Previously we discussed different types of cost and what we do about it
Let us now see how to calculate and report it.
There is more than one way to calculate cost savings. And all of them are, theoretically, correct. It depends on what is your comparison basis. And the choice of comparison basis depends on the available data. Sometimes you have the last purchase price. Sometimes the budget. Sometimes you can do a cost calculation of the raw materials and manpower required. This then becomes your base.
If we present savings using the historic savings models, we are basically comparing our current with the previous cost. This is a quite simple and precise model, as it relies on data. However, you can not use it if your Business is not buying the same item or service over and over. Even the slightest change in the specifications will make the “apple to apple” comparison impossible.
Previous Price Model
As the name says, we are comparing our current with the historic cost for the same (or similar) item.
In the article Is procurement adding value to the business? you can find the complete formula.
This is a simple model, and easy to use. Yet, it works only if you are procuring the same items. Even a change in packaging will result in the need to manually adjust the report. For example, you bought earlier oil in litres. This year you found a vendor who packs oil in gallon size containers. Unless your ERP is smart enough to have multiple units of measurement, you will have to manually calculate the new per litre price.
Process Optimization Model
This is a way of reducing costs not by working on the price, but the spend. Here is an article that dives deep into the topic
Here we are looking at the process of obtaining the product or service. While doing this, we aim to cut any unnecessary costs. It can be clapping several shipments to reduce transport costs. Removing a part of disposable packaging and replacing it with reusable options. Working on time management to reduce the required manpower for the task. Anything in the end-to-end process that may lead to a reduced cost. As this takes time and effort, it is a model recommended for large spending.
Reporting this is not easy. You have to look at the particular process as a small project. Calculate the total cost for the process. Then the cost after implementation of the proposed ideas.
Spend Control Model/ Demand Management
Firstly, let us start with a bit more details on what is demand management. Here is an excellent article on the topic.
In this model, we focus more on the spend in total, not the individual price itself. In coordination with sales and operations, we are trying to determine when and what will we require. Then we go back to our vendors and try to find with them the optimal way of covering those requirements. Again take time into consideration. As we do not want to have non-moving stock, but as well no out-of-stock events.
Let us take an example of seasonal clothes. We make a demand plan for wool (for winter) and linen (for summer). Then we look at seasonalities at prices of those raw materials. And we contract the goods when they are the cheapest and deliver either when it is required or when we have space in our storages. Have not worked in the industry, but I presume that wool is the cheapest in May, and linen in October, based on collecting time.
Capital Employed Model
Adding one more layer to the previous model, which is the capital required for our Raw material and Supply Chain assets. For those not familiar with the working capital concept, here is a good reference:
For our supply chain, especially if we buy and store large quantities of material, we have to consider the cost of capital we engaged into:
- Building or leasing our warehouses
- Operating warehouses (staff, utilities, insurance)
- Transport between warehouses and warehouse and production or stores
- Cost of capital that we have blocked in our stock
If we took a loan with an interest rate of 12%, our stock becomes more expensive by 1% for every month we keep it in our stores.
Also, if the vendor gives us 90 days’ credit, our stock is 3% cheaper compared to a vendor that gives no credit.
If we give our clients 90 days’ credit, the saving is lost.
In one of the companies I worked for, we had the ideal situation: the value of our material in stock was equal or below our outstanding to the vendors. This means that the complete stock was owned by the vendors. Hence we had no capital involved in our stock, while we could immediately deliver, as it was available.
As its name says, here we are reporting savings compared to the given budget. Budgets are usually created either within a timeframe (year or quarter) or in relation to a particular project.
I would describe budget savings as shooting at a moving target. Here we have a goal to achieve a budgeted cost. Which is fine, if the budget is created realistically. However, I have seen more than once budgets created as a pure Excel exercise. And then, someone decides that you can achieve 10 or more per cent savings without asking anyone’s opinion.
Index savings are quite similar to budget savings. In this case, however, it is not a person that determines the target price. For example, if the overall inflation for the past year is 5%, we agree with the management that the overall cost increase can be capped at 3%. Hence, a cost increase from a vendor of 2% is still considered a saving.
In this case, we use a product or service as a base for our price target. It can be one of the raw materials for the manufacturing of the product you are buying. For example, when it comes to Stainless Steel, Nickel is the material that drives the price. Even he is often below 20% of the composition of the alloy. But due to his high price and volatility, it is the only material you have to track. So, if you foresee Nickel going up 20%, you can not expect Stainless steel to go down.
In RFP savings we are not looking at any internally given cost. Instead, we are looking only into the data we got through our RFP process.
Offer Comparison Model
This is the simplest model, known and used by everyone. In simple words, we compare the offers we got and select the best one.
One thing I often notice by Procurement professionals using this model is that they focus solely on price. Which should not be the case. Based on company preferences and requirements, we have to give higher (or lower) priority to other elements of the quote, like:
- Delivery time
- Payment terms
- Financing options
- Loading, unloading and assembly services
- Buyback options
- Recycling options
Avoid price increase Model
This is a simple one. Prices are going up due to inflation. Your only target is to contract the same price as last year. This becomes very critical for companies that provide services with long contracts. For example, in the Facilities Management industry it is common to contract building maintenance for 3 to 10 years. The pricing is done based on the proposals collected in year one. And we are not targeting here so much to reduce the cost in the subsequent years as we aim not to increase them.
Here we focus more on the technical elements of the received quotes. In many cases, we can play around with the technical details of the proposed item or service and achieve significant cost reduction. But, be aware, there is a limit to it. And crossing it can have disastrous consequences.
Playing with specifications is, generally speaking, very technical. Therefore, here we need help from the end-users, internal stakeholders and the supplier.
The idea is to dig deep into the intrinsic cost of providing the good or service. Then we can see what drives the majority of the cost and subsequently change the requirements.
Let me give an example of printing. Your advertising and printing supplier is having a machine printing on paper 100 x 70 centimetres. Hence on the same piece of paper, he can print one page 60×70, but two pages 50×70 centimetres. A reduction in the size of only 10 centimetres on one side reduced the material cost by half and increased the machine output by 100%. This is a very simplified example, but I believe you got the idea.
Ratio savings are a combination of the earlier mentioned savings. We are not limited to achieving savings using one technique only. Reporting them is quite complex and on a case-to-case basis.
A word of advice: do not change your reporting every time. If one year you compare to a budget, and next year to the previous year, it may create a false impression. You can, however, have different ways for different categories. For example, your services can be benchmarked. While pantry items will have an index based on the average food cost increase index given by the government.
We will not go into the strategies and tactics for achieving those savings. In this article Procurement cost savings you can find quite a few.