Buying teams have traditionally been deemed successful pretty much based on the procurement cost savings metric only.

Procurement teams have since matured. As a function, procurement is much more professional and strategic vs. where we were 20 years ago. This obviously means that in most organisations, the proverbial low hanging fruit has long since been harvested. Understandably, this has meant that the definition of procurement cost savings has been stretched and expanded to what we consider as “fair game” today.

Let’s assume that you’re part of a more mature procurement team. Or maybe you’re an experienced Category Manager or Head of Procurement in a greenfield role.

You’re unlikely to pursue the “strategy” of just beating up a supplier every year for an annual price reduction.

As we already mentioned, the easy pickings have already been taken. Resources have been cut. Operational issues and security of supply are eating into our time. In addition, recently we have found ourselves in a more inflationary environment than at any time during the last 40 years. Many suppliers don’t have much meat on the bone, especially for manufactured goods.

Despite, or perhaps because of this backdrop, there is more pressure on us than ever as a team to deliver procurement cost savings. Given all of the supply chain disruption and additional legislative requirements on the horizon, the need to mitigate cost increases and deliver additional value is growing by the year.

This begs the question: how do I get my Financial Controller or CFO to recognise what I’m delivering on?

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What are Procurement cost savings?

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Let’s start with the basic presumption. Every company knows what they sell.

However, there are surprisingly few who truly understand, measure and effectively report on what they buy. This includes large corporates too. I know, I’ve worked for a few of them. They didn’t have a clue what they were buying. Especially if you got down to the long tail spend on non-core, non-critical goods and services.

Part of the reason is that purchasing data is notoriously messy, and more difficult to report on than sales data.

Procurement cost savings is broadly defined as any activity which has been initiated through control, avoidance, reduction or elimination of money being spent by the company on goods and services coming from external suppliers.

It typically doesn’t include savings coming from tax optimisation or regulatory incentives. These initiatives typically sit within Finance or other teams.

As the name suggests, procurement cost savings are usually instigated or delivered in part or fully by a company’s procurement team. Although, it must also be acknowledged that in most cases, business stakeholders are also participants in such initiatives. Department heads, budget holders and subject matter experts are often involved in the ideation, alignment, project delivery and sign-off for these initiatives.

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Hard savings vs. soft savings in procurement: what’s the difference?

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This brings us nicely onto the elephant in the room.

Not every “saving” or initiative that we work on or deliver within procurement delivers a hard, easily measurable benefit. Let’s briefly define this before moving on, although many readers I’m sure are familiar with the difference.

Hard savings

A hard procurement saving is something that is easily measurable against a previous price point. This is usually a last paid price. Sometimes it can also be a standard cost defined in the budget. This is often calculated as a moving average price for the previous financial year.  Savings on these products or services are often reported as purchase price variance (PPV for short).

These procurement savings are easy to report and get signed off by Finance because there is an easily traceable benefit to the company’s bottom line or fiscal year budget.

So, the obvious next question is how you measure any benefits negotiated on something that’s not a predictable, repeatable purchase.

Soft savings

Anything which doesn’t have a reference point as a last price paid or standard cost is less tangible to report a cost saving against.

Soft, or intangible, savings usually stem from one-time purchases (large investments or one-off requirements, for example). They can also come from less predictable or infrequent spend, or where a standard cost for something is not easy to define.  

Examples:

• A large industrial motor for a waste recycling plant that is only replaced every 5 years

• An upgrade to a company’s server infrastructure

• Renewing a fleet of warehouse forklift trucks with different specifications to the retiring fleet

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Cost savings vs. cost avoidance in procurement

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Procurement teams will typically refer to and consider both above scenarios as purchasing savings.

Finance, however, doesn’t systematically recognise soft or intangible cost savings. These scenarios will usually be considered as cost avoidance or cost mitigation.

Sometimes you will see posts on LinkedIn saying things like “cost avoidance is not a saving”. This is absolute nonsense. If these activities did not add value, then why would any organisation bother employing people to procure plant and equipment, or civil construction projects?

It’s one-time spend. And yes, it’s true that you can’t report a hard saving against it that a Financial Controller can attribute to P&L.

But it clearly still delivers obvious value to have an experienced sourcing manager tendering and then negotiating with the supply base on a $10 million investment, right? If Procurement did not engage in this activity, then the profit margin of a company would pretty quickly become smaller because suppliers would be subject to less scrutiny and charge higher prices.

The question, therefore, is how do we define, report and track this? While at the same time, we must also acknowledge that Finance will define it, consider it and report it as something completely different to how we may be tracking it.

Answering the question of how Procurement can report on cost avoidance opens a more complex issue. How can Procurement teams better align themselves to the needs and objectives of the wider business?

This is often a more political question, but nonetheless a vital one. If Procurement’s objectives are misaligned with those of the rest of the business, you’ll probably struggle to get Finance to recognise your less-tangible savings contributions.

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How to measure different ways of reducing procurement costs

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Let’s now look at the different ways that Procurement Category Managers and Strategic Sourcing Managers contribute to reducing costs and adding value to the businesses they work in.

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• Hard Savings – classic procurement activity based on visible price reduction. Usually delivered either through price negotiation, specification / process change or lot size.

• Soft Savings – less-tangible procurement cost savings which will typically require more alignment with Finance around the wider business objectives and how these contributions are tracked and measured. Of course, tools like Provalido help to make this activity more visible and structured to all business stakeholders.

• Mitigation – essentially a soft saving in the eyes of Finance. This is usually associated with reducing the impact of an adverse change in commercial terms with a supplier. Examples are delaying the introduction of a price increase, or mitigating the impact of raw material and energy price increases.

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So, how do these activities impact the business? Will they add to the P&L, or will they help to drive more sales? Or will they improve the company’s cash flow position?

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• Top line – the newer breed of procurement value contribution. Examples here are turning cost into revenue (for example by investing in a waste processing plant, to sell it instead of paying for disposal). Another example here is working with R&D and suppliers on higher specifications which can make a product achieve a higher margin in the market.

• Bottom line – classic procurement cost savings activity that delivers an improvement to a company’s P&L. This is either through purchase price reduction, or also through other activities such as reducing demand or working with suppliers on innovations which can reduce processing or energy costs.

• Working capital – activities that drive improvements to a company’s cash flow. The best example here of a procurement contribution is improving the Days Payable Outstanding (DPO) through extending supplier payment terms.

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Where do procurement and finance definitions of cost savings differ?

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Buyers will typically consider procurement cost savings to be anything they have worked on that delivers some kind of direct or indirect financial benefit to the business.

Finance, on the other hand, will only consider cost savings to be something that deliver value to the bottom line.

Let’s take an example. Initiatives that help to reduce consumption of certain raw materials, operating supplies or consumables will not be recognised by Finance as a saving.

Imagine that you work with your PPE supplier to install a vending machine for ear protection, safety gloves, high-vis vests, batteries and similar items. Employees now must use a chip card to obtain these products. You do this to prevent theft or losses from the stores. It also encourages more individual employee accountability to be more mindful of their consumption.

The spend on these specific PPE and consumable items reduces from $100,000 per year to just $50,000 per year.

Procurement reports this as a $50,000 saving.

Finance doesn’t recognise this. It’s not visible in the P&L. But why?

Because each individual department had a budget to spend on PPE and consumables. Procurement and Finance did not work together at the start to align on the initiative. There was no agreement to cut the budgets to reflect the anticipated reduction in consumption from the initiative. If they had done, then it would have been seen as a legit saving. Instead, working in silos resulted in the money being spent on something else. Your hard work gone up in smoke.

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How to get procurement cost savings signed off by finance

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We already touched on alignment with the wider business objectives and initiatives as a prerequisite.

Let’s assume that you already have this. Great start! The next step is to acknowledge that Finance is the custodian of controlling and reporting. We must dance to their tune. The brutal truth is that nobody except your CPO cares about the numbers that Procurement reports and tracks.

We’re not going to convince our Finance colleagues to make wholesale changes to the way they fundamentally report stuff. Where we can influence them is to help them expand their commercial literacy around where and how Procurement adds value. We need to demonstrate how strategic supplier management can contribute to delivering on wider business objectives. This applies to both the top line (revenue) and bottom line (profit margin) beyond just price reduction.

If we can do this, we may well be able to convince them to adjust or expand on the targets we’re set and measured on. This gets us then into the discussion of Procurement being a function that delivers wider business value through their strategic management of the supply base. This is a quantum leap from us being just measured on cost savings.

That’s a topic for a whole other discussion though! Let’s not get carried away just yet.

What is Capex vs. Opex, and why is this important to Finance?

In addition to these measures, there’s also another consideration we must anticipate when engaging with Finance. Expenditure in their eyes is divided into two distinct categories: capital expenditure (capex), and operational expenditure (opex).

Capex is a one-off strategic investment which impacts cash flow, but not profit margin. It is depreciated i.e. written off over a number of years according to general accounting principles.

Opex is the cost of purchases which go into running the day-to-day operations of a business. Raw materials, energy, operating supplies and consumables are rolled up into the Cost of Goods Sold (COGS). Indirect procurement spend (except for transport and MRO) is generally considered as Sales and General Administrative expenses (SG&A).

Capex savings will typically be recognised as delivering improvements against an initial project budget. Savings on expenditure which falls under opex will, on the other hand, need to show a positive impact against EBITDA.

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Our Financial Benefit Types PDF guide

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We recognise that this is a bugbear of most procurement teams. But we also know that in most cases, our colleagues in Finance are not being deliberately obstructive.

Our guide to procurement cost savings shows 16 different possible ways of reporting value that procurement teams deliver to the wider business.

It’s not a magic bullet. It won’t immediately solve all your challenges of convincing the wider business of the value that Procurement delivers.

It should, however, inspire you to confidently articulate to stakeholders in Finance and other teams on how to measure soft savings. Procurement nowadays contributes to and delivers on initiatives which impact both the top and the bottom line of a business.

We deserve some recognition for this, even if the exact number is not completely traceable to a P&L statement.

Grab a copy here.

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