Category Archives: Cost Reduction

The Real Price of Cost Cutting

Last November, Basware released a research report on “Cost of Control: The Real Price of Cost Cutting” that expanded upon their “Cost of Control” research summary (that they released last June) with in-depth interviews to illuminate some of the key issues that will form supply management strategy in the years to come. The white paper illuminated some good points which I’d like to expand on in this post.

Technology is Key to Efficiency

The report noted that respondents are alive and alert to the potential of efficiencies delivered through the use of technology, although IT investment is tight in the current market and that investment funds are likely to be made available where the business case is able to deliver tangible, short-term savings. This is positive — in that business are starting to see the value technology can deliver, and negative — in that business won’t invest unless they are convinced they can see immediate payback. In other words, as long as the market is tight, they are going to postpone new technology purchases and continue to bleed year after year, hoping that they’ll still have blood left when the economy improves.

Unfortunately, this report, like many others, did not address how to deal with this problem. The answer lies not in the ROI analysis (which is there, but not always rapid enough to justify six or seven figures up front) but in the approach to technology acquisition and payment. Businesses need to understand that it’s a tough economy for vendors too and that you don’t need to pay for it all up front anymore. Not only can you start with a SaaS pay-as-you-go solution (which will generate instant savings as long as you select a solution that costs less per month than the minimum average monthly ROI you expect), but most businesses will give you a payment plan in this economy, even if you buy a perpetual license. Furthermore, you can also pay as you go on services and support, and many organizations will even give you a payment plan on up front installation and integration if a lot of work is needed. Vendors would rather be paid tomorrow for work done today than not be paid at all.

Procurement and Finance is a Tense Relationship

A number of recurring issues erode the relationship between the functions but encouragingly cause regret on both sides. Whether Procurement reports to Finance or to the Board, Procurement has to work hand-in-hand with Finance, respect the cash-flow realities of the business, and make purchases that have the greatest positive impact to the bottom line. You’re not saving 2% by agreeing to early payment if you have to borrow the money at 24% annual interest because your customers are all paying late. Cost of capital, currency conversions, cost of commodity risk management (through hedge funds, futures, etc.) all have to be taken into your total cost of ownership equation — not just unit price, shipping price, storage price, and tariffs.

Again, the report presented no clear advice on how to resolve the conflict. While there is no answer that will be right for everyone, you need to start with the formation of cross-functional teams on every sourcing project which includes a Finance representative who can help you understand the financial impacts and ramifications of a proposed sourcing arrangement. Getting Finance’s input before the contract is signed will go a long way towards easing the tension and maintaining the relationship.

Minor Risks are Important Too

Businesses are looking for the ‘Tsunami’ events that take place in the supply chain, but failing to keep track of the ‘soil erosion’ that is more likely to be experienced over time with regards to quality and servicing issues surrounding the supplier relationship. Furthermore, respondents are happy to articulate potential failures among their key suppliers and the discrete disappearance of supplier businesses, but do not appear to pay enough attention to the broader issues created by compound supplier instability.

The fact of that matter is that if a number of minor risks materialize simultaneously, they can be just as devastating as a major risk materializing. Let’s say you make a product that requires five key components. What if all five suppliers experience problems at the same time and your orders are delayed at least 90 days from each supplier, in your peak season. One component, you could probably go into recovery mode and find a replacement quickly. Two components, super-charged fire-fighting mode. Five components? Forget it! All risks and suppliers have to be tracked and attention paid if leading indicators indicate trouble.

In other words, regardless of what fire you’re fighting today, there’s a big picture and you better not lose track of it. But it’s important to have a plan, and that’s where the report stops short.

Finally, don’t forget that, Across-the-Board Year-Over-Year Savings Targets are Stupid. After all, I even gave you Yet Another Reason Across-the-Board Year-Over-Year Savings Targets are Stupid.

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Yet Another Reason Across-the-Board Year-Over-Year Savings Targets are Stupid

This morning I told you how year-over-year savings targets are costing you a small fortune right now. Now I’m going to tell you how they cost you a large fortune over the long term.

Typically what happens in a company that gets serious about cost reduction as a result of a knee-jerk survival reaction in a recession is that, if they can attract one, they bring in a top-notch CPO. This CPO pulls the weeds out of the organization and replaces them with strong trees, acquires some decent tools (or at least access to some on-demand SaaS tools), institutes good processes, and brings in expert consultants to assist on the strategic sourcing of key categories where her team is weak. Over the next couple of years, the team kicks ass and exceeds their savings targets and everyone is happy. The corporation is saving money and the team is getting lots of kudos and bonuses for a job well done.

But then the inevitable happens. The economic cycle runs its course, the next economic boom occurs, demand for raw materials skyrockets, and prices go up, often significantly. As a result, it becomes impossible for the CPO and his team to get any year-over-year savings in any of the high-spend categories, which they had negotiated down to razor-slim margins when the supplier was desperate. (After all, not only is the supplier being offered a lot more money for a limited supply, but the supplier can’t even cover its input costs at last year’s prices.)

Then management, used to price reductions and unwilling to admit, and sometimes unable to even understand, the new market reality, makes another knee-jerk reaction and fires the CPO, with no plan for cost containment — which is much more important than cost savings. A monkey with an auction platform and the ability to use Google and access a D&B report can save you money in a recession when dozens of suppliers are desperate for your business (and will happily forego profits for a chance to survive). But only a true Procurement Pro can contain costs in a boom market when the supplier holds all the cards. A true pro can contain cost increases to only 10% when production costs go up 20%+ through skillful negotiations, collaboration, innovative delivery options, and so on. Everyone else will be lucky to secure supply at a 20% increase, which is what the company will end up having to accept without a procurement master at the wheel. And you’ll end up losing so much money that I don’t even want to attempt to calculate how much it will be, since the profuse bleeding won’t even begin to slow until you get a new CPO at the wheel, who’ll be hesitant to accept knowing that you’re last CPO, who was a superstar, didn’t make the cut.

You see, it’s not how much you save, because there is no such thing as savings. All “savings” means is that you were paying too much in the first place. What matters is the best deal with the greatest total value for every sourcing event, and a performance that outdoes the market average. When you start measuring that way (against competition, indices, and carefully researched should cost models), and calculate year over year improvements appropriately, that’s when you see real performance. Until then, you’re running a marathon you cannot win.

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Across-the-Board Year-Over-Year Savings Targets are Stupid

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.

  1. 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.
  2. 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.

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Supply & Demand Chain Executive Helps You Get a Better Deal

You can use a recent article on “the top 10 margin-killing myths about B2B pricing” in Supply & Demand Chain Executive to get a better deal from your vendor. Just like B2B companies must aggressively counter the closely held beliefs that are holding them back, B2B buyers must aggressively counter the closely held beliefs that are holding them back as well. Dispel the corresponding buyer myths implied in the article and you’ll be on your way to great deals.

  1. Myth: The Market Controls the Price
    You Control the Price. The vendor sets the list price, and you decide whether or not you’re going to pay it. The market doesn’t set the price, the contract you sign does.
  2. Myth: You Have More Important Things to Worry About
    Whether or not you buy a solution should ultimately boil down to expected annual ROI, which, simply, is your expected annual savings divided by the annualized software cost. If the price is too high, then the ROI will be too low, and you should not buy.
  3. Myth: Commodity Solutions Can Not be Price Differentiated
    Since different solutions can be expected to return different ROIs depending on how well they integrate with your business and how effectively they tackle your biggest problems, you should expect to pay less for a solution that offers less value.
  4. Myth: Price Improvement Puts Savings at Risk
    Remember, it’s not “savings” until you actually save the money. And if you spend more on software then you save from its application, there are no “savings” at all. While you shouldn’t quibble needlessly about a price that gives you an expected 20X ROI if it’s in market range, you should definitely negotiate hard on a price where you only expect a 2X ROI.
  5. Myth: Experienced Buyers Know How to Price
    Not necessarily. They know how to negotiate. Not how to price software, and definitely not how to get the best deal from an unfamiliar vendor. That’s why you have Deal Architects.
  6. Myth: Compensating on Technology Savings Ensures Good Buying
    It’s not about how much you can save on the IT budget, but about how much you can save using the IT you buy. Not buying an industry leading strategic sourcing decision optimization suite which can save you an average of 12% above and beyond the best reverse auction because it costs an extra 100K is just stupid if you spend over 100M annually. The software will pay for itself on your first big sourcing event!
  7. Myth: Pricing Has to Be Simple
    No, it has to be such that value is delivered. And sometimes, per CPU hour is the best price you’re going to get if you don’t use the software extensively for long periods of time between major buys. And thanks to modern software, it’s simple to calculate.
  8. Myth: Strict Compliance to Buying Rules Ensures Good Pricing
    And bad software. Comparing two software suites is often like comparing apples to oranges. It can be done, and you’ll find similarities, but there’s often a qualitative aspect to a preferred solution that can’t be quantitatively measured.
  9. Myth: New Solution Buys Require the Most Attention
    Really? So you’re going to stand for 22% maintenance on your ERP shelfware?

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Relocation Cost Reduction – Harder Than You Think

I recently stumbled upon a white-paper by SIRVA on “Breaking Through the Relocation Cost Reduction Paradigm: The Total Cost of Ownership Approach” that I found quite intriguing. While they made a few points in the white-paper I’m not sure I agree with (although I will admit I’m not an expert in relocation services or the housing market), they made a very good point that I’m sure most companies are overlooking when they source relocation services. Relocation services fees are usually less than 3% of the total cost of employee relocation while home sale related costs are usually 41%. In other words, it doesn’t matter how much you save on the relocation service fees because if the house doesn’t sell fast at a competitive commission rate, it’s going to cost you a fortune in duplicate housing costs. Since your employee won’t be able to buy a new house until their old one sells, you’ll be paying their rent, electricity, water, etc. until it does.

Furthermore, if you look at the total relocation cost breakdown provided by the report:

  • 41% – Home Sale Costs
  • 14% – Household Goods (HHG)
  • 11% – New Home Purchase
  • 11% – Tax Liabilities
  • 6% – Temporary Accommodations (during move)
  • 6% – Miscellaneous Allowance
  • 3% – New Home Location
  • 3% – Service Fees
  • 2% – Final Move
  • 2% – Spousal Assist
  • 1% – Expense Management

You quickly see that this is really the only expense that matters. There’s no leeway on tax liabilities, and most buyer purchase costs are fixed. You might be able to save 10% on HHG and Temporary accommodations above and beyond what a frugal and cost-conscious consumer will save, but that will only knock 2% off the total relocation cost. And it’s quite clear that the other costs are too small for cost reductions to make much of an impact.

So how do you reduce home-sale costs? If you look at the TCO, which is duplicate housing costs plus commission and bonus, you might think the answer is to aggressively negotiate down temporary accommodation costs and commission and bonus fees, but negotiating on either cost could end up costing you dearly. If you cut a broker’s commission from 6% to 4%, then you make them hungrier for the highest selling price they think they can get. They’ll assess your employee’s property high, advise them to list high, and then advise your employee to hold out on accepting an offer until that number is hit. A home that could sell in 60 days at a more reasonable assessment (that your employee might be very happy with) might now take 180 days or more, even in a good market. And if you spend all your time negotiating down temporary relocation costs, you’re missing a key savings opportunity. The fact of the matter is that if your employee can sell their old house and buy a new house that they can move right in to during the week they will be relocating, you don’t have any duplicate housing costs (and duplicate housing cost reduction becomes a moot point).

Thus, the ultimate key to relocation savings is helping your employee sell their home and find a new one fast! Furthermore, not only are rate and fee reductions of little significance, but successful attempts to reduce certain fees can actually cost you more in the long run! Considering that SIRVA found that the average cost to relocate a homeowner has risen by 20% to $77,000 over the last two years, risking additional costs in the long run is not something you want to do.

So how do you help an employee sell their home fast? Well, as far as I can tell you have three options.

  1. Follow the white-paper’s recommendation, which is to find a very successful broker and incentivize them to sell quickly with an early sale bonus (since this will be significantly less than what it will cost to keep your employee in temporary housing for the six months it can easily take a house to sell in today’s market).
  2. Negotiate a sale agreement with a large brokerage firm that will buy the employee’s house at a price mutually agreed upon up-front if the house does not sell within a pre-defined timeframe.
  3. Buy the house from your employee at a mutually agreed upon assessed value so they can immediately buy a new house. (For example, the average of the assessed value from the tax authority, the assessed value from a national market assessment firm, and the assessed value from an independent local assessor.)

For companies that do a number of relocations on an annual basis, I think options (2) and (3) might actually be the best ones. Option (2) allows you to limit your total costs. Even though you’ll likely have to provide additional compensation to the employee with option (2), since most realtor’s will only agree to buy at xx% of current market value (and you can’t expect an employee to sell for less unless you agree to compensate them), you’ve limited your duplicate housing costs and total relocation cost. While option (3) does provide some risk that a drop in the housing market could cost you some dollars if the market deteriorates before you sell, it also offers you the ability to actually make money, especially if you do a significant number of relocations. If you do a significant number of relocations annually, you could hire a property specialist who would manage the outsourced agreements to the national realtor organization and property maintenance organizations with whom you’d be able to get much better deals with due to the sheer volume of houses you’d be sending their way. Plus, in a heated market, you could let the property sit on the market longer and make money as the cost of monthly lawn maintenance (which is considerably less than the cost of temporary housing) would be a small fraction of the additional profit you could make on the sale. It’s something to think about.

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