Beyond Cost Reduction

Beyond Cost Reduction Measuring How Procurement Creates Business Value By Alex Brown, Kyle Appell and Meghan Truchan

Over the past decade, successful businesses have proactively developed strategies that not only manage cost but also mitigate risk, improve quality, integrate sustainability into all aspects of the organization, and accelerate innovation. Arguably no corporate entity is more central to achieving these goals than the procurement function. 2

To illustrate how the procurement function can bring business value to the enterprise far exceeding simple cost reduction, consider these two examples: In March 2011, the earthquake and resulting tsunami in Japan posed a severe test for the risk management strategies and capabilities of companies with operations near the earthquake zone. Yet one major producer of semiconductors was able to recover quicker than other semiconductor suppliers. What was the secret to its success? The company had developed a robust procurement, supply chain and manufacturing redundancy program, an effective disaster response plan, and a proactive collaboration model with its suppliers. Apple, an acknowledged leader in innovation, relies heavily on its procurement function for developing innovative products and processes. Apple uses a unique strategy for managing supplier relationships, creating exclusivity agreements in exchange for volume guarantees from key suppliers, and developing deep supplier relationships that allow it to scale supplier production to meet customer demand. Apple also works intensively with suppliers to develop and patent manufacturing processes and products. Finally, the company places high volume pre-orders with strategic suppliers, locking in capacity which may prevent some competitors from gaining access to the same manufacturing resources. 1 These two examples reflect a world in which CPOs are being asked to deliver more than just cost savings and financial results. Today s global companies operate in a world of complex supply chains, intense competition, and exposure to significant business risk. CPOs have a mandate to take the lead in developing and executing strategies in risk management, quality, sustainability, and innovation that drive real and measurable value for their business partners. To support CPOs operating in this challenging business environment, Accenture has developed a model called Procurement Value Measurement (PVM). PVM quantifies the value CPOs create across the dimensions of risk management, quality, sustainability, and innovation. In so doing, it gives them a tool to guide their value-creation efforts and demonstrate the value they deliver to the corporation in addition to that measured by traditional, but incomplete, spend-compliance and cost-savings metrics. 3

An Effective Measure of Value Stated simply, PVM provides a model for effectively measuring the value that procurement delivers to the organization. PVM can assess value creation across five components: Procurement Infrastructure, Risk Management, Quality, Sustainability and Innovation (Figure 1). PVM is calculated by taking the value created in each of the five components and subtracting the corresponding costs, as shown in Figure 2. The result of this calculation is a single figure that is monetary and can enable meaningful comparisons, benchmarking and ranking across organizations. The formula also has the advantages of being simple to understand across the business and able to convey all dimensions of the value procurement delivers to the business. Figure 1. The five components of PVM Procurement Value Measurement 1. Procurement Infrastructure 2. Risk Management 3. Quality 4. Sustainability 5. Innovation Value - Cost Value - Cost Value - Cost Value - Cost Value - Cost The people, processes and technology that comprise the traditional procurement function. Focused primarily on cost reduction. Procurement s contribution to mitigating risk and ensuring business continuity. Procurement s contribution to the quality and availability of a company's products and services. Procurement s contribution to a positive impact on the environment, social responsibility and human rights. Procurement s contribution to creating unique value in products, services and supply chain processes through supplier collaboration and other means. Figure 2. The PVM formula PVM=(Value Cost) 1,2,3,4,5 4

A Closer Look at Value and Cost For all five components of PVM, the formula recognizes value from three sources: revenue impacts, cost reduction and avoidance, and the development of intangible assets. Such value can include one-time (working capital impacts) and ongoing (recurring annual savings) benefits. By contrast, the sources of cost are always specific to each component of PVM. Here is an overview of some of the major ways in which the PVM formula measures value and calculates costs for each of the five components. Procurement Infrastructure The most traditional ways of measuring the performance of a procurement organization are savings and operating budget. More recently, many higher-performing companies have expanded their view of how procurement contributes to business success. These companies incorporate not only cost metrics such as total cost of ownership (TCO) but also revenue impacts from, for example, improved inventory turns, as well as value from such intangible assets as improved contract compliance and supplier relationship management. Creating value is very important to any organization, but it is of little value unless measured relative to the cost incurred to generate that value. The same is true for procurement infrastructure. In simple terms, the benefits generated through sourcing or procurement activities create value for the company only if they exceed the total cost of running the procurement organization. Expenditures to run the procurement organization include those for people, technology, administration, and physical facilities (Figure 3). Figure 3: Value and cost drivers of Procurement Infrastructure Value Revenues improved inventory turn; better adaptation to market fluctuations; lower cost to enter new markets Cost avoidance/reduction reductions in purchase price, inventory, capital expenditures, logistics and transportation expenses, TCO; improvements in specifications, demand rationalization, supplier terms and conditions, maintenance and services, purchasing processes, warehouse usage, adaptation to market changes; eprocurement Intangible assets strengthened supplier relationships; increased contract compliance; improved procurement governance; improved purchasing employee engagement Cost People salaries, wages, benefits, bonuses, other compensation of procurement FTEs; contractors directly managed by procurement personnel; purchased services and professional fees Technology including hardware, software, and IT support vv related to procurement processes and systems Administration Physical facilities 5

Risk Management Procurement organizations play a major role not only in avoiding the costs associated with risk for example, regulatory fines, higher insurance premiums, or damage to reputation and brand equity but also in ensuring business continuity amid supply chain disruption that can lead to lost revenues. Indeed the value of procurement for dealing with supply chain disruption in today s volatile environment has come into greater focus of late. This has led some companies with truly global supply chains that are not only an integral part of operations but are also critical for revenue to launch risk management centers led by procurement to track risks in their regions of supply. Costs for risk management include insuring and hedging against, and building redundancy to address, risks from supply volatility, conversion-process volatility, demand instability, and financial and regulatory volatility (Figure 4). Figure 4: Value and cost drivers of Risk Management Value Revenues predictable long-term profitable growth Cost avoidance/reduction business disruption cost avoidance; greater product availability; reduced cost of goods sold; fines and penalties avoidance; regulatory impact/influence Intangible assets improved brand equity, reputation, investor relations, employee engagement, workplace safety, community involvement, customer loyalty Cost Supply volatility Demand instability Conversion process uncertainty Financial volatility Regulatory volatility Quality To assess the procurement function s contribution to quality, the PVM formula measures value through premium pricing, increased volume, and reduced rework. This is something automotive manufacturers, for example, do by conducting extensive research and analysis on the costs of quality in the supply chain, thereby optimizing pricing and maintaining minimal rework/defect rates while keeping costs as low as possible. Capabilities in procurement-led quality analysis are improving as organizations become more sophisticated and can leverage technology for quality management. Quality costs include R&D and improved production processes to increase quality/ reduce variability inspections and quality management, for example as well as the costs of returns (Figure 5). Figure 5: Value and cost drivers of Procurement Infrastructure Value Revenues premium pricing; purchase volume increases Cost avoidance/reduction decreased returns and service costs Intangible assets improved brand equity, reputation, employee engagement, customer loyalty Cost R&D and production processes to increase quality Inspections Product returns 6

Sustainability Measures of value from sustainability include increased sales from green products that have been manufactured using socially responsible methods, plus the reduced costs resulting from energy efficiency, streamlined and more environmentally friendly logistics, and other means. Value in this component of PVM is often difficult to measure because value to the brand is itself an elusive metric. Yet sophisticated procurement organizations are attempting to grasp the full impact of sustainability issues and efforts in their supply chains. Understanding the impact on supplier companies and countries as well can provide an information advantage for targeted cost reductions and revenue opportunities. The costs of capturing value through sustainability include potentially higher raw material costs and increased regulatory and administrative costs (including employee training) for addressing environmental, human rights, safety, and social responsibility issues (Figure 6). Figure 6: Value and cost drivers of Sustainability Value Revenues new sustainable products/services; premium pricing; volume increases due to perception of sustainable practices; byproducts and waste salvage/sale Cost avoidance/reduction increased energy efficiency; reduced logistics costs; inventory and working capital improvements; decreases in raw materials consumption, business travel, business disruption, environmental and operating licensing, company reporting; fines and penalties avoidance; tax rebates/shields Intangible assets improved brand equity, reputation, investor relations, employee engagement, community involvement, customer loyalty Cost Environmental e.g., higher costs for raw materials Regulatory compliance Administrative costs (incl. training) for addressing human rights, safety, social responsibility issues Innovation Progressive procurement organizations today are pursuing innovation efforts without necessarily calculating them as such. For example, innovation value may be coming from new products or services developed in partnership with suppliers or with unique components coming from suppliers. In such instances, where the supplier has provided the differentiator, all revenue impact from those products and services should be calculated as innovation value contributed by procurement. With cost savings and avoidance, innovation can come in many forms for example, from a unique approach to sourcing that drives value, specification-optimization efforts driven or supported by procurement or suppliers, or market/supplier research that leads to changes in what is purchased. Procurement can also create value from innovation in the form of intangible assets such as improved customer satisfaction, supply chain responsiveness, and speed to market. Costs associated with developing and implementing innovation efforts in procurement i.e., expenditures above and beyond those for traditional sourcing and procurement activities can include those for R&D (including any supplier fees for R&D), dedicated headcount, supplier development, researching and testing technology, marketing, and other implementation costs (Figure 7). Figure 7: Value and cost drivers of Innovation Value Revenues new and/or uniquely differentiated products/services; byproducts and waste salvage/sale; sale of supply network capacity; identification of new sales channels Cost avoidance/reduction supply chain process improvements; reduced cost of goods sold, G&A, property/plant/equipment, inventory and working capital, switching costs, complexity Intangible assets improved customer satisfaction, brand equity, reputation, employee engagement, quality, supply chain responsiveness, visibility to/across the business/supply chain; increased speed to market; rapid customer feedback; reduced flow times and lead times; shift of FTE focus from tactical to strategic work; more patents, copyrights, franchises, trademarks, trade names; improved safety, community involvement, diversity Cost R&D incl. testing, supplier fees People incl. internal personnel, professional services Supplier development Technology incl. purchase, implementation, upgrading, training, cost of not being first to market Marketing Other implementation costs e.g., assets, facilities, temp labor, reworks, M&A expenses 7

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Calculating PVM Inputs for the PVM calculation can come from a variety of sources. The more exhaustive the data collection, the more accurate the measurement and the more useful it will be for root cause analysis and action planning. An accurate calculation will maintain credibility with the enterprise and make trends clear. Furthermore, by being tracked from one year to the next, PVM can be used to show when the benefits of given investments are realized only over time; this can help procurement leaders enter into cost/benefit discussions with other functional leaders when the cost of an investment outweighs the initially perceived value from it. Although it is desirable to obtain the most accurate PVM calculation possible, companies may wish to get started with a higher-level estimate for the various components of PVM. The score yielded by this higher-level approach can be used for discussion at the leadership level as to which component(s) should be the focus of more complete efforts to calculate a PVM score. Figure 8 summarizes some of the key stakeholder groups to engage when gathering input variables for each of the five components of PVM at any level of detail. To aid in the data-gathering effort, companies should consider consulting additional sources including, but not limited to, annual reports, internal portals/external websites, savings tracker(s), organizational charts, spend/mrp outputs, budgets, workplace injury reports, employee turnover statistics, and revenue reports. Calculating PVM can take two to six weeks depending on the size of your company and the availability of data and stakeholders. As noted above, the more you invest in obtaining an accurate measurement, the better you should be able to understand both the root causes of low or negative net value and your procurement organization s areas of opportunity. Clients who have implemented the PVM model have generally learned the same lessons about how to do so most effectively. One of these lessons is that it is important to identify a primary owner for the PVM effort within procurement: to obtain the most accurate PVM calculation for your procurement organization and make the best use of it afterwards, a procurement leader should own and foster it. Our clients have also found that having a focused data collection team can be beneficial: procurement professionals are always wearing many hats, so we recommend assigning PVM data collection to a dedicated group for a small amount of time as its primary responsibility. Figure 8: Internal stakeholders for providing PVM input Category Leads Lean / Six Sigma Engineering Marketing Risk Management Quality Sustainability Product Innovation Legal Finance/ Budget Procurement Infrastructure Risk Management Quality Sustainability Innovation 9

Delivering Business Value with PVM With new demands and expectations being placed on procurement organizations for delivering business value to their companies, it is time to move beyond familiar measures that focus only on the cost side of the procurement function. The CPO of the 21st century needs clear insight to be able to effectively mitigate business risk, improve quality, lead the charge for sustainable strategies, and drive innovation and growth. Measuring procurement value using the formula we have described can provide just such insight. PVM is a comprehensive yet simple snapshot of the various aspects of procurement value. By considering the five components of PVM, CPOs are equipped to look beyond only savings from sourcing to discover and take advantage of the many other ways in which they can deliver value. 10

The formula in action To see how the PVM formula can be used both to assess whether a procurement organization is creating net value for the business and to understand where the opportunities for such value creation lie, consider this sample calculation for two different hypothetical enterprises (Company A and Company B) in the same industry and of similar size. In this example, Company A s PVM score (net procurement value) comes out to $297M ($435M in value less $138M in costs) and Company B s is $216M. Even though Company B delivers more savings from procurement infrastructure ($295M vs. $289M) at a lower cost ($87M vs. $114M) than Company A, calculating PVM with the formula shows Company A is delivering 38% more in net value. The PVM model can help Company B evaluate value-generating opportunities in risk management, quality, sustainability, and innovation in order to deliver more net value to the business. Company A can use the PVM output to help assess year-over-year value improvement and focus on components where more value needs to be generated to meet particular company objectives. Sample PVM calculations Value Drivers Component Sample Value Drivers over 12 Months Company A (Millions) Procurement Infrastructure Risk Management Improved inventory velocity driving higher sales in new markets and products Supplier coordination activities leading to targeted sales improvements TCO reduction Inventory reduction Specification optimization Working capital improvement Demand rationalization Reduction or avoidance of supply disruption and regulatory costs clearly attributable to risk management $22 $1 $289 $295 $3 $1 Quality Price premiums and higher volumes for higher-quality products and certainty of availability $11 $2 Sustainability Innovation Company B (Millions) Byproduct and waste-salvage sales $35 $3 Price premiums and higher volumes for customer perception of product sustainability Energy usage, logistics, tax, and regulatory fee reductions $44 $3 Price premiums and higher volumes clearly attributable to product innovation from suppliers $30 $3 Supply network, warehouse capacity, and related channel sales Tooling, equipment, and facility space reduction $1 $1 Total $435 $309 Sample PVM calculations Cost Drivers Component Sample Cost Drivers over 12 Months Company A (Millions) Company B (Millions) Procurement Procurement people, technology, administration, and physical facility costs $114 $87 Infrastructure Risk Management Commodity and currency hedging costs $6 $1 Government relations Inventory surplus attributed to volatility management Quality Inspections and quality management $5 $2 Product returns costs Sustainability Regulatory compliance costs $6 $2 Supplier monitoring costs for health/safety, human rights, and environmental practices Internal training costs Cost premiums for use of sustainable direct materials/services Innovation Supply-related R&D costs $7 $1 Marketing costs for new-product introduction where product results from innovation provided by suppliers Total $138 $93 Company A (Millions) PVM Score (net procurement value) $297 $216 Company B (Millions) 11

References 1. University of San Franciso Online, Apple s Process Improvements make it a Global Supply Chain Leader http:// www.usanfranonline.com/resources/ supply-chain-management/apples-processimprovements-make-it-a-global-supplychain-leader/ About the Authors Alex Brown is a Senior Principal in Accenture s Strategy practice. His work spans multiple industries including Utilities, Energy, Chemicals, Natural Resources, Telecom, and Public Sector where he has helped companies implement numerous transformational programs. Focused on supply chain, sourcing, and procurement, Alex leads Accenture s network of North American Operations practitioners for Resources in thought capital development, knowledge sharing, and skills development. Based out of Denver, he can be reached at alexander.brown@accenture.com Kyle Appell is a Senior Manager in Accenture s Operations practice aligned to Sourcing and Procurement. He has 19 years of industry and consulting experience, centered in strategic sourcing, procurement transformation, web-based sourcing applications and finance. Kyle has led multiple strategic sourcing, spend assessment, and procurement improvement projects. Kyle s experience spans a wide range of industries, including Public Services, Resources, Consumer Electronics, Media, Food & Beverage, Telecommunications, Professional Services, and Manufacturing. Based in Northern California, he can be reached at kyle.m.appell@accenture.com. Meghan Truchan is a Manager in Accenture s Operations Consulting practice aligned to Sourcing and Procurement. She has cross-industry experience in procurement operating models, organization transformation, strategic sourcing, and procurement/ supply chain innovation serving as both a consultant and a practitioner. Based in Miami, she can be reached at Meghan.f.truchan@accenture.com. About Accenture Accenture is a global management consulting, technology services and outsourcing company, with approximately 289,000 people serving clients in more than 120 countries. Combining unparalleled experience, comprehensive capabilities across all industries and business functions, and extensive research on the world s most successful companies, Accenture collaborates with clients to help them become high-performance businesses and governments. The company generated net revenues of US$28.6 billion for the fiscal year ended Aug. 31, 2013. Its home page is www.accenture.com. DISCLAIMER: This document is intended for general informational purposes only, does not take into account the reader s specific circumstances, and may not reflect the most current developments. Accenture disclaims, to the fullest extent permitted by applicable law, all liability for the accuracy and completeness of the information in this document and for any acts or omissions made based on such information. Accenture does not provide legal, regulatory, audit or tax advice. Readers are responsible for obtaining such advice from their own legal counsel or other licensed professional. Copyright 2014 Accenture All rights reserved. Accenture, its logo, and High Performance Delivered are trademarks of Accenture. 13-3980