Procurement is always thinking about cost savings, year over year. But is this really a true measure of competitiveness? So procurement will have a budgeted amount for, say 4.5 cents per unit for a product, when the current price is 4 cents. They are able to hammer the supplier and get them down to 4.2 cents, so procurement declares victory and says they saved their organization a lot of money – .3 cents per unit! But is this really savings?
Vel Dhinagaravel, CEO of Beroe, thinks this is the wrong way to measure procurement. In fact, over lunch, on a recent visit to NC State, we both agreed that in our collective experience of over 50 years working in procurement, we have never met a procurement person who has ever missed a cost savings target!
Instead, he feels procurement should be focused on the competitive advantage they deliver to their company, vis a vis their competition. This idea extended back to a meeting Vel had with a Chief Procurement Officer and his Chief Financial Officer. At an informal dinner, the CPO half jokingly asks – “sales guys get all the limelight. Here I am delivered more than $1B of savings and I don’t get the same respect. Why is that?”
The CFO had a great answer. Sales organizations are always measured on revenue growth and achievement – but they always have a second dimension, which is market share. If you grow your top line by 30% but your market share drops, someone else is growing faster then 30%. Procurement will only get respect if you have a dimension which is the equivalent of market share.
So “Savings” is the same as revenue growth – However, what is procurement’s equivalent of “market share”? Saving $100MM is great and that might have represented a 3% reduction in the company’s cost structure – But what if the competition had been able to achieve a significantly higher reduction in that same year? Would that not erode the competitive advantage of the company?
But how can one find out how much competitors are spending? From a benchmarking perspective – every company would love to know exactly what their competitors spend on each raw material / service. This is the “holy grail” – but as the saying goes, don’t let great be the enemy of good – and should we strive to benchmark the unattainable?
Beroe came up with a way to benchmark cost savings, through a measure of the COGS – Cost of Goods Sold. This includes all production items, including Packaging, Raw materials, manufacturing costs, logistics etc. In most cases, COGS can be derived from annual reports, and can be done on an industry basis. Let’s look at a simple industry, beer. If we extract COGS from annual reports over a period of time, say from 2011-2015, and compare them across competitors, then the chart shown above is produced.
If you take 2011 as the baseline year – Each of the companies would have a different COGS/Revenue ratio, but let us normalize this and assume everyone starts at the exact same point – 100. As you can see, some companies end up below 100 in 2014 and some end up above. If revenue had stayed constant, three of these companies are actually spending more on COGS (per $ revenue) on 2014 than they did in 2011! However, the annual reports of these three companies has a write up where they talk about the massive savings delivered by procurement. This dichotomy leads to cynicism on the true impact of procurement.
This same analysis can be applied across industries, and in general, Beroe has found that half are doing really well, and half are not. It is not the intent to explain the differences – the world is changing in many different ways, and markets change, and some firms may be impacted more – but everyone is operating in the same world. Ultimately, if sales is measured on relative advantage – (generally market share in marketing), then procurement should be measured on cost competitiveness as well relative to the market.
This can actually drive some improvements in supplier relationships, if best procurement practices are followed. If you move to a model where the supplier makes a decent margin, cost management can be a much more open model. Japanese procurement organizations rarely change suppliers – they have long-term relationships, and while they certainly hold the supplier’s feet to the fire to get a competitive price, but it is open book and there is a guarantee that the suppliers will always be making a decent margin, and that the supplier will invest in productivity and pass on the margins. This competitive advantage is what procurement needs to be focused on.
In Vel’s opinion, procurement is still too focused on price – but the biggest issues are specifications and demand. The price you pay per unit, how many units you buy, and what kinds of units you buy are the key parameters. By focusing too much on price – procurement is not paying attention to whether they are buying the wrong things and are buying too much of them, which will impact cost. Every time one company went to the market to get the best prices on a product, they found they had the lowest price. But their COGS competitiveness was low. This was because they had 10 times the number of skus per $1B of spend – making it difficult for suppliers to work with them. Procurement needs to think about local optimal vs. global optima. One bad spec, and you can get a local optima – but the real cost savings comes with the right cost specifications! COGS benchmarking can help expose these types of issues.