Familiarity Breeds Higher Prices

You’ve been with your incumbent supplier forever and its newer customers are getting a better price than you are. But if leaving your current vendo...
Scott DrobesMarch 27, 2013

When multiple vendors compete for your business, you can expect to see aggressive pricing. But with your existing suppliers, competitive sourcing is not always an option, and without that you may be paying an above-market premium. This is not an easy problem to address.

True competition would require that you be willing and able to switch vendors.  But your current supplier may be working closely with your team.  Or there may be few alternatives to the current partner, and you may be in the middle of a long-term agreement with heavy penalties for ending the relationship early.  Not to mention the fact that formal sourcing methods such as requests for proposal can disrupt strategic relationships, and will eat up significant time and resources across the organization. 

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Your suppliers know that it is hard to switch, and they will leverage their incumbent position to charge a higher price than you would pay if selecting a new solution today. When your vendor’s pricing is above current market rates, developing the correct negotiation strategy requires that you quantify the nature of the premium you’re paying, and ask yourself why your supplier believes it doesn’t need to make price or service concessions.

1. Use high switching costs to your advantage.
When considering alternate vendors for a commodity product, you primarily are focused only on whether another vendor can sell you the same product (or an acceptable substitute) at a better price.  Changing service providers, on the other hand, is far more complex.  For example, if your company outsources its call centers, there is a long ramp-up to train the vendor on your processes and procedures, and to integrate its services with your internal-support organization.  Changing vendors would involve not only significant transition costs but also the risk of service degradation to your internal or external customers, and a significant time and resource investment.  In addition, such agreements tend to be long term: usually no less than 3 years.

But when market rates drop, or your volumes increase, you can actually use these switching costs to your advantage  even in the middle of a long-term agreement. 

The first step is to assign a dollar value to those transition costs, and compare that expense to the premium you’re paying over benchmark pricing over the term of the contract.  Armed with this information, you can approach your partner to explain how its current pricing requires your company to consider a move when the contract expires in a few years.  Since such a change demands significant advance planning, you would have to begin those preparations now.  Your vendor also should understand that the further your preparations progress, the more likely you are to actually make a change, since much of the transition investment already will have been made.  Indeed, the only way for your vendor to ensure that it will be doing business with you down the road is to negotiate an early renewal at more competitive rates right now, thereby eliminating the financial case for a future switch. 

2. Create leverage with sole suppliers.
John Nash, the game theorist portrayed by Russell Crowe in A Beautiful Mind, developed the concept of competitive equilibrium in which neither party has anything to gain by changing its approach.  If switching is not an option because your incumbent vendor is the sole available source for a critical product, it can be difficult to incent pricing improvements.  To do so requires unbalancing the equilibrium, which demands that you look beyond the current product set you are buying.  Are there are other products the supplier sells or could sell to your company for which competitive alternatives do exist? You should also evaluate whether parts of the supplier’s current offering, such as maintenance, could be unbundled from the core product and then sourced elsewhere.  The goal is to discover leverage within discrete areas that create competition where none currently exists. 

In addition to competitive leverage, identify other things you can bring to the table to incent pricing improvements.  Brainstorm with your provider to identify what you can do within your own organization to reduce its fulfillment or services costs.  Consider providing testimonials, as well as serving as a case study.  

Lastly, don’t underestimate the value of “good will.” Suppliers understand that while they may be your only option today, the marketplace is always evolving.  When you can point to the premium you are being forced to pay, suppliers often strive to close the gap in the interest of preserving the long-term relationship.

3. Value your relationships.
Your organization will often have a strong preference for the incumbent vendor.  Notwithstanding the occasional baseball ticket or free lunch, this preference usually is based on the vendor’s performance and working relationship with you.  Some of your suppliers may have worked with your company for so long that they have built strong ties at the senior level of your company.  There are tangible benefits to these relationships, as those long-term partners are usually more invested in your company’s success.  But CFOs should still attempt to define a hard-dollar “relationship premium” so that they can evaluate what the relationship costs as easily as they would a line item on an invoice.

Sometimes your suppliers may also be your customers, and may be leveraging that dynamic when they price their products for you.  If so, calculate whether your sales to them are more aggressively negotiated than theirs to you.  Analyze the revenue and profit they generate for your company versus the relative value of potential price improvements from theirs.

Incumbency works both ways.  It is an axiom that acquiring a new customer is far more costly than keeping a current one.  As difficult as it may be to consider alternative suppliers, any risk of losing your business is equally unappealing to your current vendor.  By working with it to understand the true value of your current and future business, you can negotiate a new deal for tomorrow closer to what you would receive as a new customer today.

Scott Drobes is a managing partner of Third Law Sourcing, an Atlanta-based consulting firm that specializes in strategic vendor negotiation.