Material scarcity, rising inflation, exploding energy prices, and an unstable geopolitical situation pose procurement challenges like never before.
The right negotiation strategy is not only essential for companies to achieve cost savings but is also absolutely vital for survival.
In the current market situation, securing material availability often takes top priority. In this case, negotiations with suppliers must be based on partnership and close cooperation. On the other hand, if contract volumes have been awarded in competition between multiple suppliers with a high degree of shiftability, the use of game theory should be considered.
But what does the game-theoretical negotiation approach look like? In a classic bilateral negotiation, the focus is on convincing the other party with the right strategy and tactics, a convincing storyline, and compelling arguments for one’s own position. In contrast, the game-theoretical approach involves developing a bidding mechanism that maximises the competitive dynamics between suppliers. The design of the bidding mechanisms is based on insights from numerous scientific theories.
In fact, since the 1990s, several Nobel Prizes in Economics have awarded in the field of game theory. This scientific approach opens up new perspectives in complex negotiations and makes it possible to forecast how people tend to behave. In strategic procurement, many companies use game theory in bids and negotiations. After realising unimaginable savings results, procurement teams are electrified and absolutely convinced of the effectiveness of game theory.
Game theory in procurement
The two most relevant and commonly used bidding mechanisms in procurement auctions are the Dutch (ascending bid increments) and English auction (descending bid increments). In combination with other elements, such as qualification and ranking rounds, they can maximise competitive pressure through credible market transparency.
However, when developing any game-theory-optimised bidding mechanism, many questions should be asked. For example: How should the lots be formed to create the greatest possible competitive pressure? What decision will a supplier make if it is assumed that they want to maximise their own benefit – and how do you optimise the bidding design to take this into account? With what bidding design can you put the best suppliers under pressure?
These criteria are met:
Game theory is fascinating – with demonstrable successes that cannot be achieved through classic negotiations, with the consistency and “purity” of its systematics, and with the surprising realisation that some game-theoretical approaches have been intuitively and unconsciously used to increase strategic competition and minimise risk aversion.
Many procurement teams believe this approach only applies to certain categories of goods. This is a misconception. Generally, only three criteria will be met. We call them the 3Cs:
•Comparability: All relevant decision parameters will be taken into account and is monetised through a bonus-malus evaluation. The offers of participating suppliers are comparable, and award decision is based on total cost of ownership.
•Commitment: The award decision is completely open. All participating suppliers are released by the department, and all cross-functions can win the contract on their own. In addition, it is clearly communicated that there will be no renegotiations or vetoes in further procurement committees.
•Competition: There must be more than one supplier interested in the scope of the award. Only this way can a competitive situation be created that is maximised with the help of a tailored award design. The right incentives for suppliers must be identified, and the appropriate signals set.
Possibly, not all of these criteria are met at the beginning of the project, but they can be developed together in cross-functional teams (consisting of colleagues from procurement, engineering, quality, logistics, and sales).
How the award is carried out:
Once the 3Cs are met, suppliers must be prepared for the award event. In transparent communication, the mechanism and rules are explained, and any uncertainties are clarified. No supplier should be unsettled, because only if the supplier has fully understood the mechanism, can he behave optimally, and the award mechanism can achieve its full effect.
The award day is then carried out with suppliers on-site or virtually via eAuction tools. Especially for larger award volumes, it is advantageous to have suppliers on-site, as signals are also sent to suppliers between rounds. In addition, you can literally feel the tension level and adjust the bid steps accordingly.
Virtual implementation facilitates the scaling of the approach with multiple providers. Smaller award volumes are carried out quickly and without great coordination effort. The selection of the appropriate tool provider is crucial. Not all tools can map more complex award mechanisms and adapts to specific individual starting situations.
Here are the first steps:
It must always be considered that game theory is a complex science and cannot be simply applied. The preparation time for the design of award strategies is often underestimated and set too low. To become a good game theorist, it is not enough to attend a weekend course or read a book. In fact, the unprofessional application of game theory can do more harm than good. Therefore, it is strongly recommended to be accompanied by a coach during the first use – only with this expertise are amazing negotiation results possible.
It is not always easy to delegate final decision-making authority to a mechanism, but it is worth it. Successful awards can ignite the fire in procurement teams. It is important to generate maximum enthusiasm, support cross-functional cooperation, and institutionalise negotiating skills in procurement teams.
By Erik Oberländer (DE), Manager, Procurement Advisory, PwC
