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Do You Cost Model? Why Not? Part IV

Supply Chain Management Training

“These activities have to take place. If you don’t do them, you are making yourself irrelevant in the field of purchasing. “

Purchasing & Supply Chain Management TrainingSo we’re on a multi-part series about cost modeling. We’ve already covered why cost modeling is important, and why cost modeling MUST be a part of your arsenal, an area where you have strength and an area in which you excel.

It’s funny, I was reading an article this last week, one meant to give deep insight to negotiation strategies, one piece at a time. The advice given in this last piece was to make sure that you (the purchasing professional) arrive at the negotiation room after the supplier, to give the illusion of being important.

I get frustrated reading this kind of stuff. I really do. Hello, this is not 1978 anymore. Do you really think that in the supply chain management model that we are trying to move towards that supply chain partners plan and perform such ridiculous gimmicks against one another?

Make it stop.

Achieving lowest TCO is not about psychological warfare or “getting what you deserve” or trying to act really important, it’s about building a case through data and using influence techniques that motivate the other party (not scare, intimidate, or make them paranoid). Period, end.

We said that should cost modeling would be used when the goods are service are unique and cannot be benchmarked or put out to bid, and that must cost models should be used when fair market value by any analysis far exceeds available budget.

So now let’s move onto Total Cost Modeling. Total cost models should be used when post acquisition costs are a substantial portion of total cost.

We’ve all made this mistake before. I always refer back to the mistakes from very early in my career. Remember, you always learn more from your mistakes than from your successes. I once negotiated a killer deal on a large software contract. Every single aspect of what was being negotiated; I nailed it all.

However, I turned around a year later and found out that our spends with the supplier went through the roof. How could this happen? Well, the end user spent well over $100K with the supplier in consulting and training costs for implementation! How come nobody told me about this when we were doing the SOW?

It’s not the customer’s fault. It was my fault. Remember, the customer wants to buy goods and services. You are supposed to be buying PERFORMANCE RESULTS. You have to ask all the questions. A critical component of TCO was missed. And it happened AFTER the goods were acquired.

Fast forward to another negotiation I worked on. The company stock price was through the roof, and we were considering buying a fleet of jets. Good times. Anyways, the cost model I put together showed that, on a pure cash flow basis, it was cheaper to have employees keep flying commercial. Management was satisfied and wanted to put the idea to bed.

However, I said I wanted to do a total cost model as well. Everything changed. The reason? It turned out that flying commercial meant longer drives for employees, more unproductive airport time, and most importantly, it necessitated rental car expenses and overnight hotel stays for what should have been day trips.

I did a study of the average time savings of going to the nearby private airport and also on how many trips based on real data could have had rental car and hotel expenses avoided. The figures were staggering. It became a no-brainer to get the jets.

Acquisition price vs commercial flight costs painted a different picture however, and none of this was clear until post-acquisition costs were analyzed.

I worked with a company that made the decision to outsource some of their operations. They had a cost model that showed costs of outsourcing, and the numbers made sense. However, I told them that this was an incomplete analysis. And it was.

You see, most companies aren’t very good at outsourcing. They want someone else to do the work, but they don’t want to let go of the work at the same time. So they kept a large staff still focused on the outsourced function, and also incurred frequent travel back and forth to the outsourced company.

Once I guided them on how to calculate the REAL cost of their outsourcing model, they were left wondering why they ever outsourced in the first place. The problem is, they didn’t account for post-acquisition costs.

There are so many factors that can come into play with total cost modeling. You have to fully comprehend implementation with the good or service being purchased and then assess what post acquisition costs may be incurred. Here are some of the types of costs to look at:

Warranty, maintenance, obsolescence, scrap value, resale value, training, consulting, insurance, utilities, switching costs, sunk costs, opportunity costs, controllable costs, uncontrollable costs, administration, personnel, travel, and there are still many others.

Then, as stated before, you need to label all your data sources and classify each data point as a fact, estimate, or assumption, following which sensitivity analysis should be performed on all estimates and assumptions.

These activities have to take place. If you don’t do them, you are making yourself irrelevant in the field of purchasing.

Next week, we will talk about benchmarking. Keep reading and try to apply these concepts.

I also offer in depth courses and seminars on these topics that will catapult your departmental capabilities and results to the next level. Contact me any time if you want to find out how to make your purchasing department world class.

Side note: Pretty soon, I will make an announcement that will shock you all, and will dramatically change the purchasing and supply chain management landscape as we know it.

Stay tuned.