Published: October 12, 2011
Procurement is the purchase of goods and services for consumption in business operations and or resale. The purchase of goods and services accounts for a major component of the costs base of manufacturing, services and retailing companies alike. For this reason, most companies are constantly examining ways to manage procurement more effectively; for many, this means increasing the level of central control over the function. As companies grow, the opportunity to drive benefit from procurement also grows – but so do the challenges, especially where the growth is across national borders.
As companies grow, the opportunity to drive benefit from procurement also grows - but so do the challenges.
The international marketplace is now a fact of business life: value chains span countries and regions and companies have both international supplier and customer bases. In response many companies are centralising control over aspects of their supply chains. For procurement this presents specific challenges, for example how to adopt a low cost country sourcing strategy whilst balancing the need for supply flexibility and managing the risk of continuity of supply, transport cost and lead time. These complex challenges contribute to the drive to centralise control over procurement and take more of these strategic procurement decisions above the individual country level. The centralisation of procurement is typically not a goal in itself, rather a staging point on the journey to a wider supply chain or corporate centralisation programme. However, the structural changes necessary to facilitate this central control can present further opportunities to optimise financial aspects of the business, including a more tax effective structure for procurement and or the wider business.
For the treasurer, initiatives to optimise and centralise procurement processes create some important challenges, but also deliver opportunity. In particular, the impact of centralisation on the nature, visibility and location of commodity exposures means that the organisation needs to consider how commodity risks can most effectively be managed in the new structure. Equally, benefits may arise for treasury in respect of centralised FX hedging, payments and third-party financing arrangements.
To address these issues, the following article will explore how the procurement function adds value in the modern organisation and how this is shaping how the procurement function itself is organised. We will look at the implications this has for the firm’s Effective Tax Rate, and the broader opportunities it presents for the finance function in areas including commodity and FX risk management, cash pooling and reverse factoring.
To understand this increase in centralisation we must first examine the ways in which procurement delivers value to the modern organisation.
The traditional focus of the procurement department has been on driving commercial benefits – put bluntly this meant getting a better deal from the supplier, more often than not by driving down the purchase price through hard negotiations. However, this tactic can only go so far, for so long. At the end of the day suppliers need an economic sales price: they too have investors who will only fund below market returns for a finite period of time. Unless an equitable price is agreed the supplier will cease business with the customer and possibly exit the industry. So purchasing professionals have had to think more strategically and look for ways to deliver sustainable benefits through improved relationships with both the suppliers and their own internal customers. Today, a typical procurement department’s focus will have four pillars:
1. What to buy (demand management) – work with supply chain, engineering and other business customers to optimise and harmonise the specification of the product to be bought, reduce purchase volumes, and increase internal compliance to purchasing strategies (e.g., get more people to buy off negotiated contracts). [[[PAGE]]]
2. Who to buy it from (supplier management) – select the optimal supplier or set of suppliers from whom to source the product, and establish an effective relationship with them. This can be anything from classical supplier rating and management techniques through to the much higher level of collaboration necessary for initiatives such as joint new product development or collaborative planning, forecasting and replenishment.
3. How to buy it (total acquisition cost management) – optimise the total cost of acquiring the product- this takes into account not only the upfront purchase price, but all associated costs incurred through the life-time of owning the product including consumables, peripherals, disposal and replacement costs, initial investment / set-up costs, quality costs, financing costs and risk.
4. What to pay for it – this final dimension almost becomes a by-product of the effective execution of the other three areas - that’s not to say that the traditional skills of negotiation are by any way redundant!
The key enabler for all four areas is scale, the ability of the company to leverage both its combined global purchasing power (spend) and purchasing capability (people). Companies are looking for procurement structures and models which allow them to capitalise on this global scale, whilst still maintaining agility and responsiveness to local market needs. For many this means a greater level of above-market procurement, often led or co-ordinated by a central procurement organisation.
There are a range of models available to such companies and options for how to deploy their capability across spend categories, geographies and business units. Typically this will be part of, or the first step on, a broader transformation seeking to optimise the wider supply chain or corporate structure. Figure 1 outlines some key considerations in selecting the most appropriate procurement model, and how this may fit into a broader journey. The first question for procurement to consider is the level of centralisation – what the accountabilities of the central function will be relative to the local operating companies. Many companies choose to move to centralised structures often around specific spend category teams to drive sourcing best practice, spend leverage and risk management across business units and geographies. This tends to be highly dependent upon the various demand and supply drivers for a specific spend category. However, the choice of model must also reflect the cultural characteristics of the organisation and where the real accountability for key decisions in the sourcing process will lie – we typically see three broad models:
1. Procurement manages the spend – this tends to be for non-contentious,
non-strategic spend areas, where there are opportunities to manage across the business – e.g., travel or stationery.
2. Procurement co-ordinates the spend – the central team play a role to bring together the business users across the company and help drive improvements and a common strategy.
3. Procurement supports the process – this tends to be for strategic items with complex specifications which require heavy input from the business.
The second question is how the procurement capability is delivered. Procurement doesn’t have to be performed in-house; an internal function can be combined with the use of third parties’ procurement capabilities: for example in co-source / buying groups, outsource, lead supplier relationships – again the applicability of each model may differ by spend and by geography. The choice of partner depends on drivers, for example where process efficiency is a priority, a company may choose to outsource to a purchase to pay shared service environment, or where access to local supply market knowledge is critical they may choose to partner with a local buying agents – often the case with Far East buying agents.
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Centralisation of key functions such as procurement can also have a significant implication on both direct and indirect taxes for the company. Earlier in the article we outlined the commercial and operational focus of a typical international procurement function (the four pillars) – the benefits of this can translate into tens or even hundreds of millions of euros in procurement savings per annum. There is an opportunity to capture these savings in a tax effective manner if the procurement organisation is set up correctly. This requires a careful alignment of all components of the operating model from the governance, through to organisation, process, technology, tax and legal layers. A company must be able to demonstrate that the central procurement organisation is truly accountable and responsible for the delivery of the savings. If this is the case, and dependent upon the model adopted, between 30% and 50% of these savings could be realised in the procurement company. If the procurement company is located in a low tax jurisdiction (where a tax rate of 10% would not be unheard of) this could present a sizeable tax arbitrage opportunity.
Unless an equitable price is agreed the supplier will cease business with the customer and possibly exit the industry.
Wherever new cross-border transactions are created the company’s indirect tax profile will also be impacted. The focus here is typically on risk and compliance - classification of goods, valuations and origins for customs purposes, VAT cash flow and reporting. However it can also create an opportunity to increase the visibility of and accountability for indirect tax costs and allow them to be more actively managed between procurement, supply chain (logistics) and finance, an area where many multinationals are historically weak, often due to a lack of centralised responsibility for VAT management.
This higher degree of centralisation and the associated broader and more international approach to procurement has led to a greater level of interaction with other business functions and many innovative strategies – for example working with supply chain on what to buy may lead to a decision to source further up the value chain to address availability, quality, and or cost issues.
In a similar way, procurement and finance are becoming closer acquainted. The increased level of cross-border transactions in a centralised procurement model, and more sophisticated purchasing strategies have a direct impact on existing and potential treasury management policy, including cash management, FX management, and commodity risk management. It is these relationships this article will now address in more detail.
Managing commodity price risk via hedging
Third-party procurement costs are a major cost component for the modern business. The price of many of these purchases will be underpinned by global and or regional commodity prices, be they directly traded commodities such as sugar or metals, or goods and services whose own input costs are heavily reliant on underlying commodities such as oil (energy) or transport. A small swing in the commodity markets can have a major impact on these costs and hence the consuming company’s cost base and profit margin. For some companies input price stability – or visibility of future price changes – is a key measure of procurement’s success. This stability of input costs allows the rest of the business the foundation on which to effectively plan and deploy supply chain, marketing and sales resources.
For some companies input price stability - or visibility of future price changes - is a key measure of procurement's success.
For many internationally diversified companies it has been difficult to get a central picture of these exposures – and so even more difficult to manage this exposure. Historically this risk may have been managed on an ad-hoc basis by procurement – principally through a portfolio of fixed price contracts. However, this is not always as flexible nor as cost effective as managing this exposure through financial derivatives.
Many companies are taking a more proactive approach to the management of this risk, a trend which is expected to intensify as commodity prices continue on their increasingly volatile path. However stronger commodity risk management requires the establishment of clear objectives for the programme, supported by appropriate policies, processes, people and systems. Companies that have been most effective in dealing with this challenge have generally chosen to increase the degree of involvement from treasury, or alternatively to establish a dedicated commodity risk management function. In both cases, the starting point has been to clarify the purpose of hedging (for example to buy time for the business to react to rising prices), whilst linking this rationale closely with the underlying competitive positioning and pricing power of the company in specific markets. Another key to success here is the implementation of appropriate systems, be they specialist commodity risk management packages, generally used by some of the larger or more sophisticated corporates, or extensions of the treasury management system’s functionality. As treasurers will be well aware, the challenges of achieving hedge accounting are another important risk and success factor in such initiatives.
By its very nature, the establishment of centralised commodity risk management is culturally more challenging in most organisations than say the centralisation of FX. Indeed for any key input commodity, this risk is by definition more intimately connected to the underlying business and competitive position than FX risk, making it all the more crucial for treasury to work collaboratively with supply chain, procurement and commercial teams to develop the right strategy.
Another major barrier to effective commodity risk management has been the challenge of collecting and consolidating accurate exposure data from the business. Here again procurement centralisation initiatives will help create a stronger platform for gathering and analysing the underlying exposure and forecast data. [[[PAGE]]]
Reducing and simplifying currency exposure management
With purchasing professionals no longer feeling constrained by national boundaries the financial complexity of purchasing transactions can increase, as can the potential exposure for the firm. Managing this across many operating companies can be a truly daunting task for procurement. However when this activity is centralised into a single purchasing centre, it can present a unique opportunity for simplification.
Our experience would suggest there are significant benefits available from a closer co-operation bewteen treasury and procurement.
For treasury too, this change has potentially very positive implication as regards FX risk management operations. Traditionally, when products are sourced locally, often in currencies other than the functional currency of the purchasing entity, companies enter into intercompany derivatives to shift the exposure into the treasury centre for centralised hedging. Whilst this process delivers the benefits of exposure netting and centralised external execution, it can create significant operational complexity, including the need to gather exposure data from subsidiaries, maintain large numbers of internal hedging contracts with multiple subsidiaries and in multiple currency pairs, and configure treasury and accounting systems to cope with the large number of transactions, both in the treasury centre’s own books and in those of the subs. Add to this the challenge of maintaining hedge accounting documentation, hedge relationships and effectiveness testing and the operational risk and cost for treasury becomes sizeable. In a centralised procurement environment however, provided internal billing currencies are correctly defined, the FX risk is effectively centralised in the procurement entity, meaning treasury need only deal with this one entity for exposure gathering and hedging, thus delivering significant simplification and reducing costs and operational risks.
Reverse factoring
The cost of capital for many multinationals is lower than that of their suppliers, so reverse factoring schemes present an opportunity to leverage this financial advantage to the benefit of both the company and its suppliers. Whilst such initiatives were historically the preserve of a few of large automotive players, mainly in the US, these initiatives have gradually started to become more prevalent in Europe, and in other industry sectors. Whether referred to as reverse factoring, supplier financing, or supply chain finance, often depending on the banking vendor, these programmes have in common an objective to lower the overall cost of financing the supply chain, whilst simultaneously reducing supply chain risk. Indeed in the post-crisis environment, a number of larger companies have chosen to use such programmes as much to reduce supply chain risk by financially supporting small but critical suppliers as to reduce cost.
To be successful, these initiatives require a high degree of homogeneity in purchase-to-pay processes, as well as three-way integration between the company, its suppliers and the bank. Reverse factoring combines well with centralisation of procurement, since standardisation of supplier-related processes can be achieved simultaneously to facilitate both projects.
Our experience would suggest there are significant benefits available from a closer co-operation between treasury and procurement, however achieving this is not without its challenges. Companies who have successfully transformed their procurement and treasury organisation have done so with a good understanding of these potential risks and a clear plan for delivering the critical enablers:
1. Senior sponsorship and alignment to a broader corporate transformation or agenda
Are the senior team fully behind the change? Is the company already moving to a more global model? Is there an existing change agenda or programme that can be piggybacked? Will OpCos be supportive of the change? What will the changes mean to the senior management in the local operations? Will there be concerns over the impact on their ability to manage full P&L (e.g,. input costs no longer under full control)?
2. A focus on the people and change impact
Does the company have the people with the skills and experience necessary to work in this new way? Who will provide deep understanding of the key commodity markets and how will this be translated into the supplier relationship management strategy? Who has the deep understanding of the extended value chain for a spend category? Who has the experience of financial derivatives? How will we integrate the procurement and treasury communities (different ways of working, background, technical languages)? How will we leverage talent on a global basis? How will we manage and communicate the overall change?
3. Systems and data enablers
Does the company have the applications necessary to facilitate commodity risk management? Are these integrated into central procurement, treasury and local ERP systems? Is the underlying data aligned, what is the master data management solution? How can we ensure the programme does not become too systems dependent or driven?
For many leading global companies, rethinking business models, with some degree of regional or even global centralisation is a clear current priority. Greater centralisation of procurement is a key element of this trend and one which creates a significant need and opportunity for treasury to add value. Treasurers should ensure they are at the table and seen as leading in these initiatives, notably with regard to improved FX and commodity risk management, but also as part of the broader effort to optimise the financial side of the supply chain. Initiatives to centralise procurement should be seen as much as an enabler of financial as operational efficiency and hence an opportunity for treasury to drive change.
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