The hidden value of growth
How your business growth can drive down supplier costs
For many organisations, annual supplier price increases seem to be an accepted norm. They often go unchallenged, even though factors that are usually referenced as their cause, such as inflation and the rising cost of raw materials or shipping, are rarely quantified or properly justified by suppliers. But while regular New Year price hikes may have become something of a tradition, those who support procurement best practice know that every proposed increase should be questioned and its potential impact on the business calculated. Price rises that are not adequately justified by suppliers should simply never be agreed. This situation reflects one of the big differences between a reactive and proactive procurement function.
- Reactive procurement means you’re always behind the game, struggling to respond to the latest price increase and ill-equipped to negotiate effectively with suppliers.
- A proactive approach is a marque of procurement excellence that puts you on the front foot with suppliers. With procurement strategies integrated into your business planning cycle, you can accurately forecast business performance for the coming year and then evaluate how this could affect supplier relationships. Importantly, if growth is predicted, its value can be calculated and used as an argument to negotiate price reductions.
Value of growth model
Why do you need it?
To calculate the value of your growth on a supplier’s costs
What is the benefit?
You can substantiate arguments to reduce prices
When to use it?
Whenever your business with the supplier is growing
How does it work?
The Value of Growth principle involves considering the impact of your projected business growth on your supplier’s fixed and variable costs. Fixed costs like sales, administration, warehousing and indirect labour remain the same in total when output increases, but reduce on a cost per unit basis. On the other hand, with variable costs such as energy, transportation, raw materials and direct labour, the total increases in line with volume growth, but stays constant on a cost per unit basis.
Although it’s unlikely you’ll know the precise split of your supplier’s fixed and variable costs, you can create a realistic business model based on published information including annual reports, company literature, industry analysis and blogs. Your supplier contacts will also often provide you with useful insights that help to build a clearer picture of their cost structure. Remember that if a supplier needs to add plant or capacity to accommodate your growth, their cost base will change.
|Total Cost:||Unit Cost:|
• Stay the same in total when output increases...
• and reduce on a cost per unit basis
Fixed costs remain constant as volume increases...
|...but cost per unit reduces
• Total increases in line with volume growth...
• but on a cost per unit basis remains constant
|Variable costs rise in total...
|...but cost per unit is constant
By assessing the variable proportion of their total cost, (fixed%=100% - variable%), you can work out the value of your business growth, or the decrease in unit costs, to a supplier. The higher the percentage of fixed costs, the greater the reduction in unit costs for an increase in volume. For a tougher negotiating position, you can quote marginal cost figures, or the percentage reduction in unit costs where you’re not subsidising competing customers. If you choose to adopt a softer approach, then you might want to use average cost data instead.
Calculating the value of increasing the size of your business with top suppliers – normally 20% of suppliers will account for 80% of your costs – enables you to develop a proactive cost reduction programme with a strong negotiating platform for reducing prices. It is a particularly effective approach when your account constitutes a significant proportion of your supplier’s business.