How to Calculate Procurement ROI—The Profitability of Procurement Initiatives

Effective procurement can be a game-changer for a company's financial health. Optimizing your supply chain or negotiating better supplier deals can save you millions. That's the power of procurement ROI. In this step-by-step guide, we'll walk you through the steps to calculate this essential metric and harness its potential to drive cost savings and enhance your bottom line.

Proactive procurement strategies and their impact

Preventing future costs through proactive procurement strategies is vital to long-term financial success. By identifying and addressing potential risks early on, you can avoid costly disruptions and maintain a healthy bottom line. Procurement ROI provides a tangible measure of the impact of these proactive efforts.

Understanding procurement ROI

Procurement ROI, or return on investment, is a critical performance indicator measuring the profitability of procurement initiatives. It quantifies the financial impact of procurement efforts by comparing the cost savings to the costs incurred in achieving them.

The procurement ROI formula

The procurement ROI formula is straightforward:

“Total Cost Savings” is the gross financial gain from procurement. In contrast, the “Total Cost of Procurement” involves all costs related to your procurement initiative, like paying salaries of procurement personnel, service fees, software licenses, etc. Therefore, [Total Cost Savings - Total Cost of Procurement] represents the net savings attributable to your procurement efforts.

Let’s look at what these costs more closely.

Gathering the necessary cost data for procurement ROI

Estimating cost savings due to procurement requires meticulous tracking of your company's total spending before and after implementing procurement initiatives. We can break these costs down as follows:

• Pre-transaction costs, including market research, supplier discovery, and qualification expenses.
• Transaction costs, encompassing purchase price, ordering costs (cost of purchase orders, invoices, etc.), logistics, and transportation.
• Post-transaction costs, including receiving, inspections, payment processing, and supplier management.
• Indirect costs (Overhead), covering salaries, technology, office space, and training expenses.

Identifying and quantifying these costs provides a comprehensive picture of your procurement expenses and enables you to accurately assess your initiatives' impact.

Calculating procurement ROI—A step-by-step guide

This section explains how to calculate the ROI of procurement using two hypothetical manufacturing companies as examples:

1. A large enterprise in the renewable energy sector, with an annual revenue of $10 billion.
2. A medium-sized automotive parts manufacturer, with an annual revenue of $100 million.

Step #1: Establish a baseline

The first step is to aggregate all relevant costs incurred by your company before implementing procurement initiatives. These costs should include any cost your initiative could impact, representing a baseline for later establishing cost savings.

In our example, we’ll assume a baseline spend of $9 billion for the energy company and $80 million for the medium-sized business.

Step #2: Determine total cost savings

After implementing your chosen procurement initiative, track the company's yearly spending. The difference in expenditure before and after the initiative represents the Total Cost Savings.

The savings will depend on the scope and reach of your procurement initiative. A smaller business might only implement initiatives with limited reach, like outsourcing a small part of the procurement process. A large enterprise might seek a more holistic solution that handles everything.

In our examples, we’ll assume the cost savings amount to $1 million for the larger company and $50,000 for the smaller one, which are reasonable numbers based on our experience.

Step #3: Establish the total cost of investment

Again, this cost depends on your particular choice. If you outsourced to a services company, this would include the service fees, any onboarding costs, and ongoing management fees.

Other initiatives, such as software solutions, imply license costs, software deployment and set-up, employee training, maintenance, and customer support.

The cost of investment typically varies as a function of features and transaction volume, so it’s commonly higher for larger corporations. In our examples, we’ll consider a typical investment of $100,000 for the larger company and $10,000 for the smaller one.

Step #4: Calculate procurement ROI

We have everything we need to calculate the ROI. The next step is to use the ROI formula mentioned earlier:

• Renewable energy company:

Procurement ROI = [($1,000,000 - $100,000) / $100,000] * 100% = 900%

• Auto parts company:

Procurement ROI = [($50,000 - $10,000) / $10,000)] * 100% = 400%

The following table summarizes both examples:

What is a good procurement ROI?

Benchmarking your ROI against industry standards can provide valuable insights. The Hackett Group estimated procurement cost and savings as a percentage of total spending for average companies and top performers.

Based on this data and the ROI equation, we can establish 350% to 850% as a benchmark for your procurement efforts. A lower ROI would mean you have an underperforming procurement process.

Using procurement ROI to drive improvement

By analyzing your ROI and breaking down the procurement cost structure that led to cost savings or avoidance, you can identify areas where you can optimize your procurement processes.

For example, outsourcing supplier discovery and data management to Babelus can reduce supplier discovery times by as much as 90%, reducing procurement costs while significantly expanding your reach in supplier markets.

Tracking this part of the procurement cost and assessing its impact on procurement ROI makes it much easier to see the benefits quantitatively and objectively.

Send us a message if you want to discover how Babelus can unlock significant cost savings, enhance operational efficiency, and strengthen your company's competitive advantage.

Ready to move forward? Schedule a meeting to set up a free pilot for your company and measure the benefits for yourself before committing. You’ll be glad you did.