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?

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.

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.

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 Friday, 18 August 2006

Simply put, procurement outsourcing to a Procurement Services Provider (PSP) is the transfer of specified activities relating to sourcing and supplier management to a third party.

Why should you consider procurement outsourcing?

It is a well known fact that businesses that outsource (well) grow faster, larger, and more profitably then those who do not. When done right, this is especially true for procurement as it can generate additional value through sourcing and compliance savings as compared to the savings opportunities from most outsourcing arrangements, which are generally limited to efficiency improvements and headcount reductions. In addition, it is a transformational type of outsourcing where a portion of the savings generated from an initial endeavor can be used to finance and expand the transformation.

One reason to outsource would be if the procurement of certain categories, such as indirect or non-critical materials, or the management of certain procurement processes, such as requisitioning and compliance tracking, were not core competencies since outsourcing provides an opportunity to increase efficiency, lower costs, and increase savings. Outsourcing in these situations is often much more economical than trying to build the competence internally.

Another reason to outsource is to keep your top performers happy. A first class sourcing professional wants to focus on strategic core purchases where she can have the greatest impact, not tactical indirect categories where savings opportunities are limited and impact minimal. By transferring manual and tactical tasks and low-impact indirect categories and class-C commodities, you give your top performers more time to focus on what they do best and what benefits you the most. On the flipside, your low-volume non-strategic indirect categories become high-volume strategic niche categories in the hands of a PSP who can aggregate volume across clients to the point where niche professionals focused on that category can be hired and kept happy by the sheer volume of opportunities.

A final reason to outsource would be if procurement is an area that, if managed properly, could drive significant value to your business but it is not an area you plan on investing significantly in or increasing focus internally. In this case, you could consider full spend management outsourcing, but it is not something we would recommend unless you were in an industry where all goods and services procured on a regular basis were non-strategic indirect or commodities. A hotel chain would be one example of a firm where full spend management outsourcing might make sense as the vast majority of goods and services procured on a regular basis are commodities.

How does procurement outsourcing work?

There are essentially three basic levels to the outsourcing of procurement functions: infrastructure transfer, tactical process transfer, and strategic category transfer.

At a basic level, you are moving or augmenting staff, technology, systems, and supplier management to or with the PSP. At the next level, you are moving certain processes, such as requisitioning or procure-to-pay, that are easily automated and tactically oriented. At the highest level, you are transferring responsibility for entire categories and expecting the PSP to undertake strategic sourcing initiatives with respect to those categories.

At a basic level, the PSP will manage e-Procurement systems that automate and streamline manual purchasing processes and transactions and provide you with improved spend visibility, compliance, and process efficiencies. At a higher level, where you transfer tactical processes and control of indirect or commodity categories, the PSP will support day-to-day activities in supplier management, order and pricing compliance management, and policy enforcement and provide you with improved services levels and reduced costs. At the highest level, where you transfer strategic categories or full spend management, the PSP will provide on-going end-to-end strategic management of these categories, implement strategic sourcing best-practices, and drive continuous process improvements that should eventually lead to significant cost savings, or cost avoidance if raw material prices are steadily increasing in your commodity categories.

What results can you expect to see?

The value associated with procurement outsourcing is extensive. In addition to the year-on-year cost savings documented by numerous studies, obtained by way of the PSPs in-depth market knowledge and volume aggregation capability, you maximize your return on your existing procurement capability by freeing up your professionals to focus on your most strategic categories. You reduce cycle times and increase the capabilities available to your users, but, most importantly, you provide your users with total indirect spend visibility as a PSP will be able to benchmark practices and prices and apply a standardized process to each category it manages.

In their 2004 Benchmark Study that surveyed 750 senior procurement, supply chain, and CFO professionals, Aberdeen found that enterprises outsourcing procurement recognized rapid and measurable reductions in cost structures, improved spend leverage and control, and operational efficiencies. In particular, they found that, even in the early stages of procurement outsourcing, on average, companies could reduce prices paid for goods and services by 18%, improve contract compliance by 60%, halve sourcing and transaction cycles, reduce administration and automation costs by over 25%, and improve rebate and volume discount capture by up to 20%.

Aberdeen also found that 43% of enterprises already outsourced select procurement processes or spend categories and that an additional 15% planned to outsource procurement functions by 2007.

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 Sunday, 13 August 2006

Friday we introduced you to the concept of center-led procurement, where a procurement center of excellence (COE) centrally creates and coordinates strategic purchasing decisions across the enterprise and yesterday we discussed the role of the procurement COE and some of the challenges in its initial creation. Today we discuss some best practices for getting the most out of your procurement COE.

(1) A Chief Purchasing Officer (CPO) or Chief Supply Chain Officer (CSCO) on the executive team leads the COE

This insures that plans, and initiatives, are aligned with the business, diverts resistance, and helps bring each of the different business units on board quickly.

(2) Cross Functional Teams

This insures that the right knowledge is in place to make the best decisions from a strategic and best practices viewpoint.

(3) Multi-Year Supply Plans

This promotes better alignment and integration with your strategic supply chain design and helps establish the center as a strategic leader in key commodity categories.

(4) Coordinated Metrics and Incentives

Each unit needs to have their performance analyzed off of the same metrics, linked to actual value creation, and the incentives of each unit need to be tied to these metrics. Everyone wins or no one wins. This insures that procurement, as the biggest potential contributor to cost savings, maintains a central role in the organization and that everyone sticks to the mutually agreed upon strategies and policies.

(5) Web-Based Automation and Decision Support Tools

They allow you to accelerate the transition to the center led model and extend sourcing activities to the desktop of every stakeholder in your organization while enforcing corporate policies and processes.

(6) Ongoing Education

Keep up to date on the latest trends and success stories and share best practices and methodologies with each unit of the organization on a regular basis.

(7) Speak to the supplier community with a central voice

This helps you fully leverage your spend opportunities and facilitates shared process improvements. Furthermore, this will help you select and integrate a key group of suppliers into the product design and specification process. Strong supplier management will allow you take full advantage of supplier performance and this will lead to better quality, faster product introduction, shorter cycle times, and more value from the relationship.

For more information on center led procurement, see the “Center Led Purchasing: The Procurement Organization of Tomorrow” wiki-paper over on the e-Sourcing Wiki [WayBackMachine].