The Purchasing Efficiency KPI
This KPI was developed at Philips. Tim Richardson helped standardise and automate the reporting from SAP's Business Warehouse tool (in effect, a glorified spreadsheet). This KPI is suitable for all businesses; small business with less sophisticated systems can use a simplified version based on sampling.
Defining the KPI
Purchasing efficiency is a weighted measure of cost reductions achieved by the procurement function. Distortions and impacts not under procurement's influence are removed to get an actionable, fair KPI.
Setting and controlling targets
At the very least, purchasing efficiency should equal the forecast price erosion. In cost-price road-mapping, certain product prototypes may receive more aggressive targets. Procurement is a fairly strategic process with commitments made to suppliers both in volumes and in supplier-development programs. Targets should look three years ahead, and performance should be measured at least quarterly.
Measuring Purchasing Efficiency
Purchasing efficiency is an index comparing the recent price paid for a component and the price paid historically.
So if a bakery buys 1 KG of plain wheat flour for $10 now, and was paying $11 a year ago, the efficiency is 10/11 -1 = -9% (although we treat this is 9% purchasing efficiency, discarding the negative sign)
Real-world calculations can be done in a spreadsheet. The rows are product codes. A purchasing efficiency score is calculated per row. The overall score is weighted by purchase value in the current quarter.
Pre-requisites for an automated approach
An automated measurement approach requires a system accurately capturing supplier invoice information (cost paid)
An alternative is manual sampling of key sourced products and components.
How to arrive at the "cost"
By default, the cost measured should be the weighted average price paid over the last three months, and for the same quarter a year ago.
if multiple suppliers provide equivalent items, use a weighted average.
Exchange rate corrections
Foreign exchange purchases should be compared at a constant exchange rate (use the rate when the report is made). This removes the impact of exchange rate. However, purchasing efficiency should also be calculated at the transaction exchange rates to keep visibility into the raw effect of exchnage rate movements. The exchange-rate neutral approach should be the leading measure for two reasons:
- Hedging. If the business hedges exchange rate exposure, the spot-rates captures by the system will ignore the effects of hedging.
- Influence. A KPI should only measure what can be influenced. In the short term, procurement can't influence exchange rates. In the medium and long term there is some argument that procurement may have a role in actively managing exchange rate exposure by looking at sourcing origins.
Components change code due to new versions, BOM upgrades or supplier changes. Sophisticated ERP systems can keep track of changes, which should be used in the report.
But when this doesn't happen, the KPI needs a policy of how to treat items purchased in the current quarter which can't find a match in the same quarter a year ago (or the other way).
The correct decision is a judgement based on how often data mismatches occur. The choices are to exclude unmatched items, to force a manual match or to assume no price erosion for unmatched products.
Interpreting a high-level score: price effect and mix effect
The detailed report will list codes, but the final KPI is a weighted average over all data.
If exactly the same products are purchased in the same quantities time after time, then only changes in purchase price can explain Purchasing Efficiency.
However, in reality the mix of what is purchased will change. If customer demand drives an increase in one particular component, this component will grow in influence over the KPI. This is mix effect. Most of the time, it's questionable whether this influence should be attributed to Procurement. If the shift in demand was one-off, then the distortion will give misleading insight into the true performance of procurement.
As with price erosion measurements, it's worthwhile breaking-out the KPI into separate mix and price effects.
Read more: Calculating price and mix effect
Setting up a Purchasing Efficiency KPI is easy
Building a good purchasing efficiency KPI is a simple fast project, part of GrowthPath's Manufacturing Toolkit.