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”.

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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].

Originally posted on on the e-Sourcing Forum [WayBackMachine] on Saturday, 8 July 2006

In yesterday’s post, we overviewed the two types of cost reduction, “hard” cost savings and “soft” cost avoidance, some of the challenges in defining and measuring savings due to cost avoidance, and the importance of metrics and a proper incentive structure for supply/spend management personnel.

In today’s post, we are going to review five of the challenges presented in the CAPS report “Defining Cost Reduction and Avoidance” and define some starting points that you can use to build hard metrics that you can use to quantify your success.

(1) “Cancellation” of net savings due to an overall increase in the business unit’s cost structure

Sourcing should not be held accountable for cost increases outside their control, such as increased demand (which generates higher spend) or increased operating costs in overhead or salaries solely under the control of the appropriate unit manager.

Furthermore, savings should be calculated on a per-unit basis relative to historical costs, market baselines, or otherwise expected spend levels, depending on the context of the project.
For example:

(i) Lets start with the example in the CAPS report where you are sourcing an existing product and you expect a cost reduction. Last year widgets cost $2 each and production required 10 units. This year, you negotiated the cost down to $1.50, but production ended up ordering 12. If you look at raw numbers, last year production spent $20 and this year production spends $18, a difference of $2. But this does not represent the true savings of $6, since production saved $0.50 per unit on each of the 12 units they bought.

(ii) If you are sourcing a new product, chances are you could still be saving the company money no matter how much the product costs per unit. Measure the cost avoidance using the average unit price in the market place, as obtained from a respected market analysis firm or other 3rd party source. (Don’t use initial supplier bids since the argument could be made that the suppliers bid high in the expectation of a reverse auction or other sourcing event designed to ultimately lower their quoted costs.)

(iii) If you are sourcing products primarily made from a commodity whose average market price or index has increased significantly since the last sourcing cycle, measure the cost avoidance relative to the percentage increase. For example, if you were sourcing gold-plated circuitry, with gold roughly $650/oz, and the last time you sourced the circuitry gold was roughly $590/oz, then you would expect the cost of your product to increase by at least 10% (on a unit basis). If the cost increase is less then 10%, then you have obtained a cost reduction by way of a successful sourcing event. (The CAPS report indicates that you could base your avoidance on a proposed supplier price increase, but like initial bids, this is a nebulous number. Market indexes are hard and can be agreed upon as impartial by all parties.)

(2) Supply management’s role in the cost savings allocation decision

If the team is cross-functional, then a decision needs to be made up front, by an appropriate manager, how much of the cost savings will be attributed to supply management and how much to the other business unit(s). This could be an even split, or a weighted split dependent on who is taking the lead and how the work is expected to be split among the team members. There’s no hard and fast rule here, but all parties involved should agree that the split is “fair” before the project gets underway.

(3) Visibility, in terms of systems, people, and metrics

The agreed-upon metrics and the data that the cost avoidance metrics are calculated on need to be accessible to the entire organization so that there are no challenges as to their accuracy and validity.

(4) TCO concept for purchases items/services

TCO is a hard calculation. It includes all the direct cost components that go into the landed cost calculation (unit cost, freight, interim storage, tariffs, etc.), storage costs, and processing costs.

Probably the easiest way to approach this calculation in cost reduction metrics is to base the cost on landed costs and then factor in adjustments for any additional costs that are above or below average.

For example, if you were sourcing a food product and only one option is frozen, then the storage costs for all items but the frozen item will essentially be same, with the frozen item costing more due to increased energy costs of using a freezer over a fridge, and only the landed cost for the frozen item needs to be adjusted. If you were a chemical manufacturer, and all but one option can be used as-is without refinement, then the processing costs for all but the option that requires refinement will be essentially the same, and only the landed cost for the product that requires a refinement phase will need to be adjusted. Similarly, when computing savings, you only need to adjust for differences in incurred costs between respective time periods.

You can argue that this is not a proper TCO, but when it comes to calculating savings, mathematically speaking, it is only the differences in cost between last year’s buy and this years buy that matters and this simple approach is sufficiently accurate for your purposes.

(5) Multi-Year Issues

Sometimes the savings from switching to a new product or new supplier will not be realized until the second or third year of a contract, due to up-front costs associated with new equipment or investments. However, it is important that your supply and spend managers be rewarded each and every year for their contribution to this savings initiative.

Although it you may think that you may not be able to accurately calculate savings from such an endeavor until the contract ends, since you have to amortize investment costs, if you equally amortize the cost over a fixed period, then you could adopt a calculation that realized savings each and every year. (And if losses occurred in the first year, they could be carried over and then your team rewarded as soon as hard savings were realized.)

For example, let’s consider the scenario where you signed a 3 year contract for gadgets with a new supplier who promised you, based on demand estimates of 1000, 1500, and 2000, all the gadgets you needed at $7 each, compared to the $10 you are spending now with your current supplier. However, you have to upgrade your production process, and this is going to cost $5,100 up front.

At a contract level, you expect to save $8,400 since instead of spending $45,000 for 4500 units, you are in fact spending only $31,500 plus $5,100, or $36,600. If, in fact, your actual demands were 900, 1600, and 2200, then your actual savings could be calculated on a unit basis using an amortized fixed cost of $1,700 a year as follows:

Year 1: (10 *  900) - (7 *  900 + 1700) =
              9000  - (    6300 + 1700) = 1000

Year 2: (10 * 1600) - (7 * 1600 + 1700) =
             16000  - (   11200 + 1700) = 3100

Year 3: (10 * 2200) - (7 * 2200 + 1700) =
             22000  - (   15400 + 1700) = 4900

or: (old contract cost) – (new contract cost + amortized cost)

Alternatively, you could estimate total savings up front, amortize savings for the year, and then correct in future years using actual demands vs. projected demands. As long as the calculation is sound and agreed upon up front, it doesn’t really matter as long as your sourcing professionals are fairly acknowledged for the contributions they make.

Other challenges highlighted in the CAPS report include the “chronology of supply management’s involvement and the need for budget cuts”, which is more of a political issue then a metric issue, and the need to “create a proper incentive structure for supply management personnel”, which will be addressed further in my next post.

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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].

Originally posted on on the e-Sourcing Forum [WayBackMachine] on Friday, 7 July 2006

A couple of months ago, CAPS released a critical issues report entitled
“Defining Cost Reduction and Avoidance” that is definitely worth a (second) read. In this report, they note seven major points that I would like to stress:

1. critical to the sourcing professional’s mission of reducing costs and delivering savings is the proper categorization of the various types of cost reduction and their application to the company’s operating budgets and profit and loss measures;
2. cost reductions come in two different categories: “hard” cost savings and “soft” cost avoidance;
3. a great deal of supply management’s efforts results in cost avoidance, yet this category is more intangible then cost savings;
4. even though many people might find it easy to discount cost avoidance as “phantom” or lesser savings to the company, these are “real” savings nonetheless and, despite the challenge, these savings must be properly quantified;
5. flexible and comprehensive IT systems are crucial, as they are the medium that will provide the visibility needed to accurately assess costs and expenditures;
6. metrics to track cost savings and cost avoidance should be standardized throughout the company, should be clearly defined, and should be available to all personnel; and
7. the key to success is to create a proper incentive structure for supply management personnel.
   In today’s post, I am going to elaborate further on each of these points, primarily with material from the CAPS study. In follow up posts, I will delve deeper into the types of metrics that could be used to measure savings and reductions and describe how one could structure a fair and comprehensive incentive-based compensation plan based on these metrics that could be used to drive success in your sourcing organization.

(1) Proper Categorization is Critical

Remember the old adage – “what can’t be measured, can’t be managed”. You need to measure, using standardized metrics, your cost reduction efforts, but before you can apply metrics, you need to have normalized data. This involves properly categorizing each type of cost reduction. Thus, your first step is to define each type of cost reduction and how it relates, directly or indirectly, to your company’s budgets and / or profit and loss measures. Some categories will be obvious, such as material cost reduction or freight reduction, some will be less obvious, such as decreases in process cycle times.

(2) Cost Reductions may be “Hard” or “Soft”
“Hard” cost savings, understood as tangible bottom line reductions, are easily defined as/characterized by:

• year-on-year saving over the constant volume of purchased product/service,
• actions that can be traced directly to the P&L,
• direct reduction of expense or a change in process/technology/policy that directly reduces expenses,
• process improvements that result in real and measurable cost or asset reductions,
• examination of existing products or services, contractual agreements, or processes to determine potential changes that reduce cost, and
• net reductions in prices paid for items procured when compared to prices in place for the

prior 12 months or a change to lower cost alternatives.
On the other hand, “soft” cost avoidance is much more difficult to define. Suggested definitions include:

• avoidance is a cost reduction that does not lower the cost of products/services when compared against historical results, but rather minimizes or avoids entirely the negative impact to the bottom line that a price increase would have caused,
• when there is an increase in output/capacity without increasing resource expenditure, in general, the cost avoidance savings are the amount that would have been spent to handle the increased volume/output, and
• avoidances include process improvements that do not immediately reduce cost or assets but provide benefits through improved process efficiency, employee productivity, improved customer satisfaction, improved competitiveness, etc.; over time, cost avoidance often becomes cost savings.

(3) Cost Avoidance is More Intangible

Some examples of cost avoidance that are given include:

• resisting or delaying a supplier’s price increase,
• purchase price that is lower than the original quoted price,
• value of additional services at no cost, e.g. free training,
• long-term contracts with price-protection provisions, and
• introduction of a new product or part number requiring a new material purchase; spend is

lower, but savings classified as avoidance due to a lack of historical comparison.

(4) Quantifying Cost Avoidance is Challenging

Some of the challenges faced by a company as they seek to properly assess cost reduction include:

• “cancellation” of net savings due to an overall increase in the business unit’s cost structure,
• supply management’s role in the cost savings allocation decision,
• chronology of supply management’s involvement and the need for budget cuts,
• visibility, in terms of systems, people, and metrics,
• Total Cost of Ownership (TCO) concept for purchases items/services,
• multi-year issues in cost savings, and
• creating a proper incentive structure for supply management personnel.

(5) Flexible IT Systems are Required

Systems, understood as both IT infrastructure and company policies, need to be in place to allow managers to get a realistic handle on what costs actually are, what areas might benefit from cost reduction efforts, and how company policies are designed to track and execute these savings. Also, processes for executing and tracking cost reduction projects should be in place and available to all personnel.

(6) Metrics need to be Standardized across the Company

The establishment of clear metrics and definitions helps avoid the accusations of “fuzzy math” or the arguments over what amount has been saved by a particular initiative. [Side note: despite common usage, fuzzy math is actually well defined and has solid foundations in centuries-old set theory and calculus, but, as per the implication in the CAPS paper, generally not your best choice for financial metrics.]

(7) The Key to Success is a Proper Incentive Structure

Like all employees, a supply manager will engage in behaviors rewarded by the company. This will create a problem if cost avoidance or cost reduction efforts beyond hard savings do not count toward a supply manager’s compensation and performance.

A successful company must count cost reduction as savings, clearly laying out how different cost reduction efforts count towards goals, and what their relative weighting or importance is. The share of credit that goes to supply management in cross-functional initiatives needs to be clearly defined and supply managers need to be recognized for their contribution to improvement projects with “soft” short-term benefits but “hard” long-term savings.

One idea is to provide supply managers with variable compensation as part of their incentive for meeting various savings goals. Such bonus plans are common for senior management, marketing/sales, and production. Such (uncapped) bonus plans could have an overall positive effect on the company’s overall cost reduction goals.

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 her salary if she hits a savings target of 5M?

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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].

Originally posted on on the e-Sourcing Forum [WayBackMachine] on Sunday, 20 August 2006

Established Procurement Service Providers focused on sourcing are usually market leaders that have a number of inherent advantages which include a larger supply base, higher levels of expertise in niche categories, and the ability to aggregate spend on a larger scale. In addition, they can often tap more economical labor sources in regional markets and implement new sourcing processes and technologies more efficiently.

A PSP reduces the headcount you need to perform certain manual and tactical processes or to manage certain indirect or non-strategic categories that are not a core competence, freeing up your purchasing team to spend a much greater percentage of their time on strategic activities and strategic categories and generate a larger return on your investment in them.

What should you do to prepare?

Managed properly, a relationship with a PSP is very beneficial. However, before you enter into such a relationship, you need to prepare for success.

The very first thing you need to do, even before you make the decision on whether or not to outsource part of your procurement function, is to gather data on the current state of your procurement practice. Do a spend analysis by category and location to determine high-volume vs. low-volume categories. Work with product development to determine strategic vs. non-strategic commodities. Understand your transaction volumes and associated processing times. Document your processes and average sourcing times by category. Determine what currently falls under procurement, what does not, and what should.

The next step is to analyze this data and determine direct and indirect savings opportunities by outsourcing low-volume or non-strategic categories, transaction management, and process execution. Procurement outsourcing only makes sense if considerable year-on-year savings opportunities exist, especially since the greatest savings will not be realized until a year or two into the relationship. Furthermore, a good relationship is driven by a Service Level Agreement (SLA) that specifies mutually agreed upon targets and goals, and incentives for the PSP exceeding those targets goals, and reasonable values for those targets and goals cannot be set unless you have a basic understanding of your current spend and internal performance.

Once you have finished your analysis, you need to decide what will actually be outsourced, what the scope of the arrangement will be, how the responsibilities will be split, and how the relationship will be managed. A governance council will need to be established to maintain control over what is being outsourced and monitor performance and compliance. The council will be key to aligning stakeholders and insuring a single cohesive message is always delivered to the PSP.

A single senior executive needs to take responsibility, coordinate the deal to the point of closure, and oversee the initial implementation. The executive is also responsible for making your employees aware of the plans, overseeing the creation of the transition approach and timing, and explaining the benefits to the procurement function and the organization as a whole.

What should be in the SLA you mentioned?

One of the keys to success, the SLA must define a formal governance and oversight structure, risk-and-gain sharing policies, staffing parameters, operating specifics, and response times. It should be based on key metrics, and measurements against these metrics should be taken and communicated regularly. It should include incentives for exceeding targets and penalties for sub-par performance. It must allow for bilateral transfer of methods, processes, and knowledge and encourage continuous process improvement.

And in conclusion?

Once the SLA is nailed down, the specifics of the relationship need to be addressed. It should be a multi-year agreement, I would recommend at least two or three, with proper incentives, a well defined governance model, appropriate categories and risk management processes, and methodologies for the transfer of best practices. It should also identify and account for any important or relevant legal issues up front to prevent issues down the road.

Remember that the most significant benefits often do not materialize until the second or third year of the relationship, when it has matured to a smooth, natural process and that it takes time to collect enough data to not only measure performance and results, but improvement.

Make sure to not only link the agreement to explicit benefit targets, and continuous, step-change performance improvements, but to include rewards if the service provider exceeds those targets. Incentives drive everyone, partners included.

Then, when the contract is in place, measure performance regularly, insure issues are escalated when appropriate, and confirm that spend visibility is available to your users. Transfer best practices on a regular basis and work together for continuous improvement.

The measurements should include, but not be limited to, Savings Targets, Process Compliance, Supplier Compliance, Supply Base Consolidation, On Time Delivery, Transaction Accuracy, (PSP) Staff Retention, and Quality of Service.

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For more information on procurement outsourcing, see the “Procurement Outsourcing: A Brief Introduction” wiki-paper over on the e-Sourcing Wiki [WayBackMachine].

Originally posted on on the e-Sourcing Forum [WayBackMachine] on Saturday, 19 August 2006

The Procurement Service Provider (PSP) landscape can be confusing, with a host of providers coming from many different backgrounds. You have traditional business process outsourcing and IT outsourcing behemoths that have invested in procurement skills, recent startups with procurement outsourcing as their sole vision, and specialist firms that concentrate on a handful of related spend categories. The result is a cloudy map of skills and capabilities ranging from transaction focused providers specializing in automation, through category specialists to comprehensive procurement service providers.

Considering that value comes from selecting the right partner with the right skill set, expertise, and experience to match your needs, it is very important that you can properly evaluate your options and choose the provider that is right for you!

So how do you identify a good PSP?

A good PSP will have access to the latest web-based e-tools, use a center-led procurement model, be driven by operating metrics, and have tools and processes in place to closely monitor compliance. It will also have a significant number of sourcing and category experts on staff who are up to date on best practices, experienced in your industry sector(s), and engaged in regular training and knowledge sharing endeavors designed to ensure they maintain world-class status. It will be based in a robust purchasing facility with integrated process and co-located teams, already have a pre-existing supplier network and supplier intelligence in your categories, extensive change management and knowledge transfer capabilities, and the flexibility to change as your corporate goals change.

Furthermore, the PSP will have a number of referenceable long-term customer relationships where they have been providing comprehensive spend management services across a significant number of companies and categories with a track record of success across industries, a solid balance sheet, a growth plan, and a commitment to maintaining operational excellence in procurement. Procurement will be its primary, if not only, focus.

What should you outsource?

Procurement outsourcing normally generates the largest returns when applied to non-strategic indirect categories and direct commodities of limited strategic value. In addition, it generates the largest return when the PSP has enough volume to identify significant savings opportunities. Therefore, you need to select a PSP that will allow you to go beyond simply infrastructure transfer and process support. (However, you should remember caution and not to go too far with your outsourcing initiative, since strategic sourcing dictates that you manage strategic categories carefully.)

Indirect purchases are ideal for procurement outsourcing because they are typically transaction driven, not part of your core business, and so varied that they generate considerable process inefficiencies for your staff, especially when most of your information systems will be designed for your direct categories. Furthermore, due to the sheer number of categories and variations therein, most of your buyers will lack the time and means to apply best practices such as cost breakdowns and benchmarking to these categories. Thus, a PSP with the right skill sets could be invaluable.

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For more information on procurement outsourcing, see the “Procurement Outsourcing: A Brief Introduction” wiki-paper over on the e-Sourcing Wiki [WayBackMachine].