Most purchasing savings reports are pure fiction.
A bold statement? Yes, but a true one nonetheless. For years, we have deluded ourselves with terms such as “soft savings.” Taking credit for “soft savings” is like congratulating yourself for not paying the sticker price on a new automobile.
The only effective and believable measure of purchasing savings is the purchase price variance (PPV) report. Yes, I know it is oftentimes a report made by a junior accountant with no real knowledge of the market or procurement functions, but I also know it is the only measure of purchasing performance that is listed in the annual report. In the past, supply and procurement professionals have taken two approaches to purchase price variance reports: we have ignored them or challenged them. Neither approach works.
Let me suggest that we should wholeheartedly embrace the concept of purchase price variance. We should do so from enlightened self-interest. For the last 50 years, we have operated in a buyer's market where capacity has exceeded demand. In this environment, purchasing has been uniquely successful in negotiating price reductions year over year. We are now at the start of a long-term seller’s marketplace, where demand is exceeding capacity. Do we honestly believe that we can continue to generate savings year over year?
The role for purchasing in the future will be less focused on generating cost savings and more focused on sustainability of sources of supply and the ability to accurately forecast prices in future periods. I would suggest that we adopt the methodology of PPV and establish our procurement and supply reporting based not on individual price reductions but rather on a market-basket approach to forecasting availability and pricing.
Use the PPV approach to develop a market-basket approach to evaluate the competitiveness of purchasing—not individual item or service savings. An effective solution is to develop a market-basket concept to identify the total impact of competitive pricing. The basket consists of the top 20 to 25 purchase commodities (materials or services), which collectively account for in excess of 80 percent of the total annual externally purchased costs of materials and/or services (excluding interplant and divisional purchases). Like purchase price variance, the approach is based on experience and research plus intuition estimates.
Get an accurate read on your purchasing performance with these steps:
- Track the historical price movements over the reference period (such as the past six months). Plot on a scatter diagram.
- Determine the upper and lower limits of pricing expected to be paid during the future history (or accounting) period.
- Establish realistic estimates of prices in the future.
- Create a specific action plan that measures purchasing’s ability to lower the upper limits and reduce the variation in prices paid in the future period. This is the future target measurement of purchasing.
For each commodity and collectively for the entire basket, statistical process control charts are developed and tracked against the targeted range. The targeted range is developed quarterly by the head of supply and concurred with by the heads of finance and operations. The target range represents historical projections and engineered or benchmarked goals that recognize the estimated total usage.
Sorry, but finance wins and purchase price variance is here to stay. Supply and procurement can only succeed by adopting the PPV approach to a true measure of performance and contribution.
What do you think of purchase price variance?
Do you have a different purchasing savings system you prefer? Let us know in the comments.