Are we focusing too much on the cost savings?
Good strategic-level procurement — the acquisition of products or services from an external source – can enable organisations both public and private to achieve sustainable cost savings. But there’s a trend emerging where the value of the procurement function of an organisation is measured purely through the potential cost savings.
Looking solely at procurement-generated savings estimates may shift the organisation’s focus away from other equally important outcomes including meeting the core business needs (or fit for purpose procurement), enabling process efficiencies, category management, contract management, procurement and probity risk management, legislative, legal and policy compliance.
In my experience, an effective organisation will generally focus on choosing products and services that are fit for purpose to ensure operational outcomes are achieved. But a procurement focus on driving savings or achieving targets can have a detrimental effect on the fit for purpose decisions, ultimately leading to declining operational performance or waste.[pullquote] “A successful organisation should be undertaking a mix of short and long term initiatives.” [/pullquote]
Focussing only on potential cost savings can also lead to a concentration on short term gains — the proverbial “low hanging fruit” — with the longer term transformational initiatives largely ignored.
A successful organisation should be undertaking a mix of short and long term initiatives.
As the procurement function of an organisation is rarely the owner of any negative business outcomes of a poor procurement process or decision, they should not be in a position to determine the procurement outcome — only to provide guidance to the process and assurance to the organisation.
So if the procurement function isn’t making the procurement recommendation, then it seems counter-intuitive to measure their performance on potential savings identified. This goes equally for both ad-hoc procurements initiated by business units and long term procurement arrangements initiated by the procurement function. Why? Because business units still decide whether or not to buy from procurement arrangements and that decision will take into account fitness for purpose and personal preference, which may mean that there is significant leakage — and therefore diminution — of the potential savings.
As the area responsible for achieving business outcomes and managing their budget, business units should be held accountable for cost savings.
I believe that realised savings need to be the new focus for measuring procurement savings, and the achievement of those savings needs to be a measure on the area making the purchase decision.
Measuring cost savings
Effectively measuring cost savings is another problem entirely. So what are procurement savings and how can they be effectively quantified? This seems like a simple question. Unfortunately, as always, the devil is in the detail and measuring procurement savings is hard to base on any real science.
Procurement savings can be stated quite simply as the baseline price less the price paid (and for commodity items, the saving is then multiplied by the quantity purchased). If the price paid is lower than the baseline then a saving was made and can be reported. This formula is commonly called purchase price variance (PPV).
But what happens if the price paid was higher than the baseline price? Who reports the premium paid — the procurement unit or the business unit? Is it really a premium or is the baseline method flawed? Does this premium get deducted from procurement’s savings target? Or, more likely, a more favourable baseline measure is substituted, or the procurement is ignored or swept under the rug?
How is the baseline price determined with any level of reliability? There are a number of methods in common use, but at best they can only be assumptions. Where specific procurement targets need to be met, is it more likely that the baseline assumption that shows the greatest savings will be the one chosen?
The following table lists the commonly used baseline pricing methods and some of the key issues associated with each of them.
|Baseline method||Key issues|
|Actual year-on-year price variation||May not take into account favourable market factors*.|
|Average (mean) of final bid prices||Using the average of all offers as the baseline to measure savings is arbitrary and irrelevant unless the products/services are directly substitutable. It also assumes that the prices received were competitive. Why not use lowest conforming offer price? I suggest because this offer is rarely chosen.|
|Average price last reporting period||May not take into account favourable market factors*.|
|Supplier base price||Does anyone actually pay this price? And if yes, it is usually the price offered for low volume supply to an infrequent or one-off customer.|
|Market price||As above, it is usually the price offered for low volume supply to an infrequent or one-off customer. Walk into any chain electronics store and ask for a discount off the sticker price and you are more likely to get one than not.|
|Current contract price (including quantity/quantity discount breaks)||A better measure, but still may not take into account favourable market factors*.|
|Historical spend data||Can be extremely difficult to analyse like for like comparisons from the data that is available.|
|Independent benchmarking||It can be difficult to obtain realistic comparisons of identical buyers (size, geographic distribution, buying habits, attractiveness to seller, etc.). While a useful guide, the list of assumptions and caveats that accompany these benchmarks make direct comparisons to your organisation problematic.|
|Market and agreement price effect (changes in market price and agreement price since last time purchased)||A better measure than direct comparison to market price, it still may not take into account favourable market factors*.|
|Negotiated savings from bid price||May be a good measure of negotiation prowess, but assumes that the offered price was competitive to start with.|
|Purchase Price Variance (PPV)||Requires a realistic baseline price to be meaningful and the standard formula may not take into account favourable market factors*.|
|Reference price||Requires a realistic baseline price to be meaningful and the standard formula may not take into account favourable market factors*.|
*favourable market factors includes natural reduction of market price over time, that is available to all buyers; favourable exchange rate or commodity price fluctuation; increased consumption rolling customer over to a higher discount rate etc.
It’s worth noting that all baseline methods must assume that the benchmark is 100% substitutable with no change in user satisfaction or product performance for it to be meaningful without adjustment (and confirmation of assumptions).
Another significant problem with procurement savings is that they are quite often reported at the end of the contract formation phase, so at best they are still only potential savings. There are many ways in which those potential savings can, and will, be eroded before they can be realised, such as:
- use of non-approved suppliers (whether intentional or not)
- poorly documented or unenforced policy and procedure
- supplier price increase (whether approved or not)
- specification variations (whether approved or not)
So unless savings are measured at the point they are realised, they are nothing more than promises, with little or no benefit to the organisation, and again, the benchmark from which savings are measured is still only a guide. Realised savings must be the new focus for measuring procurement savings, and the achievement of those savings needs to be a measure on the area making the purchase decision.
Shift the focus from cost savings
So then, how do we measure the performance of an organisation’s procurement function if not through savings? The same way that other internal service functions, e.g. finance, HR, legal and audit are measured within the organisation – by measuring their performance against their key services. For the procurement function these might typically include:
- Develop and maintain procurement policy and procedures
- Ensure organisational compliance to statutory, legal, contractual and policy requirements
- Undertake procurement planning, e.g. analyse the organisation’s procurement requirements and understand the various supply markets that the organisation engages with
- Manage key procurement categories
- Provide business units with advice and assistance through the entire procurement lifecycle (spend/category analysis and planning, market analysis, specifying requirements, market test, evaluation, negotiation, contract formation, contract management, post contract review, supplier relationship management)
- Manage the organisation’s strategic vendor management program
- Deliver savings
So while potential savings is certainly still a valid measure of the procurement function, it needs to be understood for what it is and compared to actual savings delivered, and the root cause of the variance investigated. Certainly the linking of staff incentives to (potential) procurement savings needs some thought.