Cost Reduction or Cost Optimization?

Creating an effective strategy
around supplier costs

Before we start, let’s look at the elephant in the room: many Procurement professionals don’t want to talk about cost reduction or savings without reinforcing that the function is about so much more than that. And they are right; the function is about value. Not only does value come in many forms but also what an organization values from suppliers (and their solutions) is likely to change as business needs evolve or as a product or service progresses through its lifecycle. Value is not uniform.

And in acknowledging that there are different forms of value, we must also acknowledge that if part of Procurement’s role is to positively impact the bottom line, then a combination of Cost Optimization and Cost Reduction have a role to play alongside more eye-catching approaches, such as Cost and Value engineering.

In current times, Procurement should remind organizations of its role in both architecting and delivering (total) cost improvement – sustainable cost transformation may well be where the greatest value is today. And that may mean balancing between stopping, reducing, and optimizing cost across the supply chain.

The reach and severity of supply chain disruption in the wake of Covid-19 has surprised many observers. The interconnectedness of global businesses means that disruptive events have often affected multiple processes within multiple businesses. At times of crisis, what happens beneath your “Tier 1 suppliers” is not always governed by the contract; it may be more influenced by what’s happening in the broader supply market, as the impact of disruption races quickly through networked suppliers.

Many companies have struggled to cope with volatility. It has put existing business models, both operational and commercial under huge amounts of stress, making business question what changes they need to make, how quickly, and for how long. For most, it also means a board room discussion around cost; where was it headed, and what could be reduced, absorbed, or passed on to customers?

There are several factors that continue to hit the headlines when talking about volatility, such as;

Energy Prices.

Much has been done already to mitigate some of the supply chain pressures 2021 placed on businesses; 2022 will be remembered for large increases in energy prices. As governments struggle to assure long-term supply prospects, market dynamics have driven prices sky-high, which affects nearly everything.

Component Shortages.

Post-Covid, and in the midst of the War in Ukraine, multiple supply chains have been hit by periodic shortages and shutdowns. The imbalance between supply and demand has spooked buyers sparking unpredictable buying behaviors and even moves to build new supply chains. US Commerce Secretary, Gina Raimondo, described the ongoing chip shortage as an “alarming” blight on American industry.

Wage inflation.

Shifts in the workforce and rising costs resulting from lockdowns have led to increased wage demands from workers and alterations to employment contracts. Employers report problems filling job vacancies, initially in the haulage, food production, and construction sectors, but latterly across multiple sectors.

Secondary inflation.

As business strategies converge, demand for common skills and solutions has exploded, particularly in sectors like consulting, digital, automation, decarbonization and ESG. “Greenflation,” in particular, is hitting businesses keen to advance their sustainability progress. Lithium battery prices, for example, have increased by 900 percent since January 2020.

The importance of external spend

Suppliers account for 70% of FSTE companies’ average spend and 75% of Fortune 500 companies’ average spend, dwarfing labor costs; statistics that attest to suppliers being essential sources of speed, quality, and innovation but also significant potential sources of risk and volatility. Of course, they are also the primary source of cost, with research showing that supplier spend optimization is far better at improving EBITDA than job cuts.

However, as the report outlines, cost reduction is one strategy amongst several that should be used in difficult times, sitting under the broader umbrella of cost optimization. Why not just cut, cut, cut? Research by Bain & Company rightly highlights that in recessions, a disproportionate number of winners and losers appear; there are great gains to be made by spending smart, but also great losses face those who do not.

What is Cost Optimization?

Cost optimization is all about the balance of value, and cost, so essentially ensuring that every $£ is well spent in the pursuit of business objectives.

But, whilst ensuring best value for money is a critical part of optimizing costs, it’s not simply about cost reduction; optimizing means thinking more deeply about why, how, and what you spend your money on, factoring in ambitions like growth, productivity, agility, and purpose, alongside buying considerations like risk and cost.

Exploring Elements of Cost Optimization

Although non-exhaustive, Cost Optimization can really be grouped into three levels;

Tactical waste reduction; getting the same for less or stopping spend altogether
Strategic; rolling in more value by delivering more for the same (or less)
The panacea; cost or value (re)engineering in pursuit of the big objectives

Working out where the benefits are and how to prioritize where to go first will be the output of continuous or period Opportunity Assessments, which feed into strategies and plans, many of which, at the more strategic end, will be delivered in collaboration with business stakeholders, suppliers, and other key players within the value chain.

A broad or holistic cost optimization approach will include elements of all three, either concurrently or sequentially, as businesses seek to create a more cost-conscious and value-adding approach. For Proxima, this means having a service set which covers all the bases ranging from Cost Reduction to Cost Optimization;

Opportunity Assessment

In today’s fast-paced business world, it can be hard to ensure that suppliers are consistently delivering in line with business needs, that services are appropriate and that costs are relevant.

For most businesses, fresh challenge and market insight provide an immediate and material opportunity to deliver value. After all, procurement is challenged to deliver value year on year…

An Opportunity Assessment parachutes in experts, benchmarks and insights to work with you for a few weeks to create a realistic, market-relevant value plan.

Stop Cost

Stop Cost challenges the assumption that money needs spending, and the commerciality of the process to do so.

Typically Stop-Cost programs are deployed to make a short sharp intervention in spending patterns and, rather than penalizing good practice, look at eliminating waste, getting the best terms for routine spending, and ensuring commerciality in the approach.

Spend is reviewed in real-time against business drivers such as growth, brand/reputation, customer service, keeping the lights on, and compliance. Where waste can be avoided or additional value-added, It gets quickly acted upon.

Cost Reduction

More than 70% of Fortune and FTSE companies have publicly stated cost reduction targets, but finding fast and sustainable ways to transform costs can often prove challenging.

With suppliers so Intrinsic to business performance, a haphazard approach can not only damage supplier relationships, but It can also hold back business performance.

In a Cost Reduction program, we take accountability for identifying and delivering cost savings, bringing external insights to challenge current thinking, costs, and outcomes.

Cost Optimization

Of course, spending is not all about cost, cost is ultimately one of many value drivers important to businesses.

Organizational needs can change quickly, as can supply market offerings. Every day new challenges can appear, and new solutions arise. The relationship between supply and demand is dynamic, meaning that there are often opportunities to do new and exciting things with budgets that deliver on multiple objects, ultimately Improving value for money.

Cost Optimization is going to look similar to a Cost Reduction program in so far as the “on the ground” delivery model, but the focus is very much on adding value beyond cost. Typically it will focus on Re-engineering needs or solutions and, where appropriate bringing in supplier innovation (We also offer dedicated innovation services).

Strategies and Plans

It’s clear that sensible spending plans, and well calibrated supplier relationships are critical to how a business functions, and with that in mind procurement needs to be on the front foot, working collaboratively with customers to execute on the now and plan what comes next.

Proxima’s Strategy and Plans service can provide organizations with the expert insight and practical experience required to create well-crafted strategies for category, programs or other functional initiatives.

Delivered as a service or as a coaching program we bring market knowledge, tools and templates and then co-create strategies and plans with relevant stakeholder groups.

Working Capital

With cash and resilience very much on the board agenda, Working Capital is very much in the spotlight. And it’s not just about payment terms (!) as often thought. Working capital essentially looks at the cash position of the business which usually means thinking about how much cash is tied up in things like stock, as well as how payments out are optimized.

A Working Capital program means looking into contracts, processes, and actual behaviors and making appropriate fixes, risk-adjusted of course. Alongside inventory optimization, this might mean implementing techniques like optimized buying channels, financing and dynamic discounting, ensuring that payment terms are appropriate, fair, and attractive to SME’s, whilst improving the overall working capital position and reducing process waste.

Beyond the Supply Chain and into the Value Chain

The last 2-3 years have seen higher levels of volatility and greater swings than at any time over the last two decades at least. Supply chain volatility is calculated to be twice as high at peaks in 2012 and the swings twice as great as during the financial crisis in 2008.

One of the impacts of this volatility is that it imbalances supply and demand, and continued volatility exacerbates the problem. Businesses increasing drew the dots between what was happening in the supply market and how this affects what happens in a business and on the shelves, and vice versa.

Businesses increasingly sought flexibility and resilience in equal measure, but (hopefully) not at any cost. The answers to which were to be found in the “Value Chain,” a joined-up view of the ecosystem within which a business operates.

Connected value chains is the destination as we seek to tighten our grip on how opportunities and risks in our ecosystem can and should enact change elsewhere. This joined up view also presents new opportunities to identify waste and optimization opportunities. Impact and influence here takes procurement into the realms of value chain engineering, which will ultimately be the best answer to many and most of the challenges faced by business today.

However, it is also the most complex, data-hungry and influence dependent of any procurement activity. A destination for the bold for now, but ultimately where the greatest value will be created.

Global world telecommunication network connected around planet Earth, concept about internet and worldwide communication technology for finance, blockchain cryptocurrency or IoT, image from NASA