What is Cost Optimization?

It’s an ongoing disagreement between procurement and finance: cost avoidance or cost savings.

Cost avoidance is when stakeholders in the company action to stop from incurring a cost, or to try to reduce an expense. Cost avoidance is best understood as any proactive step that helps reduce potential increases in expenses so the organization has less outlay in the future.

Cost savings, favored by finance, appear on the budget and in financial statements as a decrease in spending. Put another way, it’s the reduction from last year’s spend for the same item. The simple cash calculation for cost savings is to subtract the new price from the original price.

[Read more: What we talk about when we talk about savings: Why procurement needs to learn to speak Finance]

It can be challenging to identify cost avoidance strategies on traditional balance sheets, which often causes friction between procurement and finance teams. However, there’s a better way to think about costs that both teams can agree on: cost optimization.  

What is cost optimization?

Gartner’s definition of cost optimization is, “a business-focused, continuous discipline to drive spending and cost reduction, while maximizing business value.”

Put simply, cost optimization seeks to find the best price and terms for business purchases, while standardizing, digitizing, and automating applications, processes, and services to save costs.

“Supply chain cost management models remain short-term and functionally focused,” wrote Gartner. “Short-term cost goals are prioritized over long-term business value, and a narrow, function-specific focus limits the ability to pursue big change and meet full performance potential.”

Cost optimization centers around the concept of value, something on which both finance and procurement teams can align. Business value derives from the customer experience, profitable growth, compliance, and long-term sustainability. Rather than short-term profit, value stems from investing in supplier relationships, sourcing wisely, and continually finding cost efficiencies along the way.

Demand fulfillment, product supply, and new products are among the efficient supply chain operating outcomes that procurement teams need to hone in on. What does this look like in practice? 

Supply chain cost optimization

Organizations seeking to improve cost optimization can focus on five key areas for maximizing value and minimizing waste.

Deals

First, companies should address pricing waste, often found in the form of maverick spend or rogue spend. Tail spend management best practices and steps to reduce rogue spend can help minimize pricing waste. Examine your contracts, as well as off-book and non-compliant spending, to find opportunities to improve your sourcing and build long-term value into your supplier contracts. 

Operating tactics

Cost optimization requires automating and digitizing internal operations to save time, money, and lower the risk of error. This step focuses on finding ways to operate more efficiently, whether that means implementing a tool like Fairmarkit, standardizing your procurement policies, or implementing just-in-time ordering for optimal supply-demand balance. 

Processes and roles

Again, this step includes implementing smart procurement tools to enable effective network operation. Look for solutions that can transform your source-to-award process — reducing risk, centralizing data and offering visibility into your supplier relationships in the process. Reduce redundancy and streamline approvals throughout your supply chain.

Networks

Focus on building sustainability into your long-term supplier relationships across your supply chain.

[Read more: The 3 essential elements of supply chain sustainability]

Sustainability isn’t just good for the planet; it’s good for business, too. Supply chain sustainability is as much about social impact as it is about profitability. Towards this goal, digitization and process automation are great tools for lowering costs and maximizing profitability. Inventory management and reducing waste throughout your procurement function are also key functions. 

Portfolios

Finally, organizations should ensure they are aligning with demand. Cost optimization means only spending on what customers want and need. These needs can change all the time. Market research and tracking consumer trends are two key activities that businesses must invest in to continually optimize.

Cost optimization requires finance and procurement teams to prioritize long-term value. This means investing in long-term supplier relationships, focusing on sustainable business practices, and streamlining processes to make the best use of the company’s resources, cutting tail spend, and wasteful rogue spend in the process.

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To learn more about cost optimization, check out our blog, The Source.