Money management is increasingly a critical skill for purchasing professionals. You see it in our articles on hedging (page 36 and page 59 of this issue), and in the general areas of finding, getting and documenting savings. It's also evident in purchasing's ancillary role in ensuring that savings hit the bottom line.

First, a little background on getting the savings:

In 2005, the research firm The Hackett Group released a study that showed major gaps between negotiated and realized savings in indirect spend. Sixty-four percent of the study's respondents strategically sourced their indirect spend, but 23% of the sourced spending was bypassing preferred agreements. Sixty-one percent of invoices were nonpurchase-order-based. And there was a 19% error rate on the invoices. The study, say Hackett executives Pierre Mitchell and Chris Sawchuck, showed how poor contract visibility was affecting performance, and how critical money management is.

Separately, research firm A. T. Kearney says that less than half of contracted sourcing savings actually make it to the bottom line. Money is lost due to gaps between the terms of purchasing contracts and the ways in which internal user groups actually make their purchases. In some cases, end users don't even understand contract terms, say Kearney executives Randy Watson and Suman Sarkar. (See their white paper at www.purchasing.com/savings.)

The need for purchasing to manage contracts and communicate with end users is obvious from those findings. But to ensure that savings hit the bottom line rather than being spent elsewhere, purchasing first has to convince finance that the savings are real. To do that, purchasing has to understand what finance counts as savings.

It's probably no surprise that a financial-services firm would be among the leaders in that effort. At Merrill Lynch, Marc Marini, managing director of global sourcing and procurement services, and Kevin Newshan, director of the performance management group, have a formal system for tracking and documenting savings and getting buy-in from finance. The system includes detailed definitions of what constitutes expense reduction, cost avoidance, current-year savings and contract-term savings. The detailed definitions (you'll find them with this column on www.purchasing.com) ensure that purchasing and finance are talking the same language.

Purchasing regularly communicates with finance and asks that group to officially validate all savings. Finance then decides if business units can use the savings elsewhere. There are a lot of savings to consider. In 2007, "current-year" savings that impacted the budget were $132 million.

Medical device manufacturer Boston Scientific has a formalized system too. Vice President of Global Sourcing Karen Weinstein-Millson says indirect suppliers have to document actual savings vs. anticipated savings, and provide transaction-level backup. The information for direct suppliers is within the company's internal systems. When abnormal amounts of noncompliant spend show up, she and her staff drill down to find the root cause, identify the transactions and let the responsible parties know. And, they too rely on independent review by the finance and corporate analysis groups to validate the savings. "We help those making requisitions extend their budget allocations and become more effective," Weinstein-Millson says.

The purchasing staffs at those two companies don't see their role ending when buyers negotiate savings. They know that successful procurement professionals today have to be more than spend managers. They have to be communicators. And, as Hackett's Mitchell says, they have to be money managers.

pteague@reedbusiness.com

Merrill Lynch guidelines for recording savings


Purpose:

To effectively and consistently measure the savings reported by GS&PS and to provide a uniform definition of current year savings and contract term savings while focusing on cost avoidance and expense reductions. The intent is to capture the value that we bring from partnering with our clients in support of the firm's sourcing & procurement requirements. The expertise provided by GS&PS Sourcing Reps lead to improved efficiencies and significant cost savings.


Definitions:

Expense Reduction – savings that directly reduce the current expenses of the firm

Cost Avoidance – savings that decrease potential costs that do not directly impact the budgeted or actual expenses of the firm

Current Year Savings – savings that affect the current year based on when the contract is executed (can include both cost avoidance and expense reduction)

Contract Term Savings – savings over the life of the executed contract (can include both cost avoidance and expense reduction)

Policy:

All GS&PS savings are to be reported within the Frictionless system and all expense reduction savings are to be validated by an APR or otherwise approved by finance via email prior to approval by the Performance Management Group. All supporting documentation for savings should be attached to the project within the Frictionless projects module.


Examples of Cost Avoidance:

Cost Avoidance Savings are calculated by taking the difference between the total value of the executed deal vs. the lowest bid received on the second round of bidding. PLEASE NOTE: It does not matter how many rounds of bidding took place. As long as there are three or more rounds of bidding, the calculation is based upon the lowest bid received on the SECOND round.

NOTE ON BENCHMARKING: If a Benchmark was validated by an independent 3rd Party and we have negotiated rates lower than those resulting from the benchmark study, the rate received is a cost avoidance save to the firm.

Example 1:

RFP issued with initial quotes (this is the 1st Round) received as follows:

Vendor A       Vendor B        Vendor C         Vendor D
$10,000          $9,500            $9,000             $9,750

On the 2nd round of negotiations, revised bids are as follows:

Vendor A        Vendor B        Vendor C        Vendor D
$9,750            $9,250             $9,000            $9,500

On the 3rd round of negotiations, revised bids are as follows:

Vendor A        Vendor B         Vendor C
$9,500            $9,200             $8,900

Vendor C is selected. The final bid represents the total cost over the contract term.

Cost Avoidance Savings is $100, representing the difference between the two highlighted bids above.

If the lowest bid received is not the accepted price, Cost Avoidance savings will then be calculated by taking the difference between the total value of the executed deal vs. the bid received on the second round of bidding from the vendor that won the deal.

Example 2:

RFP issued with initial quotes (this is the 1st Round) received as follows:

Vendor A      Vendor B       Vendor C       Vendor D
$10,000        $9,500          $9,000             $9,750

On the 2nd round of negotiations, revised bids are as follows:

Vendor A      Vendor B       Vendor C      Vendor D
$9,750          $9,250            $9,000          $9,500

On the 3rd round of negotiations, revised bids are as follows:

Vendor A      Vendor B       Vendor C
$9,500          $9,200            $8,900

Vendor B is selected. The final bid represents the total cost over the contract term.

Cost Avoidance Savings is $50, representing the difference between the two highlighted bids above.

For deals that only had one round of bidding, Cost Avoidance savings are calculated by taking the difference between the total value of the executed deal vs. the next lowest bid received .

Example 3:

RFP issued with initial quotes (this is the 1st Round) received as follows:

Vendor A       Vendor B       Vendor C        Vendor D
$10,000         $9,500           $9,000             $9,750

Vendor C is selected. The final bid represents the total cost over the contract term.

Cost Avoidance Savings is $500, representing the difference between the two highlighted bids above.

PLEASE NOTE: For Sole Sourced deals Cost Avoidance savings are calculated by taking the difference between the total values of the executed deal vs. the 2nd highest negotiated price received. (See example in FAQs)

Example of Expense Reduction:

Expense Reduction Savings are calculated by taking the difference between the total values of the executed deal vs. budgeted or actual expense before contract was executed

Example 2:

GS&PS is working on the renewal of a contract with previous impact on expense of $1MM annually. Upon negotiation, the vendor agrees to reduce their fees by $100K in total if renewed for 2 years. 

- Expense Reduction for this year (if total paid for this year) is $100,000. 

- Expense Reduction for this year (if in the month of January, and paid for annually) is $50,000, which represents a full 12 months in the current year. 

- Expense Reduction for this year (if contract start date is July 1st) is $25,000, which represents the sum of 6 months of savings. 

- Contract Term Savings total $100,000.

Frequently Asked Questions

1. Q: Do I claim expense reduction or cost avoidance savings for the life of the project, or just for the first year of the project.

A: Current year saves are reported in Frictionless as an Expense Reduction – Current Year or as a Cost Avoidance – Current Year. The sum of the current year saves added to any saves that will be realized next year and beyond will be recorded in Frictionless as a Contract Term Save.

2. Q: Who do I contact in GS&PS to have my savings certified?

A: In order for savings to be realized and reported, they must be approved by Andrea Hewitt of the GS&PS Metrics and Reporting Team.

3. Q: I negotiated a discount for prompt payment. Can this be counted as Savings?

A: Yes, as long as it is a new discount; we would classify this as cost avoidance.

4. Q: What do we mean by the lowest bid on the 2nd Round of negotiations? How do we calculate savings when there are more than 3 rounds of bidding?

A: The 2nd lowest bid is the lowest price that we received from the vendor that did not win the bid, BUT WAS NEGOTIATED. This only includes NEGOTIATED bids.

Example:

Bidder A       Bidder B            Bidder C
100                90                       90 
                       80                       80
                       70                       60
                                                   50

Savings is calculated by comparing the difference between the executed prices received from a vendor who won to the lowest negotiated price on the 2nd round of bidding. Using the example above, the lowest bid on 2nd round, which is the same in this case from Bidder B or C - $80 vs. the lowest negotiated and winning price which went to Bidder C - $50. The result is a $30 save.

5. Q: How do we calculate savings when most of the vendors drop out of the bidding process?

Example:

Bidder A         Bidder B        Bidder C
100                  90                   90 
                                                80
                                                60
                                                50

The only negotiations took place with Vendor C in this scenario. As a result Savings are calculated by comparing the difference between the 2nd HIGHEST negotiated price, which in this case is - $80 vs. the LOWEST negotiated price - $50. The result is a $30 save.

6. Q: For a BAU service with cost savings – what is the acceptable way to reflect the saving whilst accounting for volume increases (i.e. the total may be rising, but the unit price is coming down.)

A: If the total value is > $250k, and there is an APR, the APR must substantiate the growth in volume. If not, we need an e-mail from Finance approving the increase in volume.

Example 1: Unit Price Reduction of $2, from $10 per unit to $8 per unit. 

                 2006       2007
Volume:    100         200

In this example we have and expense reduction of : 2 * $100 = $200. Had we maintained volumes this is how much we would have saved.

We also have cost avoidance of: 2*$100 = $200. This is the amount we have negotiated down from original spend with the vendor. Even though we have increased our volume, the change in volume of 100 more units is recognized as a negotiated save from the original price which would have been 100*$10, but is now 100*$8 which in turn is a negotiated save of 100*$2.


Example 2: Unit Price Reduction of $2, from $10 per unit to $8 per unit. 

                 2006      2007
Volume:    100        300

In this example we have and expense reduction of : 2 * $100 = $200. Had we maintained last years’ volumes this is how much we would have saved.

We also have cost avoidance of: 2*$200 = $400. This is the amount we have negotiated down from original spend with the vendor. Even though we have increased our volume, the change in volume of 200 more units is recognized as a negotiated save from the original price which would have been 200 more items at $10 each, but is now 200 at $8 each which in turn is a negotiated save of 200*$2.

7. Q: How do we account for savings when we move from a lease to outright purchase?

A: To account for save we compare the total value of the lease to the total value of a purchase. This will represent Contract Term Savings and not Current Year saves.

Example: 3 year Lease @ $1000/month plus residual purchase cost of asset at end of lease vs. purchase @ $32,000. Contract Term Save of $4000 plus the residual payment amount, which represents the difference in total payments.

8. Q: How do we account for a rebate given on an earlier period?

A: If rebate amount is the same year over year there is no savings.
If an incremental increase of $50, i.e. $100 last year vs. $150 this year, then we have a $50 expense reduction.
If this is a new rebate that was just negotiated, then the entire amount we are receiving this year is an expense reduction.


9. Q: If I have a deal that is for more than 3 years, can I take the full contract length for the Term Save?
a. Is there a limit to the number of years?
b. What if a Perpetual Agreement and there is a % reduction across the board, how many years can we go out?

A: If an APR validates the save, you can take the full contract length for the Term Save on a deal that has a >3 year term.
a. There is no limit to the number of years as long as validated by the APR.
b. The limit on a save for a Perpetual Agreement is 3 years.


10. Q: If your deal results in a reduction of space in a facility, space which can now be used for some other project or BU, can this be taken as Cost Avoidance?

A: Yes and No. If the reduction in space represents an increase in cost to another Merrill Lynch Organization or BU, then there is no Save to the firm. The saves will be realized in the reduction of expenses that would have been paid out externally. Therefore, if the reduction in occupied space leads to a reduction in Headcount, then there will be a savings related to salaries and benefits. Occupancy is a cost that is internal to the firm, therefore the firm saves no money by reducing the space utilized by one department and transferred to another department.


11. Q: There are many situations where we do not select the lowest bidder on an RFP because of other areas that the vendor scored highest on. Is there a way to record a save in this scenario?

A: Yes. The save will be the difference between the negotiated price selected and the next highest negotiated bids of the other vendors included in the bidding.

Example:

Bidder A        Bidder B         Bidder C
100                 90                     90
                        85                     80
                        70                     60
                                                  50

In this example the Bidder B was selected due to other variables. The cost avoidance save would be the difference between the selected bid of $70 and the second round of bidding from vendor that won the deal, which in this case was $85 from Bidder B, hence a cost avoidance save of $15.