Addressable Spend in Procurement - Why It Matters

It is difficult to find a Finance Director who has not participated in a budget review that had some issues with data. Non-budget purchases. Purchase invoices that do not fit into the PO process. Supplier payments that cannot be linked to an established contract. The money has been paid but to whom and for what reason? These questions have no answer.

This is the issue of visibility that procurement faces. But this is not a problem because someone does not know what should be done here. This is the reality of the organisation's operations decentralised departments, scattered information systems, and purchasing made quickly and by professionals who are responsible for other things.

Addressable spend in procurement refers to the portion of an organisation's total expenditure that procurement can realistically influence, negotiate, and control.  Some of the spending  electricity costs or fees simply falls out of the addressable area. But a lot of expenses that can be influenced by procurement remain unaddressed in most organisations.

It means that the opportunity for savings disappears. Non-conformities become commonplace. Relations with suppliers start deteriorating.

This post explains why understanding your addressable spend is critical to making procurement transformation successful.

What is addressable spend in procurement?

Addressable spend represents that fraction of the company’s total spending that procurement has the mandate, insight, and practical capability to impact, via discussions with suppliers, consolidation of contracts, strategic sourcing decisions, or even enforcement of policies.

Total spend vs. Addressable spend - What's the difference?

What is an example of addressable spend?

Example 1: Manufacturing company

Let us examine a manufacturing organization with annual expenditures totaling ?500 crore. Out of which approximately ?150 crore is accounted for by salaries, statutory charges, and utility payments these are all expenditures that are either fixed, regulated, or not negotiable and thus not within the ambit of procurement’s purview at all.
?350 crore is the spend on raw materials, packaging, logistics, software subscription, plant maintenance, travel, and professional service providers. In other words, the addressable universe comprises of expenditure areas where procurement can interact with suppliers, negotiate terms, consolidate suppliers and enforce policy.

Now out of ?350 crore expenditure above mentioned, approximately ?200 crore is being managed via contracts and approved sourcing channels while the rest of ?150 crore is being spent via departmental expenditures without any participation from procurement function at all.

Example 2: Big IT services company

Let us now take the case of an IT services company which spends ?800 crore every year. While a lot of the expenses towards salary payments, employee benefits, and compliance costs are completely out of the ambit of procurement, the rest which consists of the licensing of software, cloud services, procurement of hardware, hiring of external contractors, and renting of office spaces is entirely within the domain of procurement.

The trouble here is that the software licenses are being extended independently by each team, contractor engagement by each project manager who does not involve procurement in it, and the hardware purchased from different vendors and at different prices. All of these expenses which fall into procurement are losing their potential simply because they have never been considered as such by the organization.

Why Addressable spend in Procurement Matters

1. More Savings to Be Realized

In almost all organizations, there is untapped savings potential that is lying dormant simply because the spend hasn’t been mapped out. Once procurement identifies the scope of their spend universe, it will be able to recognize opportunities for consolidation, renegotiation of unfavorable terms, and cutting down redundant suppliers from the list. This will yield definite cost savings that procurement can track and attribute to their process. The cycle becomes increasingly focused and efficient as procurement cycles are repeated.

2. Greater influence on procurement

When procurement activities take place without the ability to see spending, they are simple to overlook. Realising and showcasing the potential addressable spending in procurement within an organisation, showing how much is uncontrolled at present, makes the case for wider participation more compelling. Influence grows out of visibility. The more that can be spent through procurement, the more strategic the procurement process becomes. When procurement uses figures that mean something to the board, they become a strategic partner in resource allocation.

3. Better spend visibility

It is difficult to control something if you cannot see it. The addressable approach to spend analysis requires an all encompassing perspective on how the company spends money across different divisions, geographical locations, and supplier relations. Additionally, the use of addressable spend analysis generates one source of truth about the company's spending that enables more precise decision-making processes for procurement and finance teams.

4. Improved compliance and risk management

Lack of control over spend results in non-compliance. By defining what addressable spend is within procurement activities, it is easier to implement a consistent strategy when it comes to compliance, whereby any purchase from an unauthorized supplier, absence of purchase order information on invoices, and payment for services to an unauthorized vendor will be identified. This helps to improve audit-readiness and minimize risks. In regulated environments, such spend control measures are standard.

The hidden cost of low addressable spend

Common Challenges Organizations Face

1. Decentralized buying

If buying decisions are decentralized among different departments without centralized supervision, control is lost even before the process of procurement starts. The departments buy things independently, work with unauthorized suppliers, bargain with weak negotiating power and pay more than the actual cost of the product/services which could have been bundled. Each of the decentralized purchasing done outside the purview of procurement represents manageable spend which gets out of reach without being managed. It is difficult to do any analysis of spend due to such buying practices.

2. Manual procurement processes

The inefficiency associated with manual processes is not the only issue, however. Manual procurement processes also tend to make it difficult to audit the entire process since there will be no clear audit trail, no matter how often you check your emails and phone logs. Expenses will be harder to track, which means that they cannot be categorized and analyzed. In short, a lot of potential for savings could slip away under a manual procurement process.

3. The problem of poor spend visibility

A lack of consolidation in terms of viewing all organisational spending prevents procurement from differentiating between what is managed and what is not. Spending remains siloed by business unit, cost centre, geography, and other dimensions and once reported, it is too late to take action. Poor spend visibility is one of the main drivers behind poor addressable spend, as well as being a problem in its own right. The issue must be tackled through an overhaul of the spend visibility process itself.

4. Separate isolated systems

A typical company uses its own isolated systems for procurement, finance, and operations which are not able to communicate with one another. The information stored in an ERP system does not correlate with the information available in the AP system. Meanwhile, the data available in the sourcing system does not reflect what is actually getting billed. In other words, the lack of connection between these three systems opens up opportunities for uncontrolled maverick spending.

How companies can increase their addressable spend in Procurement

1. Centralise procurement process

The very first step that has to be taken in order to increase addressable spend in procurement is centralization. If procurement process is standardized throughout all the departments, it will become predictable, as each purchase follows a certain course of actions, which is easy to control. The role of procurement governance practices here would be to specify the criteria for who to buy, from whom, and under what circumstances. Otherwise, the spending will remain uncontrolled whatever the sourcing strategy may be.

2. Enhance spend visibility

Classification of spend with accuracy is the difference between procurement teams who react versus those who plan. By classifying spend such as by type, vendor, department, and cost centre trends are revealed that would otherwise remain undiscovered. Aggregating spend information through the integration of purchasing information from various sources provides an even more insightful approach for procurement in terms of seeing the entire picture of spend.

3. Limit Maverick Spending

Maverick spending will cut into the addressable universe in a quiet and consistent way. Procurement policies help prevent maverick spends from taking place by eliminating their ability before they ever occur rather than dealing with the problem after the fact. Programs that promote preferred suppliers create the easiest and most compliant route for stakeholders in finding their desired vendor.

4. Expand procurement contracts

The majority of spend is from suppliers who have never received any contractual agreement through the procurement process. The more relationships procurement can manage under contractual obligations with clear terms and conditions, the more managed spend there will be. It is vital that these contractual relationships are managed properly through the procurement process in alignment with the needs of the organization.

5. Automate Procurement Workflows

It is manual processes that create a lack of visibility in spend management. Through automated procurement workflows, spend tracking will not only be more accurate, but an audit trail will be generated throughout the process. Automated purchase requisition controls allow for better visibility by ensuring all purchases are categorized and routed through the proper process before approval. Automation in supplier onboarding also means that new suppliers become part of the system faster.

6. Mobilize Cross-Departmental Stakeholders

Raising addressable spend levels in procurement cannot be accomplished by the procurement department alone. The finance department will need to agree on spending limits and budgets. Operations will have to use the company’s sourcing policies while purchasing goods and services. IT will have an important job in terms of ensuring the integration of the systems and the flow of the information. All business departments within the organization will need to know why procurement policies are in place and how much it will cost the company if these policies are ignored.

Measuring addressable spend key metrics procurement teams should track

1. Addressable Spend Percentage

The very first metric deals with the question of what percentage of total organisational spending is affected by procurement operations. To find out, one needs to divide the addressable spend number by the total spend and get the answer in percentage form. The lower this percentage, the greater is the number of expenditures that are classified as either unallocated, decentralized, or outside of procurement’s scope. That is where opportunities come into play for increasing influence and capturing savings.

2. Spend under management

This is the metric measuring the amount of spending covered by procurement operations, including through contracts and supplier relationships. This is the best indicator of procurement influence on the organization as a whole. While a high addressable spend percentage is of little value if most of the money spent is not managed by procurement operations.

3. Contract Compliance Rate

Well-negotiated contracts are meaningless if there isn’t any contract compliance. The contract compliance rate evaluates the ratio between the purchases executed based on existing contracts and the number of off-contract purchases. A low contract compliance rate is the direct evidence of maverick purchasing and can demonstrate issues related to poor policy execution or supplier programme availability. It is the quickest way to make addressable spend more efficient.

4. Supplier Consolidation Ratio

Scattered supplier databases represent a considerable source of expenses and an issue of visibility in itself. Supplier consolidation ratio measures how procurement is able to decrease the total number of suppliers within various spend categories. It also shows that procurement achieves its position of strength when it starts dealing with less vendors, which means that procurement processes become simpler for the company to manage.

5. Savings Realization Rate

Identified savings and realized savings do not mean the same. The ratio of actual savings achieved by implementation of the savings procurement negotiates compared to procurement expenditure is measured here. There will be a big difference between identified savings and realized savings if contract adherence, compliance, or change in demand occurs after the completion of procurement exercise.

6. Coverage within Spend Categories

There is no one indicator that can give complete insights into addressable spend in procurement. It means that category coverage becomes important. This ratio determines how many spend categories have active participation of procurement and how many of those spend categories do not have any procurement intervention either formally or informally.

How procurement software improves addressable spend procurement

1. Automation in Spend Classification

Classification of spends manually is not only time-consuming but is highly error-prone as well, with all such errors making those spends virtually invisible to procurement teams. Modern procurement software does away with this limitation as it categorises each and every spend automatically according to the categories, suppliers, and the cost centres involved in the transactions. Consequently, the outcome is an organised spend data that is actionable for procurement operations. Automating the process at the time of purchase increases the addressable universe by ensuring there are no missed classifications at all.

2. Visibility of Spend Data from Multiple Sources

Visibility of spend data remains a key challenge for those companies with operations in more than one geography or different business units and legal entities. Procurement tool combines all the spend data available within the organisation, bringing together the information in one place where procurement teams can easily monitor what is being spent and where. It is this visibility that makes it possible for procurement teams to make effective decisions.

3. Supplier Consolidation Insight

The majority of companies typically underestimate their number of suppliers. There are many redundant suppliers that work within the same category offering similar services for the same price range. The procurement application allows you to find those redundancies within your supplier data with the help of analytics which will indicate fragmentation of your spend among the number of vendors and possible consolidation. It gives procurement teams good justifications for cutting back on suppliers.

4. Strategic Sourcing Benefits

Sourcing is always about spending. To be strategic about it, one should gather information about spending history, supplier capabilities, and prices as well as category risks. With the help of procurement applications, you receive all necessary data for organizing strategic sourcing processes and conducting competitive tenders in accordance with predefined standards. Instead of responding to sourcing initiatives, the team may come up with a sourcing strategy based on solid spend analysis data.

Best practices for managing addressable spend effectively

1. Develop a comprehensive spend taxonomy

The spend taxonomy refers to the structure within which each spend gets classified according to its appropriate category. In its absence, spend data will be inconsistent, historical comparisons meaningless, and sourcing decisions poorly informed. The existence of an effective spend taxonomy guarantees that every transaction will be tagged appropriately at the point of entry, enabling spend analysis to be performed more quickly and reliably. The process of developing a taxonomy also fosters alignment within the organisation, providing procurement, finance, and different departments with a uniform vocabulary for all cost categories.

2. Standardize supplier relationships

A supplier relationship not documented and maintained properly is a supplier relationship procurement cannot manage. Standardizing supplier management practices in terms of onboarding, assessment, and maintenance means that every supplier within the ecosystem is brought to the same minimum levels of performance and compliance. This practice also helps procurement determine which suppliers should be considered candidates for consolidation.

3. Perform regular spend analysis

Spend analysis is never a one-time event. Markets change, consumer behavior changes, and new types of spending occur over time as companies mature. Performing regular spend analysis ensures that the purchasing organization’s perception of its addressable universe is current exposing emerging areas of unmanaged spending before they become significant, and confirming that any savings achieved from past cycles have been sustained. Organizations that approach spend analysis as an ongoing activity instead of something done periodically are always more prepared to capitalize on potential opportunities.

4. Create alignment between the procurement and finance departments

For spend analysis to be effective, the procurement department needs to work hand-in-hand with the finance department. The finance department handles budgets and expenditures, whereas the procurement department manages how those budget funds are spent. Through collaboration between these departments, the entire company will achieve a single view of spending, which neither department could do independently. By working together, decisions are made faster and sourcing cycles are shortened.

5. Continuous monitoring of procurement performance

Procurement performance is never constant; nor is the addressable spend base. With continuous monitoring, using tools such as scorecards, dashboards, and supplier performance reviews, the gains realized via procurement activities can be sustained through time. Moreover, this will generate accountability in the sense that the team gets to know in real-time what is happening in relation to its addressable spend, contract performance, and savings realization. It is through this process that organizations will excel in addressing their addressable spend.

Conclusion

Addressable spend isn't an accounting metric it's a mindset. The companies that articulate it clearly, measure it effectively, and apply it strategically will be the ones that derive the greatest benefit from their purchasing activities. The others will simply be leaving savings on the table, failing to achieve full compliance, and basing sourcing decisions on incomplete information.

Visibility that is the starting point. The procurement department can only affect what it can see, and for many firms, there exists a considerable amount of expenditure that doesn't fit into those criteria at all. The key lies in not only having the intention to change that state of affairs but also the means to do so.

It is technology that enables this scalability. Procurement software, through automated spend classification, real-time dashboards, supplier analytics, and sourcing capabilities, creates the infrastructure for expanding the addressable universe in a systematic manner. The months that used to pass with analysis can now be reduced to real-time results, allowing procurement to react much quicker.

The last take-home point is simple: higher addressable spend in procurement will mean increased number of categories to manage, increased number of contracts that will ensure compliance and value, increased supplier relationships that will provide even more benefits. Procurement will be able to understand the needs of the finance department and earn the respect of different business units, as well as achieve success in terms of ROI. Spend visibility is not the end result it is just the first step.