Don’t Avoid Cost Avoidance (Part 2 – The CFO and CPO Fireside Chat)

In the first of this 2-part series, I argued strongly for the value of cost avoidance as an important performance metric. In this second part, I will illustrate the concept via a story of a CFO and CPO having a discussion about measuring procurement value. This is basically a pathetic attempt to write a procurement version of something like Eli Goldratt’s The Goal. Here goes…

CPO:  I wanted to talk to you about the performance metrics of my group.

CFO:  Yes, great job hitting your numbers last year. So, what do you think about the 20% savings target increase? Should be doable right?  I’m not shrinking your budget, so you should be good.

CPO:  Well, I’ve been thinking about that and…

CFO:  I’m not changing the target. Do your best. I’m sure you’ll hit it.

CPO:  Actually, I don’t want to change the target. I want to eliminate the metric because it’s not fair to you or to the business.

CFO:  Huh? How’s that?

CPO:  Well, you want to make sure I’m doing my job and we’re getting us the best price while meeting the budget owners’ requirements, right?

CFO:  Well, yes, but..

CPO:  OK, well, it doesn’t make sense to give me credit for favorable PPV for reducing the price of something from $10 to $9 if I can get it in the market for $8. I didn’t get the best deal.

CFO:  Well, then you should go get it for $8 when the market will bear it.

CPO:  OK, but if I do frequent deals with short contracts, we’re not protected if prices rise.

CFO:  Well, then you should do longer term contracts then.

CPO:  So, you mean, we should hedge pricing with long-term agreements, like we do now right?

CFO:  Well, I guess technically it’s a hedge, but let’s not use that term. Still, we should probably address this in our hedging policy.

CPO:  Yes, but that’s a discussion for another day. But, for right now, you’re saying I should make the best judgment to avoid the price increases that would drive up prices and create unfavorable PPV.

CFO:  Exactly.

CPO:  Well, it would be nice if I was measured on avoiding that unfavorable PPV because that is real money too. Avoiding unfavorable PPV is basically the same as favorable PPV, right? But, unfortunately, I’m not measured on it.

CFO:  Yes, well, I guess there should be some type of measurement there, but I still want to see cost savings against a baseline.

CPO:  Agreed. Unfortunately, many times there is no baseline. When we develop a new product, my incentive should be to minimize total costs from the onset, but then there’s no room for future favorable PPV. You can see my problem. In fact, even for indirect spending, there is often no baseline for a new service (or one we’ve never purchased before). The specs are always changing so it’s basically a meaningless apples to oranges comparison. I could do a % off list if it exists, but the list price can be fairly meaningless. I want to at least get an initial baseline from an initial bid price – or at least average bid price – but again, I don’t get credit for it. So, our big one-time buys, especially in CapEx spend, don’t offer me any incentive to get involved. And I’m not even involved formally and early on our existing CapEx approval process. It’s too bad, because when we do get involved, we save about 10-15% versus average bid price. In fact, if I were in internal audit, I could see an adverse finding here of not systematically using this sourcing process we use that consistently drives shareholder returns.

CFO:  OK, let’s not get crazy, but I see your point. However, I’m glad you brought up indirect because I agree it’s harder to measure. You are driving all these sourcing savings, but I don’t know how to track it to the bottom line.

CPO:  I’m glad you brought that up! Yes, we want to reduce our spend and the budgets, but still get the business outcomes we need. But, spend includes consumption rates, and I don’t get credit for helping to reduce consumption, so it’s hard for me to reduce costs if I’m not goaled on reducing activity drivers.

CFO:  OK, OK. I’m sensing a recurring theme here. You want credit for cost/spend avoidance and you’re not getting it.

CPO:  Well, it’s not so much about me personally, but rather about ensuring that we’re incentivizing the right behaviors that maximize long-term economic value to the firm. I’m aligned with you on making sure we get the most “bang for the buck” from our limited capital, and will leave it to you and the spend owners how much of this economic value that I can help lead via procurement best practices will be shared with shareholders or re-invested in the business. But I need your help on getting the scorecard balanced to get us aligned with each other and with the business.

CFO:  OK, do you have a recommendation of the metrics we need and also the investment needed to track them and get greater insight? We need to keep it cheap and simple.

CPO:  I’m glad you asked, because I do actually have some ideas. Let me come back to you during our next meeting. I want to talk about the budgeting process.

CFO:  Terrific. So, getting back to those savings targets, we’re on track right? I promised the board and I’m counting on you.

What do you think? Should I do more of these Finance-Procurement discussions? Should we do a video? Actually, we did do a 30 minute webcast on procurement benchmarks that touches on some of this, but I’d love your feedback on where you’d like to see this go.

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Voices (5)

  1. Pierre Mitchell:

    b+t, yes, I would generally agree, although it’s easier in mfg where SVP SCM can also serve as CPO or have CPO under him/her. There’s emerging trend to procurement reporting with other line functions (IT, HR, Finance, etc.) in a GBS group reporting up to CAO type person. Also, reporting to the RIGHT CFO – or one you can manage and deal with rationally can actually work to your advantage – but sometimes it is indeed a liability.

    Steve, I agree. My only caveats to this are 1) let finance controllers negotiate how much savings comes out of budget vs. retained/re-invested – that’s not procurement’s job and I’ve seen it backfire when procurement is viewed as Finance’s bit*&^ looking to reduce their budget, and 2) make sure you can still track contract compliance to gauge ‘savings accrual’. Reducing budgets without ability to show you’ve reduced costs is not really closed loop spend management but rather merely forced demand management – and Finance doesn’t need Procurement’s help for that!

  2. Steve M.:

    Our Chief Accounting Officer uses the Justice Potter Stewart definition for cost savings, ” I know it when I see it”.
    You effectively point out how difficult it is to have separate definitions for cost avoidance and cost reduction. The time and effort spent by organizations I have worked in to define and calculate savings certainly could have been better used in capture said savings. I have come to the conclusion that negotiated savings must be removed from the budget in ordered to be realized. Too often hard won savings get redirected to other areas or allowed to be redeployed to enlarge the project scope. When the CFO and CPO get serious about taking savings out of the budget then Procurement value will be legitimized.

  3. Fabrice Saporito:

    Pierre, this is a great thought provoking piece on measurement … I believe if one looks at measuring performance applying strict financial logic the topic becomes less hypothetical and more practical … I encourage all to read Sievo’s PCF method

  4. b+t:

    This is why CPOs need to report to CEOs.

  5. Pierre Mitchell:

    Ron Larimer did a nice article (w/ downloadable slide) on 6 types of baselines – and Finance’s objections to them – that were in the same spirit of this – and I thought I’d share:

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