Download pdf - August White Paper 1/2015: Getting a Better Grip on External Spending

GETTING A BETTER GRIP ON EXTERNAL SPENDINGAugust Whitepaper

ESPM WHITE PAPER BY AUGUST JUNE 2015 2

Traditional savings reporting and accounting keep business owners and finance in the dark about external expenditure development. It doesn’t have to be that way.External spending represents 50-80% of a company’s cost base, but most business owners and finance departments know very little about it beyond the accounting breakdown.Unlike the top-line (contracts and orders, volume and price, customer and product mix, and sales pipeline) or personnel costs (headcount, recruitment plans, salary costs, and fixed-term contractors), very little information about external expenditures is visible to the CFO and senior management. As procurement people sometimes joke, if you want to know what your company bought, ask your suppliers. The problem is structural. Finance sees the accounting breakdown of external expenditures, but it doesn’t see purchases from a supply market standpoint, and it can’t track why costs in individual categories are rising or falling. Procurement, meanwhile, can only follow the cost development of sample items and expenditure categories but has no easy way of taking a larger view.These two overlapping blind spots make many questions about external expenditures that sound simple, such as why did external expenditures go up last year? or why can’t I see the claimed savings on my P&L?, extremely difficult to answer.Having so much spending hidden from view hurts the company in a variety of ways. Business owners face difficulties understanding their past results and forecasting their future results. Savings contracted with vendors are rarely realized with full-effect to the bottom-line. Finance has a much harder time planning. Lack of transparency may also lead the company to seek perverse savings, such as marginal cost reductions in a category where supply quality and availability are matters of life or death for the business. Indirectly, vendors and customers suffer too, from jerky orders and uneven fulfillment. Most seriously of all, this blind spot means that most companies have only some assurance that they have paid the right price for something, and almost none about whether they bought the right thing.

UNDERSTANDING EXTERNAL EXPENDITURES

Simple questions such as why did external expenditures go up last year? or why can’t I see the claimed savings on my P&L?, are often extremely difficult to answer.


August’s External Spending Performance Management model can shine a light on these blind spots. ESPM can give Finance and business owners greater visibility on expenditures that are currently hidden, and help ensure that Procurement is buying so as to fulfill the company’s business objectives in the most strategic way. Implementing ESPM is a three-step process:

1. Build a common view of external spending.The first stage of ESPM involves creating an integrated understanding of all external expenditures. This is often surprisingly difficult. At most companies, Finance and Procurement have distinctly different views of ex-ternal costs. Finance works over the fiscal year, Procurement over pro-rated 12-month periods. Finance considers mostly the overall expenditure, but Procurement focuses on changes in renegotiated contracts. The financial view is exhaustive, while Procurement’s is sampling-based.It gets even trickier with Capex purchases. Procurement might look at the purchase price of a generator, for example, but Finance will account for the purchase over the years of its useful life. To make matters more complicated still, subsequent refurbishments or bolt-on modules may change the value and useful life in accounting terms. To gain clarity, we recommend that for the purposes of this exercise, Finance officers take off their green visors and focus exclusively on purchase prices. Obviously this won’t always make sense, but we find apples-to-apples comparisons make it much easier for cross-functional teams to evaluate purchases together. Simply reconciling the different viewpoints can go a long way toward enabling the company to make more strategic purchasing decisions.

2. Select the metrics. Financial measures:Next, we disaggregate the non-negotiable factors, such as currency rates and underlying commodity prices, from the drivers the company controls, such as volume and price. This helps create more transparency to the drivers of external spend and reveal the true results of procurement efforts, such as the price component of the waterfall chart shown in Figure 1 (p. 4).Obviously there are some practical challenges in building a waterfall chart of external spend development. Typically, we can find proper price/quantity data for just 20% or so of the overall expenditures. But dealing with imper-fect data is not a major obstacle to adopting ESPM. When we lack price and quantity data (e.g. due to lack of or incompleteness of purchase orders), we can still build logical volume proxies using the available information.For instance, the financial executives of one major European passenger train company had been trying to find a way to get a better grasp of its

ADDING EXTERNAL SPENDING PERFORMANCE MANAGEMENT

Dealing with imperfect data is not a major obstacle to adopting ESPM.


cleaning service bill. They had no proper price/quantity data available from the purchase orders, but they knew the total amount paid to the cleaning service providers. They also had data on two key demand drivers, kilometers driven and number of passengers per route. Introducing this new measure, euros per driven passenger kilometer, brought improved visibility to their cleaning expenses. Even more importantly, this new measure changed their entire view of cleaning -- and ultimately saved the company millions. Previously the supervisors had sent workers from the external janitorial service to clean every train after each run, regardless of how full the train had been. After the introduction of the new measure, supervisors changed the cleaning frequency and also the way passengers were seated in more lightly travelled train routes. (See sidebar 2 on page 10)The specific measure will depend on the purchase, of course. Depending on the purchased product or service, cost per employee, square meter, or machine hour may be the right measure. In any case, picking the right ratio makes all the difference. The right price/quantity by proxy, as we call it, will be simple and scalable but also intuitively understandable to Procurement and the company at large. Once we identify that KPI, it becomes much easier to see where costs are increasing and to renegotiate contracts to pay for the value that actually matters and not, for instance, re-cleaning clean train cars. Non-financial measures:However, having the financial transparency on spend development and its drivers is still not enough. ESPM approach uses complementary, non-fi-nancial measures to ensure that sourcing efforts are aligned with the overall business objectives. While this sounds like common sense, we often see in practice that companies with very different business objectives are having identical sourcing KPIs. This should not be the case.

A) Exchange rates differences between purchase and reporting currenciesB) Purchase volume differences from one period to the other on recurring purchases onlyC) Paid price difference on recurring purchases only = Purchasing performanceD) Accounting for market realities and changes in the underlying raw material prices

Fig. 1 : External spend waterfall: building transparency to the drivers of external spend

A) Currency

External spend

Year N Year N+1

External spend

B) Volume C) PriceD) Market

“However, having the financial transparency to spend development and its drivers is still not enough. ESPM approach uses complementary, non-financial measures to ensure that sourcing efforts are aligned with the overall business objectives.”

5ESPM WHITE PAPER BY AUGUST JUNE 2015


For example, a global fashion retailer H&M focuses on seasonal collec-tions. Its competitor Zara’s strategy involves stocking fresh designs on a weekly basis. Considered in traditional sourcing terms, H&M is far more efficient, but an ESPM analysis shows that both strategies are defensible.H&M can use suppliers from lower cost-countries, undertake competitive bidding processes and supplier selection, and drive savings in external spend. Zara’s business model, on the other hand, cannot afford long de-livery times from low cost countries or time-consuming bidding processes and renegotiations. Inditex, Zara’s holding company, emphasizes supply chain agility, delivery accuracy, and short lead times from the drawing board to the rack. How does this strategic difference change each company’s approach to managing external spending? H&M can have a stronger focus on savings, but Zara must prioritize other metrics, such as delivery time and accuracy, that better support its business objectives. ESPM can be applied to other kinds of business challenges as well. For example, a flavoring business that offers high-volume, low-cost flavor blends to the prepared food industry might focus on creating economies of scale by trying to cut the number of active ingredients to improve scope and scale advantages. Executives would probably want to reduce the number of chemicals used in a compound (a major driver of complexity, not only in procurement but also in supply chain and production), and build a low-cost Asian sourcing strategy. ESPM would help them achieve these goals by tracking two simple metrics: number of ingredients in each formulation, and percent of spending allocated to low-cost countries. As these examples show, the metrics must be carefully thought through so that they support the overall business objectives and ensure that the most strategic issues are being discussed by the key stakeholders, including Operations, Procurement, and Finance. In the case of the train company, for example, the new metric not only led Procurement to renegotiate its contracts but also facilitated much improved cross-functional discussions on how to use the train car capacity in the most cost-effective way.Unlike most pure procurement-focused approaches to external spending, ESPM focuses on the underlying intention of the payment, not just the cost of the good or the service. An ESPM practitioner does not ask, did we get the cheapest widget?, but did we get the job done in the most cost-effective way?

3. Manage the performance.The management practices from target setting to performance follow-up must recognize the cross-functional nature of external spending. While the procurement function facilitates spending, it’s the budget owner who makes the ultimate purchase decision and consumes the product or service.Clarifying their respective roles is the first step in defining responsibilities, establishing targets, and measuring results. With Procurement entrusted with finding the right products and services at the right price, and the business units in charge of paying for them and consuming them, it make sense to introduce planning that incorporates this common-sense division of responsibilities.

Measurement has to be carefully thought through so that it supports the overall business objectives and ensures that the most strategic topics are being discussed between the key stakeholders.


Once ESPM performance management practices are implemented, external spending is no longer a “black box,” but a mathematical formula with an input, an intuitive cost metric, and an output. Not only do forecasts become more accurate, but when a shortfall does occur, the company can diagnose and correct its causes. With ESPM, leaders from Operations, Finance, and the business units are much better equipped to review past financial performance and project future needs, discuss their sourcing requirements and set priorities for cost savings in the coming year. As a result of these cross-functional discussions using ESPM, the business might redirect purchasing volume to approved vendors and SKUs, alter ordering practices, or initiate new sourcing cases with Procurement. Procurement might revise its ongoing sourcing cases, re-prioritize, and revise the scope or targets of planned cases. In the end, Finance has a clearer view of the future, and is able to make projections based on expected volume and price development.

1. Procurement function can control external spending only to a certain extent by

- Negotiating contracts (only covering part of the total spend)

- Agreeing prices and other terms

2. Development of total external spending is influenced by many stakeholders

- Business, sales, production and other functions eventually decide what is bought, how much and from whom

- Financecaninfluencetheimpact of currency rate or commoditypricefluctuations

Fig. 2 : Managing external spending: not the responsibility of one but of many

Production

Sale

sBusiness

Finance

1. External spend under Procurement function’s control

- Contracted volume- Contract terms

Volume Items

Currency ratesCommodity prices Suppliers

2. Total external spend

Example situation - CFO explaining the spend development to investors“This morning on CNBC we’re talking to Daniel Leader, CEO of Performance Corp., and his CFO, Emma Control…Daniel, your business has been doing pretty well since last year’s merger. We’ve seen year-on-year growth in Q3 of 12% in a market that’s grow-ing at less than 10%. Profits have not grown as fast as expected, though. Can you explain what’s going on here? What happened to the cost-saving synergies you guys promised?”“You are right, Alisa. Our top line growth is spectacular and I am very pleased with how customers have reacted to the merger. We do not expect any significant churn on our client base. When it comes to the bottom line we are progressing well on many fronts too. Let me pass this on to Emma, our CFO. She’ll provide you with a super-clear picture on what’s going on with our external spending. Right, Emma?”“Thanks Daniel. Alisa, as you have noted, our profitability has not developed as we hoped, since our external spending has increased faster than our top line, 14% year-on-year. Overall, purchased volume growth has gone up year on year by 11%. Our currency exposure due to the new markets we bought from cost us 1% year-on-year. But what really hurt us in this reporting period was the commodities market, which nicked another 4% off the top. Once you factor out those headwinds, you can see our procurement team has done an excellent job in beating the market, generating a year-on-year price reduction of 2%.”“Daniel, Emma, thank you for coming on CNBC today. It was good to have you with us. We were speaking to Daniel Leader, CEO of Performance Corp and his CFO, Emma Control.” Would you have a similarly credible explanation if a reporter asked you that question? Most CFOs lack transparency of their external expendi-tures and its drivers, but if you implemented August’s External Spending Performance Management model, you would be able to answer with the same assurance as our fictional CFO.

SIDEBAR STORY 1



Attaining this level of visibility is not easy, even with ESPM expertise. Suc-cessful and sustainable change in this domain demands strong sponsorship at the very top. These sponsors must send a strong signal that ESPM is not primarily a procurement savings measurement, but a strategic approach to better measurement and management of company’s external resources. ESPM can yield extraordinary results if pursued diligently. It is a mode of challenging old habits that creates lasting value for the company, the investor, the supplier, and ultimately the customer.

TAKING THE FIRST STEP

ESPM can yield extraordinary results if pursued diligently.

All Aboard – Implementing ESPM at a rail transportation companyWhen the government of one of the world’s largest economies needed to reduce its deficit, it turned first to business enterprises it controlled. As one of the largest and most visible employers in the country, the transportation company was among the top candidates for the government cost containment program. To meet the challenge, the company decided to create a new pro-curement controlling function out of a core cross-functional team drawing from Finance, Control, Purchasing, business units, and a series of other functions that would participate on an as-needed basis. This new External Spending Board would report to Procurement and Finance, the latter having ultimate responsibility.The External Spending Board’s project was to take place in multiple phases, each addressing a number of procurement categories, and in total covering 80-100% of the total external spend.

Phase 1: Setting the ground rulesThe External Spending Board began by setting the following ground rules for its work:

• Truthfulness: the goal of measurement is to track movement in external spending from one period to the other

• Recognizability: measurement could not be carried out solely in the language of Finance or Procurement but needed to be clearly understood by all the relevant business units

• Sustainability: a better procurement and budgetary system is the goal, not quick cost savings

• Pragmatism: data limitations are not allowed to become an obstacle, multiple approaches can be used to enable spend visibility

The External Spending Board found agreeing on a financial method relatively simple. Metrics for spend development, however, proved a bigger challenge. After taking stock of the available data, board members realized they would need to build systematic metrics of spend development. Unfortunately, although detailed price quantity

SIDEBAR STORY 2


data existed for most categories, they soon realized that price/quan-tity measurement would have to be complemented by a proxy-based approach that would substitute missing volume data points with cost drivers. To better track its train cleaning bill, for instance, the company developed a new measure -- euros per driven passenger km -- for cleaning services, a major component of indirect spending.

Phase 2: Chasing the cost driversIn the second phase, the External Spending Board started to im-plement the cost-driver approach. Identifying cost-drivers forced the team to understand the ultimate results the users of products or services intend to achieve with the purchase. Understanding the category strategies and their practical execution not only helped the board see the costs more clearly, but gave them a new set of KPIs they could use in parallel to the pure cost measurement waterfalls, which taken alone told only part of the story.The end result was a coherent dashboard with waterfall charts built for each category that could show the company’s total external spend development. These analyses could be taken all the way down to article levels, providing full transparency of performance. The group level dashboards were built up from category views that had not only the spend development charts but also the complementary KPIs. They provided a complete story that could be discussed between group functions and business units, and eventually taken to the external contractors for more cost-effective contracts.

Phase 3: ForecastingNow in its second year, the company’s new external spending per-formance management system is still a work in progress. Today, however, management and relevant stakeholders have an advantage: a single view of the company’s external expenditures. In the next step, the External Spending Board will advance from measuring to forecasting, and place a greater emphasis on planning and directional setting. The company’s ESPM journey is far from over, but multiple parts of the business are now, little by little, becoming more strate-gically and operationally aligned with management’s overall aims.



Tomi Ere is a partner at August. He specializes in strategy-driven trans-formations and also has a strong background in strategic sourcing programs. He can be reached at [email protected] Lehtonen is a director at August. He is a specialist in performance management and strategic sourcing, and leads August’s ESPM efforts. He can be reached at [email protected] Saporito is a senior advisor at August. He is also the founder and CEO of SpendLead, Inc., a B2B engagement platform. Previously he served as CEO of Sievo, and as a management consultant at The Boston Consulting Group and Booz Allen Hamilton.

About AugustAugust is a leading management consulting company in Finland. Our client base consists mostly of large companies and major private equity investors and their portfolio companies. We serve our clients in a broad range of topics covering Strategy and M&A, Operations, Sales and Marketing, and Organization. Our team comprises more than 20 professionals with a perfect mix of experienced seniors with extensive background in consulting and young talents with outstanding academic records from top universities.

ABOUT THE AUTHORS