What's the number?

I've negotiated a fair number of contracts over the years. Most of the time its a simple exercise of determining the how much will one pay for a good or service. But when the transaction is extended in time or over a number of payments even the simplest transaction can become difficult to conclude. I've found that one of the biggest issues is a disconnect between what is emotionally fair, and what is numerically reasonable.

Let's take a car purchase. A dealer has it listed at $38,789 after some negotiation you settle on a price of $35,600. The dealer then asks if you would like to finance the car over 6 years, and offers to do so at $702/month. Is that a good deal? In order to decide you need to be able to calculate some numbers, and have some external information. One piece of information you need is "what interest rate would someone charge me to borrow $35,600 and repay the loan over six years?"

In this case, the answer depends on whether you can get someone else to write this loan for less than 12.3%. All in all, these are not difficult calculations (and any number of web-sites, calculators, or spreadsheets will perform them for you).

However ... when you are negotiating procurement or outsourcing contracts don't assume all the parties at the table will be able to perform these calculations - especially "right there at the table" and that even if they can, that they will think the result is reasonable.

I'm often surprised at how frequently clients (and sales staffs) get tied up on this issue when services are paid on a deferred basis. You will often see sales staff asking for outrageously high margins just as often as you'll find a client wondering why they can't pay, for example, $1M in 10 years for $1M in services today.

And just when you think everyone is on the same page and being all reasonable, then we need to consider deal and partner specific risk ...

Cheers,

David Rotor

A quick hello and and some fast procurement news

I've been off working on a confidential client project so I have not been able to post anything recently. But I thought some of you might find this juxtaposition of two of my favourite topics interesting.

The rising cost of carbonfibre

"The current worldwide shortage of carbonfibre is going to make it more difficult and more expensive to build racing cars, until supply catches up with demand."

Click on the link for the full story from www.grandprix.com

Yet another supply risk post

The usual suspects of smart supply guys ...

Michael (Sourcing Innovation) - here - here - here (and many more)
Tim (Supply Excellence) - here - here - here (and also many more)
Jason (Spend Matters) - here - here - here (and you guessed it ... many more)

... keep trying to make us pay attention to supply risk. A recent quote from Michael "Your supply chain will be disrupted. Bet on it. You'll win." If only some of the brain trust in the Toronto and Calgary offices of Imperial Oil (Esso) had been paying attention. While it's been making news for a week or so, (and hitting our wallets) today's Globe and Mail article on the retail gasoline supply chain disruption in Ontario provides a nice summary of how it happened.

1. Take a couple of refinery fires to constrain production.
2. Add in the winter closing of the St. Lawrence Seaway (if you're not familar with the seaway, or perhaps more importantly if you think you do, spend some time on their site to gain an appreciation of just how important this stretch of water is to the North American economy) to limit alternative distribution
3. Simmer with a rail strike to further limit distribution

The result has been a 25% spike in retail prices for gasoline and "dozens" of gas stations being closed due to lack of gasoline. If this can happen in Ontario in a widely competitive commodity market like retail gasoline what are the odds that it can happen in your supply chain? If you disagree would you care to take me up on Michael's bet? Thought not.

Cheers,

David Rotor

A life without compliance

Ask procurement types what are their major challenges and you'll routinely hear:

1. Talent (attracting, training, and retaining);
2. Data visibility; and
3. Compliance

Let me touch on compliance today. I've worked on a variety of models to drive compliance both on the demand side (buyers using the right mix of contract, supplier, and scope of service or specification) and on the supply side (suppliers honouring their commitments). My current approach has been to treat this as a sales/marketing challenge (here and here). What if we're all wrong?

Russell Roberts, writing in Cafe Hayek, talks about "Order emerges in unexpected places". His example is the experience of a couple of European towns that are deregulating their traffic patterns by removing signs, traffic signals, and the like. I'd say it was counter-intuitive, but I guess most of us actually would guess that, indeed, accidents are reduced with fewer controls. I seem to recall reading someone (The Economist, Marginal Revolution?) on this topic not long ago, and if I recall correctly it was posited that fewer external controls meant individuals felt an obligation to have more responsibility.

Can this approach translate to the procurement world, and if so, what should procurement departments consider to make it effective? It's not so crazy, most companies have some form of procurement anarchy already:

1. Expense policies that allow travellers to select hotels and restaurants
2. R&D labs that are exempt from production procurement rules
3. Conference planning that is not restricted by corporate travel regulations
4. Gifts and trinkets
5. Media and advertising relationships

etc, etc

To make it effective I believe that three conditions are necessary:

1. The cost of the decision must be visible to the person making the decision. This is often referred to, in the negative, as "visual guilt". If you can display lower cost options, the decider will often select the lower cost. A real world example is what the folks at Rearden Commerce are doing for travellers.

2. The decision has limited impact on business processes beyond the control of the decision maker. This is really just expanding on the first condition, purchases that entail risk, long-term maintenance or support costs, or which impact other purchasing decisions probably should not be left uncontrolled.

3. Decision that are either very simple and quick to make (I'd like that pen, not that one) or extremely complex and ad-hoc (this charting software is better for my development team than that one). Simple, as the cost of involving a procurement administration to make the decision would often out weigh the cost of the purchase. Extremely complex ad hoc decisions because those decisions are very difficult for the procurement department to have expertise and add value, and if they are truly ad hoc their is little value to be gained from the experience that will translate to other buying decisions.

Any thoughts, other than to lynch the procurement heretic?

Cheers,

David Rotor

Shared savings?

I'm working on a few investment opportunities that have come up for this fund. The fund is, obviously, interested in the mechanism for shared savings and while we are starting with a bias on how the funds would flow it's been useful to work through some other scenarios.

We're exploring five shared savings models:

1. Identified Savings
2. Front End Rebates
3. Back End Rebates
4. Transaction Payments
5. Periodic Payments

Identified Savings
This is commonly used by strategic sourcing consultancies that have contingent savings contracts with their clients. Savings are "identified" but not realized prior to payment. Often the milestone for payment is at the time of awarding a contract to a supplier that provides lower costs for a good or service.

Front-end Rebate
In this model the supplier takes on the future purchased volume risk in a contract and pays the client their savings at time of contract award.

Back-end or Volume Rebate
In this model the supplier pays the rebate at some pre-determined point in time, such as quarterly, annually, or at contract expiration. This is normally defined either as a lump-sum payment (thereby having the supplier hold the purchased volume risk) or as a volume related payment (thereby having the client hold the purchased volume risk.

Periodic Payments
Savings are tracked and paid on a periodic basis (often monthly or quarterly). While there can be multiple mechanisms this form of shared savings are managed they are usually based on tracking the volume of purchases over the defined period and applying a savings formula to that volume.

Transaction Payments
Savings are tracked and included in the transaction. Payments are made coincidental with supplier payments for each relevant transaction.

Sit down and read this

Procurement "professionals" are often asked, either seriously or in jest, for retail buying help from friends and family. While there is obviously some overlap in skills and approach, it's a bit akin to asking your friend the Finance Director for help selecting a life insurance policy. Over at the consumerist, they've posted an article aimed at the consumer buyer, that has a lot a valid points for the professionals. The topic is buying on-line furniture, but just as it makes sense for a professional, it also makes sense for categories beyone furniture. Here are a few of the tips, and a link to the full article.

#7. Ask them about the shipping procedure and how long it takes for
the order to be processed.
# 12. Confirm everything. Hold them to their word, and WRITE DOWN THEIR
NAMES. Get their last name if possible.
#6. Ask them what the furniture is made of, and if it can be configured in
a number of different ways.
# 3. If they have a warehouse, ask for a tour. Take a look at the way they
warehouse employees act and handle the packages. What the retailer expects of
its employees is what they expect from their manufacturers.

Cheers,

David Rotor

Elevated pricing - supplier cooperation gone bad

Today's Globe and Mail reports that the European Union (EU) has fined Otis, ThyssenKrupp, Kone, and Schindler, Mitsubishi Elevator some US$1.3B for colluding to fix prices in Europe (appeals expected). I expect a resounding silence from industry lobby groups on this one. Lobby groups like to be loud and clear about the value of working closely with suppliers, that "strategic partnerships" are more valuable than commercial relationships, and that buyers should trust their supply partners with more of a firm's value chain.

I agree ... but in the words made famous by Ronald Reagan "doveriai, no proveriai". On more than one occasion I have enforced a right to audit supplier invoices. The first time I did it was when I was working for CN Railways, the supplier was (and is) a Canadian subsidiary of a global "MRO" parts supplier.

The relationship was worth about C$12 million a year, mostly driven through a huge number of small dollar transactions. Work to integrate the supplier into our EDI system led the team to wonder about the quality of the data feed from the invoices (a polite way of saying that their pricing seemed wacked). We had the right to audit, and on 24 hours notice put a couple of internal auditors into the supplier's offices. We agreed to sample about 1000 invoices and share the results with the supplier. We found that roughly 50% of the invoices had pricing errors which pointed to our concern about the quality of their data system, when we also observed that about 83% of the errors were in the supplier's favour it suggested that we might also have an ethical concern about their behaviour. The difference between contracted prices and invoiced prices was roughly $1M (8% of the C$12 million in sales). For a railway that only made $75M in profit that year, it was pretty significant.

The very talented guys over at "The Buying Triangle" are working on this type of problem (and others). Here's how they describe a portion of their solution:

Analyzing costs of goods and services—the third node on The Buying Triangle—can
be difficult to validate without effective price discovery. After contracts are
negotiated, the work of determining whether savings are real or theoretical
still lies ahead. This is often complicated by factors such as:

* the best pricing may be for items rarely used much of what you buy may actually be off-contract
* you can't validate contract compliance because you can't produce a detailed breakdown of historical purchases

I suspect that some of the buyers who experienced "elevated pricing" in Europe got the "verify" bit right. What are you doing to verify your supplier contracts?

Cheers,

David Rotor

If we keep quiet maybe nobody will notice - good supplier cooperation

For cell phone companies in Canada it might seem that the Ides of March are a day early this year. But if they are feeling a sense of impending doom, they're doing a great job of keeping it to themselves. As I wrote back in December, wireless number portablility (WNP) is finally arrving in Canada on March 14th. You wouldn't know it from the industry's advertisements, as Catherine Maclean writes in the Globe and mail "The lack of advertising, however, shouldn't be surprising. Some observers predict the move could lead to an uptick in so-called churn, or customer turnover, as unhappy subscribers, who are wedded to their phone number, head for the exit signs."

I am all for the awkwardly named WNP, having seen it work to great advantage in other countries. I can also support the position cell phone companies are taking, none of them are advertising this pretty significant change in their industry but they aren't doing anything illegal, colluding, or misleading their consumers. Where am I going with this comment ... see my next post.

Cheers,

David Rotor

Common sense lease advice

Terrence Belford writing in the Globe and Mail today has an article on negotiating commercial real estate leases. Here are a few nuggets of good advice for any supplier negotiations, not just negotiations with your landlord.

* Don't begin negotiations with a threat
* Understand your supply market and what options/substitutions are real
* Consider what the other side wants to get out of the negotiations
* What can you bring to the table that is more valuable to the other party than it costs for you to provide - and vice versus

The article concludes with a pitch from a real estate negotiating service "In seven years, we have never had a situation where we did not save a client and in some case those savings have been considerable."

If you're thinking about using a service to do negotiations you should think hard about that quote. Do you have the expertise and market experience to do as well as a firm that has been doing this for seven years? Consider that your internal staff haven't been held to the same standard of having to earn revenue from their expertise that a service provider is required to meet. On the other hand, also take a hard look at how they define savings and what strategic value your company expects to receive from the negotations that are not captured by the term "Savings".

This one caught my eye

The Economist has published a book review (subscription required) that caught my attention this morning. “Firing Back”, by Jeffrey Sonnenfeld and Andrew Ward, on how executives can rebound from being sacked. Here's an interesting section:

There is a five-point plan, which begins with “fight not flight”: it is
crucial not to become so preoccupied with coping with failure that you fail
to pursue a new career seriously. The story is told of how Mr Dimon decided
to seek out his former mentor, Sandy Weill, who had fired him from
Citigroup, a year later. “I wanted to get this event behind me so I could
move on. I made my own mistakes. I acknowledged I was partly to
blame.” The ousted boss also needs to “rebuild heroic stature”, prove his
mettle to regain credibility and rediscover his “heroic mission”. Much of
this boils down to reputation management. Despite Mr Dimon's admirable
private candour, the authors urge executives to devise a plausible narrative
about their failure that includes “clearly denying culpability, shifting
responsibility for the mishap, reducing the offensiveness of the act, giving
the appearance of reasonable behaviour and offering acceptable motives.”
Head-hunters may be a more important audience for this story than intimates
or the broader public. Some sources of failure are better than others: get
fired during a merger, a political clash or over a strategic disagreement,
and you have a two-thirds chance of returning to corporate leadership within
two years. Best avoid being sacked for poor performance, unacceptable
personal conduct or illegal behaviour, however.

Cheers,

David Rotor

Do you understand PPP?

There is an interesting discussion going on over at Marginal Revolution on the value and definition of Purchasing Power Parity. If you think you know what it is and how it impacts your supply contracts you might be in for a surprise or two.

Cheers,

David Rotor

Blackstone's Office Properties

In November I wrote about Blackstone's bid for EOP. It closed today at $39B. My advice still stands, they should take a hard look at their SG&A. I also recall something I had forgotten about back in November. When EOP was a client, a Vice President of Procurement had the last name "Borg" (I did a cursory check on the web-site and can't see if he's still there). It's a funny last name. For you Star Trek fans, ok, it's a little funny. For us purchasing types Borg means "B"uying "org"anization. Juvenile yes, but it still brings a smile to my face.

Cheers,

David Rotor