk of missing out on the major benefits that can be obtained by focusing on other aspects of the wider value picture.
Full Value Buying: Moving Beyond Price Negotiation, Peter Smith & Jon Milton, 2015

Why? Is it because they think price trumps all? Is it because they don’t think there’s value in non-price factors and services? Is it because they once focussed too much on the bigger picture, didn’t do their homework, greatly overpaid, did not realize any savings, got hung out to dry, and are now once bitten, twice shy? And does it really matter?

As SI has been proclaiming for years, it’s not TCO (Total Cost of Ownership), it’s TVM (Total Value Management). It’s not how much you pay, it’s the return you receive. As Finance will tell you, it’s all about the ROI. Paying a bit more for a value-added service from the supplier that saves you money is a good return. Paying a bit more in a dual-source strategy to large suppliers with high-volume production lines to prevent otherwise likely stock-outs is often the best insurance policy you can buy. And paying a bit more to use a supplier you are certain does not use child labour, does not subject its workers to poor working conditions, and does not use conflict minerals, banned raw materials, or illegally obtained goods and services costs a lot less than the PR nightmare and lost sales that could result from a brand scandal.

But these are just some ways to increase the value of a purchase. In Mr. Milton and Mr. Smith’s latest paper on Full Value Buying they describe techniques, such as specification improvement and demand management that can generate returns above the 10%+ that an organization can typically save through skillful spend analysis or decision optimization (which are the only two traditional sourcing techniques that generate consistent year-over-year savings in the double digit percentages).

In the paper they address four major mechanisms that can affect the cost of a buy and the upper bound on cost savings that each factor can traditionally bring:

 

Mechanism Saving Potential
Purchase Price (TCO model) 20%
Specifications 30%
Whole-Life Factors 50%
Demand 50%

 

These numbers may seem high, but consider the following. Changing the specifications slightly to allow a lower cost material to be used which can also be used in a more efficient (and cost effective) production process can easily shave 50% to 90% off of 40% (or more) of the cost if a (rare earth) metal that costs $50 an ounce is replaced with a metal that costs $10 an ounce. Changing the design that allows the product to be easily disassembled and valuable metals recovered (upon forced recovery subject to environmental disposal laws) can turn a losing collection business into profitable recovery one. Buying Accounts Payable and Marketing extra monitors so they don’t have to print PDF invoices to enter them or documents they need to reference when composing project specifications can cut organization paper demand by over 50%. And these are just a few examples.

the doctor strongly encourages you to check out Mr. Smith’s (co-authored) latest piece for more details on how these mechanisms can be applied across a range of categories to not only bring costs down, but even value up to the organization. After all, he went to Washington. (Figuratively and literally.)