The long and short of contract theory

My interest in the Nobel Prize for Economics was piqued when I heard that it had been awarded this year for work on contract theory. Like many procurement professionals, I’ve spent many long hours in meeting rooms with suppliers trying to get agreement on terms like liability, liquidated damages and payment. My training on contracts has been restricted to legal training and has ignored economics.

Since much of procurement strategy is driven by economics, what insights does contract theory provide?

Much of my research on contract theory has lead me to ask “so what?”. A “complete contract”, for example, “is one that describes the legal consequences of every possible scenario.” Clearly, this is impossible to achieve and therefore has little practical value. Academics say that they are not trying to provide definitive or unique answers but enable us to think clearly about the issues involved. This may be useful in a lecture hall but would be given short shrift by internal stakeholders and lawyers during a high pressured supplier negotiation.

Most contracts in the real world are incomplete and the Nobel laureates, Oliver Hart and Bengt Holmström, spent their time developing something called the principal agent theory. Hart’s work focuses on finding out whether services should be run by the public or private sector. Holmström’s work focused on the ways to motivate employees. Neither of these apply to supply agreements but some of the principles can be used to provide insights for procurement professionals.

Research, for example that summarised in Popular Science Background, provides two areas of contract theory that can be adapted to improve contract drafting and drive better performance. Firstly, understanding how performance can be rewarded in ways other than payment and secondly, developing a framework to drive overall contract performance.

Improve performance without paying for it

A key part of negotiating commercial contracts is defining who has the right to decide what to do when the parties cannot agree, for example, renewing the contract at the end of the contract duration. The party that has the right to decide has more bargaining power and therefore the opportunity to drive more value from the relationship. If the supplier, for example, has the right to extend the contract then they may invest more in the relationship, for example, by improving process efficiency or identifying ways to broadening the scope of work. In this way, allocating decision rights becomes an alternative to paying for performance. For those procurement professionals judged on savings, trading the right to decide for lower prices may deliver a better outcome.

Payment linked to information about actions

Paying suppliers for performance in high risk industries, such as the supply of commodities, runs the risk of rewarding them for good luck and punishing them for bad luck. There are two implications: firstly, it is better to reward suppliers for information about actions; secondly, payment structures should be developed in a way that takes the market into account.

A supplier who correctly anticipates an increase in cost, for example, due to an increase in the price of raw materials or an over-run by a contractor and who takes mitigating action should be better rewarded than one who unexpectantly benefits from the reduction in cost. This requires a more sophisticated contract and contract management process so may only apply to high value contracts.

To avoid rewarding or punishing suppliers based on luck, payment to suppliers in high risk industries should be more biased towards a fixed fee structure. Payments to suppliers in more stable environments should be more biased towards a performance measure.

“If you can’t measure it, you can’t improve it”

There are many adages about measurement and improvement such as the one above by Peter Drucker, the management guru. Contract theory, however, shows us that there is a risk if such adages are followed blindly.

Most supplier contracts consist of many different tasks, some of which may be difficult for the buyer to monitor. To deter suppliers from concentrating on tasks for which performance is easier to measure, it may be best to offer weak overall incentives. For example, if a supplier’s payment is dependent on (easy to measure) timely delivery then quality may slip.

Conclusion

I don’t think contract theory is going to change the way procurement professionals negotiate contracts but it provides us with some extra tools to help us get a better outcome.

Any colour so long as it is black

“Any customer can have a car painted any colour that he wants so long as it is black” stated Henry Ford in 1909 about the first mass produced car, the Model T. Simplifying products enables quality to improve and cost to reduce. As part of a demand management strategy, procurement professionals apply this maxim to most products and services. Software is purchased “out-of-the-box”, “white-label” products are available in the consumer goods catalogue and “non-branded” items are promoted as part of the office supplies contract.

If you have purchased a new car recently, you will know that most manufacturers offer a bewildering array of options, not just colour. Fuel type, engine size, interior trim, driver safety equipment must be configured before an order is placed. The automotive industry provides a single platform and then allows customers to create the final product to suit their particular needs.

The automotive sector has lead the way for the procurement profession in many ways through the adoption of just-in-time management or kaizen. The pressure of delivering extra savings should not prevent us offering our internal stakeholders a choice for items that are important to them. But this is not new, after all, despite what Henry Ford said, he still offered the Model T as a 2-door, 4-door, roadster, town car, pickup and sedan in fire engine red.

The secret to eAuctions

The pros and cons of eAuctions have been debated since the technology was launched in 1990s. Michael Lamoureux, the Editor-In-Chief of Sourcing Innovation has recently added some weight to the argument against with a white paper called  The Dangers of e-Auctions.

In summary, he argues that e-auctions:

–     Don’t capture lowest cost

–     Don’t ensure quality

–     Don’t split awards optimally

–     Increase risk

He goes on to argue that eAuctions lead to:

–     Market shrinkage

–     Relationship souring

–     Increased disruption risk

I’ve managed a number of eAuctions over the last 15 years for a variety of products ranging from stationery to complex telecoms equipment. Furthermore, I’ve managed eAuctions both as an employee and as an external consultant rewarded on the basis of a percentage of the savings.

Managing eAuctions is one of the essential skills of a procurement professional. And the secret to a successful eAuction is knowing when to use it. But like any tender it is vital to get the specification right, engage with the suppliers and evaluate their responses in line with the stakeholder’s strategy.

eAuctions are only appropriate for certain categories of spend. Where the market is an oligosony and the product is a commodity then eAuctions should be the default approach. If, however, the buyer has little power and the product or service is highly differentiated then eAuction may not lead to the best outcome.

As a procurement practitioner, I have witnessed stakeholder’s excitement during an eAuction. It has not only helped drive down the cost of a product but it has facilitated the discussion about the wider adoption of procurement technology.

If Michael’s criticisms hold any weight then they are criticisms of procurement in general and not just eAuctions. Game theory and its application in the telecoms market clearly demonstrate how auctions can drive down cost. Michael’s other points about managing relationships, quality and risk are just the secrets of being a successful procurement professional.

Breakdown in procurement governance

A breach of EU procurement rules and a breakdown of corporate governance at Southern Health NHS Trust has landed the chief executive, Katrina Percy, in more hot water.

A consultancy called Talent Works Ltd, run by a former colleague of Ms Percy’s, won a tender with a value of £288,000 over three years. Southern Health paid the supplier £5.365m – an over-spend approaching 2,000%.

The case highlights the need for a procurement function which is independent from budget holders. Furthermore, it underscores the need for effective financial forecasting and contract management.

This case only hit the headlines because Southern Health has been under intense scrutiny since an NHS England commissioned a report in December that found it failed to investigate the unexpected deaths of hundreds of patients. Breakdowns in the corporate governance related to procurement is probably more wide spread than most of us care to admit.

Procurement should vote to remain

With less than a month to go to the EU referendum, most polls show that the in and out vote is split evenly with over 10% of voters undecided. Voters have been given advice from wonks, company bosses and even soldiers. So, would procurement professionals advise voter to stay or go?

There are a range of issues to consider from the cost of membership to immigration to the environment. Procurement professionals, however, are most concerned with trade and the economy.

It is worth noting that about half of UK trade is conducted with the EU. As a share of exports Britain is more dependent on the rest of the EU than they are on us. If Britain voted to leave then we would have to negotiate access to the single market.

Trade negotiations with other parts of the world are conducted by the EU, not individual member states. The EU has shown that it has the power to take on multinational organisation like Microsoft in antitrust cases.

There is little doubt that Brexit would cause an economic shock and growth would be slower. There are a range of forecasts available on the size of the shock and the impact on growth from the likes of the Treasury and the IFS. Since the assumptions vary the size of the impact also varies, however, they are consistently showing that the impact in the short to medium term would be negative.

The procurement profession should support the campaign to remain in the EU because the UK has more power as part of the EU and would avoid an economic downturn.

New systems, old mistakes

Pete Loughlin from Purchasing Insight posted a couple of great blogs this month called Things you thought you knew about e-procurement and Why big bang can be a big mistake. Both blogs deal with system implementations but highlight the importance of people and processes.

Time and again I see system implementations fail. Buying some licenses and engaging a systems integrator is only part of the solution. Speaking to the people who will use the system, explaining the benefits in a language they understand and ensuring they have robust processes in place to support their business needs is the other part of the solution.

As Henry Ford said “If everyone is moving forward together, then success takes care of itself”.

More on “The power of game theory in procurement”

My recent post on LinkedIn called 3 essentials for successful negotiations received over 100 views. It was shared by a number of people including Richard Nixon, Procurement and Ops Transformation Leader at Collinson Grant, and received more than 200 views. The post and the article, the power of game theory in procurement, received positive feedback:

“Great article, well done” Richard Nixon, Procurement and Ops Transformation Leader at Collinson Grant

“Interesting post.” David Johns, Director at PwC

“Excellent article, an interesting insight to game theory…” Paul Nagle, Commercial Contracts Manager at Inmarsat

The power of game theory in procurement

The sequel to Let the games begin has been published in Supply Management. The power of game theory in procurement focuses on the application of game theory in negotiation. Game theory tells us that there are 3 factors that determine the outcome of negotiation.

Information

Knowledge is power, particularly in negotiation. Category management, requests for information and requests for proposals all enable buyers to gather more information. Once you’ve got the information then you can use the Nash Bargaining Solutions to identify the range of possible outcomes. The next question is whether to share this information, for example, whether to tell a supplier that he does not have the most competitively price or to conclude the negotiations and select the supplier. To help us answer this question, we can use the Prisoner’s dilemma.

Commitment

The strength of commitment on either side is heavily influenced by the information available. If the information shows that a lower price is achievable then there is a stronger reason to stay firm, and a greater likelihood that you’ll achieve it.

Time

Patience is a virtue in negotiation. Always allow enough time to negotiate properly and use the suppliers sales periods to your advantage. By working out your supplier’s limitations (information again) you can gain the upper hand and play it to your advantage.

Although we may not always be aware of it, game theory is something we all use in negotiation already; by understanding and applying it more effectively, we can use it to get outstanding results. Game theory should be considered an essential part of any procurement professional’s skill set because it can help provide clarity to the dark art of negotiation and significantly improve the buyer’s results.

Black market

They say that very few things move faster than 30 mph without oil. For this reason and because it is an essential component for a vast range of products from fertilisers to electronics to cosmetics, oil is the most important natural resource for industrialised nations. The market for the black stuff has collapsed in the last 6 months. The price of a barrel of crude oil has dropped from a high of $145 in July 2015 to $30 now.
Given the wide application of oil and the 70% reduction in price, is there an opportunity for buyers and consumers to ask suppliers to pass on cost reductions?
As anyone with a car will testify, a decrease in the price of oil does not necessarily lead to a corresponding decrease in the price of petrol. The main reason is that the cost of refined petroleum is only a fifth of the retail price of petrol. Tax makes up the lion’s share at over half the price.
The most important factor when considering the price of oil is that it has very few substitutes. Car owners and product manufacturers have to buy it. Although the big oil producers suffer when the price of a barrel of crude oil drops, those that refine crude oil and convert it into products used in manufacturing have little incentive to pass on the reduction. A lack of substitutes is characteristics of a product with low price elasticity of demand. This means that a change in price of oil has a relatively small effect on the quantity of oil demanded.
Unfortunately, buyers and consumers are unlikely to be rewarded for challenging suppliers based on the collapse of the price of crude oil. While the rest of us watch and wonder how long the slump can continue, the oil producers continue to suffer.

New kid on the block (Sourcing Portfolio Analysis)

These days there is no shortage of advice for procurement practitioners in blogs, white papers and, less often, books. I was keen to read Andrew Cox’s latest book, Sourcing Portfolio Analysis, because he is a well-known academic and the book promised to offer an alternative to the approaches developed by Kraljic and Porter.

Purchasing Portfolio Analysis was developed by Kraljic in 1983 and is the most commonly used purchasing tool. It reduces the overall sourcing decision-making process to positioning within a simple four-box matrix. In this matrix, practitioners locate their categories of spend in order to identify which pre-defined approach to use. Cox’s critique of the tool runs to many pages, however, his key complaints are that it’s too simplistic and the model is static.

Porter’s Five Forces methodology was developed in 1979 and offers a more detailed approach than Kraljic to analysing supply market complexity.  Porter identified five forces that affect supply markets. Again, Cox’s critique runs to many pages, however, the main issue is that the approach focus on structural factors such as size of the market, number of competitors and capacity utilisation but ignores information based factors such as information asymmetry, lack of transparency and buyer incompetence.

Cox believes that that “gravest error” of Kraljic and Porter is that “buying organisations have sourcing relationships with suppliers, not with supply markets”. To address this error, Cox has developed the Sourcing Portfolio Analysis (SPA). Like Kraljic, this a positioning tool, however, rather than four boxes, there are 16. Categories of supply are mapped against buyer/supplier power and criticality. Categories of supply can move from one position to another enabling a more dynamic model.

The author calls for a “paradigm shift” in thinking about how to undertake category management and the development of appropriate sourcing strategies. This revolution is predicated on the use of SPA as a more effective tool for enabling managers to make choices about the most appropriate sourcing strategies and tactical levers to use when seeking improvements in value for money from suppliers.

Cox’s students and former students at Birmingham University Business School and IIAPS’s will claim that “Sourcing Portfolio Analysis” is essential reading. At over 300 pages, I doubt many will read it thoroughly. I think the model is just too complicated for most organisations to consider. It is not realistic to expect practitioners to consider 165 “power attributes” before deciding on the sourcing strategy. I would recommend IIAPS white paper called Power Positioning & Sourcing Portfolio Analysis but even that runs to 19 pages.

Despite the justified criticism, you get the feeling that Cox envies Kraljic’s success. If SPA has any hope of matching that success then it needs to be a lot more accessible.

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