Executive Insights
Companies are aggressively looking for tactics to reduce costs and unlock savings on all their indirect and direct purchases and to more effectively manage their cash flow in procurement. Declining market demand and over-capacity is driving finished product manufacturers to put price pressure on their suppliers. They too must then re-negotiate contracts with their suppliers, thus impacting entire supply chains down to the raw materials. Regardless of where your firm holds contracts or negotiations within a given supply chain, it’s crucial to extract price concessions without harming the long-term prospects of vital suppliers.
Given the brutal nature of the current economic crisis and the still-undetermined recovery timeframe, the traditional procurement approach is ill-suited to that challenge. It relies too much on the negotiation skills of individual buyers, leads to adversarial relations with suppliers, and most importantly does not achieve the best price-performance results in a short enough time.
The following 5 tactics will help your organization achieve excellence in procurement and accelerate savings to your bottom line:
- Create competition between your suppliers. Even if you already have alternative suppliers, expand the range of suppliers from which you can invite bids. Make your alternative suppliers and the switching options visible for your most important materials.
- Use total-value-of-ownership to compare suppliers’ offerings. Start with the initial prices quoted by your suppliers. Then deduct a premium as a function of the performance of the supplier on your evaluation criteria, with the size of the premium depending on the value of the performance to your business.
- Empower the procurement department to both negotiate and decide. Allow procurement to decide to switch suppliers even during a negotiation, as long as they stay within the boundaries prescribed by the total-value-of-ownership framework. This allows quicker utilization of the lowest TCO supplier and the quickest impact to the bottom line.
- Choose the negotiation and decision mechanism that is best suited to the bidding situation. Instead of relying on the personal negotiation skills of buyers, prescribe upfront which formal negotiation mechanism (English auction, Dutch auction, etc.) you’ll use as a function of the competitive characteristics of each specific situation. Using best of breed eRFx tools can accelerate the quantity and scope of work being negotiated and drive the greatest return in the shortest amount of time.
- Use the negotiation and decision process systematically. Be transparent toward suppliers about the negotiation and decision mechanism you’ll apply and stick to it as much as possible. Revise and adapt the prescribed mechanism only by exception.
Negotiation Tools & Tactics for Procurement Teams
- Create Competition between your suppliers
The first tactic is to create competition between your suppliers. Even if you already have alternatives, it does no harm to expand the range of suppliers from which you can invite bids. The “competition matrix” is an important tool for making your alternative suppliers and switching options visible for your most important materials.
Switching or replacing suppliers can be a very political decision, sometimes involving serious internal power struggles. Purchasing processes are sometimes structured so that higher levels of approval are required for more important purchases, including intervention by the executive board. As your data and insights are driving a prioritization of opportunities, utilize a decision matrix for the levels needed for approval for switching suppliers.
- Use Total Cost/Value of Ownership (TCO/TVO) to compare Supplier Offerings
Once all the potential suppliers for a given product are identified, you can compare their offerings. The complication is that for all but the simplest components you cannot compare on the basis of price alone. You need a way to bring into the picture all aspects that determine the performance of the offerings of your suppliers. The total-value- of-ownership (TVO) framework allows you to do just that.
With the TVO framework, you start with the initial prices quoted by your suppliers, and then deduct a premium from (or add a penalty to) the initial price as a function of the performance of the supplier. The magnitude of the premium or penalty will depend on the value of the performance to your business. For example, if you expect a delivery lead-time of 10 days and every day gained represents a value of $1 to you, a supplier who can deliver in eight days gets a premium of $2. Conversely, if every day lost represents a loss of $2 to you, a supplier who can only deliver in 11 days gets a penalty of $2. By extracting all the premiums and adding all the penalties, you can generate a comparison price (see Table 2). When you start negotiating with your suppliers, they can improve not only their prices but also the factors that determine their premiums and penalties.
Several benefits can be realized from this approach—
- It leads to the selection of suppliers with the best price-performance ratio.
- It creates more intense competition, lending itself to the use of powerful negotiation techniques, as we will see later (guideline 4).
- It presents the potential for win-win scenarios, as suppliers have an incentive to improve their performance.
- It improves relations with suppliers, as the discussions are hard but fair.
- It creates internal transparency about supplier selection decisions.
3. Empower the procurement department to both negotiate and decide
The combined use of the competition matrix and the TVO framework enables you to let price negotiations go hand-in-hand with potential supplier switching discussions. The TVO framework shows all preferences and decision criteria for all the suppliers concerned.
Further, the use of an approved TVO framework allows you to empower the procurement department to decide about switching suppliers even during a negotiation. Nothing else will bestow as much negotiating power on the procurement department as this mandate to take decisions. Only when a supplier is certain that a concession granted during negotiation will decide the deal in their favor will they be prepared to offer the best price.
4. Choose the negotiation and decision mechanism that is best suited to the bidding situation
Having established “comparison prices” with the TVO framework, you can start negotiating with your suppliers in an effort to lower prices and/or improve performance. A diverse range of effective procurement eRFx negotiation tools and tactics exist to boost savings this way.
Choosing the most appropriate mechanism depends on the competitive characteristics of the situation. Explaining which mechanism (ie Dutch, English, Reverse, Japanese, e-auction) is optimal in which situation is a topic for another article, but factors that play a role in making the choice of mechanism include the number of bidders, the bidders’ aversion to risk, the cost level of the bidders, the likelihood of collusion among bidders, the bidders’ history with auctions and the level of product complexity.
As an example, consider 2 active suppliers who might take over each other’s business. You could use an all-or-nothing strategy as a negotiation tool and run a traditional eAuction event. A real risk may arise if both suppliers act defensively and find it more important to retain the status quo than to compete for more business. Neither of the two will lower its prices (or at best, by a tiny bit) and both will retain their business.
Taking the uncertain economic climate into consideration, you may conclude the risk of the two suppliers employing defensive strategies is extremely high. Given that assessment, you may decide to deploy a Dutch auction and give target pricing for 100% of the business until one of the suppliers takes the price target.
5. Use the negotiation and decision process systematically
Applying the negotiation mechanisms described in guideline 4, it looks like a straightforward process. Unfortunately, unexpected challenges do occur. For instance, an aggressive supplier suddenly appears to lose interest in a deal. In such situations it’s up to the negotiator’s skill to adapt and interpret the mechanism prescribed.
In these cases, it’s important to stick to communicated decision mechanisms as far as possible. To have a reputation for reliable decision mechanisms means that your suppliers know when they have to reduce prices in order to influence your decision. Consistently applying guidelines 1-4 above creates sustainable negotiation power.
The benefit of applying the above five tactics systematically results in better, faster and more sustainable procurement savings (see the following table for comparisons).
