Baselining purchase savings - Is there a best way? Part 1
How to baseline / calculate purchasing savings? You would expect this to be a subject of the past; discussed, debated, standardized and adapted. Unfortunately No. I have worked in several purchasing organizations across industries and have had access to savings methodologies of a variety of clients in my consulting role, and one thing is standard - there are no standards. It's like one of those things - with all the developments in electric and electronics engineering, we have different plugs and sockets all over the world.
I will cover this topic over a series of blogs. I will try and analyse various types of savings and how they are baselined / calculated, and will then leave it open for discussions. There are no rights or wrongs in such methodologies, but then certain approaches are more logical than others, and that is what I will try and bring forth.
Savings are primarily of two types - Hard and Soft. There are different names used - Cost reduction and Cost avoidance; Cash Savings and Other Savings etc. However the fundamental difference remains same. Hard savings contribute to organization's bottomline and are usually the measure of success for Procurement function. Soft savings are good to have and generally 'add' to the overall rosy picture.
For today, lets pick up the classic Hard saving - saving achieved while purchasing an item which has a previous price reference. Sounds simple! Well, largely yes, unless you start asking 'What if'. What defines 'previous price reference'? There are several possibilities:
- Last price paid, at whatever point in time it was
- Last price paid within the last one year
- Last price paid when the quantity purchased was comparable to current quantity
- Average / weighted average of the last 3 purchases (or 5 or 10 or any other number)
- Average / weighted average of all the purchases made in the last one year (or 6 months or 3 months)
- Contracted price
Which of the above is best or most appropriate? Well, none, except for the 'Contracted price'. Contracted price is indisputable. You have a contract with item A at price X; you do a new contract and item X now costs Y; saving per item is (X-Y). Pretty straightforward. Complexities come in when the item is not contracted. To me, simple is the best. Weighted average of all the purchases made in the last one year, may be the most technically correct method, but sheer tracking of this moving average is a mammoth task, and I believe, is not worth the effort. The concept of last few purchases also doesn't go well with me. What if the last few purchases happened to be great deals or bad deals. To me, the last price paid, whenever it was, is the simplest and most straightforward method. It has its downside, that the quantity could have been incomparable, that the last deal could be dated, that the last deal could have been too good or too bad and hence gives a skewed baseline. All this is true. But when you talk of hundreds of spot buy transactions, all these parameters even out eventually.
The key assumption in the above approach is that the non-contracted items are purchased as spot buy or thru' tactical sourcing (small value, large volumes), and that strategic sourcing events are largely covered by contracted spend. With this assumption, 'last price paid' is the simplest and most straightforward method, which evens out all its anomalies over a large volume of small value transactions.
I would be very keen to know your views and what methods you have seen in your organization. Please note however, that this topic is only about savings from an item which has a price reference. For other types, we will discuss in subsequent blogs.