Traditional savings reporting and accounting keep business owners and finance in the dark about external expenditure development. It doesn’t have to be that way.
2. ESPM WHITE PAPER BY AUGUST JUNE 2015 2
Traditional savings reporting and accounting keep business
owners and finance in the dark about external expenditure
development. It doesn’t have to be that way.
External spending represents 50-80% of a company’s cost base, but most
business owners and finance departments know very little about it beyond
the accounting breakdown.
Unlike the top-line (contracts and orders, volume and price, customer and
product mix, and sales pipeline) or personnel costs (headcount, recruitment
plans, salary costs, and fixed-term contractors), very little information
about external expenditures is visible to the CFO and senior management.
As procurement people sometimes joke, if you want to know what your
company bought, ask your suppliers.
The problem is structural. Finance sees the accounting breakdown of
external expenditures, but it doesn’t see purchases from a supply market
standpoint, and it can’t track why costs in individual categories are rising
or falling. Procurement, meanwhile, can only follow the cost development
of sample items and expenditure categories but has no easy way of taking
a larger view.
These two overlapping blind spots make many questions about external
expenditures that sound simple, such as why did external expenditures go
up last year? or why can’t I see the claimed savings on my P&L?, extremely
difficult to answer.
Having so much spending hidden from view hurts the company in a variety
of ways. Business owners face difficulties understanding their past results
and forecasting their future results. Savings contracted with vendors are
rarely realized with full-effect to the bottom-line. Finance has a much
harder time planning. Lack of transparency may also lead the company
to seek perverse savings, such as marginal cost reductions in a category
where supply quality and availability are matters of life or death for the
business. Indirectly, vendors and customers suffer too, from jerky orders and
uneven fulfillment. Most seriously of all, this blind spot means that most
companies have only some assurance that they have paid the right price for
something, and almost none about whether they bought the right thing.
UNDERSTANDING
EXTERNAL EXPENDITURES
Simple questions such
as why did external
expenditures go up last
year? or why can’t I see
the claimed savings on my
P&L?, are often extremely
difficult to answer.
3. ESPM WHITE PAPER BY AUGUST JUNE 2015 3
August’s External Spending Performance Management
model can shine a light on these blind spots. ESPM can
give Finance and business owners greater visibility on
expenditures that are currently hidden, and help ensure
that Procurement is buying so as to fulfill the company’s
business objectives in the most strategic way.
Implementing ESPM is a three-step process:
1. Build a common view of external spending.
The first stage of ESPM involves creating an integrated understanding
of all external expenditures. This is often surprisingly difficult. At most
companies, Finance and Procurement have distinctly different views of ex-
ternal costs. Finance works over the fiscal year, Procurement over pro-rated
12-month periods. Finance considers mostly the overall expenditure, but
Procurement focuses on changes in renegotiated contracts. The financial
view is exhaustive, while Procurement’s is sampling-based.
It gets even trickier with Capex purchases. Procurement might look at the
purchase price of a generator, for example, but Finance will account for the
purchase over the years of its useful life. To make matters more complicated
still, subsequent refurbishments or bolt-on modules may change the value
and useful life in accounting terms. To gain clarity, we recommend that
for the purposes of this exercise, Finance officers take off their green visors
and focus exclusively on purchase prices. Obviously this won’t always make
sense, but we find apples-to-apples comparisons make it much easier for
cross-functional teams to evaluate purchases together. Simply reconciling
the different viewpoints can go a long way toward enabling the company
to make more strategic purchasing decisions.
2. Select the metrics.
Financial measures:
Next, we disaggregate the non-negotiable factors, such as currency rates
and underlying commodity prices, from the drivers the company controls,
such as volume and price. This helps create more transparency to the drivers
of external spend and reveal the true results of procurement efforts, such
as the price component of the waterfall chart shown in Figure 1 (p. 4).
Obviously there are some practical challenges in building a waterfall chart
of external spend development. Typically, we can find proper price/quantity
data for just 20% or so of the overall expenditures. But dealing with imper-
fect data is not a major obstacle to adopting ESPM. When we lack price
and quantity data (e.g. due to lack of or incompleteness of purchase orders),
we can still build logical volume proxies using the available information.
For instance, the financial executives of one major European passenger
train company had been trying to find a way to get a better grasp of its
ADDING EXTERNAL SPENDING
PERFORMANCE MANAGEMENT
Dealing with imperfect
data is not a major
obstacle to adopting
ESPM.
4. ESPM WHITE PAPER BY AUGUST JUNE 2015 4
cleaning service bill. They had no proper price/quantity data available from
the purchase orders, but they knew the total amount paid to the cleaning
service providers. They also had data on two key demand drivers, kilometers
driven and number of passengers per route. Introducing this new measure,
euros per driven passenger kilometer, brought improved visibility to their
cleaning expenses. Even more importantly, this new measure changed
their entire view of cleaning -- and ultimately saved the company millions.
Previously the supervisors had sent workers from the external janitorial
service to clean every train after each run, regardless of how full the train
had been. After the introduction of the new measure, supervisors changed
the cleaning frequency and also the way passengers were seated in more
lightly travelled train routes. (See sidebar 2 on page 10)
The specific measure will depend on the purchase, of course. Depending
on the purchased product or service, cost per employee, square meter, or
machine hour may be the right measure. In any case, picking the right ratio
makes all the difference. The right price/quantity by proxy, as we call it, will
be simple and scalable but also intuitively understandable to Procurement
and the company at large. Once we identify that KPI, it becomes much
easier to see where costs are increasing and to renegotiate contracts to pay
for the value that actually matters and not, for instance, re-cleaning clean
train cars.
Non-financial measures:
However, having the financial transparency on spend development and its
drivers is still not enough. ESPM approach uses complementary, non-fi-
nancial measures to ensure that sourcing efforts are aligned with the overall
business objectives. While this sounds like common sense, we often see in
practice that companies with very different business objectives are having
identical sourcing KPIs. This should not be the case.
A) Exchange rates differences between purchase and reporting currencies
B) Purchase volume differences from one period to the other on recurring purchases only
C) Paid price difference on recurring purchases only = Purchasing performance
D) Accounting for market realities and changes in the underlying raw material prices
Fig. 1 : External spend waterfall: building transparency to the drivers of external spend
A) Currency
External
spend
Year N Year N+1
External
spend
B) Volume C) Price
D) Market
5. “However, having the
financial transparency
to spend development
and its drivers is still not
enough. ESPM approach
uses complementary,
non-financial measures
to ensure that sourcing
efforts are aligned with
the overall business
objectives.”
5ESPM WHITE PAPER BY AUGUST JUNE 2015
6. ESPM WHITE PAPER BY AUGUST JUNE 2015 6
For example, a global fashion retailer H&M focuses on seasonal collec-
tions. Its competitor Zara’s strategy involves stocking fresh designs on a
weekly basis. Considered in traditional sourcing terms, H&M is far more
efficient, but an ESPM analysis shows that both strategies are defensible.
H&M can use suppliers from lower cost-countries, undertake competitive
bidding processes and supplier selection, and drive savings in external
spend. Zara’s business model, on the other hand, cannot afford long de-
livery times from low cost countries or time-consuming bidding processes
and renegotiations. Inditex, Zara’s holding company, emphasizes supply
chain agility, delivery accuracy, and short lead times from the drawing
board to the rack.
How does this strategic difference change each company’s approach to
managing external spending? H&M can have a stronger focus on savings,
but Zara must prioritize other metrics, such as delivery time and accuracy,
that better support its business objectives.
ESPM can be applied to other kinds of business challenges as well. For
example, a flavoring business that offers high-volume, low-cost flavor blends
to the prepared food industry might focus on creating economies of scale
by trying to cut the number of active ingredients to improve scope and
scale advantages. Executives would probably want to reduce the number
of chemicals used in a compound (a major driver of complexity, not only in
procurement but also in supply chain and production), and build a low-cost
Asian sourcing strategy. ESPM would help them achieve these goals by
tracking two simple metrics: number of ingredients in each formulation,
and percent of spending allocated to low-cost countries.
As these examples show, the metrics must be carefully thought through
so that they support the overall business objectives and ensure that the
most strategic issues are being discussed by the key stakeholders, including
Operations, Procurement, and Finance. In the case of the train company,
for example, the new metric not only led Procurement to renegotiate its
contracts but also facilitated much improved cross-functional discussions
on how to use the train car capacity in the most cost-effective way.
Unlike most pure procurement-focused approaches to external spending,
ESPM focuses on the underlying intention of the payment, not just the cost
of the good or the service. An ESPM practitioner does not ask, did we get
the cheapest widget?, but did we get the job done in the most cost-effective way?
3. Manage the performance.
The management practices from target setting to performance follow-up
must recognize the cross-functional nature of external spending. While
the procurement function facilitates spending, it’s the budget owner who
makes the ultimate purchase decision and consumes the product or service.
Clarifying their respective roles is the first step in defining responsibilities,
establishing targets, and measuring results. With Procurement entrusted
with finding the right products and services at the right price, and the
business units in charge of paying for them and consuming them, it make
sense to introduce planning that incorporates this common-sense division
of responsibilities.
Measurement has to
be carefully thought
through so that it
supports the overall
business objectives and
ensures that the most
strategic topics are being
discussed between the
key stakeholders.
7. ESPM WHITE PAPER BY AUGUST JUNE 2015 7
Once ESPM performance management practices are implemented, external
spending is no longer a “black box,” but a mathematical formula with an
input, an intuitive cost metric, and an output. Not only do forecasts become
more accurate, but when a shortfall does occur, the company can diagnose
and correct its causes. With ESPM, leaders from Operations, Finance,
and the business units are much better equipped to review past financial
performance and project future needs, discuss their sourcing requirements
and set priorities for cost savings in the coming year. As a result of these
cross-functional discussions using ESPM, the business might redirect
purchasing volume to approved vendors and SKUs, alter ordering practices,
or initiate new sourcing cases with Procurement. Procurement might revise
its ongoing sourcing cases, re-prioritize, and revise the scope or targets of
planned cases. In the end, Finance has a clearer view of the future, and is
able to make projections based on expected volume and price development.
1. Procurement function can
control external spending only
to a certain extent by
- Negotiating contracts (only
covering part of the total
spend)
- Agreeing prices and other
terms
2. Development of total external
spending is influenced by
many stakeholders
- Business, sales, production
and other functions eventually
decide what is bought, how
much and from whom
- Finance can influence the
impact of currency rate or
commodity price fluctuations
Fig. 2 : Managing external spending: not the responsibility of one but of many
Production
Sales
Business
Finance
1. External spend
under Procurement
function’s control
- Contracted volume
- Contract terms
Volume Items
Currency rates
Commodity prices Suppliers
2. Total external spend
8. Example situation - CFO explaining
the spend development to investors
“This morning on CNBC we’re talking to Daniel Leader, CEO of
Performance Corp., and his CFO, Emma Control…Daniel, your
business has been doing pretty well since last year’s merger. We’ve
seen year-on-year growth in Q3 of 12% in a market that’s grow-
ing at less than 10%. Profits have not grown as fast as expected,
though. Can you explain what’s going on here? What happened to
the cost-saving synergies you guys promised?”
“You are right, Alisa. Our top line growth is spectacular and I am
very pleased with how customers have reacted to the merger. We
do not expect any significant churn on our client base. When it
comes to the bottom line we are progressing well on many fronts
too. Let me pass this on to Emma, our CFO. She’ll provide you
with a super-clear picture on what’s going on with our external
spending. Right, Emma?”
“Thanks Daniel. Alisa, as you have noted, our profitability has not
developed as we hoped, since our external spending has increased
faster than our top line, 14% year-on-year. Overall, purchased volume
growth has gone up year on year by 11%. Our currency exposure due
to the new markets we bought from cost us 1% year-on-year. But
what really hurt us in this reporting period was the commodities
market, which nicked another 4% off the top. Once you factor out
those headwinds, you can see our procurement team has done an
excellent job in beating the market, generating a year-on-year price
reduction of 2%.”
“Daniel, Emma, thank you for coming on CNBC today. It was good
to have you with us. We were speaking to Daniel Leader, CEO of
Performance Corp and his CFO, Emma Control.”
Would you have a similarly credible explanation if a reporter asked you
that question? Most CFOs lack transparency of their external expendi-
tures and its drivers, but if you implemented August’s External Spending
Performance Management model, you would be able to answer with the
same assurance as our fictional CFO.
SIDEBAR STORY 1
8ESPM WHITE PAPER BY AUGUST JUNE 2015
9. ESPM WHITE PAPER BY AUGUST JUNE 2015 9
Attaining this level of visibility is not easy, even with ESPM expertise. Suc-
cessful and sustainable change in this domain demands strong sponsorship
at the very top. These sponsors must send a strong signal that ESPM is not
primarily a procurement savings measurement, but a strategic approach
to better measurement and management of company’s external resources.
ESPM can yield extraordinary results if pursued diligently. It is a mode
of challenging old habits that creates lasting value for the company, the
investor, the supplier, and ultimately the customer.
TAKING THE
FIRST STEP
ESPM can yield
extraordinary results if
pursued diligently.
10. All Aboard – Implementing ESPM
at a rail transportation company
When the government of one of the world’s largest economies
needed to reduce its deficit, it turned first to business enterprises
it controlled.
As one of the largest and most visible employers in the country,
the transportation company was among the top candidates for the
government cost containment program.
To meet the challenge, the company decided to create a new pro-
curement controlling function out of a core cross-functional team
drawing from Finance, Control, Purchasing, business units, and a
series of other functions that would participate on an as-needed basis.
This new External Spending Board would report to Procurement
and Finance, the latter having ultimate responsibility.
The External Spending Board’s project was to take place in multiple
phases, each addressing a number of procurement categories, and
in total covering 80-100% of the total external spend.
Phase 1: Setting the ground rules
The External Spending Board began by setting the following ground
rules for its work:
• Truthfulness: the goal of measurement is to track movement
in external spending from one period to the other
• Recognizability: measurement could not be carried out solely
in the language of Finance or Procurement but needed to be
clearly understood by all the relevant business units
• Sustainability: a better procurement and budgetary system
is the goal, not quick cost savings
• Pragmatism: data limitations are not allowed to become an
obstacle, multiple approaches can be used to enable spend
visibility
The External Spending Board found agreeing on a financial method
relatively simple. Metrics for spend development, however, proved
a bigger challenge. After taking stock of the available data, board
members realized they would need to build systematic metrics of
spend development. Unfortunately, although detailed price quantity
SIDEBAR STORY 2
10ESPM WHITE PAPER BY AUGUST JUNE 2015
11. data existed for most categories, they soon realized that price/quan-
tity measurement would have to be complemented by a proxy-based
approach that would substitute missing volume data points with
cost drivers. To better track its train cleaning bill, for instance, the
company developed a new measure -- euros per driven passenger km
-- for cleaning services, a major component of indirect spending.
Phase 2: Chasing the cost drivers
In the second phase, the External Spending Board started to im-
plement the cost-driver approach. Identifying cost-drivers forced
the team to understand the ultimate results the users of products
or services intend to achieve with the purchase. Understanding the
category strategies and their practical execution not only helped the
board see the costs more clearly, but gave them a new set of KPIs
they could use in parallel to the pure cost measurement waterfalls,
which taken alone told only part of the story.
The end result was a coherent dashboard with waterfall charts built
for each category that could show the company’s total external spend
development. These analyses could be taken all the way down to
article levels, providing full transparency of performance. The group
level dashboards were built up from category views that had not only
the spend development charts but also the complementary KPIs.
They provided a complete story that could be discussed between
group functions and business units, and eventually taken to the
external contractors for more cost-effective contracts.
Phase 3: Forecasting
Now in its second year, the company’s new external spending per-
formance management system is still a work in progress. Today,
however, management and relevant stakeholders have an advantage:
a single view of the company’s external expenditures. In the next
step, the External Spending Board will advance from measuring to
forecasting, and place a greater emphasis on planning and directional
setting. The company’s ESPM journey is far from over, but multiple
parts of the business are now, little by little, becoming more strate-
gically and operationally aligned with management’s overall aims.
11ESPM WHITE PAPER BY AUGUST JUNE 2015
12. ESPM WHITE PAPER BY AUGUST JUNE 2015 12
Tomi Ere is a partner at August. He specializes in strategy-driven trans-
formations and also has a strong background in strategic sourcing programs.
He can be reached at tomi.ere@august.fi
Olli Lehtonen is a director at August. He is a specialist in performance
management and strategic sourcing, and leads August’s ESPM efforts. He
can be reached at olli.lehtonen@august.fi
Fabrice Saporito is a senior advisor at August. He is also the founder
and CEO of SpendLead, Inc., a B2B engagement platform. Previously he
served as CEO of Sievo, and as a management consultant at The Boston
Consulting Group and Booz Allen Hamilton.
About August
August is a leading management consulting company in Finland. Our client
base consists mostly of large companies and major private equity investors
and their portfolio companies. We serve our clients in a broad range of
topics covering Strategy and M&A, Operations, Sales and Marketing,
and Organization. Our team comprises more than 20 professionals with a
perfect mix of experienced seniors with extensive background in consulting
and young talents with outstanding academic records from top universities.
ABOUT
THE AUTHORS