In this guest blog, Procurement Leaders Magazine invites Kairos Commodities CEO Soren Vammen to discuss some of the problems with performance measurement.
Practically all companies measure savings by comparing the current year's average cost to last year's or by comparing the realised costs to the budgeted costs, according to a Pan-European survey we are conducting. But, less than every second company, it seems, measures the performance against the market (cost avoidance).
This is problematic, since performance measurement strongly drives organisational behaviour and savings measurements only capture one side of the coin.
Imagine a company on a monthly basis purchasing a commodity on a variable price contract, and that the price develops as follows: at the beginning of the year the price is 100, and then rises steadily to 150 mid-year, before dropping to reach 100 at the end of the year, resulting in an average cost of 125. The following year, the company enters into a fixed-price contract for the full year, at a price of 100. The market price of the commodity steadily decreases to reach 60 at the end of the year.
If performance is solely evaluated by comparing the current year's cost to last year's cost, the performance has been successful, since the company has created savings of 20%. However, when comparing the performance to the market development, it is apparent that the fixed price contract was regrettable – the company has paid an annual average of 25% more than the market price.
Companies are placing too much emphasis on reaching a budget accuracy objective, rather than focusing on improving cost competitiveness, often simply because the finance department has been empowered with authority that spans too far and has a unilateral perception of risk. Finance mitigates the risk of increasing price and focuses solely on budget accuracy.
However, companies having a significant exposure to commodities need to apply a strategy that also encompasses the possibility of improving cost competitiveness in down-trending markets.
This brief example clearly shows that a large number of CPOs ought to instigate a dialogue with senior management about how to measure performance – best of luck.