What to Say When Procurement Asks to See Your Cost Base 🗣 Podcast Ep. 91
Let’s talk about one of the most difficult things that business professionals have to face – what do you do when procurement asks cost base questions? How do you respond? Is it fair to ask these questions or is it simply a push-down method to lower your prices? Let’s dive in!
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TIME-STAMPED SHOW NOTES: COST BASE AND PROCUREMENT
[00:00] Introduction
[02:11] Cost-plus pricing
[04:38] Margin in cost-plus
[06:26] What do you do in short term?
[13:20] Value at risk
[14:33] Value Management System
How to Respond to Cost Base Questions from Procurement
In today’s episode, we want to talk about something that is probably more common than we’d like to admit. A scenario where a procurement team says “Show me your costs. I want to see your cost, so we know that you’re not charging too much.”
So what do you do? Do you show them the costs? Or do you in some way fluff around the topic and try and avoid that for a couple of weeks? Maybe get yourselves, people, to meet with them a bit more to discuss the features and benefits of the offer. And then pretty much after a few weeks like that, come back to just showing them the costs.
Is that right? Is there a better way to do it?
I think let’s be honest. Upfront showing anybody your costs is a truly terrible idea. We can’t overstate how bad an idea it is. And why would a procurement team ask you to do that? There is only one reason to drive down your prices. It’s a method to hammer you down to get you to accept a lower price.
If they’re looking at your cost, they’re probably already interested in buying your product or service. And so you’re not going to come out of this in a better position than you go in. But how do you deal with it?
Cost-plus Pricing Base
I suppose on a podcast, we’ve covered many times how cost-plus pricing, all the negatives I think. We’re all aware. But I think if a customer says, “Show me your costs!” What you’re doing is you’re almost instilling that concept of focus on cost into your business. You’re almost rationalising it.
It’s like talking to a crazy person and you’re almost trying to rationalise with a crazy person. Doing so by default, you will be in your business, see more focus on costs. You will start to try and rationalise and become a cost-plus business. Now, in reality, it’s everything you don’t want to be.
And I think if you’re coming from a business and even if your mindset is based on costs, and then a customer procurement team comes and talks to you about cost, should you be surprised? Should you be taken back when you yourself are doing that and pricing based on that?
I mean, it seems illogical to ask that question. But strangely, people are often surprised that they are asked this type of cost-based question from procurement when they indeed are giving them cost-plus pricing. It’s only natural that they kind of would ask that and sort of irrational to assume that they wouldn’t.
So, what you are actually saying is that you don’t trust your own prices. Procurement in a way, is right to question the calculations upon which you’ve drawn based on your pricing. Because there’s something deeply flawed with that.
In my opinion, when I’ve looked at a lot of clients’ work, they are coming from a cost-plus culture. Now, a cost-plus culture, what is that? Deep down if you strip all the fancy accounting away from it, it’s a very insular inward-looking approach that just focuses on your own operations.
It doesn’t take into account, a lot of the moving parts. And factors are carried around in life and in business. It doesn’t even take into account the fluctuations in commodity costs and pricing, increases in freight, changes in freight operations. Or even inflation.
So, what happens is that you get this very broad calculation across your portfolio. And one assumes that is going to be a good proxy for cost. But deep down, everybody knows that it isn’t.
So, then the basis upon which you’ve calculated costs could be problematic. And then on top of that, you’ve slept on a percentage markup. Then, all of a sudden, you have procurement asking, “How much is that markup?” I don’t want to tell them that because really deep down, you’re not very sure that your cost position was correct.
I think it’d bring into the light, the insanity of cost-plus pricing. Because, what margin are you adding? Are you adding 10%? When someone does grill you on “Why 10%? Why not 5%? Why not 7%?” Realistically, you don’t have a good answer.
I’ve had an experience of doing this. We were an industrial business selling to a major retailer. And as in many retail businesses, some of them are quite low margins. On a billion dollars, you might only be making 1% to 2% or 3% margin. But that might be a very effective or very efficient margin in a company like that.
I remember someone in the operations team in our company saying “Oh, just explain to them that they will only make a 15% margin.” It’s almost expecting that they would be happy and let you do that.
Clearly, the argument would be, “We’re only making 3%. Why should you be making 15%?” It’s simply a method to push you down. I don’t think I’ve ever heard of an example of where somebody has looked at the costs. Then come back and said, “Oh, here, wait a minute! You’re not making enough. You should add a bit more margin on top.”
So, it’s sort of like it’s a false question. It’s purely a gambet to push down your costs, so that the selling price reduces. Generally, they couldn’t care less about your long-term sustainability. Procurement always claims that. But unless they’re purchasing the vast majority of your product, if they’re less than a certain percentage, it’s not going to jeopardise most bigger companies.
So, they’re in the game of pushing you down. I have one more topic to add about this. I’ll pass it to Joanna now. But I think if somebody asks you a stupid question, I’m a big believer in giving quite stupid answers.
Yeah. Well, I think what you’re trying to get at is there’s quite a big element of bluffing going on both sides. So, what do you do in the short term? This question is a difficult question that is often asked by procurement. And yet, right.
You know your pricing isn’t great. So, what are you going to do about it? Well, I’m not going to give you an easy answer first. I think you’ve got to work on your pricing capability. Building a better system architecture to give you confidence that you actually do know the right market price.
And then after that, once you know the market price, then you’ve got to start understanding the value of your products, and the economic value that your business provides to your customer. So that’s the expert answer.
But okay. Dealing with the short term tactical answer, what do you do when somebody asks you that?
Well, I’ve seen even the most like pricing experts being given this question. And you have to almost reframe. Reframing based on what you believe you can deliver. But ultimately, what I have seen people do is just build out their costs and literally inflate their costs.
What I’m saying is that absolutely is not best practice at all and it’s a very reputation-damaging move. So, I do not advise that businesses do that.
I think what you need to do is call procurement on this (cost base) bluff. Get back and have a real conversation. Start asking better questions, start thinking about segmentation. Are these the right customers for your business? Then, start building sponsorship in your business to build a better pricing capability that safeguards you and the business from this type of risk.
Because it isn’t just short-term risk as you can see from this very difficult question. It exposes the business. The business model, the pricing capability, the whole lot.
So yes, you can bluff around the edges and that’s what most people do. Then they give a long-winded accounting explanation for all their costs and to justify their prices. But that doesn’t in any way have any bearings on the value that they’re actually offering their customers – and the value that the customers actually want from your business.
So, I disagree, Aidan. I think even procurement would agree that they’re not looking for just cross-down price decreases. They’re actually looking for value. But they ask the question about costs because they know that their sellers can’t give them a clear answer.
That’s what I actually truly believe in. If they don’t believe that, the customer has provided them value, then why are they doing business with them?
So, it’s your job as a seller to actually investigate that answer. And then provide a clear short answer to procurement and that will completely eliminate such ludicrous questions like that.
I take that on board. But I think I’m actually going to disagree on this one.
I think, obviously, as Joanna was saying, if you don’t invest in value-based pricing, if you don’t invest in your corporate value, you inevitably will increase the chance of this preposterous discussion happening.
I suppose it’s like an army you plan for years in advance and strategies. And all these things that in the situation where bad things happen, you’re prepared. By investing in your value management, your sales team, and all that articulation, you prevent this stuff from happening.
Like the idea, do you think Apple, if someone goes in to buy a telephone from Apple or a smartphone, that they can come and ask to see the cost base of Apple? It’s preposterous because companies like that understand their value and sell in those bases.
But let’s look at the scenario. Whereas in many companies, certainly in B2B, when this question is coming up, it’s sort of insinuated that they haven’t invested in value. They haven’t done any of this work. They’ve done no work at all. And they’ve just bumbled along.
Now, they’re sitting in a position where they want to get a big tender through. And they’ve got a thing on their table saying, “We want to see your cost base.”
Like my view with this is it’s a preposterous question. Accountings are very fluffy area. And when they’re asking for cost base, generally, they’re trying to say “Give a shorter marginal cost.” But the reality of it is just a portion cost to it – if you have management time, research, and development time.
One of the big issues with cost-plus pricing is it’s impossible to work out costs. We’ve discussed this ad nauseum on this podcast. It’s if you try to work out costs, move its variable cost, its total costs, its opportunity cost that you could have invested in other things. It’s ludicrous and it’s a fool’s errand.
And in this scenario, I would just suggest. Just play the fool’s errand. And the different way and apportion every single cost you can do. If that’s what your corporate decision is.
If your corporate decision is you want to do business on these terms with a supplier or a customer who doesn’t value you, or who pretends not to – and involved in these value destructive activities. But you’re prepared – that’s how you want to operate. I think that’s how you should do it.
Cost Base with Procurement – Playing by the Rules
I often think of the famous Henry Ford and Tesla. It’s probably not a real story. Wherein the factory, I had no idea of Henry Ford and Tesla ever met. But there’s the famous situation where there was a rattle in the wall. And Henry Ford said that “Tesla, can you find the rattle?”
So, Tesla walks down the corridor. Walked out, tapped the wall two or three times and heard where the noise was coming from. He then stuck a nail into the wall. And all of the sound disappeared.
Then Henry Ford asked, “How much would that cost?” And it goes on $1,000 which was a lot back then. When Henry Ford said, “How is it $1,000? It only took you two minutes?”
I think the famous answer from Tesla was it was $2 for the time. And the rest was for the knowledge of where to do it.
So that’s a cost that’s completely legitimate. Now, if you walk yourself into a scenario where you’re in a silly situation, as a business, you’ve caused yourself to a large extent. There’s no real great escape from it. So, if you’ve got to play the game, you have to play by the rules.
I don’t think that disagreed with me. It seemed to support exactly what I was saying. I absolutely agree. But there is that distinction between that tactical move which often, businesses make by just almost being creative with costings.
Now, I would even say when I see that creativity is lacking or the more strategic thing is. But actually, understanding the value of your product portfolio.
More than that, the economic value that your business provides to each and every customer. At which point, then you can reframe and blow away any ludicrous questions regarding costings with that. Because now, you’re actually getting procurement to discuss the real topic at hand, which is the value at risk (not cost base.)
Are they willing to risk the value that you can offer them? They know that you can give them and do give them. And you know that it is important to them and that you deliver it very well consistently. If you know that, then any sort of silly question like that can almost be laughed off. And I think then, you can move on and do business.
I think if someone comes and asks, “How do I know if customers don’t value me? How do I know if I don’t have a real value management system?” Let’s be honest.
If someone asks to see your costs, they’re literally yelling in your face that they don’t value – or they don’t appreciate your value, that’s a red light. It should be a warning sign. But if you get to that position, I suppose if you really are a high-value company, it’s highly unlikely somebody would ask you that.
Secondly, if you really understand your value, you just laugh it off and say no. And probably if someone keeps pushing on it, they’re not a customer you want to deal with.
You got to play the ball from where it lies. You can’t become a high-value company. The great Value Management doesn’t happen overnight. It’s a long-term build but you work hard. And then one day, you find that customers may not be asking you these questions. Or at least you can say “No,” “Yeah!”
That’s it for me today.
Bottomline – Cost Base and Procurement
It’s a long-term build. And I suppose the important part to think about here is, “Are you willing to invest in that long-term strategic capability? Whereas in the short term, being more prepared to deal with those sorts of difficult questions from customers?”
Because you can do both at the same time. But both require a mindset set to change from within from the top-down lead strategic initiative. But then, it needs to be embedded within the teams.
You can’t expect just consultants to come in and give you the answer. Because they’ll just give you an answer to one or two questions which tend to be actually quite tactical.
The longer game is ensuring that your teams understand what they’re doing. It’s building architecture and it’s a sustainable capability that’s internalised. It’s driven by your team, not by an external.
From there, there’ll be that evergreen confidence in that commercial pricing field. And you’ll be able to not only understand the value that you offer. But you’ll also be able to get the price that you deserve.
You’ll stop understating yourself and you’ll be able to deal with quite these difficult procurement teams and conversations.
Anyway, feel free to get in touch with me, my team, more than happy to discuss these types of issues. They are quite pressing at this time and we completely understand and can give you a few pointers here and there.
So anyway, thanks for listening. Appreciate your time. Okay, bye.
Bye!
Just one last one, which is just almost like a vindictive thing. If you were forced to do this sort of stuff, you should probably add a different line item of cost – which is the cost of the accountant and the consultant’s time that it took. The weeks it took to work out your cost base for this cost allocation. So, you should probably highlight that and just make sure that pushes the price up.
All right. That’s just me. Thanks!
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