World-class supply practices boost shareholder value: a focus on both direct and indirect spending, including smaller items, can have a powerful effect on corporate performance. Top companies involve their procurement group and other internal functions, plus suppliers, to boost competitive advantage.

During the last 20 years, procurement departments around the world have adopted some new and very powerful processes and tools. Done well, advanced procurement and supply management can trigger a compounding positive effect on a company's lifeblood--its return on invested capital, or ROIC.

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When it comes to improving margins and profits, procurement can build results through initiatives that favorably impact revenues--and other initiatives that directly target business costs. Figure 1 (on page 57) shows examples of some procurement initiatives that, when done properly, can significantly improve margins.

Procurement can improve the capital intensity of a business through initiatives that help working capital and that impact the total investment in capital assets. Figure 2 (on page 58) shows examples of some procurement initiatives that can significantly improve capital intensity.

What Is the Potential Impact?

If you could reduce your product development cycle time by 50 percent and beat competitors to market, while also reducing costs, would that be meaningful to your business? For most companies, that would be a huge plus. That is why world-class competitors involve their procurement group and other internal functions, plus suppliers, in an aligned effort to increase competitive advantage.

With regard to costs, the conventional wisdom is that procurement should focus principally on the "big ticket" areas of spending, such as raw materials and energy. And, you certainly should devote attention to raw materials and energy--not just to reduce costs, but also to reduce volatility through better risk management.

But if you focus only on the big-ticket spending categories, you'll be missing out on the enormous opportunities presented by all other, indirect areas. It is often possible to achieve double-digit reductions in costs for those indirect spending categories. The bottom line is this: focus on both direct and indirect spending. Doing so can have a powerful effect on corporate performance.

With regard to working capital initiatives, world-class procurement departments are including payment terms in their requests for proposal (RFPs), and are often pleasantly surprised by the responses. The impact on a business can be meaningful indeed. For example, for each $1 billion of purchases, moving from Net 30 days to Net 45, 1 percent-15 (realizing a 1 percent discount for paying early) offers the option of:

a) improving earnings by about $10 million a year (minus the interest earnings on the cash used to pay early); or

b) the ability to grow accounts payable and cash by about $40 million by paying in 45 days.

Similarly, including inventory terms in the RFP can offer suppliers the opportunity to show their creativity as well. Inventory programs with suppliers can free up tens of millions of dollars in capital for other purposes.

For capital projects, there is a direct correlation between the total costs associated with that project and the stage at which procurement is involved. The message is very simple: involve procurement and suppliers at an early stage to optimize the total costs of any capital project. Getting procurement and suppliers involved early, even at the concept stage, makes it more likely that the best ideas are considered before it is too late, and that the commercial foundation for success is established before too many "technical details" are locked in.

The total potential impact from all of these initiatives can be enormous. For example, a typical pre-transformation manufacturing company might have a n ROIC of 8 percent. By pursuing the ROIC drivers described above, the company has the potential to transform itself into a 20 percent ROIC performer!

What's Needed for Success?

You might ask, why aren't lots of companies performing at 20 percent-plus ROIC? There are two possibilities. One, there may be other adverse trends in their business that are partially or completely offsetting the gains from advanced procurement, such as weakening product selling prices or skyrocketing labor and health care costs. But the main reason you don't see more companies with more than 20 percent ROIC is that the improvements previously outlined don't just happen by themselves. It takes tremendous leadership, a well-thought-out transformation plan, the right best practices in the right sequence and a few other key ingredients.

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Experience has demonstrated that there are more than 30 critical factors that distinguish truly exceptional supply management performance from the rest of the field. Those common success factors fall into six fundamental categories:

* procurement strategy

* objectives

* leadership

* optimized organization

* best practices

* innovation and technology

The exceptional performers in the world of supply management devote their best people to leading this effort.

Compliance, Results and the Role Of the Financial Office

There are numerous reasons why savings reported by the procurement department fail to hit the bottom line. One of the principal culprits is "maverick spend."

In Figure 3, you'll see different levels of negotiated cost reduction for a new contract (5 percent, 10 percent, 15 percent or more), and different levels of compliance with that contract (from 25 percent up to 95 percent). The matrix shows the amount of benefit that actually makes it to the bottom line, based on each combination of negotiated cost reduction and actual compliance. Just to make the illustration easy to follow, we are assuming $10 million in spending that could be directed to that new contract.

For example, a fairly typical result might be to negotiate a 5 to 10 percent cost reduction with your supply base. That sounds pretty good, until you realize that in many companies, the initial compliance with that new contract might only be 25 to 50 percent (in other words, the "maverick spend" is 50 percent to 75 percent that is not going through the new contract). See the blue box in Figure 3. That's one of the key reasons executives often can't find procurement's results on the bottom line.

For modern procurement to really add value, it needs to utilize best practices to identify the best suppliers and negotiate world-class contracts, and then ensure a high level of compliance.

In the red box in Figure 3 you can see the impact of negotiating a 10 to 15 percent cost reduction through application of best practices, combined with an 85 to 95 percent level of compliance. And, to really make sure it gets to the bottom line, it's critical to communicate the new contracts and relevant spending to your plant or business unit controllers. In turn, they should adjust budgets at the cost-center level so that the favorable variances created by your sourcing successes are not automatically spent on other things.

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Transforming procurement into a driver of shareholder value for your company is not easy to do, but it can be done. The lessons from successful transformations are straightforward. And, certainly, the benefits are well worth the effort. The immediate benefit is that you can avoid being among the "walking wounded." The longer-term benefit is that you can turbocharge your organization's ROIC engine, and help ensure your firm's success well into the future.

Robert A. Rudzki is President of Greybeard Advisors LLC (www.greybeardadvisors.com), a Pittsburgh, Pa., firm that helps enterprises improve financial performance. He has held various financial executive positions, and was Chief Procurement Officer at Bayer Corp. Rudzki is co-author of a recent book, Straight to the Bottom Line, and is a frequent speaker at professional conferences.

RELATED ARTICLE: takeaways

* During the last 20 years, procurement departments around the world have adopted some new and very powerful processes and tools.

* Procurement can build results through initiatives that favorably impact revenues--and other initiatives that directly target business costs.

* A focus on both direct and indirect spending, involving both small and big-ticket items, can have a powerful effect on corporate performance.

* Procurement needs to utilize best practices to identify the best suppliers and negotiate world-class contracts, then ensure a high level of compliance.

Figure 3 Strategic Sourcing/Compliance Multiplier

($ to the bottom line for each $10 million of spend)

% Cost                 % Compliance with New Contract
Reduction    25%         50%         75%         85%         95%

05         $125,000    $250,000    $375,000    $425,000    $475,000
10         $250,000    $500,000    $750,000    $850,000    $950,000
15         $375,000    $750,000  $1,125,000  $1,275,000  $1,425,000
20         $500,000  $1,000,000  $1,500,000  $1,700,000  $1,900,000
25         $625,000  $1,250,000  $1,875,000  $2,125,000  $2,375,000
30         $750,000  $1,500,000  $2,250,000  $2,550,000  $2,850,000

[c] 2005 Greybeard Advisors LLC