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A Quick Guide to Procurement Savings Management

A Quick Guide To Procurement Savings Management

The guts and glory of procurement savings

Procurement savings is a double-edged sword.

Some colleagues use it to massage their egos by claiming millions of hot-air dollars that make no good to the company balance sheets or end-user prices.

Others save to create a lifeline for troubled businesses or to fuel up the competitive advantage.

This post will cover the most essential aspects of procurement savings management based on best practices and actual working examples.

Spend under management

Whenever you commit to procurement savings, it is essential to distinguish the basis of your future KPIs.

Naturally, the total spend is what the company's expenses are. 

Having committed to X% annual savings, make sure the underlying spending excludes pockets of uncontrolled expenses, e.g., state-controlled communal services, executive consultancy, litigation, or else. 

Spending under procurement control is the broadest possible selection of expenses covered by the procurement policy. 

Out of that, not every expense falls under a contract, as your company got tail spend - small-value transactions managed via default buying channels, e.g., p-cards or petty cash. 

Therefore, your spending under contract is lower than the one under control.

Not every expense is managed (planned, analyzed, sourced, negotiated) in the current fiscal year as you have multi-year contracts untouchable before the next maturity date. 

So, you need to consider all new agreements and ones coming for renegotiations this year to derive the spending under management.

It is suggested to monitor the procurement savings based on spending under management. 

Procurement savings types

For many years, cost savings have been considered the primary objective of procurement and a key measure of its performance. 

Procurement savings fall under two distinct types: hard and soft ones. 

Soft savings

Soft savings don't have a direct monetary effect on the firm's performance. 

For example, better payment terms, additional free deliverables, or an extended warranty period are essential but do not directly affect the balance sheet.  

Another necessary type of soft savings relates to future periods. Once you sign a longer-than-annual contract, all savings attributable to the coming calendar years won't produce any direct effect on the current P&L.

Therefore, the other name for soft savings is "non-cashable."

Hard savings

Hard savings are directly quantifiable and can be immediately linked to a company's performance (therefore, the popular term "bottom-line impact" appeared). 

Hard savings can be attributable only to the current fiscal year. It isn't possible to make hard savings in future years! 

Hard cost savings are measured by comparing the final negotiated cost versus the budgetary cost. Calculating hard savings against the budget is essential, as this is the only way to achieve the bottom-line impact.

Savings measured and even reported but not actually translated into the budget cuts don't positively affect the company's financial performance. 

With this in mind, we will suggest the working practice of procurement savings management.

How to manage procurement savings 

We suggest the following best practice for procurement savings governance:

  • Savings must be measured against the budget.
  • A distinct savings bucket should apply to the current fiscal year (hard savings.)
  • Savings reports must be verified and formally signed-off by financial control.
  • Negotiated benefits realization should be monitored based on actual consumption (not contractual forecasts!);
  • Verified savings attributable to the current fiscal year must be deducted from a respective business unit's budget.

With these six simple rules in mind, the practical implementation could be staged into

  1. Forecasting of savings targets (category planning). 
  2. Delivery of projected savings.
  3. Tracking of realized savings.
  4. Budget adjustment.

Pre-tender cost estimate

No RFP should start without the pre-tender cost estimate. Otherwise, procurement savings cannot be measured in the absence of a benchmark.

Typically, there are 5 ways to produce the pre-tender cost estimate:
  1. Historical prices of the preceding period(s) adjusted for inflation and/or applicable price indices (e.g., manufacturing or commodity ones.)
  2. The fair market price is calculated as an average of at least three quotations collected before the RFP. It is essential to eliminate "atypical" costs, which deviate by 30% and above the median level.
  3. Commodity formula-based prices, e.g., Platts-based fuel price, LME-based price of metal products, price-at-hub formulas for coal or natural gas, etc.
  4. Open-data price benchmarks for similar products or services, e.g., customs declarations, public procurement tenders. 
  5. Industry expert estimates, e.g., trade chambers, ministries, state or independent price registers, renowned industry consultants, etc.

Procurement savings calculation methodology

The name of this chapter sounds like some scientific manuscript. In fact, there's no rocket science in savings calculations.

Hard savings must be apportioned to the current fiscal year. E.g., if you saved $1M by signing an annual contract in July, your projected hard savings will be only $500K. The rest goes into future years and becomes soft savings.  

You can claim savings resulting from efficiencies, e.g., workforce optimization. But again, hard savings will only fall into the current year's portion of total benefits.

Soft savings can be different, e.g.,
  • future year's benefits;
  • additional deliverables over and above the initial scope of requirements;
  • extended warranty;
  • improved payment terms.
Such savings are essential but, unfortunately, produce no bottom-line impact, hence "not cashable."

Four critical steps to take before celebrating procurement savings

The logic behind the process above is intuitive. 
  • First, your category plan must include the forecast of savings and other benefits.
  • Second, your forecast will be gradually fulfilled in source-to-contract activities. However, this isn't the point where procurement enjoys its achievements!
Your contracts only represent the planned delivery of savings based on projected volumes of orders. The actual delivery of procurement savings and benefits only happens with each Purchase Order placed with a vendor.
  • Therefore, tracking realized benefits on a Purchase Order basis is the critical stage of the procurement savings management process!
  • Lastly, procurement needs to obtain the acknowledgment of the delivered savings. Usually, this comes from the Financial Control, who would then adjust end-user budgets accordingly. 
Only then procurement may enjoy the brief moment of glory and recognition of the genuine value delivery.   

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This post first appeared on The Good Spending, please read the originial post: here

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A Quick Guide to Procurement Savings Management