Cost Reduction and Avoidance II: Metrics

In yesterday’s post, we overviewed the two types of cost reduction, “hard” cost savings and “soft” cost avoidance, some of the challenges in defining and measuring savings due to cost avoidance, and the importance of metrics and a proper incentive structure for supply/spend management personnel.

In today’s post, we are going to review five of the challenges presented in the CAPS report Defining Cost Reduction and Avoidance and define some starting points that you can use to build hard metrics that you can use to quantify your success.

(1) “Cancellation” of net savings due to an overall increase in the business unit’s cost structure

Sourcing should not be held accountable for cost increases outside their control, such as increased demand (which generates higher spend) or increased operating costs in overhead or salaries solely under the control of the appropriate unit manager.

Furthermore, savings should be calculated on a per-unit basis relative to historical costs, market baselines, or otherwise expected spend levels, depending on the context of the project.

For example:

(i) Lets start with the example in the CAPS report where you are sourcing an existing product and you expect a cost reduction. Last year widgets cost $2 each and production required 10 units. This year, you negotiated the cost down to $1.50, but production ended up ordering 12. If you look at raw numbers, last year production spent $20 and this year production spends $18, a difference of $2. But this does not represent the true savings of $6, since production saved $0.50 per unit on each of the 12 units they bought.

(ii) If you are sourcing a new product, chances are you could still be saving the company money no matter how much the product costs per unit. Measure the cost avoidance using the average unit price in the market place, as obtained from a respected market analysis firm or other 3rd party source. (Don’t use initial supplier bids since the argument could be made that the suppliers bid high in the expectation of a reverse auction or other sourcing event designed to ultimately lower their quoted costs.)

(iii) If you are sourcing products primarily made from a commodity whose average market price or index has increased significantly since the last sourcing cycle, measure the cost avoidance relative to the percentage increase. For example, if you were sourcing gold-plated circuitry, with gold roughly $650/oz, and the last time you sourced the circuitry gold was roughly $590/oz, then you would expect the cost of your product to increase by at least 10% (on a unit basis). If the cost increase is less then 10%, then you have obtained a cost reduction by way of a successful sourcing event. (The CAPS report indicates that you could base your avoidance on a proposed supplier price increase, but like initial bids, this is a nebulous number. Market indexes are hard and can be agreed upon as impartial by all parties.)

(2) Supply management’s role in the cost savings allocation decision

If the team is cross-functional, then a decision needs to be made up front, by an appropriate manager, how much of the cost savings will be attributed to supply management and how much to the other business unit(s). This could be an even split, or a weighted split dependent on who is taking the lead and how the work is expected to be split among the team members. There’s no hard and fast rule here, but all parties involved should agree that the split is “fair” before the project gets underway.

(3) Visibility, in terms of systems, people, and metrics

The agreed-upon metrics and the data that the cost avoidance metrics are calculated on need to be accessible to the entire organization so that there are no challenges as to their accuracy and validity.

(4) TCO concept for purchases items/services

TCO is a hard calculation. It includes all the direct cost components that go into the landed cost calculation (unit cost, freight, interim storage, tariffs, etc.), storage costs, and processing costs.

Probably the easiest way to approach this calculation in cost reduction metrics is to base the cost on landed costs and then factor in adjustments for any additional costs that are above or below average.

For example, if you were sourcing a food product and only one option is frozen, then the storage costs for all items but the frozen item will essentially be same, with the frozen item costing more due to increased energy costs of using a freezer over a fridge, and only the landed cost for the frozen item needs to be adjusted. If you were a chemical manufacturer, and all but one option can be used as-is without refinement, then the processing costs for all but the option that requires refinement will be essentially the same, and only the landed cost for the product that requires a refinement phase will need to be adjusted. Similarly, when computing savings, you only need to adjust for differences in incurred costs between respective time periods.

You can argue that this is not a proper TCO, but when it comes to calculating savings, mathematically speaking, it is only the differences in cost between last year’s buy and this years buy that matters and this simple approach is sufficiently accurate for your purposes.

(5) Multi-Year Issues

Sometimes the savings from switching to a new product or new supplier will not be realized until the second or third year of a contract, due to up-front costs associated with new equipment or investments. However, it is important that your supply and spend managers be rewarded each and every year for their contribution to this savings initiative.

Although it you may think that you may not be able to accurately calculate savings from such an endeavor until the contract ends, since you have to amortize investment costs, if you equally amortize the cost over a fixed period, then you could adopt a calculation that realized savings each and every year. (And if losses occurred in the first year, they could be carried over and then your team rewarded as soon as hard savings were realized.)

For example, let’s consider the scenario where you signed a 3 year contract for gadgets with a new supplier who promised you, based on demand estimates of 1000, 1500, and 2000, all the gadgets you needed at $7 each, compared to the $10 you are spending now with your current supplier. However, you have to upgrade your production process, and this is going to cost $5,100 up front.

At a contract level, you expect to save $8,400 since instead of spending $45,000 for 4500 units, you are in fact spending only $31,500 plus $5,100, or $36,600. If, in fact, your actual demands were 900, 1600, and 2200, then your actual savings could be calculated on a unit basis using an amortized fixed cost of $1,700 a year as follows:

Year 1: (10 *  900) - (7 *  900 + 1700) = 
              9000  - (    6300 + 1700) = 1000

Year 2: (10 * 1600) - (7 * 1600 + 1700) = 
             16000  - (   11200 + 1700) = 3100

Year 3: (10 * 2200) - (7 * 2200 + 1700) = 
             22000  - (   15400 + 1700) = 4900

or: (old contract cost) – (new contract cost + amortized cost)

Alternatively, you could estimate total savings up front, amortize savings for the year, and then correct in future years using actual demands vs. projected demands. As long as the calculation is sound and agreed upon up front, it doesn’t really matter as long as your sourcing professionals are fairly acknowledged for the contributions they make.

Other challenges highlighted in the CAPS report include the “chronology of supply management’s involvement and the need for budget cuts”, which is more of a political issue then a metric issue, and the need to “create a proper incentive structure for supply management personnel”, which will be addressed further in my next post.

For more information on cost reduction and avoidance, see the Cost Reduction and Avoidance: Best Practice Principles of Corporate Procurement wiki-paper over on the eSourcing Wiki.

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