How do you calculate your savings performance for direct and indirect materials?
For example: on direct material, some people are using the price movement times the usage in a year, on indirect some using purchase requisition vs final negotiated price, some use the quote vs final price, how about yours ? and who calculate Purchasing or finance or others ? Thanks
Answers (7)
There is no ideal way to make all functions happy within the organization. For indirect, like services, we define procurement saving/effect as final price after tender/negotiations vs. lowest initial bid/price before procurement negotiations. For CapEx we estimate initial "base budget" that defines the scope and the price for each part (equipment =20$, services=10$, civil works=10$, total=40$), than the saving is calculates as final price - base budget. The business responsible for the budget of the project (project engineer) defines the scope and the price, procurement validates the price.
Savings are calculated by Procurement and validated by the business for each item.
Dudi,
there are various approaches how to handle this.
The most basic method is to use price difference (average price last year vs. current price or price 12 month ago vs. current price if you are not able to define average price of last year) x qty supplied (really supplied, not just negotiated or ordered). This is the cleanest and most transparent metrics, therefore many companies in automotive industry or other manufacturing industries only use this metrics, the other methods just seldom (e.g. change of payment terms or change of delivery term). This works for direct and indirect material both. These companies also use budget price vs. real price, but it's just for controlling purposes, purchasing depts. do not consider these figures (as the reality in most companies is that budget prices are set mostly as "desired" prices, not as "forecasted" prices, there are various "games" in this topic). These companies very rarely use saving based on difference initial quotation vs. final price, as this is very tricky, in many cases the initial quotation is a tactical play of the suppliers and for transparency reasons the advanced companies do not use this method. BUT these companies can afford it, as the majority of their spend is based on repeated purchases, which means most of their savings come from price diff. x qty, so they do not need to search for other savings calculation methods.
There are on the other hand companies, which mostly buy non-repeated items, or items which are not easily comparable to items bought previous year. These are compenies like telecoms, energy companies, banks etc. These companies therefore can't report savings based on current price vs. last year price and their job couldn't be measured, evaluated. Therefore they use mainly the formula best price from initial round of quotations vs. final price or price of the winner of tender before negotiations vs. price of this winner after negotiations.
You need to assess which type of company you are, which type of savings usually your purchasers achieve, which type of savings bring most value to your company. You also could discuss this topic with your controllers, which have good view on general companies finances and can give you good ideas on what companie's finances need.
Robert
Charles D.
President & Chief Procurement Officer at Next Level Purchasing, Inc.
Best Answers in: Purchasing (1), Interface Design (1), Software Development (1)
The traditional formula for calculating cost savings is as follows:
Savings = (PYP - CYP) x CYQ
Where,
PYP = Previous Year’s Price
CYP = Current Year’s Price
CYQ = Current Year’s Quantity
So if you reduce the price of a purchased item from one year to the next, shouldn’t it be easy to communicate your impact to senior management?
Not necessarily.
What if you negotiated a 5% reduction in price of an item but you purchased 10% more units of that item than you did in the previous year. You would be spending more money than last year right?
Are executives going to agree that money has been saved?
Imagine if cost savings were calculated like this…
Savings = (PYP x PYQ) – (CYP x CYQ)
Where,
PYP = Previous Year’s Price
PYQ = Previous Year’s Quantity
CYP = Current Year’s Price
CYQ = Current Year’s Quantity
After all, this formula more accurately measures the change in spend from year to year.
Let’s run through an example using these numbers:
PYP = $100
PYQ = 10,000
CYP = $95
CYQ = 11,000
With the traditional savings calculation, you would get the result in Example A.
Example A
Savings = (PYP - CYP) x CYQ
Savings = ($100 - $95) x 11,000
Savings = $5 x 11,000
Savings = $55,000
But if savings was calculated using the second formula, you would get the result in Example B.
Example B
Savings = (PYP x PYQ) – (CYP x CYQ)
Savings = ($100 x 10,000) – ($95 x 11,000)
Savings = $1,000,000 - $1,045,000
Savings = - $45,000
This is a negative number because your expenses increased. So even though you negotiated a lower price, the amount of money your organization spent on the item went up from the previous year to the current year.
Does that mean that your contribution wasn’t valued? Of course not. But it does mean that you will have to be a little more careful when communicating your cost savings to senior management.
So you need to address some of the challenges that purchasing professionals face when factors, such as rising demand, make expenses increase despite the fact that purchasing is obtaining lower and lower prices.
Presenting one big savings number to executives will likely be poorly received in an environment of rising expenses, particularly when most purchasing departments accompany that “one big number” with little if any supporting detail. Therefore, it is helpful to divide your impact into a number of classifications, including:
1. True expense reductions
2. Offset increase in volume with decrease in price
3. Partially offset new expenses through negotiation
4. Price increases
5. Partially offset rising price of volatile commodities
6. Those areas you didn’t address
If you want more details on this philosophy, I've included a link to a report below.
Links:
Rhizlan M.
Procurement Department Manager & Regional Procurement Domain Head Afrique
This describes the type of savings.
- Direct impact on price
Actions that impact the purchase price of goods and/or services, for example, by reducing the price per unit or auxiliary costs.
- Working capital improvement
Actions that impact working capital, for example, longer payment terms or a reduction in inventories.
- Process efficiency
Actions that impact process costs, for example, optimization of logistics processes, order processing, etc .
This shows the type of savings achieved in relation to the operating result. Only savings classified as cost savings lead to absolute cost reductions and thus to a direct improvement in earnings.
- Cost reduction
Where the costs of a good or service can effectively be reduced compared with the previous period or, in the case of one-time requirements, negotiations reduce the cost compared with the lowest unnegotiated offer, the result is referred to as a “cost reduction”.
- Cost avoidance
Effective action taken to ward off rises in costs is known as cost avoidance
- Cost increase
If, despite all efforts, a rise in cost cannot be avoided and this has a negative effect on value-added, the result is referred to as a “cost increase”.
How to Calculate the savings value
Although the complexity of procurement processes means that it is not possible to define a generally valid formula for calculating sourcing benefits, the following formula can be used in most cases:
Savings value = delta price per unit x quantity purchased
where :
Delta price = baseline price (cost) per unit - realized price (cost) per unit
Jon W. H.
Host at PI Window on Business Show
Best Answers in: Supply Chain Management (14), Government Policy (3), Enterprise Software (3), Small Business (2), Purchasing (1), Organizational Development (1), Planning (1), Career Management (1), Professional Organizations (1), Professional Networking (1), E-Commerce (1), Computers and Software (1), Using LinkedIn (1)
I am going to refer you to three articles I wrote based on my research over a 15 year period.
Funded by the Government of Canada's Scientific Research and Experimental Development (SR&ED) Program, I identified two distinct "commodity characteristics" - Dynamic Flux and Historic Flat Line.
The first link is to Part 7 of the 7-Part Dangerous Supply Chain Myths Series that provides a conceptual introduction to the Dynamic Flux and Historic Flat Line characteristics.
The second and third articles drill down even deeper into the market dynamics that are to a degree influenced by commodity characteristic performance, including the discovery of the Point of Ideal Price Viability (PIPV) - forgive the acronym.
These findings have dramatically altered mainstream thinking relative to best value pricing and related strategies such as Vendor Rationalization.
Links:
- http://procureinsights.wordpress.com/2007/07/04/dangerous-supply-chain-myth...
- http://procureinsights.wordpress.com/2008/07/16/double-marginalization-and-...
- http://procureinsights.wordpress.com/2007/08/10/double-marginalization-and-...
Clarification added August 28, 2008:
Regarding your question "who calculates the savings purchasing or finance," I will let the following excerpt (and corresponding statistics from a 2007 CFO study) from an article I wrote earlier this year illustrate the departmental challenges associated with cost savings calculations:
In Bridging the Communications Gap Between Finance and Purchasing A May 4th, 2006 article titled How to Speak Like a CFO stressed that "Too often, finance executives in Corporate America simply don't believe that purchasing departments are really bringing in the savings they claim. That may be because finance and purchasing don't speak the same language."
For example, the finance department isn't interested in cost avoidance. They are however interested in hard cost savings. This is perhaps one of the main reasons why a recent study revealed that of the 11.9% of average identified savings presented by the purchasing department, only 3.2% actually gets booked by the finance department - a difference of 73% from identification to realization.
Here are some additional findings from an Aberdeen study that may surprise you:
- Less than 20% of CFOs consider the work of CPOs and their staffs as having a very positive impact on competitiveness.
- On average only 46% of CFOs feel that the procurement team has contributed to enterprise growth.
- Only 57% of CFOs feel that procurement contributes to enterprise profitability.
This ongoing disconnect provides additional incentive to examine savings calculations from a different perspective re the influence of commodity characteristics and double marginalization.
It also illustrates the need to establish effective avenues of communication and understanding with different stakeholders such as finance.
Dinesh Kumar S.
General Manager at Divya Creations
Best Answers in: Manufacturing (2), Green Business (1)
It must be done in terms of cost per unit of production. Direct or Indirect material cheap and inferior substitute is always available except metal like gold, silver and other precious material(For Jewellery these are direct material).
After joining a new job where materials was one of my function my CEO forwarded report submitted by Materials Dept head showing trmendous saving acheived last year in procurement using reduction in procurement price with units consumed. On close scrutiny I found that by going for cheaper material cost per unit has gone down but consumption of most of the material has gone resulting in to high production cost per unit of finished goods. Not only that, maintenance down time too had gone up. This was a negative saving.
Productivity is ratio of output to input. in terms of Rs./$ and must be more than unity to maintain profitability. Production audit should be carried out to determine the savings which can be conducted by an Industrial Engineer.
In the company I am working for, we basically follow what Robert has answered :
- for indirect procurement, savings=(Current Year Price-Previous Year Price)/Previous Year Price * Amount received (i.e. consumed, not ordered)
- if Previous Year Price does not exist, we take the "Market price" which we consider to be equal to the average amount of quotations we received (not the best). I agree this can be not that clean if supplier or buyer play a bad game, but we did not find a better solution.
- for direct procurement, savings is calculated as a variance between the paid price and the price in the company yearly plan. It is the only case we use kind of budget prices, because as Robert commented, budgets are not always built on objective criteria, nor validated by Procurement Dpt !
