Redefining Procurement: Non-Labor Cost’s Growing Impact on the Bottom Line

Construction worker

We already covered a few of the highlights from Proxima’s latest report, Corporate Virtualization – A global study of cost externalization and its implications on profitability. The study, perhaps not so ironically outsourced to a third party (FTI Consulting) who conducted it on Proxima’s behalf, found a clear trend line between 2009 and 2011 around labor cost and non-labor cost (both as percentages of revenue) in companies around the world.

Based on data from 1,954 organizations, the study found that labor cost as percentage of revenue shrunk from 13.6% in 2009 to 13.0% in 2010, settling in at 12.0% in 2011. Contrast this with non-labor cost as a percentage of revenue that started at 66.2% in 2009 and rose to 67.6% and 69.9% in 2010 and 2011, respectively.

My colleague Peter Smith and I were approached with some of the previous data when Proxima conducted the survey only on UK companies. Proxima later had the chance to look at some of the global data that came in, and Peter and I agreed to write a foreword to the report based on the importance of the findings. Here’s are quick summary analysis:

Proxima’s study demonstrates that, surprisingly, on average
70 percent of an organization’s revenues are used to buy goods or services from suppliers. It also leads to some interesting conclusions. First, a reduction in third party costs has a much greater impact on the bottom line than the equivalent reduction in staff costs, which account for a far smaller element of the total cost base.

But most importantly, the findings highlight just how fundamental suppliers are
to key business drivers – including revenue growth and differentiation (through innovation, and product or value improvement), margin improvement, risk management, corporate social responsibility, and working capital management.
If 70% of a firm’s revenues are spent with suppliers, then business success must be related to and conditional on the performance of those suppliers.

Looking at the scope and procurement takeaways from the findings, Peter and I note that:

[The study explores] the strength of this trend to externalize costs, and explains perceptively why this has come about … this report should be a wakeup call to every business. Put simply, when managed well, suppliers are key assets that can create value and bring success for you and your business. But when oversight fails, they can introduce risks that go unchecked by any existing controls or management structures.

So if you are not doing so already, you should ensure that effective strategies for selecting, choosing and motivating suppliers, and managing the contracts associated with their work, are in place and successfully executed with as great a zeal as the management of internal resources and expenditure. And of course, that also requires businesses to have the skills and knowledge in place to achieve this.

We must look at this report as an asset to the industry – not just a wake-up call to consider handing off the procurement role to a third-party firm potentially more qualified to manage the function (perhaps one of the goals of the report’s sponsors, given their focus on procurement outsourcing!) Indeed, just looking at the EBITDA impact of the role of suppliers on the business should be enough to convince even skeptical executives of the importance of the function on a relative basis to labor cost expenditure. For example, the study claims that “if all the companies [in the analysis] reduced labor costs by 1 percent, they should be able to raise EBITDA by 0.7 percent (totaling $21 billion USD across these organizations).”

Contrast this with external expenditure: “Addressing non-labor costs by 1 percent would increase EBITDA by an incredible 4.1 percent - almost six times greater (totaling $115 billion USD).”

If that’s not a rallying cry for redefining what procurement is and how much attention we give to it, I’m not sure what is!

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