3 Ways to Effectively Control Purchasing Costs
The use of metrics is critical to maintaining a business. We need them to be able to measure the success of our department and identify where processes need improvement. With so many technologies and so much data being generated at all times, it’s not uncommon to get lost in what metrics should be your key metrics (KPIs) and closely followed.Thus, from time to time, it is necessary to review the strategies, processes, and which indicators should really be monitored. To help you in this process, let’s review the main indicators that every purchasing department must follow, mainly to control and reduce expenses.
1. Purchase to pay
It is the entire process involved in the relationship between customers and suppliers – purchase, payment and receipt of goods and services.
Within P2P are also included:
- Purchase-to-pay: basically, the isolated part of how an organization acquires goods and services necessary for its production;
- Sourcing-to-pay: controls the accounts payable part and sees the operation more strategically from a spending perspective.
As part of the process, companies must have tight control over spending on suppliers. Making rational spending is the best way to ensure the sustainability of the area within any company.
As this is an action that involves multiple agents at different points of contact, it is necessary to coordinate the entire relationship very well so that the final objective is achieved without causing major losses in terms of increased complexity within the supply chain.
2. Total Cost of Ownership
The TCO calculation includes the direct and indirect costs of purchasing a product and extends beyond the procurement process. As such, it includes expenses incurred throughout the entire supply chain. Transport, taxes, customs costs, insurance and packaging are accounted for, among others, as inventory expenses considering three main factors: occupied space, handling and depreciation.
This calculation allows buyers to differentiate the purchase price from the long-term cost of purchasing a product, which is related to maintenance and repair costs for the product in the near future. In some industries, this value can refer to up to 5 years of maintenance on a machine, for example.
When we think about values applied in the purchasing sector, that is, its budget, one should keep in mind that even though the final price of each purchase is important, not taking into account the TCO of an acquisition can significantly impact the area’s annual expenses. Therefore, it is important to include the TCO calculation when choosing the best suppliers, the best manufacturers, etc. There are some additional costs that allow us to calculate the total cost of ownership (TCO):
The analysis starts with the item’s negotiated price, excluding any discounted amounts related to high volume purchases and on-time payment, for example.
Cost of Transactions
They represent services provided by suppliers, including the processes for calculating inventories, requisitioning materials, preparing and transmitting the order to the manufacturer, shipping document, handling and receiving the product.
The concept of opportunity cost refers to a possible loss of income, if the supplier chosen for the purchase of a certain product does not have quality materials, which will need to be maintained in the short term. At this point, it is worth analyzing the benefits of a more expensive supplier but with a better quality service or product or a lower purchase cost.
Transport and storage of the product, both international and domestic, in addition to paying attention to the time required for its arrival at the final destination.
Currency fluctuation costs
When purchasing products from a foreign country with payment in that country’s currency, the currency fluctuation history must be taken into account. In order to guard against this variation, you can choose to buy in foreign currency at the current price at the time the purchase order is issued.
Commercial regulation costs
It is essential to list the commercial incentives and restrictions offered by the countries in which the supplier is located, including those established through commercial agreements between countries or groups of countries.
3. Purchase Price Variance (PPV)
As the name of the indicator suggests, the Purchase Price Variance (PPV) refers to the difference between two variables: the actual price of the purchased product and its standard price, always related to the number of units purchased.
To calculate it, just multiply these two variables by the actual number of units purchased.
- The formula looks like this: (Actual Price – Standard Price) x Actual Quantity = PPV.
This is one of the main indicators used to measure the variation in the price of purchased goods and services, being a tool capable of telling how effective the purchasing team is.
As a tool to understand how changes in the price of indirect materials can affect future cost of goods sold and gross margin as well, PPV aids pricing decisions by providing accurate forward-looking statements about the general future profitability.
When talking about PPV, the assumption is that the quality of the product is the same and that both the quantity of items purchased, the place of purchase, and the speed of delivery do not impact the price.
Let’s dive deeper into differentiating the variables:
- The actual price of the purchased product is how much the company actually spends on that item;
- Standard price refers to what purchasing experts believe the company will pay to purchase the item during the planning or budgeting process.
Typically, the standard price is based on the last purchase price of the previous year, the first purchase price of the current year, or a price developed based on the best case available when the standard was created.
Developing an effective measurement for the purchasing team is not always an easy task. It depends on analysis of the department’s functioning and definition of the main priorities, goals and objectives.
Once you’ve identified the real needs of the business and understand the nature of procurement key performance indicators, it’s easy to choose those that are in tune with your defined goals.
Keeping track of the indicators and KPIs with your team will enable them to better understand the company’s purchasing habits, the performance of suppliers and whether the procedures are working as they should. Thus, it becomes easier to make any personnel changes, reallocate resources, mitigate risks and avoid bottlenecks; in short: evaluating problems, finding solutions and optimizing the department.
On our blog, we bring other metrics that also need to be monitored in the purchasing department: