SRM--Payback Guaranteed By ROI Insurance
Purchasing has been the backwater of the modern corporation. The easiest way to see this is simply to visit a purchasing department. Almost without exception, the purchasing group is located in the corporation's worst facility. It is rarely at corporate headquarters and once inside, you can see the best in 1970s office furniture. It has historically attracted the least ambitious employees, the least amount of management attention, and the least amount of investment in people, process, and technology.
Many companies have begun to elevate the strategic importance of purchasing. However, purchasing remains the only function in the modern corporation still waiting for a software management system. In the 1980s, finance received their first management system. In the 1990s, human resources installed their management system; manufacturing deployed material requirements planning (MRP) and supply chain management solutions to better manage production internally and with suppliers; sales and marketing spent lavishly on customer relationship management software to manage all customer contact and lead management; and services deployed call center management systems.
There is a bit of a misconception that during the technology bubble of 1998-2001, companies did begin to deploy management systems for the purchasing function. The reality is that even though some companies spent heavily on purchase requisition tools, these simply helped folks outside of purchasing get approval for their purchases more quickly. Significant money was also spent on reverse auction service providers, but the reality is that reverse auctions only automate a tiny part of the sourcing process for a very small percentage of spend. (The CAPS Research cross-industry average for reverse auctions is only 3.14 percent of total spend.)
Purchasing's Bottom Line
While most companies were ignoring the purchasing department, a strange thing was happening: The amount of cost attributable to suppliers was going up. Companies have and continue to focus on their core competencies and much activity has shifted to suppliers. In many industries today, the dollars spent with suppliers is greater than the total cost of the companies' operations. This greatly increases the impact purchasing can have on your bottom line, and yet without investment it can easily become overwhelmed by the flood of spending. Given that the chief procurement officer manages more cost than the chief operations officer, you would think that the CPO would have at least the same reporting and pay structure as the COO. Do you have a CPO? To whom does she report? Do you even know her name?
Exposing Risk
The Sarbanes-Oxley Act and numerous industry-specific regulatory bodies have focused attention on supplier risk management (SRM) and internal controls. Regulators are increasingly treating outsourced and tier 1 supplier relationships as if they were part of your enterprise - greatly increasing the risk audit effort required. How would your company rate in a supplier risk assessment audit?
A recent audit of a Fortune 500 company found the following:
- Twenty percent of agreements were signed by people that did not have the sign-off authority for the size of the agreement;
- Thirty percent of agreements used the supplier's terms and conditions without modification;
- Ten percent of vendor selections showed conflicts of interest with suppliers and improper influence;
- Thirty percent of total purchase commitments (invoice volume, not PO volume) happened without any purchasing department involvement;
- The majority of statements of work (SOWs) with suppliers lacked termination clauses, had onerous penalties, contained open-ended pricing, lacked IP protection and had no market price-testing mechanisms; and
- A nonexistent monitoring system for outsourced agreements.
These results are fairly typical, and it is no wonder. Based on our surveys, the amount of activity with suppliers is staggering. A typical organization may have 30 category managers to manage 1 billion dollars in spend, each category manager may work with 200 suppliers and a handful of different people at each supplier, and interact with 50 or so collaborators within her own organization. This creates 1.1 billion potential interactions for every billion dollars spent. Using these figures, the result is over 7.2 million separate pieces of information communicated throughout the company in emails, phone conversations, attachments, and faxes. In this deluge of information, it would be surprising if the auditors did not find discrepancies.
Regulator's Opinion, Big Impact?
Here's one example. On July 17, 2002, Capital One's stock fell over 40 percent. That's over $4.4 billion in market value in one day. They had just announced their 20th consecutive quarter of record earnings, revenues increased 42 percent year over year, and they raised expectations by 50 percent for future earnings. How could this happen? Here is the company statement: "We have a complicated and complex setup. We are making it easier for the regulators to understand. Their concerns had nothing to do with our credit risk, our external reporting policies, or our accounting policies." The regulators were not comfortable with Capital One's internal controls and supplier risk management policies - and Capital One's stock got hammered.
The Competition
Since we are talking about suppliers, the best way to understand this question is for you to envision yourself in the shoes of a salesperson. Let me describe two companies and you decide which one is yours and which describes your closest competitor. Company A has a strong entrepreneurial culture. Each division runs its own business. As a salesperson, you can call into each division and sell your solution over and over again. Each division you call into has no knowledge that the other divisions have bought your solution or at what price. The fact that you had some severe delivery problems for one division does not seem to impact the others - in fact even within that division, people do not seem to be aware of it. You spend a lot of time personally at the company talking with as many people as possible. The purchasing system is automated and you get your purchase orders online to submit your invoices. You have made your quota three years running and have never had to sell to anyone other than company A.
Like company A, company B has a strong entrepreneurial culture and each division runs its own business. You start calling into each division trying to sell to them separately but they keep referring you to the same category manager that leads a cross-divisional commodity team. You try promoting a different type of solution but they refer you to a different category manager. You become successful in winning business, but it was a rigorous process and they used their entire purchasing power to get the best price. They did, however, reduce your cost of sales and service by accepting substitute offerings that reduced your cost as well. All person-to-person interaction is completed through a supplier portal configured to your company and your role within your company. For example, you can see the amount spent per contract and the results of surveys of your service performance. You first learned about a delivery problem in one division from an email alert you received from their supplier relationship management (SRM) solution.
Which organization would you rather sell to? Which one is your company? How long will company A be able to effectively compete against company B?
Strategic Sourcing
Many companies that found themselves in situations similar to company A, responded by creating strategic sourcing groups that formalized the supplier selection and negotiation processes. Initial results from these efforts were quite satisfying (10 to 15 percent negotiated savings below previously contracted prices in many categories). But the next time that same category was sourced, the results were minimal or prices even went up. Why? Because strategic sourcing techniques for the most part only impact the supplier profit portion of total supply costs. For most suppliers that is only 5 to 10 percent of their total revenue and any efforts to drive them lower will either drive them out of business or away from you as a customer.
What is missing from strategic sourcing that SRM provides is an ability to address the remaining aspects of the total cost of supply. A leading CPG company has estimated that its SRM initiatives impact seven times the costs of their strategic sourcing efforts. How can this be? They have found that in many categories, up to 70 percent of suppliers' costs can be impacted based on joint exploration of ways to reduce the cost of doing business through: demand management, appropriate specification, order management, product substitution, pass through cost management, supplier portals, and typically hidden costs such as poor quality, expediting, delivery errors, etc. Based on these factors, the potential savings from SRM can be seven times that of strategic sourcing.
Guaranteed ROI
To summarize, we have examined five underlying reasons for an SRM solution's guaranteed ROI: Underinvestment in purchasing has led to a high marginal product of capital; rapid increases in the percent of total cost that is attributable to suppliers has increased the total potential benefit of improvements; increased regulatory oversight of supplier risk has increased the cost of noncompliance; the revenue impact of losing sales to lower cost competitors; and the myopic focus of strategic sourcing on only reducing supplier profit (as little as one-seventh of the total cost of supply).
These five value drivers are so strong that a major insurance carrier has underwritten insurance policies that guarantee the ROI. The premiums are based on the level of investment, your company's track record in deploying software solutions, an assessment of the project plan and committed team resources, and the outcome of an SRM diagnostic. A side benefit that many companies have found with the ROI insurance policy is that it gives them a forcing mechanism to gain support throughout the company.
SRM Diagnostic
The first step in determining the specific opportunity for your organization is an SRM diagnostic. This is a data-driven exercise that quantifies the potential benefits an SRM solution can bring to your organization and pinpoints the areas of greatest opportunity. An example will help illustrate the results.
A major retailer was faced with a new entrant that was beating them on price, in most markets, and rapidly gaining share. The initial hypothesis was that the smaller rival had somehow negotiated better arrangements with the major suppliers. After some investigation this was determined not to be the case. Management was ready to write off the competitor's actions to aggressive pricing policy meant to grab market share, until the results of the SRM diagnostic came back. It turned out that the purchasing department was doing a fine job in generating savings. In fact, for every $1 invested in purchasing, $4 were returned in savings - a tremendous payback from the CFO's perspective. But this was exactly the problem. If this were an investment opportunity, potential investors would be lined up out the door. However, prior to the SRM diagnostic, the retailer's purchasing group had been unable to effectively communicate its value to the CFO to receive additional funding.
The SRM diagnostic also showed that this retailer had undercommitted to SRM relative to its peers by a factor of five. In other words, for the small amount of spend that the purchasing group actively managed - it generated savings four times the cost of the department. But because it had been neglected, it was unable to get involved in store operating expenses that were making the retailer uncompetitive with its smaller rival. Based on this diagnostic, the management team decided to invest in an SRM solution to increase the productivity of the strong core purchasing team so they could actively manage store operating expenses and increase the company's competitiveness.
Next Steps
For most companies, the opportunity is large and easily attainable. An SRM diagnostic can define the opportunity for your organization and an ROI insurance policy guarantees the return on your investment. The last function in your organization is waiting for its management system - don't wait for your competitors to impact your revenues before you take action.
