15.5 Supplier Selection—Auctions and Negotiations
Before selecting suppliers, a firm must decide whether to use single sourcing or multiple suppliers. Single sourcing guarantees the supplier sufficient business when the supplier must make a significant buyer-specific investment. The buyer-specific investment may take the form of plant and equipment designed to produce a part that is specific to the buyer or may take the form of expertise that needs to be developed. Single sourcing is also used in the automotive industry for parts such as seats that must arrive in the sequence of production. Coordinating such sequencing is impossible with multiple sources. As a result, auto companies have a single seat source for each plant but multiple seat sources across their manufacturing network. Having multiple sources ensures a degree of competition and also lowers risk by providing a backup should a source fail to deliver.
A good test of whether a firm has the right number of suppliers is to analyze what impact deleting or adding a supplier will have. Unless each supplier has a somewhat different role, it is likely that the supply base is too large. In contrast, unless adding a supplier with a unique and valuable capability clearly adds to total cost, the supply base may be too small.
The selection of suppliers is done using a variety of mechanisms, including offline competitive bids, reverse auctions, or direct negotiations. No matter what mechanism is used, supplier selection should be based on the total cost of using a supplier and not just the purchase price. In general, auctions are best used when the quantifiable acquisition cost is the primary component of total cost. If ownership or post-ownership costs are significant, auctions are not appropriate when selecting suppliers. In such settings, direct negotiations often lead to the best outcome. Next, we discuss some ideas to keep in mind when designing auctions.
Auctions in the Supply Chain
An excellent discussion on auctions can be found in Krishna (2002) and Milgrom (2004). Much of our discussion summarizes some of their ideas.
In many supply chain settings, a buyer looks to outsource a supply chain function such as production or transportation. Potential suppliers are first qualified and then allowed to bid on how much they would charge to perform the function. The qualification process is important because there are multiple attributes of performance (as outlined in Table 15-2) that the buyer cares about. When conducting an auction based primarily on unit price, it is thus important for the buyer to specify performance expectations along all dimensions other than price. Setting up an auction that accounts for multiple attributes, not all of which can be precisely quantified, is difficult. Thus, the qualification process is used to identify suppliers that meet performance expectations along the non-price attributes. If the number of important nonprice attributes is large, it is often best to engage in direct negotiations rather than use an auction.
From the buyer’s perspective, the purpose of an auction is to get bidders to reveal their underlying cost structure so the buyer can select the supplier with the lowest costs. A commonly used mechanism that achieves this outcome is the second-price (Vickrey) auction. In this type of auction, each potential supplier submits a bid and the contract is assigned to the lowest bidder— but at the price quoted by the second-lowest bidder. In general, it is in the buyer’s interest to reveal all available information before bidding. If bidders perceive a lack of information, they are all likely to increase their bids to account for this lack of information.
A significant factor that must be accounted for when designing an auction is the possibility of collusion among bidders. Second-price auctions are particularly vulnerable to collusion. If there is collusion and all bidders but the lowest cost bidder raise their bids, the contract goes to the lowest-cost bidder, but at a high price. Firms must take care to ensure that no collusion occurs when using an auction.
Basic Principles of Negotiation
Firms enter into negotiations both for supplier selection and to set the terms of the contract with an existing supplier. When the total cost of ownership has multiple components besides the cost of acquisition, negotiations generally result in a better outcome compared with the use of auctions. Negotiation is likely to result in a positive outcome only if the value the buyer places on outsourcing the supply chain function to a supplier is at least as large as the value the supplier places on performing the function for the buyer. The value that a supplier places on performing a function is influenced by its cost as well as other alternatives that are available for its existing capacity. Similarly, the value that the buyer places is influenced by the cost of performing the function in-house and the price available from alternative suppliers. The difference between the values of the buyer and seller is referred to as the bargaining surplus. The goal of each negotiating party is to ideally create a situation in which the surplus grows, thus increasing the size of the pie they have to share.
An excellent discussion on negotiations is available in Thompson (2005). We mention some of the highlights from her discussion here. The first recommendation is to have a clear idea of one’s own value and as good an estimate of the third party’s value as possible. A good estimate of the bargaining surplus improves the chance of a successful outcome. Suppliers of Toyota have often mentioned that “Toyota knows our costs better than we do,” which leads to better negotiations. The second recommendation is to look for a fair outcome based on equally or equitably dividing the bargaining surplus or dividing it based on needs. Here, equity refers to a division of the surplus in proportion to the contribution by each party.
The key to a successful negotiation, however, is to make it a win–win outcome that grows the surplus. It is impossible to obtain a win–win outcome if the two parties are negotiating on a single dimension, such as price. In this setting, one party can only “win,” at the expense of the other. To create a win–win negotiation, the two parties must identify more than one issue to negotiate. Identifying multiple issues allows the opportunity to expand the pie if the two parties have different preferences. This is often easier than it seems in a supply chain setting, especially if both parties focus on the total cost of ownership. A buyer focused on TCO cares not just about the acquisition cost, but also about responsiveness and quality (two of the dimensions identified in Table 15-2). If the supplier finds it harder to lower the purchase price but easier to reduce the response time, there is an opportunity for a win–win resolution, in which the supplier offers better responsiveness without changing the price.
An excellent example of a win–win outcome arises from a manufacturer of water treatment equipment whose focus on TCO allowed it to reduce its own production costs without changing the acquisition cost from the supplier. The company sourced specialty steel from a monopolistic supplier and was looking to reduce costs. The supplier’s bargaining power (given its monopoly position) diminished any ability to drive down the purchase price for the steel. A focus on purchase price would probably have ended all negotiations. The water treatment manufacturer studied its production process and identified a method of decreasing cost of ownership without increasing the cost for the supplier. The steel was supplied in the form of sheets of a given size. These sheets were then cut into required sizes by the manufacturer before assembly. A study of the supplier’s process indicated that the supplier would not mind changing the size of the sheet being cut as long as it did not increase the total number of cuts. The water treatment manufacturer identified three different sheet sizes that, if supplied, would reduce the number of cuts required at its plant before assembly. The supplier readily agreed to cut its sheets into the three required sizes, because this change did not increase the total number of cuts. The water treatment manufacturer had originally run three shifts for metal cutting and two for assembly. After the supplier changed the size of sheets supplied, the manufacturer was able to reduce metal cutting to two shifts. The negotiation produced an outcome in which the supplier did not decrease the supply price but the buyer was able to reduce total cost. Taking all dimensions of TCO into account often allows for more successful negotiations during sourcing because it offers multiple opportunities to create win–win outcomes.