An alternative approach to cost reduction

22 January 2013
We might expect businesses to take every opportunity to deliver stretching and sustainable cost reduction, never more so than in times of austerity. Purchasing managers I have met tell a different story. Most have cost reduction objectives and many receive bonuses based on it. The target set is often 5 per cent, which is hardly stretching, on the basis, presumably, that 10 per cent seems too much and 0 per cent is not a reduction. Salespeople have also asked me: “What is this 'buyer’s 5 per cent' we are asked for?” Sellers often respond by adding 10 per cent to their price so that they can take 5 per cent off: the target is achieved, everyone gets a bonus and the price goes up. Knowing what could be achieved, it is frustrating, but not surprising, when purchasing managers say they are happy to take the benefits over the longer term, in a steady flow. A business that measures its procurement team on delivering the budget has set the rules and the buyers are playing the game. If they are rewarded for delivering 5 per cent each year, they have no investment in delivering 15 per cent in year one. They fear they will have to achieve gains in year two and year three against a lower base and the business will have wiped off any credit for the dramatic improvement in year one at one minute past midnight on the first day of year two. So what is the alternative? Suppose the procurement team was given the licence to deliver over a four-year period, with an absolute requirement to deliver a minimum (to support in-year competitiveness), but with an over-arching goal to deliver against a total present value over the period? The benefit of delivering 5 per cent year-on-year over four years equates, on a present value basis, to much less than 20 per cent. Based on a discount rate of 8 per cent, a 5 per cent year-on-year saving represents a cumulative benefit over the four-year term of 11.4 per cent. Delivering 20 per cent all in the first year has a very significant additional effect on cash flow and in-year profitability. It will make a significant difference to the business’s ability to invest and to grow and, in a difficult climate, may save the jobs of a number of people. It is understandable that businesses wish to see regular improvements within the planning cycle. A minimum delivery should be targeted. 5 per cent may be a good minimum to set. In our alternative approach, the value of bringing forward savings from future years would also be recognised. By setting a cumulative target, a step change in performance may be achieved. Instead of the target being set as 5 per cent in each year of our four-year cycle, the target would be to achieve a minimum of 5 per cent of the year one opening cost base on a cumulative basis at the end of each year. This will encourage the consideration of projects with a longer delivery timescale. This approach requires a regular mature dialogue within the business. The procurement team needs to be able to maintain an up-to-date forecast of probable outcomes and the business needs to recognise substantial over-achievement may not be possible in every year. Buyers should continue to establish underlying costs and to drive a continuous programme of waste elimination. A professional buyer should be able to demonstrate not just that prices are reducing, but that there is a constant process of reducing costs, which supports the sustainable profitability of suppliers and competitiveness of buyers. Improvements in total cost of ownership should also be recognised as a better measure than simple cost reductions. ☛ Rod Lewis is consulting director at MaguireIzatt
Darmstadt-Dieburg, Hessen (DE)
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Brussels, Belgium
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