Standards for Calculating Cost Savings
I went through an internal audit recently, and the objective of the audit was to determine if my department was appropriately reporting cost savings from procurement activities. The reason for the audit was a steady and very significant savings year-over-year for the past few years--which, coincidentally, coincides with the time I came onboard. Hmmm...
Believe it or not, I actually love working with my internal audit department. Seriously. They really are pros at what they do, and they don't go off the deep end like some other internal audit departments I've worked with. In fact, I've actually asked them to do other audits on my operations because I've found that they have the same goal I do--to be better, faster, cheaper, and so on, and without getting caught up in audit esoterics and trivia.
The good news was that, excluding a few thousand dollars on an over $8 million dollar reporting savings, the audit found that my group had been calculating savings appropriately. So, it wasn't some new VMO voodoo math that I started using when I came onboard--the savings were the result of overhauling our internal processes, hiring better staff, and getting more training (among many other things we did to improve ourselves).
What my internal audit department recommended, and what was missing, was a comprehensive set of cost savings standards and a peer review audit to verify savings. As a result, I created the following, which my internal audit approved. You might want to consider something similar for your procurement organization. Here's the excerpt from our "Purchasing Instructions Manual." If you think my standards are missing something or could be improved, please comment!
P.S. Where I work, cost savings and cost avoidance are lumped together and referred to as "cost savings."
Cost Savings Standards and Reporting
VMO staff shall adhere to the standards described below when calculating and reporting cost savings. These standards will be reviewed with VMO customers on an occasional basis to ensure that cost savings are being calculated and reported appropriately. VMO staff are required to conduct peer review audits to ensure that cost savings are being calculated and reported consistent with the following standards.
Permitted Cost Savings
- Actual cost savings, such as reducing the cost of goods or services already being purchased. For example, reducing the cost of annual software maintenance.
- Cost avoidance, such as reducing the proposed cost of goods or services that are being contracted for. For example, reducing software license fees from what was originally proposed.
- The dollar value of concessions where such value is easily quantifiable, such as obtaining a higher level of service at the price for the lower level of service. For example, negotiating the concession of 7-day by 24-hour technical support for the cost of 5-day by 8-hour technical support.
Cost Savings Exclusions
- Cost savings resulting from contract audit reviews performed by other departments or work units.
- Cost savings associated with established discounts for ongoing transactional purchases beyond a maximum three-year period.
- Cost savings associated with any employee discount program, such as Dell EPP.
- Cost savings associated with procurements where the VMO was not materially engaged such as where the VMO did not strategize, lead, or materially participate in a negotiation.
Methods of Calculating Cost Savings
- Cost savings cannot be calculated from list price; rather, cost savings must be calculated from the first proposed non-list price.
- Where forecasted quantities or usage of goods or services can not be reasonably quantified to calculate cost savings, previous annualized quantities can be alternatively used.
- The total of multiple-year cost savings can be accounted for in the year that the negotiation occurred, provided that the savings are projected for a maximum three-year period and provided that savings are not re-counted in future years.
- The dollar value of concessions must be easily calculated and clear.
- Actual (not merely contractual) reduction of penalties, liquidated damages, terminations fees, or settlement amounts can be counted as cost savings.
- Where contractual penalties, liquidated damages, or termination fees were lessened as a result of negotiations, and penalties, liquidated damages, or termination fees were actually paid, the difference between what would have been paid had the same not been pre-negotiated can be counted as cost savings.
Believe it or not, I actually love working with my internal audit department. Seriously. They really are pros at what they do, and they don't go off the deep end like some other internal audit departments I've worked with. In fact, I've actually asked them to do other audits on my operations because I've found that they have the same goal I do--to be better, faster, cheaper, and so on, and without getting caught up in audit esoterics and trivia.
The good news was that, excluding a few thousand dollars on an over $8 million dollar reporting savings, the audit found that my group had been calculating savings appropriately. So, it wasn't some new VMO voodoo math that I started using when I came onboard--the savings were the result of overhauling our internal processes, hiring better staff, and getting more training (among many other things we did to improve ourselves).
What my internal audit department recommended, and what was missing, was a comprehensive set of cost savings standards and a peer review audit to verify savings. As a result, I created the following, which my internal audit approved. You might want to consider something similar for your procurement organization. Here's the excerpt from our "Purchasing Instructions Manual." If you think my standards are missing something or could be improved, please comment!
P.S. Where I work, cost savings and cost avoidance are lumped together and referred to as "cost savings."
Cost Savings Standards and Reporting
VMO staff shall adhere to the standards described below when calculating and reporting cost savings. These standards will be reviewed with VMO customers on an occasional basis to ensure that cost savings are being calculated and reported appropriately. VMO staff are required to conduct peer review audits to ensure that cost savings are being calculated and reported consistent with the following standards.
Permitted Cost Savings
- Actual cost savings, such as reducing the cost of goods or services already being purchased. For example, reducing the cost of annual software maintenance.
- Cost avoidance, such as reducing the proposed cost of goods or services that are being contracted for. For example, reducing software license fees from what was originally proposed.
- The dollar value of concessions where such value is easily quantifiable, such as obtaining a higher level of service at the price for the lower level of service. For example, negotiating the concession of 7-day by 24-hour technical support for the cost of 5-day by 8-hour technical support.
Cost Savings Exclusions
- Cost savings resulting from contract audit reviews performed by other departments or work units.
- Cost savings associated with established discounts for ongoing transactional purchases beyond a maximum three-year period.
- Cost savings associated with any employee discount program, such as Dell EPP.
- Cost savings associated with procurements where the VMO was not materially engaged such as where the VMO did not strategize, lead, or materially participate in a negotiation.
Methods of Calculating Cost Savings
- Cost savings cannot be calculated from list price; rather, cost savings must be calculated from the first proposed non-list price.
- Where forecasted quantities or usage of goods or services can not be reasonably quantified to calculate cost savings, previous annualized quantities can be alternatively used.
- The total of multiple-year cost savings can be accounted for in the year that the negotiation occurred, provided that the savings are projected for a maximum three-year period and provided that savings are not re-counted in future years.
- The dollar value of concessions must be easily calculated and clear.
- Actual (not merely contractual) reduction of penalties, liquidated damages, terminations fees, or settlement amounts can be counted as cost savings.
- Where contractual penalties, liquidated damages, or termination fees were lessened as a result of negotiations, and penalties, liquidated damages, or termination fees were actually paid, the difference between what would have been paid had the same not been pre-negotiated can be counted as cost savings.
excellent post. You might take it a step further and build into a status report that can be circulated or posted to internal website .. It answers the what have you done for me lately.. Fosters positive communication etc..
Reply to this
regarding your comment on "Where forecasted quantities or usage of goods or services can not be reasonably quantified to calculate cost savings, previous annualized quantities can be alternatively used" - I have an engagement in front of me to take our 2007 spend times the delta (current price - new negotiated price); but, why would i pay them a contingent fee based on a prior year base, when my spend may be much less in the current year? Would I not wait to see what my spend is, and they get their contingent fee when we actually incur the expense at the lower rates?
Reply to this
Andy,
You may not want to pay a contingent fee based on previous results if you have the belief that future spend would be lower--usually it's the other way around. The net-net is that you should structure the deal to make it work for you.
Best,
Stephen
Reply to this