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Baselining purchase savings - Is there a best way? Part 2

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How to baseline / calculate purchasing savings? You would expect this to be a subject of the past; discussed, debated, standardized and adapted. Unfortunately No. Only one thing is standard - there are no standards. Read on for Part 2 of the series.


Carrying forward the topic of savings from my previous blog, we will now discuss the second type of hard saving - saving achieved while purchasing a commodity which has no previous price reference. This situation can arise if the commodity being purchased is completely new, or if the specifications have changed so much that it cannot be compared to previous commodity even after applying adjustments, or if there is no data available to find previous reference. There are 4 popular methods of calculating savings in such situation:

    1. Average of all initial quotes minus the final selected quote
    2. Average of all initial quotes (excluding outliers) minus the final selected quote
    3. Initial quote of the selected supplier minus the final quote of the selected supplier
    4. Lowest of all initial quotes minus the final selected quote

Here the assumption is that all the quotes are from technically acceptable suppliers. There could be differences of course, in technical ratings, but they all qualify the minimum acceptance criteria. Procurement would like to table savings using the first method of averages, because that is what gives maximum savings. Some would use method 2, to eliminate outliers, which to me does not sound very logical; if a supplier is technically qualified, why should his price not be considered, even if it is too high or too low! Deciding how much of variance defines an outlier is another point of debate. Method 3 is regarded most acceptable when the technical acceptance of participating suppliers is not very clear. Finance tends to question method 1 and 2, since they do not get easily convinced on the 'average approach. 'You would not have bought this commodity 'on average' from all suppliers', they would question! So, method 3 appeals best to procurement buyers and they claim, 'user would have bought this from this supplier at initial quoted price had we not negotiated it to the final price', and so the difference is the saving. Fair enough. However, from a finance point of view, the company could have purchased the commodity from the lowest bidder had procurement not been involved and so saving should be calculated against that, thereby method 4.

Let me illustrate method 4 by an example. You want to buy a commodity for which supplier A quotes $100, B quotes $90 and C quotes $80. After negotiations, A is at $85, B is at $75 and C is at $70. User chooses to buy from B due to technical ranking. As per method 3, the saving will be $15 (90-75); as per method 4, it will be $5(80-75). Method 4 rationale is that you could have bought the commodity from C at $80, if you had not negotiated. Although one may argue that you could have still bought it from B at $90, since that is what you preferred; but the key here is your budget. You could buy the product at $80 since it fits in your budget, which you would have to manage with C initially; it's the negotiation that allowed you to buy it at $80 from your preferred supplier. So, method 4, though most conservative, is most convincing.

In some organisations, these savings are not regarded as hard saving, considering the notional aspect of it. This view is acceptable as well, as long as the hard savings targets are picked by procurement accordingly, taking into account the savings thus lost, due to previous price reference not available.

We will continue this topic in subsequent blogs. Meanwhile, I would be very keen to know your views and what methods you have seen in your organization.

Comments

This is probably the best options for procuring services and technology.

We can also consider:

Existing Contracted Rate - New Contracted Rate

for Commodities.

Regards,
Vivek RN

Three cheers for you to keep writing and clarifying mist from this one of the least understood topics. Your coverage length and precision is inspiring.

Nice Article. Well articulated. Very useful for those who are keen on cost reductions.

Khalid, good going. One other method I have come across is Savings to Budget, simply means the purchase commit should be lower to the approved budget. However this applies to both New Purchase (i.e without a previous price reference) and Existing (i.e with a previous price reference). You have also rightly pointed out, organizations (or to be precise Finance group in any organization) cannot accept all the above said savings as hard savings, very reason being these savings are only Cost Avoidance and finance has never seen it occur nor being reported in any of their books. Now is it a saving? yes absolutely, it is saving money to the company. However in all these scenarios one has only avoided the occurrence of that spending which without the SCM involvement could have occurred (cost avoidance), and SCM personnel has not actually reduced or cut down from the current cost (cost reduction) thereby freeing budgets from the books to reinvest, to make it hard savings. As such though it is definitely Savings, finance can never approve it as hard savings. However many procurement organizations has started reporting both hard and soft savings, thereby these so called lost savings are also getting captured... I believe a real value add we can provide in these scenarios would be to show how the money so saved is getting benefited per finance perspective... Thoughts and views on this would be appreciated.

Thanks for demystifying "Savings".
In my view, if there is a previous price, the Savings should be 'Hard' savings & it there isn't any previous price, the savings should be 'Realized' savings. And if its against the Budget, it should be 'Forecasted' savings.
Also, would be very pleased if you are able to differentiate or summarise 'Identified' Vs 'Realised' Vs 'Forecasted' Vs 'Audited' savings.

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