It is an age-old question that has confounded companies big and small: how can we reduce external spending without harming supply chains or sacrificing the quality of our products and services? The question becomes more relevant in times of economic uncertainty and high inflation as large companies take drastic cost-cutting measures such as reducing office space or scaling back on investments.1
While large companies can usually drive procurement cost savings with relative ease, small and medium-size enterprises (SMEs) typically lack the necessary scale despite being the backbone of many economies around the world (see sidebar “The critical role of SMEs”). When it comes to procurement, SMEs often do not have the same purchasing power with suppliers that larger companies do because SMEs lack scale and often have a single source of supply, rendering them unable to seek pricing that is more competitive. Moreover, SMEs sometimes lack focus or the wherewithal required to rein in spending—and when they do, value capture is often slow, prone to stagnation, and mostly ad hoc, resulting in incomplete, suboptimal, or even unintended outcomes.
So what factors prevent SMEs from undertaking a procurement transformation that goes beyond spending cuts—one that helps simplify, realign, and strengthen the organization to help it grow and provide a better customer experience? Is there an approach or framework that SMEs can use to regain control of their budgets and external spending in a way that doesn’t harm productivity or diminish morale? There is—as long as CFOs, chief procurement officers (CPOs), and COOs are willing to be innovative, make hard and timely decisions, and take necessary steps to transform their businesses.
What stops companies from reining in external spending?
In the United States and Canada, according to McKinsey analysis of data from S&P Global, companies with less than $3 billion in revenue represent 86 percent of total enterprises and 26 percent of total revenue (Exhibit 1). Perhaps unsurprisingly, the largest corporations (those with annual revenues of more than $5 billion) contribute the biggest chunk of revenues, while those with annual revenues of less than $1 billion make up the largest group of companies.
But while SMEs account for a significant slice of total revenue, a broad range of factors are limiting their ability to implement meaningful procurement cost savings in a way that not only boosts profits but also transforms companies along functional lines and prepares them for future shocks and economic downturns. Overcoming these limiting factors would be prudent, given the precedent set from 2017 to 2022, when smaller companies struggled most to maintain margins (Exhibit 2). The COVID-19 pandemic and the subsequent inflationary period have created challenges for companies of all sizes, but in aggregate, the biggest companies saw a much less dramatic drop in net income in comparison and have fully recovered or even exceeded prepandemic margin levels.
With the benefit of hindsight, it would have been optimal for SMEs to have had cost-cutting and procurement strategies in place before the pandemic, cushioning the blow from disruption in supply chains. However, the following example of a midsize company that produces residential components and fortuitously initiated a cost transformation program right before the COVID-19 outbreak illustrates how SMEs can mitigate risk by using better procurement strategies.
In this case, the company had long-term contracts in place for most of its business-critical external spending and reserved dedicated capacity with its top suppliers. It renegotiated better payment terms, identified and developed additional supplier sources to derisk its supply chain, and dynamically optimized sourcing decisions and logistics operations. These measures helped the company avoid some of the supply chain issues experienced by many SMEs during the pandemic. It also helped after COVID-19 containment measures were eased, when demand spiked and supplies ran short.
Overall, we find that five major drivers often hold SMEs back: a lack of spending transparency, a myopic focus on the short term, talent gaps, underused digital tools and automation, and exclusion of procurement and supply chain in business decisions.
A lack of spending transparency
Spending transparency means having full visibility into all relevant external expense information, revealed in a timely and systematic manner. While spending transparency is not new to the business sector, few SMEs adequately track and regularly reassess their spending. They often aren’t equipped with a dynamic spending database to serve as the single source of truth for functions such as procurement. This is partly because small and midsize companies often underinvest in process improvement, have a plethora of legacy enterprise-resource-planning systems, or find implementation cost prohibitive. As a result, SMEs often fail to identify basic price variances, hurting competitiveness and margins. For example, margins for a midsize industrial company that operates in North America and Europe plateaued 30 to 40 percent below peer companies; inefficient sourcing was one of the major contributors to the company’s margin reduction.
Competitive procurement has its foundation in full spending transparency. Poor spending transparency can lead to value loss and ineffective budget management. With greater spending transparency, CPOs can effectively manage external costs, exercise greater control as the situation demands, and better understand risks to supply chains.
SMEs often fail to identify basic price variances, hurting competitiveness and margins.
A myopic focus on the short term
Unlike large companies, which employ long-term strategies for most major spending categories, SMEs often fail to strategically align their business functions with procurement categories. Buyers focus the most on transactional efforts and work with single supplier sources with limited leverage and low committed volumes. As a result, supplier relationships tend to be transactional in nature as well and not focused on long-term partnerships, making suppliers reluctant to offer contracting discounts to SMEs. Moreover, the lack of a reliable demand forecast creates challenges for establishing longer-term cost savings. However, the deeper problem is centered on inefficient sales and operations planning, which directly affects supply chain strategy. SMEs could put more effort into planning and forecasting, which can enable long-term category and supply chain risk management.
It’s not uncommon for procurement managers at SMEs to spend most of their time dealing with supply disruptions. The cause of supply chain issues can be partially ascribed to a lack of the entrepreneurial or strategic mindset required to help derisk the supply chain. These issues can also be attributed to a lack of strategic direction at the executive level—for example, in setting target KPIs for the share of spending that is dual sourced or for average miles traveled for supplies. First and foremost, however, SMEs often face challenges in attracting the right talent.
While a lack of brand recognition could hinder hiring, SMEs often source talent without a strategic mindset. When it comes to hiring for a procurement function, the experience and skill sets required to make a strategic impact are often not part of the job requirements. The traditional mindset of SMEs is that experience or exposure to a category family is the main requirement for category manager job candidates. To hire the best team, however, companies might consider candidates with track records of bringing about change at the organizations they’ve worked for or candidates with more diverse profiles that have skill sets outside traditional category management, such as data scientists, to find ways for procurement to drive broader business value.
Procurement managers could also be empowered with greater analytics capabilities to address the complexities of their job. Along with buying roles, various other support roles could be introduced to best manage external spending. Data analysts, for example, could perform activities such as category analytics, spending intelligence, predictive analytics, and running advanced-analytics models of business relevance. Procurement organizations that are more advanced can even look to include software engineers and scrum masters to help develop customized automated business solutions, such as commodity indexing and forecasting supply chain disruptions.
Underused digital tools and automation
High-performing category managers at large organizations spend much of their time finding ways to propel value for the business through negotiations and supplier-sourced innovation. In contrast, category managers at SMEs tend to spend their days handling transactional work and managing disruptions. Inefficient workflow patterns at SMEs often evolve because repetitive processes are still carried out manually rather than being automated. In contrast, large companies have often digitalized procurement, thereby effectively managing costs and avoiding value loss. Legacy systems are still commonplace in SME organizations, and smaller companies often lack resources to continuously improve system infrastructure and tools.
Exclusion of procurement and supply chain in business decisions
The role of CPO at many SMEs is still limited to category and supplier performance management. Accordingly, the CPO’s role in an organization should evolve to become that of business enabler and driver of customer value. The CPO should be a partner to engineering and marketing functions from early product development stages. The evolution of the role will require new skills, including strategic thinking and problem-solving abilities. A minor change in roles and responsibilities can not only help better manage cost of end products but also get an organization ready for the future.
An action plan for procurement cost savings
No easy fix exists when it comes to external spending optimization—and addressing just one challenge is unlikely to make a transformative difference. However, five interconnected strategies can help SMEs identify procurement cost savings opportunities: establishing center of excellence (CoE) teams, improving forecasting, expanding the use of digital procurement tools, gaining greater market intelligence, establishing a culture of and processes for continuous cost optimization, and incorporating supplier-driven product improvements. In addition, SMEs can consider several structural changes—some that would echo those of their larger corporate counterparts, and others that would capitalize on the strengths of SMEs (see sidebar “Further actions to enable next-gen procurement”).
Establishing CoE teams
Establishing a CoE team to support sourcing teams is now the norm at advanced procurement organizations. The focus of CoE teams is to empower buyers with deep category analytics and negotiation support. They perform category market analysis and supplier profiling, create fact packs and negotiation playbooks for supplier discussions, and develop component “should cost” models to provide greater cost transparency and buying leverage. One reason for value loss at procurement organizations is a lack of understanding of the full opportunity potential for a supplier and supporting facts during price negotiations. CoE teams can lay the groundwork for establishing short- and long-term strategies at the category and commodity levels.
A dedicated centralized planning team that works with the procurement team can be another value add and can forecast demand at the SKU, business unit, or product levels, with input from operations and marketing. Furthermore, they can provide transparency in future award timing and volumes. Suppliers become long-term partners with a stable forecast of business and are more willing to collaborate with companies to find cost opportunities. The planning team can also answer questions about minimizing risk through dual sourcing versus single sourcing of components, request-for-quotation strategies and frequencies, annual negotiations, and local sourcing versus best-cost country sourcing.
Expanding use of digital procurement tools
Digital tools can help make processes more effective and efficient by improving communication and efficiency across operations while reducing the manual workload on procurement managers. Digital procurement tools are also affordable and can elevate the standards of SMEs to match large corporations in terms of internal capability. While there is no one-size-fits-all approach to digital procurement, successful organizations are experimenting with digital innovation, sometimes designing custom solutions. Examples of leading digital procurement tools include spend intelligence tools, e-sourcing solutions, e-auctions, parametric should-cost models, automated contract analysis and management, and negotiation simulation for capability building.
Investment in digital tools can also prepare SMEs for long-term sustainable operational efficiencies while keeping their spending in check. Taking a more data-driven approach, especially for SME manufacturing organizations, has exponential benefits because digital applications can play a major role. For example, e-auctions—online auctions with potential suppliers—help eliminate the need for multiple rounds of negotiation with suppliers and increase transparency of the business award process for both buyers and suppliers.
Gaining greater market intelligence
Market intelligence can include product changes, supplier market dynamics, material price changes, tariff changes, global and national policy changes, total capacity utilization, currency fluctuations, and other variables. For example, by carefully tracking market fluctuations, SMEs can prepare buying strategies that are more resilient in the face of external disruption. Market intelligence can also lead to greater transparency with core supplier partners, empowering buyer organizations and providing greater visibility to suppliers, which are focused on growth and future readiness.
For instance, a North American SME used market intelligence to develop a cost savings model to aid in the procurement of steel for fabricating products, sourced from countries across Asia and Latin America. The model used different indexes (such as freight and raw material) to provide data on the best total landed cost for steel products from various suppliers and is now considered by category managers to be a robust solution for making informed supply chain decisions.
Establishing a culture of—and process for—continuous cost improvement
Large organizations work to generate cultures that encourage continuous cost optimization. SMEs could start by holding internal workshops at regular intervals to create “idea banks” that map out opportunities. These workshops can be run at the product family or supplier level.
Companies will likely find it necessary to work closely with their long-standing supplier partners to find procurement cost savings, given the impact of component price on margin and, ultimately, what the customer pays.
At the same time, SMEs could define their own procurement cost-cutting programs and communicate these programs to internal stakeholders, including product design, manufacturing, and quality teams, to identify potential opportunities to reduce costs. Companies will likely find it necessary to work closely with their long-standing supplier partners to find procurement cost savings, given the impact of component price on margin and, ultimately, what the customer pays. SMEs have limited resources available, so prioritizing efforts to capture the value identified is necessary. SME leaders might also consider a five-step “escalatory ladder” to generate fast procurement savings with minimal effort (Exhibit 3).
Developing an “external spend cube”—that is, a structured data set of the firm’s spending patterns with external suppliers—and a specification library for top procurement categories could also help when establishing a cost savings performance baseline, generating cost-saving ideas, shaping category strategy, and identifying synergies across business units. Companies can define short-term and long-term opportunities by category and develop an understanding of the effort required to carry them out. As savings accrue, companies can focus their attention on the sustainability of savings through cost control cells and governance mechanisms dictated by upper management.
Incorporating supplier-driven product improvements
More SMEs could work with their suppliers to drive product improvement. As many companies look to outsource their manufacturing and maintain only key process steps in-house, suppliers now have a significant stake in the end product. Therefore, it is important to involve suppliers in product development and enhance the free flow of ideas about product improvement. SMEs can entice supplier participation in product optimization programs through an incentive program, which shares the gains of supplier-driven initiatives with the supplier.
Not only can a program optimize specification, but overall, products can also be improved by supplier-side innovations. For example, suppliers for an industrial-machinery manufacturer suggested that the manufacturer adopt new compressor technology. Newer compressors were energy efficient but came at a slight premium. But in the long run, the new compressors helped the company to differentiate its product offering and entice new customers.
Cost transformation is never easy, especially for SMEs. It requires a concerted effort on the part of CFOs, CPOs, and even CEOs. However, if done correctly—focused particularly on procurement automation, strategic sourcing, and structural changes—cost transformation can generate significant savings and boost profits. But for organizations to make meaningful, effective change, they must stay ahead of the curve. Simply responding to crises and wielding the budget knife, without ensuring business units are aligned and implementing improved processes, will only postpone what needs to be done.