Effective demand management is the next logical step to controlling costs and driving down inefficiency and waste. How does it work?
During the economic crisis, we have all become familiar with traditional methods of controlling costs. Historically, these efforts focused on addressing symptoms rather than root causes – for example, altering approval thresholds or driving purchase-to-pay compliance. Yet these are no longer viable.
Typically, the CPO’s agenda has centred on reducing unit price or total cost of a product or service using tools from strategic sourcing and stakeholder management to challenging purchasing frequency.
But as the economic crisis begins to lift, it has brought about an important change: CPOs are embracing the concept of spend re-engineering. Often referred to as demand management, investments are made in a more sophisticated way in order to understand the factors at the root of demand for products, services or internal resources. This knowledge can help to identify and put in place innovative ways to eliminate, reduce or meet demand more efficiently. And the result can be considerable savings.
Historically, procurement hasn’t used demand management to contribute to the bottom line because cost avoidance metrics are easily dismissed by the wider business as intangible and difficult to prove. As a result, procurement functions have been driven into “silo objectives” based on sourcing or volume rebates, locking in the measure of success as linked to the volume of spend. In this respect, for many CPOs, demand management will be regarded as counter-intuitive.
However, the new challenge for CPOs is to embrace demand management as part of the wider agenda for category management beyond the point of identifying the need or specification. As category management evolves, procurement must not only understand these requirements but, as part of good stewardship, also challenge them in a constructive way. This requires a totally different dynamic with the business and may be the ultimate test for stakeholder relationships.
Demand management tends to be associated with indirect spend. In these areas, such as travel and telecoms, procurement has a stronger mandate to alter demand policies and there is greater opportunity to do so. The key shift in approach, however, is in building on this and extending demand management to direct spend.
Consumer products
This has worked in some global consumer products companies. Having proved that the demand management concept works in indirect spend, they have systematically applied the same principles to areas such as primary and secondary packaging. It has resulted in measures including developing joint initiatives with strategic suppliers as part of a supplier development programme, reviewing the specifications for a selection of packaging, and identifying opportunities for reducing the thickness or “down gauging”.
It’s worth investing a substantial amount of time to ensure that the incremental benefits are tracked, even though they may not always fit existing procurement metrics. In the consumer products companies mentioned above, for example, the procurement team led the initiative by targeting key packaging, reviewing the specifications with suppliers and developing a business case for a reduced specification. Manufacturing trials were co-ordinated at the supplier to confirm that the new specification was viable and would meet the required quality standards.
At the same time, an in-house operating feasibility study was carried out to determine whether the new packaging could be used without affecting performance and costs. Colleagues in procurement, operations and marketing worked together in a cross-functional team. Where a study shows the new specification is not workable, a cost-benefit analysis is required to assess the recurring benefits of using the new reduced specification versus one-off capital modification.
Private sector healthcare operators have also embraced demand management in areas beyond indirect procurement. They have adopted its principles to review staffing, estates and consumables against accurately assessed demand patterns.
In order to apply demand management in complex services or departments, a basic approach may involve a series of five steps that aim to “right size” key services against expected demand. These steps are as follows:
1 | Producing a service demand tree
Analysis of value versus consumption will highlight primary cost areas. The first stage of the review is to produce a demand tree. A service demand tree is a flow chart of the origin of demand and what drives it (where, why, what, when and level of demand). It breaks down the service, visually, into its constituent parts and therefore aids full understanding of the services provided.
2 | Calculate demand
For each of the services represented by a separate branch on the demand tree, the annual demand (in hours or other service units) can be calculated.
3 | Calculate capacity
One of the most important factors to consider is the proportion of the services that should be available to each department and location. This can be determined using a team approach and through internal discussions.
4 | Compare capacity and demand
Having calculated the annual capacity and demand for each service, the next step is to compare the demand with capacity for each department or location.
5 | Produce action plans
Stakeholders can either contribute to and help successful implementation, or they can present obstacles and barriers. It is therefore critical that the procurement team apply solid change management principles. These will include putting in place robust performance measures; increasing visibility of procurement performance; effective communication to ensure policies and procedures are well understood; gathering feedback to find out what is working and what isn’t; creating a balanced scorecard; and ensuring appropriate training.
Organisations adopting demand management techniques have demonstrated that, with the appropriate investment, an average saving of 7 per cent can be achieved against baseline. In one example, we observed a return on investment of 4.5 times with £1 million of recurrent savings within a year.
The concept of reducing spend by increasing control is not new to CPOs. However, a systematic approach should be integrated into the category management model. Used in this way, organisations we worked with have been able to save 15-30 per cent through a combination
of demand management and process improvements.
Demand management promotes a common agenda between the CPO and the CFO in developing a deeper understanding of a business’s cost drivers. Resources and people costs (both internal and external) can be reduced using this technique. Although external expenditure has always been carefully scrutinised, it is becoming more important for organisations to know and measure their internal costs. Historically, these have been considered “free” yet the current economic climate is forcing a change in that mindset – organisations have to make better informed decisions about allocating internal resources.
The first step to achieving that is to apply internal cost modelling. Some organisations have set up internal working groups to better understand the cost of in-house services. However their cost model works, it should be comparable to the pricing models used for external suppliers. This will determine the cost-to-serve and therefore highlight opportunities for cost savings and efficiency improvements as part of demand management.
Used this way, demand management supports the controls that govern use of internal resources and challenges inefficiency, as well as matching demand with capacity for externally provided goods and services.
For CPOs who have exhausted sourcing, category management and compliance savings, demand management can prove effective. Applied consistently, it addresses root causes of cost issues in the business and importantly, can help procurement to add value to the organisation. This presents both a new challenge and opportunity for CPOs.