Purchasing Metrics: Tracking Cost Savings, Capital Reductions and Avoidances

/0 Comments/in /by

Year after year, research studies by universities, consultants, and purchasing associations have shown cost reduction as one of a company’s three most important goals for the year. Although innovation and collaboration among business stakeholders and suppliers (SRM) continue to be part of the agenda in most of the companies, cost reduction remains a key part of the Purchasing agenda. Simply put, it is the one company function that consistently provides fast and large-scale cost reduction.

Lord Kelvin’s wisdom of the 19th century is still valid today: “If you cannot measure it, you cannot improve it.” Tracking systems may vary widely. Large companies use complex tools and processes to measure and track cost reduction, while smaller companies may track cost reduction via a simple spreadsheet. Whatever your methods, you can benefit from using the simple spreadsheet below to track Cost Savings, Capital Reductions, Avoidances, Total Procurement Benefits (TPB), and Addressable Spend.

Economic Concepts

The critical starting point is to work with Finance to define the criteria of each measure. Below are five crucial concepts to understand in the process.

Addressable Spend = The amount of spend that generates reported benefits.

Cost Savings = Also known as EBIT Impact, this is the impact on the income statement relative to the previous period (i.e., previous year). This is the difference between the costs in the previous period and the costs after the activity.

Capital Reduction = This is the impact on the balance sheet, the difference between the levels that existed before and the levels after the project or activity.

Avoidance = The price increase avoided based on forecasted existing price vs. new price paid. The formula is a soft savings function of TPB to reflect value creation relative to potential or anticipated negative impact to the future Income Statement or Balance Sheet.

Total Procurement Benefits (TPB) = The total value created by Purchasing (the sum of cost savings, capital reduction, and avoidances). This is the difference between the outcomes if Purchasing had not done the project.

Expected vs. Realized Savings

At the time we calculate the benefits from a Purchasing project, we need the best estimate of the quantity expected to be purchased during the first 12 months following full implementation. To calculate the total impact, we need to multiply the quantity times the unit benefit (savings or capital reduction or avoidance). Basically these are the expected benefits for the next 12 months after the project is implemented.

If the project is completed in June, then the benefits will be realized between July of the current year through June of the following year. In other words, the tracking of expected benefits and realized benefits happen in a different time frame.

Because metrics drive behavior, each one (expected and realized) will drive different behaviors. Expected benefits drive the organization to do sourcing activities every day up to the last day of the year because it counts in the current year. Realized benefits, which show the impact on Income Statement, drive the organization to improve the effectiveness of the activities: as percentages of benefits by spend; higher percentages equal more savings per spend.

Tracking Benefits

Although companies normally track their total spend and total savings, in most of the cases, the savings were generated by only part of the spend, not the total spend. The part of the spend that generated the savings is called Addressable Spend.

The correct tracking system should capture these five elements: Addressable Spend, Cost Savings, Capital Reductions, Avoidances, and Total Procurement Benefits (TPB).

  • Addressable Spend: measures the efforts in Purchasing in sourcing products and services. The average addressable spend per employee shows the efficiency of the organization; the existing capacity or production rate that can be used to justify new resources with increase of the spend in the company.
  • Cost Savings and Capital Reduction: measures the quality of the projects or activities performed by Purchasing. This is a measure of the effectiveness of the organization and can be measured by the percentage of savings per addressable spend.
  • Avoidances: measures the efforts from Purchasing to avoid price increases. Research studies show that companies tracking avoidances present lower long-term costs than companies without tracking.
  • TPB: measures in one single metric the overall performance of Purchasing.

Sourcing Activity and Savings (SAS)

Inspired by an existing client need, PM2Consult developed an SAS Tool where all Purchasing employees can input their projects or activities to capture expected benefits.

Please click here to download SAS Tool

In addition to capturing the Addressable Spend, the tool automatically calculates Cost Savings, Capital Reduction, Avoidances, and TPB. Importantly, it also registers the request for price (RFP) and competitive bids, so that leadership can approve the results of each project.

Conveniently, there is also a tab that summarizes the results by employee and by commodity.

Once the tool and process are implemented, the company is able to report the benefits at any time up to the end of the year. For the following year, leadership is able to set goals by employee and by commodity in terms of Addressable Spend and Benefits.

If you have questions about such an SAS tool implementation, please contact me by email at paulomoretti@pm2consult.com  for an initial consultation.

Taking Purchasing to the next level,

Paulo Moretti

Metrics for Purchasing: A Framework that Works

/0 Comments/in /by

A 19th century quotation from Lord Kelvin, who was an Irish-born British engineer, is still valid today: “If you cannot measure it, you cannot improve it”.

Metrics are developed in each field in order to help measure performace of a current situation. The metrics are the key elements of KPI – Key Performance Indicator.

This is also applicable to Purchasing with the objective to improve work processes, programs, methods, or employees who are producing results that are effective and efficient. And for sure the most important metric in Purchasing: Savings.

From Wikipedia we have very good questions if you do not have metrics in place:

  • How do you know where to improve?
  • How do you know how you compare with others?
  • How do you know whether you are improving or declining?

A suggested framework relies on the main activities in Purchasing: Client, Supplier and Sourcing; and, transforming the KPI results into scores.

Depending on each Purchasing organization and their respective objectives, you may prepare a Balanced Scorecard from each activity. It is not practical to measure and track everything; however you may select different metrics from each activity to build your Balanced Scorecard.

Client

Client refers to the business or function you buy products or services for. Some metrics for Clients are: Service Satisfaction Level, Risk Level and Time to Protection, and Purchasing Benefits. ROI (Return on Investment) may be also included (see below).

Satisfaction Level can be achieved by survey to measure how satisfied your Client is with your services. Purchasing Benefits are savings/avoidances (see details below) that you generated to them. It can be in total dollar and also as total dollar divided by addressable spend, so it gives the effectiveness of your sourcing projects in percentage.

In terms of Risks, you can measure different kinds of risks and their respective drivers as described in my article “Risk Management – A comprehensive view for Purchasing”.

For each KPI, you create a scale, and this scale is aligned to a score from 0 to 100.

Suppliers

Several articles have been written to describe different ways to create a Supplier scorecard. I think the most important of these is the framework of performance metrics that is able to be aggregated to be comparable between suppliers, but also able to drill-down specific aspects of supplier strengths and weaknesses.

First you create five dimensions which can be applicable to any supplier from Raw Materials, Logistics, Packaging to MRO (Maintenance Repair Operation). The five dimensions can be: Quality, Financial, Technology, Risks and Services.

For each dimension you may have specific KPI related to the dimension, and these KPIs must attend the Client’s needs. For example, for Quality you may include: Ontime delivery, percent of correct product quality, invoice accuracy, etc. For Financial you may include: Price competitiveness, revenue generation, cost reduction initiatives, etc. For Technology you may include: New products, process improvements, market leadership, etc. For Risks, you can see the article mentioned above. And for Services you may include: Emergency orders, service level, technical assistance, etc.

For each KPI, you create a scale, and this scale is aligned to a score from 0 to 100. Each time these KPIs are measured, quarterly or yearly, you have a score that can reflect the supplier performance in that period. You can also sophisticate the model by imposing different weights for each KPI as well as different weights for each dimension. By doing this, you are able to aggregate all KPIs into one final score.

The final score for each Supplier in each period reflects the overall performance and is comparable between suppliers and allows you to check the evolution of each one.

Sourcing

You are able to measure and track the efficiency and effectiveness of your organization by having the appropriate metrics.

First you need to define your spend which can be the total spend for the company, or managed spend (how much Purchasing manages). From total spend or managed spend, you measure addressable spend (or sourced) each year.

Efficiency can be measured by Spend per FTE (Full Time Equivalent), so you can compare yourself with other companies as to how efficient you are in managing your spend. Another metric may be Addressable Spend per Total Spend. As you have contracts in place, you do not need to source everything in every year, so the Addressable Spend is the amount you sourced each year.

In terms of operational, you may measure the efficiency as number of Purchase Orders (PO) per FTE, or number of invoices/FTE, percent of order to ship on time, etc.

Another measure of efficiency can be the organizational cost divided by the Purchasing Benefits you generated, so it is a kind of ROI (Return on Investment).

For effectiveness we may have two metrics: Price Competitiveness and Purchasing Benefits. For Price Competitiveness you can compare your prices versus published market prices from ICIS, IHS or YQ Matrix.

For Purchasing Benefits, we include Savings, Avoidances, Capital and Working Capital Savings as wells as Revenue Generation. The effectiveness of your organization can be measured with Purchasing Benefits per Addressable Spend, so this percentage shows how effective you are in your sourcing projects. According to AT Kearney, in 2011 the first quartile effective Purchasing organizations achieved 8% Purchasing Benefits.

Balanced Scorecard

You may select some KPIs you defined for each activity and construct a Balanced Scorecard which reflects the entire Purchasing. As described in the activity Supplier, you can define different weights for each KPI as well as different weights for each activity. By doing this, you are able to aggregate all KPIs into one final score and be able to track the Purchasing evolution as a whole.

Take Away

Certainly I did not list all potential metrics available for efficiency and effectiveness in Purchasing; however this may help you to think about a framework of metrics to be used in your organization according to your objectives and Client’s needs.

The mantra “metrics drive behavior” is true. So, depending on the objectives of your Purchasing organization you can build your Balanced Scorecard using the metrics which will drive different behavior from your organization.

Are you measuring what you can improve to drive the appropriate behavior?

References: Procurement Strategy Council, AT Kearney, CAPS Research, KPMG, Institute for Supply Management, ICIS, IHS, YQ Matrix, Michigan State University and University of Pennsylvania.