You ran the procurement process, agreed the budgets, and signed the suppliers – so why did the expected savings never hit the P&L?

Generating cost reductions is a fundamental goal of any Procurement function. And ‘savings delivered’ is usually a key KPI. Yet in many organizations there seems to be a perennial mismatch between what is promised by the CPO at the start of the year, and what is found in the P&L at the end of the year.

Why does this mismatch exist? Were the CPO’s projections unrealistic? Did the savings simply not happen, despite being reported? Or did they happen, but just can’t be pinpointed in the P&L?

Beware assumptions

Let us use a hypothetical example, which we can refer back to throughout this article. Let’s imagine that, in a medium-sized manufacturing company, the buyer for maintenance, repair and operating supplies (MRO) – which includes factory supplies such as valves, pumps, motors, bearings, pipes and nuts and bolts – has just concluded a new deal with a new MRO supplier.

The buyer (let’s call him John) has followed a world-class strategic sourcing process. He has:

  • Articulated last year’s baseline down to the price paid for each and every nut and bolt;
  • Agreed with Manufacturing to harmonize the number of products used, so that instead of using 1,500 SKUs, there is a new parts list of only 800 SKUs;
  • Negotiated favorable prices for each of these items; and
  • Produced a document that calculates the annual savings, showing that the coming year’s cost across the 800 items is 27% lower than last year’s cost of buying 1,500 line items. 

The contract with the supplier is signed and, as far as the buyer is concerned, his work is done. If only it were that simple. It’s already apparent that the ‘saving’ is not actually that easy to define. The buyer is telling us that the 27% is “the difference between what we would have bought if we had bought at last year’s prices, and what we think we’re going to buy next year, assuming that we will buy a similar volume, and that we actually buy off the harmonized items list rather than continuing to buy the items we buy today”. There are plenty of assumptions, which mean plenty of things can go wrong.

Even if we buy exactly as planned, one could argue that the saving is still predicated on the assumption that, if we hadn’t made the saving, we would have bought at last year’s prices. But what if steel prices had crashed and sent MRO prices nose-diving?

Then the saving inherent in the new deal would be much smaller. A ‘saving’ in this context is a somewhat theoretical construct based on a number of assumptions. So even before we start to look at what happens to John’s savings in reality, we need to recognize that, whatever happens, the numbers will change.

It is not uncommon to lose more than half the savings through lack of compliance

Leakage points 

There are a number of ‘leakage points’ along the ‘journey’ of a cost saving as it travels from supplier price negotiation to P&L account.

These leakage points combine to erode the saving. So the more of them we can plug, the smaller the delta between what’s promised and what’s delivered. Let’s consider each leakage point in turn:

1.    Savings calculation

This is John’s calculation of ‘baseline cost versus new cost’ as discussed above. If this is erroneous, then the savings figure will also be wrong. So it’s important to get this right, which means basing it on very granular volume and pricing data, and making assumptions that stand up to scrutiny.

2.    Implementation 

The savings will not materialize in their entirety if the deal is not properly implemented. This includes making sure that: 

  • The new deal is fully communicated to all business units/divisions 
  • The buying channels and ordering mechanisms are set up 
  • The supplier is clear on what products are to be delivered to whom and at what price. 
  • Failure to complete any of these tasks properly will lead to the company continuing to buy from the wrong suppliers, or at the wrong price points.
Compliance metrics

3.    Compliance

Even if the contract is properly implemented, there will be compliance issues that need to be proactively managed if the full savings are to be fully realized. 

It is not uncommon to lose more than half the savings through lack of compliance.  Compliance has a number of elements, including vendor, price, and item compliance.

In our MRO example, some of the factories will likely continue to buy from their existing suppliers rather than from the new suppliers (vendor non-compliance), or they may continue to buy ‘off-spec’ parts (item non-comppliance). Finally, the supplier itself may be non-compliant, in terms of not honoring the agreed prices (price non-compliance).

For example, if the MRO deal is pan-European, then one of the supplier’s country units may apply its own local prices rather than adhering to the centrally agreed prices.

In most cases, post-contract compliance is simply not measured or managed, because it falls between two stools – procurement steps out of the process once the contract is signed, and the users of the contract have little interest in measuring the savings. It is simply assumed that the savings will materialize as per the plan, but of course this is naïve. 

Leading companies implement a proactive compliance measurement and management process to address savings leakage from non-compliance.

The image above shows a real example of compliance metrics for an MRO contract put in place by one of Efficio’s clients.

It shows how vendor, item and price compliance were very weak in the first two months of the contract, and how they were managed to an acceptable level over a number of months. 

The key point here is that, left to its own devices, compliance will simply not happen... it needs to be managed.  Managing compliance is a time-consuming, iterative process that involves:

  • Identifying instances of non-compliance
  • Looping back with users to understand the reasons for non-compliance
  • Addressing those reasons, and/or taking corrective/punitive action as appropriate. Driving up compliance involves changing behaviors, which is never easy.

4.    Poor budgeting

If money saved is not taken out of budgets, then the result will be a windfall – ie, the company’s various factories will simply spend the money on other goods and services.  

The saving will only hit the bottom line if the saved monies are taken out of the users’ budgets. This is often not done. Good CPOs work closely with Finance to make sure that operational savings are translated into budget cuts. 

When and how these cuts are made is also important. Wherever possible, Finance should look to cut the users’ budgets before Procurement comes in to do the sourcing; that way, Procurement can be positioned as the ‘friend’ who comes in to help save the money that’s already been taken away by Finance.

5.    Poor measurement

Doing the budgeting of course doesn’t in any way facilitate the operational saving – this still needs to be diligently tracked and measured. 

Because most companies operate in functional silos, the ongoing measurement of procurement-generated savings falls between the cracks. No surprise then, if the savings can’t be found in the P&L.  

6.    Business-driven volume or mix changes 

These can obscure the savings delivered, even if they don’t actually reduce them. Thus, in our MRO example, if the company opens a new factory, spend will go up, and if the company switches to new machinery that requires more expensive parts, the item mix will be unfavorably impacted. These changes need to be stripped out/corrected before the P&L saving can be clearly articulated.

Leading companies implement a proactive compliance measurement and management process to address savings leakage from non-compliance.

Working together 

Clearly there is a lot that can go awry as a saving travels from contract signature to bottom line. Savings leakages of 50%-plus will occur if leakage points are not proactively managed. 

In order to do so, companies have to work effectively across Procurement, Finance and the budget-holder functions. Specifically, they need to ensure that:

  1. One of these functions actively monitors and manages compliance
  2. Finance takes the money out of budgets

For this to happen seamlessly, Procurement, Finance, and the budget-holder functions need to work together from the start, not just when it comes to finding the money at the end. Then they can jointly agree on the cost baseline, the supplier volume allocation, and the compliance picture as it emerges over time. Articulating and capturing the savings then becomes easy.