A few insights from our experience

Please feel free to contact us with your thoughts as we are always interested in other views.

1. Measuring Value Added by Procurement

Procurement reports value added by its activities as a measure of performance and as a gauge for prioritizing work and efficiently allocating resources. While there are many possible methods for calculating value, procurement must follow a procedure that is simple and can be widely accepted.

Procurement’s measure of value has evolved over time due to the changing nature of procurement activities it is known that it will not serve every purpose, for example, it will not serve as a measure of individual performance because many important and necessary activities may not generate value measured in dollars.

Procurement value-add will also, not serve as a measure of the movement in the cost base because it includes factors beyond our control and not reflect the historical costs, such as capital expenditures, inventories and external factors such as inflation, currency exchange rates or other changes in the market. The movement in a cost base resulting from a procurement activity, (both increases and decreases) should be reported. Movement in the cost base however is not necessarily a measure of procurement value-add and consequently this measure should be reported separately to the measure of procurement value add. As a result, for each procurement activity the following two measures should be reported:

• Movement in the cost base; and
• Value added by Procurement.

2. Value Improvement

Procurement’s measure of value-add is “Value Improvement” (VI). 
Value Improvement:

• Is a projection of the average annual value-add from current procurement activities, (including joint activities with others) and includes sourcing, contract management, purchasing, and supply chain initiatives. 

• Includes all types of value including price improvements, working capital reductions and other differences in operating and maintenance costs resulting from improved product performance. 

Value Improvement is net of known incremental costs, and should be reported when the project activity is completed, the VI figure agreed and trading under the new terms has begun or the Supplier has signed the contract, (for those initiatives requiring execution by suppliers). 

Where a contract has been entered into for more than one year the average annual value-add will be reported as VI “carried over” in each subsequent year of the contract. This VI is reported separately from new VI and is to be adjusted for any changes to the initial estimate of VI, (such as a price review at the end of the first year).  

3. Calculating Value Improvement

Price Improvement
Where VI results from a price improvement it is the new price negotiated compared to the market price at the time of negotiation that determines the value that has been added by procurement. VI resulting from price improvement is measured as the difference between the new price and the market price, multiplied by projected annual purchases.
There are two approaches to estimating the market price, depending on the circumstances:
Historical Price: the last price paid for a good/service prior to the new price negotiated. Historical price however is not always a good estimate of market price. In situations where the market has moved significantly, the good/service has not been purchased before or where the historical price was previously negotiated by procurement and hence does not necessarily reflect the market price, historical price may not be a good measure of the market price. In particular, historical price does not necessarily recognize the value in defending a previously negotiated position.

Where the market has moved significantly, the historical price may be adjusted for inflation or foreign exchange movements, as appropriate to provide a better estimate of market price. Not all market movements however are associated with inflation or foreign exchange movements and hence adjusted historical price will not be appropriate in all cases.

Average of Tenders: Where historical price is not considered an appropriate estimate of market price, then the average of the initial tenders received may be used. Any anomalous tenders should be excluded when calculating the average, (eg. if a tender is significantly higher than other tenders because the specification has not been clearly understood).

If all of the initial tenders are considered higher than the market price then the average of the final negotiated positions may be used as the estimate of market price, (eg. the initial bids submitted during an auction may be inflated and therefore are not a reasonable measure of the market).

Cost-downs
Cost-downs may only be reported as VI when they have been realised.

Avoidance of Contracted Costs
Where costs that are provided for within a contract have been avoided, (e.g. if a price escalation included in a contract is avoided through contract management), then the cost avoided may be reported as VI.

Working Capital Improvement
Procurement may add value through actions that allow reductions in input inventories, resulting in reduced holding and financing costs. Although the cost savings are perpetual, VI is to be reported on a one-time basis as 10% of the amount of the inventory reduction. The value of the inventory cannot be reported as VI.

Asset Disposals
Where procurement has assisted a business unit in disposing of an asset by increasing the competition for the asset, (eg. through a competitive tendering process) and thereby increasing the price achieved on disposal, then VI may be reported. The calculation of VI achieved in the disposal of an asset may be calculated on a one-time basis as the difference between the price received from the sale and the average of the initial bids received.

Longer Life
Where longer product life can be reliably estimated, VI may be reported on a one-time basis as the average annual value of the estimated reduction in purchases.

Lower Maintenance Costs
Where lower maintenance costs can be reliably estimated VI may be reported on a one-time basis as the estimated annual reduction in maintenance costs.

Labor Productivity Improvements
Where improved productivity has been achieved and a reduction in full time equivalent staff (FTE) can be calculated, then the labour cost of this FTE reduction may be reported on a one-time annual basis as VI. An FTE reduction can result in either reduced staff numbers or the freeing up of employee time that can then be spent on other activities. Where staff numbers have been reduced, VI is calculated as the annual reduction in labour cost, (severance payments are not netted off).

Warranty Claims
Warranty claims cannot be reported as VI to business units. Contracts and transactions are based on the assumption that the items being purchased are fit for purpose and will perform to expectations. Should an item fail to perform and a warranty be enforced, the business unit does not receive any additional value.

Supplier/Vendor Management

One of the most important aspects of the procurement and operating teams work is Supplier/Vendor Management.

There are considerations when selecting and managing our suppliers, new technology and a system approach simplifies the process, which allows informed decisions too be taken quickly. There has been much written regarding Supplier/Vendor Management and to our mind it’s simple process however, requires rigour and commitment in its application.

The underpinning principle is the relationship must be mutually beneficial to both parties and built on trust with transparency in all dealings. I use an expression “our suppliers and vendors are only as good as the customer” therefore as a customer we must take the lead in developing the relationship.   

By building strong partnerships where the suppliers and vendors are full aligned with our business objectives will drive the behaviour which will leverage our cost and performance. It also, provides the opportunity to improve their capability and reduce risk.

Building these relationships does not remove competiveness in the market place as the process and systems approach allows continuous competitive testing for the goods and services by publishing the business supply needs to a web portal which is open to the market. This approach has the advantage of ensuring our strategic partner remains the most competitive. 
We are interested in other views please add a comment..

The difference between Purchasing and Procurement

It is important to understand that while similar they are different, we have been asked a number of times to clarify the difference. Particularly as it relates to the eProcurement systems.

Procurement is the process of identifying and selecting strategic suppliers or vendors, negotiating/establishing agreements and contracts, procuring goods and services.
Procurement is the overarching business process and has a strategic focus that is core to the business and generally includes market outreach i.e. identifying potential suppliers and the examination of supplier capability which includes ownership, reputation, management structures, service delivery, supply chain options, market position.

Purchasing refers to buying goods or services and is the basis of the purchase to pay process and includes receiving the goods or services, verification of delivery and payment. We generally use the term Buyer when referring to the purchasing function, the buying is a way orders are placed, acknowledged by the supplier and receipted for payment. The Buying process is standard methodology and should be applied uniformly regardless of the size of a business.  

Its important to establish business processes that address the procurement and buying [purchasing] functions either manual or via eProcurement. We recommend first understanding your business needs from a procurement system then look at options to implement the most practical solution.

Traditional Sourcing vs Best in Class

We are not saying the traditional ways are wrong, they work well and have stood the test of time however, we need to complement the traditional with Best in Class. Our term Best in Class is deliberate rather than Worlds Best Practice, we are strong believers in the practical application of systems and processes that deliver the buyer the best for their business.

Looking at both goods and services we suggest adding to the traditional some examples.      
Goods and Materials:
Traditional – Price, delivery, installation, inspection testing, warranties
Best In class – Design for safety, downtime reduction, redesign for specific use, consumption modeling, maintainability, performance analysis, inventory costs, usage data capture, product substitution, delay reduction.

Services:
Traditional – Price, installation, mobilisation.
Best in class – Effectiveness of processes, number of service providers, service quality, service delivery safety, resource availability and supplier turnover, environmental compliance, performance scorecards.

We recommend setting up sourcing plans to capture both the traditional and Best in Class. 

Sourcing Value

There is always debate regarding what is the real value of the sourcing activity the first response is normally price point followed by competitive price agreements and for logistics setting up the supply agreements for DIFOT or OTIF.

All of these are elements of value that can be derived however, sustainable value is more likely to be realized by some simple analysis and engagement with the suppliers some examples:

* For materials and goods: giving suppliers visibility of the end use of products so they can assist in identifying improvement or substitution opportunities, e.g. design for safety, downtime, redesign for specific use etc.

* For services: analysing the interaction between service providers and end users to identify improvement opportunities, e.g. effectiveness of processes, service quality, safety etc.

Our challenge as procurement professionals is to capture all the value available. There is also, the concept of Value in Use watch this space for more on ViU.

Pathway to Best in Class Supply Chains

We are often asked what are the steps in best in class supply chains so we have summarised our thoughts below there are fundamentally 5 stages to evolved an optimised supply chain:

Stage 1 Basic Supply Operations – Cost, spend/ savings analysis, supplier management, local leverage, quality assurance, efficient supply operations

Stage 2 Differentiated Supply Tactics – Contract strategy, make or buy decisions & insourcing or outsourcing, regional and global sourcing, commodity focus, cost analysis, regional and global leverage, a good procurement strategy, life-cycle cost improvement.

Stage 3 Supply Chain Improvements – Supply chain strategic competitiveness and improvement teams, process mapping and alignment, supplier input into new products/services, strategic supplier alliances, process improvement, best practices aimed at reducing cycle time, capital employed and total cost of ownership.

Stage 4 Integrated Supply Chains – Enhance customer response, pro-active outsourcing, supplier key strengths analysis, cross-enterprise decisions, supply chain core competencies, world class supply chain links, alliances unleash, improved value to customers.

Stage 5 Optimum Value Chains – Value optimisation, differentiated users/stakeholders, customer value driver analysis, high value adds, new products, maximum value/cost ratio.

Each of the elements require absolute focus to deliver the benefits .

Supply Chain Strategy

Supply chain management from the supplier side includes procurement processes, manufacturing or production management, logistics and transport, purchase order management both with their suppliers and customers, data management and information flows which are necessary to manage and monitor all activities in the supply chain.

To our mind one of the key drivers in the supply chain is Strategic Sourcing it plays a significant role in driving the bottom line creating business value, which has a direct impact on savings however, establishing strategic relationships and partnerships can have a larger impact on the performance of a business.

Robust, efficient and rapid procurement ensures accurate estimates when establishing the strategic relationships and during negotiations. It is essential to improve internal collaboration within a business to ensure there are no gaps in understanding or knowledge of the requirements particularly when applied to contracted services.

Regardless of an organisations size small, medium or large they need to consider investing in the right technologies to help drive the efficiencies creating transparency in sourcing projects that lock in the value. Using the technology and effective negotiation techniques will create an aligned supplier base that will improve business efficiencies and reduce costs.

Don’t second-guess the procurement professional

You wouldn’t second-guess the engineer, or the lawyer, so why do we second-guess the procurement professional. In past 10 years the procurement function has become the key lever in optimizing the supply chain and reducing costs. 

The use of systems and apps to reduce the sourcing cycle time by applying standard process models and at the same time building a library of reusable documents requires a good understanding of how the procurement and supply chain works. 

This requires the Procurement Professional using good process models utilizing practical systems that interface with the data architecture of the business. 

So next time you are presented with a supply recommendation remember the procurement world is a professional business. 

Three steps to improved supply chain

There are always 3 steps to improvement firstly recognizing the need, secondly identifying the solution and thirdly implementing the solution. With the downturn in economies across the world taking cost from the supply chain is essential to protect margins not just smart business, the challenge is to respond rapidly to the changing economic environment to effectively manage the acquisition of goods and services. 

Suppliers are normally responsive to improve the supply chain particularly around the logistics and delivery mechanisms however, there is a reluctance to deliver improvements on the price and margin often for good reasons our suppliers are being pressured by their vendors to maintain margin.  

Using third party systems an applications is part of the solution along with building the relationship with our suppliers and having flexibility in our processes that put competitive pressure in the market that drives the cost and margin improvements. The way we have found to apply the pressure is to open the bidding process not just to preferred or contacted suppliers but also to the entire market, we have been surprised on the price point savings that have been generated.

It is not overly complicated but does require commitment to do things differently.