Relative Cost Power -- How to Not Know the Cost of Your Products and Win Negotiations Anyway

With product cost accounting for 70% to 90% of every revenue dollar on the income statement, it’s not hard to understand why cost is such a big deal to many companies.

In the last decade, there has been a renewed focus on the world of product cost management, including techniques like design for manufacturing (DFM), should costing, spend analytics, etc.

Many of these techniques are used (or are intended to be used) *before* the sourcing phase of the product life cycle. While procurement professionals should be involved up front in product design, a lot of the responsibility for success with these techniques will rest on the design engineering staff.

Regardless of whether your company is best in class in design to cost or whether you have the most cost-oblivious design staff in the world, your designs eventually must be made or bought. With the dominance of outsourcing, it’s more difficult than ever to know what the should cost of a product is. Purchasing agents are told that they should know the should cost of products before they walk into a negotiation with a supplier. However, that is not easy, and the fact is:

Your supplier will typically know more about their costs than you do.

So, how do you proceed in a negotiation where your supplier has more and better information? Are you completely at its mercy? And, what if your supplier holds oligopoly, or even monopoly, supplier power? Are you just a price taker?

ANSWER: No, you don’t have to be a price taker, at least in the case of buying multiple variants of a similar spend item.  Recently, I wrote a blog post about how the human brain does not like non-linearity, discontinuity or non-monotonic functions. This is a fancy way of saying that people are very good at detecting pricing inconsistencies within multiple similar products.

This inconsistency is the key to being able to better control a negotiation in which you really don’t know what the absolute cost of a product should be, or where you know the should cost but have little buyer power. Let’s explain this with an example.

Case Study in Relative Should Cost: Pick-up Truck Drive Shafts

In the late '90s, I had the privilege of being the product development owner for the drivelines (axles and drive shafts) used in the full-size pick-up that was best-selling vehicle in the world for over 30 years. This truck made over 100% of the profit for my employer (making up for losses on other vehicle lines). I was very young and inexperienced at the time, so it was a great experience but a big challenge.

Within the first few weeks in the assignment, I was told that it was time to negotiate the contract for the driveline commodity (over $450 million annually) for the upcoming 2004 vehicle. I was told that this was a very complex process but that the purchasing group would lead it.

However, my first meeting with our purchasing team lasted about 10 minutes … long enough for the purchasing team to say, “Oh, your supplier is *that* supplier? We don’t get involved with them. Have a nice day.” And, they walked out of the room.

After the Shell Shock

After the shell shock of the experience wore off, my manager explained that our supplier was the former components division of our employer (the OEM) and that our CEO had desperately wanted to spin off the component divisions from the OEM.

To do this, our CEO had negotiated a deal with the powerful automotive union, agreeing that the union members would technically work for us (the OEM) but be leased to the newly spun-off supplier. If the OEM did not give enough business to the components supplier to keep the union members employed, the OEM was responsible for paying a large portion of their wages while they waited to be deployed somewhere else.

Effectively, this removed almost all negotiation power from us, the OEM. Therefore, our purchasing team had made a decision at the executive level to not participate in negotiations with this particular supplier. Instead, these negotiations were dumped into the laps of the product development team, with some support from finance.

Suppliers with Complete Supplier Power

The product development team had its own problems already. The marketing team was demanding much better performance and quality out of our parts. But the finance team demanded that those parts be cheaper than the previous generation of parts. And now we had an AWOL purchasing team.

In terms of the old Porter’s Five Forces framework, our supplier had tremendous supplier power! What to do?

I certainly was not an expert in drivelines yet, but I had just completed a master’s thesis focused on product cost. So, I first reached out to the cost estimation team within the OEM. The team helped us understand what the absolute cost might be for a drive shaft. We were also able to negotiate with purchasing to do an “unofficial” price study with other driveline suppliers.

Our first negotiation with our supplier (the OEM’s former component divisions) was pleasant but utterly futile. I excitedly explained what we thought the absolute part cost of these drive shaft parts should be and hinted that we had quotes from other suppliers to prove it.

Our supplier, being quite shrewd, politely explained why its product was, obviously, so much more valuable, combined with a tangible undercurrent of, “Well that’s nice that you have should costs and quotes from other suppliers, but we really don’t care because you have to use as a supplier regardless.”

Relative Should Cost to the Rescue