Procurement today is under constant pressure from management to reduce costs and deliver ongoing savings towards their company’s bottom line. Procurement departments are continually working within their ranks to develop both tactical and strategic supplier management methods tied to various negotiation approaches. This is done to achieve the goals of reducing cost increases by deflecting them all together or reducing the prices paid for supplier’s products or services. In terms of creating sustainable, longer term cost management, procurement should work closely with their suppliers to identify ways to drive cost savings on both sides as opposed to allowing suppliers to try and justify extending a price increase and to that end, procurement agreeing to accept these increases.
Understanding how costs should be classified is important. When relating these classifications towards price savings that would be considered impactful or sustainable, it is important to relate them to how they affect a company’s budget and P&L. In general, cost savings come in two basic forms - “hard” and “soft.”
Hard cost savings can have a greater year-over-year impact on budgetary outlay and cost of goods sold. For example, procurement might negotiate a reduction of an operating expense, such as a decrease in the material price for packaging or a reduction in IT hardware costs. This equates to a net reduction in prices paid for the raw materials procured when compared to prices paid in the previous year.
Soft, or intangible savings, are related to avoiding cost that would have “otherwise” impacted the company’s operation in some manner. Soft saving can be considered process improvement related or avoiding a cost increase by disallowing it from a supplier all together. In terms of measuring softer cost savings, procurement might avoid a price increase through comparative material analysis, as compared to not challenging the supplier with this analysis who then may use rising markets as a wedge to drive the increase through. Other examples can be negotiating down a price that is lower than what was provided from the supplier or contracts with escalation and de-escalation clauses and negotiating free services that would have been otherwise charged out such as training or service calls. Important to consider, is the supplier price increase percentage as an attempt to meet quarterly sales commission goals or relay a cost issue within their business. Thus they are in need of increasing prices because there is an economic justification related to their own costs going up and thus impacting their margins. At this point, procurement would need to discuss if the supplier performance overtime has been positive and what is fair in terms of accepting any small percentage increase due to the supplier’s cost management issues. Essentially, avoiding an increase all together is most important. Then the relationship should be examined as to whether it is truly considered a long term performance based relationship.
If an organization distinguishes that sustainability in terms of cost management is essentially tied to savings that has a direct extended term impact to the company, then as an example cost avoidance could be justified as a impactful measureable event, if procurement through comparative analysis, market price testing or challenging a supplier’s cost structure, understand that the price they are currently paying from a supplier is the lowest current price in the market. And, if that price compared to other suppliers that can provide the same product or service is the “best in market” price. In essence, the supplier is the absolute lowest cost provider. Ultimately, it is up to the organization to determine how best to properly qualify or measure the relative impact of cost avoidance. Executive management stakeholders in finance or operations typically do not see it as impactful or providing sustainable benefits to the organization. To them, only hard dollars taken out of the budget or re-invested back into the operations is justified. As you can see, this can present issues in clearly defining cost savings versus cost avoidance as it relates to sustainable cost management. The need for rigorous measurement and tracking methods between procurement and finance is critical to avoid budget or operating expense allocation issues.
Consequently, procurement must present numbers that are meaningful and validated by upper management. Procurement plays a very key but reticent role in reporting savings that is actually realized and impacts the bottom line short and longer term. Procurement should work closely with finance to coordinate on savings classifications so there is no misunderstanding of how budgets are analyzed and allocated. In many cases, senior management with direct P&L responsibility make the decision how savings should be allocated and recognized.
Procurement should present numbers they have faith in, and to present their view as to whether the savings is hard savings or soft cost avoidance and what are the overall benefits that impact the company. It is through this diligence and rigorous of communication, classification and reporting that decisions collectively can be made as to which savings should be validated, disregarded or redeployed within the business.