Michael Jacobs, Vice President, PRTM
Linda Meloro, Principal, PRTM
Chief Procurement Officers are victims of their own success. With external purchases representing 40 – 60% or more of revenue, most leading corporations have relied heavily upon the Procurement Organization to drive significant cost savings – often in the range of 4 to 6% or more of overall spend. This becomes particularly evident in times of economic instability such as what we experienced in 2009.
A critical question facing all organizations in the future is: What is a reasonable annual cost reduction expectation given your current stage of procurement maturity? Although there may be corporate pressure for year-on-year savings of equal or greater magnitude to the past, this might not be feasible, particularly for firms that have already maximized the savings potential from large scale strategic sourcing efforts, achieved significant supplier consolidation, introduced effective supplier management programs and have fully embraced traditional levers such as low cost country sourcing.
PRTM recently executed a benchmark study, focused initially on High Tech and Medical Device Companies, to understand historical and projected future cost reduction for those industries and begin to develop a model for setting future savings targets. Our rationale was that these two industries have historically placed different emphasis on sourcing as a strategic weapon and therefore may exhibit opposite ends of the spectrum in terms of cost reduction performance. Our measure of sourcing savings included “total cost” measures, but excluded cost avoidance. Interestingly, very few companies in our survey used a strict price-to-price measurement for savings, but instead relied upon standard price changes.
Preliminary Results from in-process PRTM 2009 Direct Material Cost Reduction Survey:
As might be expected, in the High Tech sector, where product life cycles are shorter and margins are tighter, and developing advanced sourcing, outsourcing and offshoring capabilities has long been a key focus, annual procurement cost reductions of 7% to 9% per year have been the norm. However, this may be difficult to maintain, as evidenced by the projection that cost reduction targets are expected to decline to 5.8% annually going forward.
Conversely, In the MD&D sector, safety and regulatory concerns as well as ample profit margins have resulted in less emphasis on operational cost performance. Direct material cost reductions in that industry have been ? 5% per year. Even in this environment, however, investments in sourcing can deliver attractive near term benefit as MD&D industry leaders have demonstrated that focusing on enhancing direct material sourcing can yield a 2X annual cost reduction advantage over industry competitors. Still, median long term cost reduction in this industry is expected to be only 4.3%.
A further examination of individual company data surfaces a strong historical cost reduction performance of those companies that have focused on leading sourcing practices - broadly within Hi Tech and selectively with Medical Devices industries, leading to an “efficient frontier” of savings expectation, as illustrated in the figure below. In this model, savings potential declines as sourcing maturity increases, but still represents a large competitive opportunity for those in early stages of maturity.
Our advice is that when it comes time for annual target setting, historical performance is not necessarily an appropriate start point. Companies need to assess and measure where they are along the efficient frontier and then set appropriate cost reduction targets and make investments accordingly. For those early in maturity, the opportunity to achieve competitive advantage through traditional sourcing programs is particularly high. Once this level of maturity is reached, greater emphasis is required on value engineering and true design collaboration with suppliers to continue to drive cost reductions.
If you have questions or would like to participate in PRTM’s ongoing cross industry benchmark, please contact Michael Jacobs at firstname.lastname@example.org.