To understand the different ways savings can be calculated it is helpful to have a definition of the term "Savings" and an example that illustrates the concepts. The Sorcaro Procurement Dictionary provides the following definition of savings...
Savings Definition
A calculation of the change in monetary value due intentional intervention when compared to the historical baseline or external market changes.
Importantly, this definition of savings allows for the mitigation of cost increases due to inflationary pressures like increase labor costs, raw material increases and taxes, but should avoid soft savings like "free" training classes or other "sweeteners" that would not have otherwise been purchased.
This may also be seen as a very procurement centric approach by finance, as finance often compares savings versus the budget rather than a baseline. This approach is easier, but it is subject to gaming by inflating budgets, or delaying spend until the next period, and it holds procurement accountable for changes in volume and currency exchange rates that are outside of their control.
Example
No two savings projects will be exactly alike, but it does help to have an example to reference when savings calculations; not only to understand how and when the calculations are applied, but also to help understand the math. For the calculations on this page, please consider the following scenario.
Industrial Propane
A large diversified manufacturer operates as 4 individual brands and each plant is run atonomously and has individual agreements with local branches. In this case because propane at any single location is a relativly low spend, all of the existing contracts were expired, or the plants were buying at a spot rate. Company A was buying cylinder's "per cylinder" and therefore an actual usage was unknown. Companies B & C were having cylinder's refilled, but buying the propane by the gallon (calculated based on weight). Company D had a bulk tank and was located very near a distributor.
| Company | Loc. | QTY | UOM | Baseline $/GAL | New Price $/GAL | Baseline Spend | Savings |
|---|---|---|---|---|---|---|---|
| Company A | IN | 94 | Cyl | 1.84 | 1.12 | 1,383.68 | 541.44 |
| Company A | WI | 16 | Cyl | 3.10 | -- | 396.8 | 0 |
| Company A | MI | 2,216 | Cyl | 4.75 | 1.10 | 84,208 | 64,707.20 |
| Company B | NC | 38 | Gal | 3.12 | 1.16 | 118.56 | 74.48 |
| Company C | GA | 5,582 | Gal | 3.69 | 1.16 | 20,597.58 | 14,122.46 |
| Company D | IL | 11,500 | Gal | 0.98 | 1.10 | 11,270 | -1,380 |
| Totals | 19,446 | 117,974.60 | 78,065.60 |
Line Item Savings
The gold standard of savings calculations is the line item savings. This methodology is most suitable for categories with consistant and discrete items and units of measure and perfectly accounts differences in quantity and product mix.
In our propane example, each line represents 1 discrete item, a unit of measure of propane at a given location.
The Wisconsin facility for Company A purcahses 2,216 cylinders for $84,200, or $38/cyl. A 40# propane cylider holds 9.4 Gal of propane, but it was standard to change the bottles at the beginning of each shift. We estimated that approximately 8 gallons was used per shift, making the effective cost $4.75/gal. Since the new negotiated price was $1.10/gal the savings at this location can be calulated as:
This was an exceptional 76.8% savings and creates the interesting case where the savings is greater than the new budgeted spend!
Extrapolated Savings & Discounted Savings
Extrapolated savings are typically calculated when the data is imperfect or incomplete. This may be because there are a large number of items, for which it is impractical to obtain quotes or when there are new items that don't have a baseline; while a discount can be negotiated from a published price, but it is most frequently earned based the size of an order, the cummulative value of orders during a period based on a negotiated schedule or accelerated payment terms.
It is easy to calculate savings on a given invoice, when the discount percentage is known, it is simply:
However when calculating savings, you will only have access to the invoiced amount and the calculation is less intuitive.
The initial reaction of most people is to multiply the New Price by 1 plus the discount because that feels like the opposite of 1 minus the discount. This will underreport the actual savings.
For our example, lets assume that Company C is opening a new North Carolina location in 3 months and they expect to need 6,000 gallons of propane per year. If we add them to the new agreement they will pay $1.16/Gal. There are a number of ways that could be approached.
| Opt. | Decription | Pros | Cons |
|---|---|---|---|
| 1 | Assume there is no savings and place them on the negotiated agreement | Easy | Creates an incentive to delay implementation and miss out on 3 months of savings |
| 2 | Allow the plant to source the propane and then alert them to the agreement | Accurately reflects the value of the sourced agreement | Wastes the plant buyers and vendors time; plant may enter into a contract |
| 3 | Apply an estimated savings percentage to the locations propane spend. | Easy and gives procurement credit for the value provided | The savings are not provable |
Each option is trying determine a baseline for the Line Item Calculation above, if it will affect a budget, it needs to be done with all appropriate parties, otherwise it probably makes sense to select the one that "feels" the best.
- 71.16 - The average of all of the using delivered 40# cylinders
- 68.6% - The average of the Company C & location closest in size
- 62.8% - The location nearest the new location
- 39.1% - The lowest of all locations
In this extreme savings case the difference is still only about ~$4K.