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AberdeenGroup

Procurement service providers offer enterprises the ability to improve spending coverage, reduce costs for goods and services, employ industry best practices, leverage the latest procurement technologies, and streamline source-to-pay processes, all without taking on the risks and assets required to achieve such results.

It is now common knowledge that reductions in procurement costs have a dollar-for-dollar impact on the bottom line. Likewise, the supply relationships defined and managed through the procurement process drive an enterprise's overall cost structure and responsiveness.

However, Aberdeen Group's ongoing research into the sourcing, procurement, and supply management practices of U.S. and European enterprises clearly indicates that even the largest firms lack the skills, expertise, and infrastructure necessary to effectively manage procurement across all spending categories. Specifically, we have identified the following gaps in enterprise procurement strategies:

• On average, enterprises have applied strategic sourcing principles to less than half of their overall spending.
• Nearly 70 percent of companies continue to make sourcing decisions at the divisional or site levels.
• Nearly a third of purchases are off- contract, "maverick" buys.
• At most enterprises, domain expertise is limited to the most strategic or high-dollar-volume categories of spending.
• Few enterprises have standardized sourcing and procurement processes.
• Clear visibility into total spending remains elusive for most companies.
• Sourcing, procurement, and supply management activities are labor intensive, time-consuming, and manual at most firms.
• Procurement continues to lag other enterprise functions in the utilization of automation and analysis tools.

Such factors strongly suggest that even the largest enterprises suffer from inadequate spend coverage and fragmented, under-leveraged, and inefficient procurement operations. In short, procurement is an under-performing asset at many companies. As a result, it is not hyperbole to estimate that enterprises are leaving billions of dollars on the table owing to suboptimal procurement processes and under-leveraged spend. This is a luxury few companies can afford in today's tight economic environment.

Outsourcing Comes of Age

Considering these factors, it is not surprising that many enterprises are turning suboptimal procurement activities and poorly controlled spend categories over to highly specialized providers of procurement services. For the past decade, enterprises have been narrowing their focus to a core set of competencies — and outsourcing the rest. The most commonly outsourced business processes include travel services, employee benefits, payroll, and other financial activities. However, companies are increasingly outsourcing supply chain processes that were once deemed core competencies, including inventory management, logistics, manufacturing, and even product design and customer service. Procurement outsourcing is merely the next logical extension of the business process outsourcing (BPO) movement.

In fact, a closer inspection reveals that businesses have been quietly outsourcing procurement processes for years as part of larger BPO initiatives. Travel firms have long managed travel sourcing and procurement on behalf of corporate clients. Major industrial distributors are now managing entire categories of spending for their customers under "integrated supply" relationships. Group purchasing organizations (GPOs) have long been commonplace in specific industries, such as health care. And contract manufacturers often negotiate and manage entire networks of supply relationships on behalf of their customers.

And recent advances in Internet-based procurement technologies (such as e-procurement, e-sourcing, reverse auctions, and exchanges) and analytics provide the necessary visibility and control to effectively monitor and manage outsourced procurement processes.

Aberdeen labels BPO firms that specialize in procurement and supply management services as procurement service providers (PSPs).

Why Outsource Procurement?

Success requires enterprises to view outsourcing as a way to enhance overall procurement and supply management operations by transitioning under-performing assets or processes to third parties that can deliver greater economies of scale, process efficiencies, and enhanced domain expertise than are available or practical to develop in-house. In other words, an enterprise should outsource a procurement activity if it cannot sufficiently perform the process internally or if the process does not support the company's competitive differentiation.

Chief benefits that enterprises have derived from outsourcing procurement include reducing costs, improving processes and expertise, and enhancing their focus on core competencies.

Cost Reductions

Aberdeen research of enterprises that have outsourced management of specific procurement processes and/or specific categories of spending have been able to achieve material cost reductions that average between 10 percent and 25 percent. In some cases, material cost reductions topped 30 percent for specific categories of spending.

PSPs are able to deliver such cost savings through deep category domain expertise and market knowledge, proven procurement processes, and purchase volume aggregation across multiple clients.

Likewise, PSPs deliver services to multiple clients using a common infrastructure. Such economies of scale enable PSPs to deploy and manage the latest technologies and expertise and to distribute the costs of this infrastructure across all customers. As a result, PSPs can enable certain procurement processes faster and at a lower cost than most enterprises could develop on their own.

And because the PSP manages the process and the resources and assets required to execute that process, outsourcing enables enterprises to achieve these benefits with much less risk. In this sense, outsourcing can be viewed as a strategy to turn fixed assets with fixed costs into flexible assets that carry variable costs and that can be rapidly scaled and adjusted to meet changing requirements.

Process and Domain Expertise

Cost savings are not the only reason to outsource procurement. PSPs can provide access to market-leading procurement technologies, as well as the methodologies for effectively deploying and utilizing these technologies.

PSPs can provide access to best-in-class procurement solutions on a hosted basis. Aberdeen research shows that hosted procurement solutions can be deployed 60 percent faster and at 40 percent lower cost than on-premises applications.

PSPs have the potential to streamline implementation costs and cycles further by leveraging experience and methodologies from previous deployments. Most PSPs also offer programs and strategies for improved negotiations, user and supplier adoption, and contract compliance.

PSPs can also provide the supply management and infrastructure support required for companies to maximize the value of their e-procurement investments. Because they service multiple clients, most PSPs manage a network of national and local suppliers. Many PSPs have enabled most, if not all, of their supplier network to present and manage product catalogs, receive orders, and exchange messages electronically.

Most PSPs also offer services to electronically enable an enterprise's existing suppliers. Such supplier enablement capabilities are critical to e-procurement success. In 2002, Aberdeen research found that the typical e-procurement deployment had enabled just 30 suppliers. Poor supplier enablement limited the amount of spending that enterprises could channel through their e-procurement systems. Specifically, users reported only processing an average of 18 percent of their total nonproduction ("indirect") spending through e-procurement.

Another chief reason for poor spend coverage is that many organizations lack the expertise and strategies to effectively source and manage specific spend categories. Case in point: Aberdeen research of sourcing practices at U.S. and European enterprises found that the average company applies strategic sourcing to less than half of its total spending.

Such factors strongly suggest that even the largest enterprises could benefit from tapping external domain expertise and process methodologies for sourcing and controlling certain categories of spending, particularly indirect goods and services, which have been poorly controlled by most enterprises.

PSPs offer considerable category expertise and access to sourcing and supply base management best practices. However, Aberdeen has found that, like enterprises, PSPs tend to have greater competency in managing certain categories of spending. This finding highlights the need for enterprises to thoroughly evaluate the competencies of each PSP. It also suggests that enterprises may need to support multiple outsourcing relationships to get optimal spend coverage and management.

Focus on Core Competencies

Outsourcing procurement frees companies to focus resources on their true core competencies — designing new products or winning and servicing new customers, for example.

Specifically, outsourcing procurement allows companies to avoid the burdens of building and maintaining an advanced procurement infrastructure for categories of spend that are either non-strategic or that do not warrant additional resources. Transitioning suboptimal procurement activities to a third party can also help enterprises achieve larger savings in those areas faster than building such competence internally.

What to Outsource?

Aberdeen advises enterprises to first assess their procurement competencies on two key matrixes. One matrix should evaluate the strategic value and spend "control" of the purchase category. The other matrix should assess the internal domain expertise and infrastructure to support specific spend categories and specific sourcing, procurement, and supply management processes required to effectively manage the category (see Figure 1).

Figure 1: Supply and Spending Characteristics — One Example
Source: Aberdeen Group, 2002

Strategic Value

The relative strategic value of a good or service category is largely determined by the impact it has on the successful manufacture, delivery, and differentiation of a product or service. The strategic value of a spending category is further defined by the uniqueness and availability of that good or service in the marketplace.

For a PC manufacturer, Intel's Pentium 4 microprocessor would likely have high strategic value because of its competitive processing speeds and its brand equity in the market. However, dynamic random-access memory (DRAM), a potentially large portion of total production spending, may have lower strategic value for the manufacturer because it is a commodity part that is currently in surplus.

To be clear, having high strategic value does not necessarily eliminate a spending category from consideration for outsourcing. In the above example, the PC manufacturer may still consider outsourcing procurement of the Intel chip and DRAM if the outsourcer — most likely a contract manufacturer — has a better relationship and can arrange better terms with the supplier.

Spend Control

Spend control is determined by examining the total spend of a particular category and how well that spend is "leveraged" across the enterprise. A company's ability to leverage spend is based upon how much of total enterprise spending on a particular purchase category under contract and how many suppliers are used to support a particular category of spend. The less spending under contract and the more suppliers used for a particular category of spend usually indicate poor spend control.

For example, items such as office supplies and maintenance, repair, and operating (MRO) items have relatively low strategic value and, on an individual basis, are a smaller portion of overall spending. Such purchases are also poorly controlled at most organizations, resulting in a high incidence of maverick buying and spending distributed among a large number of suppliers.

Procurement Infrastructure

Companies must be careful to examine spending categories at the detailed level. Examining spending at a high level can result in misinformed sourcing and planning decisions. For example, services, which account for 54 percent of spending at most companies, vary greatly in strategic value, depending on the type of service and the needs of the enterprise. Service purchases with high strategic value may include advertising, consulting, and shipping. Services with low strategic value may include building maintenance, janitorial services, and catering. Adding to the challenge of managing services is spend that 41 percent of all services purchases are not controlled by the purchasing department, suggesting that few firms have developed standard procedures for acquiring and managing services.

Competence

Understanding the nature of corporate spending is only the first step to determining which areas of procurement are viable for outsourcing. An enterprise must also evaluate its expertise and its capacity to manage a particular category of spending (see Figure 2). Some ways to gauge internal domain expertise and competency include:

• Categorize spending and review the internal resources dedicated to managing each category (note how well category managers are tracking market dynamics and supplier capabilities, for example).

• Examine the procedures in place to renew contracts for each category and how often these contracts have been renewed (note whether sourcing decisions for each category are made on a site, division, or company-wide basis, for example).

• Benchmark pricing, terms, and processes against best-in-class procurement organizations. Benchmark data is available through purchasing associations, trade publications, and consulting firms.

Figure 2: Competence and Procurement Infrastructure
Source: Aberdeen Group, 2002

These high transaction cost ratios make the procurement of indirect goods ideal candidates for automation as well as outsourcing. Enterprises that have adopted e-procurement have been able to reduce prices paid, improve contract compliance, and improve process cycles and costs for indirect goods purchases.

Procurement Infrastructure

The value of existing procurement infrastructure can be measured by understanding the ratio between the costs of an item and the transaction costs associated with the purchase of that item. For example, capital equipment — such as manufacturing equipment — typically has high-dollar value, but relatively low transaction costs when compared against the total cost of the product. On the other hand, low-dollar, high-volume purchases, such as indirect goods, have high transaction costs relative to the value of goods purchased.

Driving Continuous Improvement

It is critical that supply management professionals understand that outsourcing the management of procurement activities does not relinquish them from responsibility. Successful outsourcing requires the enterprise to establish a relationship that provides visibility into procurement processes and spending and that has checks and balances for the outsourcer's performance.

Such expectations must be laid out in a detailed contract that includes service level agreements (SLAs) that set specific expectations for cost savings, technology, and performance. These SLAs should incorporate detailed and process-specific metrics and milestones, such as purchase price savings, compliance improvements, administrative cost reductions, and cycle time reductions. The PSP should report on these metrics at predefined intervals.

Most PSPs offer some form of value-based pricing in which solution costs are determined by the value that is expected to be returned to the client. This "value" is often defined by the amount of spending that the outsourcer will control and the average savings the PSP believes it can obtain in each category. The contract should include penalties for sub-par performance and incentives for performance that exceeds these predefined expectations.

In light of the clampdown on budgets, enterprises might be wise to craft revenue- or profit-sharing agreements in which the procurement outsourcer receives a portion of the cost savings it generates. Such a deal has low up-front cost, enabling enterprises to go around budget constraints. However, these arrangements require detailed performance metrics and vigorous measurement to ensure that all parties are fairly compensated.

Outsourcing also requires significant change management. Enterprises will need to carefully manage the transition of business processes to the outsourcer and ensure that internal employees are motivated to make the relationship work. Such issues are often eased when the outsourcer hires some of the enterprise's existing procurement staff. These cross-company liaisons understand the processes, culture, and personalities of the enterprise.

Aberdeen Conclusions

Under-performing procurement operations and under-leveraged spending are causing enterprises to leave billions of dollars on the table. Unfortunately, developing the competencies and infrastructure necessary to optimize control of all spending categories is either too costly or too time-consuming or impractical for most enterprises.

In response, many enterprises are transitioning suboptimal procurement processes and poorly controlled spending categories to procurement outsourcers. These procurement service providers offer the economies of scale, category expertise, and infrastructure that many firms lack. And recent advances in procurement and analytics technologies provide the visibility and control to enable enterprises to effectively manage these relationships.

Enterprises utilizing PSPs have been able to improve spending coverage, reduce costs for goods and services, employ industry best practices, leverage the latest procurement technologies, and streamline source-to-pay processes — all without taking on the risks and assets required to achieve such results.

If used wisely, procurement outsourcing can augment overall supply management strategies and enable enterprises to reduce their cost structures, better control total spending, and improve operation efficiency. Within five years, enterprises will be hard-pressed to justify the need to internally manage the procurement of spend categories or activities from which they do not gain a competitive advantage or for which they lack the skills, expertise, and infrastructure to operate at best-in-class levels. Enterprises not considering procurement outsourcing should be asking why.