At some point a buyer and supplier will talk about pricing, maybe not right away – but it’s always the elephant in the room. Pricing is also potentially the most volatile topic, and could be a deal-breaker if the negotiation is not handled correctly.
Once the deal is completed the buyer might well wonder: “Am I getting what I’m paying for?” The answer to that question could elicit sweaty palms and a sinking feeling. But actually there are two equally important, related questions to ponder: “Do I really know what my company is paying for?” and “Do I know why and how we’re paying for what we’re getting?”
If you’re asking those questions once the ink is dry, you’ve probably got a severe case of buyer’s remorse. Buyer’s remorse is a serious, and potentially costly, business. The malady can also afflict the seller – so perhaps I should be talking about buyer’s and seller’s remorse!
So why is negotiating a fair price for a product or service for both parties often difficult and frustrating? In simple terms, the typical process is broken. It starts with misalignments and misunderstandings. It is then compounded as suspicions creep into the negotiation – further putting a wedge between the buyer and supplier who are each seeking to maximise their position in “the deal”.
If you are unhappy with your “deal” or your outsource relationship, look in the mirror. The foundation of your sourcing business model and pricing structure are likely the culprits much more often than a bad supplier. And if you are not fixing the root causes, the cycle just repeats itself even when you switch suppliers.
A fresh approach is needed. And it is described in detail in the latest Vested white paper, ‘Unpacking Pricing Models: Make ‘you get what you pay for’ Real for Business Relationships’, produced by The University of Tennessee and the Sourcing Interests Group.
Issue #1: Focussing on “Price” vs. a “Pricing Model”
At the heart of the misalignment and misunderstanding is the lack of a well-thought-out and aligned approach for managing the dynamic nature of business. In the rush to “get to yes” parties negotiate and lock-in a “price” too early — only to find that business conditions change, and unknowns become known. Suddenly that fair “price” you have negotiated turns unfair with the natural course of business. As I say, “business happens” and companies should face the reality that strategies will change, as will business requirements, scope or work mix, and/or the foundational economic fluctuations that make up the cost structure.
Unfortunately, many companies do not take the time to use more advanced pricing mechanisms that have triggers to keep a buyer and supplier relationship in equilibrium as “business happens”.
The solution? Companies need to shift their “price” focus to a more collaborative, flexible “pricing model” formulated by the parties that uses progressive pricing techniques, rather than simply setting “the price”. A well-structured, flexible pricing model creates a realistic and fair pricing approach that keeps the economics of the relationship and “the deal” in balance when “business happens”.
Issue #2: Short-term Opportunism
Another cause of dissatisfaction stems from companies that use a muscular, lowest-price-possible mindset in which buyers aim to squeeze short-term price concessions from their suppliers to get a short to “win” in order to reduce costs. Whether the “saving” is in the form of a price reduction or shifting a risk to a supplier, the reality is that a buyer is burying its head in the sand if it believes a short-term opportunist “win” is really a win. Oliver Williamson – the 2009 Nobel Laureate in Economic Sciences – offered excellent insight about opportunism in his research, observing that “organisations that use the muscular approach for buying goods and services not only use their suppliers — they often use up their suppliers and discard them. The muscular approach to buying goods and services is myopic and inefficient.”
Short-term “muscular” opportunism is like playing the whack-a-mole game at your local arcade or county fair: the buyer claims a victory with a short term “win” only to find out later that another darn mole popped up in another place. Some common examples? Service level misses, “scope creep” charges, or replacing the “A” team with the “C” team to reduce the supplier’s costs at the buyer’s expense. Let’s face it: businesses are in the business to make a profit – and attacking a supplier’s profit means it will make a counter move to protect its margins.
The solution? Look beyond price and instead base your decisions on total cost of ownership and best value. A Total Cost of Ownership (TCO) analysis determines the direct and indirect cost of using a product or service. It is vital to consider all costs associated with buying a product or service. In the case of outsourcing, this includes the usual suspects, but also transaction costs, retained costs, governance costs, any HR related costs and the like. The best and most accurate approach is to document total costs from an end-to-end perspective — capturing the costs from both the supplier and the buyer. Best Value is closely related to TCO, but is slightly different. Best Value bases pricing decisions on the value associated with the benefits received and not on the actual prices or cost: it uses decision criteria that go beyond costs and includes intangibles such as market risks, social responsibility, responsiveness, and flexibility. They should work together because TCO is a foundational component for any Best Value decisions.
Issue #3: Misaligned Interests
Once the parties get past short-term opportunism the next step is to align interests so that there are no conflicting goals or silos that will undermine the enterprise. In conventional outsourcing, the buyer typically attempts to reduce costs while the supplier or service provider wants to increase their revenue. The Vested methodology results in the creation of innovative solutions that resolves these conflicting goals. In a Vested deal, the economics of the business model are structured so that the company that is outsourcing reduces its costs while maintaining or increasing service levels and the service provider improves its profits. Aligning on costs, service levels and margins by agreeing on a set of desired outcomes for the deal will translate into a balanced win-win contract. Ultimately, you should be willing to change places with the person sitting on the other side of your outsourcing deal and feel good about it.
Issue #4: Using the Wrong Sourcing Business Model
Finally, and the most elusive reason, is that many companies still rely on the conventional transaction-based business model rather than using more progressive outcome or investment-based sourcing business models that will best meet their specific business needs. Research by the International Association for Contract and Commercial Management (IACCM) finds that most companies still operate under transaction-based models grounded in formal, legalistic corporate policies, especially with respect to risk and liabilities.
The legalistic approach fails to account for the dynamic nature of today’s business environment and does not always give each party the long-term results they are after, or need. Instead, it often creates perverse incentives and missed opportunities to drive investments and innovation.
The solution? Start by learning more about alternative sourcing business models. A white paper produced by The University of Tennessee, SIG, IACCM and the Centre for Outsourcing Research & Education, ‘Unpacking Sourcing Business Models’, provides wonderful background about each of the sourcing business models and when they should be used. The white paper’s conclusion? For strategic, long-term relationships buyers and suppliers should move away from the conventional transaction-based business model. Rather, they should shift to outcome-based frameworks based on performance-based/managed services agreements and Vested agreements. The general rule of thumb for shifting to an outcome-based model is to drive a step function change in performance and costs. Performance-based agreements typically shift risk to the supplier and guarantee savings, while a Vested sourcing business model is better suited for a highly collaborative supplier relationship where the buyer and supplier share risk and reward with the goal of creating value and a competitive advantage through innovation and transformational process changes.
A Next Generation Approach
Many companies are finding success in fighting these issues by shifting to a Vested Outsourcing approach with their strategic suppliers. The Vested approach is a highly collaborative sourcing business model where a buyer and the supplier share risk and rewards—in essence a buyer and supplier are committed to each other’s success. Buyer-supplier alignment goes to a new level by structuring a “win-win” pricing model that generates value for all parties. Procter & Gamble (P&G) uses the analogy of having buyers and suppliers “tug on the same side of the rope” when referring to its Vested agreements because a Vested supplier sits on the same side of the table with the buyer. The better P&G does, the better the supplier does…and the worse P&G does, the worse the supplier does.
There are five characteristics working in sync in the Vested pricing model, as illustrated in Figure 1 below.
Vested pricing models often mirror Abraham Maslow’s Hierarchy of Needs, which states it is vital to meet certain lower needs before higher needs can be addressed. A Vested pricing model usually establishes relatively small margins for base services. Pricing models often will guarantee a minimum profit for the supplier in exchange for performing base services at greater levels of efficiencies.
Second, a supplier’s minimum fee is coupled with incentives that enable suppliers to earn high margins as value is created by achieving their customers’ targets and by solving complex business problems. This enables the buyer to reward the supplier when value is created and outcomes are achieved rather than paying a suppliers profit in the base fee. It also allows the buyer and supplier to align their interests and focus efforts on reducing the cost structure – not just the price. In a well-structured Vested agreement, the supplier’s profitability is directly tied to the buyer’s success, which aligns their interests. For example, a supplier would receive an incentive and earn additional profit for reducing the cost structure and total costs.
A third attribute is fair risk allocation. A well-structured agreement does not have a supplier assume the entire risk of uncontrollable events, unless the buyer agrees to pay an appropriate and fair risk premium. Each risk is identified, discussed and the cost of the risk transparently shared. Then the parties determine who is better suited to take on that risk and what the appropriate risk premium (or price discount) should be associated with that risk.
The fourth characteristic of Vested pricing models is that governance is a distinct cost. This is very different from most transaction-based and classical performance-based approaches that “lump” the cost of governance into the supplier’s price, or even worse, allows muscular buyers to use hard-ball negotiating tactics to insist their suppliers provide governance for “free”. Like it or not, managing the business does cost money. A Vested approach recognises the need to properly resource for key personnel and prevents the temptation for the A team to become the C team when the supplier may be facing profit pressures
Finally, the Vested pricing model focusses on value creation based on a transparent and fact-based view based on Total Cost of Ownership and Best Value approaches. These approaches ensure that the buyer and supplier are looking well beyond price – and seeking to maximise value for both parties.
The Bottom Line on Your Bottom Line
The bottom line is simple. Our experience and research has proved what your grandma has likely been saying for years: you get what you pay for. That oh-so-obvious statement is just as true when you go to the flea market or when you are spending millions of dollars in an outsourcing deal.
This article was first published in Outsource #36 (Summer 2014).