Calculating Cost Savings In Multiple Years

PurchTips edition #144


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Do You Calculate Cost Savings Like Your CEO?

Imagine this situation:

  • You are responsible for buying a certain item
  • Last year, you bought 10,000 units of the item at $100 each
  • This year, you've signed a 3-year contract with your supplier
  • The contract price is $90 per unit of the item
  • You will buy 10,000 units of the item in each year of the contract

How much cost savings will you calculate and when will you report the cost savings?

Did you say that you would report $300,000 in cost savings when the contract is signed?

Senior management may disagree with you.

As I've explained in previous editions of PurchTips, when you report cost savings, senior management expects to see a reduction in expenses from the previous year to the current year. So, in the scenario described, your expenses will not be reduced by $300,000 this year - they will only be reduced by $100,000 which is this year's quantity multiplied by the difference in price.

Then, because there is no price reduction between contract year 1 and contract year 2, senior management usually doesn't accept cost savings claims in contract year 2 or thereafter. So the first year of cost savings is all that is recognized by senior management.

This approach to calculating cost savings concerns many purchasing professionals. You may feel that you deserve more credit for achieving a price reduction and locking in that lower price for three years.

That is commendable but, unfortunately, not consistent with the way that executives typically account for cost savings. So how can you get credit for cost savings across the entire life of a multi-year contract?

One way is to negotiate a price that declines each year during the contract. For example, instead of starting at the $90 price, you would negotiate the price to be $95 in the first year, $90 in the second year, and $85 in the third. While the contract value is the same to the supplier, you'll get to report savings in each year of the contract and senior management will recognize three years of year-over-year expense reductions.

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