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Focus: Sourcing/Procurement

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From SCDigest's On-Target e-Magazine

SCDigest Editorial Staff

Jan.12, 2011

Supply Chain News: Can Procurement and Finance get on the Same Page in Measuring Savings from Supply Management Improvements?

Partial Disconnect between Cash Savings and P&L is Part of the Problem; A Calculation Framework

Calculating the hard value from supply management and procurement efforts is never easy, given the common difficulty in establishing a baseline measure and the numerous external factors that can impact the cost up or down regardless of procurement's efforts.

Still, it is important to make an effort to calculate that value for both the procurement organization as a whole within a company and for individual procurement managers.

One challenge to this effort is that fact that procurement and financial managers are often talking a somewhat different scorebook. While procurement managers tend naturally to think of savings as simple cash improvements, financial managers are often more concerned with the profit and loss statement, using accrual accounting methods.

SCDigest Says:

It is essential to build a value calculation framework that can work for both procurement and finance, one that includes both cash and P&L dimensions.

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But differences between the two perspectives do not have to be fully reconciled to establish a functional relationship and an commonly accepted measuring systems, say Eric Walsworth and David Yungbluth, procurement analysts at Reed Elsevier in London, writing in the CPO Agenda, a publication of the UK’s Chartered Institute of Purchasing & Supply.

"Procurement can gain endorsement of cost and risk reduction activities, and finance can get useful information to deliver profit improvement," as a result of finding this common ground, Walsworth and Yungbluth write.

Establish a Savings Framework and Definitions

It is essential to build a value calculation framework that can work for both procurement and finance, Walsworth and Yungbluth say, one that includes both cash and P&L dimensions.

In their model, savings are effectively captured and reported as the first 12 months of estimated financial statement impacts. The relationships between the types of benefits are summarized by the following equation: Cash = Secured P&L + Deferred P&L on Balance Sheet + Mitigated P&L, as shown in the graphic below.

What goes into each savings bucket? According to Walsworth and Yungbluth, each category of savings in the above formula is defined as follows:

Secured P&L Savings: These represent any instances in which favorable terms of purchase are acquired through changes secured in pricing, mix, demand or quality from the vendor. This bucket is a measure of historical or genmeral market prices/terms versus prices/ terms secured from suppliers through negotiation and other strategic sourcing practices. Secured P&L savings can be further categorized as on-going spend measuring period-over-period improvement, or as a one-time spend. This distinction will provide further insight to finance in understanding the impact the savings may have on current and future financial reporting periods.

(Sourcing and Procurement Article Continues Below)

CATEGORY SPONSOR: SOFTEON

As always, establishing the spend baseline can be challenging, especially for some indirect and much services spend. In these cases, the authors says, procurement and finance will need to make reasonable assumptions, such as starting with the previous 12 months’ spend as a beginning baseline, and remembering that the current budget does not necessarily reflect an accurate spend baseline from which procurement efforts should be measured.

Source: Eric Walsworth & David Yungbluth, CPO Agenda

Deferred P&L Savings: A measure of the benefit delivered to the balance sheet (not the income statement) for the current financial period. Logically, these types of saving will often originate through a capital purchase or a pre-payment scenario. The question is how to capture this as a 12-month cash savings. Savings from spend that is depreciated or amortized should be treated the same as spend that starts on the balance sheet and migrates to P&L over time.

To make this measure work, procurement must team up with finance and have a working understanding of the depreciation/amortization accounting rules for the spend they address.

Mitigated P&L Saving: This includes savings that come from agreements in which favorable terms of purchase are retained in pricing, mix, demand or quality from a vendor. Once superior purchase terms have been achieved, the authors say, much effort is often required to preserve the current level of benefit when it is time to renegotiate.

This catergory of savings is also commonly referred to as "cost avoidance" and is often an effort to protect against inflation, loss of leverage, or adverse market conditions. "Mitigated value should be conservatively quantifiable to ensure the total cash value generated by procurement is credible," Walsworth and Yungbluth say.

Walsworth and Yungbluth note that building better relationships with the financial organization has other likely benefits as well - such as creating a partnership to better ensure the opportunities procurement has created for improving the bottom line are actually realized by the business.

"A united front is necessary to promote approved spending in the business and ensure that the proper channels are being utilised for purchases as needs arise. Neither group can independently employ these critical controls to responsible spending," they say.

Do you like or not like the procurement value model? Is the difference between cash savings and the P&L an issues for working with finance and calculating procurem,ent''s value? Let us know your thoughts at the Feedback button below.

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