Comparative Economic Advantage

by Alex Howerton, Business Development Manager, Source One

This month’s book excerpt from Managing Indirect Spend makes a good case for a business to examine its procurement practices, especially in the area of indirect spend. Many businesses, however, can be tempted not to take the time to examine approaches to their procurement processes. This may be due to the inertia of existing processes, a fear that changing processes may actually damage productivity, or a feeling that no one has the time to address tangential issues like indirect spend. “We’re doing good enough,” a senior executive might be inclined to muse, “and I don’t want to risk rocking the boat.”

This is not an uncommon sentiment in business, and it has been around for centuries.  All things being equal, most business leaders opt for concentrating on their core businesses, because that is where the time and energy spent will produce the greatest results, in terms of revenue growth or productivity.  But all things are not equal, and the leaders of the businesses who are leaders of their industries know that all aspects of a business must be made as efficient as possible to achieve and maintain that edge that makes a business best-in-class.

These leading business leaders employ, among other things, a principle known as comparative economic advantage, whether they call it that or not. The idea has been a force in commerce for centuries, but received its theoretical formulation by the economist David Ricardo in the early 19th century. In its essence, Ricardo’s principle of comparative economic advantage states that it is to the advantage of an entity (he concerned himself with nation-states, but the principle applies equally well to businesses) to trade with another entity for a certain commodity if the second entity’s relative costs to produce that commodity are lower than the first entity’s relative costs.  This is true even if the first entity’s absolute costs to produce that commodity are lower.

The foregoing, stated in such abstract theoretical terms, can be rather obfuscating. So let us consider an example directly relevant to procurement practices. Let us suppose you run a business that manufactures car parts. Your revenue derives from selling car parts, so the more energy you put into manufacturing and distributing car parts, the more revenue you will generate.  This is your comparative economic advantage. This advantage extends to developing and making most efficient the in-house capability to procure raw materials to manufacture those car parts.

However, to run that business, you need to procure many more items than just car part raw materials. You need telecommunications services, office supplies, maintenance services, computer equipment and IT services – the list is rather long. Perhaps you are a large company, and actually have the resources to build a complete procurement department, and could do quite well in generating efficiencies in all these areas.  However, any resources dedicated to these activities are necessarily diverted from being applied to the core business of car parts manufacturing.

The principle of comparative economic advantage states that it is ultimately more profitable for you to outsource your indirect procurement, and even core procurement, so you can concentrate all resources possible on revenue-generating activities. This is true even if you are better at the task than the contracted service provider, but especially true if that service provider can bring best industry practices to bear on achieving the optimal cost savings in your procurement activities, achieving results unattainable by the in-house department.

This is the goal of strategic sourcing providers such as Source One: to provide you with best-in-class procurement services, so you can turn a greater portion of your resources to your core business, thereby maximizing revenue generation.  No matter how you decide to configure your procurement services, it is worthwhile to heed the 200-year-old advice of a prominent economist, and try to determine where your greatest comparative economic advantage lies.

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