Spend Analysis

Procurement savings | Definitions and calculation examples

Jasmiina Toikka Jun 16, 2021

The main goal of procurement is to ensure products and services are bought at the right price. Cost savings still is still the #1 key performance indicator for CPOs. This can be measured via hard savings or so-called cost avoidance. The debate between Procurement and Finance about how to measure the value of procurement savings is ongoing. There is no right or wrong method. For procurement to have credibility it needs to build trust, transparency, and alignment with Finance as well as prove its value to business stakeholders. To succeed in this the basics need to be right: we have to agree on the savings definitions and the methods used to calculate and validate savings.

How Procurement looks at savings

Procurement prefers to look at cost savings as the negative change from the previous cost paid to new negotiated cost. In the absence of a previous cost reference, savings could be calculated from the first offer received or market benchmarks. Procurement would ideally like to record savings at the point of negotiation or on confirmation of a signed contract when they can sit back, relax and hand over the contract to business for execution. But that doesn’t translate to actual cash savings - it only tells us what is the savings potential. The actual realized savings are harnessed later. Realized savings are dependent on any change in the level of business activity and stakeholder compliance to the contract. In addition, factors outside of our control have an impact on cost level: changes in raw commodity prices, currency fluctuations, and labor cost index level.

How Finance looks at savings

Finance views savings from a different angle. For Finance, savings are something that has an immediate impact on the company budget and balance sheet. These are often called “hard savings”. Finance professionals expect reported savings to translate immediately into a decrease in costs. Unfortunately, this is not the case as it may take time for the savings to realize and there may be external hiccups along the way. Finance’s approach to measuring savings is to match expenditure against budget, i.e. what did we spend compared to what we planned to spend in a given period. Budgeting, therefore, plays its own part in the Finance savings equation.

There is often a mismatch between Procurement’s claimed savings and what Finance sees when it studies the profit and loss (P&L) account. Key reasons for misalignment and conflict between Procurement and Finance include:

  1. lack of common language and terminology when talking about savings
  2. measuring only contracted savings rather than all the steps of the savings lifecycle model
  3. focusing only on proactive savings projects and neglecting the external factors

If there is a major gap between actual and budgeted spending, one could ask how collaboratively the budget was constructed, how careful the initial assumptions were, and how actively the budget was updated to consider possible market changes during the budgeting period. These mismatches could be partly avoided with active dialogue, expectations management, and higher levels of transparency between Procurement and Finance.

The level of collaboration between finance and procurement varies in organizations. When the Procurement function reports directly to the Chief Financial Officer (CFO), agreeing on the budgeting and savings calculation principles is relatively straightforward. Sievo uses the SavingBridge model to connect procurement and finance thinking.

A note about cost avoidance

Cost avoidance is often termed” soft savings”. Treatment of cost avoidance is the most argued issue when talking about procurement savings. Definition of cost avoidance:

 

“Cost avoidance is a reduction in cost resulting in a spend that

is lower than would otherwise have been if the cost avoidance

exercise had not been undertaken.”                                 CIPS

 

What is value leakage?

Value leakage means the difference between identified savings potential and actual realized savings. Value leakage can be caused for instance by suboptimal design, poor measurement of savings, weak adoption, insufficient change management, and/or inefficient execution of the contract.

 

Procurement savings leakage

Source: Aberdeen, State of Strategic Sourcing, 2011​

Understanding the complexity

Procurement savings can be divided under 4 savings types:

  1. Cost savings (price change or rebate)
  2. Total cost of ownership savings (productivity improvement or make-or-buy)
  3. Working capital improvement (payment term improvement or inventory reduction) and
  4. Procurement value creation (cost avoidance).

In addition, procurement savings can be categorized based on their occurrence (recurring or one-off) and impact on cost structure (opex or capex impact):

Procurement savings opex and capex

Savings opportunities present themselves in various ways. Let’s look at the following examples:

  • Sourcing a new commodity. We receive competitive price offers for a new type of carton. There is no baseline to measure savings against. Procurement negotiates a 10% discount on the best price offered across all bidders. The actual savings can be calculated as: average bid price less price achieved X number bought = savings
  • Project sourcing. Through strategic sourcing initiatives, we manage to limit the impact of cost increases in plastic cartons through monitoring the global market for raw materials. This year has seen a price rise of 20% in the price of plastic. Through long negotiation, the cost increase was limited to 15%. Is this a real saving?
  • Design change. The design team changes the specifications on a type of carton.  The closure on the carton is simplified and there is a saving of 10% on the price of a closure. This is a cost-saving but is it a procurement saving?
  • Total cost of ownership. Procurement identifies together with business that a certain part of its operations should be outsourced to a specified vendor. The handover is successful and eventually, the total cost of that service decreases compared to in-house operation. Is this procurement saving?
  • Consumption change. Procurement has negotiated a lower price for paper cartons. However, in the next period sales are up and we buy more cartons. Despite the lower unit price, the total expenditure increases. How is the unit cost saving recorded?  
  • Working capital change. Procurement has changed to a supplier with a lower unit cost for paper cartons, but with a higher minimum order quantity (MOQ) and longer payment term. Unit cost per carton is considerably lower, but a new higher MOQ leads to higher inventory value and warehousing costs. Procurement has negotiated a longer payment term with the same supplier. This has a positive impact on working capital at hand. Is this calculated as cost-saving or cost increase, or both?
  • Rebate. You are currently paying a license fee per annum for a software tool. After year one the vendor sends you a renewal contract. The renewal for year 2 includes a 10% increase over last year. You avoid the 10% increase by promising to renew for year 3 or by foregoing some of its features. This is cost avoidance but is it a real saving?  

Calculation of savings is further complicated by the impact of one-off costs, volume rebates, changes to payment terms, late deliveries, emergency orders, warehousing costs, and more.

How to succeed in savings calculation

There is no right or wrong method for calculating savings, but there are three success factors for doing so:

  1. Formalizing and agreeing on savings methodologies

Successful savings calculation starts with agreeing on a common methodology. Regardless of the saving type, it’s important to always align the savings with finance in a way that savings can be identified in the financial statements, the way the savings will be visible.

These are the type of questions to ask:  

  • Do you set baselines by category or commodity or by cost center?
  • What is the baseline for savings you will calculate savings against?
  • Are you taking verified market cost changes into consideration?
  • Are you considering cost avoidance as saving or only focusing on “hard savings”?
  • Over what period will you measure and report savings? Monthly or quarterly or annually?
  • For multi-disciplinary sourcing projects who gets to claim the savings?

Answers to these questions will provide the basis for the agreement on reported savings.

  1. Tracking realized savings

At what point is it fair to claim a procurement saving? The concept behind realized savings tracking is clear – after a contract has been executed, invoices are tracked for an agreed period to validate exactly how much money has been saved. Many well-negotiated cost savings may be lost during a contract period due to ”leakage” of orders to non-contracted suppliers. This is called “maverick buying”. Therefore actual purchases need to be monitored via paid invoices to ensure the accuracy of cost-saving claims.

Savings tracking can be complex if there is a large amount of data and there are multiple rules applied to different types of savings. Software tools have been developed to automate these calculations and are often offered as a facility in cloud-based spend analysis solutions.Procurement savings lifecycle

  1. Reporting realized savings accurately

Savings should only be reported on addressable spend, i.e., the spend that is under the influence of procurement. Reporting to Finance needs to be focused on the “hard savings “, those that can be proven and that find their way into the accounts and eventually have an impact on the PL sheet and future budgeting. When reporting savings to other stakeholders and showcasing their impact on business it is possible to also include those “soft savings” achieved through cost avoidance initiatives. Even if it might not be recognized by Finance, procurement should be tracking both “hard savings” and “soft savings” to capture and communicate the total value delivered to the business.

From a procurement perspective, it is important to track planned vs actual savings. What matters for the bottom line of your business is that identified savings opportunities through spend analysis are turned into an actual reduction of expenses. This information helps with future resource planning as well as performance management. Understanding savings achieved by the cost center or division highlights where the contribution is coming from.

A note about performance reward systems

The people-related aspect to keep in mind is that savings tracking directly influences the professionals that work to make them happen. Procurement could be negotiating hard to keep the current cost level while the market is experiencing dramatic changes, i.e. avoiding cost increases to their best ability. Company rewards programs are designed to motivate and retain those who are most successful in their efforts and perform well. Rewarding based on hard savings only can therefore be seen as discouraging or even unfair between different procurement categories when several elements are simply out of Procurement control and categories have their own market characteristics.

Where to find the opportunities for cost savings

Identification of savings opportunities is the key to smart procurement and focusing efforts on initiatives that deliver the most value. Opportunities for future savings are identified through spend analysis. For any given commodity or service the following data may provide insights into where savings may lie:

  • Annual spend
  • Number of suppliers
  • Spend-per supplier
  • Spend-per division or cost center
  • Comparison with chosen benchmark

Cost reduction can be achieved through spend consolidation, leveraging discounts, and reducing the number of suppliers.  Re-specification of the product or service can also lead to cost-efficiency. One area of opportunity that is relatively easy and is often overlooked is to work with your key suppliers in a transparent and collaborative manner, where both parties can benefit from cost efficiencies and benefits can be shared. 

Cover picture by: BP Miller

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This guide explains the 5 major approaches to cost savings in procurement. 23 different savings methods are explained, from Hard Savings to Cost Avoidance. In addition, you'll learn how best to identify, measure, and communicate those savings to your organization.

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