How to Conduct a Spend Analysis: Methodology in Detail
Conducting a spend analysis is an essential cost saving component in any business, but is especially important for manufacturing.
We can’t fully comprehend where our cost saving opportunities are until we understand how we are spending our money today.
Experienced sourcing managers using a spend analysis to meet product cost reduction goals typically achieve savings of 3-5% of the spend analyzed. For optimum savings, we recommend you conduct your spend analysis continuously, working through each manufacturing process to identify outliers, analyze those outliers and execute on cost reduction plans.
In this post we explore what a spend analysis is in manufacturing and the steps of this methodology in detail.
What is a spend analysis in manufacturing?
A spend analysis is defined as the process of collecting, cleansing, classifying and analyzing expenditure data with the purpose of decreasing procurement costs, improving efficiency, and monitoring controls and compliance.
In manufacturing, a spend analysis refers to the process used to analyze the many things that you buy and narrow them down to only those components for which you have the opportunity to renegotiate costs with your supplier or redesign products to save money.
As a sourcing manager, the primary driver for conducting a spend analysis is to meet your cost reduction goals. A spend analysis helps you achieve those goals by identifying cost outliers – the most promising parts on which to focus your cost reduction efforts.
After conducting a manufacturing spend analysis you should be able to identify:
- The specific parts for which you may be overpaying for and an estimate of how much
- Products that could be redesigned for cost reduction
- Items which are not being made in the most cost effective manner, i.e., via the most cost-effective routing or process
- Which suppliers may be a better fit for the parts that you are buying
The Manufacturing Spend Analysis Methodology
When conducting a spend analysis, we recommend the following methodology, which has three phases consisting of seven main steps.
Phase 1: Outlier Identification
A standard product cost outlier is a part for which the price difference between what your product cost management platform estimates it should cost and what you pay is between 25% to 40%. Identifying these products is the core of phase 1 of the manufacturing spend analysis.
1. How to Determine Spend Analysis Scope
You likely have thousands of parts that you buy and simply cannot examine all of them at once. That’s why it’s important to be able to narrow down the scope of what you’re going to analyze.
- Start by segmenting your spend into manufacturing process groups such as sheet metal or casting parts and then segment by material. You may not be able to find out what material your parts are made out of until you look at the actual 2D drawings or PDFs but if you can, segment by material at this stage.
- Next, you want to go to your ERP system and get the current price that you’re paying for the part and the estimated volume that you buy for the part. Multiply the two to figure out how much you spend on each one of these parts.EQUATION: Current Price of Part x Estimated Volume of Part = Product Spend
- After that, you can add the total product spends to a Pareto chart containing all of the parts that you have selected to analyze. Once your parts are in your chart, select the top fifty, one hundred, or two hundred parts to analyze. It’s up to you where you make the cut-off, but you want to prioritize based on the highest annual spend.
Here is an example of a Pareto chart that showcases this theory:
The cutoff in this chart shows the top 100 products by total product cost.
2. Gather Important Data
Once you have narrowed the scope down to your top 50-100 parts, begin to obtain the data for these parts. Data to gather includes:
- 3D models
- 2D drawings, usually in PDF format, which may contain data not found on the model (such as material type or secondary processes required, and tight tolerances)
- The actual or estimated annual production volume for each part
- And the estimated batch size. If you don’t have the batch size, then use the order size from your ERP system
If you were not able to segment by material type when determining your scope, having gathered the 2D drawings, you may now be able to do so.
PRO TIP: You also want to collect the current cost or quote for later comparison, the manufacturing process used to make the part today (if known), and the name of the supplier making the part. You will need to know which supplier is making the part if you want to do some extended trend analysis later.
In addition, you will want to know the location where you’re buying the part. When you generate the estimated cost, you want to make sure that you don’t compare the cost of a part that you buy in China to an estimated cost of making that part in the United States, for example.
3. Estimate Should Costs and Identify Outliers
At this point, you’ve determined your scope of review and gathered your important data pieces.
The next step, and one of the most critical, is to estimate the costs of your one hundred parts. You can do this with whatever tool you have available. Whether that is a set of complex spreadsheets or sophisticated manufacturing cost estimating software, such as aPriori.
PRO TIP: Save time on your estimates! A Product Cost Management platform is a highly intelligent manufacturing costing software that uses both global and highly-localized product cost inputs to help businesses estimate the should cost of their products. And it does so at a fraction of the time of custom spreadsheets.
Once you have estimated the cost of your parts, you will be able to identify the outliers by conducting a should-cost analysis. A should-cost analysis is an exercise in comparing your should-cost estimate to what you’re actually paying and then identifying parts where the gap is significant.
Across all industries, a standard product cost outlier is a part for which the price difference between what your product cost management platform estimates it should cost and what you pay is between 25% to 40%.
However, your outlier percentage may be different. I recommend that you calculate the annual potential savings (potential savings multiplied by annual volume) per part and make your prioritization based on that figure.
Phase 2: Outlier Analysis
The next phase involves reviewing the outliers you have identified and beginning to select those where you have cost saving and negotiating opportunity.
4. Review Initial Outliers
After identifying your initial outliers, which may be 20 – 25 out of your original scope of about one hundred parts, you want to re-review the estimate for each part to ensure you have accurately forecasted the product cost.
This is an important step because you don’t want to move forward with the next steps if the data that you have is not valid.
If the gap is significant, meaning the estimate is 3 – 4x lower than what your paying, this is an especially critical step. Are you including the cost of shipping? Spend time reviewing your selected materials, volumes, manufacturing processes, etc.
5. Analyze your Outliers and Make a Plan
After confirming the estimates were calculated correctly, analyze your remaining outliers in detail to determine the best possible method for cost savings and develop an action plan for each of them.
There are two key areas of outlier analysis: Redesign and Renegotiation.
Identifying Candidates for Redesign
To identify candidates that may be a good fit for a redesign for cost savings, first plot the estimated cost of each part divided by its weight. Why use weight? Because heavier parts often have the greatest redesign or cost saving potential.
EQUATION: Estimated Cost / Product Weight = X
Weight may be obtained from your cost estimating software, the CAD system if density is available to it, or the estimated shipping weight from your ERP.
Plot these points on a scatter plot.
You may notice that your scatter plot aligns into a straight line. Identify the parts for which the ratio of weight to estimated cost is very high relative to the rest.
This is an indication that the part is complex or has high tolerance requirements.
As you plot, be sure to prioritize candidates for supplier discussion, based on the highest annual spend or greatest savings opportunity. Learn more about how to frame your supplier collaboration here.
Identifying Candidates for Renegotiation
If the difference between your current cost and your estimated cost is significant, say 20% or more, then a discussion, regarding how the supplier arrived at that price is in order.
Key areas where you may see cost negotiation opportunity are:
- Material costs
- Tooling costs
- Manufacturing routing techniques
- Supply base
Develop a list of questions which can be used for supplier negotiation/collaboration. For tips on collaborating with your supplier using fact-based negotiation, read this article.
Phase 3: Cost Reduction
6. Take Action
Once you have finished your analysis of the outliers it’s time to do something about it.
For Redesign Opportunity:
Take the part that you want to redesign – or want to explore a redesign of – and go to engineering to discuss redesign and cost-saving potential. Alternatively, you can talk to your suppliers to see if the part can be redesigned to better fit with the manufacturing process.
PRO TIP: I will tell you from personal experience, if you go to your suppliers and simply ask them for ideas on how to save money on all the parts they make for you, you may get general suggestions that are very seldom worth pursuing. However, if you do the work to run an informed spend analysis and then go to your supplier and say – Hey, I have one or two parts that I think there is an opportunity for us to collaborate on to make it cheaper – they will be very happy to look at those one or two parts in detail and give you targeted suggestions for reducing costs. This has been a worthwhile exercise for many of our customers.
For Renegotiation Opportunity:
If the part is simply too expensive, you have to develop a plan for how to approach the supplier based on the data from the analysis and then renegotiate the expensive costs with the supplier. There may be opportunities to save in areas like expensive premiums or tooling even if the product can’t be redesigned to save.
7. Validate Your Savings
Finally, you want to validate your savings. See if what you estimated as potential savings (the difference between your should-cost estimate and what you were actually paying) was actually realized, and how much was realized.
Does this really work? Yes, it does.
As an example, we worked with a $6.5B manufacturer and supplier of commercial trucks, parts, and diesel engines. They wanted to accelerate achievement of annual cost reduction goals. We analyzed 7.7 million Euros in spend across 86 sheet metal parts. Seventeen of the 86 parts turned out to be outliers.
At the end of the exercise, the manufacturer had confirmed savings of 1.6 million euros, which was 20% of the spend analyzed.
Guide to Should Cost Analysis & Negotiation
Negotiate based on facts, not feelings. In this guide, we show you how to calculate should costs in minutes. Conduct more effective negotiations and build collaborative long-term relationships.Read the Guide