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With inflation, labor shortages and supply chain issues, corporate CFOs are looking for strategies to increase revenue and mitigate risk.
And, like the virus, the financial situation resulting from the pandemic is lasting longer than expected. To fight back, CFOs are taking inspiration from the private equity playbook and turning to procurement as a major lever for improving EBITDA.
Instead of viewing sourcing as a back-office function, CFOs are adopting many of the same complex sourcing strategies that private equity firms have relied on for years to quickly improve a company’s finances. holding company. Now, executives are seeing what good looks like, and more companies are beginning to understand and embrace this foolproof cost optimization method.
CFOs who work alongside their purchasing managers can significantly improve their EBITDA through purchasing-related optimization, mitigate risk through supplier resilience, and gain a competitive advantage in the marketplace.
Rapid supply changes mean rapid savings
From the onset of the massive and unprecedented disruption caused by COVID-19, businesses have had to look for new avenues to save money. Private equity – long known for moving with speed – long ago discovered that sourcing strategy is one of the fastest ways to accelerate the value of their portfolio companies. Supply changes can generate savings in months, unlike revenue growth, which can take years. When the pandemic hit, private equity operators began to leverage purchases almost immediately, while other organizations lagged. But they are learning.
Over the past decade, most private equity firms have invested in building operating teams focused on exiting several key strategies, often in parallel, to deliver value focused on both growing the turnover and improved margins. In an environment where companies are valued at >12 times multiples of EBITDA, many private equity operating partners rely on procurement as a key lever to reduce costs. Using this strategy, supply value can be achieved within months and the savings have a direct dollar-for-dollar impact on EBITDA. For example, if a portfolio held by private equity generates $10 million in bottom line savings, this could have an impact of more than $100 million on the company’s valuation.
Supply in an inflationary market
The prices of almost all goods and services, from raw materials to labor and transportation services, are skyrocketing. In the wake of the COVID-19 pandemic, demand for goods has increased and supply chains are currently strained like never before.
And while it is recognized that it is difficult to reduce procurement costs in times of runaway inflation, private equity operating partners ensure that their company’s procurement strategies are not solely based on cost and price. Instead, using a total cost of ownership (TCO) approach that includes the use of demand and process levers has proven to be an effective strategy to counter price increases and growth in inflation.
As CFOs and sourcing managers take a more aggressive view of sourcing’s ability to impact earnings and earnings per share (EPS) – similar to PE’s view on improving valuation – here are examples of the TCO approach to sourcing in an inflationary market:
- Price– With inflation continuing, there is less room to reduce the cost of goods and services. So what pricing levers can help a business get the most out of its spend? A full competitive offer, incumbent renegotiations, extension of an ongoing agreement to avoid price increases, and protection against future price increases should all be part of the procurement toolkit.
- Demand– How can an organization influence the demand or need for goods and services? Possibilities include streamlining SKUs, optimizing schedules, reducing complexity, streamlining usage, substituting or streamlining items, and reducing demand.
- To treat– How does a company purchase goods or services in a way that maximizes value? Answering this question requires looking at metrics such as order size, compliance, and lifecycle cost management.
Supplier Continuity Helps Mitigate Risk
Beyond cost reduction, demand reduction and process change, we have seen a major focus over the past 18 months on supplier continuity programs to mitigate supplier risk. If you can’t rely on key suppliers to fulfill the orders for the materials you need to make finished goods, you can’t generate revenue. When risk management begins at the procurement stage by identifying and closely managing suppliers, threats can be identified early in the process.
To reduce risk, they should expand their supplier base by identifying new partners, including potential second and third tier suppliers. Other risk mitigation strategies include moving production to cheaper countries; relocate it to neighboring businesses to shorten the supply chain; and switching to JIC supply chains (just in case), which involves purchasing in greater volume to maintain additional inventory.
Sourcing changes can add up to 40% EBITA improvement
Are these sourcing strategies working? The answer is yes.
A 1% decrease in expenses will increase EBITDA by more than 1%, in our experience. In most cases, a company’s procurement expenses are many times its EBITDA, so a 10% reduction in expenses can improve EBITDA by 20% to 40%. Compare those results to the $5-20 of net new sales companies need to generate a single dollar of EBITDA impact. Few savings levers offer such a spectacular and immediate impact.
Significant cost savings through smart procurement strategies can change that, as can vastly improved procurement data collection and analysis, a pain point for many organizations. Savings that make a measurable difference to EBITDA provide the financial predictability sought by CFOs. Alignment between the procurement function and the CFO’s office can be a company’s best weapon in times of financial hardship – and help leave competitors in the dust – pandemic or no pandemic.
Jake Wojick is Executive Vice President and Head of Private Equity at Insight Sourcing Group.