A typical Procurement negotiation often involves a range of suppliers in unstructured and uncommitted negotiations, rendering them ineffective. Dr Sebastian Moritz, Director of TWS Partners, explains how the application of game theory enables Procurement to achieve negotiation excellence by leveraging commitment and adopting insights from ground-breaking economic research in sourcing decisions.
Applying game theory turns negotiation from an art to a science
Game theory, which is the scientific modelling of interactions between different parties in competitive situations, can consistently ensure that best value is obtained. This can ultimately lead to Procurement being seen as a much more strategic and value-driving function in any organisation.
How can this be achieved?
A sourcing process is naturally a cross-functional workstream. However, many organisations struggle with the fact that the internal functions involved do not necessarily have the same objectives. In many cases, they even have conflicting interests. For example, while Procurement focuses on delivering commercial targets, the R&D department might be much more interested in obtaining a superior solution. This is also why most organisations make a sourcing decision only after all negotiations with suppliers have been concluded.
However, this approach has severe disadvantages for all participating parties, both within and outside the organisation. Procurement is in a weak bargaining position, as it is not empowered to make independent sourcing decisions. It cannot make committed statements to the suppliers. Stakeholders struggle to see how their preferences are taken into account, and suppliers perceive the awarding process as a ‘black box’, making decisions based on criteria they do not know and cannot control.
The consequence is a suboptimal outcome and a waste of internal resource in cumbersome internal and external negotiations, but there is a better way.
A Procurement process designed by game theory
A Procurement process optimised by game theory contains the same steps, but rearranges their order to enable commitment both internally and externally. In particular, the cross-functional alignment is pulled forward. This crucial step is conducted before the commercial negotiation takes place. Obviously, the stakeholders cannot decide which supplier will be nominated, but they can align on the commercial and non-commercial elements that will drive the awarding decision. The aim of the cross-functional alignment is to get a holistic view of the suppliers and make them comparable, taking into account all commercial and non-commercial aspects of their offer. To achieve this, a Bonus/Penalty evaluation is used.
True TVO perspective enables commitment and advanced negotiation techniques
In the Bonus/Penalty evaluation, each function independently defines their relevant non-commercial sourcing criteria and evaluates the suppliers according to these criteria. This evaluation must be conducted in monetary terms, so that a supplier’s commercial and non-commercial performance becomes comparable. This includes aspects like project management capabilities, reliability or technical performance. These are added to the quoted price, artificially increasing or decreasing the supplier’s total business case. This means that the result of the Bonus/Penalty evaluation reflects the true total value of ownership (TVO) of each solution/product offered by a supplier. This also implies that the most complex sourcing situations can be mapped into an analysis where only one single number per supplier can fully represent a company’s view on a supplier. All considerations from all stakeholders are incorporated, all factors are monetised and reflect the true TVO offered by each supplier. This approach circumvents further internal ‘haggling’ between stakeholders at the approval stage.
The result: An empowered sourcing team
The whole organisation can stand united behind the cross-functional assessment, Procurement can speak with one voice to suppliers, and more importantly, make commitment statements to suppliers during negotiations.
The power is in your hands
If Procurement has the mandate to source the best supplier from a TVO perspective, and the advantage of a single criterion, Procurement can literally run any negotiation format – ranging from traditional negotiations where Procurement could now make committed statements and offers to suppliers to more mechanistic negotiations formats. In the most extreme scenario, Procurement can even run auction style processes for their most strategic and complex products and services.
Why do advanced negotiation techniques make a difference?
The answer to this question goes well beyond the scope of this article, but let’s think about a simple example. Let’s assume three suppliers are competing for a piece of business. All suppliers have been given a mandate from their management (A – 100, B – 110, C – 120), i.e. a number at which the business is not profitable for them anymore.
1. If the buyer decides to use decreasing negotiation schedule, where prices are lowered during the negotiation and suppliers start to undercut their competition during the process, Supplier A would win at 110 minus a penny slightly undercutting Supplier B.
2. If, alternatively, the buyer decides to run an increasing negotiation schedule announcing prices until the first bidder is happy to accept the announced price, the process would most likely see Supplier A winning at a price of 100 or slightly above*.
If we then think about a third alternative of a simple sealed-bid process, often used in public procurement, where suppliers have to submit a bid and the lowest one is awarded the business, the pattern becomes obvious. Most likely supplier A would win again, but the buyer would again be paying another price.
Three different scenarios, three different prices.
In any of those alternatives, nothing has changed – it is the same suppliers and the same mandates. Only the negotiation process makes the difference, and if we turn this around it means that a suboptimal negotiation design leaves money on the table.
Now, reality is much more complex, but the power is in your hands if you have a full understanding of how to game-theoretically optimise a negotiation process – the very heart of game theory and its subdiscipline mechanism design.
Objectivity, fairness and best value
The power of this methodology is being realised throughout the globe. 90% of people who use game theory are convinced it contributes to their success and 80% of people who don’t use game theory yet, believe that it will make a difference. **
Leading manufacturing companies are applying this methodology to their most strategic sourcing activities as it ensures objectiveness, fairness towards suppliers and best value for the organisation. Advanced applications even include sourcing for innovative technologies (electrification, high end electronics or bespoke solutions), new manufacturing technologies, complex services such as logistics or engineering services, or capital investments.
To find out more and learn how to implement game theory in your organisation today, read the white paper “Procurement Redefined”, the survey “The power of game theory is in your hands” or contact TWS Partners on +44 (0)203 5804276.