The challenge of sector-regulated procurement
Utilities, grid operators, transportation, and mining companies are subject to European and national regulation. Sector-regulated procurement has to comply with rules similar to public procurement.
The client had been particularly unhappy with several past negotiations:
- Inflated pricing: Suppliers had consistently increased prices despite a fair number of suitable suppliers with sufficient capacities.
- Alleged bid coordination: There were strong indications that suppliers were coordinating bids and capacities to maintain an excessive price level and even elevate prices further.
- Failed to break collusion: Previous attempts to weaken the suspected collusion had been unsuccessful.
The client intended to tackle the challenge in a radically new way and identified game theory as a potential solution.
They contacted and engaged Competitio in the hope of three clear outcomes:
- Improve their negotiation position.
- Break up any alleged cartels.
- Preserve compliance with all relevant regulations.
Application of game theory for procurement
Game theory is a set of mathematical methods that help analyze strategic interactions between two or more players.
Non-cooperative game theory covers concepts such as the nash-equilibrium, strong or weak dominance of options, randomized strategies, imperfect information, bayesian equilibria, and different degrees of rationality.
Mechanism design, a subfield of game theory, helps design rules that generate desirable outcomes and behaviors from participants, such as revealing actual cost positions, offering available capacities, and lowering inflated prices in competitive bidding or reverse auctions.
Game theory and mechanism design have proven to be particularly useful in supply chain management, strategic sourcing, and purchasing negotiations and are widely used in many industries such as automotive, metals, and regulated industries.
They help procurement professionals in decision-making, supplier management, managing supply risk, increase their negotiation power, and lead to significant cost savings by transforming the nature of the interaction in the supply chain from buyer vs. supplier to suppliers competing against each other.
Implementing the game theory for procurement process
Setting up the game theory pilots
We assessed the suitability of the negotiations our client was particularly concerned about based on several criteria and found that the negotiations could all be optimized using game theory for the following reasons:
- The suppliers were generally keen on winning the contracts.
- There was sufficient time for preparing the negotiations.
- The volume was sufficiently large.
Creating an awarding and negotiation design
The next step was understanding the competitive situation and developing an awarding and a negotiation design for that specific competitive situation. Larger and smaller suppliers seemed to coordinate their bids to ensure high prices. The procurement team awarded contracts through framework agreements.
We developed a combined awarding and negotiation design to prevent supplier coordination on market shares. The sizes of each lot won by a supplier were not pre-defined by procurement. Still, they resulted from a highly competitive negotiation process considering the share size preferences of individual suppliers.
Aligning a flexible share approach for regulatory compliance
This design solved the issue of low competition on large shares that only a few large suppliers could supply. Smaller suppliers had to focus on smaller shares, for which competition was intense. The flexible share allocation ensures intense competition between suppliers of all sizes. We designed the flexible share approach in a way that is fully compliant with relevant regulations.
To consider crucial non-monetary differences between suppliers, we developed a transparent approach transforming the outcomes of supplier evaluations into monetary values. That innovative approach enabled us to make the total cost of ownership subject to the negotiations and our client’s awarding decisions.
Our game-theoretic approach boosted competition among suppliers and increased the number of capacities offered. We achieved significant savings in the range of 15% to 40% across the selected pilots.
Rolling out the game theory solution
Given the momentum created by the successful pilots, we received support from executive management, and the client started to roll out our approach throughout the entire organization.
The procurement organization started screening forthcoming procurement negotiations for their suitability and identified dozens of projects for game-theoretic optimization covering a considerable spend.
In parallel, Competitio introduced the game-theoretic approach to the procurement organization in presentations and workshops.
The payoff
Our client benefits in several ways from engaging Competitio:
By changing the dynamics of negotiations to our client’s favor, they lowered strategic supply reduction significantly.
Our innovative methodology of considering evaluated differences between suppliers enables the total cost of ownership to be the subject of sector-regulated negotiations. This improved transparency allows bidders to control the variable used to take the awarding decision individually and intensifies competition.
Procurement’s enhanced strategic and operative skills generate additional considerable cost reductions: Strategic buyers gained additional means of analyzing, understanding, and designing competitive situations.
Competitio provided the client with theoretical and methodical knowledge, practical tools, and robust designs that offered highly efficient solutions for almost any competitive situation. The knowledge transfer strengthened the bargaining power of strategic procurement and led to considerable cost reductions.
The executed game theory projects generated two-digit-million EUR direct savings. Once fully implemented in the procurement organization, the new methods created significant indirect benefits as the organization independently applied game theory.
Our game theory projects foster and improve cross-functional understanding, cooperation, and balance of power by involving decision-makers from all relevant functions in tenders.
Procurement’s role, ROI, and assessment of consulting
The additional savings and improved cooperation between stakeholders strengthened the procurement department’s role. While previously procurement managers were often involved at a later stage of the awarding process when the ability to influence critical parameters of the negotiation was usually low, an earlier involvement became more common.
Technical stakeholders liked the improved cross-functional cooperation and the rationality of the approach.
Moreover, with game-theoretic optimization, the negotiation no longer depends on individual negotiation skills – but a negotiation becomes a process that anyone can develop and execute following the logic and insights of game theory.
Depending on the procurement volume optimized, our engagement generated ROIs in the realm of medium double-digit or low triple-digit numbers. Competitio’s game theory projects tend to achieve cost savings even after repeated price reductions. Project team members enjoy project work and are generally eager to conduct further projects. Average ratings of our consulting by team members in the range of 9,65 to 9,85 of max 10 points underlined the positive reception.
Conclusion
Several factors are crucial for initial and enduring success: Procurement management took a strategic decision to conduct several game theory pilots and signaled towards the organization that it backs the innovative approach. Staffing project teams with open-minded members led to excellent discussions and creative ideas. Game theory workshops laid the theoretical background and trained the application of theoretical knowledge to specific situations in case studies.
Finally, there is one ideal way to learn how to apply game theory to procurement negotiations: Conduct as many supported projects as possible.
Final advice
Applying game theory to strategic procurement offers significant potential for further improving your negotiation skills. Competitio specializes in conducting game theory projects in industries with regulated procurement.
If the ideas presented above appeal to you, please feel free to contact us.