Procurement function is the center of attention because Procurement Savings have an immediate effect on the corporate result.
Time and again, organisations complaints that they do not have any method to determine the performance of procurement function or say the Procurement Savings that can be related to companies profitability.
I have tried here to relate the Procurement Savings with Organisations Profitability.
One of the major Financial Ratio that is frequently used to measure Profitability of any organisation is Return on capital employed (ROCE). Return on capital employed (ROCE) helps to understand how well a company is generating profits from its capital. The ROCE ratio is an important profitability ratio and is used by stakeholders as well as investors for deciding new investments in any organisation.
So, ROCE = EBIT / CE, where EBIT is Earning bore interest & tax represents the profit and loss account and Capital Employed (CE) is provided by relevant balance sheet items.
For increasing ROCE, there are essentially five levers.
2- Cost of goods sold (cost of production)
3- General & Administrative expenses
4- Property, Plant & Equipment (tangible assets); and
5- Net working capital (net current assets).
ROCE can be increased by 2 ways.
Firstly by increasing EBIT, i.e. increasing Sales and reducing COGS and Expenses. Secondly by maintaining Asset both Tangible and Current Asset.
Now let’s discuss how Savings and improvements from Purchasing can directly influence this ratio by impacting these five levers listed above?
- Sales increase due to the procurement of high-quality materials and components which, in turn, justify higher sales prices to keep customers loyal. However, any monetary effect is generally difficult to determine.
- Cost of Goods Sold (COGS) comprises all direct costs, direct labor costs and production overhead. Direct Cost includes all raw materials and components purchased from supplies. Purchasing realize savings in the cost of materials through negotiated price reductions in commodity groups like Raw Materials, Components or personnel leasing for production work force etc.
- General & Administrative Expenses include all overhead a company incurred during value added process. Occasionally this also includes distribution costs and advertising materials. Overhead costs include, energy costs, rental fees or insurances. Administrative costs comprise, among others, office materials, IT hardware and software, or legal counselling etc.
For purposes of analysis of Procurement saving, these cost items should be separately considered and analysed. There is lot of savings potentials in these areas. When suitable purchasing methods are applied for these externally procured repeat factors, cost savings impacting on operating results can be realized.
- Property Plant & Equipment is the tangible/fixed assets in the balance sheet. In this area, purchasing has a significant value leverage to reduce this balance sheet item in terms of valuation. Life cycle costs should be taken into account, i.e., the inclusion of current and future expenditures, such as start-up, commissioning, maintenance and repair costs all together, to be able to fully evaluate actual expenditures and potential savings.
- Net Working Capital is the Current Assets reduced by short-term, not interest-bearing outside capital.
Current assets include inventories, accounts receivable for supplies and services, as well as securities and other liquid funds. In general, these components are available fast and will therefore be important in case of looming liquidity bottlenecks.
Purchasing Savings can strengthen a company’s internal financing by reducing tied-up capital that will improve the alternatives to an organization of outside financing and making it easier and cheaper to obtain loans.
Purchasing should negotiate a more favorable payment term with suppliers, discount rates and cash discounts should be increased. In inventory management, average inventory levels should be reduced and the ordering process accelerated while keeping an eye on the security of supplies. Furthermore, purchasing efficiency will increase through standardization of process and establishing transparency between management and suppliers.