Seeking the Mystical Tome of Prices: How overreliance on price benchmarking hurts your company
Recently a head of procurement asked me “why do you all use a scoring model to estimate savings potential…why not just compare the prices we pay to comparable prices at other companies?” We hear forms of this question every few months, so we think it’s worth laying out our reasoning and explaining why this question misses the point and how it reflects a mindset that is actually quite damaging to many companies.
Here’s our perspective, in summary:
- Such an approach is not possible on a large scale
- Even if it were possible, such an approach would miss the point and ignore the main sources of value
- Most importantly, the quest for price benchmarking misplaces organizational focus and breeds the wrong kind of thinking, which sacrifices long-term value creation. As such, it is not just misguided; it is damaging.
Comprehensive price benchmarking is not possible on a large scale
Ask yourself- just how massive would this great tome of benchmarks have to be to be useful? How big would this database have to be to contain relevant price benchmarks across multiple categories, across thousands of buyers and sellers, over time? Sure, one could do this for a given category or two– we see this in commodity markets and with GPOs already. But this hardly addresses the bulk of a typical mid-market company’s spendbase.
Next, consider what must be true for these data to be comparable. Are unit prices adjusted for purchase volume? Same specifications? Same delivery terms? Same payment terms? What about minimum volume commitments? Bundle discounts? How recent are the observations- and how recent must data be to be useful? We could go on. Sales 101 teaches us to avoid becoming a pure commodity distinguished only by price, if possible. So how confident are we could compare unit prices across companies, given that every supplier would be actively trying to confound such comparisons?
We admit, unit price comparison is useful as a supplementary tool—it can confirm in a very tangible way, for selected areas of spend, that there really is potential where other factors would suggest there should be. If industry factors suggest there should be price reduction potential and the company’s internal process rigor is low, it shouldn’t be hard to find a relevant quote well below the current price. But this doesn’t mean that unit price comparison should be the primary basis of evaluation because…
…Even if comprehensive price benchmarking were possible, such an approach would miss the point and ignore the main sources of value
Assume you had a comprehensive unit price benchmark database, or that you were a member of the world’s biggest and best Group Purchasing Organization…this would still tell you nothing about the very factors which tend to be more critical to value creation, e.g.:
- Demand management: regardless of price paid, is the company buying the right amount (no more, no less)? Are they utilizing all their software licenses? Is there product spoilage / obsolescence due to overbuying? In the pursuit of low unit prices is the company buying too much or too infrequently?
- Specification setting: is the company buying the right model / specification for the right application? It does no good to get a great price on a deluxe model when the basic package would have sufficed. Likewise, a bargain on an ineffective product is a false economy.
- Impact on Total Cost of Ownership: how does a given good/service affect incremental labor costs? Incremental inventory costs? Product quality / reliability costs? One could logically purchase a more expensive product that reduces labor rework and simplifies inventory stocking, delivering 10X more value than an incremental unit price reduction on the same product… yet this sort of opportunity would never surface from a price benchmarking approach.
In fact, over Inside Consulting’s 16 year history, less than half of our sourcing value creation has come from unit price compression. About 35% has come from demand management and about 25% has come from other TCO factors (improved labor efficiency, inventory efficiency, product quality).
This is why our sourcing potential diagnostic focuses more on understanding the maturity of a businesses sourcing capabilities and processes and the economic market potential of a given category, as this correlates much more strongly with overall value creation potential than does unit price comparison.
Most importantly, the quest for price benchmarking misplaces organizational focus and breeds the wrong kind of thinking, which sacrifices long-term value creation. As such, it is not just misguided; it is damaging
Price comparison is seductively straightforward. It lends itself to nice charts and simple action plans. Custom comparison and holistic Total Cost of Ownership analysis, on the other hand, is hard and it takes time. It requires engagement across functions and clean-sheet analysis. Every hour spent on price benchmarking is an hour not spent on some other sourcing initiative. Managers should consider which uses of time offer the best incremental return.
More insidiously, reliance on price benchmarking becomes a mental crutch. If the job is simply consulting the benchmark database, people stop thinking. The kinds of people who enjoy custom problem solving (e.g., finding new supplier alternatives, crafting win-win contract structures, quantifying switching costs to inform negotiations) tend to be different from those who are content to use and maintain simple benchmarks. To the extent a company’s culture embraces heavy reliance on benchmarks (which at best provide ~40% of the potential value at stake), that company risks losing creative problem solving and forgoing the bulk of their potential sourcing value creation.
We close with a couple warnings:
- Beware the consultant who pitches unit price benchmarking as the core of their profit improvement approach
- Beware the Sourcing Director who prioritizes this mythical quest over other value-creation initiatives