Managing Opportunity Costs Is More Important and More Difficult than Reducing Transactions Costs in Procurement
Why are opportunity costs more important than transactions costs? They’re larger.
Why are opportunity costs more difficult to manage than transactions costs? They’re hidden. There is no line item for opportunity costs. There is only foregone revenue or higher costs than what the company could have realized in the future because of decisions made today.
When a company purchases solution A instead of solution B and solution B had a better problem-solution fit, say in terms of lower total lifetime costs, then solution A carries it with the opportunity costs of these foregone future savings.
We never see what the income statement or the balance sheet or the cashflow would have been if the company had selected B, instead of A.
Now imagine this issue occurring hundreds of times.
Many companies focus on the transparent costs of the procurement today. What are the transactions costs for executing this purchase in terms of internal resources it will expend to go through a compliant process? How much are we paying upfront for solution A vs. what we would pay for solution B?
The CFO might say, why would I use a procurement approach if the transactions costs are higher than executing internally without considering the opportunity costs?
What gets measured, gets valued.
Of course, this is a knife that cuts both ways.
The company’s revenue, cost structure, cashflow, and net assets will be measured in the future. And the market will value them.
Good CFOs optimize future financial statements by making the right decisions today. They set up systems and processes that create the best path in the future. They realize that they need to tradeoff current costs for future opportunities. The cheapest solution or the most easily purchased solution isn’t necessarily the best value-for-money, fully costed for opportunity costs.
How do companies lower opportunity costs? Opportunity costs arise when buyers don’t consider enough solutions in competition or when buyers prioritize more tangible economics such as transactions costs.
The key to driving opportunity costs down (and which also drive down initial purchasing costs) is competition. You can’t buy the better solution B if you never see it. You won’t see competition on price unless suppliers know it’s a real auction with multiple potential solutions.
Good CFOs create procurement processes that manifest the greatest competition on price and solution, subject to the tradeoff of manageable procedural costs.
Key to success here is the notion that procurement is reverse sales in that the buyer is selling the supplier just as much as the supplier is trying to close the deal.
The stereotype of enterprise purchasing is that the buyer is in the catbird’s seat. But the Pandemic has reminded us that it can be a seller’s market just as easily.
In a buyer’s market, there is perfect competition. Vendors trip over one another to capture the business. They bid down the price until there are no profits left for them to capture at the margin.
These conditions only apply to commodities. In a commodity market, each vendor is selling precisely the same thing. This is almost always a good. Imagine a pile of copper. Copper is a commodity. People trade it with one another. The terms are standardized.
Most goods that companies purchase are not commodities. They are specialized.
Services are distinct from one another, even when they offer the same type of service, by the people who deliver them. Indeed, most goods that companies, even industrial firms, acquire have services overlaid.
Straightaway, we can see that the vast majority of enterprise purchasing is not commodity-like, with variation from sector to sector.
We’ve written previously about the supply chain risk of poor vendor relations. When things get tight, suppliers put bad customers on allocation.
“Buyers who treat their suppliers as vassals will end up with vassals as suppliers.”
Even more importantly, companies that treat suppliers as objects don’t get real competition on price and solution. Companies that suffer from the delusion that their relationships with suppliers in anything other than a complex ecosystem of relating interests are most likely to have large opportunity costs, leading to underperformance against their potential.
This is really a question of risk management.
We built EdgeworthBox to be a set of tools, data, and community that help B2B buyers and B2B suppliers. It’s built as a way to deal with the supplier ecosystem as it is. Buyers get to buy the right solution, from the right supplier, at the right price. Suppliers see a shorter sales cycle, lower transactions costs, and superior customer fits. You can see more in this short video.