How do we measure up? An Introduction to Performance Measurement of the Procurement Profession
Introduction Stakeholder buy-in is definitely one of the biggest problems facing procurement in Australia 1. Accordingly, one of the key areas of interest for many procurement organisations is improving performance measurement. It is widely accepted that procurement performance measurement has historically been inadequate with the focus placed on traditional indicators such as cost rather than efficiency or effectiveness. This has led to an inability to demonstrate the value that procurement creates and captures for organisations. As a result, a lack of stakeholder buy-in and low levels of procurement credibility are generally apparent within the broader organisation. Procurement practitioners however, are fully aware of the important role that they play in risk management, quality and bottom line contribution. The important link that is often missing is the use of a comprehensive, clear and credible performance measurement system that enables the measurement and articulation of procurement achievements to all stakeholders. Historically, procurement performance has been focussed on cost or savings. This narrow approach fails to address the trade-offs with quality, inventory and supplier relationships (to name a few). Due to increased focus on business results, performance measurement has 1 CIPS Australia, 2004 2 CIPS Australia, 2005 been extended to broader business (risk, inventory) and operational objectives (% of spend) as illustrated by Figure 1. However, there is significant difficulty with quantifying the full range of contributions by procurement and therefore there has been inaccurate measurement and communication of procurements contribution to the organisation. Without communicating achievements in terms of impact/ output measures (such as return on total assets - ROTA), the link of procurement to the overall financial objectives of the business has been unclear. Another major issue for procurement organisations has been the credibility of savings that have been reported as procurement achievements. Unless the savings are apparent in the bottom line of the business through profits, stakeholders have been reticent to attribute cost savings to procurement functions. In reporting savings numbers, procurement organisations need to distinguish between cost avoidance and savings. This can be achieved through the use of a standardised benefits capture system. Such systems facilitate stakeholder endorsement and cross functional collaboration through strict reporting and standardisation guidelines. The incentive for applying a robust performance measurement system is that both the procurement function and the broader organisation will benefit from an enhanced appreciation of procurement contributions. This paper outlines detailed aspects of a performance measurement system for procurement organisations. The system that is most applicable to procurement organisations measures both efficiency (doing things right) and effectiveness (doing the right thing). It also tracks structural features such as process, technology, people/hr and strategic alignment. Pro-activity Price Business Results Figure 1 Focus on increased sophistication of business results has required procurement to become more proactive and move from price management to cost management, risk management and value adding 2 Cost Risk Value 2 Introduction
An ideal performance measurement system There are a number of key attributes of a comprehensive performance measurement system. These include 3 : 1. Eliminating influence of external factors to isolate procurement contribution 2. Creating internal alignment with finance, strategy etc. 3. Accessible by and understandable to stakeholders 4. Consistent compares like with like and is applied consistently regardless of any impact on Procurement value reporting 5. Credible ensuring that all claims for credit are credible 6. Measuring and reporting on factors that are important 7. Balancing level of detail and extent of analysis with business relevance and impact Of these attributes, the internal alignment, selection of factors to be measured and credibility are generally considered to be most important. These aspects will be discussed further to establish the context for an optimal performance measurement system. Internal alignment Business alignment and integration are both vital elements for successful organisations. In aligned organisations, investment decisions are more effective in positioning the entire firm to improve performance as collaboration, consistency and cohesion between business functions is increased. Alignment and integration are usually achieved through improvements in the strategic planning and operating processes of the firm such as objective setting and budgeting. Effective strategic alignment is demonstrated by companies such as Nokia which is focussed on speed to market and designs internal processes and procedures with this strategy in mind. For alignment to be successful, the objectives of each function need to be clearly linked to the organisational and enterprise objectives that support the business strategy. The following diagram illustrates the cascading nature of enterprise strategy, to organisational strategy and finally to functional strategy. Enterprise strategy Organisational Strategy Functional Strategy 3 Procurement Strategy Council, Demonstrating procurement value 2005 An ideal performance measurement system 3
In aligned systems, the organisational strategy (which supports the enterprise strategy) forms a basis for the targets of different business functions. These targets can be function specific (eg. ROTA) or crossfunctional (eg. service level agreements). It is important that the overall risk management approach of the organisation is taken into account when setting the targets for the business functions. The performance targets for the procurement function need to be clearly linked to the organisational objectives as well as reflecting concerns of the senior management team (these objectives and concerns need to be consistent). The alignment of such targets should be reviewed on a regular basis to ensure that they are still consistent with the organisational strategy and there hasn t been any deviation. By ensuring that performance measurement and other internal systems are aligned internally, it will be easier to communicate the impact that procurement has on overall business performance. Factors to be measured A challenge with performance measurement is choosing the variables to measure. There are three main categories of measures input, process and output. Output measures are not transferable between or comparable across companies, however, they can often be easily linked through to the broader business objectives. Input measures such as cost and competence can have direct bearing on the output measures eg. increased competence may lead to increased performance, however this link may not be transparent and often needs further explanation. Regardless of the measures used, the metrics and the performance targets need to be aligned with the overall business strategy to ensure that procurement reflects and supports the business. The type of measure chosen for performance monitoring can conflict with other objectives eg. measuring cost, introduces tradeoffs with quality and time. Additionally, the type of measure output or input can give different messages about what is important to the organisation. The mantra of if it is measured then it must be important still permeates throughout organisations. For instance, output measures (which are often a result of a number of inputs) will reflect business performance, however, input measures can be tracked to identify possible improvements in business operation. By measuring outputs, the message given to the organisation is that the results are very important. However, some businesses may only be interested in tracking key input variables as the link with results is transparent. The type of measure used to track performance can also vary dramatically in sophistication. Increased refinement can be achieved by placing the focus on outcomes which signal that performance and delivery are important, eg. ROTA rather than % In Full on Time (IFOT). This message can then be supported through the setting of internal targets that are proven to be directly related to the output. However, organisations need to ensure that the measures and associated 4 An ideal performance measurement system
targets are actually important and relevant. This can be assessed through asking the following questions will we take action if this indicator increases or decreases? How many people are interested in and accountable for this indicator? If changes in the metric will not drive a reaction, or there is no-one accountable for the processes that contribute to the measure, then the relevance of the metric needs to be questioned. It is not worth measuring just for measurement sake. All these issues should be considered when deciding on the performance measurement for your business. It is also important to note that the measures need to be tailored to fit a particular organisation and are not necessarily applicable or transferable between organisations. Table 1 outlines the four main categories for metric choices (both input and output) and the way they can be used in the business. Measures across Type of measure The Supply Chain OUTPUT INPUT Measures of Provides Highlights inputs from focus for risk and areas Suppliers discussion of opportunity of KPI s Measures of value Records Assists with added within progress development the business and tracks needs analysis achievement and target setting Measures of Highlights Illustrates progress areas where areas of efficiency within further strengths and the business measurement weaknesses may be required Measures of Transparent Highlights outputs to and provides achievement customers motivation as and assists in well as deliverable illustrating identification achievement Recognise limits Table 1 Types of measures 4 Measurement systems are inherently fallible. They are only as good as the accuracy of the metrics used. Accordingly, any assumptions and vulnerabilities behind the measures need to be understood and articulated. A good way of doing this (particularly for cost savings tracking) is implementing a staggered measurement system, which categorises the vulnerabilities and benefits according to the type and reliability of measure. This system will be discussed further in the savings reporting section. To maintain credibility of the measurement system, it is very important that all savings and performance numbers communicated are valid. Unsubstantiated claims should be avoided at all costs as they can easily lead to erosion of the tenuous credibility that may have been developed. 4 Measurement and baselining Chptr 11 An ideal performance measurement system 5
Benchmarking For measures and targets to be useful, it is helpful to have relevant comparisons wherever possible. This is advantageous particularly when identifying areas for improvement in your business by understanding what best practice may look like in similar organisations, it is much easier to identify internal gaps and develop improvement plans.the difficulty lies in obtaining the relevant data from sources which usually are competitor firms. There are a variety of challenges for companies in the benchmarking process. Some of these include the potential of data overload, validation of external data, and ill-defined benchmarking objectives 5.To manage these challenges, procurement functions should define clear objectives for benchmarking exercises, validate data, and establish standardised procedures for use of the benchmarking data. In addition to assessing how well the organisation is performing, benchmarking enables organisations to objectively target and quantify opportunities that may be identified. It is also important to acknowledge the dynamic nature of the global environment and to update your benchmarking basis on a regular basis. 5 Procurement Strategy Council, Strategies for Procurement Benchmarking, 2005 6 An ideal performance measurement system
Procurement performance measurement There are a wide range of metrics that can be tracked and used to drive improvements in procurement performance. These range from spend visibility, process efficiency, talent management, supplier relationships to strategic alignment. Recent research has illustrated that there appear to be a number of key attributes that are tracked by those organisations whom excel in regards to organisational performance. Specifically, these attributes include a mixture of efficiency and effectiveness metrics; and structural issues such as; talent management, internal alignment and complexity. The following discussion illustrates the importance of these issues in greater detail. Trade-off between efficiency and effectiveness Efficiency and effectiveness represent different competencies and capabilities for procurement organisations. Efficiency reflects that the organisation is doing things right, whereas effectiveness relates to the organisation doing the right thing 6. There is a trade-off between efficiency and effectiveness as a highly efficient organisation may spend less than peers (particularly when compared to highly effective organisations), however, quality and value may suffer. Organisations focussed on efficiency tend to make decisions based on cost and investment pay back likelihood, whereas effectiveness focussed organisations make decisions based on quality and value rather than costs and productivity. The challenge for procurement organisations is targeting and achieving the right balance between the two. The Figure 2 illustrates this trade-off. An organisation can be highly effective, yet not efficient and visa versa. The balance between efficiency and effectiveness will need to be assessed for each organisation relative to the activities they are involved in. For example, a service orientated organisation may place more emphasis on effectiveness measures rather than efficiency measures. High Best effectiveness performers Best performers high efficiency and effectiveness Effectiveness Medium Best efficiency performers Low Low Medium High Efficiency 6 The Hackett Group, 2005 7 The Hackett Group, 2005 Figure 2 Efficiency Vs Effectiveness 2 Procurement performance measurement 7
Examples of Efficiency Performance Metrics Some key categories for efficiency performance metrics include; cost, staffing, productivity, technology leverage and cycle time. The associated measurements for each of these metrics are outlined in Table 2. Efficiency Metrics Cost Procurement cost as a % of spend Staffing Staff per million of spend Productivity Purchase orders/material receipts per employee Cost per purchase order/receipt Technology Leverage Technology cost per billion dollars of spend Technology cost as a % of procurement cost Cycle Time Hours required to complete a requisition and purchase order Table 2 Efficiency Metrics By monitoring efficiency measures, procurement organisations can ensure that they are operating competently and not wasting energy or effort. These measures are outlined in the following section. Cost Investment in procurement functions should be focussed to the high value areas such as supplier relationship management and strategic sourcing. By tracking the costs of the procurement function, any opportunity for reallocation of funds consumed in needless costs to the higher value activities such as strategic sourcing is facilitated. Staffing Organisations with an efficiency focus will tend to have significantly lower staffing levels compared to those focussing on effectiveness. Staffing levels can be split between those involved in operational support (eg. purchasing), those involved in decision support (eg. strategic sourcing) and risk management. One would expect increasing ratio s of metrics for the decision support and risk management functions particularly for effective organisations as people are being released from operational roles to value-adding roles. Other areas of interest in staffing are the mix between clerical, professional and managerial staff. 8 Procurement performance measurement
Labour cost per employee (a loaded number) is also a measure of efficiency as an efficient organisation will usually have a lower labour cost than those organisations with exceptional effectiveness. Productivity Productivity rates clearly reflect the levels of efficiency and effectiveness an organisation is targeting. The key methods for tracking productivity are; a) number of purchase orders processed annually per employee, b) number of material receipts processed annually per employee, c) cost per purchase order, and d) cost per receipt. Technology Leverage Technological advancements in the last two decades have dramatically changed the traditional purchasing roles. Improvements have resulted in huge advancements in the level of technical expertise required in procurement organisations. As a result of the technology advancements, the efficiency levels of procurement have been significantly improved. However, to achieve this efficiency, technology is still a large proportion of procurement cost. This is more of an issue for effectiveness firms than efficiency firms as those with high levels of effectiveness are still spending a large proportion of their procurement budget on technology. Whereas efficient firms are optimising their use of technology already purchased. Technology leverage can be assessed through the ratio of technology cost per billion dollars of spend or technology cost as a percentage of procurement cost. Additionally, the ratio of technology cost to labour can indicate the levels of proportional investment. Cycle Time Cycle time is also a good indicator of relative effectiveness and efficiency. The efficiency focussed approach will result in a longer time period required to complete a requisition and purchase order compared to effectiveness focussed. Suggested Effectiveness Performance Metrics Effectiveness measures outlined in Table 3 such as cost savings supplier leverage and error rates enable organisations to track if they are operating in a way that achieves results. Additionally, their customer related metrics such as IFOT are also good indicators of effective procurement performance. Effectiveness Metrics Cost savings Supplier Leverage Error rates Customer satisfaction Annual cost savings as a % of spend Number of suppliers per X dollars of spend Percent of suppliers providing 80% or more of the annual spend Percent of purchases made from preferred suppliers Percent of transactions requiring correction after process Percentage of deliveries received in full and on time - IFOT (measurement can sometimes be difficult). This metric can also be used to track the quality of items being delivered Table 3 Effectiveness Metrics Procurement performance measurement 9
Cost savings An effectiveness focus will create more savings than an efficiency focus due to the different strategy of the two extremes. Effectiveness focussed organisations tend to operate at a higher level of procurement costs as a percent of spend. As a result, there is more opportunity to capture savings. Supplier Leverage This metric is critical for procurement organisations and is essentially related to assessing the effectiveness of sourcing, negotiations and supplier development/ innovation. Reducing the number of suppliers enables firms to focus on developing relationships with suppliers and also reduces the costs of ongoing monitoring and management. However, this process needs on going management and assessment of preferred supplier performance, savings obtained and customer satisfaction. Error rates Efficient organisations will typically generate fewer errors than their effective counterparts. Customer satisfaction An effectiveness focus can result in higher levels of customer satisfaction. The IFOT metrics is one such customer satisfaction effectiveness measure. 10 Procurement performance measurement
Other relevant metrics The following metrics can also be used to track performance of procurement organisations. These metrics are related to the structural factors of organisations. All these structural metrics can be tailored to specific organisations. They are important in ensuring that procurement can deliver on the effectiveness and efficiency requirements that have been set. Additional Metrics Standardisation Use of company-wide policies, commodity codes Supplier Percentage of companies Rationalisation reviewing over 25% of suppliers annually for rationalisation opportunities Technology Percentage of automatic integration (Vs manual) transactions Percentage of PO s communicated directly to suppliers Percentage of RFIs/RFPs/RFQs communicated electronically to potential suppliers Percentage of companies where information on spend analysis is available company wide Percentage of purchase orders approvals done online Business Process Tracking of outsourcing % in key processes eg. Data management Use of a competency and capability model for procurement personnel Use of retention and development plans for procurement staff Tracking of training hours per employee (internal and external) Talent management - % of staff with high potential % of staff with business degree split in management and professional Partnering Procurement control over material spend Procurement control over goods spend Use of cross-functional teams in supplier development, sourcing and negotiation Use of scoring models for suppliers Strategic alignment Visibility of a formal documented procurement strategy Percentage of objectives linked to business strategy Percentage of procurement time spent on global / enterprise-wide focus Table 4 Additional performance metrics Procurement performance measurement 11
Credible savings reporting It is important to develop a rigorous framework for savings reporting as savings is still a key measure used by procurement organisations to assess performance. A typical reporting system includes; a) a clear benefits tracking governance structure, b) standard documentation and c) reporting protocols 8. Data integrity is also a key ingredient in a comprehensive savings reporting system. Accordingly, a series of data normalisation steps should be included to; account for market and currency shifts, eliminate uncontrollable price factors (taxes, duties etc), adjust savings for volume changes based on estimated usage, deducts implementation costs from expected savings and adds in volume from expected operational improvement. Savings can also be broken down into four key categories 1.Year on year savings reported as EBIT, 2. Cost avoidance such as negotiated reduction from contracted increase or avoidance of proposed cost increase, 3. Revenue improvement through volume impacts resulting from process improvements, bottleneck elimination or decreases in selling costs or penalties, 4. Balance sheet improvements improved working capital, capital expenditure reduction or reduced investment in non-value assets. By categorising the type of savings, the credibility of numbers reported is increased. Additionally, by obtaining business unit sign off on the savings that will be reported stakeholders are involved in the process which increases transparency and integrity. Conclusion A credible performance measurement system that is aligned with the business objectives and measures factors such as effectiveness and efficiency enables procurement organisations to better communicate their contribution to the overall business performance. This results in increased stakeholder buy-in and improved representation of the procurement function throughout the broader organisation. 8 Procurement Strategy Council, Demonstrating Procurement Value, 2005 12 Credible savings reporting
References CIPS Australia, The TOP 3 issues facing the procurement profession, November 2004 CIPS Australia, Presentation material, 2005 Likierman,Andrew, Measurably Better, Supply Management, 7 July 2005. The Hackett Group Performance Metrics and Practices of World-Class Procurement Organisations, 2004,The Hackett Group Procurement Strategy Council A Model of Effectiveness Designing a High-Performance Procurement Organisation, 2004, Corporate Executive Board Procurement Strategy Council A Model of Effectiveness Procurement Organisation Performance Benchmarks, September, 2004, Corporate Executive Board Procurement Strategy Council Anatomy of a World-Class Procurement Organisation Benchmark Results and User s Guide, 2003, Corporate Executive Board. Procurement Strategy Council Enhancing Procurement Performance Methods and Measures for Maximising Value-Add, 2002, Corporate Executive Board. Procurement Strategy Council Linking the Purchasing Function to the Balanced Scorecard, September, 2002, Corporate Executive Board. Procurement Strategy Council Moving to Performance-Based Agency Compensation, June, 2005, Corporate Executive Board Procurement Strategy Council Strategies for Procurement Benchmarking, February, 2005, Corporate Executive Board. Smith, Peter A vision of purchasing perfection, SupplyManagement.com Measurement and base-lining from Jonathan Dutton About the author Kate Hart has a bachelor degree in Chemical Engineering from the University of New South Wales and is approaching the completion of her MBA from the Melbourne Business School. During her broad supply chain management experience in the Oil & Gas and Mining sectors she has specialised in business and process improvement. Procurement Strategy Council Demonstrating Procurement Value Measuring and Communicating Procurement s Enterprise Contribution,April, 2005, Corporate Executive Board. References 13
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