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Cost Savings vs.
Cost Avoidance
Definitions and
Clarifications
Key Issues/
Problems
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Executive Summary
Hot Topics
in Today’s
Supply Chain
Management
DEFINING COST REDUCTION AND COST AVOIDANCE
BRYAN ASHENBAUM
CAPS: CENTER FOR STRATEGIC SUPPLY RESEARCH
EXECUTIVE SUMMARY
Purchasing and supply management departments are
under increasing pressure to reduce costs and deliver savings to their organizations’
Case Study I:
PSEG
bottom lines. Crucial to this mission is the proper categorization of the various types of
cost reduction and their application to the company’s operating budgets and profit and
Case Study II:
NCR Corporation
loss measures. Generally speaking, cost reductions come in two different categories:
“hard” cost savings and soft“ cost avoidance. However, neither of these has a
universally accepted definition or method by which it is tracked and applied to company
Case Study III:
Northrop
Grumman
financials.
Appendix A: PSEG
Cost Reduction
Breakdowns
and Examples
this issue, participants attempted to provide clarity and standardized working
At a recent CAPS: Center for Strategic Supply Research Critical Issues conference on
definitions for these cost reduction categories. These definitions and clarifications are
detailed in the first section of this report. The next section details the following key
issues and problems faced by companies as they seek to properly assess cost
Appendix B: NCR
Cost Reduction and
Cost Avoidance
Examples
contributes
advantage
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to
competitive
organizations
by delivering leading-edge research
reduction:
• “Cancellation” of net savings due to an overall increase in the business unit’s
cost structure
• Supply management’s role in the cost savings allocation decision
• Chronology of supply management’s involvement and the need for budget cuts
• Visibility, in terms of systems, people, and metrics
• Total cost of ownership (TCO) concept for purchased items/services
globally to support continuous
• Multi-year issues in cost savings
change and breakthrough perform-
• Creating a proper incentive structure for supply management personnel
ance improvement in strategic
sourcing and supply.
The report then focuses upon three case studies, detailing selected approaches and
best practices in defining, tracking, and validating cost savings and cost avoidance.
Finally, Appendices A and B provide additional examples of cost savings and cost
avoidance categories at two of the case study firms.
Critical Issues Report, March 2006; www.capsresearch.org
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COST SAVINGS VS. COST AVOIDANCE: DEFINITIONS AND
CLARIFICATIONS Purchasing and supply management departments are under
increasing pressure to reduce costs and deliver savings to their organizations’ bottom
lines. To that end, strategic sourcing strategies are developed and sophisticated
negotiation techniques are deployed to reduce the prices paid for goods and services.1
In addition, strategic sourcing personnel are encouraged to find new and innovative
ways to work with suppliers to reduce mutual costs rather than to simply demand from
those suppliers a yearly price decrease.
Crucial to this mission is the proper categorization of the various types of cost
reduction and their application to the company’s operating budgets and profit and loss
measures. Generally speaking, cost reductions come in two different categories:
“hard” cost savings and “soft” cost avoidance. However, neither of these has a
universally accepted definition or method by which it is tracked and applied to company
financials. A great deal of a supply management’s effort results in cost avoidance, yet
this category is more intangible than cost savings. As a result, many supply
professionals are concerned that they do not receive proper credit for delivering cost
avoidance savings to the company. By some estimates, $1 of cost savings can equal
$7 (or more) of increased revenue in bottom-line impact, making clear definitions and a
way to properly quantify all cost reductions a worthy goal indeed.
A brief example might serve to show why clear definitions are necessary. At one
company, a purchasing manager negotiates a 5 percent decrease in price for a raw
material, resulting in a savings of $100,000 that year. At another company her
counterpart successfully resists a supplier’s attempt to raise prices by 10 percent,
allowing the company to avoid spending an additional $200,000 that year. Although
greater in value, the second savings is also more intangible—is the $200,000 a “real”
savings? If so, can a high-level manager put his or her hands on that “saved” $200,000
and re-invest it in the business? This is the very heart of the cost savings versus cost
avoidance issue.
Cost Savings
The CAPS conference participants largely agreed that cost savings (hard) are defined
as/characterized by:
• Year-on-year saving over the constant volume of purchased product/service.
• Actions that can be traced directly to the P&L.
• A direct reduction of expense or a change in process/technology/policy that
directly reduces expenses.
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• Process improvements that result in real and measurable cost or asset
reductions.
• The examination of existing products or services, contractual agreements, or
processes to determine potential change(s) that reduce cost.
• Net reductions in prices paid for items procured when compared to prices in
A significant challenge
place for the prior 12 months, or a change to lower cost alternatives, i.e., [old
price - new price] x volume.
for supply management
professionals is how to
properly quantify cost
avoidance intangible
savings as “real”
savings.
Generally speaking, cost savings are understood as tangible bottom line reductions
resulting in saved money that could be removed from budgets or re-invested back into
the business. There also needs to be a prior baseline or standard cost for the
purchased product or service so that these savings could be measured against the
prior time period’s spend.
Cost Avoidance
Cost avoidance is a more difficult category to define. Is it simply “everything else”
beyond hard price reductions for products and services that are repeat buys? Some
definitions of cost avoidance that emerged from the conference include the following.
• Avoidance is a cost reduction that does not lower the cost of products/services
when compared against historical results, but rather minimizes or avoids entirely
the negative impact to the bottom line that a price increase would have caused.
• When there is an increase in output/capacity without increasing resource
expenditure, in general, the cost avoidance saves are the amount that would
have been spent to handle the increased volume/output.
• Avoidances include process improvements that do not immediately reduce cost
or assets but provide benefits through improved process efficiency, employee
productivity, improved customer satisfaction, improved competitiveness, etc.
Over time, cost avoidance often becomes cost savings.
Needless to say, cost avoidance is more open-ended and is more difficult to quantify.
As a result, cost avoidance is something that many people feel free to ignore, or to
discount as a “phantom” or lesser savings to the company. Generally, cost avoidance
does not hit the P&L directly and does not result in a tangible budget savings that can
be pulled out or re-invested. A significant challenge for supply management
professionals is how to properly quantify cost avoidance intangible savings as “real”
savings.2
Some examples of cost avoidance include:
• Resisting or delaying a supplier’s price increase
• A purchase price that is lower than the original quoted price
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• Value of additional services at no cost, e.g., free training
• Long-term contracts with price-protection provisions, i.e., multi-year contracts
• Introduction of a new product or part number requiring a new raw material
purchase. Spend is lower than previously, but the savings is classified as
avoidance because there is no historical comparison.
There are some actions related to cost or price that are neither cost savings nor
avoidance. (Note the conflict with the list above, as various companies had different
ways to recognize cost avoidance.) These include:
• Technology development funding used to pay for intercompany goods and services.
• Supplier quote used as baseline.
• Negotiating an expense increase when industry average is increasing at a higher
rate than negotiated.
• Negotiating risk mitigation for contract or legal exposures.
• First-time spend on a good or service where there is not a defined business unit
budget.
This section has attempted to provide some working definitions for cost savings and
cost avoidance, and to provide some understanding of how firms perceive them and
apply them to their budgets and purchasing goals. The next section sketches the key
issues and problems that arise as companies try to define and track cost savings and
avoidance.
KEY ISSUES/PROBLEMS
The following key issues and problems have been faced
by companies as they seek to properly assess cost reduction:
• “Cancellation” of net savings due to an overall increase in the business unit’s
cost structure
• Supply management’s role in the cost savings allocation decision
• Chronology of supply management’s involvement and the need for budget cuts
• Visibility, in terms of systems, people, and metrics
• Total cost of ownership (TCO) concept for purchased items/services
• Multi-year issues in cost savings
• Creating a proper incentive structure for supply management personnel
“Cancellation” of Net Savings Due to an Overall Increase in the Business Unit’s
Cost Structure
Cost savings efforts do not occur in a vacuum. The business may be growing, other
input costs may be changing, or the strategic mission of the firm itself may be shifting.
What often happens is that supply managers may announce a savings of X dollars or of
a certain percent, but functional managers who run the various divisions may observe
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that their overall cost structure has increased due to other factors. This increase in
other areas can obliterate or mask the savings that were realized. How does this affect
the recognition of those savings? Does this turn those hard savings into cost
avoidance?
Many firms indicate that hard savings are only recognized as dollars that could be taken
Many firms indicate that
hard savings are only
recognized as dollars
that could be taken out
of the budget or reinvested into the
business.
out of the budget or re-invested into the business. If the overall divisional cost growth
flows opposite from supply’s saving efforts in one area, then the savings are not
present in a tangible sense.
Consider the following sub-scenario of this larger issue. Suppose a company buys 10
widgets for $2 a piece in 2005. In 2006, supply management negotiates a price of
$1.50, but volume growth means that 12 of the widgets must be purchased. What
savings were truly realized (see the chart below)? The difference in actual spend is only
$2. Yet a plausible savings of $5 or $6 could be claimed if either one of the years was
held as a baseline volume. How are these savings divided into hard/soft categories?
Another view is that there are two savings streams. The first is a “price” variance on
the base (2005) volume ($0.50 x 10 units). The second is a “volume” variance base on
the additional units purchased in the following year ($0.50 x 2 units). Is the price
variance hard savings, and the volume variance cost avoidance?
Spend
2005
2006
for
Price:
Price:
Widgets
$2.00
$1.50
$20.00
$15.00
$24.00
$18.00
2005
Volume: 10
Widgets
2006
Volume: 12
Widgets
Supply Management’s Role in the Cost Savings Allocation Decision
A rigorous measurement and tracking process is essential to maximize value from cost
reduction initiatives. Supply management is by and large responsible for generating
many cost reductions and also for managing this process. The numbers that emerge
from this process must be meaningful and recognized by upper management.
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That being said, supply management must play a vital yet cautious role once cost
savings have been realized and reported. First, supply management and finance must
be coordinated on the reporting of savings numbers so that budgets can be assessed
properly and so that supply management does not come off as the villain, or get
caught up in internecine battles. Second, most conference participants indicated that
while supply management identifies the savings, it is the senior executives with P&L
responsibility who make the decision regarding the allocation of the savings—whether
they are to be removed from the budget and taken straight to the bottom line or reinvested elsewhere in the business.
It is supply management’s job to ensure faith in the numbers—to ensure that whether
regarded as hard savings or cost avoidance, the benefits were realized overall. The
managers can then make decisions regarding the elimination or redeployment of hard
dollar savings at their disposal.
Chronology of Supply Management’s Involvement and the Need for Budget Cuts
A consistent theme in discussion of cost savings focuses on the timing of cost
reduction efforts. Often, cost savings efforts are seen as a threat to budgets. No one
seems eager to participate in a project that will result in their budget being reduced for
the following reporting period. In this case, supply management comes looking for
cooperation on cost reduction initiatives and finds a lack of enthusiasm, or perhaps
even downright hostility.
On the other hand, if the business unit is tasked to reduce its budget first, then supply
management can be looked to enable that goal with suggestions for cost savings.
When the budget push is on, supply management arrives with a cost-cutting toolkit
and receives a much warmer welcome.
As such, it almost appears better for supply management to wait to be approached by
the functional units after budget cuts are announced, looking like a hero rather than a
villain. Of course, this is a rather short-sighted and dysfunctional view of supply
management’s role and of the need for continuous improvement. Supply management
will be tasked with cost reduction regardless of whether senior managers have been
tasked to reduce their budgets by a set amount or not.
This is certainly not an endorsement for supply managers to wait until approached by
panicked managers in order to gain access. This report is merely pointing out a
bureaucratic political reality that supply managers will have to navigate even more
carefully than their negotiations with key suppliers. Supply managers need to be aware
that the warmth of their reception in other departments may well depend upon the
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current climate and attitude toward cost savings and budget-setting at their firm at the
given time.
Visibility, in terms of systems, people, and metrics
For optimal cost reduction efforts, visibility is needed on three levels: systems, people,
and measurement. Systems, understood as both IT infrastructure and company
For optimal cost
reduction efforts,
visibility is needed on
three levels: systems,
people, and
measurement.
policies, need to be in place so that managers can get a realistic handle on what costs
actually are, what areas might benefit from cost reduction efforts, and how company
policies are designed to track and execute these savings efforts. Flexible and
comprehensive IT systems are crucial, as they are the medium that will provide the
visibility needed to accurately assess costs and expenditures. Likewise, processes for
executing and tracking cost reduction projects should be in place and available to all
personnel. Hierarchical roll-up mechanisms need to be in place to collect, report, and
roll up operating unit benefits.
Once systems are in place, then adequate staffing must be provided to track savings
projects and to consistently fine-tune the procedures and policies. In some companies,
a single supply manager individual tracks projects and results in a database. Other
firms place responsibility with the individual buyers for entering their own cost savings.
Within this second group, there will often be some sort of central auditor or team to
examine and extract this data. Finance is also required to verify the cost savings
numbers put forth by supply management. It is typical that finance personnel will serve
in parallel with those in procurement to track savings and spend. These people are
often part of finance with a dotted line responsibility, or can be analysts specifically
assigned to the purchasing group.
Measurement standardization is the third piece of visibility. Complications arise in
calculating cost savings — changes in volumes, different business unit accounting
practices, not all units on the same ERP system, etc. Measurement standardization
and the use of a set of common metrics are needed to keep the company speaking
one “common language” on cost reduction. It is an old but accurate saying that “what
gets measured gets improved,” and another that “if you can’t measure it, you can’t
manage it.” Metrics to track cost savings and cost avoidance should be standardized
throughout the company, should be clearly defined, and should be available to all
personnel. The establishment of clear metrics and definitions helps avoid the
accusations of “fuzzy math” or the arguments over what amount has been saved by a
particular initiative.
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Total Cost of Ownership (TCO) Concept for Purchased Items/Services
It is widely acknowledged that price reductions are only one way to achieve cost
reductions.3 The value that global supply management provides goes well beyond mere
price reductions; it extends to supplier reliability, purchased goods quality, and initiating
early supplier involvement in product design to grow market share.
But price reductions are often the only visible and tangible proof of supply
management’s effectiveness. How can quality and efficiency issues be factored into
savings calculations so that price and differential are not the only proxies for cost and
savings? How can production efficiencies, customer satisfaction, and market-share
increases be tied back to a single purchased item? In other words, how can a TCO
model be developed for an individual purchased item?
In some respects, we are chasing the “holy grail” of purchasing with this issue. But
the reality remains that consistent year-over-year price reductions are not always
feasible. A more expensive good or service that yields a higher market share or greater
production efficiency undoubtedly delivers a cost savings to the company, but methods
are not in place to effectively tease out this result from other factors.
Multi-Year Issues in Cost Savings
Many cost savings efforts are multi-year, with realized savings spread out over several
reporting periods. Do the cost savings (or at least their recognition) only last for a single
year, even though the benefits may flow over a several-year period? For items that
have a market scenario, a fixed price over a multi-year period can count as a loss or
gain as the commodity market price fluctuates up or down.
Many companies counts hard savings on multi-year contracts for the first 12 months,
but then the savings in subsequent years are counted as softer cost avoidance (if at
all). Others do count savings over the length of the contract, not simply the first time
period. However, in the second year, that revised price is built into the budgets of the
functional units (see Case Study II: NCR in this report for more examples of multi-year
cost reduction approaches, particularly with regard to the calculation of cost reductions,
purchase price variance, and carryover).
A final thought is that for multi-year contracts, Year One investments are often greater
than anticipated savings that year (even though over the lifetime of the contract the
savings will be positive). In this case, is supply management denied credit if the
subsequent-year savings are not counted to offset the initial year investment? In some
instances, the answer seems to be yes, even though many other companies seem
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willing to amortize the cost savings over the life of the contract so that the positive
impact is recognized.
Creating a Proper Incentive Structure for Supply Management Personnel
The issues raised thus far all lead to the following question: How should the proper
incentive structure be created for supply management personnel? Like anyone else, a
If supply management is
compensated only for
hard savings, then the
supply manager will engage in behaviors rewarded by the company. This creates a
problem for the company if cost avoidance, multi-year savings, or other cost reduction
efforts beyond hard savings do not count toward the supply manager's performance
and promotion goals.
tendency will be to
ignore other forms of
cost reduction.
If supply management is compensated only for hard savings, then the tendency will be
to ignore other forms of cost reduction. The company must clearly lay out what forms
of cost reduction count toward goals, even if there is a scale of importance attached to
them. There are many improvement projects (such as risk mitigation) where the cost of
implementation requires hard dollars (training, hardware/software, capital equipment,
reconfiguring facilities, etc.) but the short-term benefits are “soft.” Supply management
must be able to receive some credit for these.
Likewise, it must be determined clearly who gets the credit for the benefits delivered
from cross-functional team initiatives to improve processes and reduce costs. If, for
example, supply management works with logistics to reduce carrier freight, which
function gets the credit? Do both parties get full credit, or half-credit each? (Of course,
the money is only counted once, but some companies still give both parties equal
credit for full benefit delivered in terms of individual promotion plans).
One idea that has been suggested but has yet to see much traction is to provide
supply managers with variable compensation as part of their incentive for meeting
savings goals. Such bonus plans are of course common for senior management,
marketing/sales, and production. Perhaps such bonuses would also have a positive
effect on the company’s overall cost reduction goals.
CASE STUDY I: PSEG
Background
Public Service Enterprise Group (PSEG) is a publicly traded energy company
headquartered in New Jersey. Main subsidiaries include PSEG Power LLC, Public
Service Electric and Gas Company (PSE&G) and PSEG Energy Holdings LLC. It has
approximately 10,500 employees and annual revenues of $11 billion. (www.pseg.com).
PSEG is currently undergoing a merger with the Exelon Corporation (www.exeloncorp.
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com). The merged company is expected to employ over 28,000 people, have
approximately $27 billion in annual revenue, and serve over 9 million customers.
Supply chain management (SCM) at PSEG is a hybrid organization; procurement is a
center-led group, while logistics and operations are fairly decentralized. The centralized
procurement group seeks to leverage cross-company spend volume (wires,
transformers, street services, etc.) and indirect (that which supports the plants in
operation) purchases. Tactical plant-level purchases are executed though a central
procurement operations group. PSEG’s spend is approximately $1 billion in non-fuel
materials and services (another group purchases and trades fuel).
Approaches to Hard Savings vs. Cost Avoidance
SCM as an organization has evolved from a decentralized organization to a centralized
organization within the shared services organization. The mission was to generate $25
million in savings. The objective was to create a rigorous savings measurement and
tracking process to maximize value from SCM initiatives and to ensure that the value
from these initiatives was realized.
PSEG categorizes cost savings into A, B, and C categories based upon bottom line
impact and the hard savings/avoidance demarcation:
A = Price or cost increase/decrease on recurring spend
B = Value-added savings/increase where no prior price/cost information exists
C = Avoided costs
More comprehensively, the categories break down as follows (see Appendix A for
specific examples and calculations for these savings categories).
❖ Category A
• A-1. Calendar-year negotiated savings from prior agreement
• A-2. Continuous improvement
• A-3. PO extensions with price increases
❖ Category B
• B-1. Calendar-year negotiated savings where no prior agreement exists
• B-2. Process savings (budget-impacting)
❖ Category C
• C-1. Process savings (non-budget-impacting)
• C-2. Cost avoidances (non-budget-impacting)
Some Category B savings are not hard and do not count toward actual budgetary
impact. Category C savings are clearly cost avoidance and are therefore the hardest to
quantify or make a convincing case for budget impact.
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The PSEG tracking and validation process for cost savings projects is shown below in
Figure 1.
The upper half of Figure 1 shows the tracking and reporting process to document the
savings from various savings projects. Projects with a savings (or increase) greater than
$25,000 go through extra approval steps, ultimately being signed off by the internal
Quarterly validation
meetings are held to
functional manager and the vice president of SCM.
The lower half of Figure 1 shows the validation process by which savings resulting
determine the budgetary
from cost reduction projects are applied to company financial statements and budgets.
impacts and budgets are
Quarterly validation meetings are held to determine the budgetary impacts and budgets
adjusted accordingly.
are adjusted accordingly.
Figure 1
➢
The SCM group pursues savings and presents them to senior managers. These senior
managers determine the budget impact (i.e., does the budget get reduced or do the
savings get migrated to other areas where the resources are needed).
CASE STUDY II: NCR CORPORATION
Background
NCR is a publicly traded hardware, software, and data warehousing company with
28,000 employees and approximately $6 billion in annual revenue (www.ncr.com).
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NCR’s product offering includes ATMs, financial services kiosks, financial software,
check imaging technology, retail point of sale (POS) software, data warehousing, and
computer printer consumables. NCR was founded in 1884 as a manufacturer of
mechanical cash registers and went public in 1926.
Strategic purchasing at NCR is center-led, with a CPO and direct reports responsible for
international purchasing offices, compliance, indirect spend, shared direct spend and
major initiatives. There are supply line management roles in each business unit that
Figure 2
Lever
Rate
Calculation
Data Required
- Net reductions in prices paid for items
procured when compared to prices in place
for the prior 12 months or change to lower
cost alternatives [Old price - New price] *
Volume
•Summary PPV reports from the
BUs
•Copies of the old and new
contracts plus data that supports
actual volumes (POs, etc.)
•Travel information (# of tickets,
cost per ticket, etc.) from travel
provider
•Temporary Services information
(# of hours, rates, etc.) from
Managed Service Provider
Rate “Market”
- Industry market movement (positive and
negative) by commodity [Old price - New
price] * Volume.
•Data from manufacturers (e.g.,
price information form Dell,
Solectron, etc.)
Demand
- Proactive programs to reduce usage
[Volume reduction] * Price.
•Copies of cancelled contracts
(including emails or other written
documentation to suppliers)
•Lists of names (mobile phone
cancellations, etc.)
•Temporary Services information
(# of directed hires, moving work
in house, etc.) from Managed
Service Provider
Compliance
- Calculations vary depending on the
commodity and type of cost reduction.
Driving demand to approved programs or
preferred suppliers and eliminating the
premium paid when “outside” of the
program.
•Lists of names (mobile phones
and pagers — getting them on
the correct programs)
•Temporary Services information
(# of people outside the bill
rates, etc.) from Managed
Service Provider
•Travel exception report from
travel provider
E&S - (Engineering &
Proactive programs which change the
manufacturing product specifications and
designs [Old bill of materials – New bill of
materials] * Volume.
•Summary MUV reports from the
BUs
Specification)
Monthly/Quarterly
Commodity
Director submit
cost reductions
Cost reductions
reviewed &
validated by
Spend Analyst
Quarterly
Sourcing Council
Review held
Quarterly BU
CFOs reviews
held and results
locked off
Reports published
to Procurement
community
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report to the CPO as well as to their own business units. Transactional purchasing (PO
release, receipts, and day-to-day operational activities) is decentralized.
Approaches to Hard Savings vs. Cost Avoidance
Cost reduction efforts at NCR involve the examination of existing products or services,
contractual agreements, or processes to determine potential changes that reduce cost.
NCR defines cost
avoidance as those
savings that do not
NCR looks at five different cost reduction levers: rate, rate market, demand,
compliance, and engineering and specification (E&S). Figure 2 explores these cost
levers in greater detail and provides the formulae for their calculation (and data required
to do so).
impact the P&L and do
not lower cost compared
to historical results.
Figure 2 also provides an overview of the tracking and validation process used by NCR.
Monthly cost reductions are validated by a designated spend analyst, and a quarterly
sourcing council (the CPO, his/her direct reports, and business unit supply line
management leads) reviews the aggregate savings numbers, which are then reviewed
by the CFOs and applied to the financial systems. Examples of cost reduction at NCR
are shown in Appendix B.
NCR defines cost avoidance as those savings that do not impact the P&L and do not
lower cost compared to historical results, but that instead minimize or cancel negative
bottom line impacts from potential price/cost increases.
NCR’s methods of calculating/measuring cost avoidance are shown below:
❖ Price increase avoidance
• Calculation: [Proposed price increase – negotiated price] x volume
❖ Cost avoidance for one-time purchases
• Calculation: [Quoted price – Negotiated Price] x Volume. Use the final contract
price and the first offer of the preferred supplier. If no preferred supplier then
use the average of all offers or the first offer of the selected supplier; if
averaging the offer would skew the savings, use judgment.
❖ Value added savings — Goods or services that are received and have an intrinsic
value not billed as part of the contract.
• Calculation: Value of additional service (which is at no cost)
Examples of cost avoidance at NCR are shown in Appendix B.
Figures 3 and 4 illustrate NCR’s approach to evaluating cost reduction changes on
standard costs, cost reduction, purchase price variance (PPV), and carryover.
NCR also tracks spend in low-cost regions, spend through global suppliers, and spend
through reverse auctions. Reverse auctions in particular are perceived to give a greater
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Figure 3
Figure 4
NCR Standard Cost for Current & New Products
Cost Reductions
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Current Products
New Products
Carryover
Not in PPV
N/A
New
PPV
ICR - Not in Cost
Reduction
Considered Cost Avoidan ce
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transparency to market prices. These auctions are conducted with a standardized set
of terms & conditions (i.e., payment terms) and no post-auction bids are accepted. The
lowest bidder is not necessarily guaranteed to win (some auctions consider supplier
switching costs). In more commoditized markets (e.g., memory), the lowest bidder is
guaranteed to win the bid.
Cost reduction at
Northrop Grumman
focuses upon process
improvement initiatives
and on defining and
Up until this year, hard savings have been the only measure that “counted” for
purchasing employees from a performance and promotion standpoint. However, in
2006 NCR will be implementing cost avoidance measures as well. From NCR’s
perspective, cost avoidance often provides greater benefit to the company, because
the higher cost is never incurred in the P&L statement.
CASE STUDY III: NORTHROP GRUMMAN
tracking key metrics to
track performance.
Background
Northrop Grumman is a global defense company employing 125,000 people and with
annual revenues of approximately $30 billion (www.northropgrumman.com). It is a
leading defense systems integrator, the largest military shipbuilder and the largest
provider of airborne radar and electronic warfare systems. The integrated systems
division employs 14,000 people and had 2004 revenues of $4.7 billion.
The Materiel Organization at Northrop Grumman Integrated Systems reports to the vice
president of operations. Materiel is organized into integrated delivery teams (which focus
on business area and programmatic unique issues) and shared services teams, which are
centralized functions for supplier quality/supplier performance, general procurement,
major subcontracts, business management, materiel fulfillment, and strategy.
Approaches to Hard Savings vs. Cost Avoidance
Cost reduction at Northrop Grumman focuses upon process improvement initiatives
and on defining and tracking key metrics to track performance. Process improvement
initiatives contain the following key elements:
• Strong executive support
• Process owner commitment and stakeholder engagement
• Program office infrastructure — people, processes, and systems
• Communication plan
• Project sponsorship and resource prioritization
• Funding
The following types of metrics are tracked and defined to measure the success of
process improvement initiatives:
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• Cost savings (hard benefits)
• Cost avoidance (soft benefits)
• Cash flow
• Sales/revenue
• Customer benefits
• Non-financial
Definitions of cost savings and cost avoidance at Northrop Grumman have been
included in the previous section of this report that detailed definitions and clarifications.
Some examples of the metrics tracked in these areas include:
• Cycle time reductions resulting in lower unit cost (hard savings)
• Reduced process operating expenses (hard savings)
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• Productivity improvements that don’t result in staffing reductions (soft savings)
• Process improvements that increase asset utilization, thus avoiding future capital
or lease investment (soft savings)
• Reductions in liability and risk premiums (soft savings)
Northrop Grumman’s definition of cash flow savings is: process improvements that
result in real, measurable, and permanent improvements in the balance sheet (such as
short-term assets, receivables, payables, etc.). Examples include:
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Northrop Grumman’s definition of sales improvement is: process improvements that
result in revenue increases, additional funding, contract change, etc. Examples include:
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to place additional orders
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customers
Northrop Grumman’s definition of customer benefits is: process improvements that
result in customer benefits not covered by current contractual efforts. Examples
include:
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eliminating need for customer quality personnel
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delivery
Northrop Grumman’s definition of non-financial metrics is: those metrics that focus on
the cost, quality, and cycle time of a process and its outputs. The objective in this case
is the drive toward process maturity. Mature processes are statistically stable,
standardized, lower in variation, and generally achieve desired results.
Northrop Grumman generally gives equal credit to various functions that participate on
cross-functional teams that yield significant cost savings. The money can only be
counted once, but from a score-keeping (i.e., counting toward performance and
promotion plans) standpoint, multiple functions can receive full credit for the savings.
Endnotes
Smock, Doug (2002) “Buyers Shift Strategies as Cost Reduction Goals Grow,”
1
Purchasing, Vol. 131, No. 14, pp. 13-14.
Keen, Jack M. (1997) “Turn ‘Soft’ benefits into Hard Savings,” Datamation, Vol. 43,
2
No. 9, p. 38.
Porter, Anne Millen (1994) “Beyond Cost Avoidance,” Purchasing, Vol. 117, No. 8, pp.
3
11-12.
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APPENDIX A: PSEG COST REDUCTION CATEGORY BREAKDOWNS
AND EXAMPLES
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APPENDIX B: NCR COST REDUCTION AND COST AVOIDANCE
EXAMPLES
Cost Reductions - Examples
Lever
Example
Rate
Year over year net
reduction in prices
paid
Demand
Proactive programs to
reduce usage
Compliance
Driving demand to
approved programs
Engineering &
Specification
Programs to change
product design &
specifications
Cost Reduction
•You have a contract in place for catering
services. If you renew your contract for
the exact same service at a lower cost,
this would be classified as rate cost
reductions.
✓Old Contract - $100K
•Your company has decided only certain
employees will have cell phones, as a
result, 100 cell phones are eliminated
from the total cell phone population.
✓Cell Phones Eliminated – 100
•Your company has three preferred cell
phone providers. A program is launched
to ensure all employees are using the
preferred suppliers. 1,000 employees are
discovered to be paying a $10 premium.
These employees were moved to one of
the three preferred suppliers.
•Your company redesigns Widget ABC to
use plastic components instead of metal
ones. The new bill of materials shows a
net reduction in cost of $10/unit. 10K
units were manufactured in the current
year.
✓New Contract - $80K
✓Cost Reduction – $20K
✓Monthly Cost - $40/phone
✓Cost Reduction – $4K/Month
or $48K/Yr
✓Cost Reduction – $10K/Yr
✓Cost Reduction – $100K/Yr
Cost Reductions - Examples
Cost Avoidance Type
Price Increaes
Avoidance
Cost Avoidance
for One Time
Purchases
Value Added
Savings
Example
Cost Reduction
•Your supplier tells you they are having
a 15% rate increase. However, by
negotiating, you are able to hold the
increase to 10%. The 5% difference
would be classified as cost avoidance.
Had you not taken action your company
would have paid more.
•Your company needs to purchase
Widget AB for a one time project, you
have never purchased this product
before. You receive quotes from your
preferred supplier as well as two other
suppliers. You choose to purchase from
Supplier B.
•Your company contracts with a local
temporary agency to hire contractors for
a short term project. To ensure the
project is completed on time the agency
also sends a on-site manager to the job
site. The value of the on-site manager is
$200/day. You did not contract for the
on-site manager nor are you billed for
the services.
✓Old Contract price - $100K
✓New Contract price - $110K
✓Cost Reduction - $0
✓Cost Avoidance - $5K
✓Preferred Supplier Quote - $40
✓Supplier B Quote - $25
✓Supplier C Quote - $35
✓Cost Avoidance = $15 ($40-$25)
✓Cost Avoidance - $200 * Number
days
Critical Issues Report, March 2006; www.capsresearch.org