Cost Optimization 101 | Introduction

Spending more than a Decade and a Half in Industry and largely in the procurement field, I have realized that Procurement professionals are spending more than 50% of their time controlling the costs of the categories they are managing (among others, such as New Product Development, Sourcing strategy formulation, de-risking supplies, etc.), however, not many organizations have a guiding document on how to go about it.

In the initial years of my career, I always used to search for the literature on the ways one can analyze the cost and ways to optimize it. However, there were limited resources available at that time.

In a series of articles, I am trying to summarize all that I have learned about Cost Analysis and Cost optimization tools. I am open to feedback from all my connections to add-in their experience to make this more useful to the Procurement Category Managers.

This article is going to be an introduction to the subject indicating how the series will be structured and where to start your cost reduction journey.

Introduction

As a first step procurement managers should know 'what's on their plate?' i.e. a complete understanding of the width and depth of their procurement spend. For this, one needs to take the entire spend (preferably for a year) of their purchases and classify it into level 1 and level 2 categories. While doing so, the most optimum way to get the data is from 'finance payment records' (if they maintain it at the item-code level), otherwise, the next best method is to take it from the 'PO database' (however, please ensure that open PO qty are removed from the dump). The spend data is then taken up for classification into level 1 & level 2 Categories as explained further.

As a rule of thumb, the spend is managed in A-B-C Class (A=80%, B=15%, C=5% of $ value). This is generally done at Level 2 categories. If you are starting your journey, then it will always be advisable to pick Class-A categories for optimizing the outcome-to-efforts ratio.

In Series 10X, I am going to discuss tactics for Level 1.1 categories vis. tools to approach the cost reduction of "Direct Materials". I am going to have the following articles, in a different series nomenclature (20X, 30X, etc.) to tackle other categories as well.

Level 1

All the purchases in an organization are either Direct (going into the final product or used directly to deliver services of the organization) or Indirect (going into the management of their delivery). These can be further as below:

1. Direct Material
2. Direct Services
3. IT hardware & services (Indirect)
4. Sales & General Administration (Indirect)

Level 2

Each of the categories in the Level 1 is further broken down into further manageable categories. Some of the methods of this sub-classification are:

• Direct Material - Material purchases can be sub-classified based on the Manufacturing Process, Design Ownership, Raw Material involved, Supplier geographic location, Category of Supplier relationship (Owned, Ancillary, Strategic, Commodity), etc.
• Direct Services - Services can be classified based on some of the common methods as of direct materials vis. Supplier geographic location, Category of Supplier relationship (Owned, Ancillary, Strategic, Commodity, etc.), and other methods such as Technology involved, Skill of manpower required,
• IT hardware & services (Indirect) - Again some of the ways of previous categories can be used over here, however, the category-specific classifications are Hardware vs Software, Ownership (leased or owned), Software product vs SAAS, Technology-based, etc.
• Sales & General Administration - This is a very vast category from the perspective of the varieties involved. This is a category that involves high-skill categories such as legal, marketing, Consultancy, real estate, etc. to some of the more common facility management categories of travel management services, cleaning & upkeep services, Electrical & Mechanical maintenance services, event management services, Access Control services, etc.

I am adding sample spend analysis for reference from two industries - Automotive / Engineering Industry and Telecom Infra. These are representative Level 1 & Level 2 Break-up of spend. The values and the categories can be as per the specific company & Industry. These graphs are samples for understanding the spend analysis in a product & service Industry.

(Some of the Level 2 categories are not visible due to the relative size of the spend. You can leave a comment, if you want to know a typical Level 2 category names.)

AUTOMOTIVE / ENGINEERING

TELECOM INFRA

In the subsequent articles, I'll be picking up a few categories at Level 2 of Direct Material and dwell deep on tools to optimize the cost in that category.