It is likely that no other subject gets as much attention when two companies are entering, or extending, their outsourcing business relationship as the effort to come up with a fair pricing structure. Money is money after all, and money talks. You know the drill by now: the conventional procurement process pits buyers and sellers on opposite sides of the table – and there’s no way around it, right? Wrong!
The classical and conventional approach to negotiating employs tradeoffs and concessions as tactics to get the best possible price – or preserve as much precious margin as possible from the supplier perspective. It comes down to the typical I-win-you-lose struggle, a zero-sum game, where even the “winner” might not stay that way for very long. It’s really not a sustainable long-term strategy, and one that’s more costly overall for the sake of a transitory short-term gain.
It’s time to shift the mindset from price to value – creating, sharing and expanding the value of the business relationship. The University of Tennessee and Sourcing Interests Group’s “Unpacking Best Value” white paper says progressive companies are challenging conventional approaches, realising it is not how much they pay, but how much they get. That’s the Best Value mentality.
Best Value takes procurement professionals out of the price-only focus so that they understand the total cost of the deal or enterprise at hand. This is called total cost of ownership, or TCO. Best Value and TCO go hand-in-hand, and when understood and implemented properly, pricing becomes value-based and becomes a win-win.
Best Value and TCO are not new concepts, but unfortunately, their use is not very widespread. They’ve become industry buzzwords that signify “more than just price,” but many companies either don’t fully understand these concepts, or if they do, don’t know how to embrace and implement them. They lack the proper buzz!
So what follows is a short introduction to using value-based approaches for procuring goods and services.
Price vs. Best Value
As stated earlier, it’s not about how little you pay: it’s about how much you get. In a nutshell, that is the basic difference and tension between price and value.
Best Value approaches become the bridge that spans that tension because determining the true cost and value equation translates into confidence that companies are getting the best deal.
But what usually happens is that businesses go for immediate gratification through low bids and price reductions. Best Value? That’s too long-term, too complicated, too nuanced and involves too many departments. Companies consider it simpler to just default to the “lowest price” approach as a matter of corporate policy, and for some transactions, such as buying a commodity or one-off deals, that may be the way to go. But even then there can be pitfalls that are hidden by underlying and unrevealed cost structures.
Sticking solely with low-bid contracts does not necessarily generate savings. Ever hear of cost and time overruns? Sure you have! They crop up regularly in low-bid contracts; there is little motivation for the contractor to innovate or reduce expenses because that might hit its bottom line. And many organisations with low-bid policies in place will often fail to do the due diligence needed to scrutinise what has actually gone into the bid “price.” They fail to determine the total costs of ownership or do a Best Value analysis: they are blinded by that low number on the page. Like the Titanic, companies that don’t see what is below the surface can sail to disaster.
TCO and Best Value
Best Value approaches, tools and methods – such as TCO – are gaining traction. Even government agencies that traditionally relied on competitively bid “lowest price” policies have started to deploy Best Value concepts.
In 2001, the state of Minnesota enacted a law that put discretion into the bidding process. The Minnesota Department of Transportation then used the new law to select the contractor to build the I-35 St. Anthony Falls bridge replacement after its collapse in 2009. Why? It enabled the agency to balance cost, quality, incentives and timeliness as the key factors in choosing the contractors that would do the bridge construction. The result? It selected the contractor with the highest price, but the overall Best Value. It became one of the most successful bridge construction projects in history, erected in a staggeringly short time period of time (less than 18 months), and it eventually won dozens of awards.
While the concepts of Best Value and TCO are closely related, Best Value goes a step further than TCO: it compares alternative solutions based on value derived not simply on cost. While a TCO analysis seeks to identify true and underlying costs, a Best Value assessment adds decision criteria to include intangibles, such as market opportunities, social responsibility, responsiveness, and flexibility.
The general consensus is that TCO is the “sum of purchase price plus all expenses incurred during the productive lifecycle of a product, minus its salvage or resale price.” This is a useful, but somewhat static “cradle to grave” approach for defining TCO; for instance, current thought is to encourage suppliers to capture their total costs including risk factors.
By its very name, TCO is mainly concerned with the cost side, but its real power lies in the way it provides the foundation for making Best Value sourcing decisions. The advantage of using the TCO model is that businesses can make clear, informed decisions when it comes to price and value. Determining the value side of that equation is where the Best Value analysis enters the picture.
An easy way to explain the Best Value concept is through a simple example, such as picking a restaurant for lunch. There are many reasons why someone might pick one restaurant over another eatery. Factors in the decision might include distance, service levels and type of cuisine, atmosphere, ratings and price. Depending on the situation, different restaurants will come into play. A great choice for a business lunch with a client might not be the same choice an individual might make for a quick bite to eat between meetings or in order to get back to the office to finish working on a report.
Determining Best Value for a product or service works in the same way: it is about picking the best option that fits the need. The options go well beyond costs. The researchers Jaconelli and Sheffield describe the intent of Best Value as enabling a balance between cost and quality considerations, while ensuring ongoing value for money and promoting continuous improvement to further value for money.
Think of Best Value as an equation that balances the decision criteria when choosing from alternatives. A simple calculation provides a visual representation of how to calculate Best Value: Best Value = Optimum Benefit (sum of criteria as defined by the buyer) – Buyer’s Total Costs
In the case of the I-35 bridge replacement project referred to earlier, six criteria were identified by the Minnesota Department of Transportation:
a. Provide a safe project area for workers, the traveling public, community, environment and emergency services during the execution of the Project.
b. Provide a solution consistent with Mn/DOT design and construction standards.
c. Provide a solution adaptable to the recovery efforts of the collapsed bridge
a. Implement a quality management system that ensures the requirements of the Project will be met or exceeded and ensure public confidence.
b. Reduce future maintenance costs by providing a high-quality project.
a. Complete construction by December of 2008.
a. Provide a quality product with minimal impacts to the environment while using context-sensitive solutions.
a. Implement innovative solutions to maximise the return on taxpayer investment by reducing costs and improving quality of the transportation system.
a. Utilise visual quality techniques and context sensitive design to incorporate the bridge into the surrounding environment.
MnDOT ultimately created a “Best Value Formula” that would become the litmus test for selecting the winning bidder, with the contract award going to the contractor with the lowest adjusted bid representing the Best Value for MnDOT – not the lowest price. The formula comprised a technical score, the number of days to complete the project, and the contract bid price. The results? The highest price supplier actually had the best value! The ultimate result was the right supplier for the right job. The contractor – Flatiron Manson – completed the bridge rebuild in 15 months (three months ahead of schedule for a project typically taking five years) and under budget! The bridge received more than a dozen architectural, construction, and other awards and saved the state hundreds of millions of dollars.
Transparency: The Foundation for TCO
Procurement professionals should examine and weigh the best net value for the whole organisation. Unfortunately, sometimes outdated ideas such as “that’s not what I am measured on” or “that’s someone else problem” can creep in. It is important for management to reaffirm on a continuous basis that shareholders care about the best net long-term decision — not on saving a little this quarter while costing another function a lot more. A transparent, boundary-spanning approach is necessary when doing TCO analysis and Best Value assessments.
Documenting the entire picture by capturing the costs of the buyer and the supplier is the only way to get to the actual total costs. This includes all cross-departmental costs within the buyer’s organisation as well.
A cost model is a key component for any strong sourcing process and helps buyers identify areas for improvement. It also helps to establish the groundwork for a good pricing model, since each has different variables that might influence the outcome. If done effectively, a cost model analysis will result in recommendations that can be built into action plans designed to take costs out of the supply chain. Cost modeling can also be used to develop performance measures in contracts and can help monitor the effectiveness of contract incentives.
Think of cost modelling as a tool to:
- Identify opportunities
- Set baseline areas for negotiations
- Analyse whether process improvements are grounded in logic or emotion
- Help the parties think about Total Cost.
Be aware that cost modelling is not the only item to consider when considering a supplier. It is not a “product”, nor is it a way to judge performance or an answer to all questions.
Components of a Cost Model
A baseline TCO analysis includes the costs under current conditions as well as projections based on a set assumptions. The preferred approach is always transparency, where the total costs to own a product or use a service over time is factored into the price. Some of the most common items to include in a TCO analysis include:
- Design and development costs
- Hard costs (e.g. labour and assets)
- Operating costs (e.g. energy and maintenance costs)
- Soft costs (e.g. overhead, “corporate allocations”, training)
- Installation and Commissioning costs
- Governance costs (e.g. cost to manage the relationship)
- Software costs
- Supply chain support costs
- Retirement, disposal costs or residual value
- Opportunity costs, including reduced downtime, increased production yield, or sales value or increased sales or margin for developing a better product
- Transaction costs, including cost of switching suppliers and costs associated with a competitive bid and contracting process
- Environmental or sustainability costs or savings
Identifying all of the true total costs is not so straightforward in many, if not most cases, and it is often not easy. Drilling down to the hidden or below-the-surface costs is a vital exercise because those hidden costs can comprise about 80 per-cent of total costs.
As the Priceberg aptly underscores, transparency and honesty are paramount when it comes to uncovering hidden costs. Understanding only the price – the number above the waterline – is like seeing only the tip of the iceberg. Eventually the parties in the deal will get that sinking feeling, because what is out of sight can cause the greatest damage. Numerous studies have found that the initial purchase price can often be the smallest component of a company’s costs. For example, in industrial equipment (such as pumps, fans, or gearboxes) an Accenture Consulting report found that the purchase price represents only 12 per cent of an equipment company’s total cost.
The best way to capture the all of the TCO components is a high degree of transparency that exposes the hidden costs of all the parties – both those within a company and with the supplier. It might be difficult to capture all internal costs, but it’s virtually impossible to capture costs without transparency with the supplier.
Using an “open-book” approach with suppliers allows both parties to build a fact-based discussion around actual costs. Bottom line: by understanding true costs, the companies can shift their focus from negotiating simply on price to a discussion on how best they can work collaboratively to eliminate non-value added activities, duplicative efforts and risks that drive up costs. It’s a pricing mentality that emphasises value.
Suppliers can feel very exposed when sharing costs, and rightfully so. If a supplier reveals total costs, it is easy for the buyer to determine the supplier’s profit – which makes many suppliers uncomfortable. The company could use the information to attack the supplier’s margins, which in turn reduces their profitability. Buyers that attack a supplier’s margins often find suppliers are good at hiding the real costs, which results in a virtual shell game as the supplier shifts costs around in an effort to maintain target margins. Best Value gets lost in the shuffle, as does trust and transparency.
Smart buyers will work collaboratively with suppliers to drive efficiencies and reduce non-value added work rather than focus on margin reduction as a quick win for a price concession.
For example, transparency is enhanced when the parties understand the business at hand; a Statement of Intent will describe margin targets and what a company will do with the TCO assessment; and by jointly creating and end-to-end process map.
Choosing the path of transparency will enable a much higher shared understanding of the actual TCO. Transparency, while strongly favoured in establishing accurate total costs, may not be feasible for some company cultures. Therefore, the only way to get close to a true TCO is for buyers and suppliers to share as much information as possible. Over time, as companies get more trusting, they can then revisit and refine the pricing model as they learn more.
Once a company has developed the total cost model, the procurement focus should go to making the supplier selection based on Best Value. As stated earlier, TCO and Best Value should go hand-in-hand. However, many companies do not use Best Value principles for procuring goods and services. For those that do apply Best Value principles, a common trap is to focus solely on reducing costs and risk.
Best Value should be about quantifying the total value created; including viewing how suppliers can help the buyer increase revenues, reduce risk, reduce working capital or fixed capital investment, or any other value-adding activity that positively impacts the company’s profitability. For this reason buyers and suppliers should adopt a “pricing model” philosophy – instead of a “price” philosophy – that turns on what is fair.
It’s not easy to establish a pricing model that fosters a win-win relationship because there is no magic wand, generic template or spreadsheet for the right pricing “answer”. Establishing the right pricing and incentive mix can be complicated and technical.
But buyers and suppliers do not have to be rocket scientists to recognize the benefits of fair pricing models that reward for value creation. The good news is that developing a pricing model is not a guessing game. Rather, it is a process that parties go through together with the goal to create value. They develop a Best Value wide-angle lens, and put aside the price-only microscope.
It’s OK for companies to demand more value from their suppliers, but at the same time they must realise that suppliers need to be fairly compensated for their investments, ideas, and innovations that are at the heart of creating value.
With transparency, collaboration and an atmosphere of growing trust, which is the Vested model, a proper pricing mentality and the Best Value for the long-term viability of the enterprise will fall into place.
This article originally appeared in Outsource magazine Issue #34 Winter 2013.