Lowest Cost Doesn't Always Equal Lowest Price

Sales and procurement professionals should realize that this economy requires a focus on total cost of ownership rather than price.

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Jeff Weiss is an adjunct professor of business administration at Dartmouth's Tuck School of Business and a partner at Vantage Partners, LLC.

Buyers are looking to reduce costs, and suppliers are looking to improve margins. It feels like this is one negotiation that will end with a winner and a loser, and, of course, that is the inevitable result in many situations. However, in this case, negotiations that could have been mutually beneficial often become zero sum because of the assumptions procurement and sales organizations make and the resulting strategies they choose to employ. Given the current state of the economy, this might be precisely the time to shake this up.

Of the hundreds of these negotiations in which my colleagues and I get to participate and observe in any given year, the one commonality we witness is that they have become all about price. Procurement accuses sellers of inflated margins, pricing that is out of whack with their competitors, and value pricing products that have no value added. Sales views buyers as having a singular focus on reducing price, being rewarded based on price concessions, and using competitive bids as a hammer for all situations. 

[See a collection of political cartoons on the economy.]

Sellers start high. Buyers start low. In the end, they reach some kind of agreement at a given price and volume (unless one or both parties walk away), and each often reports feeling like they wish they had gotten more, like something was left on the table. If the seller feels like he lost, he vows to get back at the buyer when he goes to sell his next new product during the time when there is no competitive alternative. If the buyer feels like she lost, she vows to make it up on the next purchase from the seller (or perhaps when she no longer needs this seller and can buy from someone else). While this might sound like an overly simplified description, many senior sales and procurement executives share that even when there are lots of meetings, reams of data, occasional threats, and even some creative proposals thrown into the mix, in the end, it looks at lot like this.

But does it need to be this way? More often than not, the answer is no. But, success hinges on changing the focus of the conversation—from one about price to one about total cost, or what is often called, "total cost of ownership." Procurement demands, "Get your price down, or I will go to your competition who is offering to sell this piece of equipment to me for 20 percent less" (let's imagine for $400 per unit versus $500 per unit). Sales comes back stressing that its features and functions are better, and yet Procurement keeps hammering on price. But what if sales could persuasively demonstrate to procurement that the product it is selling lasts twice as long, has three times as much output, is consistently in stock, can be transported at half the cost of moving around the competitor's product, costs less to service, involves much less expensive training to operate, and is manufactured in a region not prone to the kinds of natural disasters that their competitor's production facilities regularly face? Or even just a few of these things. Suddenly, while its price might be 20 percent more than its competition, the total cost (including the $100 difference in price) of its product to the customer is actually a good bit less.  

[See Photos of iPhone 5: Customers Line Up for Apple's Newest Product.]

But it takes two to tango. Both sales and procurement need to take a different approach.

To successfully effect this shift, sellers must:

  1. Abandon the following assumptions: The sale must be zero sum, the buyer will focus on nothing but price no matter what I do, and my best bet is to highlight the particular features and functions of my product that make it the best. Plain and simple, the seller will never be able to "change the game" if they hold on to these assumptions.
  2. Put five times more emphasis on preparing for conversations and negotiations with the customer than on engaging in the conversations or negotiations. Sellers need to put the time in to evaluate (from multiple angles) their customer's total cost of ownership for their product, and, as best they can, do the same for their competitors' products. If they cannot do this on their own, they should engage the customer in doing this analysis with them, or even in simply helping their customer do it on their own. How well is a particular medical device reimbursed compared to the competition's? How much does it save by preventing costly readmissions due to complications? How much less training is required? How much less is it to transport or stock? How much less time or manpower does is it take to implant? How much less money needs to be spent on drugs or other devices that must be used today, or used in combination with competitors' current products, to have the same effect? These are not new concepts and they are not new questions. However, far more often than not, sellers do not have the data or a way to specifically and persuasively demonstrate the true overall cost to the customer. When pressed, many sales executives will readily admit that their companies will hire 10 more salespeople, put in place new incentive programs, or even try to adjust the product itself before they will set aside three people to take the time to do the analysis, build the case, and develop the sales aids that will allow their people to clearly and persuasively demonstrate the real win for the customer.
  3. Be disciplined and persistent in the negotiation. It is incumbent upon the seller to bring the buyer back to the data, and to help them define the components of, and assess the overall dollar value of their cost of, owning the product. Walk the buyer through the analysis. Let them challenge it, and rebuild it with them. Actively put forward new ideas (terms, conditions, production methods, shipping vehicles, simplifications to coding and tracking, etc.) for how to reduce their cost even more. Do not let the buyer trump you with price. Remind them that this is only one factor in their overall cost, and arm them with the information they need to go back into their organization to make the argument that while your price is higher than the competition's, the total cost of owning your product is, in fact, lower. Of course, if you can't do this and do this well, then expect that they will understandably threaten with the competition and press for a price reduction.
  4. Focus not just on the sale and negotiation, but also on managing the ongoing relationship with the customer. The conversation described above is best initiated in between sales cycles. During this time, make the case for a focus on total cost of ownership, and develop the case with the buyer for why this is a better for both of you. Educate the buyer on what your company is doing to affect total cost of ownership, and have them educate you on what their costs are (related to your product) and how you might help reduce them. Best case, you'll prove yourself to be a true partner and set yourself up for the next sale. Worst case, you will at least cause your customer to consider a broader array of buying criteria for the next sale, and you'll be the company best positioned to respond to it. Most importantly, when pursued with constructive persistence, you will begin to change the myopic focus on price.
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    To successfully effect this shift, buyers must:

    1. Abandon the following assumptions: My job is to get the best price possible; the best way to compare products is the easiest way (price to price); and I will always do better to keep information about our costs and risks and core concerns from suppliers. Of course, the buyer should not throw caution to the wind and lay it all out for the supplier. However, if they share some core concerns or objectives about costs and risks, the seller might actually be able to do something to help. As well, sharing at least some core information with a supplier or two might allow buyers to shake up the assumption that those who sell to them could never possibly understand (or perhaps care to understand) the complexities of their business.
    2. Change your negotiators' instructions. Buyers are often measured, and even incented, based on concessions achieved from initial bid or on year to year price reductions. While price reduction is an easy measure, it may not be the one most helpful to a company's bottom line. Consider altering the instructions given to individual buyers, tasking them to reduce the overall cost of the product (or category of products) which they are responsible for procuring. Most companies have sophisticated, talented buyers. Have them use their smarts and skills to define the key components of cost for any given product, gather the appropriate data from suppliers, engage in the analysis (and any testing that might inform the analysis) with suppliers, and propose new terms and ideas to suppliers that might additionally reduce the cost of the product. Pushing for price concessions can be helpful too, but overall measurements and incentives should be changed to reflect how much total cost reduction the buyer has achieved.
    3. Demand the data. It is time to get sellers into a different mindset. Buyers need to let sellers know that they expect to hear about more than just price. RFIs and RFQs should explore total cost, asking the supplier to provide information on the various dimensions of the buyer's cost of ownership. Buyers should also consider sharing at least basic information about areas of expense or potential expense. Perhaps they are building redundancy, stockpiling supply, or paying for insurance to manage the risk of not having enough product when needed. Perhaps they are experiencing costs (invisible to the seller) in one or more processes (e.g., manufacturing, testing, delivery, customer service) in which they use the seller's product. Perhaps, once they buy it, they are doing something to the product that adds to its cost, but they have never shared this with their suppliers. In any of these situations, it is possible that the seller might have no idea what to do with this information, or might find a way to leverage it against the buyer. It is even more possible that the seller might be able to find a way to modify the product, how it is supplied, the training around it, the support provided with it, its development roadmap, or the key contractual terms generally associated with it in order to help the buyer reduce its costs. Is this more work for the buyer? Absolutely. However, if you leave the discussion focused solely on best price, you might reduce your cost a bit, but you are also likely to miss real opportunities to reduce it substantially and to work with the provider who can best help you to do so.
    4. Consider a "joint innovation session" with key suppliers. In this session, take price off the table, and jointly with key suppliers look for outside the box ways to help you reduce your cost of owning their product. To make it even more interesting, consider asking key suppliers what you are doing to increase their costs of development, manufacturing, sales, delivery, and service, and see if there might be ways you can help them reduce their costs, and as a result, their price. Having conducted many of these sessions over the years, my partners and I never cease to be amazed by the often simple (and sometimes very complex) ways buyers and suppliers are able to identify to reduce buyer cost and seller price, once they are willing to talk about the full array of (not the amounts, but the many drivers of) costs of ownership and costs of sales.
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      In the end, this requires a real shift in thinking, interaction, and analysis. It takes more work, and a basic belief that working together will yield better results. That said, it does not require a huge leap of faith. Crunch the numbers and see if it makes a difference. Just ensure you crunch all of the numbers.

      While examining total cost of ownership is not a new idea, it is certainly not a widely applied practice. In current economic times—when there is all the more need for both buyer and seller to thrive, and when there are many opportunities for each to do so at no expense to the other—perhaps it is time to shift beyond the easy conversation of best price, to a real conversation about lowest cost.

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