Strategic Sourcing III
Within the realm of Strategic Sourcing, the term “savings” is probably featured more prominently than others. It is a fact that organisations who implemented a Strategic Sourcing function expect some benefits from the function. Otherwise, why invest time and resources into a business function if not for its positive benefits. And many organisations who operate a matured Procurement function often had savings as the only objective at their start-up phase. For such organisations, their “burning platform” for implementing Procurement was to reduce cost, often during an economically uncertain period. But as the Procurement function develops and matures, other forms of measurements for Strategic Sourcing is needed. Here is a look at the key performance measures of Sourcing.
The idea of savings is a simple one, and in economic terms it is the ‘reduction in money, time or other resource’ (Oxford Dictionaries). And yet, the application of savings in Procurement can be a contentious one, especially between the Sourcing Manager who executed a well-planned strategic sourcing program and the business user who is supposed to have benefited from the sourcing initiative. To understand such a contentious subject, let’s consider a few scenarios of ‘savings’.
In its most basic form, savings is defined as the difference between the current price and previously purchased price, if the current price is lower than the latter. This is a definition of savings which everyone understands and accepts readily, and we shall term this form of savings as ‘Cost Reduction’. A number of sourcing strategies are effective in bringing cost reduction savings, namely Best-Price Evaluation, Volume Concentration and Global Sourcing. This situation can be illustrated in the following diagram:
Another form of savings which can be defined is termed as ‘Cost Avoidance’, and this is where differences of opinion come in. Consider a situation where price inflation or scarcity of supplies in the market saw an increase in price over the last purchased price. The business will have a negative financial impact based on the newly offered price, which is commensurate with market prices. If the Procurement team was able to negotiate with the incumbent supplier and limits the price increase to a smaller quantum over the previously purchased price, the difference can be recognised as a form of savings, even though the actual price would have increased. A number of organisations would not recognise this form of savings, and have derogatory remarks over it. And yet, if we were to recognise that the role of Procurement is to secure economic benefits for the organisation, then this is an effort that should be acknowledged, for there is an economic benefit to the organisation compared with an option of ‘doing nothing’.
Besides these two examples, consider the scenario where a business user has an expense budget of $xx. Based on the last known transaction, the user anticipated that the $xx budget will secure N number of units, and requested the assistance of the Procurement function. By applying the right sourcing strategy, the Procurement function was able to secure N + 8 units of the required commodity at the budget level. In the same approach as ‘Cost Reduction’, the user could have accepted the required N units and saved on the budget. However, the user decided to expense the full budget amount to support the growing business needs. In this case, the Procurement team recognises the additional 8 units (at the contracted price) as a ‘saving’ in the form of Free-of-charge Extras. There is no ‘savings’ in the correct sense, but the free-of-charge extras is quantified as a financial benefit.
Achieved savings remain one of the most prevalent performance metrics of Procurement. When defined properly, savings provide an indication on the success or outcome of Strategic Sourcing. Other metrics that are often used to measure the performance of Strategic Sourcing are:
- Addressable spend that is sourced – This measurement looks at the effectiveness of the Procurement function in managing the organisation’s spend. The target of every Procurement function should be to increase this metric progressively, indicating the confidence the organisation has in the professional Procurement approach.
- Spend that is contract compliant – This measurement looks at the effectiveness of the contract implementation process. As stated in our last article, Strategic Sourcing is not only about establishing supplier contracts, but its implementation as well. Well negotiated contracts that are poorly implemented will see leakage of the financial benefits from the Sourcing process.
- Transactions that are contract compliant – Similar to the previous measurement, this metric looks at the effectiveness of contract implementation but from a transaction (as compared to financial) perspective. A low achievement (62% being market average) of this metric indicates a long tail-end spend which may not have been addressed by Procurement, or a symptom of inefficient ordering channels.
- Contracts stored in a central, searchable repository – This measurement tests the proficiency of the Procurement function in internal processes. Using central repositories to store and manage contract records (hard-copy or otherwise) will mitigate the ill-effects associated with staff movements and resignations, as well as promote the knowledge exchange and development of Procurement resources within the team.
- e-Enabled suppliers – This metric measures the extent of the Procurement function in adopting and using enabling technologies such as eSourcing, ePurchasing, eInvoicing and marketplace catalogues. Connecting suppliers with technology has been proven to deliver process efficiencies for both the buying and selling organisations. As there are numerous facilities and service offerings that provide enabling technology at reasonable rates, the excuse for not using such technology becomes moot.
Success of Strategic Sourcing
Based on the last two example above, should these financial benefits be recognised as savings? If the Procurement function had taken no actions to influence the outcome, would the organisation be in a financially disadvantaged position? These examples show that the definition of ‘savings’ is not a straightforward and simple exercise. It does not help when Procurement professionals could not establish a common definition of savings, unlike other more established professions like Accounting. And yet, the expectation to demonstrate results from Strategic Sourcing is ever present.
And here lies the predicament of Procurement, which is to adopt a definition for savings that recognises the efforts of Strategic Sourcing, and without excessively overstating the outcome or benefits of their efforts. Eventually, the organisation’s stakeholders (executive management and business users) will have to determine if a definition of savings will support the organisation’s core and/or financial objectives, and at the same time use the definition to reward or motivate further actions from the Procurement function. Debates with the absolute terms of ‘right’ or ‘wrong’ in the definition of savings (besides the simple and most basic definition of the Cost Reduction) is both counter-productive and distracting to the organisation. Hence, Procurement Managers are well advised to seek the organisation stakeholders’ agreement and buy-in to any definition of savings which deviate from the obvious, and to establish other measures that demonstrate the value contribution of Procurement.
From the market perspective, this mindset is reflected from Ardent Partners’ latest CPO Rising research, which states that “only 7% of procurement departments use savings as the sole measure of their performance”. Of the rest of the organisations, a variety of measurements are used to demonstrate the value of Procurement. These metrics again do not seem to be standardised, and will likely to remain as such for a further period of time, before the Procurement function reaches the next level of maturity.
As with other performance metrics which organisations use, there is no single rule that applies and no absolute right or wrong. Each organisation is unique in their own right, and is well advised to establish clear definitions of ‘savings’ to measure the effectiveness of Procurement. Let the definitions be applied to actual cases and scenarios, and adapt the definitions to avoid any dysfunctional and undesirable effects that distract the organisation from its core objectives and goals.
This is our last article on the topic of Strategic Sourcing. There are other articles in this blog that provide deep market insights and knowledge that can help Procurement Managers in the conduct of their Sourcing initiatives. Readers are well advised to consult and refer to these other articles for ideas and inspirations for their Sourcing efforts. In the continuing articles on the strategy of Procurement, we will look at Operational Buying. Please stay tuned.