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Avoiding pricing dangers
Don't let commodity-minded purchasing strip value
By Jeff Thull
SwitchCrafter makes electronic switches that are installed in the dashboards of semis. For years, its biggest customer has been TruckMaster, who bought these vital little parts for $6 apiece. One day, the purchasing department at TruckMaster decided perhaps $6 was too much, and decided to shop around. He found CopyCat Corp. sold a switch for $4. So he called up Fred, his loyal SwitchCrafter sales rep, and gave him the “opportunity” to match the price.
Not surprisingly, Fred hesitated. “I’m familiar with CopyCat’s switch,” he said. “It’s a fine part, but the lower price is due to the type of plastic used in the switch. It is not designed to withstand the cold temperatures your trucks operate in, which will lead to a higher failure rate.” But Joe dismissed his advice with a curt, “That may be, but my job is to reduce the cost of all our parts, and your competitor can save us $2 a pop. Are you willing to match his price or not?”
Fred could not. TruckMaster switched providers and, low and behold, the new components started to fail in the field. TruckMaster found itself sending out heavy-duty tow trucks, to the tune of $350 each time, to replace a $4 part. It doesn’t take a math genius to realize the $2 cost savings was eaten up quickly. So TruckMaster’s service/warranty repair people started voicing complaints—loudly—and SwitchCrafter started looking good again. Before long, Fred was back in business.
The above story is true. It happened to a client of mine, and it illustrates what can happen when an organization’s purchasing department is driven to achieve its goal (lower acquisition costs) with little or no regard for the value impact to other areas of the organization—a classic case of tripping over dollars to save pennies.
The point of this story is the truck manufacturer allowed purchasing to make a decision that the service/warranty department knew nothing about. The purchasing agent was doing his job, lowering acquisition costs, as mandated by upper management.
If purchasing departments are commodity-minded, unfortunate decisions will likely occur. In these cases, purchasing is a key culprit (though by no means the only one) in what I call “cross-functional dysfunction”—the phenomenon in which departments operate in conflict with each other.
I have two big concerns with today’s purchasing departments. Most obviously, purchasing is incented to save dollars of cost, a mandate that too often means dollars of value are lost. And the other problem—which is interconnected with the first one—is that purchasing often operates by obsolete and counter-productive rules.
I am speaking specifically of the “x number of bids required” or “create a level playing field” rules that pit vendors against each other with the intent to drive the price downward. It certainly does, but the net effect of creating a level playing field is that solutions at the high value side are systematically eliminated from consideration.
So what can organizations do to ensure purchasing is not undermining other departments by diluting value and ultimately bringing down profits? Here are some tips:
• Make sure procurement incentives do not overpower other functional interests.
In other words, purchasing should undertake a quality decision process that ensures a complete value impact is reviewed. A purchasing department should never be driven by the lowest common denominator of price. In far too many cases, such purchasing departments are generally not held accountable for the value a solution delivers in business performance terms.
A department that has to live with the outcome of a purchasing decision will almost always have a better grasp on the big picture and an eye on revenue as well as the bottom line. That’s why input from the actual users of the product is so critical.
Too often, centralized decision-making equals lack of accountability. We have a big manufacturing client that buys tons of resins every year. In the past, each local plant would buy the resins it needed from the vendors that best served it. But one day, the organization decided it was better to buy mass quantities, so it consolidated its purchasing at corporate headquarters.
At that point, the people in the plants, those familiar with the service of the resin vendors and the quality and applicability of their products, were taken out of the equation. All corporate cared about was—you guessed it—“how much is this resin per pound?” Purchasing was allowed to ignore individual problems at individual plants. This is not an unusual scenario. Purchasing ignored a documented $6 million value impact to capture a $600,000 cost savings.
• Exercise caution when buying raw materials.
If you are buying raw materials—for instance, a truckload of sand—the purchasing function may make sense. Sand is sand is sand. It would make sense to have vendors place bids and then go with the cheapest one. But as soon as you buy something for which there is a variant in quality or capability—say, consulting services, complex components, or software for a new database—that same process begins to lose effectiveness and to impinge on the value purchased from the supplier. It’s always a mistake to apply commodity purchasing processes to a value-added service, especially when support given by the vendor is a critical ingredient to success.
Think of it this way. What if you had the choice of a $10 haircut or a $50 haircut? Further, suppose that you are a politician, a profession in which appearance really counts. If the decision-maker were driven totally by price, he would certainly go with the $10 haircut. But in the long run, you, the politician with a very bad $10 haircut, would experience the voting impact of the negative image. Your career would fail. Absurd as it sounds, there is no difference between this scenario and the electronic switch scenario at the beginning of this article.
• End the “five bids” charade.
It may lower price but it also dilutes value. Somewhere along the line, organizations came to believe that in order to purchase properly they must get a certain number of bids and pit multiple vendors against each other. Many organizations do this even when they already know which vendor they want to use. By forcing their preferred vendor to compete with others, they believe they can drive the price downward. Sometimes it works. Usually, it backfires.
To compete with the lowest bidders, quality vendors must strip all the value out of their program and sell it as a skeleton, or leave the value in and sell it at a razor thin margin, or simply walk away. The best vendors won’t bother. I realize that, historically, the multiple bidding practice was a way to ensure an organization wouldn’t be overcharged by an unethical vendor. But like other well-intentioned plans, multiple bidding mandates have unforeseen consequences. We’ve now reached a point where organizations go through a charade that’s devoid of all common sense. And everyone loses.
• If it (a vendor relationship) isn’t broken, don’t fix it.
If you have a superb relationship with a vendor who understands your business, is well equipped to do the job, and has a successful track record with you, hang on tight. Don’t bid out your next project to someone who might be a few dollars cheaper, or worse, ask your vendor to match a competitor’s price. Not only do you risk losing a valuable business partner, you end up delaying projects and squandering your own time and resources, or force your valuable business resource to take out some of the value you require.
Strong vendor relationships are hard to find. If you’re paying a premium for someone’s services, chances are you should. There’s a common belief that if you buy from the same person all the time you’re being taken advantage of, but the truth is, they’re probably looking out for you. Think back to our original example of the truck switches. The manufacturer gained absolutely nothing from changing suppliers and, in fact, it cost them money. I see this all the time and it’s amazing to see so many organizations allowing commodity-minded approaches to undermine their organization’s success.
• Give your vendors the access they require.
Strong business relationships and the value-laden solutions that come from them don’t happen magically. They develop over time. And they cannot develop until you allow suppliers to diagnose your problems—problems that you probably don’t even know you have—and work closely with your team to develop solutions. That means you must allow vendors access to the inner workings of your organization and to knowledgeable people in the appropriate departments.
It’s amazing how many organizations allow vendors only a single point of contact. This is a major weakness in the purchasing process. Invite the vendor to diagnose the situation, allow access to all relevant parties, and design a solution that’s acceptable. If it makes good business sense, go ahead with it. Don’t bid it out in hopes of finding someone who can do it cheaper.
I will offer one caveat: if you have a vendor who doesn’t show you a thorough process for understanding your situation, who can’t speak in financial terms, who can’t show you a return on investment for his solution, don’t work with him.
In conclusion, strong buyer/supplier relationships are a two-way street. What looks like an incompetent purchasing department may actually be the result of incompetent salespeople on the vendor end.
Salespeople must do a better job of helping their customers understand the value of their solutions. If they are selling on price, purchasing agents can hardly be blamed for buying on price. The key is for you and your vendors to work together to discover where your processes and products are falling short and design solutions that optimize your business performance.
Your vendors should be a source of continual competitive advantage for you. By changing the way you buy from them, you open the door that lets that happen.
Jeff Thull is a leading-edge strategist and advisor for executive teams of major organizations worldwide. As president and CEO of Prime Resource Group, he has designed and implemented business transformation and professional development programs for organizations such as Shell Global Solutions, 3M, Microsoft, Intel, Citicorp, IBM, and Georgia-Pacific.
He is also the author of The Prime Solution: Close the Value Gap, Increase Margins, and Win the Complex Sale. He may be reached at support@primeresource.com, www.primeresource.com or (800) 876-0378.
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