Why Auctions are Trumping Negotiation when it comes to Strategic Sourcing

July 14, 2014

Alan Holland

The art of negotiation has existed for millennia. In more recent years it has evolved into a number of techniques used by the respective contracting parties, as they endeavour to have full clarity; re the range of possible outcomes, and their walk-away positions/ best alternative to a negotiated agreement.

As with poker, negotiating strategies can sometimes involve feigning a position of strength to achieve a preferred outcome, while on other occasions the only option is to accede to your opponent’s demands. Experience and skill play an increasingly important part in any negotiation. Any strong negotiator will benefit from having a good grasp of game theory in order to understand an opponent’s likely response to moves and intuitively this forms part of the initial strategic reasoning.

For most individuals, negotiating with an estate agent when purchasing a house tends to be the biggest transaction individuals negotiate on, but senior procurement professionals negotiate high value transactions on a much more frequent basis. However, the main problem with negotiation as a tool for large-scale procurement is that it simply doesn't scale well. As a result, negotiators tend to simplify the discussions they have in order to reduce the number of dimensions they negotiate over.

We've seen how large contracts such as telecoms spectrum licenses are increasingly sold via auctions rather than via negotiations (which would

have been a preferred approach in the past). In an effort to instil best practice and more efficient outcomes, auctions have evolved to include expressive and richer bid processes so that finer descriptions of conditional offers or variant products/services are explored. Ordinary auctions, sealed bid or Open Outcry (English), just don’t provide enough freedom of expression for such exploration of a richer space.

Increasingly, the preferred auction mechanism for large contracts is a Combinatorial Auction (1). This form of auction helps the buyer capture economies of scale and scope that suppliers may have across items in large scale tendering exercises. This information is captured through richer bidding 'rules'. For example, a buyer can split demand for a product that is bought in many locations nationwide into city-based contracts. Bidders can then communicate economies of scale by offering conditional discounts subject to winning more contracts across their defined footprint.

This approach maximises openness so that all bidders can; play to their strengths, reduce their risks, spread their costs and avoid where they are weak. This approach also permits delayed commitment to contracting with a preferred number of suppliers until the bids are collected.

In this auction setup, there is no need to construct a specific number of lots in order to split an outcome; instead the buyer can inspect the trade-offs between alternative supplier numbers in the absence of making that commitment before the competition. Determining the optimal blend across two or more suppliers relies on an ‘evaluation engine’ to calculate the best way to combine the conditional offers. Without an evaluation engine, a buyer would not be able to reason about the winner determination problem in a manual negotiation process, because it is simply too complex to do so (and thus the opportunities for efficiencies would be lost). Hence an auction format that invites enhanced bid information can actively encourage more innovative offers and drive greater savings in procurement as a result, once an evaluation engine is available to compute the best outcome. This evaluation engine can thus compute the best overall outcome from the increased number of resultant permutations.

In summary, the art of negotiation is moving up a gear with the advent of powerful sourcing optimisation tools with evaluation engines at their core. It is now possible to gain a much clearer picture of the myriad of possible outcomes through rich analysis. Negotiators can then leverage this informational advantage to fine-tune an outcome through multiple rounds of bidding or one-to-one negotiations. The range of benefits extend beyond cost reduction to other strategic capabilities such as prioritising incumbent contracts for switching, facilitating Corporate Social

Responsibility within the award criteria and also permitting fine-grained control of outcomes so that buyers can be more particular about awards.

Dr Alan Holland is the CEO and Founder of Keelvar.

This article originally appeared in Spend Matters UK.

(1) Combinatorial Auctions, Edited by Peter Cramton, Yoav Shoham and Richard Steinberg. MIT Press, 2005.

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