Be wary of very high ROIs in procurement
I’ve had numerous conversations with CPOs in my time who have said they are very proud of achieving a 10x, 20x, or even 30x ROI on their team cost. And research has claimed that world class procurement functions achieve a ROI twice as high as the average. But both of these measures are not only far too simplistic, they are misleading and are forcing the wrong behaviors in our business leaders. And here’s why...
Imagine you put all of the projects you could do in procurement in a list, and then order them by descending ROI. And let’s not forget all of the projects that generate a benefit to the business which are not measureable in financial terms. If you want to generate a very high ROI, reduce the size of your procurement team, and simply do the first few projects... and then stop. At that point you might be able to guarantee a ROI of 50x, perhaps more. It will certainly be high. And guess what, a version of that is what some functions do.
But what about all the other projects which have been ignored? There will be a long, long list of these. Some might only generate a ROI of 3x. Some may only break even. Some may even cost money to generate no financial benefit – but other important business benefits are achieved, such as innovation, reduced risk, improved customer service, etc. Either way, a lot of financial and non-financial benefits will be left on the table.
Now let’s compare the ROI achievable through procurement with the ROIs achievable through business investments in HR, Finance, IT, R&D, etc. My guess is that you will find the ROI of the procurement projects is much greater. And yet the procurement projects typically get de-prioritized, in favor of other areas of investment. From a financial perspective, in other words, the business is mis-prioritising where it puts its money. I see it happen again and again; businesses demand much higher ROIs from procurement than any other area of the company.
Why is this?
Well, firstly, and frustratingly, it’s not a lack of available funds that’s at the heart of it - other functions receive their funding, despite generating a lesser return (the irony is that procurement projects are often self-funding within the financial year).
The answer partly lies in businesses’ misguided obsession with savings (which we covered in this previous post). But it goes deeper than this. I think procurement is failing to make its case as successfully as other functions. It is not ‘selling’ what it can do to senior executives. What’s more, business leaders themselves fail to realize the importance of managing their cost base as they don’t recognize the sheer scale of their cost base relative to their labor costs – as our recent research around cost management nicely demonstrates.
The truth is that for the average FTSE-350 company, non-labor costs (at 68.3%) outweigh labor costs (at 12.9%) by more than five times.
The net impact of all this is that every year procurement fails to get the investment it desperately needs. Across the globe procurement functions are under-invested in and under-resourced compared to other business functions.
So be wary of claims of very high ROIs from procurement – especially when they are claimed year after year. I believe it is world class to persuade the business to undertake projects which generate low, or even, dare I say it, negative ROIs, which drag the overall procurement ROI down, but which ultimately improve business performance.
Put simply, world class procurement functions do not have astronomically high ROIs – think about it logically and you’ll see that a world class procurement function is going to be managing the cost base extremely well, so there shouldn’t be continuous, very large scale cash savings.
Business leaders are mature enough to understand this. But is the procurement community?
Our latest research reveals that businesses spend, on average, two-thirds of their revenue on non-labor costs – 68.3% in 2011. This far outstrips their collective labor costs, which averaged just 12.9% of their revenue. Yet headcount reduction is traditionally seen as the best way to tackle cost. This raises a number of questions:
- Are businesses ensuring that their non-labor cost base is being effectively managed?
- If not, why not?
- And what are the potential benefits of making that investment?