Monday, January 31, 2011

Opportunity Costs

In negotiations you mostly focus on direct and indirect costs associated with the Supplier relationship. In motivation behind the negotiation, you may also have opportunity costs that may drive the behavior of the Supplier or Buyer. For example, a common tactic in product development and sales is to be the first one out with a Product or Service so that you become designed into your customer’s product or solution so that it becomes difficult or costly to switch to another Supplier. In that situation the opportunity cost that drives their behavior is all the residual and annuity business they would get once they are selected.  If they don’t close the contract, they don’t just lose that sale, they also lose any residual or annuity sales that would flow from that.  It doesn’t hurt to remind a Supplier of that during the negotiation.

There can also be opportunity cost that you can use in negotiation of the renewal of service contracts. For example, I once negotiated a renewal bonus if we were to renew a major service agreement. The rationale that we used in negotiating the bonus was that if we walked away and went with a new supplier, the Supplier would have significant expense in bringing in new business to replace us, so if we saved them that cost we should get a benefit from that renewal.

Another form of opportunity cost to a Supplier can be in simply having your company as a customer.  There are two types of potential value involved. One is in what they can learn from you if they do business with you. The other is the value of your name or brand in the marketplace in their selling to other customers.  Being able to list certain companies as your customer can be like having the “Good Housekeeping Seal of Approval”.  Potential customers view Suppliers that have prestige customers different than ones that don’t, and that provides substantial marketing advantage to a Supplier.  If they don’t get your business or lose you as a Customer, that’s an opportunity cost to them.

In preparing for a negotiation one of the things you should always check is recent business news about the Supplier such as recent announcements, awards, cancellations, claims etc. That type of information can help identify their need for your business.

Buyer’s can have opportunity cost which also can motivate their behavior and it’s important in dealings and conversations with the Supplier to not disclose the facts behind such opportunity costs. For example a Buyer could need the Supplier’s product to do the same thing as the Supplier (such as try to be first to market with Buyer’s product so they can lock in their own customers in and get the same benefits of being designed in to a solution). Buyers can also have opportunity cost in terms of costs they accrue waiting for work to be done. I once had to negotiate a contract to fit out a Computer Store that we were locating on Wall Street. In that case the opportunity cost was the substantial rent that we had to pay each month until we could use the space.  The longer it took to negotiate the agreement the longer we would have to pay rent without using the space.

Buyers may also have opportunity cost tied the profit they can make once the work is complete. I once negotiated for the construction of a plant in Hong Kong and the Vice President who had control over the future plant made it very clear to me that he wanted the agreement closed as quickly as possible and he want the work done as fast as possible, but still pay a competitive price. It wasn’t until later that I found out the reason was that once completed, the operation would make enough profit in six months to pay for the entire building and all the equipment in it. That’s a real potential opportunity cost if there were delays.

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