Cost Modeling Purchasing Training

 

OK, so we’ve talked about the importance of cost modeling and why this is something you must be good at as a purchasing professional.

I’ve consistently seen that purchasing professionals want their finance people to do cost models and want their legal people to do contracts. These are career killing practices. Cut it out!

These are golden opportunities to make strengthen your arsenal, show that you defer to no one when driving aggressive TCO solutions, and that you understand every facet of what it is you are negotiating. Suppliers know when you don’t know. And they love it.

So we covered Must Cost Models last week and we will talk about Should Cost Models this week.

A should cost model is used when the product/service being purchased cannot be benchmarked via an RFX process (due to uniqueness of what is being purchased), and therefore the method of choice is to break down suppliers costs and find out what it “should cost” to be providing this product or service… hence the name.

This can be a great tool in negotiations. In an era where supply chain management is coming, putting things out to bid will happen less and less. Instead, you will be collaborating with suppliers in the supply chain with whom you have long term relationships to identify joint cost opportunities. Getting good at should cost models will greatly ease this transition.

The first guy who trained me in purchasing had no idea what he was doing. And he’d been at it for years. This was in a Fortune 50 purchasing department mind you. We had lots of accolades on the outside and lots of inept practices on the inside. Sound familiar?

I was negotiating a consulting agreement for unique services. That means that benchmarking was not an option (we’ll talk about benchmarking next week). Budget wasn’t overly constrained, so a must cost model wasn’t appropriate either. We needed to do a should cost model.

So Mr. Trainer had me do a cost model that looked at how many employees this consulting company had, what types of employees, how many computers they had, how many fax machines, what the square footage of their building was, and so on.

I then had to determine what each of those employees should be getting paid, what the cost of the hardware they had was, and what the cost of real estate was in that area. Then I added on insurance costs, burden rates, and many other extraneous pieces of financial information.

The net result? A multi-page spreadsheet that that couldn’t help me close a car door, much less a negotiation. It took two full weeks of my life – that I’ll never get back – to gather that data.

A should cost model was the right tool, but the right tool can be used wrong. What I should have done (or rather, what Mr. Smarty Pants should have told me to do) was something far more basic:

Let’s assume the consultant wanted $400/hour. I should have taken the consultant’s resume and shown it to the internal customer and ask “what would you pay this person if you were to hire them as a full time employee?” Let’s say the answer was $110K/year.

Now I just need a few more piece of information: burden rate, consultant utilization rates, and industry average profit margin. Burden rate (the costs of an employee beyond cash compensation – insurance, cubicle, 401K contributions, etc) is usually 30%.

Consultants usually have only about 50% of their time as billable. Anything less is a red flag. Anything more, and they aren’t spending enough time researching and ensuring they are at the top of their game.

Then if I were to look up the NAICS code for the consultant ( you can ask any supplier what their NAICS code is – it is 6 digits and you can then research financial averages for that industry), their profit margin would probably be about 50%. Consultants have high profit margins.

The average employee works 2,000 hours a year – a nice round figure. We will cut this in half though, due to billable time by consultants in the average year.

So let’s do the math:

$110K + 30% burden rate = $143K, which is the cost of hiring that consultant as an employee. It doesn’t matter that neither party is proposing to do this.

$143K + 50% industry average profit margin = $286K (I know you think it should be $214.5K – this is a common financial modeling mistake), which is what the consultant should then expect to gross in a year if both burden rate and industry average profit margins are included.

$286K/1,000 hours = $286/hour, which gives you a benchmark rate to work off of in should cost model based negotiations.

The argument is “if we were to hire you at market rate, and to add on burden to address all costs, and add on industry average profit margins for your NAICS code, and even assume only a 50% billable rate per year, we would still be at $286/hour vs the $400/hour you are asking for. Help me understand the data here, because my analysis points me in a different direction that what you’re charging.”

If you don’t think this works, you are dead wrong. The supplier will be stuck. You will have painted them in a corner. The data does all the talking. And compared to all the useless analysis I did before, this was a walk in the park.

I would like to run through many more examples, but it’s just not practical in a blog. The point is, you have to negotiate with data.

The first choice is benchmarking in most cases. If that is not available or feasible, then you move onto Must, Should, or Total Cost Modeling.

Suppliers hate it when you negotiate with data and they love it when you don’t.

Stop believing that just taking a negotiation class that teaches you how to influence with behavioral techniques is all you need. That only works in glossy airplane magazine advertisements.

You have to couple those techniques with in depth data analysis, and *only then* can you make a case for negotiation success.

Feel free to contact me if you want world class TCO training for your organization. Just don’t use any of the techniques I taught you above when we talk price!

I took a long weekend and went to Carmel and Monterey with my wife and brother in law.  I just love the California Ocean.

I have to admit though; it was pretty hard shifting from 62 ° weather back to 92 ° when we got home to Sacramento.

Anyways, we stopped at the Strybing Arboretum in San Francisco on the way back.  It’s been free my whole life and now they charge $7 admission.

Also, parking in SF used to always be free on Sundays and now Sundays cost money too.

Finally, a few years ago, a 3 – 4% healthcare surcharge has been added to most San Francisco restaurants.

My dad told me that he remembers when there was a 25 cent toll charge introduced on the BayBridge in the 1970’s, and it was announced as being “only temporary”.

My intention is not to complain, I still love SF and these costs won’t deter me from enjoying it.

My intent is to convey that it’s easy to miss costs when they come in little bunches from different places.   You’ll hear people complain a lot more about a sales tax increase than about any of these other costs.

This reminded me of what suppliers do as a negotiation strategy:  “nibbling” is what they call it.  They find little ways that fall below purchasing’s radar to keep increasing their financial gain from a transaction.

Suppliers are trained how to do this really well.  They keep your attention on price and they nibble elsewhere, both during and especially after negotiations.  You think you’re done negotiating, and from their perspective, it never really ends.

Nibbling can be done in the form of charging you more for lesser items (bells and whistles) that you may not be focusing, or charging you for something that would normally come free.  We’ve all experienced it.  I remember once when a software supplier tried to charge us maintenance fees for our backup servers.  Nobody pays maintenance for software on backup servers, but it was an attempt on their part to nibble.

Suppliers nibble in different ways.  They can slip the nibbling charges into other parts of their proposal, separate from their main pricing proposal, hoping you won’t see it.  They can introduce it as a concession (“ok, we’ll do that for you, but how about you guys cover ________”).

Or they can introduce it later, through phone call or email agreements with the end customer, who may view it as a benign concession that does not affect purchase price.

My wife attended a timeshare presentation recently in Cabo San Lucas, Mexico.  Honestly, I’d rather have a highly invasive proctology exam than go through one of those. I warned her, but sometimes you just have to experience things on your own.   Based on her subsequent assessment, it’s probably the last one she’ll attend as well.

In any event, those presentations are a great example of supplier nibbling in action.  They talk to you about the cost of the timeshare, but they spend little time talking about maintenance and cleaning costs that get allocated to you.  They won’t even show you the contract Ts and Cs unless you’ve already agreed to buy one (if you don’t believe me – ask them for a copy of their contract during a timeshare pitch – they won’t give it).

I have nothing against timeshares or timeshare owners, I’m just pointing out that this is another business model where part of the revenue stream is generated through creative nibbling. You have to really be paying attention or you might miss a big TCO component.

Are you anticipating and recognizing supplier nibbling tactics?  Are you capturing the financial consequences of nibbling in your negotiation cost models?  Do you scour supplier RFX responses for nibbling?  Have you educated your customers on supplier post-contract nibbling practices? 

It’s our job as purchasing professionals to have a mastery of TCO.  A big part of that is to make sure there is no nibbling going on by the supplier.  If we do agree to some ancillary charge, it has to be a conscious decision and it has be part of a deliberate TCO strategy on purchasing’s part.

If you have any nibbling stories, please post them here, we’d love to hear them.

I’m a huge fan and history buff of the original Three Stooges. Back then, they would produce two-reel 20 minute “shorts” that were shown before a movie would start at the cinema. Nowadays we have to endure an endless litany of undesirable advertisements before movies start – which is usually not until 15 minutes after the broadcasted start time. Not all progress is good progress.

In any event, whether you like the Stooges or not, they have a very interesting history of contract negotiations, from which there is a lot to be learned. They signed their first contract as the Three Stooges in 1934. It was an annual contract, for a reasonable rate of pay for actors just breaking into the business. Columbia Pictures was run by a person by the name of Harry Cohn, who ruled with an iron fist, and he negotiated the exact same way. He was known as “King Cohn” by his underlings, and that was not considered a compliment.

The Three Stooges were immensely popular, but Cohn would never let them know it. He isolated them from public demand for their comedy. He would cruelly make them sweat out their contracts to the last minute every year, before finally agreeing to renew them for another year. In doing so, he would say “the market for shorts is dying out, fellas.” The Stooges took the bait and felt lucky to get a renewal. They endured 24 years of 11th hour annual contract renewals, and because of their fear of not getting a contract at all, they never once asked for nor did they ever receive a raise. It was nothing short of highway robbery on Cohn’s part.

What the Stooges lacked was market information. They didn’t do their benchmarking. They didn’t talk to other studios to see what they would pay for their services. They didn’t put their services out to bid. They also didn’t know that Columbia Pictures would use the popular Stooge shorts to force cinemas to also buy their B quality movies that were otherwise in little demand. They came together as a package. If the cinemas wanted the Stooge shorts, they had to buy the B quality movies too. The Stooges didn’t know any of this.

Knowledge is power in negotiations. You can’t always believe what the other side is telling you. If they tell you they may walk from the negotiations, you have to test that. You have to be able to call the other side’s bluff, and the Stooges didn’t know how to do that. They were masters of their craft, but they were complete novices at the art and science of negotiations. As a side note, they did not think to negotiate safety measures either. They were the victim of broken bones, teeth, and stitches, as they performed many dangerous stunts themselves.

Do you verify when a supplier tells you that they may walk from a deal? Do you take measures to ensure that you can call a supplier’s bluff? Do you let lack of information lock you into bad TCO arrangements? Do you let contract renewals work for you or against you? Do you step up the competition when you think a supplier is charging too much?

Suppliers are trained to make you think you have left them bloody and bruised after negotiations are over, even if they are in fact laughing all the way to the bank. Harry Cohn was the master of this. He did it for 24 straight years with the Stooges.

Information gathering is critical to verify that what a supplier wants you to see and believe is really what’s happening. Information + competition = power and leverage in negotiations.

I know I did without both in my first negotiation as a purchasing professional. The results were predictable. I would have made the Stooges proud, but that’s not a good thing.