Procurement 20/20

Capabilities and Culture—Recognizing Talent as the Key Asset in Procurement and Investing Accordingly

Category Management and Execution—Improving Effectiveness through Advanced Procurement Tools and Approaches

Integration and Alignment—Using Success in Cost Management to Advance toward a Truly Strategic Role for Procurement

Chapter 4: The Productivity Imperative: Orchestrating the End-to-End Value Chain

Chapter 5: Big Data and the Global Grid: Procurement’s New Role in Data-Driven Decision Making

Chapter 6: Volatility as the New Normal: Translating Sourcing Risk into Competitive Advantage

Chapter 7: The New Economic Drivers: Capturing the Total Impact of Environmental, Social, and Regulatory Factors

Chapter 8: Getting Ready for Real Change: Steps for Starting the Journey toward Procurement 20/20

“Shaping new products through early involvement, bringing outside perspectives to better design a company’s value chain, or fully managing a company’s outsourcing network—the expectations for CPOs are rising constantly. Procurement 20/20 compellingly explains what CPOs should expect, and how they can shape the future.”

“Procurement 20/20 provides valuable insights into the impact globalization and volatility will have throughout the value chain. Leaders will benefit in understanding how these factors and others will shape their sourcing strategies today and into the future.”

—Michael Radojevic, Managing Director of Technology and Corporate Services Procurement, United Airlines

“In today’s fast changing world, managing to a benchmark is important but simply not enough. Future development and trends have to be anticipated and management adjusted accordingly. In this spirit Procurement 20/20 is an excellent resource for any CPO. It provides compelling visions for the future of the function and hands-on solutions for a challenging business environment. A must read!”

“Procurement 20/20 looks beyond the classical sourcing tasks and explores how to establish strategic business models with the supply base, reduce risks, and drive growth to create more value along a company’s full value chain. An inspiring thought-piece for any procurement professional.”

“We aspire to mastering all opportunities offered by the rapidly changing marketplace, and this book provides an excellent road map for the journey that lies ahead of us.”

—Hans Melotte, Vice President and Chief Procurement Officer, Johnson & Johnson

“Procurement 20/20 takes a bold look into the future and explores the changes that the procurement function needs to make. It is a must read for the ambitious CPO.”

“The next decade will require the procurement function to better understand the dynamic and volatile world, particularly where sourcing strategies must be flexible and creative to operate in a global footprint. This book provides the CPO and the procurement team with several provocative trends that will shape the coming years, and a structured road map to address the opportunities.”

“Procurement 20/20 is an inspiring invitation to stop and reflect on the ‘new normal’ for procurement. And it sends a clear message to CPOs: It’s time to get ready for the next decade!”

“This book explores very convincingly how CPOs and their organizations need to adapt to deal with the challenges of the future.”

“A highly inspiring book: The strategic insights draw the necessary change agenda for all CPOs. It is written in a most engaging style, provides numerous examples relevant to today’s world, establishes the burning platform, and outlines the key elements that the new procurement agenda must address. If there ever was a book to motivate the CPO to action, this is it!”

“Today’s global megatrends make the strategic side of procurement increasingly vital for the success of any business, from strategic supply management to sourcing innovation. A revealing book on supply entrepreneurship.”

—Christian Terwiesch, Andrew M. Heller Professor at the Wharton School of the University of Pennsylvania

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Procurement 20/20 : supply entrepreneurship in a changing world / Peter Spiller, Nicolas Reinecke, Drew Ungerman, Henrique Teixeira.

ISBN 978-1-118-80008-9 (cloth); ISBN 978-1-118-80047-8 (ebk); ISBN 978-1-118-80070-6 (ebk)

For decades, McKinsey & Company has worked with clients to improve their procurement practices and achieve distinctive and sustainable impact. We have averaged more than 250 engagements per year and served chief procurement officers (CPOs) from Fortune 100 companies and startups alike. Those companies have come from industries ranging from automotive and assembly, chemicals and basic materials, electronics and high tech to energy, banking, and other services. Many of them have been long-standing clients, served on a broad range of strategic and operational topics, and a large share we have been advising at different procurement inflection points over time: when a new CPO came on board, a merger required significant synergy contributions from procurement, a general reorganization offered the opportunity to strengthen the central procurement governance, or when new sourcing markets had to be explored.

In working with our clients on these engagements, we have been exposed to the most important questions faced by CEOs and CPOs around the world—such as how do we develop cutting-edge sourcing strategies, exploit favorable market conditions, and optimize supply chains to reduce cost across the value chain? How do we build a base of external suppliers that give us the first access to their proprietary innovations so that we can jointly develop the products consumers want, more profitably and more quickly? How do we manage a vast and complex network of suppliers and contract manufacturers to ensure constant supply in a world where supply chains are globalizing, lengthening, and susceptible to more volatility? And how do we make our procurement practices robust enough to avoid the increasing scrutiny of environmental, safety, and regulatory demands, magnified by vastly different expectations from a diverse set of consumers and governments?

This book shares the hard-earned insights from more than 10 years of dedicated procurement research conducted with leading academic institutions and practical experience with marquee clients in the field of procurement and is the natural successor to the many articles we have published on the topic. As such, we’ve attempted two things with this book: to explain and codify the best practices that leading companies have pioneered in procurement and to frame how procurement must evolve to grapple with new global, social, and economic issues affecting business over the next decade. We wanted it to be as forward thinking and strategic as you’ve learned to expect from our publications, yet practical enough to spark a conversation between a CEO and CPO about the near-term actions their procurement organizations must take to stay ahead in the new world. And while this book is focused on procurement, any company executive—from CEO to COO to CPO—will find relevance in our discussion of the five major megatrends that will impact every function across the business.

Why are we devoting an entire book to procurement excellence today and how it must evolve to be ready for tomorrow? We look at procurement’s past evolution for an answer. In his 1983 article “Purchasing Must Become Supply Management,” our former colleague Peter Kraljic noted, “A decade ago, any chief executive who was losing sleep over his company’s procurement function might be thought to have had his priorities wrong. Today, the likelihood is that he is simply more alert than his competitors to the new and potentially dangerous strategic dimension that materials sourcing has taken on.” As a result, Kraljic argued, procurement must transition from a tactical, operational mind-set to one that is strategic and fully integrated with other key functions in the business.1 Even back then, Kraljic argued that procurement could deliver significant impact by responding to the increasing risks of resource depletion and raw-material scarcity, intensified competition, political turbulence and government intervention in supply markets, and accelerating technological change. In fact, the past 10 years have provided a natural conclusion to what Kraljic predicted: The digitalization of information spread the news of the 2008 Lehman Brothers bankruptcy in seconds, causing world stock exchanges to plunge simultaneously and putting companies out of business; the 2011 Japanese earthquake and tsunami sent reverberations across global supply chains; and the 2010–2011 Arab Spring resulted in instability and speculation across the most oil-rich region in the world. The decade ahead will be no less tumultuous, and procurement’s role will be more important than ever before in maintaining constant supply, best cost, reduced volatility, faster and improved innovation, and positive corporate-brand image. Our purpose is to take Kraljic’s view deep into the twenty-first century by describing the next step in the evolution, the step in which supply management must become supply entrepreneurship.

Toward that goal, we have brought to bear our insights, which have, time and again, proven their entrepreneurial and strategic effectiveness as our external partners compete in the global economy. We have drawn on more than 1,500 global procurement studies from the past five years that optimized in excess of U.S. $200 billion of spend, examinations of more than 700 procurement organizations, and 2,000 hours of interviews with CPOs and their staffs across every industry to determine the key dimensions of procurement excellence and its link to corporate performance. The research presented in this book is unique because of the challenges inherent in measuring the success of a single company function. Enlisting top academic institutions, we have developed a framework to isolate the performance and impact of a single business function and to evaluate its impact with a very high confidence level using partial least squares (PLS) statistical methods and multiple-level blind interviews. This framework is, in our view, unrivaled in its detail and provides essential insights for other organizations seeking to remain competitive into the future. The McKinsey Global Institute, our business and economic research arm, has partnered with our strategy practice to identify the five fundamental megatrends that will shape the next decade and beyond. On the basis of the implications of these megatrends, we have tapped into our global network of C-suite officers across leading companies to help define how procurement must evolve. And finally, we’ve drawn on our organization practice to provide practical advice on how to accomplish transformational change—from defining the aspirations to executing them so that they become part of your function’s DNA.

Numerous executives and companies were involved in the development of this book. In particular, we would like to thank the more than 700 clients who took part in our Global Purchasing Excellence survey and served as the inspiration behind the disguised case examples that bring to life the concepts in this book. We would also like to thank the many CPOs who have shared their insights on the book’s content during roundtables and conferences and on a one-on-one basis, ensuring it is simultaneously inspirational, relevant, and actionable.

Hindsight is 20/20, and in 10 years, we’ll have the benefit of knowing much more than we do today. And at that point, our hope is that you might be browsing your library or your tablet and thinking, “I’m glad I read this.”

1Peter Kraljic, “Purchasing Must Become Supply Management,” Harvard Business Review, September/October 1983.

It is becoming more and more important for every senior executive to know how to manage the external parts of the company’s value chain.

The evidence is all around us. Look at the news headlines and the experiences you or others in your organization have faced in recent years. Natural disasters and scarcities of raw materials have exacerbated volatility in supply chains, disrupted operations, and caused significant swings in input pricing. As one example, Honda had to weather a tripling of its raw material index between 2009 and 2012; was hit hard by the tsunami in Japan and floods in Thailand, causing a 59 percent profit drop; and has to deal with business-endangering materials scarcity, for example in some specific rare earths like lanthanum. External functional specialists—contract manufacturers and third-party logistics providers, to name just two categories—have proliferated, in both the developed and the emerging worlds, and they regularly deliver new levels of innovation and efficiency up and down the value chain. And yet increasingly stringent ethical, social, and governmental requirements mean that if those specialists have a slipup, it can spoil the brand image of the company whose procurement organization is sourcing from them.

The data further prove the point. Across all the companies listed in Standard & Poor’s 500 stock index, external spend as a fraction of total cost has increased by an average of 40 percent since 1970. Specifically, it has grown from roughly 60 percent of a company’s total expenditure in 1970 to an average of 85 percent in 2010. This is true across sectors as disparate as health care, industrials, banks, and energy. Looking at external spend as a fraction of total revenues reveals the same trend: an increase of more than 30 percent over the past 40 years.

In parallel with this increase of external spend, the employees of those companies have been expected to deliver more. In 1970, companies on the S&P 500 were realizing $40,000 in revenues per employee (RPE). That value has risen almost 22-fold, to roughly $900,000 per employee. Seems like a radical shift? Absolutely. And yet this radical shift is not a one-off occurrence—it is seen across both successful and trailing industries, and industry leaders and laggards alike. Take information technology (IT) industry giant Apple, which brought in roughly $1,700,000 in revenues per employee in 2011, despite hiring an astounding 30 percent more employees in just the previous year. While seemingly much higher than fellow player Hewlett-Packard (HP), at $360,000 RPE, HP’s RPE has increased a whopping 17-fold since 1970, showing the same focus on greater employee efficiencies. Dow Chemical Company, FMC Corporation, and DuPont, all diversified chemicals players, saw increases in RPE of from 16-fold to 29-fold. Even struggling industries, like automotive, saw companies like Ford bring in over $800,000 per employee, for a 24-fold increase.

The implication is clear: The ways in which the procurement function manages its external spending can confer enormous competitive advantage.

In fact, our research demonstrates that best-practice procurement consistently lowers costs, freeing funds for growth initiatives. Our seven-year Global Purchasing Excellence (GPE) survey of more than 700 companies, across every sector, found that, in total, the participating companies generate U.S. $84 billion in annual cost savings every year. GPE participants were divided into three groups—leaders, average performers, and followers—on the basis of their average overall performance across the criteria in the survey. The leaders not only generated higher cost savings from procurement—30 percent more than average performers—but they also performed better against a broader set of indicators, reducing their cost of goods sold four times faster and achieving higher overall returns from operations. The procurement followers have the highest potential for improvement: Catching up with the leaders would more than double their annual cost savings. The research also shows that opportunities for leveraging procurement exist in all industries—in fact, performance differences among companies in the same industry were much wider than differences among whole industries. Even in industries known for their weak procurement practices, such as financial institutions and utilities, we have found strong procurement leaders that stack up to the best automotive leaders.

The call to action is all too clear. CEOs must hold their chief procurement officers (CPOs) accountable on two levels. CEOs have to demand programs that, in short order, bring procurement practices much closer to those of today’s top performers, focusing on traditional levers to achieve significant cost savings and performance improvement. And they must look to their CPOs to successfully exploit the value offered by a growing external supply base, in the context of the opportunities and risks of the decade to come. The issue in both cases is timing—any transformation, and in particular a cross-functional transformation, takes time to achieve because each one requires a mind-set change by a broad set of employees.

And actions must be taken soon. For many companies, the world is changing uncomfortably fast. A few snapshots: Google—not long ago just a convenient web search-engine company—has taken technology to the next level by pioneering the driverless car, which has the potential to revolutionize the auto industry and transportation infrastructure. In 2011, Latin American and Eastern European companies opened more outsourcing facilities than were opened in India, capitalizing on the time zone and multilingual opportunities to service North American and European customers, respectively. The U.S. government debt has surpassed $16 trillion as public policy expands to provide wider social safety nets and universal health care. And the Libyan revolution sparked a mad dash for power over oil reserves, even though that nation accounts for only 2 percent of the world’s oil supplies.

As disparate as these occurrences might seem, they all have significant implications for how the field of procurement must evolve to lead—in an entrepreneurial spirit—in this new world. Are CEOs and CPOs discussing these implications? More important, are they ready for them?

This book is designed to help inform and enrich those conversations—and in some cases to initiate them. Here is a quick overview of each chapter and its purpose:

Chapter 1, “The Drivers of Sustainable Procurement Performance,” dives into the four key dimensions of procurement excellence we uncovered through our GPE survey. This is essential reading for CPOs who want to understand how their organizations stack up against these foundational elements and who welcome practical advice for how to close the gap with the best practices described.

Chapter 2, “The Megatrends That Impact Competitive Advantage,” showcases the five megatrends that will change the way business is done in the next decade. It draws heavily on research from the McKinsey Global Institute and our Strategy practice. This chapter should have a profound impact on how every senior executive thinks—not only about the company’s procurement function but also about its entire operations, sales and marketing, IT, and external-relations activities.

Chapters 3 through 7 form the heart of the book and constitute its second major part, “Responding to the Megatrends of the Next Decade.” Each provides a detailed exploration of the profound impact of one of the megatrends that will have a major impact on companies as a whole and on procurement in particular. Throughout, we provide strategies that business leaders can adopt in the face of these trends, together with practical advice about next steps and case examples for inspiration. Chapter 3, “The Great Global Rebalancing,” explores the implications of the rise of developing economies and especially how Western companies need to adapt by building a dynamic sourcing footprint. Chapter 4, “The Productivity Imperative,” illustrates how companies can create productivity gains by designing and orchestrating their business as an end-to-end value chain, consisting of internal and external parties. Chapter 5, “Big Data and the Global Grid,” highlights the opportunities presented by superior, data-driven decision making at the interface to a company’s supply base. Chapter 6, “Volatility as the New Normal,” explains how companies can translate sourcing risk into competitive advantage. And finally, Chapter 7, “The New Economic Drivers,” explores how sourcing decision-making processes will have to increasingly reflect environmental, social, and regulatory factors.

Our final part, “The Road Map to Procurement 20/20,” is designed to prepare your procurement organization for the changes that the preceding chapters have indicated are necessary. These chapters, “Getting Ready for Real Change” and “Your Agenda Now,” provide the framework and give practical advice for redefining your vision for procurement and implementing the required changes.

We cannot predict which chapters will resonate most with your executive team and your procurement organization; everyone’s situation is, of course, unique. But we do believe that the chapters’ collective contents add up to a message you cannot afford to ignore.

Part 1

From Good to Great Procurement

Chapter 1

The Drivers of Sustainable Procurement Performance

Does my procurement organization already employ best-in-class practices, sophisticated tools with the right talent, and the necessary formal and informal cross-functional linkages?

Some 50 to 90 percent of the companies that answer this question will respond “no.” On the one hand, this realization is a good indication of readiness for change and the acceptance that development is needed. On the other hand, though, these organizations should realize not only that they are missing an opportunity today but also that they will not have the basic building blocks in place to be ready for the challenges that the next decade will bring.

How do we know that the gap is so large? Over the past five years, McKinsey & Company has conducted more than 1,500 global procurement studies. And we have also examined more than 700 procurement organizations in detail and spent more than 2,000 hours interviewing chief procurement officers (CPOs) and their staff members. The result of this Global Purchasing Excellence (GPE) research is an in-depth examination of the links between procurement health and corporate performance.

The findings confirm that procurement pays: Companies with high-performing procurement functions consistently outperform their rivals on a range of financial indicators, and the best companies are building advanced talent-management strategies into the very heart of their procurement organizations.

So why is not everyone capturing the value at hand? Often, the reasons are quite trivial: lack of talent, overhead cost pressures, unclear governance, and insufficient systems and data. The research we conducted clearly shows that not paying attention to procurement is a significant lapse of judgment. While many reasons are indeed significant management challenges, the impact achieved with good procurement far outweighs the efforts needed to overcome them.

In this chapter, we discuss how procurement pays across all industries, and we detail the key drivers for procurement success.

Procurement Pays

High-performing procurement functions deliver huge value to their companies. This is the case regardless of industry. In addition to the U.S. $84 billion (cumulative) in yearly cost savings cited earlier, procurement leaders deliver superior returns from their operations, as well as lower cost of goods sold.

Our research confirms that every industry has its high performers in procurement. But we also find significant variations in performance among companies within an industry—much wider, in fact, than the performance differences between industries.

Of those companies surveyed in the energy and utilities industry, for example, only 11 percent were considered to be procurement leaders, delivering a GPE score greater than 3 (1 = low, 5 = high), while a whopping 40 percent were rated as procurement followers—that is, those whose performance was below the average for the total sample (see Exhibit 1.1). Even in the automotive and assembly industry, long considered a model of advanced procurement performance, only 51 percent were ranked as procurement leaders. It’s clear that there is plenty of room for improvement across all industries.

Our data on the spread of procurement performance across industries provide compelling evidence that an effective corporate procurement function generates significant and sustainable value. As one CEO we interviewed put it, echoing the views of many others, “The profit lies in purchasing now—and even more so in the future.”

The same GPE research points to four key dimensions that enable best-practice procurement organizations to stand apart:

1. Capabilities and culture—defined as the way that procurement professionals think, plan, conduct themselves in the workplace, and communicate, individually and collectively.

2. Category management and execution—that is, the procurement strategies and processes that the company follows in order to create value.

3. Structures and systems—meaning how the organization manages the procurement function’s resources through formal and informal structures and how the function interacts with other company functions.

4. Integration and alignment—defined as procurement’s alignment with and support of the overall business strategy.

The best procurement organizations excel along each of these four core dimensions. But it is essential to point out that one dimension in particular—capabilities and culture—is the key to driving procurement health and the strength of the bottom line. It correlates 1.5 to 2.2 times more strongly with the health of a company’s procurement function than does any other dimension.

At the same time, capabilities and culture have an important, two-way relationship with the other three dimensions: a procurement function needs the right talent to achieve its key objectives, but it also adopts an approach to each of the core dimensions that optimizes the use of that talent. Category management and execution are much more effective if executed by excellent people. Structure and systems cater to excellent people by creating leverage and exposure. And integration and alignment are much easier to achieve with outstanding talent than with mediocre personnel.

In one case, the CPO of a global logistics and transportation company set out to improve his procurement organization’s performance, focusing exclusively on talent for the first three years. He spent his time “recruiting the right people, developing the right skills, and building an appetite for real impact,” he recalled. “Everything else came a distant second.” The result? Double-digit percentage cost reductions in each of the following three years!

Capabilities and Culture—Recognizing Talent as the Key Asset in Procurement and Investing Accordingly

The most effective procurement practices make enormous demands on the people whose job it is to implement them. Of all those on procurement leaders’ staff, 40 percent are educated to the postgraduate level, compared with only 14 percent of those on the staff of companies rated as followers. But procurement leaders don’t look only for high educational attainment. They also look for attitude and ability, recognizing how much harder it is to change an employee’s hardwired attitudes than it is to develop function-specific capabilities. The best organizations select “supply entrepreneurs”—high-performing individuals who are ready and willing to take full ownership for their categories and to push boundaries as if they were spending their own money. These profiles are business-oriented and aligned with the requirements that were articulated by other business functions, such as sales and marketing and business development, several decades ago. The CPO of a global conglomerate summarized it this way: “I hire for attitude and train for skill.”

The training programs used by procurement leaders are both broader and deeper than those of the others. While nearly all companies in our research train their people in core procurement skills such as negotiation, the procurement leaders also offer training in more advanced skills such as sourcing-strategy development, advanced analytics, and the structured identification of category-specific improvement levers. Furthermore, they build more general business, leadership, and intercultural skills among their strategic procurement personnel.

That is just the start. Procurement leaders build on these training programs by building experience: They deliberately rotate staff both within procurement and across functions. For example, 70 percent of the procurement leaders run internal job-rotation programs (with the majority of program participants moving into higher-level positions), whereas only 29 percent of the average performers do so. In many cases, these rotation programs keep category managers in their positions for only three years and have them rotate to other functions after five or six years.

During their job-rotation programs, the leaders work hard to balance the outflow and inflow of talent by earmarking capable individuals to return to the purchasing functions. In this way, they avoid excessive brain drain. All in all, their efforts make procurement an important career stepping-stone.

Talented people are also rewarded for outstanding performance. The bonuses offered by procurement leaders are both higher and harder to get than those offered by followers. For example, high-level strategic procurement staff at leading procurement organizations have a maximum potential bonus of approximately 45 percent of their base salary, while at procurement’s average performers, the comparable figure is only 30 percent.

Category Management and Execution—Improving Effectiveness through Advanced Procurement Tools and Approaches

Category management is the fundamental driver of procurement value, and the best organizations ensure that their category management machinery is both powerful and effective. Power comes from high-caliber staff: Procurement leaders invest 29 strategic full-time equivalent (FTE) employees per U.S. $1 billion in spending, compared with just 17 FTEs at purchasing followers. The return on these investments is typically between 15 and 25 times the cost. (That is, they earn their salary by mid-January or, in dollar equivalents, there is a $20 million to $30 million impact created by 12 additional FTEs.) Purchasing leaders also extend the influence of the procurement function to ensure that more of the company’s overall spend is controlled by procurement. At procurement leaders, the average figure is 82 percent compared with 65 percent for procurement followers. The leaders are heavily involved in procurement of nontraditional categories such as marketing and capital expenditure.

Effectiveness is ensured through excellence in execution. Strong procurement organizations share an unflinching focus on process standardization, but they are careful not to let a dogmatic adherence to standards detract from performance. They develop standards for building a procurement function in which everyone works as one team, speaks the same business language, rotates freely among roles and categories, and measures success in common terms. But at the same time, staff members in these organizations have the freedom to adapt to the specific needs of particular categories, markets, and projects, tweaking or creating new standards to ensure that the most effective approaches are absorbed into the fabric of the organization.