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

Outsourcing business cases

I'm spending some time thinking through an outsourcing business case. The client has an expectation that the proposal will fit into their existing budget for the function (procurement and payables), independent legacy systems will be retired and new functionality will be added with the introduction of an integrated system, and ideally costs will be lowered. On the other side the service provider understandably wants to do all that, and turn a reasonable profit. So far, so good.
The difficulty is that the service provider's business case is turning up at about 150% of the existing budget. The work can be pretty quickly broken down into three areas to explore, plus one more:

The existing budget

This is a classic outsourcing issue, service provider's routinely strive to identify expand what's included in the existing budget, and client's routinely try to limit what's included. Direct costs are reasonably straight forward to nail down, allocated indirect costs such as contributions for space, corporate technology, support functions such as HR and accounting, are the usual areas that cause conflicts, and can determine whether a deal proceeds or fails.

The service provider's cost model

This tends to be a great area for "pursuit teams" (sales) to delve into in great depth. Most large outsourcing service providers have built wonderfully complex cost models to help them capture what it will cost to service an account. Routinely, I'll find that there is a bit of a fortress mentally around the cost model and it can often be as difficult to get the team to disclose line item details from the cost model as it is to get the client to share detailed budget information.

The first area to explore is whether the costs are market based or internally derived - don't accept the assertion from the cost team that they are market based, go and test the market yourself.

The second area to test is whether the internal costs have been inflated with an internal mark-up, again the cost team will routinely suggest they do not mark up costs, prove it for yourself.

The third area to examine are the overheads, are there too many people loaded onto the deal, are there costs loaded such as standard space or technology charges for people that have already had those costs modelled as direct costs for the contract, etc.

Going back over the last decade I've seen numerous cases where the cost team has contributed to proposals being, literally hundreds of millions of dollars over the market.

The service provider's pricing model

There is often little a pursuit team can do about the margin the company wants to earn from a contract, you win or lose in the market and margins will be adjusted to reflect that reality. What the pursuit team can do is vigorously target the "risk" model that can increase or decrease the margin calculation. Most (likely all) the major outsourcing service providers have developed formal risk management frameworks in their internal deal approval process. The one for the deal I'm looking at now runs about 200 questions, such as: Is the proposed deal a "factory" deal or a "fortress" deal? “Factory” means that it can be managed in a shared service facility, “fortress” means it is a unique offering that is customized for the client. Fortress deals have, in the model, a higher risk factor, and the discount rate applied to the price model is increased. Each of the 200 or so questions have similar impact on the discount rate. The pursuit teams need to spend time understanding the risk model, but often it is viewed as an administrative exercise, and the pursuit team doesn't ever really understand how the model will impact the success or failure of their proposal.

Strategic Sourcing

Outsourcing teams should also consider lowering the cost of goods and services in the function they are taking over by using strategic sourcing. I won't get into it in this post, but it's often possible to lower those costs by 10% or more, enough that many deals will live or die on the application of sourcing to the deal. Spending time to have an expenditure analysis performed to determine if there is an opportunity is well worth considering.

Cheers,

David Rotor