By David S. Yin
Procurement, like any other corporate function, is valued by its contribution to the company’s bottom line. In recent years, procurement has gained greater prominence as companies emphasize cost-cutting as a principal way of improving margins. However, the value that procurement brings is much more than just a function of balance sheet cost savings, which is often overlooked by CFOs and others who may take a strictly P&L (profit and loss) approach. In fact, procurement more often brings value through cost avoidance rather than “hard” cost savings.
Defining Cost Avoidance
Cost avoidance includes any actions taken to reduce future costs. It is often referred to as intangible cost savings; those that do not directly appear on the company’s bottom line but can still have a significant positive impact.
The Importance of Cost Avoidance
While hard savings still has a quantifiable P&L contribution, cost avoidance creates important strategic value for an organization, per the following:
Cost Avoidance and Procurement
Unlike hard savings, which are calculated as the difference between current and prior year spend for the same or similar recurring purchases, there is definitely room for subjectivity and estimation when assigning value to cost avoidance activities. Therefore, procurement should clearly define a mutually agreed-upon approach to calculating cost avoidance with finance and corporate leadership so as to fully capture its value delivery. Providing clarity to cost avoidance activities helps create alignment with P&L purists, and hopefully generates further improvements to corporate cost efficiency.
Five Ways to Deliver Cost Avoidance
Depending on the organization, methods of cost avoidance delivery can include:
Price protection. Delaying price increases, or slowing the rate of price increases with price protection. For example, if forecasts for the pulp and paper index are projected to increase, include provisions in the contract when sourcing corrugated boxes to mitigate rising prices.
Negotiation. Negotiating prices that are lower than initial quotes. This is usually employed for one-off capital expenditures (e.g., construction projects, technological investments) as opposed to recurring operational expenditures.
Value-add. Including additional value-added goods and services free-of-charge to an agreement. For example, when bidding on a large piece of industrial equipment, the supplier can also include installation and maintenance services free-of-charge.
Continuous improvement savings. Signing long-term contracts with continuous improvement savings requirements. These are often provisions in contracts that require the supplier to create ways to reduce the buyer’s total cost of use through standardization, labor reduction, etc.
Substitutes. Identifying substitutes that perform the same or similar functions at lower cost, or those that are the same cost with greater quality/efficiency. For example, replacing previously-used electrical components for those that have greater energy efficiency and thus save on energy costs.
Also see this blog post by David S. Yin at My Purchasing Center: Trade War Against China: A Supply Chain Perspective
David S. Yin is an Associate Consultant with GEP, based in Clark, N.J. In this role, he focuses on delivering concrete solutions across clients’ procurement functions, and is currently engaged with driving strategic initiatives across the North American procurement operations of a Fortune 100 company.
Prior to joining GEP, Yin worked at a boutique investment consultancy, coordinating with investors and conducting in-depth financial analyses. He also helped manage a student-led real-money investment portfolio, achieving substantial gains during the process. He holds a Bachelor of Science in Business degree with concentrations in Finance and Operations, cum laude, from the Leonard N. Stern School of Business at New York University.
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