How Procurement Excellence Creates Value

When is cutting costs and improving quality not enough? "Now," say CEOs from around the world. A.T. Kearney's 2004 "Assessment of Excellence in Procurement" (AEP) study reveals that senior executives expect supply management to go well beyond its traditional role. Rather than focusing

on price reductions, executives are challenging the organization to capture value from the supply market. This view represents a huge advance in their understanding of procurement's potential. In 1999, 28 percent of supply management organizations had goals aimed at value creation; in 2004, that figure rose to 66 percent.

Top supply management practitioners are already delivering more value. The study's leaders are outperforming the pack in generating savings and driving these savings to the bottom line. (See Exhibit 1 on page 46.) The additional savings come in large part from reducing total cost of ownership, rationalizing specifications, and managing demand. In three of four procurement categories—direct materials, capital expenditures, and services—the leaders' savings percentages are more than twice those of followers. This broader view of value has helped leading companies to deliver net income margins that have consistently exceeded their industry averages since 1999.

It was not easy to achieve leadership ranking in the 2004 assessment. The study yielded 18 leaders from a global, multisector benchmarking group of 238 companies. (For more on the study, see the sidebar on page 47.) The leaders scored in the top 10 percent on a rigorous questionnaire and demonstrated world-class performance in at least three of eight dimensions of procurement excellence. (The eight dimensions are shown in Exhibit 2 on page 46.) (For a closer look at one of the leaders see the sidebar on page 51.)

Nearly all leaders and most followers recognize that the key to their business strategy is value creation. Yet leading organizations use their foundation of excellence to create more value and gain competitive advantage from supply markets by focusing on four key areas: innovation and growth, value chain optimization, risk management and supply continuity, and advanced cost management. (See Exhibit 2.)

How Leaders Create Value

While all four value-creation approaches are powerful, they are not all suited for all spend categories. For example, some service categories might not incur great supply-continuity risks. Companies with a large direct-materials spend would place a heavy emphasis on advanced-cost-management techniques. If highly engineered subassemblies are critical, procurement professionals may concentrate more on innovation, advanced cost management, and risk-management solutions than on value-chain optimization.

The following points highlight the study's findings in all four areas of value creation.

1. Innovation and Growth. To meet customer demands for a constant stream of new products and to stay ahead of competitors, leaders involve suppliers early in the new product or service development process. (See Exhibit 3 on page 47.) What can suppliers bring to the innovation party? Coca-Cola's Fridge Pack was developed by a supplier; so were the fiber-optic-enabled light rings around BMW headlights. Procter & Gamble's Global Baby Care Unit expects 50 percent of innovations to come from suppliers.

Yet even the most forward-thinking companies may be leaving innovation opportunities undertapped. Just over one-quarter of the leaders bring their key suppliers into the initial concept stage, compared to 6 percent of followers. Even at the launch stage—the culmination of new-product development—78 percent of leaders and 34 percent of followers report full participation by key suppliers. Clearly, there is room for improvement.

Leaders caution, however, that involving suppliers early in the game can put intellectual property at risk. Smart innovators set the stage for success in both personal and legal terms: They build strong, trust-based relationships backed up by ironclad agreements. Furthermore, knowing that innovation is a living process, they review and refresh their knowledge of supplier capabilities every six to 12 months.

2. Value Chain Optimization. Companies that are focusing on core competencies need to find external partners with other best-in-class capabilities. For many, the current focus is on cost-driven outsourcing. Findings in a separate study1 reveal that 89 percent of companies outsource to reduce operating costs, 81 percent to enable a focus on the core business, and 60 percent to access supplier technology. In contrast, far fewer companies focus on outsourcing to help them with the top line. Only 46 percent outsource to increase speed to market, 38 percent to grow revenue, and 22 percent to gain access to new markets.

Leaders invest time and effort not only to leverage value chain partners for the right reasons but also to make the partnerships work. The study's leaders spend more time managing these external relationships. They are more than twice as likely as followers to set and track project goals and milestones, use cross-functional teams from both companies, and have formal supplier-development roles.

How can a company move from outsourcing to optimization? In our experience, it first has to define what is truly core, without being trapped by tradition or underestimating what suppliers can do—especially to help grow revenue. Then it can segment suppliers, focus on the strategic few, and invest in building and formally managing the partner relationships.

3. Risk Management and Supply Continuity. Most companies in the study recognize risk management as a strategic issue. Yet leaders are more likely to have—and to have tested—contingency plans to protect themselves from supply disruptions. For example, six months before it happened, Dell anticipated the 2002 West Coast dock strike. Even before the ports closed, Dell chartered a fleet of 747s, locking-in freight rates at half of spot-market peaks. It also worked with suppliers to ensure that parts were delivered on time to Shanghai and Taipei airports to minimize turnaround times.2

Another recent study finds a shift in the numbers and types of risks that have become top of mind.3 Traditional risks stemming from regulation and legal decisions, country financial changes, currency and interest rate volatility, and political or social disturbances remain important but less so than in previous years. The emerging risks of governance issues, intellectual property theft, terror, and other security threats have moved from secondary status to the forefront of business leaders' concerns.

Even unanticipated market shifts can disrupt business. In the past two years, a spike in steel demand from China, coupled with supplier consolidation and production capacity constraints, caused a doubling in steel prices and shortages that forced some automakers to cut back production.

Procurement must take the lead to place supply continuity at the heart of the corporate risk-management strategy (and demand that key suppliers have contingency plans as well). Key steps in this complex process include defining the strategic categories that deserve risk-management plans, prioritizing along multiple dimensions, conducting scenario-based analyses, and developing supply risk-management strategies.

4. Advanced-Cost-Management Techniques. Companies pursue global sourcing with the tenacity of a bull dog. They consolidate volume. They evaluate best prices and quality for thousands of items and services. What's left? The answer is a whole menu of advanced-cost-management techniques that match purchases to needs and reduce the total cost of ownership.

The survey reveals a sizeable gap between how leaders and followers use advanced techniques. More than three-quarters of leaders systematically rationalize specifications, compared to just over one-third of followers. The same proportion holds with respect to working collaboratively with suppliers to reduce costs. Better than half of the leaders undertake tiered sourcing, which demands an understanding of their suppliers' suppliers; only about a quarter of the followers have adopted this technique. Solutions like these are complex, and success requires more creative approaches and greater collaboration than traditional sourcing.

The menu of advanced cost management techniques includes:

Complexity reduction —rationalizing specifications to eliminate value-draining complexity.

Tiered sourcing —combining company and tier-one supplier volumes so the supplier negotiates more favorable contracts with its own suppliers.

Mega-supplier strategies —offsetting a supplier's advantage in a non-negotiable category by bundling other categories in the negotiation.

Supplier tiering —restructuring the value chain by bundling or unbundling activities at various value-added stages (for example, transferring management responsibility for tier-two and -three suppliers to the tier-one supplier).

Value-based sourcing —using supplier capabilities to generate other kinds of value such as shorter time to market or innovation.

Best shoring —finding competitive suppliers in inherently cost-advantaged countries along each step of the value chain.

Target costing —determining what a company ought to pay for an item by analyzing appropriate performance, technical, and other characteristics to its price.

Design-to-cost —revising specifications to avoid costs, for example, by eliminating over-specification or optimizing subsystem design.

Collaborative cost reduction —generating and implementing cost reduction ideas (and sharing risks and benefits) with suppliers.

Demand management —rationalizing requirements, controlling approval, and reducing or eliminating nonessential purchases in certain (primarily indirect) categories.

The last three techniques, in particular, have been proven to hold potential for value creation. We now discuss each of these three in greater detail.

Design-to-Cost: Down with Waste

Waste is endemic in product design. Think of the features never used: How many people ever program their VCRs or use all the functions in their cell phones? A.T. Kearney's experience shows that excessive functionality and features can boost costs by 5 to 15 percent. In fact, product design is the single most important driver of cost, as Exhibit 4 illustrates. By the end of the early, creative design phase, about 70 percent of the product's lifecycle cost has been established and two-thirds of the cost reduction opportunities have vanished.

Leaders are involving suppliers in a systematic lean-design approach that leverages the supply base and aggressively identifies waste. Suppliers join buyers in structured, rigorous idea-generation workshops. In the first month of one leader's program, the company hosted 27 workshops with tier-one suppliers that examined $670 million in spend, raised 434 ideas, and identified $43 million in potential savings.

When combined with sourcing, design-to-cost efforts pack an added punch. A European electronics-equipment manufacturer needed to reduce product costs drastically to remain competitive in Asia. Its pricing was about 15 percent above the market. Part of the problem was the company's project-oriented culture did not encourage a big-picture view of engineering and manufacturing. To turn around both its thinking and product design, the company investigated all the product cost levers in a phased approach that alternated analytical and creative phases. The result was nearly a 30-percent reduction in product cost.

Collaborative Cost Reduction: It Takes Two

Collaborative cost reduction (CCR) is a formal program for working with a supplier to identify and implement ways to reduce the costs of a product or process. Can a part be modified to make the end product easier to assemble or less costly to service? Can production efficiencies be raised or inventories be trimmed by exchanging better information? Can unproductive work or duplication of effort be eliminated?

Despite the opportunities, A.T. Kearney research has shown that collaboration does not come easily, even for companies that use advanced supply chain practices. While 82 percent of companies interviewed encourage key suppliers to take on value-added roles in product design and supply chain management, only 46 percent say that the practice is providing benefits.

One reason may be that CCR requires collaboration both between companies and across functions within the buyer's and supplier's companies, as Ericsson found. This world leader in mobile communications had outsourced a significant amount of manufacturing to one of its largest suppliers, then found that the new relationship overwhelmed the existing interfaces. Customer service issues surfaced, orders were late, and fluctuating demand created problems. The companies invested in joint process improvement to improve supply chain performance. In addition to cutting manufacturing, distribution, and inventory costs significantly, the companies saw a big boost in service. On-time performance rose from 70 percent to 97 percent, lead times were reduced by 60 percent, and orders were confirmed in hours rather than days. Achieving these results, however, demanded cooperation across departments in both companies to electronically enable the process, jointly identify and implement improvements, and link factory operations to product strategy.

Demand Management: Looking in the Mirror

Companies that are truly serious about cost reduction exert pressure not only on suppliers but also on themselves, through demand management for discretionary expenditures. Because demand management cuts down on purchases at their source, savings show up quickly. And the numbers are substantial indeed. Savings of 10 percent of analyzed spend are not uncommon. Depending on the category and the aggressiveness of the demand management effort, savings of 10 to 20 percent are within reach.

For example, one company applied demand management to its technology spend, discovering that it had few controls on the purchase of small, nonessential peripherals. Most of these items cost less than $200 apiece, but the total spent on an ad hoc basis was nearly half a million dollars per year. By educating the workforce and instituting controls, the company drove demand to nearly zero.

Similarly, a large global bank used a demand management program to target four categories that represented 25 percent of its external spend: technology, telecommunications, consulting, and travel. The program—which included a range of recommendations—reduced spending in these categories by nearly 8 percent and generated $40 million in savings.

An Increasingly Visible Role

A few years ago, only a handful of supply management organizations were prepared to deliver value in the ways described in this article. However, supply management is rapidly evolving. Two years ago, even leading procurement organizations spent just half their time on strategic activities and the other half on tactical activities, such as transaction execution, supplier payment support, and general contract administration. In the 2004 study, however, leaders report spending two-thirds of their time at the strategic level. This strategic focus places leaders roughly two years ahead of the followers. Not surprisingly, the new focus has helped to elevate the stature and influence of supply management within the leaders' organizations.

Indeed, 89 percent of leaders agree that their supply management organization has a standing comparable to finance, marketing, and sales, compared to 61 percent of followers. Likewise, 89 percent of leaders, compared to 58 percent of followers, are involved in setting company strategy rather than simply executing it. And 100 percent of leaders, vs. 63 percent of followers, report that senior procurement people are on the executive management team of the company.

To make new supply management approaches work, leaders are increasingly demonstrating keen political and negotiating skills. Because approaches that make use of skills and resources normally dedicated to other functions may threaten organizational fiefdoms, it is essential to have senior-level sponsorship to avoid turf wars. Proponents of change may have to challenge long-held assumptions behind product requirements or specifications, the value gained from purchases, or procurement's mandate in the overall company. Internal policies outside procurement's traditional scope may need to be questioned and revised. For example, until its newly hired chief procurement officer questioned the practice, a major forest-products company never had minimum mileage requirements for company vehicles assigned to individuals. Using demand management techniques, the company analyzed fleet utilization and introduced a mileage policy, reducing the size of the fleet and capturing significant savings.

Along with highlighting the broader role of supply management, the study also underscores the importance of the right organization, IT systems and tools, processes and measurement techniques, and human resources. Respondents confirmed the recent trend toward "center-led" models, in which most strategic decisions are coordinated centrally while transactional activities tend to be decentralized and executed by users or suppliers.

IT as Essential Enabler

Advanced value-creation techniques require advanced tools for managing information. Yet many things can go wrong between IT vision and reality. Companies may make large IT investments without confirming that new tools and systems can integrate smoothly with existing ones. If cross-functional workflows are to become a reality, procurement systems for direct materials must integrate, for example, with those in product lifecycle management. Companies may also under-invest in training employees to use the tools. Or they may fail to ensure data standardization and quality, leading to analyses of questionable value.

Leaders are taking a holistic view of how procurement IT can support value creation, applying tools more broadly to provide better visibility and control across their spend base. (Exhibit 5 shows the key value-creation activities being supported by IT tools and contrasts the relative spending on these tools by the leaders and the followers.) The leaders are empowering electronic collaboration communities, yet building a single repository for all product information within the extended enterprise. To this end, leaders demand easy-to-use tools that will integrate with other company systems. Often, the choice of technology provider is the deciding factor between success and failure. Nearly as important as the technology itself is choosing suppliers that deliver solid user training and support, understand both the business issues and the analytics involved, and make user friendliness a high priority.

In leading companies, key IT systems support the approaches to value creation from beginning to end. The first step is to standardize spend hierarchies globally across all divisions and consolidate data from all systems including accounts payable (A/P), general ledger, and EDI (electronic data interchange) systems into a single format. The data then can be analyzed and manipulated to support procurement goals.

Beyond this, leaders are broadening the reach of IT systems to support product lifecycle management, integrated requisition-to-pay, electronic sourcing, and closed-loop spend management approaches. These advanced IT systems embed best practices, enable cross-functional teaming, build a repository of knowledge management, and integrate with workflows from other teams to deliver more value to the company.

Consider, for example, a U.S. telecommunications giant that was not happy with its high rate of maverick buying, low compliance with spend procedures, limited spend transparency, and an inconsistent procure-to-pay process. Accordingly, it developed a consistent, streamlined, and digitized requisition-to-pay process, which was centralized and integrated with accounts payable. The company strictly enforced new purchasing policies and went through the painstaking effort of standardizing item and supplier codes across the enterprise. After implementation, compliance rose to 98 percent. The system captures 96 percent of spend and provides unparalleled transparency. The technology allowed the company to centralize and integrate accounts payable, and reduce A/P headcount by 65 percent. Most importantly, the company now has a base in place for moving toward advanced techniques that require detailed analyses and easy access to accurate data.

To obtain dramatic improvements, companies must invest in the enabling technologies and take care of the details. While the sums are far from trivial, one study participant reports that investments in procurement systems are the best investments his company has made. These outlays represent mere fractions of a percent of the spend managed and return the cost many times over.

Executing Processes and Measuring Benefits

The benefits actually delivered by a value-creation approach depend on three things: executing the approach with thorough and complete processes, choosing appropriate metrics, and accurately measuring and tracking performance.

Follower companies tend to encounter a common set of pitfalls. They apply inconsistent or informal processes and policies across their geographies, organizational units, categories, or suppliers. And, their measures are too narrow—usually metrics dealing only with annual cost savings. Such metrics do not encourage efforts to reduce the total cost of ownership or attract innovation from supply markets.

Leaders, on the other hand, formalize supply management processes and apply them systematically across the enterprise. For example, leaders take well-defined steps to develop outsourcing strategies—from monitoring supply market changes and identifying candidates for outsourcing, to negotiating with chosen suppliers and tracking performance. Less than half of the followers take consistent steps early in the process.

When using new value-creation approaches, it is particularly important to ensure that savings are realized, not just identified. Indeed, 100 percent of leaders studied have IT systems that track and report results achieved vs. benefits identified, as opposed to 60 percent of followers. Also, 94 percent of leaders and 65 percent of followers make the profit impact transparent and auditable. These tracking processes must cut across numerous internal borders, so cross-functional coordination and cooperation are essential at this stage.

Leaders use broader and more effective performance metrics for the procurement organization and its employees. For example, there is a large leader-follower gap in the use of innovation as a performance metric; specifically, 83 percent of leaders and only 31 percent of followers are measured on the amount of contribution suppliers make to helping companies reach their innovation goals. In addition, leaders build bridges to other functional areas by aligning and agreeing on shared metrics where it makes sense.

Stepping Stone to the Top?

Does a senior role in supply management help prepare an executive for corporate leadership? It did at specialty chemicals producer Hercules Inc. Before becoming Hercules' CEO in 2003, Craig Rogerson served as corporate vice president of global procurement (and president of two business units). Procurement also led to the top at Chrysler Corp. Thomas Stallkamp joined Chrysler in 1980 as a general purchasing agent, rose to head worldwide purchasing operations in 1996, became president of Chrysler Corp. in 1997, and vice chairman of Daimler Chrysler in 1999. Before he left in 2000, his collaborative approach to supply management had made Chrysler the world's most profitable automaker.

Stories like these will likely become more common going forward. Based on our survey, 100 percent of leaders, compared to 64 percent of followers, encourage high-potential employees to be involved in procurement as part of their career development. Some respondents suggest regular rotation of supply management staff and even chief procurement officers, proposing a three- to five-year maximum for procurement tours. Survey leaders report that supply management veterans—many of whom have gained valuable experience leading outsourcing initiatives—often move to head other units, seeding the organization with procurement allies. One company said that its last four chief procurement officers (CPOs) went on to run business units within the corporation.

Leaders encourage skill development: 89 percent offer training in project management and financial and accounting skills for procurement staff. Only 64 percent of followers offer training in project management and 52 percent offer training in fianancial and accounting skills.

Study participants report that retaining their best people is a growing challenge. One participant aims to keep the function fresh and leading-edge, so people want to stay. Another approach is to tailor recruiting and training strategies for people at different points in their careers—one program for undergraduates, a separate program for those with five to seven years' experience.

Looking ahead, we wonder if the chief procurement officer title is destined to change. As "procurement" is increasingly replaced by "supply management," will the leader of this function come to be called the chief supply officer? Or more drastically, as the company increasingly relies on its suppliers for more sources of value, might chief relationship officer be the future title for what we now know as the CPO?

Rating Your Company Against the Leaders

How can companies improve their supply management capablities and move closer to the leaders indentified in our latest "Assessment of Excellence in Procurement" study? A notable first step is to determine how well your organization is currently performing relative to these leaders. The short list below provides a useful starting point.

• Our supply management organization helps set, not just execute, company strategy.

• Key suppliers provide innovation throughout new product/process development.

• Supply management is involved in identifying and managing outsourcing and alliance opportunities, not just negotiating and creating contracts.

• Our company systematically applies advanced cost management techniques across the spend base.

• We understand supply risks in major categories and have mitigation strategies in place.

• Our supply management organization promotes cross-functional teaming throughout the company.

• Our procurement processes reflect best practices and are applied company-wide.

• Our IT tools embed best practice and allow us to execute procurement processes efficiently.

• Our supply management organization is actively developing the employee skills needed to apply advanced techniques.

• We have a comprehensive plan in place to attract and retain the best supply management talent.

John D. Blascovich is a vice president in A.T. Kearney's Supply Management Practice. William J. Markham is a principal with A.T. Kearney.

Footnotes:

1 Robert M. Monczka, William J. Markham, Joseph R. Carter, John D. Blasovich, and Thomas H. Slaight. Outsourcing Strategically for Sustainable Competitive Advantage , CAPS Research and A. T. Kearney, 2005: www.atkearney.com/main.taf?p=5,4,1,118

2 Bill Breen, "Living in Dell Time," Fast Company , November 2004: www.fastcompany.com/magazine/88/dell.html

3 A. T. Kearney Global Business Policy Council, Foreign Direct Investment (FDI) Confidence Index , A.T. Kearney, 2004: www.atkearney.com/shared_res/pdf/FDICIOct_2004_S.pdf