It is pretty much a given that no other subject gets as much attention when two companies are entering, or extending, their business relationship as the effort to come up with a fair pricing structure. Getting to a fair price and pricing structure dominates the procurement field, and rightly so.
But for progressive procurement and sourcing professionals price is not just about "the price" and pitting buyers and sellers against either as they stare at each other across the negotiation table.
The conventional negotiation approach employs tradeoffs and concessions as tactics to get the best possible price, or from the supplier perspective, to preserve as much margin as possible. This is the typical I-win-you-lose struggle, where even the "winner" might not hold that position very long as economic conditions change and unforeseen events occur. It's really not a sustainable long-term strategy, and ultimately one that's more costly overall for the sake of a transitory short-term gain.
It's time to shift the mindset from "the price" to value; creating, sharing and expanding the value of the business relationship. The University of Tennessee and SIG's "Unpacking Best Value" white paper says progressive companies are challenging conventional approaches, realizing it is not how much they pay, but how much they get. And that in a nutshell is the Best Value mentality.
That's because 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.
Despite the fact that TCO and Best Value have become industry buzzwords, their implementation far from widespread. While it is widely understood that both terms fundamentally mean "more than just price," the fact remains that many companies have yet to embrace the two concepts in a way that shows they truly understand them, and how to use them to maximize value.
When companies determine the true cost and value equation under Best Value approaches, they know they are getting the best deal. That's why Best Value approaches, tools and methods - such as TCO - are gaining traction.
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 the value derived, not simply on cost. While a TCO analysis seeks to identify true and underlying costs, a Best Value assessment adds another dimension - various decision criteria that 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."1 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.
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 a 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 similarly - 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.2
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:
Procurement professionals should examine and weigh the best net value for the whole organization. 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 organization 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.
Identifying all of the true total costs is not so straightforward in many 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 percent of total costs. The Priceberg illustrates the importance of looking at the hidden costs:
As the Priceberg aptly shows, 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.
Ideally, Best Value is 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.
Simply put, it's not about bragging rights on how little you pay - it's about how much you get for what you are paying for.
1 Anderson & Narus, (2004); Business Market Management: Understanding, Creating, and Delivering Value, 2nd Edition, Pearson Education, Inc.
2 A. Jaconelli and J. Sheffield, “Best Value: Changing Roles and Activities for Human Resource Managers in Scottish Local Government,” International Journal of Public Sector Management 13, no. 7 (2000): 624.
Kate Vitasek is an author, educator and business consultant. She has been lauded by World Trade Magazine as one of the "Fabulous 50+1" most influential people impacting global commerce and is an international authority for leading the University of Tennessee's award-winning research efforts on the Vested sourcing business model for highly-collaborative relationships, Her practical and research-based advice for driving transformation and innovation through highly-collaborative and strategic partnerships is profiled in five books, including Vested Outsourcing: Five Rules That Will Transform Outsourcing, Vested: How P&G, McDonald's and Microsoft Are Redefining Winning in Business Relationships and Getting to We: Negotiating Agreements for Highly Collaborative Relationships. She can be reached at email@example.com.