Know exactly what you are paying for
Procurement Learning Centre
Tips and tricks to take your procurement to the next level.
Indirect Spend & Potential Savings
If you had followed our previous article, you would have understood the structure and key elements of Procurement. Now when you are ready to implement a new procurement function, a key question is the resources that are needed in the new function and its scope. In other words, “What is the size of the problem?”
All organisations use measurements in one way or the other. On the organisations’ top level, a key measurement must be financial related. As the saying goes, money makes the world go round, and it is prudent to follow this saying by relating the size and scope of Procurement to a financial indicator.
Definition of spend
Spend is defined as the amount of money paid out from an organisation. For manufacturing and production organisations, the cost of raw materials and direct services that went into the production of the finished product is regarded as spend for the company.
Other spends for the organisation include expenses on overheads such as real estate services, office support services and professional fees paid to external parties. For service and non-manufacturing organisations, the concept of spend is simply associated to the organisation’s expenses, and easily identifiable from the organisation’s profit and loss statement. However, the true definition of spend can be quite diverse, and capturing and interpreting the data pose challenges to many organisations.
Top-down Spend Analysis
Let’s use the real life example of an organisation whose main activity is the design, manufacture and distribution of digital entertainment products. This is a public listed company (on SGX) and the company’s data is available in the public domain. We will use this company as an example on how a top-down spend analysis can be performed in a few simple steps.
From the company’s latest Annual Report, we can see the overall performance as:
As the company has been in operation for a number of years, we can say that it has a good control over its direct spend (Cost of goods sold) of US$ 61million. The other expenses that amount to US$ 52million require closer scrutiny to estimate the indirect spend amount. By examining the accompanying notes to the Financial Statements, notably Note 4, we can determine the following:
Among the items listed here, a number of them clearly cannot be deemed as indirect spend. These are:
- Depreciation of property and equipment (US$ 0.5million) is an accounting entry and no money is actually paid by the company.
- Employee compensation (US$ 30million) reflects the company’s hiring practice and market forces and is under the scope of HR, not Procurement.
- Inventory write-off (US$ 0.9million) is an accounting entry and no money is actually paid to external parties.
All the items listed under Note 4 sum up to US$ 51million. Bear in mind that the company reported expenses totalling US$ 52million in its overall performance. Hence, a further US$ 1million of expenses not mentioned in Note 4 could be related to miscellaneous indirect expenses.
From the above, we can conclude that the company has an indirect spend of US$ 20million comprising of the following:
- Advertising expenses: US$ 4million
- Rental expenses on operating leases: US$ 4million
- Research and development related expenses: US$ 2million
- Travel, entertainment and transportation expenses: US$ 1million
- Legal fees: US$ 8million
- Miscellaneous expenses: US$ 1million
It should be noted that for the company, the depreciation of property and equipment actually dropped from the previous to the current financial year. A closer examination of this situation revealed that the company added a modest amount of machinery, furniture, fixtures and office equipment (US$ 54 thousand) during the financial year. Addition of fixed assets is regarded as spend under the scope of Procurement as money is paid out to suppliers. But for this example, the addition is not significant compared to the overall spend, and we will ignore this for now.
Scope of Indirect Procurement
This example shows a method to rapidly estimate an organisation’s indirect spend from its financial statements. There is little granularity of spend available from the published financial report, and this reflects the apparent weakness of this approach.
If the company was in the course of implementing a new Indirect Procurement function, or creating a focus among its current Procurement function to manage indirect spend, it would be prudent to prioritise the spend to address first. Based on the company’s history and business environment, its spend on legal fees (US$ 8million) and advertising (US$ 4million) can be regarded as under control and make it as outside the scope of Procurement for now. That leaves US$ 8million for the indirect Procurement function to manage, and a good starting point.
Assuming that halve of the US$ 8million spend is covered by well negotiated supply contracts that are in place, that would leave US$ 4million for the Procurement team to manage and source. Taking an entry level of 3% cost savings from professional procurement practices, the company stand to gain US$ 120 thousand cost savings a year, boosting the net profit by the same amount. Should the company continue to operate in the same business environment, the upward potential of Procurement will be US$ 0.5million cost savings a year*, or another 0.6% contribution to the net profit margin.
*Best-in-class Procurement organisations manage more than 91% of their spend, delivering an average of 7.7% actual savings – Ardent Partners, CPO Rising 2016
This simple estimation of indirect spend helps to identify the potential of the Procurement function. While the method has its own weaknesses (insufficient granularity to prioritise the areas to be managed), it is nevertheless a rapid method of estimating and sizing the situation to support a business case for implementing indirect Procurement. Further analysis needs to be undertaken to understand the spend pattern, before the Procurement function can effectively conduct strategic sourcing on the spend.
In the next article, we will highlight the importance of proper spend data, and the methods of conducting spend analysis using a bottom-up approach. It should be noted that the use of spend data to drive Procurement activities cannot be over-emphasized.