Benefits of spend reduction depicted with an image of Category Manager on a rocket about to fire - Spend Analysis Consulting
By: EmpoweringCPO Insights Team

Multiplier Effect of Spend Reduction on Profitability & Valuation

Most of the industries and countries worldwide are facing either stagnant economy or even if they are growing the growth rate is very low. In these tough times, increasing sales is a challenge, so how come some of the companies are reporting increase in profitability, earnings and valuations. The answer lies in their sourcing capabilities, their ability to ensure year on year increase in savings and their ability to increase spend under management.

For these organization Procurement & Sourcing is a strategic arm and has helped them achieve competitive advantage. Their procurement and sourcing department is more efficient and effective compared to their competitors. These best in class companies have a robust Spend Management and Strategic Sourcing Programs in place, every year they conduct spend analysis and opportunity assessment, and prepare sourcing road-map. Many times these companies also leverage expertise of spend analysis consulting firms to prepare sourcing road-maps. These are the companies where spend under management is more than 80% unlike laggards where it is below 50%. The savings outcome of their sourcing project on average is more than 9% unlike laggards where it is below 3%. These savings are religiously tracked and monitored to ensure they enter the P&L statements of their companies. There exercise for sourcing project is not just limited to savings, at the same time year on year they ensure improvement in quality and SLA’s, focus for them is TCO and not just savings.

So why these best in class companies focus so much on savings and spend reduction. The answer lies in the table presented below, the multiplier effect. To demonstrate the impact of spend reduction versus increase in sales revenue on the bottom line of companies, refer to the below table for two different scenarios. To highlight the impact a very simplistic example has been presented below:

 

$ MillionsDecreasing External Spend by 7%Increasing Revenue by 7%
Revenue$1,000$1,000$1,070
Cost of Revenue$700$651$749
Gross Margin30%35%30%
SGA$200$186$214
Cost of Revenue + SGA$900$837$963
Operating Margin ($)$100$163$107
Operating Margin (%) 10% 16.3%10%
Taxes at 38%$38$62$41
Net Income$62$101$66
Change in Net Income$39$4
Change in Net Income %63%7%
Valuation (PE Ratio of 12)$744$1,213$796
Change in Valuation$469$52
Difference in Impact between two Scenario900%

The above table is based on simplistic assumptions but in reality the outcome can be almost similar. Some of the assumptions are as follows:

  1. Spend reduction is assumed as 7%. This can vary based on the type of industry and level of maturity. Best in class companies have reported more than 9% annual savings.
  2. In most of the companies 50% of spend is through 3rd parties, and hence ideal candidate for cost reduction.
  3. The spend reduction is assumed on pro-rata basis on SGA as well as on Cost of Revenue.
  4. P/E ratio is assumed as 12, this again varies across industries and countries.
  5. Taxes are assumed as 38%, this may be lower or higher for different countries.

The above table presents two scenario and their impact on bottom line as well as valuation of the companies. It is evidently clear, the reduction in spend has a multiplier effect if measured along with same percentage increase in revenue. This is the reason procurement organizations should focus on savings. CPO’s can definitely change the course of their companies if sourcing projects are planned and executed properly year on year. In-fact it is far easier to execute sourcing projects and achieve savings, the effort and time required is less as compared to achieving same percentage increase in revenue, this is truer for mature industries.

In addition to achieving savings and improving supply quality, procurement organizations also contribute towards new product development, it is very critical to identify right kind of quality suppliers during the initial stages, as these are untested categories. Success or failure for new launches can entirely depend on creation of efficient supply chain on the buy side. Companies cannot afford to launch new products with low quality suppliers and pay higher prices. They will immediately lose their competitive advantage.

So with the above listed note it can be summarized that CEO and CFO’s cannot afford to ignore building procurement organization and creating a support system for them if their goal is to achieve competitive advantage and delight their shareholders.

Leverage Our Procurement Services  – One of the Leading Spend Analysis Company

We at EmpoweringCPO with vast pool of experience, we have plenty of case studies to elaborate on how we were able to transform procurement organization into strategic arm. Our focus on procurement intelligence and procurement analytics have been our two key ingredients to achieve successful results.

 

Leverage expertise of EmpoweringCPO, one of the leading procurement outsourcing companies globally.  Contact us today
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EmpoweringCPO Services Private Limited

EmpoweringCPO is a team of experienced sourcing and procurement professionals with hands on experience of having worked with many fortune 500 companies. The company was founded in 2011 and since then has executed multiple strategic sourcing projects and have achieved average savings of 9% so far. In addition to Strategic Sourcing their other offerings are Spend Analysis, Procurement Intelligence, Procurement Analytics, Best Cost Country Sourcing, Procurement Outsourcing, Built Operate Transfer, Supplier Diversity and Sustainable Procurement.

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