Calculate savings over the long term

Do you reason like your CEO?

Imagine the following situation:

• You are responsible for the purchase of a given product.
• Last year, you purchased 10,000 units of this product at a unit cost of €100.
• This year, you signed a 3-year contract with your supplier: the negotiated price is €90 per unit.
• You plan to buy 10,000 units of this product for each year of the contract.

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How much savings are you going to make for the business, and when will you report them?

Are you going to declare 300,000 euros in savings when signing the contract (€10 x 10,000 units x 3 years)? Management may not approve such an amount...

In fact, when you report savings, Management expects to a reduction in expenses from the previous year for the current year. Thus, in the scenario described above, your expenses will not be reduced by €300,000 this year, but only by €100,000, an amount that corresponds to the following calculation:

Quantity (number of units ordered this year) X the price difference.

Because there is no price reduction between year 1 and year 2 of the contract, the Directorate generally does not accept requests for savings in year 2 (or thereafter). So, the first year of savings is all that is recognized by Management.

This method for calculating cost savings concerns many Purchasing professionals.

You may think that you deserve more credit for achieving a discount (and a lock up!) prices over several years, but unfortunately this does not correspond to the usual reasoning of Directorates in terms of cost savings.

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So how can you value savings over the entire life of a contract?

You have the option of negotiating a price that decreases every year during the contract.

For example, instead of starting at €90, you can negotiate the price at €95 the first year, then €90 the second year, then €85 for the third.

While the value of the contract is the same for the supplier, you will have to report on the savings for each year of the contract and the Management will recognize three years of reduced expenses while obtaining additional gains at the end of the contract.

What is a smart contract?

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