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How to calculate cost savings

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04 September 2003

Q: I work for a UK-based manufacturing company and have been tasked with reducing purchasing costs. Owing to the huge variety and volume of products purchased and potentially large movements in price and volume mix, no one measure of this saving can be agreed between purchasing and finance. But is there a measure that would be relevant to buyers day-to-day and prove to finance that savings have been made?

A: Gary Caswell, director of consultancy PPCL, writes: First, I hope you will take comfort from the fact that almost all buyers have faced this situation, many more than once, so you're not alone. Assuming that the commitment to cutting purchasing costs has been agreed across the business, the finance team should ultimately have as much interest in achieving the appropriate level of benefits as procurement. Therefore, setting aside the possibility of internal politics clouding the issue, the answer lies in agreeing baselines, metrics and key performance indicators.

As a manufacturer your purchasing costs probably fall into two main areas: expense-based indirect costs and direct material costs that, along with labour, form a major part of your costs of sales. Notionally, it is easier to measure a direct cost saving than an indirect one, as the finance team should have a clear breakdown of the direct costs associated with manufacturing a single product.

The most frequent measure employed is purchase price variance (PPV), which reflects the financial impact on the business of buyer activity and therefore seems to be the most appropriate to you. This is the difference between the original price paid before the procurement exercise (agreed with finance; it could be an actual invoice cost or standard cost depending on accounting practices) and the newly negotiated price taken from an invoice.

To solve your current impasse, your finance function together with procurement could work through a jointly agreed process. Benefit estimates should be derived from agreed spend areas or material groups. The estimates could be based on previous experience, comparative examples or recent market testing.

These benefits should have a strong probability of being delivered. How to measure these benefits in terms of purchasing performance must be agreed at this stage, and this is where PPV comes in.

Assuming that the purchasing team has little control over use, it should be agreed that finance measure your performance on direct materials on a volume-neutral like-for-like basis. Indirect patterns of demand can only realistically be controlled by finance cutting expense budgets as a direct result of your achieving a cost saving.

It is unrealistic for finance to fail to recognise a PPV if demand increases, as your pro-rata cost of sales will have reduced. This should flow directly through into your profit and loss account, as should expense-based savings, assuming that finance and budget holders agree to cut local budgets as a result of an improved PPV.

Lastly, assuming that finance and purchasing can agree what a benefit actually is, purchasing should develop a savings reporting document with the suitable metrics, evidence of the saving and an audit trail sufficient to satisfy both finance and other interested parties.


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