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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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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