How do you effectively and efficiently measure cost savings?

If you are like most company leaders then you have established one or more Key Performance Indicators (KPI’s) for cost control and/or cost savings in 2012. How have you ensured that the measurements drive the right behaviour to support the strategic objectives such as competitive edge and improvement of the profit margin?

I continuously get surprised when I see how cost savings are measured. The typical way is ‘actual absolute spend’ versus budget. Does this tell you anything about whether you have the right cost level or how your costs have developed compared to your competitors? In my opinion – No!

This simple comparison does not consider critical aspects and might give you a wrong picture of your performance. To make a value adding measurement you have to consider:

• Activity level
• Consumption pattern / mix
• Unit prices
• Benchmark against market prices

Let us quickly run through these elements. I will use freight of goods from China to Denmark as the example.

Activity level – So your freight costs in 2011 have been 10 % lower than budgeted. Good? Maybe it is, but not if it is because you have only shipped 70 containers against a budget of 100 containers. Then, all other equal, you should have saved 30 %. Similarly, then it is not necessarily a problem to have spend 10 % above budget if it is because your freight volumes have increased 10 % or more.

Consumption pattern / Unit Prices – Next you have to look at unit prices for the individual goods – here the various corridors. Let us say that you have budgeted to ship 70 containers from Shanghai at a price of EUR 1,350 per container and 30 containers from Xi’an at EUR 1,600 per container. In total EUR 142,500. Now you have shipped 100 containers and spent EUR 152,500. Why? Maybe your consumption pattern has changed. In this example you have shipped 70 containers from Xi’an and 30 from Shanghai. The activity level is the same, the unit prices are the same. Only due to the change in consumption pattern have your total spend increased.

Benchmark – If you would like to ensure a competitive advantage you need to know how your costs have developed compared to the market. Let us say that you have obtained a 10 % saving on the unit price and thus paid EUR 137,250. This gives a 10 % saving on unit costs and an absolute saving of EUR 15,250 despite the changed consumption pattern. Can you be happy with this?

Not in 2011! According to Shanghai Container Freight Index (http://en.sse.net/index.jsp) then the average freight rate has dropped 25 %. This means that you very likely have lost out compared to your competition. And you have missed out on a saving of 22,875!

I would like to stress that with benchmark I do not mean collecting 3-4 offers from various suppliers and then selecting the cheaper option. Benchmarking is either using an external price index, like the above mentioned freight index, or a larger database of marked prices. The latter can be obtained by cooperating with other companies with similar requirements and compare prices; however, this can quickly become time consuming, if you wish to do it yourself. Even worse, such project can take focus and resources away from your core business.

Cost control is a critical activity to protect the profit margin and ensure competitiveness. If it is done wrongly, it is inefficient, take focus from the core business and/or provide a false impression. Done right it is offering strong advantages both short and long term.

Good luck with your targets and measurements in 2012!