The conventional wisdom about procurement is that cost savings are the fundamental priority. One sees this emphasis all the time. Here is Procurement Magazine referring to the 2023 Hackett Group survey:
“Procurement’s main priorities for the year include ensuring supply continuity, combatting inflationary pressures and reducing spend cost.”
Who could argue with the importance of cost savings?
Just because cost savings are vital, however, doesn’t mean that they should be the sole factor driving the purchasing decision: what and from whom to buy, and what price to pay. Where is it written that cost is the paramount factor?
The only reason to justify purchasing on price alone (or price predominantly) is if there is no differentiation between the goods or services being offered in competitive proposals.
Imagine that you are in charge of buying a commodity, such as one thousand pounds of a specific grade of copper. Each bidder is offering exactly the same type and amount of what you want. So, of course, price in this case is the sole determining factor. The buyer should do everything they can to make the process appear as competitive as possible to keep the suppliers on their toes when it comes to price. (For all the lip service to cost savings, how many people when purchasing commodities manage to do even that much?)
How often is the modern B2B buyer purchasing a commodity? How often do they get to make the decision by themselves instead of having to develop a consensus across a committee of relevant stakeholders?
The truth is that companies engaged in strategic sourcing need to review multiple proposals characterized by significant differentiation. It’s more like apples-to-electric cars than it is an apples-to-apples comparison.
An academic approach to the problem might be to perform a discounted cash flow analysis accounting for not only the present value cash outflow of the consideration for the thing being purchased, but also the cash inflows of the margin improvement over the life of the project from adopting the solution in question.
Overweighting cost (or, worse, making cost the sole driver of the decision) means ignoring these subsequent positive cash flows.
Even if we assume that the buyer is evaluating the true cost, it may still be the wrong thing to do because doing so ignores the purchase’s impact on margin.
Consider two solutions: A and B. A was a piece of industrial machinery that cost $100k upfront. B sold a different piece of industrial machinery that cost $120k upfront.
This seems like a simple decision for many. Obviously A.
What if I told you that A created a $5k monthly improvement in margins for a 3-year life and B led to a $12k monthly improvement for a 5-year life? We would say that B has a better problem-solution fit than A.
That’s a different calculation, isn’t it?
When we talk about opportunity costs of picking A over B, we refer to the incremental $7k per month in margin benefit that the buyer foregoes.
Then, we should layer on the dimension of supplier risk. What if company A is a less risky company? Say, it’s been around for decades and has a fortress-like balance sheet while B is a venture-backed growth company that has not generated positive free cash flow in any quarter of its existence?
Shouldn’t we discount B’s margin improvement more heavily?
We should. But how many do?
How many buyers understand the correct, multi-dimensional balance between upfront acquisition cost, lifetime opportunity cost, and supplier risk? A buyer who was focused on multi-dimensional risk in this way would want to ensure (at least) two things. First, they would want to see as many competitive proposals as possible. Second, they would want to make it as easy as possible to understand supplier risk, as quickly as possible.
What’s more likely to lead to discovery of the best problem-solution fit, a reverse auction with three proposals or one with ten proposals? Clearly, the more proposals the buyer can see, the better.
What’s more likely to lead to a reverse auction with ten proposals, one in which the buyer invites only suppliers with which they have a pre-existing relationship or one open to any vendor with a relevant solution? Is it one with a difficult supplier user experience or one with a simple supplier user experience? Logically, inviting multiple suppliers to respond, regardless of their onboarding status with the buyer, is more likely to surfacing the best option.
This is what we have built at EdgeworthBox. Buyers can execute reverse auctions in a simple user interface, casting a wide net with suppliers, confident that you can use our rapid vetting tools to get comfortable enough with new supplier risk to proceed with an initial contract while engaged in the longer, more formal onboarding. Give us a shout. We’d love to talk to you.