Reducing Outside Spend

Why is it important to manage outside spending? How much can a company save?

Outside spend can account for a major portion of a company’s cost structure – outside spend can reach 30-60% of total costs. Reduction in spend can have a significant impact on your company’s bottom line.

A 10-30% reduction in outside spend is possible with a programmatic approach – effectively managing spend offers a significant opportunity to improve profitability, because even a 10-20% reduction can translate to a 5% increase in overall margins for most industries.

What are some indicators that a company could have unrealized savings in better managing outside spend?

Category-Specific Factors:

The economics and cost dynamics of different spend categories – are you talking about software spend, fasteners, or commodity steel? The economics of those things are different and they create different switching costs, market structure, etc.
Categories with more compressible costs logically have higher savings potential – if you have spend in categories with more compressible costs, that’s a logical place to look to reduce outside spend.

Areas of opportunity related to internal company processes:

Strong fracking of information about suppliers and contracts – this applies whether you’re buying steel or software. You should know the relevant details about your supplier and your contract with them.
Strong management of deadlines and negotiation timelines – how much time it takes to negotiate a new agreement? How much time would switching take? When do you need to begin negotiations? The administration of timing is an important lever to manage outside spend.
Accountability and processes for creating and exerting leverage systematically – do you systematically create and exert leverage with your suppliers?
Buying only what is needed, no more and no less – if you understand the specifications of what you need, you can work with vendors to cut extraneous spend.
Creating leverage through cultivating supplier alternatives – are you creating leverage and exerting leverage optimally on your suppliers?

Performing analysis on switching costs and relative costs of alternatives to negotiate optimally – are you doing the math on switching costs? Do you know the relative costs of different alternatives? This can help you negotiate from a well-informed position.

Differently sized companies mismanage spend in different ways:

Larger companies tend to focus risk reduction and compliance to the extent they sacrifice value creation – they lean heavily on checklists and administrative processes to reduce risk from suppliers. This can make them difficult to work with for suppliers and can reduce competitiveness of their spend.
Smaller companies often underestimate the potential of outside spend management and/or lack the requisite systems/processes- if they are growing and have high margins, smaller companies might assume they don’t need to think about cost reductions. They don’t understand the issue or see the potential for optimization.

Inside Consulting has a diagnostic scoring model – we use a calibrated model to develop savings estimates, based both on the category dynamics and the company’s internal process rigor. This is what lets us go really deep in some areas (with higher perceived upside) and economize our effort elsewhere

What are the different buckets of outside spend?

	Example	Notes
Software	Spend with Salesforce for your CRM	*Note:* This spend is often highly compressible—or you can look to consolidate and eliminate tools.
Telecom	Spend with AT&T for your customer support line	—
Business Services	Spend with a tax consulting firm to file your taxes	*Note*: human costs for consulting are labor-based and less compressible than other areas.
COGs Materials	Industrial supply/product parts items (e.g. spanners)	—
Commodities	Commodity steel	—
Energy	The electric bill at all of your facilities	—
Travel and Entertainment	Travel expenses incurred for internal meetings	*Note*: this used to be a much more significant portion of compressible spend pre-Zoom. Much travel is already replaced with video meetings.

What are guidelines for deciding when you should do something in-house, when you should partner with one supplier, and when you should have multiple suppliers?

Step one: Decide whether to outsource or handle it in-house:

Consider the opportunity costs of time and capital deciding whether to outsource – avoid the bias of doing something in-house just because it’s possible internally. Analyze whether it makes more economic sense to outsource. What else could you be doing with that time and capital?

Step two: Decide whether to partner with a single supplier or multiple suppliers:

Concentrating spend with one supplier often leads to better pricing but comes with risk- ideally, the more you concentrate your spend, the more the supplier will make it worth your while with better pricing. But this increases risk when you entangle a crucial portion of your business with the supplier’s business. Using backup suppliers can provide risk mitigation at some cost penalty–so you have to run a risk-reward calculation to find the ideal supplier setup for your business.
If you use a single supplier, check if they have inherent risk diversification – you might find you can pool your volume with one supplier, and they have multiple facilities anyway. So that can create some inherent risk diversification.

What sourcing tactics and methodologies can help with cost savings?

Understand your leverage with the supplier:

Understand alternatives and costs to pursue them – know what you would be walking into if your supplier says take it or leave it and you leave it. What would it cost to go to another supplier or handle it in-house?
Conduct should-cost analysis to estimate appropriate pricing based on supplier economics – should cost analysis can help you understand the margin picture of your supplier and how much room on pricing they might have.
Cultivate other potential suppliers that could enter the market – could someone else enter this market space and provide what you need even if they’re not doing so today?

Zero-Based Budgeting:

Understand your consumption needs – before you go source and try to get x% off the price of something, how much do you even need and why? And with what specification? If it’s software, does everyone need the deluxe version, or can most people get by with the very basic version?
Model out future purchasing volumes to maximize leverage – understand your future purchasing volumes under various assumptions and scenarios. What might you need?

Total Cost of Ownership Analysis:

Look beyond unit pricing to all relevant costs like shipping, payment terms, rework, etc. – figure out all the relevant costs, and then do an assessment based on that more holistic view of total cost of ownership.
Understand the time period and costs that should be included in your analysis – this is the only way to get a complete view of the total costs for different solutions.

When there are large switching costs, how do you evaluate the payback period?

Every company has a hurdle rate that factors into the Net Present Value (NPV) analysis – of whether the ongoing operating savings justify the one-time switching cost. No matter the investment, whether it’s in energy efficiency, labor efficiency, or switching off a vendor, there’s some one-time cost and an ongoing stream of OPEX savings. How you look at it depends on their hurdle rate in terms of weighted average cost of capital.

Oftentimes companies systematically overestimate switching costs – they assume it’s prohibitive without actually quantifying the effort required. This is especially true in private equity-owned companies. It sounds like a hassle or people assume it will be their responsibility to handle and if something goes wrong they’ll face the fallout.

What are the different ways to solicit bids from vendors?

There are often at least two steps:

First, building an understanding between yourself and the vendor for what you need – this allows your organization to understand what you need and at what volume, and communicate it to vendors.
Then, put out a request for quotes (RFQ) to understand requirements – this allows vendors to give their quotes. These can be in an Excel spreadsheet and allow you to compare pricing from different vendors.

Occasionally, final pricing is done through a live bidding event – this can be advantageous to do for final pricing in order to drive competitive responses. Your organization can reveal certain information like where each vendor ranks, and allow them to update their bids if they desire.

How should you manage supplier relationships long-term to control costs collaboratively?

Maintain transparency and openness – maintain transparency with suppliers about your ongoing needs, challenges, and strategy. An open dialogue allows for collaborative cost control. If you can find wins to be a more profitable customer for them, that will lead to a successful long term relationship, and make yourself an attractive customer. Help suppliers understand your needs and challenges. Provide them with information to generate the sharpest possible bid pricing aligned with your operational efficiency. Suppliers make assumptions and build those into their bids—if you can help them really understand you, you can collaborate towards a more productive relationship.

Work on continuous improvement of the relationship – don’t let the relationship go stale after initially negotiating favorable terms. Constantly re-evaluate market conditions, alternatives, and your leverage position. There can be ongoing win-wins that can

Align on shared incentives – where possible, structure supplier incentives to align with your company’s cost objectives. Incentives can help drive continuous innovation on their side. Things like delivery schedules, work to collaboratively get what you need with a vendor. If you can become a lower-cost account to serve for the vendor by aligning incentives, you can end up with a more favorable relationship with them.

Avoid systematically fooling or bullying suppliers – that will reduce the attractiveness and competitiveness of your business over the long run. The misconception people have is that tougher is better, and more checklists and more controls are better. That has the subtle effect of reducing the attractiveness of your business, and then there’s less competition for your business.

Have a profitable customer mindset – strive to make your company an attractive, profitable customer so that your suppliers will strain to win your business. You can improve relationships with your suppliers with efforts like:

Committing to certain volume levels to reduce their risk – this might cost you nothing but lead to
Collaborating on operational aspects like delivery schedules – you can collaborate with your vendor to both of your benefits.
Negotiating mutually beneficial payment terms based on differing capital needs – the vendor may prefer that you pay me early, and if you are willing to give concessions in areas like payments, the vendors may be willing to offer discounts commensurate to the value they see in early payment.

How do you avoid snowballing costs for usage-based vendors?

Have discipline with your usage and apply zero-based budgeting – do this to interrogate why your usage levels are needed, and analyze the key drivers behind them. Reconcile any large discrepancies between projected and actual usage. Approach your spend from zero and build up to what you actually need.

Negotiate volume pricing tiers into contracts – so that per-unit costs decrease as higher usage volumes are hit, rather than scaling your costs linearly. This can be beneficial to both you and the vendor.

Who should own procurement and supplier management?

The CFO should own procurement/supplier management – the CFO will help you apply quantitative rigor to your procurement and supplier management. If you don’t involve the CFO, you might get shadow analyses and bogus cost-avoidance arguments with little accountability for how initiatives translate into invoice and accounts payable impacts.

A programmatic approach to outside spend requires cross-functional collaboration – your CFO needs to know what the other supplier options are and what your organization needs from its vendors. This often implicates other functions in your procurement and supplier management efforts.

What negotiation tactics can help you reduce outside spend with vendors for new purchases or during renewal?

Position yourself as a profitable customer – present your company as an attractive, profitable customer by communicating your expected growth and future spending potential, your needs, and service level commitments you can make .Then, provide them with information to show your operational efficiency as a low-cost customer to serve.

Be transparent about your requirements – be open about your needs and ask suppliers what information they require to bid most aggressively, accounting for your efficiencies. Understand their economics and what information they need so you can generate the sharpest possible bid.

Build leverage that you can use during negotiations – share insights that suppliers may not have to help compress their uncertainty premiums and drive more competitive pricing. For example, you can offer them insights into the alternatives or your ability to handle it in-house.

How can you structure contracts to best control costs?

Address key risks in your contracts – identify the primary areas of uncertainty and risk, then structure appropriate clauses, such as:

Performance SLAs if supplier performance and execution is a concern
Linking pricing to commodity indices if input costs are volatile
Testing different contract durations to balance flexibility vs. discount
Evaluate needs for redundancy/backup suppliers and associated pricing impacts.

Link pricing tiers to volume – including pricing tiers linked to volumes purchased often allows for reduced per-unit costs at higher committed volumes. This can help you keep spend down as your needs scale.

How should you think about evaluating different vendors during negotiations to increase your leverage?

There is no magic number, but more alternatives means more leverage – the optimal number depends on the competitiveness of the particular market. It comes down to identifying the key risks and the key variables.

Your objective is to get the supplier to reveal their hand, not to reveal yours – if you are deciding between a supplier’s offering and an alternative, you don’t necessarily want to reveal the pricing of the alternative until you know what the supplier’s initial offer is.. The objective is to get the supplier to reveal their price point by making it clear you have a motivating alternative option unless pricing is sharpened.

What are the most important things in reducing outside spend?

Build leverage systematically – for key spend categories, invest time and effort in understanding your needs and then build leverage and alternatives for negotiation with your vendors and suppliers.

Understand the economics of insourcing or using alternatives – are you buying what you need? No more, no less? How sure are you? And then are you creating leverage and exerting leverage optimally?

Consider supplier cost structures to identify appropriate pricing – being tough on vendors because you think their job is to pull the phone away from their head, let you yell, and then do what they’re going to do is not the right way to go. Vendors respond when you have leverage to go to alternatives, and propose pricing that will work for your firm.

What are common pitfalls in outside spend reduction?

Assuming purchasing volume/power is the only lever for savings – don’t assume that volume and purchasing power is the only lever you have to push vendors for savings. It’s actually among the weakest levers, because without any alternatives, the suppliers will presume that you’re becoming even more reliant on them, and think they have increased pricing power.

Assuming there are no viable alternatives or that switching is impossible – don’t assume that you are stuck with the current supplier that you work with. It may take work to find or cultivate alternatives, but it can be done in most cases.

Mismanaging timelines/deadlines required for switching suppliers – don’t think that your renewal date with the vendor is coterminous with the timeline you should evaluate alternative suppliers on. If you have to respond within 60-days to cancel, you may have to take much longer than that to switch suppliers. Give yourself the chance of being seen as a marginal customer, and undertake the steps needed to give yourself alternatives.

Failing to cultivate a competitive environment among suppliers – everyone thinks that they got a great deal at the used car lot. Everyone thinks they manage outside spent effectively. But oftentimes, the level of rigor that companies display isn’t sufficient.

Self-inflicted purchasing wounds – poor management of timelines, allowing auto-renewals of unfavorable contracts, and being excessively difficult towards suppliers in a way that reduces competition are all self-inflicted wounds that can really hamper your spend management work.

Overbuying – rigorously define your minimum sufficient specification needs and avoid purchasing more than you need. Similarly you should avoid premium pricing for unnecessary premium offerings.

Assuming that an intermediary or GPO leaves you with the best pricing – sometimes it pays to do custom analysis and sourcing. Given the multiple on EBITDA and the one-time cost of doing the work, customer analysis and sourcing can pay off in the long run.