I hope that you have enjoyed the article “Why ‘Last Price Paid’ Is A Dangerous Metric.”
I think that the article concisely illustrates why last fiscal year’s average price is a better baseline for your cost savings calculations than last price paid. One thing that I didn’t have the space to address that I anticipate coming up as a question from someone not familiar with my body of work on cost savings reporting is the challenge of quantity changes from fiscal year to fiscal year.
The example in the article has you buying the same quantity – four – in both the current and the previous fiscal year. That makes it easy to attribute P&L expense changes strictly to price. But what if you bought two units last fiscal year at $10 and $14 and four units this fiscal year at $9 each?
I say apply the same baselining principles. The trick is how you present your procurement contribution.
Now, the previous fiscal year’s average price is $12 and your current fiscal year’s average price is $9. That’s a “savings” of $3 per unit. But your P&L expenses actually increased from $24 to $36. In the book that I co-wrote with Dr. Soheila Lunney, The Procurement Game Plan: Winning Strategies & Techniques for Supply Management Professionals, we advise you to report this as “partially offsetting an increase in volume with a reduction in price.”
CEO’s and finance executives use and understand the term “offset” much moreso than procurement jargon like “cost avoidance” and “soft cost reduction.” And this makes more sense to them than calling it “cost savings” – a term that implies P&L expense reduction.
Let’s flip this around and say that quantities decreased.
Let’s say that your quantities and prices for the previous fiscal year were the same as specified in the article: four units for an average price of $11. Let’s also say that you only purchased two units this year at $9 each.
Your cost savings would be the difference in average price ($2) times the quantity purchased (2) for a total of $4.
But your P&L expenses for this item went from $44 (4 x $11) to $18 (2 x $9). That’s a reduction of expenses of $26.
Should you claim $26 of cost savings? Or $4?
Just $4, assuming that it was not a procurement decision to reduce the quantity. Under that assumption, only the reduction in price paid was attributable to procurement work. The cost savings was $4. The rest of the expense reduction ($22) would be attributable to whoever decided to purchase less. If the procurement department didn’t decide to decrease the quantity to reduce expenses, then the procurement department should not take cost savings credit for the full amount of P&L expense reduction.
It is important to continue sharing these types of examples so that procurement professionals like you can improve the credibility of your cost savings reporting. My vision is to have a world where at least everyone with the SPSM Certification can present 100% defensible, 100% indisputable cost savings claims.