Cost Reduction Measures

According to a study by the Center for Applied Purchasing Studies (CAPS) Research, the primary goal of most purchasing executives is to reduce total costs (1). Supply managers in general are under an increasing amount of pressure to assure the accuracy and validity of their cost reduction measures. Their goals are often directly linked to promotions and bonuses as an incentive help their purchasing department reach its goals. As such, cost reduction measures must be able to withstand rigorous questioning from top management (2).

In a later study, CAPS Researchers Smeltzer and Manship presented the results of their research on cost reduction in a recent Supply Chain Management Review article. They studied a bank, an airline, a software provider, a consulting company, a national restaurant franchise, a hospital, a mining company, and five manufacturing companies. In each of the case studies, the authors interviewed key managers and analyzed supporting documents to identify seven different techniques for measuring savings. Smeltzer and Manship’s synopsis of each of the seven techniques follows:

1. Price over Price. The new contract price is compared to the previous contract price, and any downward variances are recorded as a savings. But to record an accurate savings, market adjustments must also be considered. For instance, if the price of the appropriate Producer Price Index (PPI) decreased for the year by 2 percent and the new contract price decreased by only 1 percent, did the new contract save anything? It is true that the cost decreased by 1 percent, but no savings is recognized against the PPI. In fact, the price variance compared to the competition may be a 1-percent increase.

items if they are raw commodities such as aluminum, copper, or iron ore. However, when components or finished products are compared, it is difficult to make exact comparisons from one year to the next because of continual changes.

2. Successful Bid vs. Average Bid. All of the bids received for a particular good or service are averaged to obtain the mean price. The successful bid after negotiation is then compared to the average bid to calculate the savings.

When using this approach, it is important to assure that each bid is for the same item. Also be cautious when determining which bids to include in the average. It is possible to obtain an extremely high bid that is not competitive for some reason. Should this outlier be included with the other bids that make up the average? Furthermore, the averaged bids may have been offered with the anticipation of further negotiation; however, only the successful bid was negotiated. If the unnegotiated figures are compared to the negotiated successful bid, an inordinately high “savings” may result.

3. Market Comparisons. This is often considered a “catalog approach” because the purchase price is compared to other posted prices. A market comparision is similar to how many consumers buy their everyday goods. They go to the shopping mall or look through a catalog and obtain comparative prices on the same item. The difference between the average catalog price compared to the purchase price is the savings. But two warnings are necessary. First, if the purchase price was negotiated, could the catalog prices also have been easily negotiated? Second, if the purchase price resulted from a volume discount, could the catalog prices have been easily lowered with a volume purchase?

4. Total Cost. Rather than just considering purchase price, total cost perspective also includes all the related costs. Typical total costs may involve such items as transportation, inventory, warranty, payment terms, and disposal. Total cost is often a more accurate cost measure than purchase price. The necessary cost data, however, can be difficult to obtain because it must come from a number of different departments. For instance, the inventory cost figures may have to be obtained from the manufacturing or materials management group in addition to the finance department. Or it may be extremely difficult to put cost figures on some items such as periodic maintenance or disposal. Finally, putting all of the cost figures together to make a meaningful comparison can be a time-consuming and complex process.

5. Target Price or Cost. This approach is often used in the initial stages of a new product development cycle to establish and meet a price or cost goal. The challenge is to design a product with the required functionality and quality within the pricing parameters. The marketing and/or product-design group generally establishes the target. A cost or price savings is recognized if the components or materials that make up the product can be purchased for less than the target.

Two cautionary notes are necessary with this method. First, the purchased materials must meet the quality requirements of the product-design team so that the savings are not met by sacrificing quality. Second, the initial target price or cost must be accurate. To ensure accuracy, make sure the purchasing or sourcing group helps establish the target.

6. Cost Avoidance. Is cost prevention the same as a savings? Many would argue that cost prevention or avoidance should be considered the same as a cost savings. However, how can something that does not occur—or is avoided—be measured? In some cases, it is relatively easy to measure a cost avoidance. For instance, a higher grade of upholstery on the office chairs for a large banking institution reduced the amount of annual furniture replacement and repairs over a three-year period. The problem with this example is that it took three years to determine and document the actual savings.

In other instances, it is extremely difficult to document the actual savings. For example, one purchasing department attempted to use cost avoidance to justify the use of an application service provider’s XML purchase-order system with its suppliers. The justification was that the XML system would reduce the number of errors and speed up the processing of orders. The new system may avoid costs but those costs were extremely difficult to quantify, and the finance group did not accept the figures as cost savings. Similar situations occurred in several of the other companies studied.

7. Innovations or Product Improvements. If an improved component is purchased at the same price as the one that lacks the improvement, is there a savings? In one situation, an instrumentation device had a digital panel that was difficult to read in certain light conditions. The buyer worked with a supplier to develop a nonglare panel. The buyer was also able to purchase the instrument with the improved panel at the same price as the original instrument. This improvement provided a competitive advantage to the instrumentation manufacturer. While its competitors still had the glare problem, this company could sell the better device at the same price as the older models. How should this improved component be measured in cost savings? Should it even be considered a savings? In this situation, the purchasing department asked a second supplier to estimate the cost of developing and producing the nonglare panel. The purchasing department then used the second supplier’s estimate as the cost-savings figure.

The same savings-estimate problems exist with service agreements that include service-level improvements. If an enhancement is added to the service agreement but the purchase price remains the same, should this be considered a savings? And if so, how should it be measured? One possibility is to conduct a benchmarking study to determine what other suppliers may charge for the same service. Another possibility would be to conduct a cost analysis of the service provided.

Smeltzer and Manship believe almost every company can benefit from re-assessing the way it determines cost savings. Identifying best practices is a good place to start. For more on cost reduction, see Six Best Practices in Cost Management.

References:

(1) Hendrick, T. and Ogden, J. (2002). Purchasing and Supply Managers’ 2001 Compensation Benchmarking and Demographics CAPS Research Focus Study. CAPS Research.

(2) Smeltzer, L. and Manhsip, J. (July, 2003). How good are your cost reduction measures? Supply Chain Management Review.