In our definition, total cost not only accounts for prices paid, but also other factors that drive costs. A simple example that everyone can relate to is printers. The price of a printer (and improvements in that price from competition for example) is only one factor in gauging cost performance. Other factors include identifying appropriate specifications for that printer, ensuring that the “need” is consistent with the defined specifications, managing the total number of printers bought, etc. Total cost can be broken into four key components. These components measure how well an organization is applying various leading practices in managing cost and driving savings. Screen Shot 2015-07-20 at 12.48.25 PM While we discuss these factors today in the context of metrics, any professional can also take these to apply specific actions as they go to market for any product or service. Below we elaborate on each of the four savings metrics of managing total cost.
Prices paid often grabs all the attention, but the truth is that price may be the most basic and incomplete part of managing total cost. Nonetheless, benchmarking prices paid is an important factor that should be monitored and measured. As we illustrated in our other article, price benchmarking must take into account the context of any purchase including the volume, strategic rationale for supplier, industry conditions. For more on how to improve pricing, you can see our article diving into six proven techniques. In terms of the metrics you need for measuring improved prices, you’ll want to employ ones that measure reductions in pricing and the absolute savings achieved as a result.
Though sometimes lumped in with improved pricing, cost avoidance is more applicable to products and services where prices tend to increase year over year. The goal here is to measure how well a procurement performed in managing price increases against what the overall market is showing. In other words, if prices are increasing for the market overall, were we able to do better than the market. A good example of when cost avoidance comes into play is watching the price of oil and similar “commodities” go through inflationary periods. Another example is labor costs for various types of services—we often see year-over-year price increases in these types of spend areas. It’s procurement’s job to make sure the price increases for our organizations are managed relative to a relevant market index. Or even better, we want to manage the price increase to be less than a relevant market index. The most helpful metrics to this end are ones that measure whether price increases are favorable relative to previous contract terms and/or relative to a relevant market price index.
Standardizing specifications across an organization and keeping specs as close to market standards as possible is another way to manage total cost. Both of these are difficult in practice but can yield significant benefit. Metrics for savings due to managing specifications measure how much is saved as a result of identifying alternate, lower-priced products or services to achieve desired mission outcomes. A couple of examples illustrate the point. One federal agency, for express air and ground shipping needs, increased the “on time” guarantee by 2% above commercial standards. When the suppliers informed the agency of the potential cost increase versus the relative benefit, luckily both the agency and suppliers were able to change the guarantee requirement to the accepted commercial standard, saving both the government and suppliers money. Another example, different users may require different amounts of memory, speed and overall computing power for their computers, depending on their jobs. By establishing groups of users based on their needs and standardizing around 3 or 4 models, government can work with suppliers to provide higher volumes and other efficiencies.
Reduction in Demand
Best way to reduce cost is to not buy something. Seemingly obvious, this is one place where we see a lot of waste and a lot of opportunity. Government organization should be working to measure how much total volume of something they are purchasing and whether it can and is being reduced over time, to match real “needs.” Metrics that identify savings from a reduction in demand measure the total savings achieved for eliminating a portion of the demand. In other words, every “unit” reduction in demand represents a 100% savings for that unit! That’ll look good on any report. A common example in the government has been cell phones. One agency, for instance, found thousands of lines that were not being used because users had left the agency. Working with suppliers, they were able to shut down those lines.
What you can do today
Regardless of what your organization is buying, you can start today by measuring total cost.
- Establish clear metrics around total costs, starting with your largest programs and categories.
- Break down the total costs into its many components, including price and the other factors mentioned in this article.
- Identify opportunities where factors can be applied.
- Work with your customers and stakeholders to put an action plan in place.