How Amalgamated Widget Determined Its Benefits Stream

By Ray Trotta  |  Posted 11-19-2002

In hopes of detailing some of the financial inputs to the case study on Amalgamated Widget, presented in CIO Insight's November 2002 Whiteboard, we looked at how the company determined the benefits stream it was hoping to reap.

The story begins when Amalgamated, in hopes of boosting profitability, and thus shareholder value, brought in Mega Integration, a systems integration vendor, to do a study of how Amalgamated could realize savings by increasing its buying power in procurement, on which the company spends about $225 million annually.

The Mega study identified $70 million in savings annually that could be achieved through four sources of benefits from an e-procurement system: strategic sourcing, driving buyers to contract suppliers, process streamlining, and future volume discounts.

Amalgamated's CFO, very conservative by nature, was skeptical: The savings looked too good to be true. As a traditional manufacturing company without a great deal of experience in deploying large IT projects, Amalgamated's management wasn't sure it could successfully implement such a system, and it was generally averse to taking risks even when the alleged rewards were so high.

So the company's management team engaged Consolidated Consulting to scrutinize Mega's estimates. In doing so, Amalgamated and Consolidated agreed to three key directives: An independent and objective point of view had to be maintained, the cost savings estimates had to be substantiated by evidence, and alternate solutions that could achieve savings at lower risk had to be explored.

When Consolidated and the management team looked more deeply at the benefits to determine which required the technology, they found that only one of the benefit sources was directly attributable to the new e-procurement system. Here's a run-down of their analysis:

  1. Strategic sourcing could be accomplished by simply pooling spending (buying in bulk) and putting these bulk purchasing contracts out to vendors to bid. This effort only required a team of five staffers for 90 days and a Microsoft Access database; a large-scale systems implementation was not needed.

  2. Since Amalgamated has a decentralized management style, the odds of driving a significant number of its employees to buy from suppliers mandated by Amalgamated's management were remote, at best. This benefit probably would not be realized at all.

  3. Amalgamated prides itself on process simplification. Their cost of cutting a check to a vendor was already below the industry benchmark. The new IT system would actually add to the cost of the purchasing process, not reduce it.

  4. This left the benefit of generating volume discounts—the ability to negotiate future discounts on spending. The system would help Amalgamated know what they were spending with suppliers on a companywide basis, thus helping them negotiate better deals based on higher volumes.

    This narrowed the benefit pool derived from the new IT initiative from the original vendor estimate of $70 million per year to $10 million (see Table 1).

    Table 1

    Area
    Percentage
    of Total
    Savings
    Estimated
    Savings
    Summary
    Analysis
    Use e-procurement
    Strategic Sourcing
    55%
    $40 million Requires no more than small team effort with minimal technology investment
    No
    Driving Buyers to Contract Suppliers
    15%
    $10 million High resistance to change would limit real benefit
    No
    Process Streamlining
    15%
    $10 million Would not ultimately lower costs
    No
    Future Volume Discounts
    15%
    $10 million Best use of e-procurement
    Yes
    Total
    100%
    $70 million  

    Actually getting the $10 million benefit from potential future volume discounts is a function of two things: the amount of spending that can be put through the system, and the adoption rate of the system. Getting the spending through the system depends on how the system is rolled out.

    The team felt that the percentage of spending that could be put through the system would increase gradually over four years, starting at 17 percent in the first year and rising to 100 percent by the fourth. Discounts could not be realized until the second year because Amalgamated would need to collect a year's worth of spending information to negotiate effectively with vendors.

    And the adoption rate? Adoption depends, of course, on how many internal users use the system for purchasing and how many suppliers are willing to sell goods on the system.

    The actual adoption was expected to be gradual, for two reasons: Internal users would have to move from vendors they have been doing business with for years, while suppliers may not be willing to make the investment to link their technology to the e-procurement system just when they're being forced to cut their prices to keep doing business with Amalgamated.

    How realistic is that estimated annual benefit of $10 million? Not very, it turns out. Given the pace of the system's rollout to Amalgamated's numerous locations, Amalgamated estimated that only $7 million in spending would be put through the system in year three. And just because you build it doesn't mean the users will buy.

    Consolidated cut that $7 million in half because research with other companies showed how tough it is to get people to use the technology. The result: $3.5 million, a far cry from the $10 million initially forecasted (see table 2).

    Table 2

    Year 3 Estimates  
    Future Volume Discounts $10 million
    Spending Put through System $7.0 million
    Adoption Rate Adjustment of 50% $3.5 million

    This case has been greatly simplified in order to illustrate the basic calculations. There are many additional considerations in getting the greatest value from a technology initiative. For example, management should examine making process changes without a systems implementation.

    In addition the Amalgamated analysis was done without considering value generated by the system after year four or the terminal value of an initiative, both of which could be substantial.

    For details on process changes, see "Reengineering without Systems Development". To understand more about what is involved in a full analysis of a technology initiative, see the TCI case study at www.ivalueinstitute.com.