Purchased goods and services can account for 50 to 80 percent of a company’s expenditure. It is hardly surprising, therefore, that after pricing, reducing purchasing costs is the most powerful way to improve shareholder returns, and that most companies have at some point embarked on a purchasing cost reduction program (Exhibit 1 and Exhibit 2).

What is surprising, however, is that many executives still believe the benefits of better purchasing and supply management (PSM) begin and end with a one-off cost reduction, essentially achieved by telling their purchasing departments to lean on suppliers to cut prices.

Those executives would do well to think again. For, properly managed, PSM can give companies a network of suppliers capable of delivering the technology, knowledge, products, or service quality that will beat competitors, at the same time as securing ongoing cost reductions. There are many examples. A leading fast-food company cut the number of its suppliers so that it could work closely with the remainder to improve their performance. The result has been not only annual cost reductions of 4 to 5 percent over several years, but faster product development and innovative packaging that sees the company now selling its food in unique environment-friendly containers.

An automotive manufacturer integrated PSM personnel into its product development teams so that sourcing is considered during, not after, development. This integration means development teams constantly consider the cost and manufacturing implications of their decisions, and usually enables suppliers to be brought into the development process, lending their own knowledge and skills to improve design and speed up development. One development team that collaborated with a supplier to redesign an instrument panel was able to cut the part count by 30 percent, halve the number of assembly steps and materials specifications, and shrink development time from years to months. Similar efforts in other areas have enabled the manufacturer to produce two vehicles in the time it takes competitors to turn out one.

A leading clothing retailer formed close relationships with a small number of suppliers to redesign its supply chain. Shipments now arrive at lower cost and up to seven days earlier—a significant advantage over rivals in the fast-moving fashion business. And sound PSM management helped a defense company discover that many of its engineers had for years duplicated suppliers’ work in areas such as R&D, parts-engineering support, and quality audits. The duplication, inevitably costed into the final product, amounted to an unnecessary 7 percent "tax" which, once discovered, was easy to eliminate. The company’s engineers now take on higher value-added tasks such as value engineering, giving it an edge over competitors that have yet to look for similar overlaps.

These examples, and our experience of working on PSM improvement programs with more than 250 companies in a range of industries and services, reveal the same simple message: companies must define PSM more broadly if they are to use it to the full as a strategic weapon. Indeed, PSM lies at the heart of any successful continuous-improvement program, helping best-practice companies constantly to upgrade their performance at the same time as reducing costs. In other words, PSM helps them improve their "spend productivity" (that is, year-on-year cost reductions on goods and services) faster than competitors do.

Beyond cost reduction

The key to successful PSM is to configure and manage supplier networks to emphasize the purchaser’s competitive strengths. Technical innovation, for example, is vital in information technology. Therefore, computer manufacturers must use suppliers to speed up the rate at which they introduce new products. Packaged goods companies also need suppliers that will help them get their products to market faster, as well as lower their costs. Healthcare providers’ priority is to offer high quality care while lowering the cost. And electric utilities need to work closely with suppliers that can help them meet market-based prices.

To configure their networks in this manner, best-practice companies do two things. First, they aggressively outsource. Most companies talk about outsourcing, but actually do it only in areas such as office supplies or administration, which will never seriously affect performance. The most successful companies are more radical. They outsource so that they can put all their energy into what they do best, in the process reaping benefits such as lower costs, reduced development time, improved service and quality, and access to new technologies, skills, or market information.

One leading European airline has decided to retain only the activities that create most value: managing routes and load factors. Everything else, including catering, ground personnel, and reservation agents, is to be outsourced. A large healthcare provider farms out activities such as materials management and nutrition services so that it can concentrate exclusively on patient care. And a fast-growing fast-food chain prepares less and less food at its stores, having discovered that suppliers, with their larger volumes and more specific focus, can reduce logistics costs and improve product consistency. It, meanwhile, concentrates on product innovation and marketing.

Second, best-practice companies reduce the number of suppliers, then choose a few as partners. Again, most companies are familiar with the mantra about consolidating suppliers and forming partnerships with them, but few have really seized on it. Reducing the supplier base is undoubtedly a sensible cost-saving tactic. Fewer suppliers generally means higher volumes for those suppliers, which should encourage them to lower their prices, as well as lower processing costs.

One consumer products company found that it had more than 4,000 suppliers of small parts, and that the expense of processing an order often exceeded the cost of the part. Yet it would be a mistake to believe all suppliers in a consolidated base have to become partners. A pulp and paper company selected a single vendor to supply all of its miscellaneous nuts, bolts, motors, and electrical parts, and ended up paying as much as 70 percent above market prices—a state of affairs that would not have occurred if the supplier had periodically had to compete for the business.

Companies that have achieved the best results generally reduce the number of their suppliers by 40 to 50 percent. They then select a few with which to work closely, and play off the rest against each other. The problem is deciding which suppliers should become partners.

One electronics manufacturer quickly eliminated small and poorly performing suppliers, and sorted the remainder into three categories: seven "strategic suppliers" for critical materials, 50 smaller "key suppliers," and a larger number of non-essential suppliers. It is with the strategic suppliers that the electronics manufacturer strives to build partnerships that extend beyond delivering high-quality goods or services. It sets them demanding standards for costs, timing, and quality, but in return invites them along to visit customers to discuss product design, helps them fund new technology, and may allow them to operate from its own site. Since the manufacturer invited its laminate supplier to set up a factory on its site, delivery time has dropped from two weeks to two days.

Another best-practice company, a laptop computer maker keen to emphasize innovation, has built its network of core suppliers from companies willing to give it temporary exclusive rights to new parts in return for help funding R&D and larger orders. And the automotive manufacturer that so successfully reduced its product development time chose as its core suppliers those willing to give its product development teams R&D, engineering, and purchasing resources in exchange for assured orders for the lifetime of the platform.

Companies that have formed such relationships with suppliers are in no doubt about the advantages. "We can achieve continuous improvement without our suppliers, but the level and rate of attainment is far greater when we work with our suppliers as full partners," says the CEO of a leading electronics company. And the CEO of a defense contractor remarks, "It’s co-everything when it comes to working with our suppliers: co-design, co-development, co-location, co-manufacturing, and co-customer service."

PSM at the hub of the network information flow

Once a network is configured, the flow of information within it has to be managed. PSM personnel are at the hub, gathering information from customers and suppliers and passing it around the organization. Their goal is continuous improvement. They work with suppliers to identify cost cuts and areas of mutual growth, and with key users within the company to discuss sourcing issues. They also regularly assess suppliers, aiming to spot glitches before they become serious problems. Poor performers are rarely just dropped; instead "SWAT" teams are organized to help them improve.

Such a partnership depends on trust, which can be fostered in various ways. Japanese car companies typically hold "open book" reviews of suppliers’ finances and enjoy free access to their facilities. A US retailer shares customer feedback with its suppliers so that they too benefit from its insights.

The transformation

How can other companies emulate best practice? Many concede that they have yet to surmount the internal barriers that prevent them making even the most straightforward cost cuts. Instead, they are "stuck in first gear," as a purchasing executive at one consumer goods company puts it.

In our work with companies that have run successful PSM improvement programs, we have observed five changes that must be made to surmount these barriers:

1. From a price focus to a total cost focus. Best-practice companies understand and quantify the total cost of ownership (TCO), that is, the actual price of any purchase plus hidden extras. Merely average companies are more likely to focus exclusively on price reductions, with the result that costs pop up elsewhere like air squeezed from one end of a balloon to the other. What, for example, is the point of buying in bulk at a low price if large warehousing costs are then incurred or the goods become obsolete? Both eventualities affect overall expenditure. Similarly, poor forecasting can impose extra costs on suppliers by increasing their set-up expenses, which will eventually be charged for. One utility learned about TCO the hard way. It thought it could generate savings by keeping down gasoline stocks, but the price of buying the gasoline in sub-optimal quantities was a 25 percent per gallon premium that far outweighed the inventory savings.

The best approach is to work across functions to quantify important elements such as warehousing expenses, field failure, freight, and the cost of poor forecasting, and to include these in the TCO. Only when it has a clear idea of the TCO can a company make sensible decisions, certain that price reductions in one area will not simply crop up as increases elsewhere. Companies that do not track the TCO, moreover, risk leaving as much as half of the potential cost savings—those unrelated to price—on the table. The end game must be a lower TCO, even if it means a higher purchase price (Exhibit 3).

2. From a vertical, stand-alone process to a horizontal, integrated one. A purchasing department that functions as a separate unit, restricted to cutting purchase orders, expediting parts, and trying to wring price concessions from suppliers, does not produce the best results. Instead, PSM must be a horizontal, integrated process encompassing most areas of spending and all important users, led and supported by top management. Take the example of a bank that discovered 70 percent of its non-labor expenditure was controlled not by the purchasing department but by individual branches: by looking at more of the bank’s spending, PSM saved $50 million.

But purchasing cannot run the whole show. User groups have to be involved in better buying practices because without their cooperation, purchasing is unlikely to be able to get at non-price elements of TCO. Discussions between design engineers and purchasing at one auto parts supplier revealed that engineers were specifying different types of fasteners for different products, when one common fastener would have sufficed. Functions such as marketing and operations also need to realize that their involvement is needed to improve PSM. As the CEO of a transportation equipment manufacturer says: "Purchasing controls and/or influences nearly three-quarters of our costs. As I see it, they should work upfront as equal partners with sales, engineering, and manufacturing in product design, strategic planning, and so on."

And the CEO of a utility, having learned the lesson the hard way, says: "PSM at our company is now a team and contact sport. We have no time for lone rangers—the industry is moving too fast and requires the speed and insight that can only be delivered if the PSM organization is working well with all other functions."

3. From low-skilled to best-skilled people. PSM needs to be carried out by a company’s best and brightest people, which calls for better training, job rotation, and recognition that PSM can be part of an attractive career path. Many purchasing departments do not have the right people to undertake a radically new approach to PSM. One CEO was dismayed to discover that his purchasing department was little more than a dumping ground. "Purchasing is the home of engineers who can’t add, accountants who can’t foot, and operators who can’t run their machines," he says. It does not have to be that way. Another CEO, from a leading multinational industrial concern, notes both the results and the challenges of working within PSM. "This is an MBA’s dream—everything is strategy and everything is a deal!"

To find people with the skills to design, build, and manage a supplier network, one industrial company has established a summer associate PSM program for students from leading business schools, while a leading computer company requires all new engineers to begin their careers in PSM.

The demand for new talent is reflected in compensation. "Annual compensation levels are now equivalent to those for a general manager running a business, meaning $200,000 salaries with 20 to 40 percent of compensation linked directly to performance," one recruiter says. A large industrial goods manufacturer claims the success of its purchasing transformation lay in a compensation strategy that put purchasing on a par with sales and marketing, and which was flexible enough to reward personnel according to the strategic importance of the impact they achieved.

Job titles have changed in line with responsibilities. The head of PSM is now often known as the chief procurement officer (CPO)—and any company that has searched for one knows how difficult it is to land a top candidate.

4. From standard approaches to innovative tools. Companies that extract most value from PSM have found traditional bidding and administrative tools inadequate to create and manage supplier networks, and have had to develop new ones. "We simply couldn’t have moved beyond our earlier cost reductions without expanding the PSM tool kit," the CPO of a large utility says.

Among these tools, linear performance pricing helps manufacturers and suppliers quantify the link between function and cost for large capital items or for unique and infrequently purchased items. Partnership performance contracts are used to identify and quantify value-creation opportunities and to ensure they are fairly distributed between partners. Lean production diagnostics help suppliers identify where and how they can improve performance. Electronic market making and online bidding are applied to obtain the lowest possible TCO. One specialty metals company now trains its purchasing personnel in the use of 15 analytical tools, reflecting the degree of skill needed to set up and run a supplier network.

5. From data to insight. No one can excel at PSM unless they have the right information on which to base decisions. Often, purchasing departments rely on data—much of it incomplete—about what their company buys. What they need is established facts and insight in three main areas: TCO, supply markets, and supplier economics.

Understanding supply markets helps a company determine, among other things, how much leverage it has over suppliers

Quantifying the TCO will ensure the right total cost elements are taken into account when new business is awarded to suppliers. Understanding supply markets helps a company determine, among other things, how much leverage it has over suppliers. And analyzing supplier economics can help ferret out where a supplier might be extracting disproportionate profits, or running ruinous losses. Without this knowledge, a company is at a disadvantage to suppliers and competitors. With it, PSM helps achieve continuous improvement.

This knowledge is also crucial in establishing yardsticks by which to judge PSM performance. Purchasing departments often make independent savings estimates that have little credibility with other departments. It is like offering students the chance to grade their own exam papers. One consumer products CEO recently challenged his PSM director’s claim of significant annual cost savings. "If you got me this 20 percent you’re promising me this year, plus all the savings you’ve claimed in previous years, our spend would be down to zero." Targets need to be set for PSM just as they are elsewhere in the organization.

The most effective single measure is known as the sourcing efficiency ratio, defined as TCO per unit, adjusted for changes in volume and mix. For a consumer goods company, this measure might be the TCO per case shipped; for a steel company, it might be TCO per ton of steel produced. Several best-practice companies have learned that the measures chosen need to be few, simple, broadly communicated, and created (and thus shared) by important functions across the company. Costs that are beyond purchasing’s control, such as market movements in commodity prices, need to be extracted; important non-price measures, such as defect rates and warehousing costs, need to be included. These performance measurements must be linked transparently to bottom-line results, and PSM held accountable for those results.

Jump-starting the change program

So how do CEOs determine if there is an opportunity to improve their PSM in the first place, and, if there is, what they can do immediately to begin to exploit the opportunity?

The first step is to take stock. Most companies have purchasing improvement efforts under way. The question is, how far have they got? The boxed insert, "Identifying potential improvements," gives a list of questions that can be discussed with the head of PSM.

The answers will indicate the progress a company has made. Unless PSM managers know exactly how much is spent, and on what, it is impossible to arrange areas for attention in order of priority. Unless goals are set, there can be no impetus for change. Unless results are measured, there is no way to assess their true value. Unless time is dedicated to suppliers, there is no way of knowing what more they might contribute. And unless top managers are involved, PSM will never achieve its continuous improvement goals.

Comparing itself against the PSM practices of top-performing companies will also indicate to a company exactly how much ground has to be made up (see the boxed insert, "World-class PSM").

Having established that there is an opportunity to improve PSM, CEOs must then do three things to initiate change. First, they must establish the PSM program on senior management’s agenda. The challenge of executing a multi-year PSM program cannot be underestimated; those few companies that have successfully transformed their PSM capabilities all had commitment from their senior managers.

Second, CEOs must establish aggressive targets. They need a clear idea of the total cost reduction sought over, say, two years; the spend-productivity improvement rate they desire (versus competitors); and any further advantages they wish suppliers to deliver.

Finally, the choice of the PSM improvement leader is crucial. He or she must above all have credibility within the company. A candidate with a background in marketing would be likely to command respect in a consumer marketing company, for example.

With the right level of commitment and the right people in charge, it will be possible to start transforming purchasing’s role within the organization. Some companies have already seized upon PSM as a means of gaining competitive advantage. Many others are beginning to rethink the contribution that purchasing can make to corporate performance. The remainder need a wake-up call. Otherwise they will find themselves lagging behind and not even know the reason why.