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.

Transparency in Supply Chains

The Transparency in Supply Chains clause from the Modern Day Slavery Act came into force last month. In brief, organisations with a turnover of £36 million or more are required to produce and publish a slavery and human trafficking statement each financial year. The Act has been well publicised and much has been written about it by people whose expertise far exceeds mine. If you want to find out more then I recommend the CIPS’s Modern Day Slavery 2015.

I’m sure that we all agree with the home secretary, Theresa May, when she said that “The presence of modern slavery in today’s society is an affront to the dignity and humanity of every one of us”. Unfortunately identifying issues such as modern day slavery in long, complex supply chains is difficult. And there are a raft of other issues to consider including the environment, health & safety, discrimination, corruption, conflict minerals, confidential information and supplier diversity.

The challenge for CPOs is to decide what to focus on and which resources to dedicate to it. Whilst some organisations like Unilever make corporate responsibility central to their strategy and define the scope clearly in their Sustainable Living Plan, wide variation in approaches still exists between sectors and organisations. A summary can be found in my article called More on sustainability.

The starting point for tackling any of these issues is having an excellent knowledge of the supply base. Despite the advent of big data and spend analytic tools, many procurement organisations still manage their data on spreadsheets. Although most procurement organisations conduct due diligence on new suppliers, the majority do it manually with a narrow focus on financial performance which is seldom repeated during the term of the contract. Finally, although procurement professionals are encouraged to visit their suppliers, their workload is often heavy and travel budgets are tight. Admitted there are a number of providers of supply chain audits, however, most organisations are unwilling to invest in them.

I fully support the Transparency in Supply Chains clause. The legislation represents is a positive step but its effectiveness will depend not on the statute book but on organisations choosing to prioritise modern day slavery over other initiatives and making the resources available to carry out robust due diligence.

Nobody ever got fired for buying IBM

Not a month goes by without a new scandal being uncovered at a large corporation. For a while financial services dominated the news with tales of price fixing and mis-selling. This month the automotive sector joined the front pages in spectacular style when Volkswagen admitted installing software that cheats emission tests.

At the same time as large corporations are dominating the news for the wrong reasons, start-ups are attracting attention for phenomenal growth rates and astronomical valuations. Although the press’s favorites tend to be B2C start-ups like Uber and Airbnb there are plenty of noteworthy B2B start-ups: Deem is a cloud-based, integrated suite of travel, expense, and purchasing management software which raised $50 million in July valuing the company at $1.4 billion; Mesosphere received $36 million in funding in December to build what it calls a new kind of “data centre operating system” that takes all the machines a company uses in the data centre and makes them work like one big machine.

The lead article in the Economist this week is entitled “Re-inventing the company”. The article explains how public companies are declining due to a combination of conflicting interests, short-termism and regulation. The costs for start-ups, by comparison, are reducing. A new company can incorporate online for a few hundred dollars, raise money from crowdsourcing and buy-in services to enable them to expand globally without employing an army of staff.

This trend presents procurement with both an opportunity and a threat. By disrupting markets, start-ups offer procurement the ideal opportunity to reduce costs and improve service. On the other hand, start-ups cannot comply with the due diligence requirements that procurement traditionally demand such as providing 3 years audited accounts or being accredited with international quality standards. And by their very nature most start-ups fail. Better Place had a bold vision to reinvent the electric-car infrastructure. It raised $850 million but struggled to win over both carmakers and drivers. It declared bankruptcy in May. Color Labs raised $41 million from such venerable names as Sequoia Capital, Bain Capital and Silicon Valley Bank for its online photo sharing site. It was dubbed “the start-up from hell” by The Atlantic Wire and imploded under a lawsuit that alleged toxic culture, poor leadership, and shady bookkeeping.

So does the old adage that “nobody ever got fired for buying IBM” still hold? The procurement profession has changed a lot since the 1970s when the phrase was first used by salesmen to create “fear, uncertainty and doubt” (FUD) in the customer. Research from the Hackett Group show that procurement’s priorities continue to shift from cost to expanding the scope of spend influenced. In the never ending search for savings procurement can no longer afford to limit its focus to public companies. Managing a start-up presents different challenges that require different approaches. Due diligence is no longer a one-off activity but on-going. Relying on a fixed specification is replaced by developing business cases to influence product development. Waiting for a decision from a senior official is substituted by negotiating directly with the founder and owner.

Without doubt risk adverse organisations will only deal with start-ups when they begin to act like public companies, however, more entrepreneurial organisations should engage start-ups and explore opportunities to work together. If procurement can develop an effective approach to managing the unique risks associated with start-ups then they can bring significant value to their organisations. Perhaps the old adage should be replaced by fortune favors the brave.

Marginal gains

England’s narrow defeat against Wales in the Rugby World Cup at the weekend will lead to some sole searching in the England camp this week before the critical game against Australia on Saturday. From what we know about the Rugby Football Union the sole searching will be accompanied by a concept called the “aggregation of marginal gains.” The cumulative effect of improving every aspect of the game by a small amount results in a significant improvement in overall performance.

Marginal gains can trace its history back to Sir Clive Woodward’s world cup winning team of 2003. As Sir Clive explains in his autobiography, Winning!, every aspect of the players preparation was looked at, analysed and improved. For example, players were given laptops so that they could receive their performance data and key information about their opponents. It also helped them keep in touch with family and friends at home while they were on tour. This approach was successfully applied to cycling by Sir Dave Brailsford. Matt Parker, a physiologist, is a key figure who worked with Sir Dave at the Olympic GB cycling team and more recently with Stuart Lancaster, England Head Coach at the RFU.

Marginal gains is a relatively new concept for sport but has been used in industry, and supply chain in particular, for decades. Some of you will recognise the term, kaizen, a Japanese word meaning “change for better”. Kaizen was first implemented in several Japanese businesses, most notably, Toyota after the Second World War.  All employees, from production line staff to board members, were expected to come up with ways to remove waste and improve performance. While the majority of changes were small, the combined effect was large. Kaizen is one of Toyota’s guiding principles which helped it become the first automobile manufacturer to produce more than 10 million vehicles per year.

The rise of big data and development of spend analytic tools provide Procurement with the opportunity to facilitate a step change in their organisation’s performance. If everyone involved in the supply chain has access to relevant data and an easy method of communication then Procurement can gather their ideas, evaluate them and work with suppliers to implement them. If Procurement could manage this then it would feel like winning the Rugby world cup.

The price of supplier relations

Much has been written about supplier relationship management (SRM) but the claimed benefits are rarely expressed in financial terms or supported by robust evidence. I was therefore interested to read the 2015 Annual Automotive Industry Study by Planning Perspectives, Inc.. Now in its 15th year, it tracks suppliers’ perceptions of their working relationships with their automotive customers. This type of research always produces headline grabbing numbers and this study is no exception: Ford, General Motors, FCA US and Nissan collectively would have earned $2 billion more in operating profit last year had their supplier relations improved as much as Toyota’s and Honda’s during the same period.

Putting the narrow focus of the study and headlines to one side for a moment, I like the report because it quantifies and, for the first time, puts a price on the value of supplier relations. The approach is based on game theory and so can be applied to most supplier relations situations whether buying services in Sweden or commodities in China.

The study incorporates an economic model developed by John Henke, president and CEO of Planning Perspectives, called the Working Relations Index (WRI). It has 5 components each with a number of different variables (see below):

  • Supplier/company relationship – measures trust and the effectiveness of the working relationship
  • Company communication – measure the degree to which communication is honest, timely and sufficiently detailed
  • Company help – measures the help provided by the customer to reduce the supplier’s costs and improve quality
  • Company hindrance – negative measures including the degree to which objectives conflict, specifications are unclear, the customer is inflexible and supplier has a say in product development
  • Supplier profit opportunity – the supplier’s perception that rewards/costs are shared and the customer understands the profit impact on the supplier from changes in their behaviour

Although I think the WRI can be applied widely, it is interesting to read Henke’s comments on this year’s study (particularly if you are a petrol head).

“Toyota and Honda had the highest ranking because supplier relations were a priority throughout their organisations and particularly within their purchasing organisations. This included the vice president of purchasing down to the buyers who work with the suppliers on a daily basis. They executed the basics better, that is, they had good business practices (eg does the customer have fair and equitable financial practices, are contracts honoured, is the head of purchasing working to improve relations etc) and the buyers were sufficiently skilled to carry out the work (eg do they have the required knowledge for their job, do they work to resolve issues quickly and effectively, are they open and honest when communicating with suppliers etc).”

“Once the basics were in place then working on activities such as the nature of the relationship helped improve the WRI score. The nature of the relationship changed depending on the degree of open and honest OEM communication, the help the OEM provided the supplier to reduce cost and improve quality, the level to which the OEM hindered the supplier in doing its best job, and finally, the long-term profit opportunities the supplier perceived were available.”

Henke thinks that GM, Ford, FCA and Nissan did poorly because “their supplier relations programs were not sufficiently focused, the buyers and engineers responsible for implementing the improvements were not capable of doing so, or more likely, were not sufficiently motivated do so and when internal mandates came down to reduce cost, buyers reverting back to their old adversarial ways of getting the reductions, because for them building collaborative supplier relations was of little importance.”

The study offers a fascinating insight into the supplier relations in a specific industry over a long time period. By comparing the dollar value of each component across the different customers it provides a clear illustration of the opportunity cost of supplier relations. I suspect that Henke’s comments are not surprising to those actively involved SRM, however, I hope the research helps them articulate the importance of engaging across their organisation and building the business case to secure investment in the appropriate resources.

The Sustainability Marathon

I’ve written extensively on sustainable procurement mostly with the aim of describing best practice. I recognise, however, that many organisations struggle to delivery anything close. The Supply Management blog called On sustainability – what you contract for is what you get by Shaun McCarthy offers some interesting insights into London 2012 which vowed to be “the most sustainable Olympic Games ever”.  He says that “energy consumption was not well managed, the energy plan wasn’t implemented soon enough, the Games energy team was recruited too late and venue managers were inadequately trained.” He goes on to describe how the Games reflect building and facilities management practices across the industry. Let’s hope the lessons have been learned by Rio 2016 and more widely.

Marriage of convenience

Supplier relationship management is becoming an increasingly important part of the service offered by procurement. Globalisation continues to produce longer, more complicated and riskier, supply chains. Procurement is seeking new opportunities to drive additional value.

Most procurement functions actively manage their top suppliers based on spend. The more mature functions evaluate risk and manage those suppliers that are both high spend and high risk. One of the biggest challenges to calculating risk in long and complex supply chains is knowing which suppliers are critical. This is getting increasing difficult as more suppliers collaborate.

There is nothing new about businesses collaborating, however, their is increasing pressure to form joint ventures or looser alliances despite the inherent risks. An article last month in the Economist called Managing Partners outlined the pressures which include the increasing cost of developing new technology, greater cross-sector and cross border opportunities and greater expectations from consumers.

Car manufacturers have a long tradition of collaboration in the areas of technology and manufacturing. The cost of some new technologies, however, is so high that even the largest companies cannot bear it alone. Toyota, the world’s largest carmaker, is working with BMW, one of its main competitors, on fuel-cell technology. A similar trend can be seen in telecoms with Apple and Samsung. Apple’s main supplier of microchips for its iPhones is Samsung, its main rival in the smartphone business.

Companies from different sectors are forming seemingly unlike partnerships which is putting pressure on their rivals. Allianz, a German insurer, has teamed up with Google to create an “accelerator” centre in Munich, to foster start-ups that are seeking to use data analysis to improve the insurance market. Mobile-telecoms operators and financial institutions are collaborating to offer mobile payments.

The tide is changing between rich countries and emerging economies. Procurement has led many of the initiatives to outsource to low cost countries. Now, however, it is as likely to be an emerging-market firm seeking a Western partner to help it go global. Dr Reddy’s Laboratories, an Indian pharmaceutical company, and Merck KGaA, a German one, are working together on cheaper versions of cancer therapies that are losing their patent protection.

The fourth pressure comes from consumers. Most department stores and supermarkets have offered concessions to niche providers as part of their proposition to consumers.  As more people move to shopping online, owners of physical shops are having to find new ways to get customers to visit them. H&M, a fashion firm, invites consumers to free space in their wardrobes by bringing their old clothes to its shops and receiving a discount on new ones. To do this it works with I:CO, a logistics firm, which sends some of the used clothing to the second-hand market and the rest to be recycled.

By understanding the pressures that suppliers face, procurement professional will develop better predictive indicators that provide insights into the risks. In the future, we will find that the risks arise not only from our supplier but also from their arch rival or one that doesn’t even compete in their market.

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