Procurement is a source of significant unrealized value and savings for many manufacturers. On the direct spend side, companies often spend 65% or more of their direct-spend just managing the procurement process. The great majority of that effort is associated with procuring non-strategic materials and class-c items (the majority of items representing only 5-25% of all direct spend) where even large improvements yield the smallest results as a percentage of spend. Accordingly, they these same manufacturers fail to focus enough attention on strategic materials and class-a items (the minority of items representing 50-95% of all direct spend) where even the smallest improvements can yield tremendous results as a percentage of spend.
Direct material spend often rightly receives the most attention since collectively it often represents the majority of spend. Unfortunately, while indirect spend can easily represent 10-18% of revenue it is often inconsistently managed across multiple functions and completely overlooked as non-core spend.
Outsourcing the procurement of some materials (direct or indirect) is appealing since most manufacturers lack the capabilities or capacity to successfully capture the full value of total spend optimization. Procurement outsourcing providers employ many resources that client companies often lack in sufficient quantities such as procurement expertise, category knowledge, technology, and processes.
While outsourcing procurement has its advantages (covered below) it also poses some risks. For example, it is not uncommon overtime to witness a decline in the performance of the overall procurement process which isn’t exactly the outcome leaders are expecting. For reference, often the first two years of outsourcing procurement are the best years before there is a significant decline in performance. While this can be prevented, it’s often the product of poorly developed relationships between the outsourcing partner and the client company’s stakeholders which undermines performance and sabotages continuous improvement.
Of course, most companies that successfully partner with a procurement outsourcing partner determine the best way to optimize the procurement function is not simply outsourcing all procurement, but strategically outsourcing some procurement, freeing internal resources to better focus on managing key suppliers and strategic procurement initiatives.
What are the Benefits of Outsourcing Procurement?
Reaping the most benefits from the procurement function requires comprehensive planning, and disciplined execution for a sustained period. Many organizations recognize that they lack either the talent, systems, or tools necessary for such an approach. Outsourcing procurement can be a compelling proposition due to the many benefits offered by procurement business-process outsourcing (PBPO providers:
- Category expertise: PBPO providers have access to teams with significant functional and category expertise. While this means they are often far more efficient at procuring those items, this also empowers them to more quickly recognize opportunities for savings. For example, Falcon Client Advocates frequently identify easy-to-implement design changes or substitutions able to save clients over 90% in some cases. Additionally, PBPO providers often possess superior insights on industry, suppliers, cost, and pricing, including pricing benchmarks.
- Discipline: A properly integrated source-to-contract (S2C) and procure-to-pay (P2P) process, along with well managed controls such as ensuring contract compliance, and limiting maverick spend, significantly improve procurement’s productivity.
- Technology: Many PBPO providers deploy multiple technologies that greatly improve sourcing, purchasing, logistics, and accounts payable, which the client company would otherwise have to implement and manage alone. The client company reaps the benefits of these technologies often with limited or no additional investment and with little required learning.
- Risk management: PBPO providers often excel at maintaining compliance and managing procurement risk far better than client companies because they have far more experience and expertise with a wider range of commodities, industries, and situations.
- Pricing: Because PBPO providers manage the spend of multiple clients, they often provide scale, cost, and market intelligence advantages that greatly benefit negotiations, resulting in better pricing.
These value-adds often result in better spend visibility and control, improved operational reliability, a faster process improvement cycle, and reduced operational cost.
What are the Downsides of Outsourcing Procurement?
Many PBPO providers focus much of their energy on optimizing rudimentary procurement practices such as achieving better pricing by leveraging volume discounts on consolidated spending. It’s far less common for them to employ advanced techniques such as cost breakdown analysis, structured negotiations, and advanced RFQ processes. That said, many outsourcing initiatives suffer from a few common drawbacks:
- Over-employing transactional tactics: Even when performed right, only 40-50% of the full potential value from procurement optimization can be achieved from strategies such as changing suppliers or haggling over price. Unfortunately, since these levers are effortlessly delegated to and easily managed by external parties, they are often the only tactics effectively employed, limiting the full benefits of working with a true partner.
Relationship barriers. The remaining value to be captured by procurement optimization comes from strategies such as demand management. Demand management includes activities such as routinely reviewing specifications to identify opportunities for substitution or simplification and working with stakeholders to adopt common configurations.
This level of involvement necessarily requires internal relationships which many client companies often unintentionally undermine through neglect or even intentionally prohibit external partners from ever developing. Unfortunately, the lack of such relationships often significantly sabotages the efficiency of even simple operations, robbing the client of some of the savings produced from the transactional tactics.
- Misaligned incentives: Many PBPO providers deploy multiple technologies that greatly improve sourcing, purchasing, logistics, and accounts payable, which the client company would otherwise have to implement and manage alone. The client company reaps the benefits of these technologies often with limited or no additional investment and with little required learning.
- Risk management: Although PBPO contracts often incentivize rapid cost reductions, sometimes service is sacrificed as a result. When total cost of ownership isn’t paid sufficient attention, there are often few incentives for continuous improvement and innovation. Thus, most of the program’s impact is realized in the first few years of the partnership, after which savings plateau. A key first step to preventing misalignment is to collaborate on a program proposal upfront that explicitly includes continuous improvement objectives.
Where Procurement Outsourcing Help?
Outsourcing can empower stakeholders to improve their execution of strategic initiatives that ultimately deliver far greater savings and efficiencies to the organization. For procurement outsourcing to be successful key stakeholders must agree on how the partnership will drive the most value now and in the future. Often, the first key factor to consider in this analysis is whether outsourcing procurement will generate value or simply preserve value.
Procurement value generation utilizes both commercial and demand management within a strategic total-cost framework. Commercial management primarily focuses on procuring through the best channels at the best price. Demand management focuses on fully understanding stakeholder needs in order to standardize, simplify, streamline, and ultimately optimize what truly needs to be procured, in what quantity and when.
Procurement value preservation focuses on ensuring that any initial savings from value generation efforts flow in full to the client’s bottom line. Many factors can cause value leakage such as maverick spend (e.g., purchasing from unauthorized channels), inefficient purchase order process, supplier non-compliance, mismanaged supplier relationships, and even inefficient PBPO partner or client receiving and stocking processes.
- 1. Strategic importance of the specific category: Does the category produce a competitive advantage (such as differentiation) or would outsourcing its procurement introduce significant additional risk?
- 2. Internal procurement’s current capabilities: A holistic assessment of internal procurement’s current skills, tools, process maturity, performance, goals, etc.
Similarly, outsourcing value-preserving activities is also largely determined by 2 key considerations in order:
- 1. Current internal economies of scale of the specific category: For each category, is internal procurement’s current economies of scale equal to or greater than those of the potential outsourcing partner? Do you efficiently procure more of the category than a potential partner?
- 2. Internal procurement’s current capabilities: As described above.
Once a company’s current state has been fully accessed a sound decision can be made on what to outsource and what to keep in-house. While various scenarios can arise from your assessment, a common one is only outsourcing the procurement of all non-strategic goods and services (direct and indirect), while keeping the procurement of all strategic needs in-house.
Outsource Non-strategic Procurement
Outsourcing may be the right move if your organization lacks either capability, capacity, or scale, or for categories of little strategic importance. A few common examples of categories with little strategic importance for manufactures include travel, maintenance-repair-overhaul (MRO) items, personal protective equipment (PPE) items, standard components, and class-c components (standard and custom-made parts collectively representing a minority of direct spend) such as fasteners, electrical connectors, and nameplates. These items often are necessary but are not a key strategic differentiator or advantage. Many PBPO providers are far more efficient and reliable at procuring these items than a manufacturer is.
In some cases, companies have the necessary capabilities and capacity to manage the procurement of even non-strategic items at subscale. In these cases, its best to adequately access the costs and benefits of keeping the procurement of those items in-house versus outsourcing. Keep in mind however, that even in cases where a manufacturer may effectively manage the procurement of such items internally, doing so may not be the best use of internal talents and resources. For example, often such resources are better allocated to further improving the internal procurement of strategic commodities.
Procurement is a vital business function. Thus, whether to outsource or insource some facets of that function is a key business decision that should only be made after thorough review and sufficient analysis of the strategic impact. Only then can manufacturers optimize their procurement investment, ensure strategic success, and experience continuous improvement.
Falcon helps manufactures overcome their procurement challenges. Contact us to discover how.