Sourcing (and Procurement) departments have long debated with internal customers, including Finance and the Lines of Business, of whether cost avoidance brings the same value to a company’s financial results as sustainable (cost) savings. Are sourcing efforts to avoid costs wasted? Should Sourcing departments focus entirely on sustainable savings?
To better address this issue and for the purpose of this article, it’s important to establish a common understanding of these “savings” types to determine their value.
Sustainable savings may also be referred to as cost reduction to the “run-rate” or budgets. They are savings resulting from specific actions to eliminate expenses. These savings may also be a result of reduction in costs relating to purchases or expenditures already planned in the company’s budget, and are easily recognized by Accounting and Finance departments as reductions to the company’s expense line. As an example, if a company planned to purchase 1000 widgets in a given year for $1 million and the final purchase price was $900K, then the obvious savings are $100K.
Cost avoidance savings (CAS) are typically economic (not accounting) in nature. Generally speaking, these savings arise from price negotiations for unplanned purchases. Sourcing plays a key role as the driver of the negotiation and strategy to maximize CAS. Some of the ways Sourcing drives CAS when:
Negotiating cost reduction for in-year deals that were not included in the current year’s budget plan.
Negotiating cost reduction for future deals. These deals, by definition, are not planned for in the current-year budget. They are typically multi-year deals which may also include an in-year expenditure element.
Decreasing the total demand. This scenario can occur despite an increase in the per unit price. Often this scenario is not a direct result of a strong negotiation capability by the Sourcing departments, but rather be a reflection of a better internal assessment of the desired quantity demanded to eliminate waste. Managing demand is prevalent in Supply-Chain organizations to improve logistics and efficiency.
Finance departments will typically discount the value of cost avoidance savings because they cannot directly attribute this reduction to the company’s overall expense line. As a matter of fact, if these savings occur, as mentioned earlier, they are typically related to unplanned purchases and; therefore, the company’s expense line would increase. If this were the case, then is cost avoidance a true savings to the company?
While it is counter-intuitive that savings do occur, by virtue of avoidance, while the company increases its expense or capital investment, the fact remains that in the absence of the cost avoidance reductions, the actual cost to the company would have been higher (in current and subsequent years). By avoiding these costs, the company is able to achieve a lower overall expense and capital levels than otherwise would have been achieved.
The paradox of allocating resources to avoid costs that are not as valued by the company’s Finance department is a difficult situation to balance from multiple perspectives. Sourcing and Finance Departments are joint guardians of the company’s bottom line and have the company’s best interest at heart. Finance Departments are concerned with the various impacts to the company’s Profit and Loss statement, while Sourcing departments are better positioned to see the economic leakage and the potentially forgone value of particular transactions by being close to market conditions and by understanding a supplier’s price sensitivity.
Indisputably, Sourcing professionals must always focus on obtaining the best value for the company whether it is through sustainable cost reductions or through cost avoidance. Ultimately, it’s a balance that the two (Finance and Sourcing) departments have to strike for the company’s best interest. On one hand, Finance must recognize the true value of cost avoidance. While it is economic in nature, similar to sustainable savings, presuming of course that all transaction-related expenditures and investments are critical to the company. After all, it may well be that Sourcing’s ability to avoid certain costs that enables the company to afford placing the necessary bets (investments) it requires on unplanned purchases. On the other hand, Sourcing professionals should be very diligent in the amount of time they allocate negotiating savings, particularly when future expenditures are not contractually committed and are simply optional purchases.
It is in a company’s best interest to ensure that Sourcing obtain the best value through negotiations of deals, and that the appropriate incentives to reward sustainable savings and cost avoidance savings equally are in place to drive the behavior of obtaining the maximum value for deals.