A frequent roundtable topic at recent SIG roundtables has focused on the appropriate measures of procurement effectiveness. Of course cost savings comes up as number one on virtually every list, along with measures of efficiency, cycle times, volumes of requisitions or contracts processed, spend under management and so on. The challenge of most of these measures is that they 1) are not measured in a way that is meaningful to key stakeholders in the company, 2) they tend to be managed from the perspective of what is important to procurement and not its customers, 3) most of our measures reflect only a component of a process rather than an end result, and 4) many of them are focused on an older paradigm of procurement instead of a transformational strategy.
Procurement is situated at a unique position within a company, having key visibility into the strategies and operations of the business as a whole and those of individual business units and departments and visibility into the markets of our companies’ suppliers and trading partners. We understand competition, contracting and negotiating techniques, and in many cases also bring deep expertise in financial analysis and operational effectiveness. All of this provides us with a great opportunity to serves as a “trusted advisor” who is “involved earlier in the process” and has a “seat at the table” for key business decisions, but only if we are up to the challenge. There is not faster way to not be invited back to the table then to behave the way that reinforces many of our clients stereotypes of procurement – compliance focused, bureaucratic, only focused on price and so on…
A key way to transcend these stereotypes and to bring credibility as a trusted advisor is to bring the right measurements back to the corporation. At a high level, these can be grouped into corporate metrics, business focused metrics and internal procurement metrics. We will only be able to address corporate metrics within the space of this article, and will explore business focused metrics and internal procurement metrics in future articles in this series.
First on this list are financial measures. We have been tracking “cost savings” for years, but from a credibility standpoint, we are living with the consequences of fallacies that we have propagated for just as long. The first fallacy that we have created is the notion that savings are delivered at the time they are negotiated. Negotiated cost savings are only potential savings and not real savings, because at the time of negotiation, we can only estimate what actual spend will be, whether the contract will be in effect for full term, and what the rates of utilization and compliance will be. From a CFO perspective, savings does not occur unless it can be shown coming out of the bottom line, and our measures should focus on “realized savings.” Tracking realized savings requires a significant investment in financial resources because frankly, it comprises an accounting discipline lacking in most procurement organizations, but this investment is critical because it enables procurement to measure its real value in the same terms that the CFO will report to investors. Achieving realized savings also requires an investment in vendor management and governance, a real cost that is often relegated to “someone else’s responsibility, and performed inconsistently across the company.
The second fallacy is there implication that costs can always move closer to zero. The reality is that there is an optimal range of pricing for a solution that will meet the company’s business objectives in terms of fitness for purpose, quality, timing and similar parameters. If we are measured by our ability to continue to reduce price year over year, we face a situation of diminishing returns and face difficulty in justifying continued investment in our organizations. Our measures of savings should always be tied to the net delta that we provide to what the company would otherwise have paid in the market without our support. Again, this means that we need to bring a more sophisticated level of insight into prices and costs than simply how much we reduced the price from a midpoint bidder or vis-à-vis a budget, and this requires a different level of financial analytics than we typically deliver at present.
The third fallacy is that most of our TCO analyses reflect, at best, price and transaction costs and don’t get into a true analysis of support costs, vendor management costs, and program, transition and change management costs. We typically look at a single year model rather than a three or five year business case, and we don’t fully analyze the puts and takes to various internal budgets that might make a decision the right one on a corporate level, but challenging from the perspective of individual departments. Managing at this level of detail is required for credibility.
A secondary corporate measure is in the area of risk. In this case, we can demonstrate value to the company through a valuation of risk mitigated. This means calculating the negative impact of a negative risk times the probability that it will occur. For example, by negotiating termination for convenience, we may avoid a potential $5 million termination fee on a contract that is terminated early. In this simple example, by multiplying the $5 million by the probability that we might terminate the contract early, we can assign a value to the risk avoided. Other ways to estimate the impact of risks include the potential magnitude of a regulatory penalty, a lawsuit, reputational damage or a service outage. While admittedly these will usually need to be estimates, you will generally find it possible to agree on a reasonable estimating methodology that will serve as a meaningful proxy for the value being provided. Additionally, it’s important to note that the status quo also has a risk, and a calculation of status quo risk should be an integral part of the analysis. The key here is to convert a qualitative statement that “procurement reduces risk” to an auditable measure of value.
As we indicated above, the other areas of Business Focused Metrics and Internal Procurement Metrics focusing on transformation are equally critical to the long term success of the procurement organization and will be addressed in subsequent articles. In the interim, procurement leaders should give thought to the corporate metrics outlined in this article as they are critical to enhancing the prestige and impact of the procurement organization as a strategic resource for your company.