Procurement departments should focus on value and risk, but instead they prioritize cost.
Value-for-money means buying the right solution from the right supplier at the right price.
A key criterion for figuring out the meaning of the word “right” involves understanding how the purchase enhances the buying firm’s competitive advantage, including an assessment of how the acquisition changes the buyer’s risk picture. How is the upside changed in different scenarios? What about the downside?
The “right price” means not leaving money on the table.
If a supplier sells the product profitably for $100 to other buyers (and he is the right supplier with the right solution), and the buyer ends up paying $120, we can say this is not the right price. The $20 difference is what economists call “rent,” paying above the level you need to pay.
As McKinsey writes, buyers need to transition from cost-based behavior to value-based behavior.
A value orientation considers opportunity costs. If I purchase one solution, it means that I am not purchasing one of the alternatives. What benefit from the alternative am I forgoing? How would my risk profile and my competitive advantage look in different scenarios with that solution?
Obtaining value-for-money does not mean buying the solution with the lowest up-front cost.
Total cost of ownership of the option with the lowest up-front cost may turn out to be higher than the alternative, or the lifetime impact on the firm’s competitive advantage could be small (or even negative).
For much of what we purchase today, game theory would describe the interaction between a buyer and a supplier as a repeated game where the payoff is value for each player.
Think of a SaaS service, for example. The supplier wants the customer to renew on an annual basis, ideally adding subscriptions when they do.
A good supplier wants to develop a long-lasting relationship with their clients. They want to sell the right solution to the right customer at the right price.
If the solution does not address the client’s needs or they can’t figure out how to use it, then they will not renew.
If a customer finds out that they have been overpaying relative to other buyers for the same solution, then they will not renew.
But, if the supplier has found someone who needs what she sells, who is effective at incorporating your solution, and for whom she charges a fair and reasonable price, then they are her customer for life.
She has created value for them, in enhancing their competitive advantage and shaping their risk profile to open up the upside and foreclose the downside, at least on the margin.
Bad suppliers will try to jam their solution on people who shouldn’t buy it or who don’t need it.
Bad suppliers will try to extract as much economic rent as possible, in part because they know there is going to come a point at which they will get pushed out.
What’s the old joke? “How much does it cost?” “How much do you have?”
One game is an infinite positive-sum game and the other is a finite zero-sum game. One buyer-supplier relationship is sustainable, while the other is doomed from inception.
Let’s assume that you have found the right solution with the right supplier.
How do you figure out what you should be paying? People today will use market research or they might use some sort of Wizard-of-Oz service to look behind a curtain and give them a precise answer of how much they overpaid based on proprietary data.
That is, buyers will outsource their judgment to those who have the data or claim to have the data.
Ironically, people will pay handsomely to outsource their judgement about cost.
Often, or perhaps for a subset of overall categories, people don’t have the budget to figure out if they are overpaying, even as they scour for cost savings.
The only way you can know if you’re leaving money on the table by paying more than what others are paying is to know directly what others are paying.
Assessing value-for-money is difficult because buyers lack the access to data they need.
So, instead of optimizing for competitive advantage, they minimize cost.
Instead of looking at a risk budget, they look at an expense budget.
This is dangerous. A recent McKinsey study showed that companies can expect to lose up to 45% of a year’s EBITDA every decade from disruption.
With the risk cost of supply chain decisions hidden (or at least ignored), the optimization of competitive advantage becomes distorted.
A blind obsession with cost minimization leads to concentrated purchasing to obtain volume discounts, offshoring to vulnerable locations in pursuit of labor or regulatory arbitrage, and contracts in which the buyer trades away various types of flexibility to lock-in reductions in price.
Admittedly, without data, it’s difficult to manage risk. How do you perform scenario analysis without data?
For example, let’s say you wanted to simulate your supply chain’s behavior if there were a virus that spread pandemically in Southeast Asia. How would you be able to gauge what happened without access to data from prior pandemics? The best you can do is make assumptions about how your suppliers would react and what the second-order and third-order effects might be.
You might as well be assuming the outcome if you do that.
In contrast, it’s easy to analyze your spending. They call it the Spend Cube, in which there are three dimensions to consider: the vertical category, the stakeholder, and the actual spending across suppliers.
For a buyer, spend analysis, generally, means collecting, cleansing, preprocessing, and performing descriptive analysis of their purchasing history. Done well, it delivers transparency and insight into where the money is being spent.
For a buyer, cost minimization means picking the most efficient means of delivering their good or service, assuming perfect certainty as to the environment.
A single-minded cost minimization approach implicitly assumes that there is no cost to complexity because it first assumes no negative shocks with potentially devastating cascading consequences.
Contrast that with risk management: identifying, quantifying, and understanding the impact of different scenarios in a world of many potential paths.
A good risk manager will be able to distinguish between these different paths, assess their likelihood and their costs, and shape the firm’s production profile to handle them in a way that is optimized for the firm’s tolerance for risk.
Spend analysis is a necessary subset of risk management. You can’t manage risk if you don’t know where and how you’re taking risk currently.
Spend analysis is necessary but not sufficient to managing risk.
If we have learned anything from the Covid-19 crisis, it is that we can no longer afford to assume an idyll that permits us to build Rube Goldberg supply chains of complexity and inflexibility in exchange for apparently lower costs.
Instead of the spend cube, buyers need to think about risk hyper-cubes that incorporate the spend cube, augmenting thems with information about supplier performance, contract flexibility, purchasing concentration, etc.
EdgeworthBox is a platform that brings features from financial markets to sourcing, sitting as a complementary layer in the procurement technology stack for both buyers and suppliers. These include central clearing of vendor administration for efficient supplier engagement, central clearing of data for more informed decisions, and social networking that connects buyers to other buyers, suppliers to suppliers, and buyers to suppliers.
Buyers and suppliers can see data from public sources and, privately, from their own history, in a structured, searchable format. Buyers can get valuable market information directly from others in the marketplace.
Let’s talk.
