Unlike others, we in procurement have a special relation to cost. It is our goal, we look at it from very different angles.
What is the cost for procurement?
In procurement, we look at cost from more than one angle. This is the reason why we have several ways to measure cost changes
Compared to the previous purchases
This is the simplest way to measure cost changes. What we have spent earlier compared to what we spend now. Due to its simplicity, we use it very often. However, this way of looking at cost is possible only if our purchases are standardized and the same year after year.
As a part of the P/L
If the first way is not possible we look at the profit/loss statement from the finance team. There we compare how much was the Cost of goods sold (COGS) for the timeframe or project. If we have a standard production we can compare the previous year and this year. Our goal is that the cost is relatively lower every year. For example last year the COGS was 23%, this year it is down to 22.5%. We reduced the relative cost by 0.5% of the total spend, bringing, therefore, the same amount to the bottom line. This is not exactly the most precise method. The cost reduction could happen due to efficiencies in the production, changes in the products or price increases. But, at the end of the day, the total cost went down, which is the most important parameter for the management
In relation to the budget
At the start of the financial year (or project) you will get a budget. Those are basically target prices you need to achieve. And then you go out to the market and try to find a vendor that can match your budget for this product or service.
While it sounds simple it is not. Budgets are usually created by the finance team. And they do not take into consideration market fluctuations or new technologies. So, you can end up being 50% below (or above) the budget due to factors you can not influence. Did fuel go down? The budget will be reduced. Fuel goes up? The budget stays the same, use your negotiation skills to keep it at the same level as last year. You manage to do it? Expect a further budget decrease next year.
As you can see, it is a bit of trying to hit a moving target. Sometimes it works in your favour, sometimes not.
I had a case where the sales team reduced a budget line by 20% in order to win the deal. Not aware of this, finance reduced the same line by a further 20%, expecting that my team will be able to get a 20% discount from the vendor. And it is a service that involves a lot of manpower, hence playing with the scope is not an option that can affect the cost. Unless we find a way to place a half of a person on the job 🙂
How procurement looks at the cost
Firstly, let us discuss something that often sparks heated arguments between procurement and finance.
Cost savings
This is saving money by reducing the purchase price. In articles like this one you will also find the term “hard savings”. This saving has a direct impact on the bottom line of the company. Procurement has negotiated a contract and reduced the cost by 10,000. This means that for the same item the company will pay 10,000 less. and, as a result, have 10,000 more profit.
Cost avoidance
Here we focus on the future. We attempt not to spend money on a product or service in the future. It is also called intangible saving, as there is no visible effect on the bottom line. For example, if we buy an energy-efficient asset, we did not make any savings on the asset itself. But we have avoided future energy costs that will occur if we had not considered this. Very often you will find in TCO calculations cost avoidance as a reason for supplier selection.
Cost reduction
In this case, we are going deeper into the product specification or the scope of work. In a nutshell, we are going to remove something in order to reduce the cost. For example, if a product is packed as single, then in 10 pieces, then in a box. By removing the 10 piece packaging, the supplier can reduce the price.
Of course, this is, and will always be, the main focus of procurement. We refer nowadays more to the right than the lowest price.
Here we are not talking only about the purchase price. And this is a mistake many make. In the article about the TCO-total cost of ownership, you can find more about addressing all costs that occur during the lifecycle of an item.
A note for the end: I use a lot of “mostly”, “majority” and similar words. Procurement works based on the 80/20 rule. It is rarely possible to use one system or principle on 100% of the company spend. Therefore, we focus on the top 80% of the spend and build our systems, strategies and reporting around it. The rest we try to fit in or analyze manually and make a “sub-strategy” for this part. Take this into consideration when working on your next cost avoidance or cost reduction project
