January 30, 2017 - Ask people in an organisation how procurement is or should be measured, and the most common answer is still “cost reduction”. For many it’s then necessary to expand on their response: “but the savings never show up on the P&L,” or, “this unfortunately means that our service, quality and user experience are likely to deteriorate.”
Based on my experience as a CPO in multinational companies, procurement should always be measured on cost-reduction performance, but it should be part of a more integrated measure focused on driving earnings per share (EPS) or absolute profit growth.
Procurement has a strategic and operational role in helping organisations accelerate and increase EPS growth that can be reflected in five core metrics:
- Revenue growth
- Cost reduction
- Working capital optimisation
- Risk mitigation
- User experience
These measures should be at the heart of every procurement transformation programme to optimise the operating model, governance, processes, and capabilities.
For many organisations, over 50% of their operating cost base is external. They are therefore highly dependent on suppliers to support product creation and service delivery. However, procurement should not limit its involvement to managing external supply chains and value streams to just assure supply.
Procurement plays a pivotal role in driving improvement and innovation across internal business functions as well as external suppliers.
More companies recognise the need to collaborate with suppliers and many have effective supplier relationship management strategies. However, very few have successfully enhanced the segmentation of their supply base, integrated their suppliers with commercial and operational transparency, or aligned governance and performance metrics supported by incentivised contractual constructs.
I’ve seen high-performing procurement functions drive revenues by improving time-to-market, price-point elasticity, and service and product innovation, creating new customer channels, and increasing customer loyalty and satisfaction.
Procurement’s ability and credibility to deliver cost reduction have improved significantly in many organisations through the execution of structured strategic sourcing and category management processes. This approach has moved the focus from price-down negotiations to more sophisticated methods, including comprehensive cost modelling and target costing (value analysis/engineering).
Many of these organisations, however, still focus on unit-cost reduction rather than more holistic expense management to address demand management, spend compliance, and broader strategic business change.
This approach creates granular transparency, drives conscious decision-making, and integrates business planning and budgeting processes. It also enables fiscal lines of sight to the P&L and balance sheets, and reframes the cost discussion to include ‘cost out’. But it also focuses on where cost should be expended to increase profit growth.
Procurement functions and CPOs that cannot effectively frame the need for cost rigour to support growth end up pushing a mandate for engagement rather than creating a pull for the value they can unlock.
Take, for example, the unwillingness of a pharmaceutical R&D function to engage with procurement to reduce cost. The R&D goal is to improve the quality and quantity of the pipeline of new drugs, and in many instances there is a perceived philosophical difference between the two functions on what is more important: cost or pipeline. The reality is that the two are intertwined and one can drive the other.
If R&D and procurement align their goals to increase pipeline value and therefore revenues, profits and EPS, they can work together to reduce costs that can be reinvested into the acquisition of molecules or running a greater number of trials.
Rather than drop the savings to the bottom line, the reinvestment will generate five to 10 times more profitability.
Similarly, engaging with sales and marketing to identify where cost savings can be reinvested in new digital channels, campaigns or sales optimisation initiatives will create clear line of sight to ROI.
Of course, procurement doesn’t make the reinvestment decision. The decision sits with the business and finance, typically at the executive committee, but the ability to generate that value, create transparency and execute the sourcing elements of the reinvestment requires procurement to operate differently. Robust governance and insightful analytics across procurement, finance, other functions, and suppliers, are critical to reframe the focus on procurement transformation, deliver EPS, and drive the necessary alignment, identification, prioritisation and execution.
To achieve these outcomes procurement must transform the way it operates with new and enhanced capabilities, integrated governance, and simplified and standardised processes enabled through analytics and technology. A best-in-class procurement operating model should be structured across integrated front, middle and back office activities that deliver these five core metrics.
It is the forward-thinking CPOs who recognise that increased investment in people, training, tools, and technology is necessary in critical skillsets, including business relationship management, financial integration and supplier management and development.
The transformed function can then leverage the back office as a utility/shared service with high levels of standardisation, simplification and automation, while the middle office enables greater integration, insight, control, and agility.
This is first of a series of blogs on how procurement needs to transform to be recognized as not only a source but driver of core enterprise value.
This blog was first published by Procurement Leaders.