Category Archives: Cost Reduction

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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There’s More to Cost than Cost Analysis

While it was exceptionally well written, I was a little disappointed with this article on “uncovering hidden costs” over on SupplyManagement.com.

The article, which made the acute observation that there is no fixed arithmetic formula between the cost of producing the goods and services sold to us and the price charged for them: sellers charge what the market will bear and that to break down a suppliers’ figures, we need to know the proportion of each area of cost that the goods or services are likely to attract, did a great job of describing the different types of analysis one could bring to bear on costs, but a poor job of actually indicating how to reduce the “hidden” costs once found. The advice boiled down to “collaboration is key” which, while correct, doesn’t help you answer the important questions that will arise during the collaboration.

While questions like:

  • Can we give our suppliers access to our contracts to reduce cost?
  • Does our supplier have contracts we could access to cut cost?

are theoretically easy to answer (but not always easy to answer in practice due to the poor state of contract management in many organizations)

questions like:

  • What is the thing made of and what is happening in the market for that material?
  • Where are the cost drivers in these goods or services?
  • How can you buy that material most effectively?

are a little harder to answer.

You need to understand how to perform market intelligence, you need to understand how the goods are assembled (using virtual modelling environments like those offered by Apriori) or the services delivered, and you need to understand what innovative new technologies or processes could be applied to reduce those costs. And that’s more than you’re going to get from a purchase-price, open-book, or total absorption cost analysis. You have to start with a true Total Cost of Ownership and then dive in on each cost.

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Use Your Data Analysis System to Analyze Your Green Data and Save Money

As I noted in my recent post on Why You Need Visibility, if you put an energy meter inside a home and show people total usage in real time, a miraculous thing will happen: they will use about 10% less energy. And, more importantly, you can use this behaviour to drive savings, revenue, and innovation in your business. How? Consider these five uses courtesy of Andrew Winston and the Harvard Business Review which give you a green advantage (Five Ways To Use Green Data).

  • Usage Reductions
    If you provide operations with information on resource use, they will be inspired to find ways to cut back.
  • Internal Competition
    Share footprint data across departments, organize a competition, and see the troops rally! Some factory heads would rather miss financial targets than green goals because its just too embarrassing to be at the bottom of the list. (And since every dollar saved goes straight to the bottom line, you might just find yourself more profitable in the current stagflation.)
  • Customer Inquiry Satisfaction
    A great green story can sway customers to your product, and if you are a CPG manufacturer, get you more prime shelf space at Walmart.
  • Initiative Prioritization
    A focus on the value-chain impacts of your operations can help you to quickly zone in on those initiatives that will deliver the biggest results.
  • New Market Opportunities
    When P&G did a study on detergent, they discovered the vast majority of energy use was a result of consumers needing to heat the water to use the detergent. Thus, they invented Tide ColdWater, which generated 2B in revenue in its first year. You could find similar opportunities.

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