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Barriers to New Market Entry: Sunk v. Relevant Costs

inside of warehouse with a tractor trailer

The way you handle sunk costs when attempting to break into a new market in the federal contracting arena can be the difference between success and failure. Deciding how best to treat these costs depends on how well you understand the difference between a “sunk cost” and a “relevant (or future)” cost, so let’s start there.

A sunk cost is a cost that has already been incurred and cannot be recovered. On the other hand, a relevant cost, sometimes called a future or prospective cost, is a cost that may be avoided if certain actions are taken. 

Because they have already been incurred and are unrecoverable, sunk costs are typically not considered when making future decisions.They are excluded because their cost will remain the same regardless of the outcome of a decision. The relevant costs, however, are contrasted with the potential revenue of one choice compared to another. In other words, in order to make an informed decision, an organization should only consider the costs and revenue that will change as a result of the decision at hand.

Think of it this way: a manufacturing firm has various sunk costs. These include their monthly lease of the factory and the cost of the equipment they have purchased. If the company pays $10,000 per month to lease its factory and has purchased equipment outright for $50,000, those sums are considered their “sunk costs.” 

When the manufacturing company expands into new markets, these sunk costs are typically not recouped. When bidding against another contractor who already has the infrastructure in place, trying to recover the cost of elements purchased is going to quickly drive your price into non-competitive territory. 

How do you know if the competitor has the infrastructure in place? This is where ethically sourced, accurate Competitive Intelligence (CI) can provide the information you need to create your bid in a way that has a good chance of success.

More often than not, it’s expensive to get into a new market. There are always barriers to entry that are cost-related. Although there can be acceptable ways to go about recouping sunk costs throughout the course of a contract, attempting to do so may create an insurmountable, cost-related barrier to successful entry into a new market. Sometimes, these costs just need to be absorbed as the “cost of doing business” that you will choose not to charge back.

Sometimes, the way into a new area within the federal market space is to invest in the infrastructure you will need to complete the deliverables, view those as sunk costs, and proceed accordingly.

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Understanding Your Customer’s Budget

Businesswoman calculating customers budget

Can you afford NOT to know what your customer can afford?

Your company has products and services to offer, and you have identified a customer who needs them (or something like them) and plans to procure them (competitively, of course).  But the question is– what can they afford?  This is a simple question, but one that is all too often neglected by capture teams too focused on the features and benefits of their solutions to recognize how costly they’ve become.  Never mind the competition (for now). Start with understanding your customer– in particular, your customer’s budget.  What happens when you design a product that your customer can’t afford?  Answer: You either discount it heavily and take a loss, or it sits on the shelf and you eat the entire cost of designing it.

Every customer has a budget–this much should be obvious– and it behooves every capture manager to endeavor to understand that budget.  But how?  Here’s a great place to start … ASK!  That’s right.  If you have meetings with the customers, ask them what their budget is for the program. If you don’t have meetings with the customers, pick up the phone or send an email and ask them.  They may not know, or they may not be willing to share that information with you.  If that option fails, or if it isn’t an option at all, don’t despair! There are several other ways of assessing your customer’s budget.

In the case of government agencies, budgets are formed through a lengthy (typically year-long) approval process, and in most cases, finalized budgets are published and available for download.  These budgets do tend to be high-level and therefore may not provide detailed budget data for your individual program (unless it’s a large or high-priority program). It’s always worth checking, and a savvy analyst can usually look at historical spending and make some reasonable assumptions to project what the program budget will be as a percentage of the high-level budget. This is obviously more challenging in the commercial space, where customers do not typically publish budget data, but even there you may be able to determine what they have paid for similar goods and services in the past and make some projections based on that data.

Once you’ve developed an estimate of the customer’s overall budget for a program, you’re not done yet.  Typically, program budgets must also cover certain expenses related to running the procurement and the program office itself (i.e., “keeping the lights on”). This represents what we call “holdback” or “management reserve.”  When you subtract this reserve from the overall budget, what remains is called “contractor addressable budget” or simply “addressable budget.”  THIS addressable budget is the figure you need to understand in order to ensure your solution is affordable.

Determining holdback can be tricky. Sometimes, customers publish their program office expenses in their budget documents, but not always. Otherwise, find someone knowledgeable about the customer (perhaps a former government employee or contracting officer) who can comment on standard practices, or make some logical assumptions and move on (don’t get stuck in the weeds!)

Finally, keep in mind that budgets change. The annual budget requests are just that:  requests. They present a snapshot of what the customer expects to spend on a program at one point in time, but that can (and often does) change. So it’s imperative to maintain good customer intimacy and listen carefully to what the customer is saying, watching for signs that either the budget, or the customer’s definition of value, may be shifting.

For more information on customer funding analysis, Competitive Intelligence, or Price To Win, contact Richter & Company.