As a purchasing function, procurement is in the spotlight when it comes to saving money within an organization. One of the primary metrics that procurement uses to track success is cost savings. More and more, businesses are looking to cost avoidance strategies to continue optimizing once maximum cost savings has been achieved.
Cost savings vs. cost avoidance
Cost savings happens when you reduce what you are paying and therefore improve financial gains for the business. Cost avoidance, on the other hand, occurs when you can simply remove the need for a cost altogether. Rather than spending less, you avoid a cost. Cost savings and cost avoidance both share the same goal of reducing expenses.
Cost savings is often referred to as hard savings, whereas cost avoidance is usually coined soft savings.
- Cost savings: Hard savings is often considered to be easier to track. Hard savings refers to a reduction in the purchase price of an asset. This metric is easy to track by simply calculating the difference in price for the asset after you have negotiated a reduction in price.
- Cost avoidance: Soft savings is more difficult to determine as the monetary gains often come from categories such as legal fees, accounting costs, banking, other associated fees along with ongoing maintenance and other risk mitigation measures. This metric is harder to quantify due to difficulty with forecasting. Although not seen on an invoice, soft savings is frequently a part of improvement initiatives and is often a valuable way to keep a project growing once maximum savings has been achieved.
A cost savings vs. cost avoidance example
A company was paying for HVAC maintenance service for part of their critical system infrastructure. They had been using the same provider for years because the business unit owner claimed to have expertise that couldn’t be found elsewhere. They were paying $5,000 per inspection every month. This was built into their annual budget of $60,000 per year.
A new CPO came on board who wanted to engage in a go-to-market sourcing exercise with the business unit leader. They discovered that they could move to a new qualified vendor who would charge only $4,000 per inspection. The move would equate to a $12,000 per year cost savings or 20% reduction in budget. Additionally, it was found that inspections would only be needed once every two months, thus reducing the cost by another $24,000. In this scenario, the company could book a cost savings of $36,000.
From a cost avoidance perspective, there is additional value to be provided through ongoing maintenance. By paying the $24,000 a year for maintenance, the company was ensuring that they were not going to have a $100,000 or higher future expense to replace an expensive piece of equipment, but could also result in loss of profit if it caused delays or shutting down of the production line, spoilage of product, etc.
Strategies for cost savings and cost avoidance
Both cost savings and cost avoidance offer the potential for enhanced value. Procurement teams specialize in cost reduction, but also identifying places where cost avoidance is more effective and can provide extra value.
Cost savings strategies
Cost savings is the key metric when it comes to financial reporting. Reductions in the price of an item are not only immediately noticeable, but also easily quantifiable and visible to key stakeholders. This may involve reductions in projected costs, staff time, materials, equipment, etc. Other cost savings can result in volume reductions by lessening the amount of goods or a service needed, also frequently referred to as demand management.
Here are other ways procurement teams often engage in cost savings:
- Contract renewals: Cost savings often come from contract negotiations and renewals where a lower fee schedule is agreed upon, often as the result of a long-term agreement or negotiation of discount points. Locking in a longer contract also locks you into a lower fee schedule for the duration of your contract.
- Strategic partnerships: Another way to cut costs is to engage in strategic partnerships such as using a cloud option instead of on-premises infrastructure or switching to a lower cost supplier.
- Forecasting: Using historical numbers as a baseline allows you to predict your needs so that you have anticipated supply needs in advance and are not faced with overages or rush costs.
Strategies for cost avoidance
At a high level, cost avoidance involves actions that lower anticipated increases in expense for future needs. This could involve the following:
- Preventative maintenance: By incurring a small monthly expense to maintain equipment, you prevent catastrophic mechanical breaks, employee accidents related to equipment failure, repair or replacement costs, and loss of operational gains due to failure.
- Improved efficiency: By identifying better processes or supplies, you can lower costs through enhanced efficiency. An example might involve replacing LED lighting in your facilities to reduce the cost of light bulbs.
- Value adds on contract: Rather than negotiate price, procurement teams often identify value adds that help to avoid other costs. This might come in the form of extended warranties or maintenance on fleet vehicles or industrial machinery.
Measuring procurement’s performance with a single source of truth
There is often misalignment between finance and procurement when it comes to measuring added value outside of cost reduction. In order to create greater collaboration and the ability to show where value is being created, you need a single source of truth for all procurement activity. This solution should house everything from sourcing engagement, sourcing pipeline, negotiation details, contracts and their renewal status, as well as any other cost avoidance activity.
How can you ensure that you are accurately measuring the success of procurement? Begin by establishing a baseline for each procurement activity using historical data, low/mean/high RFQ, along with pricing data, also utilizing industry benchmark data to help inform your analysis. Identify how you will measure each metric and categorize activities under divisions such as cost savings, cost avoidance, or segmented parts. Also, make sure you can tie each activity back to a specific business unit and budget holder.
Integrate single source of truth into technology stack
More and more, businesses are leveraging enterprise systems to consolidate data across the organization. Currently, procurement technologies that support a single source of truth and insight into the sourcing pipeline are difficult to come by. However, if organizations truly want to get the value from insight into procurement activity, that single source of truth needs to integrate with other major platforms.
Per Angusta supports more than 30 integrations with major P2P, ERP, and S2P technologies that allows for visibility into procurement activities and the tracking capabilities to identify hard savings and soft savings.