Calculating procurement savings is a critical deliverable for almost all procurement professionals. Furthermore, procurement savings are often made visible to organisational executives and even board members. Therefore, getting them right can be the difference between being praised and being marginalised.
To help all procurement professionals, their managers, and their organisations, we have included three approaches to calculate procurement savings that are best to be avoided for formal procurement reporting.
1) Savings based on the difference in average costs
Comparing the average cost of the set of products pre and post tender can seem like a fast and attractive approach to calculating savings. However, more often than not, this figure can be vastly different to the actual saving achieved as volumes and individual prices differ by product. Therefore unless the tender is for a limited number of products with similar prices and the volume of the products consumed is evenly distributed, this method should be avoided.
The most accurate way to calculate cost savings is the total itemised cost saving method. This involves calculating the price difference between products on the lowest item level and multiplying that difference by the volume of that item. Although this can seem time consuming, if tender spreadsheets are setup initially with this in mind, it should be a fast and straightforward approach which provides a high degree of accuracy that can easily be traced and verified.
2) Only considering historical demand to generate future savings
In 8 out of 10 situations, past consumption volumes are indicative of future requirements. However, on the few occasions that it is not, significant errors can occur if savings are generated based on historical demand.
A couple of years ago, a large listed company had identified hundreds of millions of dollars of identified procurement savings. The board reviewed these savings and approved the public release of cost reduction targets.
Unfortunately, recent and significant operational changes within their business had not been considered when the savings were calculated. This meant that future demand requirements were quite different to historical consumption. The result was that three quarters of the savings never eventuated.
Therefore, to avoid you and your procurement team being placed in an uncomfortable situation, make sure that future demands are considered when calculating procurement savings.
3) Forgetting to consider the impact of the price rise & fall formula
In the rush of finalising a supply contract, the future impact of pricing rise & fall (variation) calculations can be overlooked. Often, issues with the indices used or the formula are not picked up – until it is too late.
Price rise and fall calculations can be complicated so it is important to understand their potential issues. If not well understood, the procurement savings calculated can be eroded over time.
To avoid issues with price rise & fall calculations, it can be helpful to model (possibly even a number of scenarios) the potential changes to the underlying indices and the resulting changes to the future cost savings.
Calculating cost savings is a critical component of procurement and generally the final deliverable when you are tired and jaded from the process. Thinking about how savings should be calculated and discussing this upfront will save time and make it a very simple final step in the process.