Category Archives: Cost Reduction

What’s Your Procurement Value Level? … Strategic? (II)

In Part I, I reminded you that Pierre Mitchell of The Hackett Group invited you to participate in a study that would help you identify where you were on your procurement journey by way of 18 value streams that range from “naive apprentice”, where you’re measuring performance at an elementary (tactical) level, to “expert sourcerer”, where you’re extracting procurement value at a very advanced (transformational) level. Considering that this survey will not only help you identify a path to increased value but that Pierre has promised to share some of the results with all survey participants for free, it’s a survey that’s definitely worth your time as Hackett has the premiere benchmarking data in the space.

I also told you that the first seven value streams were tactical and provided relatively little ROI compared to the ROI that is available through more advanced value streams. The next six value streams are strategic and will generally provide you with good payback over a longer term. They range from:

Costs avoided by receiving ‘no charge’ items and services
through
Early payment discounts, P-card rebates, or other supply chain finance benefits
to
Internal enterprise process costs are reduced via a new supplier solution

Costs avoided by receiving ‘no charge’ items and services

Now we’re into strategic procurement where the “savings” are real and sustainable. By negotiating in more items and services for the same money, you’ve considerably reduced your costs and increased the value that you can provide your end customers for the same price. And while it’s true that the ‘no charge’ items and services could disappear at contract termination, you’ve established with your supplier(s) that you expect a higher level of performance and service, which will make future negotiations, and cost-avoidances, easier.

Early payment discounts, P-card rebates, or other supply chain finance benefits

Now you’re starting to look at the total cost of the buy from an organizational perspective, and not just a unit cost or landed cost perspective. If your supplier’s annual cost of capital is 36%, and yours is less than 12%, you could be saving yourself up to 24% annually, or 2% for each month you shave off the total payment time. This can be substantive and is easily sustainable. Plus, once you get good at managing your working capital and finances, you’ll start to see even more savings opportunities appear.

Internal enterprise process costs are reduced via a new supplier solution

Once you get to the point where you start recognizing that sometimes you don’t know all the answers and that a smart supplier can point out additional opportunities for you to save money, you have not only mastered the art of strategic sourcing, but have reached the point where your sourcing is on the verge of becoming transformational … which is the topic of Part III.

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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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