Why the Procurement ‘return on investment’ headline isn’t enough to justify more resource

For someone with 66.6% (recurring) of a Maths degree, and who considers numbers to be fun, I can be really stupid sometimes. So I’m writing this wondering whether everyone who reads it is going to go ‘well, duh, of course, what an idiot.” Or whether a few people at least might think –“yes of course, but actually I hadn’t really thought about it like that.”

We often hear CPOs and similar talking about the return on procurement investment, including people. The discussion usually goes along the lines of, "I have 50 procurement staff, total cost is therefore, say £5 million to run the function, and we save the organisation £25 million a year. So that’s a return ratio of 5:1."

Now an obvious thought from this is that, if the return is 5:1, then why wouldn’t the organisation spend more on procurement, and get some more of that return? Even accepting diminishing returns, you would think a little more investment would pay off.

But the point that hadn’t struck me before is that the diminishing returns have almost certainly come into play already within the current situation. It is fair to assume that if we were building a procurement function from scratch, we would focus attention first on wherever we could get the best return – the most rapid savings or value improvement.

So let’s look at a simple model, just to illustrate the point. Assume a small business has a function with just five procurement people, each costing £50,000 a year and that each one brought a little less benefit than the last – not unreasonable given that obvious strategy of focusing on high return.  A table of cost and return might look something like this.

Person

Benefit delivered (annual £’000) Cost (£’000) Cumulative benefit (£’000) Cumulative cost  (£’000)

1

500 50 500 50

2

350 50 850 100

3

250 50 1100 150

4

100 50 1200 200

5

50 50 1250 250

TOTAL

£1,250,000 £250,000

You can see the point. The fifth person is just worth employing, just covers their cost – in fact, employing four would show just as good a net return as five. Diminishing returns means you would not take on a sixth person. And yet, the overall return is 5:1 on the procurement function!  So clearly, having that sort of return is not a strong enough argument in itself for more investment in procurement. The next person recruited would probably not cover their costs.

This also arguably explains why, even when procurement is showing a decent return, Boards are not shy about insisting on cutbacks at times.  I’ve always thought it was because they don’t believe the savings we put forward, and that may well be the case, but this shows that perhaps they’re also very savvy about the marginal costs and benefits of procurement effort.

Interesting? Blindingly obvious? Something you’ve understood for years?   Let me know what you think!

Voices (4)

  1. Ger Clancy:

    While I do get the mathemathical logic of the example, if I was responsible for this dept, before worrying about hiring an additional employee and going into negative return, I’d be examining what can be done to raise the productivity of the existing employees.

    I’d be looking at what duplication or multiplication of effort have I got that’s already bringing little return. I’d also be considering options for lowering costs outside of the control of the staff themselves. I’d want to automate as much of my purchasing as possible, and I’m conscious this may not considered an achievable goal by the majority of smaller businesses.
    These are enterprises who may already trade electronically with a number of larger partners. While they see this trade as economically vital, they also know that it is generating back-end costs where purchasers are having to manually re-do many tasks in multiple systems, reducing their productivity, and introducing errors and associated costs. If asked, they could well think “standardisation” back onto paper would be desirable.

    Specifically I’d be looking to the electronic trade interoperability of the PEPPOL standard to address this. I believe that the next months will see PEPPOL becoming a key player both in European electronic trade and beyond. As the NHS begin to ramp up for adoption, their supply chains are going to very likely be compelled to do so too. Thus many enterprises of all sizes and in all sectors may find themselves joining (or having to join?) PEPPOL in the near future, and will probably initially perceive this as “just another format enforced by a bigger partner”

    Is there anything else “in it for them”? And if it does happen as above, why should any business not affect by the NHS care?
    PEPPOL is available to anyone who wants it today, though the region with the biggest volumes of trade are still the nordic countries. As potentially many more UK businesses join up, then many smaller businesses will begin to find their trading partners are now “on PEPPOL” – even those smaller businesses who they would never have dreamt of trading electronically with in the absence of PEPPOL.

    So, if you find your company being compelled to join up… be happy. And if you’re still reading this far, then you’ll hopefully understand that there is something in it whether being forced or not.

    Now what about that other purchaser I needed to hire???

  2. RJ:

    A nice summary of one of the key factors in the “why we never get the recognition we deserve” argument. Paul and Alun also make good points – you won’t get double the return by employing two people to manage your stationery spend so why would you just stick more people in a function to manage more of the same?

    Overall, it adds more to the argument screaming out that we have to offer more than just cost-cutting as our USP.

  3. Alun@MarketDojo:

    A very nice point Paul. Is this just following the well loved pareto rule. As with procurement spend, 80% is generally covered by 20% of your categories. With sales, you generally find that 80% of the sales are made with 20% of the sales people. If everyone was looking after the same size and type of spend, would the same rule still hold, 80% of the savings comes from 20% of the procurement staff? Is it purely down to individual skill differences? However I suspect it is a mixture of both some people looking after tail spend and individual capabilities to the reducing benefits. What I do find amazing though about ROI in procurement is how often it can be brushed aside. You can invest huge sums of money in a capital machine with a 10 year ROI and yet many times I have seen a far quicker ROI from a negotiation exercise in the procurement department ignored or untouched due to resource constraints You certainly need to find that tipping point.

  4. Paul Gurr:

    An interesting analysis! I’ve been tempted to think that the ROI of additional resource in a procurement team is largely dependent on % of spend managed, so if there’s plenty of virgin spend to go after then a larger team makes sense. However, the fact that the areas of spend that have been left are probably either low or slow return means this analysis would still hold true. It’s finding the tipping point that’s the key to optimum size.

Discuss this:

Your email address will not be published. Required fields are marked *