The benefits of the compound effect are very well known. Every one who is setting aside money – be it for savings or retirement – takes advantage of it to maximize the value of their savings or investments.
However, what is less understood is how the compound effect drives outsized returns when it comes to investing in strategic procurement.
When companies invest in strategic procurement, they focus on the source to contract process, supplier management and risk management (see chart).
They are buying deep subject matter expertise that is directly related to the products or services they are purchasing, and a detailed understanding of supplier markets. They are also investing in the processes, tools and technologies that enable them to understand and manage their third party spend in more detail, and to enable the execution of their category and sourcing strategies.
(for more information on the procurement process, watch Procurement Answers EP03: What is the Procurement Process? )
This investment does not come cheap. However, it offers handsome rewards thanks to the compound effect that impacts three key drivers of procurement ROI:
- Spend Under Management
- Product and Service Pricing
- Compliance with Supplier Contracts
Let’s look at those three areas in more detail:
Spend Under Management
Spend Under Management defines the amount of third party spend that a procurement organization is actively influencing through category / commodity strategies and sourcing activities, measured as a percentage of total addressable spend.
Spend Under Management =
Spend Influenced by Procurement / Total Addressable Spend
These two definitions are important. The spend has to be influenced by procurement. It is not the spend that comes through the procure-to-pay process. And the total addressable spend means the money that a company spends with third party suppliers that is influenceable. It is not total third party spend which includes costs that cannot be controlled by procurement such as taxes, and pass through items.
Increasing spend under management can be incredibly difficult. Those who do it best have 4 times the spend under management than the companies than under perform (source).
So how do the companies that invest in strategic procurement achieve such high spend under management? While this subject is worthy of its own post, at a high level success is due to two things:
- their ability to understand their third party spend. They know which categories and suppliers to target. This comes from investing in spend analytics technology.
- the ability of their procurement team to build respect and trust based relationships with key stakeholders. This is achieved by investing in subject matter experts that are able to influence spend owners through their domain knowledge and personal skills, and compounded by ensuring their procurement teams share similar goals and objectives to their stakeholders.
Product and Service Pricing
With increased spend now under management, strategic procurement organizations are now well positioned to drive value back to the business. Value can be defined in many ways – for example improving supplier performance and quality, mitigating risk, and driving product innovation. However, the most prevalent metrics of procurement value are still cost savings and cost avoidance.
The savings achieved by procurement and the business stakeholders working together vary wildly.
In companies that do not have access to strong strategic procurement capabilities, the supplier typically has the upper hand in negotiations.
When purchasing Indirect (or non-core, non-COGS) products or services, you are in the market only once every 3 to 5 years. The suppliers being considered understand the marketplace, and your points of leverage (or lack of) better than you do. Scope is often not well defined, and so the suppliers play a big role in determining the scope by which they will quote.
At best, you engage with a supplier at a price you think is fair and that provides what you asked for. However, you never know what else they are holding back that you are not asking for. At worst, you have a bad deal with a supplier that is a poor fit, with contract language that seriously limits your recourse.
With the right subject matter expertise, the process is different.
Procurement and the stakeholder will have partnered in advance to build a longer term strategy, creating a market place for the product or service that is to be bought long before you actually go to market.
Scope will be better defined, and the sourcing process will be designed to enable you to select the right partner, at the right price.
You will be as informed about market pricing and conditions as the participating suppliers, leveling the playing field.
Your procurement lead will agree and implement a contract that drive the right behaviors needed to maximize the value achieved from your supplier relationship.
Finally, for your most strategic suppliers, your stakeholder and procurement lead will partner to develop a long term supplier relationship strategy. This positions you to become a client of choice, and benefit from additional value add such as access to your suppliers’ innovations.
In short, you control the process, not your suppliers or potential suppliers.
What is the bottom line impact? While benchmarks vary, general consensus suggests a 33% – 50% increase in the cost savings achieved by investing in strategic procurement.
Compliance with Supplier Contracts
The final compound effect that impacts your returns from investing in strategic procurement is contract compliance.
The major concern that a CFO has with claimed procurement savings is that she often doesn’t see these show up to the bottom line. In fact, on average, only 60% of claimed savings actually realize (source).
The reason is two fold:
- Rogue spend. This is the concept that individuals within your business do not comply with the contracts you have put in place, and buy from their preferred suppliers directly. The root causes for this are that the contract you put in place is not appropriate and so employees are forced to buy elsewhere, or the change management associated with the implementation of a new contract was not effective, and so your employees do not know how to buy from your chosen supplier.
- Lack of a savings capture mechanism. If a company isn’t able to accurately capture achieved savings, it creates two issues. Firstly, savings are always going to be estimated, and actual volume usage may differ from estimated usage. Secondly, you are not able to recognize rogue spend until a significant number of your employees are buying off contract and the damage is done.
Companies that invest in strategic procurement are able to effectively mitigate the lack of compliance with negotiated contracts.
The expertise of your procurement lead, coupled with their partnership with your stakeholder means that it is far more likely that the contract you sign is appropriate and in line with the needs of the business. Furthermore, access to real time spend data will ensure you can quickly identify and address any rogue spend that does exist.
Benchmarking (source) suggests that companies who are effectively able to manage compliance enjoy 71% more of their claimed savings hitting the bottom line than those who do not. That is a lot of lost savings!
The Compound Effect
Adding it up, the compound effect is huge. As you can see from the chart below, the difference in bottom line savings can be 5X. Apply that to a company with $500M in annual third party addressable spend, and that is a difference of over $30M.
And herein lies the value proposition for investing in strategic procurement. Previously, these returns were available only to the largest of companies. They have the scale to hire subject matter experts to support every type of third party purchase. All others have struggled with the question: “how can I access the talent, intelligence and tools to maximize my procurement returns?”.
Procurement-as-a-service is making this possible. That is why it has the ability to revolutionize the procurement value proposition for mid-sized companies.
Here at ProcureChange, we help companies take their procurement returns to the next level by levering procurement-as-a-service outsourcing. The first step in this journey is to understand if procurement outsourcing is a good fit for your company.
Contact us today to understand if this is a delivery model which could make procurement a competitive advantage for your organization.
(this post was inspired by the subject of Procurement Answers EP05: What are the Multiplier Effects of Investing in Strategic Procurement)
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