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esourcingwikilogoThis week's eSourcing Wiki-Wednesday topic is Metrics for the Rest of Us. An excerpt of the article is below, but you can also read the full article on the eSourcing Wiki by clicking here. Have something to add? The eSourcing Wiki is an open content community and you are invited to register and contribute to this resource, which benefits our whole professional community.

If you are interested in reading more about measuring success, read today's blog post on "The Point": How do you know if your Spend is 'Under Management'?.

Introduction

You can't manage what you can't measure ... and you can't measure without metrics to measure to. But what metrics should you use? Especially when there are literally thousands to choose from? It's a hard decision to make, but since such a decision cannot be made without a set of metrics to choose from, this wiki-paper is going to present some of the more common basic metrics and discuss some of their advantages and disadvantages, so that a decision can be made.

After all, with energy and raw material prices rising rapidly, the value of certain currencies falling more rapidly than most of the world expected, and outsourcing on the rise, it's more important than ever to get one's house in order and identify savings opportunities. The first step, as always, is to create a baseline, and that, of course, requires metrics.

Cost Avoidance and Reduction

Unit Cost Reduction
This is the one of the simplest cost reduction metrics that one can define. It is simply calculated as:
(last year's unit cost - this year's unit cost) x units purchased
However, it's also the most dangerous. If the lowest cost is from the supplier furthest away, then this could cause freight costs to considerably increase. Thus, some organizations will measure:

Landed Cost Reduction
This is the next simplest cost reduction metric. Where landed cost is defined as unit cost plus freight cost per unit, this metric is calculated as:
(last year's landed cost per unit - this year's landed cost per unit) x units purchased
However, it's still quite flawed. When an organization is buying globally, it also has to consider import duties and tariffs, export duties and tariffs, temporary storage costs, and so on. Thus, some organizations will measure:

Total Landed Cost Reduction
This is the next cost reduction metric in a sequence from simplest to most complex. Where total landed cost is defined as unit cost plus freight cost per unit plus tariffs and duties per unit plus incidental transportation costs per unit, this metric is calculated as:
(last year's total landed cost per unit - this year's total landed cost per unit) x units purchased
However, this is still not perfect. There are still storage costs if JIT (Just-In-Time) delivery is not an option, utilization costs if processing is needed or if there is associated waste, and if there are quality issues and a certain number of units will have to be tested and returned, then there are associated costs that should be taken into account. Thus, some organizations will measure:

Total Cost of Ownership
This is about the most complex, and complete, cost reduction metric that can be defined. Where total cost of ownership is defined as total landed cost plus total inventory costs plus total utilization costs plus total reverse logistics costs, this metric is calculated as:
(last year's total cost of ownership per unit - this year's total cost of ownership per unit) * units purchased

However, it's not always about cost reduction. Sometimes costs are going to go up, and there's nothing that can be done about it. The key in this situation is to restrict cost increases to an amount that is less than the market average. This brings us to our first cost avoidance metric.

Basic Unit Cost Avoidance
This is straight forward to calculate.
(average cost increase per unit - actual cost increase per unit) * units purchased
where the average cost increase is based upon accepted market indexes.
However, this is not the best metric because it does not capture why the cost increased and whether the average cost increase was justified. A better metric takes into account the expected cost increases based upon the market cost increases in the labor, raw material, and production (energy) cost increases.

Advanced Unit Cost Avoidance
This involves calculating the expected increases based upon the increases in the appropriate market indexes and the percentage of unit cost they contribute to. Where last year's raw material cost per unit equals % raw material cost * total unit cost, last year's labor cost per unit equals % labor cost * total unit cost, last year's production cost per unit equals % production cost * total unit cost, and last year's other cost per unit equals % other cost * total unit cost, then a complete calculation would be along the following lines:
(last year's raw material cost per unit * (1 + average % increase in raw material costs) + last year's labor cost per unit * (1 + average % increase in labor costs) + last year's product cost per unit * (1 + average % increase in labor costs) + last year's other cost per unit) * total units purchased this year - this year's total cost.

Of course, all the cost reduction and cost avoidance in the world is not going to help if the negotiated savings are never realized. That's why an important metric is realized savings.

Realized Savings & Avoidance
This is simple to calculate.
(Last Year's Total Cost Volume Adjusted - This Year's Total Cost) / (Last Year's Total Cost Volume Adjusted - This Year's Negotiated Cost)
where
last year's total cost volume adjusted = last year's cost per unit * this year's volume

Of course, the key to realized saving is contract compliance.

Compliance
The goal is to have 100% of spend on contract for a contracted commodity or category. For a given contract, this is calculated as:
Commodity Spend on Contract / Total Spend on Commodity
For all contracts, this can be calculated as:
Total Spend on Contract / Total Spend on All Contracted Commodities

It's also important to get a global picture of the reach of your efforts. This is captured by the spend under management metric.

Spend Under Management
This is a straight forward calculation.
Total Spend Under Management / Total Spend


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