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.
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.
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.
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.