A Research Paper on Procurement

OutsourcingThe Time is Right?

Alsbridge Plc, 22-24 Ely Place, London, EC1N 6TE, +44 (0)20 7242 0666www.alsbridge.eu

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Organisations typically spend twice as much with their suppliers as they do on staff costs. As a result, reducing supplier spend can have a proportionally bigger effect on earnings than the same percentage reduction in staff or staff costs. This effect is often further amplified as supplier savings have a direct earnings benefits whereas staff costs carry other overheads and so do not have a direct one-to-one effect.

Supplier costs are thus an obvious area for organisations to address. Despite this, in many cases, when profit improvements are needed, the main focus has been on staff numbers and staff costs.

We believe that reducing bought-in spend is the simplest and least painful way to reduce cost. It also produces less corporate stress and upheaval than reducing headcount, can be quicker to realise benefits with less risk than other forms of outsourcing?

In order to achieve supplier cost savings, expertise in areas such as procurement and change management are required. And those are becoming increasingly difficult to find as competition among different organisations for the same skills intensifies.

One solution that achieves all these aims is outsourcing or “Right Sourcing” of procurement, either in its entirety or for selected categories.

The growth in the procurement co-sourcing and outsourcing markets demonstrates that the time has come for Procurement Outsourcing.

The basic value proposition is very simple – achieve significant bottom line savings by leveraging the core competencies of sourcing and category management (mainly but not exclusively in indirect categories) that an external, specialist can provide and that a corporate might not maintain in-house for a wide range of reasons. This includes a range of value generating capabilities, such as technology to support category management and process compliance.

In line with the market, Alsbridge is seeing significant growth in Procurement Co-Sourcing and Outsourcing deals and is advising an increasing number of clients in this area. It is a concept at a tipping point in terms of market acceptance and one, we believe, that has now finally arrived. As a result Alsbridge believed that it would be timely to carry out some unbiased, objective research to understand what it means in practice, what it can and cannot deliver and what the opportunities and obstacles are. Potential clients will then have a sound basis for considering whether it will work for them.

We’ve researched data sources and we’ve spoken to outsourcing service providers, their clients and procurement specialists to prepare this research paper, so that organisations can make up their own mind about Procurement Outsourcing.

We hope you find it useful.

Introduction

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Summary of findings

Procurement Outsourcing is actually a combination of co-sourcing and outsourcing. The former is the more prevalent but full outsourcing is rapidly catching up both in the number and total value of contracts.

1. Procurement Outsourcing does deliver significant benefits

In the right circumstances, as a result of a well implemented deal, clients can realise a 2 to 4 (or more) times ROI on the service provider’s fee, or between 5% and 20% of in-scope spend, with a payback of less than 12 months. This depends, however, on the size of the in-scope spend. Larger service suppliers will say that a minimum in-scope spend of £50-100m is required to make an outsourcing deal really worthwhile, smaller suppliers will be happy to work with less. But obviously, the greater the in-scope spend the better.

Below are some indicative saving benefits for three categories:

2. The largest benefit (usually about 40%) comes from sourcing and category management

The chart below summarises the main sources of benefits:

Improved compliance and prevention of value leakage (often through introduction of technology) can also be a significant benefit, depending on the client. Other benefits accrue from economies of scale across a business. The other 10% comes from general efficiencies and lower cost processing but the labour arbitrage benefit is very small compared to other forms of outsourcing for the reasons given above.

Aggregation of small deals into a larger deal may appear to be an easy win but actually it delivers fewer benefits than might be supposed (and probably fewer than smarter purchasing). Some years ago it was the accepted wisdom that Procurement Outsourcers would consolidate requirements from several clients and thereby get a better price. However, complications such as difficulties in getting a common specification and different costs to serve between different clients have meant this isn’t as straightforward as it seems. This isn’t to say that aggregation can never be successful, just that it is one of several routes to savings and not necessarily the best.

3. Getting the right deal shape and commercial terms is important

There is a wide range of options regarding pricing models, with pure gainshare at one end of the spectrum and fixed price at the other. The chart below sets out our findings with regard to the basis of pricing mechanisms:

A minority of deals are gainshare only models (i.e. no gain, no fee). Nearly 50% of deals are on a pure fixed price basis and about 30% include a performance bonus (gainshare or risk/reward). Often negotiations with a new supplier start out on a gainshare basis and finish up as risk/reward.If the extent of realised benefits drives pricing in any way, it is important to consider their timing – one client

18%

16%

14%

12%

10%

8%

6%

4%

2%

0%

IT/Telecoms Temporary Labour Marketing

45%

40%

35%

30%

25%

20%

15%

10%

5%

0%

Sourcing and category management

Compliance Economies of scale

Other

30%Fee plus

performance bonus

50%Pure fixed

price

20%Gainshare

only

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we came across had set the bar too low for benefits and the target was achieved very early on in a five year deal, with the result that the service provider wasn’t obliged to deliver any further savings beyond year two.

In general, Procurement Outsourcing deals are 3-5 years in deal term which is a little shorter than other forms of outsourcing.

4. Procurement Outsourcing seems to be easier to implement than other forms of BPO

There are lower set up costs, less in the way of transition disruption (as often only the procurement department is largely affected), and it seems that the benefits don’t have to be worked at quite so hard. This is not to say it is easy but it may be easier than other BPO options.

5. There is strong growth in the market

Our research indicates that there is significant growth, particularly for indirect and ‘tail-end’ categories. Everything we have seen and heard in the market backs this up, especially from service providers already in this space and perhaps more interestingly from those not already in it but who are gearing up to enter the market. Indeed, some service providers are very bullish about the future and have predicted increases of over 40%, with an average around 30%.

In terms of industry sectors, the trend of adoption of procurement outsourcing has varied over recent years but now seems to be fairly evenly divided amongst Financial Services, Telecoms, Utilities and Manufacturing companies. The most common categories of spend outsourced appear to be IT, telecoms, facilities, HR related (such as temporary staff) and marketing/sales. The most active markets considering procurement outsourcing are Consumer Packaged Goods (CPG) and Manufacturing.

It is also worth noting that within this overall upwards trend there appears to be a move towards deals focused on fewer categories, which is thought to indicate a change in buyer approach rather than a lack of interest in Procurement Outsourcing.

6. Outsourcing of strategic procurement took a dip in the number of new contracts about 6 years ago

We suspect that this was because the contracts signed by the early adopters ran into the problem that the suppliers, while good at providing centralised transactional services, were not able to use the same model for sourcing. Category Managers need to be close to their customers to understand requirements and to ensure that the supply deals put in place work for the business (and are adopted).

As a result, two things happened. There was a growth of co-sourcing where supplier and organisation staff worked side-by-side in the same category teams – ensuring good expertise was available at the same time as good client interfaces. Secondly, suppliers grew their regional and local expertise – organically, through TUPE of client staff and through acquisition. The suppliers are now in a position to offer regional and local client working and, as a result, outsourcing is now rapidly growing again.

7. There is a wide and growing range of service providers

In the course of this work we interviewed a wide selection of current service providers. These providers approach the market in different ways – some tend to major on sourcing and category management, others provide a full set of services and technology applications. Some promote the leverage of their own procurement functions which are dealing with huge volumes of transactions for other parts of their businesses, and for others their expertise exists purely for client purposes. Some develop one-fit common category strategies for all their clients; others develop strategies on a client by client basis. Each option has its benefits and drawbacks.

Some seek to provide a full service across multiple geographies, from sourcing strategy through to transaction processing, whilst at the other extreme some specialise in category management in specific regions.

8. The market has matured significantly over the past couple of years

Although there are some very good examples of Procurement Outsourcing, some experienced service providers and strong demand, the fact is that the uptake is still relatively low in absolute terms – it’s about where Finance & Accounting (F&A) Outsourcing was maybe four or five years ago. Since then, F&A Outsourcing has experienced quite a boom in demand – it is believed that procurement will go the same way.

Clients also stated that the benefits from sourcing and category management (i.e. the largest part of the benefits) vary according to the service provider staff involved. No provider is good at everything and it is important to recognise this point, not necessarily as a weakness of the Procurement Outsourcing model but as a fact. Different categories may require different service providers.

Service providers told us that the main inhibitors to the uptake of Procurement Outsourcing are a “do it yourself” attitude on the part of clients, fear of a loss of control and a lack of scale.

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What is the value proposition for Procurement Outsourcing?

The basic principle is simple – the procurement service provider provides expert category management in areas where the service provider is a specialist and the client organisation is not. This means that the categories in scope for Procurement Outsourcing are usually indirect i.e. where procurement is not a core competence for the client.

Typical examples of indirect categories commonly in scope are set out below.

IT and Telecom spend1. Network/Mainframe

infrastructure

2. Computer hardware (Desktops, Servers)

3. Desktop Software

4. Infrastructure Software (Mainframe, Network, Systems management, etc.)

5. Telecom infrastructure & services

6. Printing management & Hardware (e.g. printers, copiers, multifunction, etc.)

7. IT Outsourcing and out tasking

8. PDAs and cell phones

9. IT consulting and software development

Marketing and Sales related spend1. Trade shows/Events

2. Marketing research/ ad-hoc studies

3. Advertising agencies

4. Public relations/ communications

5. Promotional/Direct/ Interactive Agencies

6. Mailing Fulfilment

7. Design/Pre-press agencies and services

8. Experimental/ Niche marketing

Finance and Corporate spend1. Tax and audit services

2. Consulting services

3. Third party legal services

4. Technology related services

5. Third party outsourced services

6. Contract labour

7. Facilities/Equipment & Administrative services

8. Treasury related services

Direct materials1. Corrugated/Line board

2. Poly films/Bag

3. Folding cartons

4. Automotive parts/tiers

5. Fuel/Lubricants

6. Metals

7. Bulk and packaged gases

8. Chemicals

9. Fertilizers

10. Capital equipment

HR related spend1. Executive search/

Recruitment/Relocation agency management fees

2. HR Consulting (workforce, benefits planning, compensation planning)

3. Temporary and contingent staffing

4. Drug screening/job testing/ Background checks

5. Events and recruiting logistics spend (displays, collateral, materials)

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It follows that the key benefits are related to the cost of the categories in scope, rather than the cost of the people involved, and as a result they can be very significant. But this is not the full story – there are a number of different ways in which Procurement Outsourcing can generate value:

• Expertmarketknowledgeindefinedcategoriesusually generates the largest part of the added value, and this was confirmed by service providers and clients alike. A good example is a category where an organisation does a deal relatively infrequently but where the market is relatively complex and constantly changing – for example, mobile phones. For many organisations it is not feasible to maintain specialists in this market. Procurement Outsourcing service providers maintain specialists whose full time job is to research and understand the mobile phone market and whose knowledge can be leveraged whenever required.

• Usingtechnologytohelpensurecomplianceandto share knowledge. Several of the service providers we spoke to cited much improved compliance through technology as a key benefit of Procurement Outsourcing. Many of them provide technology either as a core part of their offering or as an add on to facilitate and control the end to end transactional process – from requisitioning goods or services at one end to payment at the other. Which means that clients have the ability to either prevent or to identify and deal with rogue purchasing, resulting in significant benefits. And clearly there’s no point in having great deals if the organisation doesn’t know about them, so sharing knowledge through technology is also key.

• Leveragingeconomiesofscale. Clients who are not familiar with Procurement Outsourcing might think that this yields the major part of the benefits, but in general this isn’t the case. Although service providers are able to negotiate deals in certain areas by using the aggregated buying power of their client base, and in some cases leveraging their own buying power (usually derived from their other activities) for clients’ benefit, there are obstacles. For example, aggregation may require clients to accept standard specifications that

might not be quite right for them and in addition each client will have a different cost to serve, which makes it more difficult for the end supplier to provide better terms. As a result, aggregation appears to be less of a benefit than it was thought to be, say, ten years ago.

• Lowercostprocesses.In the scheme of things this usually contributes the lowest proportion of the benefits and in most cases on its own is unlikely to be the sole reason for outsourcing procurement. Nevertheless, over time a Procurement Outsourcing service provider would expect to achieve lower cost processes and efficiencies through automation, continuous improvement and the use of lower cost locations

• Indirectprocurementisoftennotaclient’s core competency :

– Hiring category specialists may be uneconomic. Why hire a mobile phone specialist when you only do deals infrequently? Why hire an energy specialist for the same reason?

– Lookingaroundfornewtechnologycanbetime consuming and distracting. Why take the time and resources to research the market when a Procurement Outsourcing service provider can provide the technology that is measured on the service it provides? In addition, many organisations have already made an investment in e-Procurement applications and believe that Procurement Outsourcing means renewing their IT systems.

– Putting greater focus on indirects might not be the best way of management to spend its time. Organisations might be able to win in the market through their abilities in procuring direct materials but no one ever wins because they got a great deal on consumables.

• MarketingOpportunities. In some cases, limited so far but growing, a service provider has been used as a ‘back door’ opportunity for organisations in to start to form strategic alliances. This can be both with organisations in different industry sectors and also the same sector.

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SowhatisProcurementOutsourcing,exactly?

There are a number of different elements in Procurement Outsourcing and clients can take all or (more commonly) some of them. The diagram below sets out an overview of the end to end procurement process and indicates the main areas which can be outsourced.

To keep things simple we divide procurement services into three functions:

Source

This covers all activities necessary to define a sourcing strategy for a category and to enable its implementation, right up to the point before actual procurement. It covers activities such as spend analysis, sourcing strategy, market analysis, agreement of requirements, bid management, contracting, vendor management and contract and relationship management. Everything in fact to get a deal in place that the organisation can use. Sourcing can cover both strategic (longer term, high volume) and tactical (one off, more infrequent) deals though ‘Transactional’ or ‘Spot’ Buying falls between Source and Procure as it involves some negotiating with suppliers. It is also process-driven as seen in a Shared Service function. How best to handle this is a key strategic decision to be made as part of the Target Operating Model. We have also included Supplier Relationship Management in this definition.

ProcureThis function includes all the activities necessary to requisition goods or services and enable the organisation to “consume” them, in accordance with the agreed deal. As it includes requisitioners communicating with service

providers, in many instances there can be a huge number of interactions, so this part of the service is often heavily technology-enabled. Technology can include online catalogues, requisition management, order tracking and fulfilment monitoring. This technology isn’t just a way of keeping track of everything that is happening; it performs a vital function in disseminating the deal throughout the organisation and helping to ensure compliance. There is no point in negotiating a great deal if no one knows about it or if no one uses it.

Pay

This function generally starts with a fulfilled order and takes the transaction right the way through to payment, including receiving and validating the invoice and making the payment. As well as paying service providers, this service also forms a key part of the compliance and control feedback loop, as transactions with unauthorised service providers should be picked up at this stage and appropriate action taken. This part of the service is more commonly thought of as Finance & Accounting Outsourcing (FAO) rather than Procurement Outsourcing, but nevertheless is important for completeness of the end to end process.

By the way, in these difficult economic times it is worth mentioning supply chain finance as a final link in the chain, although it isn’t outsourcing in the usual sense. Nevertheless it is something that a proactive service provider could and should be proposing to clients and even helping to arrange. It works like this:

Companies, especially large corporates, may well squeeze suppliers by unilaterally extending payment terms, which increases the possibility of suppliers going out of business through lack of liquidity. As a result, there has been increased interest in Supply Chain Finance i.e. how to provide finance at the right place at the right time, at the right cost. The obvious starting point for suppliers is receivables discounting or factoring, which has been around for a long time. However, more recently other approaches have emerged whereby the good credit rating of large corporate customers can be used for the supplier’s benefit in funding receivables. Essentially, a customer would provide visibility of approved invoices on their system and would work together with a bank to extend credit to the supplier against those invoices, which would be at a lower rate of interest than the supplier could obtain independently by leveraging their own credit rating. The net effect is that the customer has extended their payables without placing undue pressure on suppliers.

Spend analysis End user requisitionDay to day purchasing

Category strategySupplier selection and buying

Accounts payable

Contract and relationship management

Catalogue content and order management

Performance management

Sourcing focused Procure to Pay

Source to Pay

Sample for services in a Procurement Outsourcing

Source Procure Pay

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The commercial aspects of a Procurement Outsourcing deal

Commercial terms can vary widely but as with any outsourcing deal it is important to get this right. It not only determines what the client will pay and their business case but inevitably it will also drive service provider behaviour.

Deal length

Typically, Procurement Outsourcing deals tend to be in the region of three to five years, which is a little shorter than most BPO deals. This is because a lot of the benefit, certainly in terms of cost reduction, should have been delivered within two to three years, after which savings stabilise.

Commercial modelFirst of all, it is important to be clear on what kind of service the client is buying and for example whether it is outsourcing, co-sourcing or just consultancy – the distinction can be blurred. At one end of the scale, transaction processing (processing requisitions or purchase orders) is likely to be outsourcing. At the other end the service provider may be providing advice that the client may or may not choose to act on – and that’s probably consultancy. In the middle, there is a wide range of activities which may be repetitive, but which all come under the heading of ‘Business As Usual’ when managing categories. As a result, Procurement Outsourcing is generally more difficult to categorise than some other types of BPO.

So how should commercial models work? There are two main possibilities for Procurement Outsourcing and these are described below.

Gainsharing Price Model

Given that one of the main objectives of Procurement Outsourcing is to save costs, at first sight it would appear logical that a gainshare mechanism would be a good approach. Indeed the first deals in this space followed this approach to a considerable extent. However, through experience, a number of drawbacks became apparent. From the service provider side, it quickly became apparent that, although clients signed up for significant gainshare in the contract, when savings were realised difficulties were encountered in agreeing payments.

Arguments such as “we could have done that” and “we were going to do that anyway” surfaced, along with disputes about the baseline. In addition, some clients didn’t make provision in the accounts for the gainshare and so had difficulties getting significant payments approved. From the client side, there was a fear that, if the service provider has the opportunity for significant reward through cost savings, then there is no surprise that that is what they are going to focus on, despite other controls such as quality, service and cost of ownership. However, this is not to say that a gainshare model is unworkable, just that it needs to be handled with care so that both sides, client and service provider, achieve the right outcomes.

The gainsharing model is strongly preferred by some service providers, who believe that the perceived downsides can be managed.

FixedPriceModelAt the other end of the scale from a gainshare model is fixed price, where the service is predefined for the various scopes of work, for example transactional or sourcing-based. As the scope varies the fee will vary. In general the fee will be higher in the initial term of contract (as there is more sourcing) and reduces over time as deals are set up and savings are realised.

In addition to the fixed fee there is often (but not necessarily) a performance bonus depending on certain criteria such as savings, compliance, spend under management and user satisfaction. The performance bonus can be thought of as a low leverage gainshare – it should be big enough to be interesting but not so large that it completely skews behaviour.

One senior executive from a service provider told us that for them the advantage of fixed fee plus a performance bonus model is that it gives ample room for innovation and gives enough incentive to think in terms of long term savings. Their view point on gainsharing was that it encourages short term behaviour as the provider tends to seek much easier targets but the long term target might be overlooked. Overleaf is a brief summary of the key points of the two models.

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FixedFeePricingModel (with or without Risk/Reward)

a Outsourcing provider has freedom to innovate

a Customer cannot determine provider’s profit-margin and knows little about provider costs

a Negotiations are complex

a Customer offers many incentives to deliver value-added services

a Relationships are trust-based, i.e., weaker performance measures

a May cost more due to talent required to provide added-value

a Issue like re-engineering and dealing with stakeholders can be handled well

Gainsharing Pricing Model

a Outsourcing provider has freedom to innovate

a Customer cannot determine provider’s profit-margin

a Customer offers few incentives to deliver value-added services

a Customer knows provider costs

a Customer shares gain with provider

a Customer must closely track performance

a Provider might seek to gain some easy targets

Based on our research less than 20% of deals are gainshare only models (i.e. no gain, no fee). Nearly 50% are on a pure fixed price basis and about 30% include a performance bonus.

There are also some deals that involve a risk/reward element where the fee can be put at risk if outcomes are not achieved. This is a variant on gainshare and often works well with CFOs who do not wish to share too much of the benefits with the service provider.

There are a couple of other points to note concerning commercial models:

The first is the distinction between identified and realised savings. This may seem obvious but some clients we spoke to noted that this is a key distinction to make – the commercial model should focus on the latter, not the former.

Secondly, the timing of savings over the lifetime of the deal is important. If there is a savings target over a multi-year deal it is important not to be in the situation (as one corporate was) where all of the savings were achieved in the first year of a five year deal, because the bar was set too low. As a result, the service provider wasn’t obliged to deliver any further savings beyond year two. The secret is to set stretching annual targets to avoid this situation.

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The challenges – whyisn’teveryonedoingit?

We saw through our research how procurement outsourcing can deliver real benefits that a client could not have realised for themselves. We also saw that set up costs can be relatively low and that, per dollar or Euro or pound saved, it probably causes the least upheaval within an organisation than any other form of outsourcing.

So, on the face of it Procurement Outsourcing appears to deliver a relatively painless win – if a third party can achieve sustainable cost savings through their expertise, and there is relatively little upheaval involved (at least, compared to shipping whole departments off to India), why doesn’t everyone do it? In difficult economic times it would appear to be a godsend – a painless and victimless route to lower costs.

The main challenges we identified through our research are as follows:

• The“DoItYourself”option. Most Procurement Outsourcing service providers will say that this is their main competitor. Because none of the approaches and methodologies that a Procurement Outsourcing service provider can bring are trade secrets or rocket science, any organisation could deploy them, just as they can mirror what an outsourcer could do in other

fields, such as moving to low cost locations. So, once a service provider has done a feasibility review, the client may well try to implement the actions themselves. This option is of course perfectly valid but is not risk-free – can the client really deliver? Can they deliver in the timescales? Can they deliver within a budget?

• Fearoflossofcontrol. Clients tend to have concerns around losing control over procurement. This is an interesting perspective because in fact outsourcing can actually enhance control and compliance through the implementation of new technology. We heard from all sides of one way of mitigating this concern, which is strong stakeholder management

• Lackofscale.Larger service providers will say that a minimum in-scope spend of £100m is required to make an outsourcing deal really worthwhile, whilst smaller service providers will be happy to work with less. But obviously, the larger the in-scope spend, the better.

• Confusionaboutthemarket.There is still a lot of confusion as to what the service providers can offer, who is good in which categories and which geographies and also, what types of commercial deals are possible.

Alsbridge can help

If you are interested in exploring Procurement Outsourcing but you don’t have the experience, Alsbridge can help. First of all we can help you decide whether Procurement Outsourcing is right for you and, if it is, how to ensure the deal is a success. We do this by guiding you through a process which ensures all of the relevant operational and commercial issues are addressed and the outcome is a sustainable deal which meets your requirements.

Specifically, Alsbridge can advise on:

• FeasibilityofProcurementOutsourcingandwhatyourbusiness case might be

• AstrategyandTargetOperatingModelforyourprocurement organisation

• ThekeyserviceprovidersofProcurementOutsourcingservices and what they can do

• Whichcategoriesandactivitiesshouldbeinandout of scope

• Shouldyouincludetransactionprocessinginthedealor not?

• HowtoputaRequestforaProposaltogether

• Howtoevaluateresponsesandselectaserviceprovider

• Contractualandcommercialterms

• Implementationandtransition

In short, Alsbridge can help you generate real value from Procurement Outsourcing.

To find out more information or to discuss your requirements in more detail, please contact:

DavidEakin

Senior Manager

david.eakin@alsbridge.eu

+44 (0) 7884 183872