Let us think together about how much does Procurement affect the total financial result of your company? Does it influence company profit at all?..
How can we analyse that?
Of course we know that if we fail with the Procurement – we might end up with the empty shelves in the stores, or no goods to deliver to our customers. If the components are late to the manufacturer – it will lead to the production delays of the manufacturer and make even bigger impact further in the supply chain. So in case of any disruption of supply chain – we risk very practical losses. The results of mistakes can be very visible, very tangible and sometimes very painful for entire companies. This can mean customers dissatisfaction, big risks for the contracts penalties… this is clear, right?
But at the same time think about the positive scenario: what if you have established good processes, you manage the risks in supply chain well, there are no shortages… How do we measure the financial impact of Procurement?
Leverage effect of Procurement
In order to measure this impact – we can look in the typical cost structure of the manufacturing company, where we divided the costs by external costs (which stands for Materials and services which were purchased from other organizations). Then we have so called added value costs – which is Depreciation, labour and other costs, fixed costs. And on top of this costs we add the sales margin.
All right, so here we have a typical cost structure for the manufacturing company, where procurement as we assumed here is responsible for 60% of the turnover.
So now let’s imagine what will happen that procurement department has done a good job this year and agreed the 2% price decreases with the external vendors
What it means is that instead of 60% – procurement will stand for 2% less. Two percent of 60% is 1,2% from the total turnover are saved by procurement organization.
If the sales prices remain the same – where do we allocate those 1,2%? Of course to the profits!
So now the profit would become not 5, but 6,2. Fantastic!
Profit increase in percentage? Well it is a lot – 24%. So by decreasing purchase prices by 2% we have managed to increase the profit by 24%.
The same effect will happen with improvement of Returns on investment. 24% increase by decreasing the purchase price by2%
And such leverage effect is called the leverage effect of Procurement.
This is a truly great feature to have in your head and to keep in mind when talking to the other departments in your company. So this leverage effect can serve you as a good argument when you are having the tough internal discussions inside your company.
P.S. Pay attention that the opposite effect can also take place J. If you are increasing the purchase costs by x% you will have the much bigger bad impact on the profits of the company…
Read other article by Robert Freeman:
Article by Robert Freeman
Procurement expert at Future Procurement
You can learn more about Procurement and Supply Chain Management at our web-site www.futureprocurement.net