The Return on Investment (ROI) of procurement is a key metric used to determine the profitability and cost-effectiveness of the money spent on operating a procurement function. It measures the financial return generated by procurement activities relative to their cost.
One widely accepted measure for calculating Procurement ROI is:
Procurement ROI = Annual cost savings / Annual procurement cost
This formula directly reflects how much financial value (in terms of savings) is created for every dollar invested in the procurement department.
Understanding the Procurement ROI Formula
Let's break down the components of the formula:
- Annual Cost Savings: This represents the total financial savings achieved by the procurement function within a year. These savings can come from various activities such as:
- Negotiating better prices with suppliers.
- Finding alternative, lower-cost suppliers.
- Improving purchasing processes to reduce transaction costs.
- Reducing waste or optimizing inventory levels.
- Annual Procurement Cost: This includes all the expenses associated with running the procurement department for a year. Common costs include:
- Salaries and benefits for procurement staff.
- Costs of procurement technology and software.
- Expenses related to sourcing events and supplier management.
- Overhead costs allocated to the procurement function.
Example:
If a procurement department achieves $5,000,000 in annual cost savings and its annual operating cost is $500,000, the Procurement ROI would be calculated as:
ROI = $5,000,000 / $500,000 = 10
This result is often expressed as a percentage (multiplying by 100), meaning the ROI is 1000%. This indicates that for every dollar invested in procurement, $10 in cost savings was generated.
Procurement Value Beyond Cost Savings
While cost savings are a crucial element captured by the basic ROI formula, procurement value delivery is more than just cost savings. A successful procurement function contributes to the organization in numerous other ways that may not be directly reflected in this simple calculation. These include:
- Risk Management: Ensuring supplier reliability, mitigating supply chain disruptions, and complying with regulations.
- Quality Improvement: Sourcing high-quality goods and services that meet organizational standards.
- Supplier Relationship Management: Building strong relationships that can lead to innovation, better terms, and reliable supply.
- Efficiency Gains: Streamlining purchasing processes, reducing cycle times, and improving operational efficiency.
- Innovation: Collaborating with suppliers to drive product or process innovation.
- Sustainability: Promoting ethical sourcing and environmental responsibility within the supply chain.
Therefore, while the cost-savings-based ROI provides a vital financial perspective, a comprehensive view of procurement's value requires considering these broader contributions as well.
