When it comes to the technology and the labor necessary to purchase something (either from a catalog or with a reverse auction), who should pay for procurement events? Should it be the buyer or should it be the supplier?
Logically, we know that the buyer is going to pay one way or the other.
Either the buyer eats the cost of administering the acquisition of some good or service, paying for the procurement systems and the procurement talent or the buyer charges the supplier a fee that the supplier embeds in the cost outlined in their proposal.
We could say that it doesn’t matter. Except that it does.
Consider the following scenarios.
Scenario A: a buyer spends hundreds of thousands of dollars per year to license and use a Big Procurement system. Most likely, the buyer only purchases seat licenses for people in the procurement department, given the expense. Suppliers pay nothing to use this portal to submit their proposals. Suppliers spend internal resources to develop their proposal.
Scenario B: a buyer spends hundreds of thousands of dollars per year to license and use a Big Procurement System, purchasing only seat licenses for the people in the procurement department. On the face of it, suppliers pay nothing to use this portal to submit their proposals, but this is a function of the level of utilization. Respond to a small number of events and it’s free for the supplier. Use it past a certain point, the Big Procurement systems provider starts demanding fees to engage. Suppliers spend internal resources to develop their proposal.
Scenario C: a buyer does not have a procurement system in place. They use email and spreadsheets to run the purchasing process. The buyer does not charge suppliers a fee for submitting their proposal. Suppliers spend internal resources to develop their proposal.
Scenario D: a buyer does not have a procurement system in place. They use email and spreadsheets to run the purchasing process. The buyer charges suppliers a fee for participating in the reverse auction. Suppliers spend internal resources to develop their proposal.
Scenario E: a buyer may or may not have a procurement system in place. They use a pay-as-you-go system to run the purchasing process, paying 1 to 5% of the total contract value to the system provider. The buyer does not charge suppliers a fee for submitting their proposal Suppliers spend internal resources to develop their proposal.
Scenario F: a buyer may or may not have a procurement system in place. They use a pay-as-you-go system to run the purchasing process, paying 1 to 5% of the total contract value to the system provider. The buyer charges each supplier a fee of up to 1% of the total contract value for each proposal the supplier submits, perhaps administered by the procurement systems provider. Suppliers spend internal resources to develop their proposal.
Believe it or not, a big part of deciding which path to take comes down to accounting.
For Scenarios A, B, C, and D, the expense of the procurement process should be an operating expense. But, and here’s where it gets interesting, the expensing of the procurement process in Scenario E and Scenario F should be as part of the cost of goods sold.
Ideally, the cost of the procurement process should be variable and should be expensed as part of the cost of purchasing the good or service being acquired. Think of procurement as being part of the total cost of acquisition. Having to report it as an operating expense because it is administered as a fixed cost function distorts the actual decision making, leading potentially to overpaying for the wrong solution. The accounting can have real-world consequences.
Does the business model for the procurement process distort the outcome? Does the accounting distort the outcome?
The key driver justifying procurement is the minimization of “waste, fraud, and abuse.” We’ve written about the motivation for having a procurement department previously.
To accomplish this end, the key principle underlying procurement is competition. Buyers can eliminate the possibility of “waste, fraud, and abuse” with a transparent competitive process. Because this involves costs, on both the buyer and the supplier side, this paradigm is difficult to obtain. There are tradeoffs.
The more competition we can drive, the better the outcome buyers can obtain. The more potential solutions we can see, the more likely buyers are to pick the one with the best problem-solution fit for the issue the purchase seeks to address. The more proposals the buyer can solicit successfully (and importantly transparently), the more competition the buyer sees on price.
For buyers, the costs of the procurement process include the cost of the procurement system and the value of the time of the employees dedicated to running the process. These employees may come from the procurement department, augmented by staff from line units. Or they could be line employees, say in IT, whose activities procurement oversees.
For suppliers, the costs of the procurement process include discovering and qualifying the potential customer, as well as the significant expense involved in developing a proposal with little to no certainty as to the outcome. They submit a costly proposal without knowing if they will win the deal. It’s a bet. It’s an investment. It involves the time and attention of people who deliver the solution, as well as staff from the sales department and potentially other groups such as finance and the c-suite.
As we’ve discussed elsewhere, suppliers don’t like reverse auctions like RFPs or RFQs. They don’t like the expense of putting together the proposal. They don’t like the uncertainty that makes such proposals a bet. They don’t like the length of the decision cycle, something that negatively affects their return on investment. They don’t like the perception (and often the reality) that the RFP is a pro forma exercise in compliance to execute a pre-determined decision. They don’t like playing games that are obviously fixed in favor of the incumbent or some other supplier.
If buyers want to increase the number of supplier proposals they receive, the need to reduce the frictions that keep suppliers at bay.
- Make it easy for suppliers to engage: Email and spreadsheets are painful and inefficient. Big Procurement systems aren’t much better.
- Don’t charge suppliers to participate: They’re already investing in the proposal.
- Lower the cost of responding: Ask the right questions (and only the right questions) so that suppliers know you’re serious. Buyers need to do their homework.
- Speed the cycle: Have a process that enables you, the buyer, to get to a decision quickly and make sure suppliers understand this.
- Make it transparently fair: Communicate to suppliers that this is not a done deal and that the process will be fair and professional.
- Pay for proposals: This is not for everyone. Pay your suppliers to respond, even if it’s only something like 0.25% of total contract value. Make the payment contingent on finishing in the top three suppliers so that you don’t reward people for submitting sales brochures that aren’t responsive. The good proposals are more like consulting reports. Buyers benefit for years to come.
- Execute on a platform that helps suppliers develop proposals: The ideal system would include collaboration tools and AI tools to expedite responding and lower costs.
If buyers get this right, then paying 1 to 5% of total contract value can generate competition that lowers the price by a much greater amount, in addition to lowering the larger opportunity costs associated with purchasing the wrong solution. The overall lifetime return on investment of changing the procurement business model (and its accounting) can dwarf the investment that buyers make in conducting an attractive, competitive RFP or RFQ.
By embedding the expense in cost of goods sold, where the buyer has already achieved greater savings than the pay-as-you-go expense of the alternative procurement system platform, the buyer reduces substantially the operating expense of the procurement improving gross and operating margins.
This is what we have built at EdgeworthBox.
We call it elastic procurement™. Buyers and suppliers get access to tools, data, and community, with an unlimited number of seats for free. We charge when there’s a procurement event or for additional value-added tools. Buyers can pay or they can have their suppliers pay.
This overcomes the IT problem because our variable cost solution is much less expensive than costly, fixed cost Big Procurement systems. We make collaboration between departments possible. We can accommodate the natural entropy of acquisition. We free up procurement to focus on minimizing “waste, fraud, and abuse.”