Operations Management Viewpoint

Procurement Performance Measurement
What CFOs expect from measuring Procurement Success

Procurement excellence is increasingly becoming an important factor in delivering efficient operations within successfulcompanies. On the surface, effectively measuring procurement performance is no rocket science. However looking deeper,adequate measurement of procurement success is a big issue, as bottom-up reported savings can significantly deviate from thekey financial figures a CFO looks at. Arthur D. Little’s latest study on procurement performance identifies the key challenges thatcompanies currently face in developing a CFO-friendly procurement performance measurement. This report suggests a bestpractice approach to overcoming these challenges and consistently measuring purchasing success in the future.

Why the views of CFOs and procurement officers
often differ
During a downturn, when companies must consider every
avenue for cutting costs in order to simply survive, theprocurement department plays an increasingly important role inachieving this strategic goal. A purchasing performance figure
benchmarks the target achievement within the organization while
functioning at the same time as a key performance indicator forthe control and allocation of liquidity respectively assets.
Even if the purpose of a dedicated procurement performance is
not up for discussion, its quantitative measurement remains a bigissue. Practical experience shows significant divergences between
performance figures reported by procurement departments andthose in the CFOs’ books. On average, management executives
are able to analyze less than 50% of bottom-up reported savings(see figure 1). There are a variety of reasons for this:nnDifferent working definitions of the term ‘savings’nn

Missing arithmetic for measurement and aggregation ofsavingsnn

The overlap of procurement results with external effects(e. g. sales development)nnInconsistent links between procurement strategy and thebusiness plannn

‘Maverick buying’ (purchases made without involving theprocurement departments)

The study focuses on how to overcome these barriers toeffectively measure a procurement department’s performance.
It offers companies insights into how to resolve theseinconsistencies and increase their overall effectivenessby providing a properly designed generic framework forprocurement performance measurement.

Figure 1. Savings measurement of the CFO & diverging
reporting of the purchasing department
Degree of potential savings realization(in %)
100

Not leveraged
potential

90
80
7060
5040

Inconsistent metricmeasurement,
intransparency, error
in measurement

30
20
100
CFO-savings
measurement
Source: Arthur D. Little according to Aberdeen Group

Purchasing
department –savings reportingOperations Management Viewpoint

Procurement managers’ key challenges1

procurement community has to learn how to speak the CFO’slanguage” in order to bridge this gap in performance reporting.
Although procurement should not be directly measured according
to P&L – as it does not influence valuation decisions – thetransition between different metrics must be clearly defined.

In a recent study Arthur D. Little investigated a series of realworld challenges currently facing procurement performancemeasurement. The report outlines an innovative approach toovercoming these challenges, based on a cross-industry bestpractice approach (see figure 22).

Setting up a measurement framework
Based on in-depth interviews, Arthur D. Little has observed thatprocurement departments tend to be self-critical in regard to thecurrent inconsistency in their measurement criteria: “Savingscalculated by procurement departments are typically notaligned with the well-known principles of adequate and orderlyaccounting”. This is because the financial framework chosen toanalyze purchasing success is critical to its accurate measurement:“Most purchasers still think within an ‘internal’ world of cost/
performance accounting according to the ‘amount * price’ principle.
But for a CFO’s controller, the effects of purchasing actions on abalance sheet and cash flow calculation are critical. Therefore theCFO doesn’t care about a hypothetical calculation.” In fact, “theIt is also quite evident that “a savings performance indicator
can only claim to be a financial metric if it also includes negative
effects, e. g. taking account of increasing prices.” Against thisbackground it is quite astonishing that sixty-three per cent of
the procurement departments surveyed simply ignore theirresponsibility for rising purchasing costs.

Considering cost avoidance and market pricedevelopment
In addition, so called ‘cost avoidance’ has no universal definitionin the procurement world hence the term should be handledwith care. Some refer to it only on initial or one-time purchases,
while others also use the term to refer to rising market prices forrecurring purchases.

Figure 2. Key challenges, practical examples and best practices for procurement performance measurement
Key challenges for procurement
performance measurement
Select financial framework for successevaluation”Practical examples”
Mix of repetitive & onetime purchases & indirect/
internal benefits (TCO)

49%

Determine key reference prices (particularly Target price/internal costrequirement
for initial and one-time procurement)

36%

Consider increasing costs(i. e. rise in prices)

Generally not considered(“buyer‘s perspective“)

63%Include & define cost avoidance

Addition to “real“ savings ONE KPI

41%

Include market price development (i. e.
take into account increasing & decreasingprices)
Consider effects of procurement
decisions over a longer time period
Measure optimized working capital

Transition into P&L & cash
flow/expenditures ensured
together with bookkeeping
Price per offer e. g. best
offer of negotiation
participantsConsidered“Real“ vs. “hypothetic“savings  TWO KPIWithin the context of cost avoidance
Short-term one-period
measurement76%

Poured into the performance measurement via“other purchasing benefits” or “total value” savings
No “capital-value-based” steering of procurement

Measure the success of decentralized
departments

Consistent performance measurement systemwith individual types of targets
No participation of procure- 36%
ment, budget is the baseline
for initial-/one-time purchasing

37%

26%

37%

Define one KPI according to P&L & cash
flow; another KPI according to internal cost/
performance accounting (TCO)
Budget after procurement involvement
based on external market data
Consider increasing costs

36%

Define additional KPI:
“Savings vs. market price development”

54%

Define additional KPI:
“Savings vs. market price development”

12%
Baseline-related for theyear effects incur respectively

Develop a capital- or value-based steering
approach (i. e. EVA*)

Consider the influence of the budgeting
process on performance measurement

Possible best practice approach

52%

89%

96%

Procurement integrated
17%
in cost center planning,budget targeting measurementConsider baseline-related for year incurring
Measure only in context of “term ofpayment”“Nice to have approach“, not obligatory
Measure consistently with individual typesof targets
Integrate procurement into the budget
process with cancelation of budget baseline* EVA = Economic Value Added
Source: Arthur D. Little’s 2009 Purchasing Value Excellence Study and expert interviews with a cross-industry selection of European multinational companies; percentages indicate
the portion of companies that agree with the respective statement

1 Quotes are taken from selective interviews with experienced procurementexecutives across all industries
2 Percentages give the share of interviewed companies that follow the named
approach
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Operations Management Viewpoint

Forty-one per cent of procurement departments only use one
figure to represent both the nominal ‘cash’ savings compared tothe expenditures of the previous year, as well as the ‘real’ performance measured on market price level. In Arthur D. Little’s
survey, this proved to be a popular issue facing procurement
managers. For instance: “General consideration of market
price development in the context of procurement performancemeasurement is a very fair method to evaluate a purchaser’soutput”. However, both cash savings and market price-based
analyses should be stringently represented with separate performance figures in order to avoid a mixture of ‘real’ performance,and ‘cash’ savings respective ‘cost cutting’ effects.

The budgeting process and value-based controlling
The study revealed that until procurement departments address
and overcome the basic challenges outlined above, theirmeasurement will not meet further expectations of the CFO.
For instance, eighty-nine per cent of the companies interviewedbelieve that value-based steering of procurement is not a
critical business issue of the day. However, as procurement
departments become increasingly involved in the budgeting
process, it will become more important to consider payment
terms. Seventeen per cent of the procurement departmentsinterviewed for this study already play an active role in theirorganization’s budget process. With this trend set to grow itwill become clear that “savings measurement with a budget
baseline often leads to a so-called ‘sourcing dilemma,’ since
procurement defines its own measuring criteria.”
Budget is only an incentive-compatible baseline if theprocurement department is not involved in the budgeting
process. In companies where this is not the case, the CFO
should define an alternative target against which to measuresuccess.

2. Period reference: Which measuring point and reference
date are used? (e. g. annual budget versus actual figures)
3. Depth of examination: To what extent is value creation
measured in the context of purchasing? For instance, does
the measurement system only consider material costs, oralso follow-up costs? Where is the functional reference basefor measurement? (e. g. last year’s prices or budget/target
prices versus actual market prices)
Different aspects of these three dimensions must be combined
and target-oriented according to the specific purposes for measurement within an organization. However, all companies canincrease the transparency of their procurement measurement byagreeing upon selective, generic definitions for the four different
key figures used to explain the depth of examination:nn‘Cash savings’: Financially measurable changes inexpenditure3, which are directly influenced by purchasing.
Procurement departments must determine an “internal”
reference price as a precondition for measuring cost
reduction. For example, reducing leasing rates for the car
fleet by 10% compared to last year’s rates results in a 10%
cash savings.

nn‘Savings vs. market price development’: Measuring
expenditure versus market price development involves
determining market price as a precondition, and takes
particular account of ‘cost avoidance’ (e. g. defense against
price increases). For example, since the market price index
of car leasing rates shows a 15% decrease compared to lastyear, our 10% ‘cash saving’ is not more than a –5% negative‘saving vs. market price development’.

nn‘Total value savings’: Change in direct and indirect costs(TCO/TVO4 approach) caused by purchasing; this also includes
follow-up costs (e. g. for storage), as well as the evaluationof process efficiencies and changing risk positions (e. g.
consequences of supplier’s shortfall). This figure is calculated inaddition to ‘cash savings’. For example, since our new leasing
rates include administration benefits, we reduce internaladministration costs by 5% relative to leasing rates, whichmeans ‘total value savings’ of 15% compared to last year.

nn‘Contribution to return on capital’: Measuring
procurement’s contribution to return on capital includes
changes in capital costs, and comprises all contributions ofpurchasing to changing deployed or fixed capital. Savings
are therefore also set relative to used capital. This figure iscalculated in addition to ‘total value savings’.
Example: The new fleet leasing contract generates positive
impact on capital costs through its provision of valueinsurance and termination options.

Recommended best practice approach for a proper
performance measurement
The first and most important challenge for procurement
departments and their CFOs is to design a consistentframework for financial evaluation of procurement performance.
To help companies develop such a framework, it is usefulto draw a model along the following three dimensions. The
final model should, of course, implicitly consider the above
mentioned recommendations and further key challenges as
outlined in figure 2.
1. Metric of measurement: Which financial figures andvaluation of assets are considered for measurement?
(e. g. P&L respective balance sheet or cash flow calculation
respective cash-based accounting or cost-/performanceaccounting)

3 Specifically, the terms ’payout’ ‘expenses,’ or ‘costs’ are needed here
4 TCO: Total Cost of Ownership; TVO: Total Value of Ownership

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Operations Management Viewpoint

The suggested framework and best practice examples outlined
above provide an important understanding of consistent
performance measurement. The general framework should
serve as a guide to companies, and can be customized to meettheir specific needs.

ContactsBernd Schreiberschreiber.bernd@adlittle.com

Arthur D. Little’s insight
The above-mentioned core characteristics of an innovative
procurement performance measurement have been identified
by combining results from Arthur D. Little’s ongoing Purchasing
Value Excellence5 study with findings from selected expert
interviews. The interviews with decision makers in morethan ten different industries elicited up-to-date, practicalexamples, and illustrated some misconceptions concerningcurrent performance measurement practices. By naming thekey measurement challenges facing today’s procurement
departments, this report provides a framework to outline current
procedures and identify future best practice.

Conclusion – how CFOs measure the future
As mentioned above, any CFO-friendly performancemeasurement system will clearly differentiate between the
popular terms ‘cost reduction’, ‘cost avoidance’, ‘total cost ofownership’, and ‘optimization of net present value’. By designinga clear measurement framework that takes into accountconsistent metrics, time frames, and levels of examination,
procurement departments and CFOs can achieve transparent
performance measurement from the start. With a consistentmeasurement system in place, it is possible for businesses
to understand the true value of their target-oriented cost
reductions, based on more well-defined and customizedsavings figures. Arthur D. Little helps its clients to customize
this framework to the specific needs and requirements to suitorganizational structures and reporting processes.

Arthur D. Little
Arthur D. Little, founded in 1886, is a global leader inmanagement consultancy; linking strategy, innovationand technology with deep industry knowledge. We offerour clients sustainable solutions to their most complex
business problems. Arthur D. Little has a collaborativeclient engagement style, exceptional people and a firm-widecommitment to quality and integrity. The firm has over
30 offices worldwide. With its partner Altran Technologies
Arthur D. Little has access to a network of over 18,000
professionals. Arthur D. Little is proud to serve many of theFortune 100 companies globally, in addition to many otherleading firms and public sector organizations. For further
information please visit www.adl.com
Copyright © Arthur D. Little 2009. All rights reserved.

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