According to the Deloitte Global Chief Procurement Officer Survey 2016 cost reduction remains the focal point for many organisations around the globe. 324 of the most senior procurement leaders in organisations from 33 countries around the world took part, with the combined annual turnover of those organisations representing over £3 trillion. With such a focus on cost reduction, using techniques such as Pareto analysis can really assist in achieving this goal.
Focus on cost can only be achieved if the procurement process can identify where the costs exist and having procurement strategies to manage and reduce them. Therefore the first step is to analyse spend to establish what costs can be reduced or eliminated. Successful procurement professionals should already have their finger on the pulse to map out where their highest spend is located. Spend data is critical for supply management and business success. The benefits of spend analysis include reduce costs, lower inventory levels, improved supplier management and allows refocusing resources on strategic issues.
For example: a company currently spend £2,300,000 on materials. This is included in the cost of sales which stands at £4,600,000. This affects the operating income of £400,000 against a sales revenue of £5,000,000. The resulting profit margin is 8% with Return On Investment at 10%. By focusing on this spend procurement are able to reduce the costs of materials by 5%. This reduces material costs to £2,185,000 and cost of sales to £4,485,000. Operating income is increased to £515,000. This, in turn, increases the profit margin to 10.3% and Return On Investment to 13%. All of this achieved simply by focusing of spend.
A key element of the procurement process is, therefore the identification and management of spend. Pareto analysis is named after Vilfredo Pareto (1848 – 1923) who established that roughly twenty percent of the people controlled or owned eighty percent of the wealth in Italy. It was found that this principle, known as the 80/20 rule, could be applied to almost all other distribution scenarios including spend.
Applying this principle to the total expenditure of a company on its purchases identifies the items that the procurement process can focus on to reduce their spend. A normal distribution will find that eighty percent of spend is made on twenty percent of the purchases made. Once established, procurement can then analyse the materials, products and services that are being purchased to categorise those that can be approached to reduce costs and prices. Procurement can then use this information alongside other analyses to create procurement strategies to meet their organisational goals.
These strategies will then reduce the spend on the purchases found in the twenty percent. Thus the purchases move down the ranking and move out of the twenty percent range to be replaced by another item from the remaining eighty percent. Procurement then begin the process once more on the new twenty percent. This begins a constant cycle of analysis and evaluation to ensure the materials, products and services being procured are cost effective and bought at the right price.
This reduction in spend will have a direct impact on the bottom line. A decrease in spend on purchases increases profits before tax. Reducing spend will also have an impact on Return On Investment as assets are managed more effectively. It is no surprise that the ability to identify and reduce spend has seen a greater focus on procurement management in organisations around the world.
If you are interested in how to undertake a Pareto analysis and how it can be used to develop procurement strategies, why not find out more about the CIPS Diploma in Procurement and Supply. For more information about this qualification or the range of procurement courses from The Oxford College of Procurement and Supply, call one of our course advisors today on +44 (0)1865 515255 or email firstname.lastname@example.org.