The Traditional Mindset of Cost Savings Is Dead

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Even today, 90 percent of procurement teams measure effectiveness by pure-play cost savings, which for a product or service is traditionally calculated as old price minus new price, multiplied by the volume.

Over time, the concept of measuring savings has evolved to creating a baseline by comparing items under the form, fit and function framework.

Top-quartile procurement teams have adopted the total cost of ownership (TCO) into their RFP modeling, instead of purely price comparisons. Components of the TCO analysis include incumbency advantage, payment terms, cash discount, transition costs, shipping costs and e-commerce capabilities like EDI, e-catalogs and electronic-funds transfer (EFT).

A key point is that this TCO criteria measure costs that can be principally influenced by procurement teams. High-performing procurement teams are adding other components to the analysis to justify organizational value.

These elements include:

  • Percentage of spending on e-catalogs
  • Managed spend as a percentage of total spend
  • Percentage of spend with the top 50 strategic suppliers
  • Organizational revenue from supplier sourced innovation
  • Cost savings as a percentage of functional budget.

When Returns Start Diminishing

The most successful organizations have extracted value from their supplier bases over the last two decades by consolidating spend, eliminating tail spend and increasing managed spend through e-catalogs. However, some of these companies are reaching a point of decreasing returns from repeatedly running the same playbook — for example, always issuing RFPs six months prior to the expiration of multiyear contracts.

I’ve been a supply management professional since 2013, and in my current role, I now have visibility and ownership of the entire supply chain — from first mile (the supplier) to middle mile (distribution) to final mile (the customer). This role has given me a better understanding of the value chain analysis of systems and activities by Michael E. Porter, architect of the Porter’s Five Forces framework.

An end-to-end view has forced me to be critical of the TCO mindset, as it’s very procurement focused. My thought process has evolved to emphasize a more holistic metric — total cost to serve (TCS), which measures costs from the first mile to the last mile and ultimately within reach of your customer in the last 3 feet. In my opinion, TCS is the future.

When Returns Start Diminishing

TCO Versus TCS

Once your mindset shifts to the TCS model, you will no longer gauge the success of an RFP simply by how much you reduced the cost of widgets. An example involving a large utility company illustrates this point:

Imagine a procurement category manager negotiates a 5-percent lower TCO for rubber gloves used by utility foremen. The outcome is celebrated because (1) the unit price is lower, (2) the company will transition from a manual to an electronic procure-to-pay (P2P) process and (3) internal customers can add a single pair of gloves, reducing the amount of working capital invested in gloves. From a TCO standpoint, this is a big win.

Every time a foreman needs a new pair of gloves, a supervisor goes to the internal procurement portal and places an order with the glove supplier (typically a distributor). In an ideal world, this automatically triggers a pick ticket to the supplier’s distribution center, where a glove multipack is broken and a single pair of gloves is picked, packed and shipped. Once that pair of gloves reaches the purchasing company’s dock, someone checks the shipping manifest with an internal-issued PO and inspects the material.

These steps are critical in the threeway match process. Another associate in the warehouse places the item on a shelf (assuming it’s a fully functioning warehouse with separation of duties, meaning the person receiving and checking goods is not responsible for bin or rack put-away). When the foreman is on-site the next day, an employee in the storeroom will pick the item as it’s requested.

Keep in mind that this example does not even consider costs associated with transportation and the multiple handling touches across the supplier and customer, which typically are five to 10 times the glove’s replacement cost.

From a TCS standpoint, this is a big loss.

Optimizing TCS

Engaging with the supplier on the economic order quantity (EOQ) discussion, which factors both inventory and handling costs, consolidates shipments so deliveries are made only once a week.

This will reduce congestion on your docks and inject productivity into your warehouse. For example, the handling cost to receive a 10-pack of gloves is the same as for one pair of gloves, meaning the productivity of that task can be improved by 900 percent.

Cost savings can increase from 5 percent to 50 percent if the procurement manager understands the value chain and engages with both internal stakeholders and the suppliers on the TCS discussion.

Procurement professionals should think hard about what they would rather present to a CPO: 5 percent in TCO savings or 50 percent in TCS savings. For CPOs who have run a traditional cost-savings playbook, now is the opportunity to redefine supplier collaboration and leverage the entire value chain. It requires a new level of engagement with internal stakeholders and true understanding of the value chain as envisioned in Porter’s 1985 book Competitive Advantage: Creating and Sustaining Superior Performance.

Value Chain Analysis

CPOs who are successful in making this transition will be primed and uniquely positioned to take on a COO role.

To help optimize the supply chain for efficiencies, consider issuing multiple pairs of gloves to the foreman, which adds productivity to the extended value chain. The future of supply chain lies in redefining the first and last mile.

This article was originally published in the May/June issue of Institute for Supply Management®’s Inside Supply Management® magazine. Reprinted with permission of the publisher.

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