Cost savings can be generated through either cost reductions and/or cost avoidances. As purchasing and sourcing professionals, it’s easy to measure and report cost reductions because the baseline cost (forecasted/expected) and actual cost figures are readily available. For example, your anticipated spend for a printed circuit board assembly is $100 per board ($10,000 annually) and the actual spend is now $75 per board assembly due to strategic sourcing, so a cost reduction of $25 or $2500 has been achieved and success is easily measured.
As another example, let’s say a commodity with a variable cost structure like electricity was $100,000 last year and estimated to be $150,000 this year due to a surge in gas prices; however, because of strategic supplier selections and the use of negotiated alternative energy credits, the actual cost of electricity turned out to be $120,000. So, although the actual raw cost was $20,000 more than the previous year, the cost avoidance came out to be $30,000 which you should take credit for.
As the example above demonstrates, cost avoidance measures are any actions or countermeasures you or your organization have taken to avoid incurring higher costs in the future. They represent potential increases in costs that are averted through specific preemptive actions, such as the alternative energy credits. Unlike hard cost savings, which are calculated as the difference between current and prior year spend for the same or similar repeated purchases, there’s certainly room for bias and approximation when assigning value to cost avoidance activities. Therefore, procurement departments should clearly define a mutually agreed upon approach to calculating cost avoidance with other departments such as finance and corporate leadership to fully realize its value.
5 Methods for Capturing Better Cost Avoidances
1. Continuous Improvement Savings
Remember the 8 areas of waste in Lean: Defects, Overproduction, Waiting, Non-Utilized Talent, Transportation, Inventory, Motion, and Extra-Processing. Signing long-term contracts with continuous improvement savings requirements. These are often provisions in contracts requiring the supplier create ways to reduce the total cost of a component or service through the use of standardization, labor reduction, or other lean practices.
Identifying substitutes that perform the same form, fit and functions at lower cost, or at the same cost with increased quality/efficiency. Some of the best cost avoidances, due to substitution, have been achieved through collaboration with a supplier resulting in the ability to produce a functionally equivalent specification that is more economical. For example, replacing a high tech $400 camera with a Go Pro for $200. Substitution cost avoidances are very easy to substantiate (Original product cost – New product cost) * Quantity = Cost Avoidance.
3. Price Guarding
Delaying price increases or slowing the rate of price increases with price guards. For example, if forecasts for the energy and gas index are projected to increase, then include provisions such as tax credits, use of alternative energy or even a price ceiling.
Negotiating prices that are lower than initial quotes. This is usually employed for one-off, high-dollar amount capital expenditures (technology or fixture investments), as opposed to repeated operational expenditures.
5. Value Adding
Including additional value-added goods or services free of charge to a contractual agreement. For example, when quoting on a large piece of business, the supplier can also include delivery, installation and/or free maintenance services for a year.
The tracking and reporting of cost reductions and avoidances are critical in showing the impact of your work in the purchasing department. As a purchasing professional, it’s your role to identify cost avoidance opportunities, and it’s also your responsibility to quantify, document and present the numbers. Once the avoidances are captured, share your results with team members to help optimize purchasing strategies for your organization, producing more cost avoidance success and larger margins that contribute to the bottom line.