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Common Sense

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Irrational spending is costing corporations millions. Like the consumer who values the expensive, name brand product more than the exact same generic version, companies often behave in what Duke University behavioral economist and bestselling author, Dan Ariely, calls "predictably irrational" ways, in which consumer purchasing decisions are based on emotions and expectations rather than logic. Only the price tag is bigger.

Consider this: up to 40% of a company's operating expenses go to outside vendors. That is a rather significant slice of the company pie, one you wouldn't expect to be spent lightly. And yet corporate purchasing patterns are all too often made based on illogical decisions rather than common sense. Say your company buys 100,000 widgets and receives a 30% discount. The company's goal is to grow and the vendor, assuming the company's future need will be greater (and, of course, trying to sell more widgets), offers an even deeper discount if the company agrees to buy 120,000 widgets going forward. Sounds good. However, what happens if the company does not (or should not) even use the initial 100,000? Although a discount always sounds attractive -- in essence, getting something for nothing -- you are now stuck with an even larger purchase and you ultimately end up paying more. Cost avoidance appears logical, but in reality, in green dollars, that money you think you are saving is going from the company's pocket into the pocket of the vendor.

Common sense. Too often, global giants don't even know what they already have in inventory and therefore can't possibly evaluate their needs. I had a client that dealt in something far more expensive than widgets, computer servers numbering in the tens of thousands! The company began negotiating with hardware vendors without even knowing exactly how many servers they had; there were conflicting numbers and until they could tighten up the inventory and compile accurate data, any negotiation would be futile. And expensive. Know what you have and know what you need before heading to the negotiation table. Sounds obvious, but it needs to be said ... and it is easier said than done!

In an effort to lower costs and retain flexibility, many large organizations hire contractors, negotiating a master service agreement, or contract, with the lowest possible rates. As often happens, there will be times when the contracted firm doesn't have the specific expertise to tackle a particular project and the corporation must then hire a specialty firm. These firms, however, are not covered under any master service agreement so the original contractor agrees to sub-contract this niche firm, adding a 20% mark up to "manage risk." The original cost containment negotiated so carefully into the master service agreement has suddenly disappeared. So much for the cost reduction. The logical solution is the 80/20 principle: redefine your sourcing strategy by devoting only 80% of your sourcing budget to the primary contracts, keeping the 20% available for the inevitable niche source.

Another key to keeping costs down is to periodically measure the cost benefits of outsourcing. The savings look good on paper, but especially in today's complex, multi-national environment, the reality changes quickly and you may very easily wind up overpaying for unforeseen or rapidly changing demands. Consider: do you really need to outsource? Do you have a contingency plan for cost overruns? Can the work be done for less elsewhere? Can you define the scope well? One frequent pitfall is when a company locks into the misguided mindset of "mess for less." Before an organization considers parceling out its workload, it must first accurately baseline its own internal capabilities versus what it may actually need to outsource: can outsourcing really handle your mess for less? Again, be certain you know what you have and what you can do before hitting the negotiation table. By optimizing these existing capabilities to keep them in-house as much as possible, vendor costs will be lower, translating into real savings for the company rather than becoming a "margin" for the vendor. Do not make the mistake of outsourcing your mess for less. It will not happen. Once again, this is nothing more than common sense that is repeatedly ignored.

In the troubled economy we've been facing, the tendency has been to lower costs by quickly shutting down the discretionary spending while running the core business, simply keeping the lights on. As the economy recovers and projects are brought back online, it is time to reevaluate your vendor expenditures. Purchasing groups, for example, are an excellent way to increase volume and negotiate better terms with vendors. By pooling the resources of multiple companies in the same industry, much like what many have done with telecom services in the past, you will have added leverage to negotiate lower rates. This obviously doesn't work for all types of services but works well for commodities and simple offerings. And it's a start.

Ultimately, like the consumer who is seduced by a 'free' offer to buy something he doesn't need, the corporation is equally susceptible to irrational decision making. In order to prevent this, consumer and corporation both must take a step back and summon that rational part of the brain before making a purchasing decision. If this sounds obvious, almost simplistic, it is. After all, "rational" is just another word for common sense.