Monday, November 14, 2011

The Good, The Bad and The Ugly of Cost Savings Programs

The Good, the Bad and the Ugly of Cost Savings Programs

Most procurement groups have goals or targets they need to meet for cost savings. I thought I would write a post about what I consider to be the advantages and disadvantages of such programs.

Let me start by saying that I’ve worked for companies who year after year would report significant cost savings. In fact over time if you added all the cost savings up the suppliers should have been paying the buyer to take the product. That simply did not happen in fact the suppliers still made a profit. How did this occur? I think it all goes back to the fact that most products have a limited life cycle. During the term of a product’s life most products also have a price curve (see Price Curves post). In the introduction of a new product with new features, functionality or improved performance
where there is little or no competition the price always starts high, is driven down by competition, and usually goes up toward the end of its life as competitors exit that market. Supplier’s end of life products when they have replacement products with those
new features, functionality or performance. This means that the prices that the buyer worked so hard to reduce the cost of are no longer available and they need to start the
process over again with the replacement product.

The Good/
What’s good about cost savings programs? It places a clear focus on reducing cost. It eliminates complacency. I remember a commodity manager who reported to his manager that for that year he couldn’t drive any savings. The manager simply replied
“then what do I need you for.” The message was sent and savings were found. It can drive reductions in price because of that focus. Those savings can also do good things. For the internal customer it can expand their budget or allow them to lower their price or simply make more money. For the company it can generate additional cash to make investments. For procurement the programs can help drive you to find new, lower cost suppliers that can meet your requirements

The Bad
What’s bad about cost savings programs? Any metric that people get measured against
will drive the individual’s behavior. If all you measure is reductions in price the individuals may be assuming more costs or risks in dealing with suppliers, more costs or risks in terms, or more total life cycle costs simply to generate price reductions. I’ve never seen a cost savings program where the results were measured against the total life cycle of a purchase. The second thing that is bad about cost savings programs is suppliers that know about your program will plan for and manage that to their advantages. If a supplier knows that every year you will come back to them seeking to further reduce the price, do you think they will take that into account in their initial product pricing and in any reductions they give? Suppliers manage their pricing (See Pricing - How Suppliers manage their pricing). With the exception of commodities that are highly volatile, suppliers know what their costs will be. They know how much they can save from volume, learning curves, liquidation of investments, etc. If they know you will be back next year for more savings, do you think they are going to give you the best price today? Will they hold some in reserve for next year? I think they do.
The other area where cost savings is bad is when you have multiple suppliers for an item. Assume you have three qualified suppliers. At the time of award all suppliers prices are competitive. Supplier A you have a contract with that meets all your requirements. You plan to give Supplier A 60% of your business as that’s equal to their available capacity Supplier B you have a contract with but it has certain additional costs or risks that Supplier A. You plan to give Supplier B 30%. Supplier C has refused to come to agreement on certain terms but they have a product that is qualified. You need to keep them in the event you have a problem with either A or B. You plan to give Supplier C 10%. During the course of the year either Supplier B or Supplier C approaches you and offers you a price reduction of they get a larger percentage of the business. Do you give them more so you can meet your cost savings goal, or do you stick with the original percentages. If a supplier knows that they can not agree to your terms and increase the amount of business by simply giving you a lower price, what impact does that have on your contract negotiations with them? I’ve seen this happen too many times. Then a problem occurs whatever the savings was pales in comparison to the losses.

The Ugly
What’s ugly about cost savings programs? The ugly occurs when they buyer that is seeking to reduce cost is simply over their head in terms of knowledge and capability that’s needed to effectively manage what is required to drive savings. One of the best examples of this is sourcing in low cost geographies. For every one company that has been successful in sourcing in low cost geographies, there are probably 10 companies that have horror stories to share. They had problems simply because they didn’t know what they were doing, didn’t want to invest in doing it right, or because they hired and trusted someone that simply didn’t warrant that trust. They may not have realized that contract protection in low costs countries is simply not the same as contract protection at home. They may think that suppliers will respond like the supplier down the street when they don’t. A second great example of ugly is when companies use “Independent Distributors” to generate savings (see Independent Distributors and Brokers post). I’ve personally seen a number of situations where people went to independent distributors and brokers to wind up with counterfeit product that failed in their application where the cost was in the millions and the chances of recovery was slim to none.

If you would like to read about any of the referenced posts go to my wen site click on the tab hot-links to blog and simply scroll down to the title. It;s hot-linked to the blog topic

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