People do matter most really

Excellence in procurement is delivering dramatically better business performance, a major new research study reveals. The best performing CPOs are concentrating their efforts on their people, capabilities, mindsets and aspirations. In an exclusive feature for ELP, Peter Spiller and Nicolas Reinecke explain the McKinsey/Supply Management Institute findings.

Purchasing professionals may know instinctively they do much more for company performance than keep raw materials coming into the loading dock, but sometimes the hard evidence to support this view is difficult to find. The importance of the purchasing function may only be recognised in discontinuity situations such as mergers and cost reduction programmes.

At other times, it is difficult for CPOs to bring influence to bear in the upper levels of their organisations. The role of the modern CPO is complex and multi-faceted. They are expected to deliver all required materials and services to all sites in quality and in full – all of the time. At the same time, suppliers must be quality checked and developed, new sources identified and qualified, cross-functional teams staffed and systems implemented and queried.

How should they achieve all that? This is where the problem starts: CPOs will increase the number of opinions with everyone they ask – IT systems and e-procurement are key, global and, particularly, low-cost country sourcing is a must, risk management and corporate social responsibility are mandatory, supplier development is essential and the key lessons from Toyota must be absorbed.

And this is just the start. Because there are only so many hours in a day, the key question becomes: where can one make the strongest impact and, consequently, on what should one focus?

To answer this question, a research team from global management consultancy McKinsey & Company and the Supply Management Institute at the European Business School conducted a two-year, 200-plus company, in-depth survey of the activities and results of purchasing departments across a wide range of countries and industries.

The conclusions of the study may turn some conventional wisdom that surrounds the management of the purchasing function on its head. Reassuringly for CPOs, the study shows clearly high-performing firms have high-performing purchasing departments. The study shows that high purchasing performance is strongly correlated with higher margins, higher earnings and reduced costs.

Significantly, however, when the most important drivers of this high performance are examined, many of the activities normally regarded as key to purchasing success such as widespread supplier management, use of e-procurement, or software to manage and control spend, for example, turn out to have a relatively minor effect on the overall performance of the purchasing supply management (PSM) function.

What matters, the survey demonstrates, is the people in the purchasing department: how talented they are, how capable they are, how motivated they are, and how they interact with the wider organisation.

Purchasing departments that excel in these aspects of their activities achieve savings two and a half times higher than those that don't. And their positive influence branches out beyond the historical territory of PSM to include areas such as revenue, innovation opportunity generation and the leadership of commercial change in the company.

Objective Metrics
One of the fundamental problems in accurately evaluating purchasing performance is a shortage of objective data. Most surveys on purchasing practice rely on self-reporting of performance by CPOs. As in many areas of management, those involved can be poor judges of their own performance.

To overcome these issues, the McKinsey survey used a new approach to correlate PSM practices with financial performance in a rigorous and statistically reliable manner.

The survey used a series of structured interviews, with 42 questions to which interviewees could give open-ended answers. The interview questionnaire was designed to measure purchasing performance along four fundamental dimensions, with subsequent analysis aiming to identify which of these dimensions had the most powerful effect on overall performance. These dimensions are:

Strategic alignment and posture: The degree to which the PSM function manages to align its activities with overall business strategy, and its influence over this strategy. Capabilities and culture: The way PSM professionals think, feel and conduct themselves in the work place, individually and collectively.
Category management and execution: The strategies and processes the PSM function uses to deliver value Structure and systems: How the resources of PSM function are formally managed, and how the function interacts with the wider organisation. These four dimensions were further broken down into 10 performance drivers.

The interview process explored each driver through three or four detailed questions. Each company was given a score for each of 10 PSM performance drivers, ranging from one (poor) to five (best). Participating firms were then clustered into poor, average or good performers, based on their average score over all the measures. (Fig 1)

Each interview was conducted by two PSM specialists. Participants received a detailed analysis of the results at the end of the study, including a comparison of their individual performance with the overall results and with other companies in their sector. This feedback allowed every participant to identify the strengths and weaknesses of their own PSM organisation and to make decisions about their future development.

Purchasing Pays
The good news for CPOs is companies in the survey reap tremendous benefits from a well-designed, high-performing PSM function. The best performing firms in overall PSM measures showed better results in a full range of financial metrics from the specific (purchasing savings, reduction in cost of goods sold) to the very general (EBITDA margin – earnings before interest, taxes, depreciation and amortisation). The research demonstrates this is not just the overall effect of a well run enterprise, but originates directly from PSM performance.

High performing firms, with an average PSM performance score of 3.4 out of 5, demonstrated annual purchasing savings of 3.5 per cent, a 1.4 percent annual reduction in cost of goods sold and an average EBITDA margin of 17.7 per cent. Low performing firms, by contrast, with an average PSM performance score of 2.1 out of 5, achieved annual purchasing savings of only 0.6 percent, a 0.5 per cent annual increase in cost of goods sold and an average EBITDA margin of 12.7 per cent.

People are Vital
How are the leaders achieving their impressive results? Three soft elements of the purchasing function accounted for 57 per cent of the overall difference in business performance between high performers and middle- and low-performing firms. These drivers were the talent and capabilities of the PSM professionals (25 per cent), mindsets and aspirations of the PSM department (16 per cent), and the degree to which the PSM function was aligned with, and able to contribute to, overall business strategy (16 per cent) (Fig 2).

High-performers were five times more likely than low performers to employ purchasing managers with analytical expertise and general management backgrounds, in addition to deep knowledge of a particular purchasing category. These individuals tended to treat their category responsibility like a line manager would his business responsibility, employing resources wisely for superior purchasing effectiveness.

Likewise, purchasing managers at top companies were six times more likely to have worked in another functional area (such as product development or engineering) than were managers at low-performing companies. Top companies also set clear career paths for purchasers. Seventy-six per cent of highperforming companies tailor the training that purchasers receive, for example through functional rotations that ensure purchasers obtain broad business experience. Only 11 per cent of low-performers did so.

In our experience, such organisational insularity prevents purchasing executives from contributing to the product- and service-development discussions with suppliers and other stakeholders that often lead to bigger savings.

The second factor involved the way purchasers view their roles, and the aspirations they associate with them. Among top performers, 69 per cent of purchasing executives felt their CEO expected more from them than cost reduction (and 81 per cent of these purchasers articulated a clear vision for achieving these goals).

By contrast, 49 per cent of purchasers at low-performers believed their CEO viewed purchasing as a limited support function, and nearly two-thirds saw little indication that this would change.

In our experience, such attitudes discourage purchasers from exploring new practices or ideas that might create value. While the solution to this chicken and egg problem is not trivial, the impact is stunning. Among low performers, only 11 per cent of purchasers felt their efforts contributed to a culture of continuous improvement within the company, compared with 62 per cent of high performers.

Finally, high performers were more likely than the others to actively involve purchasing executives in strategy development at the corporate level, including them in product and go-to-market strategies, acquisitions and operations configuration – influences that, in our experience, results in better decision-making. For instance, 80 per cent of top companies involved purchasing executives during the concept phase of product development, and 90 per cent reported that purchasers were actively engaged with sales and marketing executives – for example to explore how innovations among suppliers might inform new products or services, or how the use of particular suppliers might boost the customer perception of the product.

This influence extended to mergers and acquisitions: top companies were twice as likely as low performers to involve purchasing in due diligence before a merger, and in valuecapture activities after one.

That skilled and motivated purchasing professionals deliver much is emphasised by the purchasing personnel strategies of the leading companies in the survey. Among surveyed companies, medium and high performing firms had an average of 20 strategic buyers for every billion US dollars spent. Low performers, in contrast, had only 13 people responsible for the same amount of purchasing. What did high performers achieve in return for spending around $1.5 million extra on strategic sourcing per billion dollars spend? They delivered annual reductions in cost of goods sold of 0.8 per cent to 1.4 per cent – ten times their extra investment in purchasing capability. Low performers had 0.5 per cent cost increases.

This is a significant result for CPOs and management teams that measure the efficiency of their entire purchasing organisations using simple relationships between headcount and transaction volume or value. The modern PSM function has both strategic and operational elements, usually conducted by different people. While operational personnel should be measured by their efficiency, at the strategic level – as we shall see below – effectiveness is far more important.

Systems Less Crucial
Within the past few years, companies have adopted a range of techniques to try and maximise the effectiveness of their PSM functions. Automation through e-procurement systems and online marketplaces, integration of external organisations into the supply chain and top down control through the implementation of organisation-wide spend management systems have all been identified as essential for PSM best practice. While efficiency apparently seems to have been achieved through the use of
these tools, they are not the key to top level PSM performance. Contrary to our initial expectations, among the companies in our survey, IT tools and formal processes such as these accounted for a mere 8 per cent of the difference between high performing firms and the rest.

Position, Influence and Control
The acceptance of the PSM function by the wider organisation also has important implications for purchasing's impact. In general, CPOs of higher-performing companies report to a more senior position in the organisation. In 27 per cent of high performing companies in the survey, the CPO either reported to the CEO or was a member of the senior management team, and thus truly was a “C” PO.

This was the case for only 12 per cent of low performers. A principal benefit of position, of course, is influence. High performing PSM functions do much more than excellent purchasing. They tend to exert a significant influence on strategic decision-making. Analysis of the overall effects of different aspects of PSM behaviour on performance suggests that this influence accounts for 45 per cent of the overall performance of the PSM function.

The conclusion from this finding is a compelling one. Companies that restrict the influence of their purchasing departments are denying themselves nearly half the available benefits. The structure of the PSM function is another key decision for CPOs that can have a significant influence on their ability to achieve high performance. Once again, the survey results indicate that some strategies are significantly more powerful than others. Essentially, it seems, successful purchasing departments lead from the centre.

Among high performing firms in the survey, 69 per cent had centralised control of their purchasing function, either using a conventional structure or, as often, a lead buyer network. Together with the strong people component described above, this network approach leads to strong central co-ordination while encouraging entrepreneurial execution – clearly the best of both worlds. Low performers were half as likely to centralise their purchasing and none of them made use of lead buyer networks (Fig 3).

The consequence of a strong, centralised PSM function is two-fold. High performing purchasing departments have formal control over more of their organisation's spend (79 per cent against only 71 per cent for poor performers) and they exert a stronger influence over the spend that falls under their control. Rated on influence and reach of PSM' in the survey, high performers scored 3.1 out of 5, compared to only 1.8 for low performers.

Anxious Leaders, Complacent Followers
While the survey based its overall assessment of purchasing performance on objective financial measures, obtained from annual reports and external databases, CPOs were also invited to assess their own performance on the same 1 to 5 scale used by the interviewers as well as assess the performance of peers within their industry.

While most CPOs could correctly predict the relative performance of their industry (including their own performance), top performing CPOs consistently underestimated their own absolute performance, by around 1 point compared with the survey results. Poor performers, by contrast, were likely to overestimate their performance by the same amount.

Two possible conclusions are suggested by this result. Perhaps complacency prevents poor performers from striving to improve their departments, since they don't recognise the room for improvement. Alternatively, high performers may be more likely to realise that there is a journey to excellence and that, whatever their current position, there is always more to achieve.

Every Sector is Involved
As significant as the link between PSM and overall performance was the broad spread in PSM capability among the surveyed firms. Achieving high performance in purchasing, it seems, is not simple or obvious. Some sectors have a reputation for effective PSM performance and the results of the survey did indicate significant differences in overall PSM performance between different industry sectors.

Top ranked in the survey for PSM performance was the automotive and assembly sector, with an average score of 3.25 over all measures, closely followed by high-tech and telecoms (3.21) and packaged goods (3.16). At the bottom came energy and utilities (2.42) and financial institutions (2.45), both substantially below the overall survey average score of 2.88. The drive for purchasing excellence seems to be accelerated by the excessive cost pressure and rapid innovation cycles experienced in certain industries.

But even in strong performing sectors, the gap between leaders and followers was wide, with a spread of 1.9 points or more between highest and lowest performers in seven out of the eight sectors analysed. And among high performing firms, the survey still indicates considerable room for improvement. The top 6 per cent of companies scored 4.0 or higher in only five out of the 11 performance drivers.

Nor is industry sector an excuse for poor purchasing practice: high performers were identified in nearly every industry sector surveyed. The financial services sector achieved generally poor results, for example, beating only energy and utilities, but 4 per cent of the banks and financial institutions surveyed were in the high performing category, and the best performer came close to the top of the survey overall.

Take Action Now
What do these survey findings indicate for CPOs seeking excellence? We have identified four key mandates to drive PSM performance.

Leadership – setting vision and aspirations. Does the whole purchasing department understand the fundamental role it plays in the success of the wider organisations? Have you set demanding objectives for PSM that directly support overall business goals?

Capabilities – the right skills for the job. Does the purchasing department have experienced, talented individuals in key strategic positions? Does it have the right mechanisms to develop and retain these people?

Position – a seat at the top table. Is PSM taken seriously by the top management team? Do you have the ear of the CEO?

Influence – across the organisation. Do strategic purchasing personnel have a position in cross-functional teams? Do they lead these teams?

Conclusion
The findings of this survey should make for reassuring reading for ambitious CPOs – and frightening for purchasers seeking a quiet life. By reaching out to the wider organisation, becoming involved with strategy development, product design, manufacturing decisions and a host of larger business decisions, high-flying purchasing departments can strive to achieve twice the impact they might by concentrating on traditional purchasing processes alone.

To do this, however, many purchasing organisations may have to look rather different from the way they do today. Strong, centrally structured departments, staffed by capable professionals with broad experience and the ability to interact on a peer-level basis with senior people from across the organisation are essential if purchasing is to demand the recognition it requires in order to deliver the best results.

Dr Nicolas Reinecke is a principal at McKinsey & Company, Hamburg. Peter Spiller is a principal at McKinsey & Company, Frankfurt.

This study is ongoing. Companies interested in participating should contact the authors: Nicolas_Reinecke@mckinsey.com / Peter_Spiller@mckinsey.com