Baselining purchase savings - Is there a best way? Part 2
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:
- Average of all initial quotes minus the final selected quote
- Average of all initial quotes (excluding outliers) minus the final selected quote
- Initial quote of the selected supplier minus the final quote of the selected supplier
- 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.