Scott Sparks, Deputy Chief Executive Officer and Senior Vice President of Client Services for Proxima, discussed cost externalization, and how it impacts a chief financial officer in today’s highly competitive corporate world.
[Scott Robbin]: Proxima’s global study on the externalization of the modern company’s cost base has recently been the focus of media coverage in publications like The Wall Street Journal, CFO.com and The Sunday Times in London. Why the intense global interest in this topic? Can you tell us what this is all about?
[Scott Sparks]: By analyzing the spending patterns of almost 2,000 large organizations across North America, Europe, the UK and Asia, we found that, on average, 70% of an organization’s revenues are used to buy goods and services from suppliers, while only 12% are focused on in-house labor … and the trend toward externalization of business functions is accelerating over time.
The study shows that the cost base and operating model of global businesses has changed dramatically. This has ultimately been caused by three unstoppable forces: specialization, globalization and technology. These forces have made it increasingly advantageous to transfer large portions of companies’ value delivery chains to specialized third parties.
The fundamental nature of what a ‘company’ is has been transformed. Modern corporations are largely externalizing their cost base for everything from marketing and advertising, to transportation and logistics, to IT infrastructure and customer contact call centers. What was once a paycheck is now a supplier invoice.
Now all of this gets very interesting when you consider the implications for CFOs and their need to adapt the management model as they seek improved business performance, cost control and closer management of risk, reputation and quality. New approaches are required to manage beyond the office walls of the 12% (company employees) and into the organizations of hundreds or thousands of suppliers.
With this ‘externalization’ occurring globally what does it mean for the corporations of tomorrow? How do these factors impact global businesses?
The externalization of the cost base is a trend that has continued over the last 3 years. We found through the study that revenues have increased 31%, EBITDA has increased 35% and revenue per employee has increased 18%, but the number of employees has only increased 11%.
These trends suggest that the increase in revenues and underlying profitability have been made possible – not by more employees – but by a greater use of suppliers.
This trend of Corporate Virtualization is set to continue. Suppliers now form a critical part of today’s businesses. This has implications for business management in terms of profitability, governance, innovation and risk management. Traditional management practices have become outdated and are not effective in aligning suppliers with corporate objectives.
The worry for business leaders is that if they continue to neglect the strategic aspects of their supplier base, or fail to maximize its value, they risk missing out on significant levers for developing a competitive advantage and delivering long-term shareholder value.
“For many companies where third-party costs dwarf in-house costs, supplier relationships start to define the success of the business. There is a huge opportunity for businesses to redefine the operations around this reality, and the impact can be profound.”
You discuss this trend of Corporate Virtualization and how this trend is impacting global businesses, but when did this shift in behavior occur and what’s been driving it?
In the 1970s, the world began to change profoundly – with three very powerful forces driving economic change: the technology revolution, specialization and globalization. Together, they contributed to a dramatic gearshift, comparable in its power and scale, to the Industrial Revolution. This shift has brought about larger productivity gains, more complex business practices and waves of disruptive innovation, much faster than experienced before this time.
These three forces have been aided by a series of independent factors – and together they explain why it has become so advantageous for companies to transfer large portions of their value chains to specialized suppliers
1) Currency liberalization
From the early 1970s onwards, with the collapse of the Bretton Woods Agreement, it became easier to access international goods and services.
2) Open trade
The falling trade barriers between countries have also contributed to easier buying of goods and services from abroad.
3) The Internet
Above and beyond transparency of pricing, the Internet has made it easier to find new suppliers and access new customers and markets.
4) Better shipping logistics and travel
It is now possible to get products and people to places not commercially possible before.
Growth of third-party providers offering highly customized or niche solutions. These providers are often more agile, innovative, provide more expertise and can offer a lower-cost solution (compared to building it in-house) as a result of their focus on a particular area of specialization.
6) Accounting pressures
The use of third parties is sometimes encouraged because it enables businesses to remove fixed labor costs from their income statements and substitute variable third-party costs.
7) Risk and HR pressures
The risks associated with having an internal function, together with the HR consequences of managing the function, can make a third-party supplier a more attractive proposition
8) Labor cost differentials across borders
As international trade becomes easier to transact, lower labor costs have become a catalyst for change in all areas of business
Collectively, these factors make the world more global, better connected, more accessible and provide more choice at lower costs. The decision to ‘make’ or ‘buy’ has increasingly been filled by ‘buy.’
“Change behaviors to create a leaner, fitter, stronger business. Instead of merely aiming to extract every last penny from suppliers, business leaders should be directing time and effort into managing their network of suppliers more effectively, tapping into the respective strengths to get the best value.”
So what are the opportunities for global business leaders who understand and adjust for this corporate virtualization trend, and just how big is the opportunity?
Our experience, and this research, tells us that managing cost and business performance across this extended enterprise requires a fundamentally different approach to conventional supplier management techniques. We see that for many companies where third-party costs dwarf in-house costs, and supplier relationships start to define the success of the business. There is a huge opportunity for businesses to redefine the operations around this reality, and the impact can be profound.
First, there’s a boost to profitability. In most cases, we find that the cost reduction potential alone is large enough to have a material impact on shareholder value and company financial performance. For our clients, measurable shareholder value improvement on the order of several hundred million dollars is typical.
If the organizations in the study reduced their labor costs by 1%, they could improve EBITDA, on average, by 0.7%. Conversely, if the organizations reduced their non-labor costs by the same 1%, they could improve EBITDA by 4.1% – six times higher than the labor equivalent.
But it goes much deeper than this. Supplier activities become more closely aligned with your operational and strategic aims. You get enhanced visibility and greater control over your cost base, supplier-led innovation flows deliberately back into the business and risks that sit within this large external supply base are reduced.
What are the implications for business leaders who fail to recognize the importance of the opportunities you outline?
Before we dive into the implications, it’s interesting to note how poorly recognized the externalization trend is by senior business leaders. A key question asked to the C-suite level interviewees as part of our study, was what percentage of their revenue they thought was attributable to supplier costs. Only one executive estimated the number to be greater than 40% – and remember that the actual number is 70%! All other interviewees estimated the percentage to be less. All 44 expressed surprise to hear that the average labor cost is just 12.5% of revenue.
Now, to answer your question, we have talked about how an overwhelming majority of operating activities for most companies are now occurring outside the business; often in extended supply chains, with little transparency. As a result, there are several areas of business management – not just raw cost – that are materially affected:
Corporate governance and risk
- Also, they need to re-evaluate where their business risks lie
Innovation and intellectual property
- Sources of innovation have been shifted externally and
- There’s a need for clarity over intellectual property
- Suppliers are one of the main engines of income
- Cutting headcount has limited effects and
- Headcount cuts can diminish agility and productivity
There are new sources of value to explore
- Collaboration creates value.
In short, change behaviors to create a leaner, fitter, stronger business. Instead of merely aiming to extract every last penny from suppliers, business leaders should be directing time and effort into managing their network of suppliers more effectively, tapping into the respective strengths to get the best value. The role of finance and procurement shifts from overseeing a cost-focused mechanical sourcing process to understanding internal stakeholders’ real business issues, and then aligning the power of the vast supply market to address these business issues. It’s time to recognize the growing role and positive impact suppliers can have on profitability and shared success.
The research has suggested that a new business practice is needed for today’s globalized economy. Uncertain and volatile markets make agility and change inevitable and important. Many business leaders have ambitions to improve profitability by reducing costs. But as the research has shown us, they could also be reshaping supplier relationships, aligning their supply chain with a more progressive strategy and securing a competitive advantage. What are a few actions business leaders can take away today?
The new realities that we have seen in the most successful companies are:
- Supply base management is treated as a strategic issue
- Suppliers are managed in the same way that internal areas of the company are managed
- Suppliers are viewed as an asset rather than simply as a cost
- Taking a long-term perspective pays rich dividends
- A focus on cultural change is essential
Business functions inside the company need support to manage the cost base commercially, influence and change behaviors, ways of working and business rules and execute sourcing and supplier management in a very different way.
The rewards are there to be reaped for those willing to embrace the changing nature of business and think differently about how supplier costs are managed.
Scott is responsible for Proxima’s North American business where he works closely with U.S. based organizations helping them to improve their cost management and business performance. Before joining Proxima, Scott was a Senior Partner in Accenture’s Business Consulting Practice. He was with Accenture for 12 years’ and held several leadership positions in the firm’s Supply Chain and Business Strategy Practices. Prior to that, he was with A.T. Kearney. His work at these firms included partnering with Fortune 500 companies to drive substantial improvements in financial performance and market value through restructuring internal costs and supplier relationships, assessing merger and acquisition opportunities, integrating company operations post-merger, and optimising global supply chain operations.