Calculating Procurement’s Value

Brian Rounsavill, Princeton University (Co-Chair)Chris Mihok, Yale University (Co-Chair)Jim Hine, University of California, San Francisco Judy Smith, University of MichiganJohn Riley, Arizona State University Kevin Lyons, Rutgers UniversityMichael LaPointe, University of Illinois

NAEP Ad Hoc Committee on Defining & Calculating Cost Savings:

April 8, 2008

2

Agenda

• Introduction, Overview & Background • Cost Savings & Benefits

– Sourcing Savings– Usage, Supplier Incentives Savings– Process Efficiency Improvement– Compliance & Risk Reduction

• Reporting Cost Savings & Benefits• Responding to the Campus Community• Critical Success Factors & Conclusions• Q & A - Panel Discussion

3

The “Bull’s Eye”

Procurement

Campus Departments

Vendors

PurchasingTools:•POs•Credit Cards•E-Commerce

RequisitionsOrders

Campus Training / Information Exchange

Contracts / Strategic Supplier Relationships

Cost Savings & Benefits

Cost Savings & Benefits

4

Core Assumptions

• Procurement = Purchasing + Accounts Payable

• Hard and soft savings are equally beneficial and valued (savings = savings)

• Cost savings and cost avoidance are equally valued (savings = avoided cost)

• As Ben Franklin said….

“A penny saved is a penny earned”

5

Sourcing Savings

• Achieved through the actions taken by Procurement

• Reduction in the purchase price of goods / services

• Examples include:– Competitive bidding– Negotiated quantity discounts– Negotiated tiered discounts– Identification of alternate sources of supply

6

The Role of Market Competition

• Essential in balancing supply and demand and achieving sourcing savings

• Ensures that a reasonable price is paid• Snapshot of the current market for a specific

commodity at a specific time (i.e. the market basket approach)

Key Point: The moment competitive bids are obtained, the “last buy” price no longer applies since the economic elements of a perfect market are in play

7

Calculating Multiple Bid Savings

Definition: • When multiple bids can be obtained, the savings shall

be the difference between the awarded bid (what you will pay) and the average of the non-awarded bids (what you would have paid elsewhere in the market)

Formula: (Average of Non-Awarded Bids - Awarded Bid) = Savings

Percentage = Savings

Average of Non-Awarded Bids

Calculating Competitive Bid Savings

8

$0.49 savings (36%)

$ 1.57

Bids$ 1.15

$ 1.36

$ .87

Bidder 1

Bidder 2

Avg. of 1 and 2

Bidder 3 (Low Bidder)

Example:• Bid results obtained for a widget were: $1.57, $1.15 and

$0.87• The contract was awarded to the low bidder ($0.87)

9

The Role of “Last Buy Price”• In the absence of competition (i.e. single bid / sole source), the

“last buy” price is the starting point to determine a reasonable price for the specific commodityKey Point: The use of a list price will dramatically over-inflate savings

• To bring the “last buy” price current, use the generally accepted index measure to account for inflation and/or new market conditions (CPI, PPI, etc.) www.bls.gov/cpi/

• The “last buy” price is multiplied by the % change in index measure to bring it forward to the current time period – In situations where a contract is several years old, this is required for

each year the contract has been in place– Key Point: Losses occur if the price increase exceeds the index

• A tool for monitoring whether the supplier is trying to gain back initial price concessions, or an indicator of market conditions

10

Calculating Single Bid Savings

Definition: • When no competitive bids can be obtained, the cost savings

shall be calculated as the difference between the new awarded price and the last buy price adjusted for inflation (i.e., CPI / PPI)

Formula: [Last Buy Price x (1 + % ∆ CPI) ] - Awarded Price = Savings

Percentage = Savings Last Buy Price x (1 + CPI)

Calculating Single Bid SavingsExample:

• The new bid price is $1.53

• The last buy price for this product was $1.40

• The change in CPI is 3.5%

11

- $.08 savings/loss (-5.52%)

Last Buy Adj. for CPI

New Bid

$ 1.40Prices/Bids

$ 1.45$1.53

Last Buy

12

Calculating Total Sourcing Savings

1. Days Active:

The contract begin/end date range is compared against the specified date range to determine the actual number of days within the specified period the contract was activeNote:

Some contracts will contain two entries, which indicates that the contract expired and was renewed within the specified period. The cost savings associated with each entry will be different, which reflects both the previous and renegotiated contracts

13

2. Total Spend:

Run total vendor spend reports for all contracts that were active at any time within the specified period to calculate the total discounted spend with each vendor for the specified date range

Note:

Total vendor spend is calculated from a combination of: e-commerce transactions, purchase orders, credit card transactions, and other AP distributions (i.e. all payments to a vendor)

Calculating Total Sourcing Savings

14

Calculating Total Sourcing Savings

3. Cost Savings

The individual contract cost savings percentages are calculated as we have outlined in the previous slides

Competitive Bids:

(Average of Non-Awarded Bids - Awarded Bid) = Savings

Sole Source:

[Last Buy Price x (1 + % ∆ CPI)] - Awarded Price = Savings

15

Calculating Total Sourcing Savings4. Total Savings:

A weighted-average approach is used to approximate the total savings associated with each contract over the actual valid dates of each contract to achieve an approximation of total savings over the entire specified period

Note:

This methodology associates specific savings with each contract for specific dates to account for the fact that vendors may have more than one valid contract during the period with differing savings percentages (i.e. the contract was renegotiated during the year)

* For multiple year contracts, this concept holds true in that pricing was held firm for the entire term, or may include price increases, each of which are recorded for specified periods over the life of the contract

16

4. Total Savings: The following total savings calculation is used to approximate the pre-discounted spend with a vendor for the number of active days in the specified period, which is then multiplied by the contract cost

savings to achieve a weighted-average total savings

Calculating Total Sourcing Savings

17

Example: • The following three contracts were renegotiated during

the fiscal year beginning on July 1 and ending on June 30. You are asked to provide data on the total sourcing savings achieved for this period:

Contract Date Range (Days Active) % Savings FY Spend

Contract A Aug 1- Dec 31 (152) 10% $100,000

Contract B Jan 1 – Dec 31 (181) 5% $250,000

Contract C Jul 1 – Jun 30 (365) -3% -$125,000

Calculating Total Sourcing Savings

18

Calculating Total Sourcing Savings

Answer:

Using the total savings calculation, the individual weighted-average total savings are calculated for each contract and added together, which estimates the total sourcing savings achieved for the period:

Contract Days Active

Spend % Savings $ Savings

Contract A [(152/365) * $100,000 / (1-.10)] * 1.0 = $4,627.09

Contract B [(181/365) * $250,000 / (1-.05)] * .05 = $6,524.87

Contract C [(365/365) * $125,000 / (1+.03)] *( -.03) = -$3,640.78

Total Savings for Period = $7,511.18

19

Other Hard Benefits: Usage

• Item Specification Savings – Convert to lower lifecycle cost specifications– Benefits: [(old specification cost) - (new specification cost)] * usage

• Consumption/Usage Savings – Identifying/eliminating overuse/waste/expired product – Benefits: historic costs vs. revised costs

• Inventory Savings – SKU consolidation, inventory sharing, vendor managed inventory,

JIT, surplus and auctions– Benefits:

• Inventory work-down: avoided procurement cost during work-down• Lower carry cost: value of space, manpower, obsolescence savings• Revenues from asset sales/recovery

20

Specifications Savings

Example:• Requirement = 1,900 cases of usable gloves

Company A Company B

Price/Cast $10.86 $10.97

Yield 95% 97.5%

Implied Cases Required 2,000 1950

Total Cost $21,720 $21,391.50

$328.50(1.5%)

21

Inventory DrawdownExample:

Due to improved vendor delivery, able to work down stocked inventory of expensed gloves by 500 cases from 2,000 to 1,500

$21, 391.50

$15,906.50$5,485 one-timesavings

InventoryValue

22

Other Hard Benefits: Supplier Paid Incentives

• This category can include a variety of incentives derived directly from suppliers:– P-card rebates– Catalog fees– Electronic transaction fees (i.e. EDI)– Prompt Payment Discounts (i.e. 2/10 net 30)– Volume-based patronage/earned incentives– Retroactive supplier payments– Signing bonuses

• In most cases, these incentives can be used to help fund centrally-driven improvement efforts

Tip: Negotiate price first, then additional incentives to prevent suppliers from merely increasing their unit prices to cover the costs of these incentives

23

Additional Benefits: Process EfficiencyExample:

Implement eProcurement - increase efficiency, reduce non-value added and reconciliation tasks frees substantial capacity.

AnnualFTE’s

Spent On P2P

600

500

400

300

200

100

Purchasing

AccountsPayable

Departments

>100 FTE’s (> 20%)

24

Additional Benefits: Compliance and Risk Reduction• Tighter, more automated procurement and sourcing

processes can substantially reduce key risks and improve compliance:– Increased small, diverse business sourcing for federal/state funded

research grants– Reduced risk of use of unqualified/debarred suppliers through

comprehensive supplier tracking– Increased SAS 112 compliance and reduced fraud risk through

automated closed loop processes (approvals, 3-way matching, exception monitoring etc.)

– Increased supplier compliance to contract and reduction in risk of double payments

• Though hard to attach monetary value, keeping key stakeholders out of the newspaper can bolster any business case

25

Reporting Cost Savings & Benefits• By using the methodologies outlined in this presentation,

total savings can be fairly measured for the contracts or sourcing transactions during the reporting period in question

• In the absence of a market analysis (competitive bidding), existing active/valid contracts are included in the total measurements because they are still actively saving the institution money

Note: There has been a great deal of discussion concerning whether savings should be reported for multiple year contracts. Some institutions have chosen to report cost savings in the first year only, while others have reported cost savings over the entire contract term. Regardless, any total savings calculation should be viewed as a tool for institutions to apply as necessary and appropriate within their own environments

26

Reporting Cost Savings & Benefits

“The Bottom Line”

This approach does the following:– Approximates the total savings and benefits – For each active contract or sourcing transaction – For their specific valid date ranges– To estimate a measurement of total savings for the

reporting period in question Tip:

Electronic databases or spreadsheets can allow the total savings calculation to be adjusted for any date range at any point in time

27

Responding to the Campus Community

• In order for a cost savings and benefits program to have endorsement, the campus community must understand and agree with the methodology

• Campus departments typically view “savings” from what they actually paid last year

• The campus must be educated on what would have been paid if there was no Procurement intervention (i.e. current market price / conditions, effects of inflation, etc.)

The Litmus Test: “What would it have been?”

28

Critical Success Factors• Documentation

– The file should contain competitive bids and other documentation necessary to establish price reasonableness and justify the reported savings/benefits

• Data-Driven– Cost savings and benefits must be linked to actual supplier spend for the date

ranges over which the savings are projected

• Price Point of Comparison– The use of competitive bidding or the “last buy” price adjusted for inflation are

standard methods that provide process, analysis and details to substantiate price point comparisons

• Report Losses and Savings– Both savings and losses should be reported

• Be Conservative– The credibility of your entire Procurement program can be undermined if

exaggerations, errors, or discrepancies are found

29

Conclusions• A reasonable approach and generally-accepted definitions

have been defined by this Committee

• A basic set of tools have been developed that can be applied to different and changing institutional procurement environments

• A structured program will provide relevant information to departments and demonstrate the value provided by Procurement

• When Procurement can adapt to changing environments and demonstrate a return on investment; sourcing and savings results will continue to validate Procurement’s efforts and solidify Procurement’s credibility and necessity within any organization

ConclusionsCampus’ view of Procurement

“The speed bump between me and a Nobel Prize?”

Or

“My strategic partner who delivers value.”

Show me the money.

Appendix

• The complete White Paper that formed the basis for this presentation has been published as an NAEP monograph and was distributed to all session attendees and is also available on the NAEP website (www.naepnet.org)

• Excerpts from this article have been published in the December 2007 and March 2008 issues of the NAEP Journal

• The Ad Hoc Committee on Defining & Calculating Cost Savings wishes to thank the NAEP for the opportunity to present at this session and work on developing standards for this important industry topic

31

Q & A – Panel Discussion

NAEP Ad Hoc Committee on Defining & Calculating Cost Savings:– Brian Rounsavill, Princeton University (Co-Chair)– Chris Mihok, Yale University (Co-Chair)– Jim Hine, University of California, San Francisco – Judy Smith, University of Michigan– John Riley, Arizona State University – Kevin Lyons, Rutgers University– Michael LaPointe, University of Illinois

32