What’s the difference between Procurement Cost Savings, Avoidances and Total Contribution and why does it matter?

A saving is a financial measure of a reduction or lessening of costs of products and/or services purchased. Typically the cost baseline is a previous year’s price, but may also be a budget, estimate or planned expense multiplied by a quantity purchased in the same period. Typically business track savings performance of both Procurement and Production (manufacturing department) – in the rest of this blog we will be focusing on Procurement only.

 To reach a high level of transparency the savings are broken into two basic types: cost savings and cost avoidances.

• Cost savings typically have a direct impact on Profit & Loss (P&L) statement and EBITA and are calculated as a variance between a previous year’s price and a newly negotiated price multiplied by the quantity purchased.
• Cost avoidances maintain current spend levels by avoiding price increases and inflation or market effects and are calculated as a variance between the budget price and a newly negotiated price multiplied by the quantity purchased. Though cost avoidance initiatives normally do not have an immediate impact on the P&L compared to a prior period, a healthy Procurement organization will track the impact of such activities to fully capture the efforts and value provided by performing such activities.

Cost Savings compares previous year’s average cost per material with the current financial year’s actual cost for exactly the same material.

Cost Savings

• Cost savings are calculated as a difference between previous year’s cost and new cost (Price X Quantity) and have a direct financial impact on the P&L statement. Previous cost is the previous year’s price (last reasonable price) multiplied by quantity purchased. 

• If there’s no price available within last 12 months from the Savings reporting time, then the part/service purchased shall be treated as “new” and entered as Budget cost and consequently reported as Cost avoidance.

 Cost Avoidances

• Cost avoidances shall be used for all the situations where previous year’s price is not available.
• They are calculated as the difference between the Budget or Estimated price and Final negotiated new price multiplied by the quantity purchased.
• Typically cost avoidances are reported under the following scenarios:

1. 1. No previous price available within the last calendar year
   2. New part being purchased for the first time
   3. Prototype
   4. Comparing Sales budgets/estimates VS the actually paid price
   5. Credit note, early payment discount, yearly volume rebate
   6. Capex avoidance
   7. Avoided cost increase – Improving the lowest quote even further but still paying more than the previous year’s price

Having a clear understanding of the above is essential for any Business that wants to get serious about transparent savings planning and reporting. It is of utmost importance to establish clear definitions and processes for the reporting purposes and implement these quickly. Any vagueness in this area typically results in savings over reported and similar errors that ultimately lead to Procurement department losing credibility in the business and not being taken seriously anymore. Additionally it can also lead to constant discussions about the source of reported numbers, whether they are right or wrong and so on.

All this can be simply stopped by clear definitions, processes and using the best savings planning, tracking and reporting tools instead of Excel and similar tools. Contact us and let us help you get your Savings reporting, tracking and planning to the Best in class levels.