Description
The first rule is to create competition between your suppliers. Even if you already have alternative suppliers, it may do no harm to expand the range of suppliers from which you can invite bids.
Prism / 1 / 2009
67
It all sounds so obvious for sub-assembly manufacturers.
On the one hand, their customers, i.e. ?nished product
manufacturers, are currently suffering from declining de-
mand and overcapacity, and are pressuring sub-assembly
manufacturers for lower prices. On the other hand, raw
material prices have collapsed dramatically. For example,
prices for raw steel, cathode copper and brazen semi-
?nished products declined by between 40 and 60 per cent
during 2008. As a consequence, the only thing that sub-as-
sembly manufacturers seemingly need to do to cope with
the price pressure from their customers is to claim lower
prices from their own suppliers of components.
Alas, supplier price reductions don’t just happen. If sub-
assembly manufacturers want to extract supplier price
reductions that will really give them relief from the price
squeeze by their own customers, they will have to excel in
negotiation with their suppliers. But achieving excellence in
procurement negotiations without harming your vital sup-
pliers is more easily said than done. In our experience, you
will achieve excellence if you obey the following ?ve rules:
1. Create competition between your suppliers
2. Use total-value-of-ownership to compare suppliers’
offerings
3. Empower the procurement department to both
negotiate and decide
5. Choose the negotiation and decision mechanism
that is best suited to the bidding situation
5. Use the negotiation and decision process
systematically.
In this article, we will explain these ?ve rules in detail, and
illustrate them with a real-life but disguised case study of
a company called Hamstadt (see side text for background
Effective procurement negotiations
in the downturn
Gregor Berz, Andy Dvorocsik, Daniel Deneffe and Ralf Gampfer
The squeeze is on for sub-
assembly manufacturers.
Sharp declines in demand
for the products of their
customers has left them
under heavy pressure to
reduce their prices, and
the only way they can do
that is by ensuring lower
prices from their own
suppliers. But getting
substantial price reduc-
tions without risking the
survival of your precious
supply chain is no simple
matter and requires the
best possible negotiation
skills. This article sets
out ?ve rules for negotia-
tions that will ensure that
your company ?nds its
way through this dif?cult
procurement situation
and emerges with both
lower prices and an intact
supply chain.
68
Prism / 1 / 2009
69
Effective procurement negotiations in the downturn
information about the company). While Hamstadt operates
in the automotive supply industry, the rules have proven to
be effective in any industry.
Rule 1: Create competition between your
suppliers
The ?rst rule is to create competition between your sup-
pliers. Even if you already have alternative suppliers, it
may do no harm to expand the range of suppliers from
which you can invite bids. The “competition matrix” is an
important tool for making your alternative suppliers and the
switching options visible for your most important materials.
Table 1 shows the competition matrix for a complex
mechanical component at Hamstadt. It indicates current
prices for current suppliers and offered prices for potential
suppliers. Hamstadt developed and effectively used similar
matrices for all of its important materials such as plastic
parts, metal parts and electronic components. The matrix
shows that for each customer OEM project, at least two
suppliers were potentially available.
Switching or replacing suppliers can be a very political
decision, often characterised by internal power struggles.
Hamstadt’s purchasing process was structured in such a
way that higher levels of approval were required for more
important purchases, and could include intervention by the
executive board. For the selection of strategically important
development partners, even the CEO joined the discussion.
Fortunately, the competition matrix helped the company to
assess and reach decisions on more objective grounds.
Case study 1
Hamstadt is a tier-one automotive supplier. In the midst
of preparations for the 2009 annual price negotiations
with its suppliers, Hamstadt was hit by the economic
crisis. Two unexpected situations occurred:
1. Automotive OEMs (original equipment manufacturers)
reported dramatic drops in demand for vehicles. They
responded by reducing 2009 forecasts, cutting cost
brutally and closing down plants. Hamstadt was sud-
denly under enormous pressure and forced to reduce
its own volume forecasts. Initially some of Hamstadt’s
suppliers tried to bene?t from this situation by raising
prices in response to the increased uncertainty and
reduced economies of scale. Soon, however, the
overall decline in demand made Hamstadt’s smaller
volumes even more highly sought-after by suppliers.
2. Buyers at Hamstadt’s procurement department ob-
served drastic price reductions in raw material prices.
This was an excellent argument for them to force sup-
pliers’ prices down, as raw materials play an important
role in price calculations even for complex products. In
order to realise the price reductions, Hamstadt’s chief
procurement of?cer initiated a negotiation process in
accordance with the ?ve rules explained in this article.
Table 1 Example of a competition matrix
Source: Arthur D. Little analysis
current prices Current supplier
Potential supplier (business shiftable)
Business not shiftable to this supplier (technical reasons)
Business not shiftable (supplier not approved by OEM)
offered prices
OEM 1
OEM 2
OEM 2
OEM 2
OEM 2
OEM 2
OEM 3
OEM 3
OEM 4
OEM 5
OEM 6
Project 1.1
Project 2.1
Project 2.1
Project 2.2
Project 2.3
Project 2.4
Project 3.1
Project 3.2
Project 4.1
Project 5.1
Project 6.1
117.30 ?
117.30 ?
126.90 ?
105.90 ?
107.40 ?
111.30 ?
Customer Project Supplier A Supplier B Supplier D Supplier C
103.50 ?
117.90 ?
124.20 ?
128.10 ?
109.80 ?
111.60 ?
115.50 ?
$198.00
157.20 ?
112.50 ?
106.50 ?
106.50 ?
106.50 ?
106.50 ?
106.50 ?
Switching or replacing sup-
pliers can be a very political
decision, often charac-
terised by internal power
struggles.
Five rules help companies
achieve excellence in pro-
curement negotiations. But
a clear negotiation process
in accordance with them is
necessary.
70
Prism / 1 / 2009
71
Rule 2: Use total-value-of-ownership to com-
pare suppliers’ offerings
Once all the potential suppliers for a given component are
identi?ed, you can compare their offerings. The complica-
tion is that for all but the simplest components you cannot
compare on the basis of price alone. You need a way to
bring into the picture all aspects that determine the per-
formance of the offerings of your suppliers. The total-value-
of-ownership (TVO) framework allows you to do so.
With the TVO framework, you start with the initial prices
quoted by your suppliers. You then deduct a premium
from or add a penalty to the initial price as a function of
the performance of the supplier on your supplier evalu-
ation criteria. The magnitude of the premium or penalty
depends on the value of the performance to your business.
For example, if you expect a delivery lead-time of 10 days
and every day gained represents a value of € 1 to you, a
supplier who can deliver in eight days gets a premium of
€ 2. Conversely, if every day lost represents a loss of €
2 to you, a supplier who can only deliver in 11 days gets a
penalty of € 2. By extracting all the premiums and adding
all the penalties, you can generate a comparison price (see
Table 2). When you start negotiating with your suppliers,
they can improve not only their prices but also the factors
that determine their premiums and penalties.
This approach has several bene?ts:
• It leads to the selection of suppliers with the best price-
performance ratio.
• It creates more intensive competition that lends itself to
the use of powerful negotiation techniques, as we will
see later (rule 4).
• It presents the potential for win-win situations, as sup-
pliers have an incentive to improve their performance in
general.
• It improves business relations with suppliers, as the
discussions are hard but fair.
• It creates internal transparency about supplier selection
decisions.
At Hamstadt, supplier evaluation criteria included payment
terms, currencies, liability clauses, logistics concepts and
quality. Future decision criteria such as the supplier’s con-
duct in long-term business relationships, e.g. materialising in
sliding-price clauses for raw materials, were also considered.
With the TVO framework, internal discussions at Hamstadt
about potentially switching suppliers became structured,
objective and target-oriented. Whenever a discussion about
a potential switch moved up to the executive board, the
discussion was held and the decision made based on the
TVO framework. For example, an exception was made to
grant a premium to a special long-term development part-
ner, with the direct approval of the executive board.
Hamstadt also used the TVO framework externally with
suppliers, often involving bilateral pre-negotiations about
individual aspects of the framework. Discussing the TVO
framework with suppliers generated concessions from
some suppliers about terms and conditions, such as pay-
ment terms and signed liability clauses, and raised the
sense of competition among the suppliers.
Discussing the TVO frame-
work with suppliers gen-
erated concessions from
some suppliers about terms
and conditions, such as
payment terms and signed
liability clauses, and raised
the sense of competition
among the suppliers.
Table 2 Example of a total-value-of-ownership comparison
Source: Arthur D. Little analysis
Price
supplier A
Premium 5 ?
Penalty 7 ?
90 ?
97 ?
95 ?
100 ?
Price
supplier B
“Comparison prices”
Effective procurement negotiations in the downturn
72
Prism / 1 / 2009
73
Rule 3: Empower the procurement depart-
ment to both negotiate and decide
The combined use of the competition matrix and the TVO
framework enables you to let price negotiations go hand-in-
hand with potential supplier switching discussions. The TVO
framework in particular shows all preferences and decision
criteria for all of the suppliers concerned.
Furthermore, the use of an approved TVO framework
allows you to empower the procurement department to
decide about switching suppliers even during a negotiation.
No other argument will bestow as much negotiating power
on the procurement department as this mandate to take
decisions. Only when a supplier is certain that a conces-
sion granted during negotiation will decide the deal in his
favour will he be prepared to offer his best price.
Rule 4: Choose the negotiation and decision
mechanism that is best suited to the
bidding situation
Having established “comparison prices” with the TVO
framework, you can start negotiating with your suppliers
in an effort to lower prices and/or improve performance. A
diverse range of effective negotiation mechanisms exists
(see box).
Which particular mechanism is the most appropriate de-
pends on the competitive characteristics of the situation
at hand. Explaining which mechanism is optimal in which
situation is beyond the scope of this article. Factors that
play a role in making the choice of mechanism include
the number of bidders, the bidders’ aversion to risk, the
cost level of the bidders, the likelihood of collusion among
bidders, the bidders’ history with auctions and the level of
product complexity. “Mechanism design theory” provides
a full explanation about these choices (see reference at the
end of this article). Let’s use the Hamstadt case to give
some practical examples.
Hamstadt suppliers C and D (see the competition matrix
in Table 1) are active suppliers that might like to take over
each other’s business. In a situation like this, the “prison-
er’s dilemma” mechanism could be used as a negotiation
tool. However, in on-going business the use of this mecha-
nism contains a risk: it will lead to nothing if both suppliers
Basic Procurement Negotiation and
Decision Mechanisms
English auction:
Suppliers underbid each other in a bidding process with
more or less transparent prices until all bidding stops.
The business is awarded to the bidder that placed the
lowest bid.
English ticker auction:
The buyer reduces the price in prede?ned steps until
only one vendor remains who accepts that price.
Dutch auction:
The buyer increases the price in prede?ned steps until a
?rst vendor accepts.
Second price sealed bid:
Every bidder places a one-shot offer. The business is
awarded to the bidder with the lowest bid at the price
offered by the second lowest bidder.
First price sealed bid:
Every bidder places a one-shot offer. The business is
awarded to the bidder with the lowest bid at the price he
offered.
Chain of take-it-or-leave-its:
A ?rst supplier is asked to accept a very low price. If he
accepts, the business is awarded to him. If he declines,
a second bidder is asked to accept the price, and so on.
Prisoner’s dilemma as negotiation element:
Two suppliers are asked to reduce their prices on run-
ning business.
Factors that play a role
in making the choice of
mechanism include the
number of bidders, the
bidders’ aversion to risk,
the cost level of the
bidders, the likelihood of
collusion among bidders,
the bidders’ history with
auctions and the level of
product complexity.
Effective procurement negotiations in the downturn
74
Prism / 1 / 2009
75
act defensively and ?nd it more important to retain the
status quo than to compete for more business. Neither of
the two will lower its prices (or at best, by a tiny bit) and
both will retain their business.
After evaluating the behaviour of suppliers C and D and
taking the uncertain economic climate into consideration,
Hamstadt concluded that the risk of the two suppliers
employing defensive strategies was extremely high. Both
suppliers had to be put under pressure to lower prices.
Furthermore, an internal decision called for only one single
supplier for all customer projects, i.e. either supplier C or
supplier D.
To that effect, Hamstadt gave supplier C a target price
for all projects concerned. If it did not accept this price,
supplier D would be presented with the same target price
adjusted by the premium established by the TVO frame-
work. If supplier D were to reject the price as well, supplier
C would in turn be presented with a slightly higher target
price. This procedure is basically a Dutch auction with a
minor advantage for supplier C.
Rule 5: Use the negotiation and decision
process systematically
Applying the negotiation mechanisms described in rule 4
looks like a straightforward process. Unfortunately, unex-
pected challenges do occur. For instance, a supposedly
aggressive supplier suddenly appears to lose interest in
a deal, and vice versa. In such situations it is up to the
negotiator’s skill to adapt and interpret the mechanism
prescribed.
In these cases it is important to stick to once-communicat-
ed decision mechanisms as far as possible. In the context
of its yearly price negotiations for 2009, Hamstadt man-
aged to apply all prede?ned decision mechanisms. It was
able to establish a reputation for reliable decision-making.
Effective procurement negotiations in the downturn
Case study 2
As part of its contract to supply an OEM’s upcoming production
run, a tier-one electronic control supplier needed to contract a tier-
two ASIC (Application Speci?c Integrated Circuit) supplier. Based
on technical considerations, the electronic control company’s de-
sign department identi?ed a preferred ASIC supplier, negotiated
a seemingly attractive price and recommended that the procure-
ment department execute a contract.
Procurement immediately recognised an opportunity to reduce
its purchase price by increasing competition between suppliers
(rule 1). They then identi?ed three additional quali?ed tier-two
suppliers to participate in the negotiation process. The design
department’s initial preference was re?ected as a premium in the
TVO framework (rule 2).
Each of the four suppliers found the opportunity to be very attrac-
tive, due to the volume - € 60 million over seven years - and the
credentials conferred by providing ASIC technology to the auto
industry. Procurement began negotiations with all four suppliers,
quickly reducing its purchase price level signi?cantly below the
starting point. Bearing this in mind and after the preferred tier-
two supplier had been granted an adequate premium, the design
department was prepared to let procurement make the ?nal
decision between the four tier-two suppliers (rule 3). Thus procu-
rement found itself in a position to hold a ?nal round of negotia-
tions in which the decision was made.
For this ?nal negotiation, procurement conducted a Dutch auction
with all four suppliers. Mechanism design theory recommends a
?rst-price-type auction, when at least one supplier can be ex-
pected to bid for the business at a very low strategic price (rule
4). The electronic control supplier successfully used the Dutch
auction (which is a special ?rst-price-type auction) to reduce its
purchase price by 35 per cent, or about € 20 million below the
initial level.
After the auction the losing bidders were interviewed about their
calculations and bidding intentions (rule 5). Bidders revealed that
if the tier-one supplier had used a standard approach such as an
English auction, a reduction of only 15 per cent would probably
have been achieved. The structured approach used here resulted
in incremental savings of 20 per cent or € 12 million.
The various auction and
bidding mechanisms help
companies get the best
prices.
76
Prism / 1 / 2009
77
To have a reputation for reliable decision mechanisms
means that your suppliers know when they have to reduce
prices in order to in?uence your decision (see case study 2
in side text). Consistently applying rules 1-4 creates sus-
tainable negotiation power.
The bene?ts of applying the above ?ve rules systemati-
cally rather than using a traditional procurement approach
are better, faster and sustainable results (see Table 3 for a
comparison).
Effective procurement negotiations in the downturn
Table 3 Comparison of the five rules with the traditional procurement approach
Source: Arthur D. Little analysis
1
2
3
4
5
Rule Main advantages Traditional procurement
Classic material group strategies often
reduce shiftability and competition
between suppliers. This happens when a
"target supplier portfolio" is defined
without consideration of dynamic
negotiation results.
No systematic choice of negotiation /
decision mechanism. Procurement results
depend on negotiation skills of buyers.
The competition matrix summarises the organisa-
tion's objective assessment of its own negotiating
power and of realistic ways to strengthen that
power.
Every negotiation has its own competition
scenario for which an individual negotiation and
decision mechanism will be the optimum choice.
At this point the current situation of the suppliers
in their respective markets is taken into special
consideration.
Create compe-
tition between
your suppliers
State-of-the-art procurement considers a
"total view" on all relevant decision criteria
in a complex, multidimensional
comparison scheme, but without direct
link to price negotiations. In particular,
usually no discussions with the suppliers
about single decision criteria take place.
The price-performance ratio of alternative
suppliers is compared using a total-value-of-
ownership framework. With it, internal
discussions about switching suppliers become
structured, objective and target-oriented. Openly
discussing the framework with suppliers easily
generates success and creates an impression of
real competition among the suppliers.
Use total-value-
of-ownership to
compare
suppliers’
offerings
Procurement has to reduce prices, but
supplier decisions are taken by internal
stakeholders ahead of the negotiations.
A cross-functionally aligned bonus system makes
it possible to provide procurement with a decision
mandate in negotiations. No other argument will
generate as much negotiating power as this
mandate to decide.
Empower the
procurement
department to
both negotiate
and decide
Choose the
negotiation and
decision mecha-
nism that is best
suited to the
bidding situation
Occasional usage of certain negotiation
tricks. In extreme cases, a negative
reputation for non-reliability of promises
made by certain buyers may be observed.
The relevant goal besides reducing prices in
the short run is to create a reputation for
reliable decision-making in the negotiation
process. This will secure sustainable success
in negotiations.
Use the nego-
tiation and
decision process
systematically
Insights for the executive
Declining market demand and over-capacity drives ?nished
product manufacturers to put price pressure on their sup-
pliers, i.e. the manufacturers of sub-assemblies. This forces
the latter in turn to re-negotiate contracts with their suppli-
ers. Given the brutal nature of the current economic crisis,
it is crucial to extract important price concessions from
suppliers fast, yet without harming the long-term prospects
of vital suppliers.
The traditional procurement approach is ill-suited to that chal-
lenge. It relies too much on the negotiation skills of individ-
ual buyers, leads to adversarial relations with suppliers and,
most importantly, does not achieve the best price-perform-
ance results. In our experience, you will achieve excellence
in procurement if you obey the following ?ve rules:
• Create competition between your suppliers. Even if
you already have alternative suppliers, expand the range
of suppliers from which you can invite bids. Make your
alternative suppliers and the switching options visible
for your most important materials.
• Use total-value-of-ownership to compare suppliers’
offerings. Start with the initial prices quoted by your
suppliers. Then deduct a premium as a function of the
performance of the supplier on your evaluation criteria,
with the magnitude of the premium depending on the
value of the performance to your business.
• Empower the procurement department to both
negotiate and decide. Allow the procurement depart-
ment to decide about switching suppliers even during
a negotiation, as long as they stay within boundaries
prescribed by the total-value-of-ownership framework.
• Choose the negotiation and decision mechanism
that is best suited to the bidding situation. Instead
of relying on the personal negotiation skills of the buy-
ers, prescribe upfront which formal negotiation mecha-
nism (English auction, Dutch auction, etc) you will use
as a function of the competitive characteristics of each
speci?c situation.
78
Prism / 1 / 2009
79
• Use the negotiation and decision process systemati-
cally. Be transparent toward suppliers about the nego-
tiation and decision mechanism that will be applied, and
stick to it as much as possible. Revise and adapt the
prescribed mechanism only by exception.
The approach presented in this article is grounded in mechanism
design theory. For more information about the application of this
theory in price negotiations, please see Gregor Berz, “Game Theory
Bargaining and Auction Strategies” (“Spieltheoretische Verhand-
lungs- und Auktionsstrategien”), Schäffer-Poeschel Verlag, Stutt-
gart, 2007.
Effective procurement negotiations in the downturn
Gregor Berz
… is a Principal in Arthur D. Little’s Munich of?ce and mem-
ber of the Operations Management Practice. He specialises in
(reverse) pricing and strategy development in sales and procure-
ment.
E-mail: [email protected]
Andy Dvorocsik
… is a Director in Arthur D. Little’s Houston of?ce where he
leads the Americas Chemical Practice. He specialises in strategy,
pricing, and procurement.
E-mail: [email protected]
Daniel Deneffe
… is a Director in Arthur D. Little’s Brussels of?ce and member
of the Strategy and Organisation Practice. He specialises in the
area of marketing strategy, margin management and pricing
excellence.
E-mail: [email protected]
Ralf Gampfer
… is CEO of the Institut für Angewandtes Mechanism Design,
Munich, and cooperation partner of Arthur D. Little. He spe-
cialises in the application of game theory in practice.
E-mail: [email protected]
doc_853718542.pdf
The first rule is to create competition between your suppliers. Even if you already have alternative suppliers, it may do no harm to expand the range of suppliers from which you can invite bids.
Prism / 1 / 2009
67
It all sounds so obvious for sub-assembly manufacturers.
On the one hand, their customers, i.e. ?nished product
manufacturers, are currently suffering from declining de-
mand and overcapacity, and are pressuring sub-assembly
manufacturers for lower prices. On the other hand, raw
material prices have collapsed dramatically. For example,
prices for raw steel, cathode copper and brazen semi-
?nished products declined by between 40 and 60 per cent
during 2008. As a consequence, the only thing that sub-as-
sembly manufacturers seemingly need to do to cope with
the price pressure from their customers is to claim lower
prices from their own suppliers of components.
Alas, supplier price reductions don’t just happen. If sub-
assembly manufacturers want to extract supplier price
reductions that will really give them relief from the price
squeeze by their own customers, they will have to excel in
negotiation with their suppliers. But achieving excellence in
procurement negotiations without harming your vital sup-
pliers is more easily said than done. In our experience, you
will achieve excellence if you obey the following ?ve rules:
1. Create competition between your suppliers
2. Use total-value-of-ownership to compare suppliers’
offerings
3. Empower the procurement department to both
negotiate and decide
5. Choose the negotiation and decision mechanism
that is best suited to the bidding situation
5. Use the negotiation and decision process
systematically.
In this article, we will explain these ?ve rules in detail, and
illustrate them with a real-life but disguised case study of
a company called Hamstadt (see side text for background
Effective procurement negotiations
in the downturn
Gregor Berz, Andy Dvorocsik, Daniel Deneffe and Ralf Gampfer
The squeeze is on for sub-
assembly manufacturers.
Sharp declines in demand
for the products of their
customers has left them
under heavy pressure to
reduce their prices, and
the only way they can do
that is by ensuring lower
prices from their own
suppliers. But getting
substantial price reduc-
tions without risking the
survival of your precious
supply chain is no simple
matter and requires the
best possible negotiation
skills. This article sets
out ?ve rules for negotia-
tions that will ensure that
your company ?nds its
way through this dif?cult
procurement situation
and emerges with both
lower prices and an intact
supply chain.
68
Prism / 1 / 2009
69
Effective procurement negotiations in the downturn
information about the company). While Hamstadt operates
in the automotive supply industry, the rules have proven to
be effective in any industry.
Rule 1: Create competition between your
suppliers
The ?rst rule is to create competition between your sup-
pliers. Even if you already have alternative suppliers, it
may do no harm to expand the range of suppliers from
which you can invite bids. The “competition matrix” is an
important tool for making your alternative suppliers and the
switching options visible for your most important materials.
Table 1 shows the competition matrix for a complex
mechanical component at Hamstadt. It indicates current
prices for current suppliers and offered prices for potential
suppliers. Hamstadt developed and effectively used similar
matrices for all of its important materials such as plastic
parts, metal parts and electronic components. The matrix
shows that for each customer OEM project, at least two
suppliers were potentially available.
Switching or replacing suppliers can be a very political
decision, often characterised by internal power struggles.
Hamstadt’s purchasing process was structured in such a
way that higher levels of approval were required for more
important purchases, and could include intervention by the
executive board. For the selection of strategically important
development partners, even the CEO joined the discussion.
Fortunately, the competition matrix helped the company to
assess and reach decisions on more objective grounds.
Case study 1
Hamstadt is a tier-one automotive supplier. In the midst
of preparations for the 2009 annual price negotiations
with its suppliers, Hamstadt was hit by the economic
crisis. Two unexpected situations occurred:
1. Automotive OEMs (original equipment manufacturers)
reported dramatic drops in demand for vehicles. They
responded by reducing 2009 forecasts, cutting cost
brutally and closing down plants. Hamstadt was sud-
denly under enormous pressure and forced to reduce
its own volume forecasts. Initially some of Hamstadt’s
suppliers tried to bene?t from this situation by raising
prices in response to the increased uncertainty and
reduced economies of scale. Soon, however, the
overall decline in demand made Hamstadt’s smaller
volumes even more highly sought-after by suppliers.
2. Buyers at Hamstadt’s procurement department ob-
served drastic price reductions in raw material prices.
This was an excellent argument for them to force sup-
pliers’ prices down, as raw materials play an important
role in price calculations even for complex products. In
order to realise the price reductions, Hamstadt’s chief
procurement of?cer initiated a negotiation process in
accordance with the ?ve rules explained in this article.
Table 1 Example of a competition matrix
Source: Arthur D. Little analysis
current prices Current supplier
Potential supplier (business shiftable)
Business not shiftable to this supplier (technical reasons)
Business not shiftable (supplier not approved by OEM)
offered prices
OEM 1
OEM 2
OEM 2
OEM 2
OEM 2
OEM 2
OEM 3
OEM 3
OEM 4
OEM 5
OEM 6
Project 1.1
Project 2.1
Project 2.1
Project 2.2
Project 2.3
Project 2.4
Project 3.1
Project 3.2
Project 4.1
Project 5.1
Project 6.1
117.30 ?
117.30 ?
126.90 ?
105.90 ?
107.40 ?
111.30 ?
Customer Project Supplier A Supplier B Supplier D Supplier C
103.50 ?
117.90 ?
124.20 ?
128.10 ?
109.80 ?
111.60 ?
115.50 ?
$198.00
157.20 ?
112.50 ?
106.50 ?
106.50 ?
106.50 ?
106.50 ?
106.50 ?
Switching or replacing sup-
pliers can be a very political
decision, often charac-
terised by internal power
struggles.
Five rules help companies
achieve excellence in pro-
curement negotiations. But
a clear negotiation process
in accordance with them is
necessary.
70
Prism / 1 / 2009
71
Rule 2: Use total-value-of-ownership to com-
pare suppliers’ offerings
Once all the potential suppliers for a given component are
identi?ed, you can compare their offerings. The complica-
tion is that for all but the simplest components you cannot
compare on the basis of price alone. You need a way to
bring into the picture all aspects that determine the per-
formance of the offerings of your suppliers. The total-value-
of-ownership (TVO) framework allows you to do so.
With the TVO framework, you start with the initial prices
quoted by your suppliers. You then deduct a premium
from or add a penalty to the initial price as a function of
the performance of the supplier on your supplier evalu-
ation criteria. The magnitude of the premium or penalty
depends on the value of the performance to your business.
For example, if you expect a delivery lead-time of 10 days
and every day gained represents a value of € 1 to you, a
supplier who can deliver in eight days gets a premium of
€ 2. Conversely, if every day lost represents a loss of €
2 to you, a supplier who can only deliver in 11 days gets a
penalty of € 2. By extracting all the premiums and adding
all the penalties, you can generate a comparison price (see
Table 2). When you start negotiating with your suppliers,
they can improve not only their prices but also the factors
that determine their premiums and penalties.
This approach has several bene?ts:
• It leads to the selection of suppliers with the best price-
performance ratio.
• It creates more intensive competition that lends itself to
the use of powerful negotiation techniques, as we will
see later (rule 4).
• It presents the potential for win-win situations, as sup-
pliers have an incentive to improve their performance in
general.
• It improves business relations with suppliers, as the
discussions are hard but fair.
• It creates internal transparency about supplier selection
decisions.
At Hamstadt, supplier evaluation criteria included payment
terms, currencies, liability clauses, logistics concepts and
quality. Future decision criteria such as the supplier’s con-
duct in long-term business relationships, e.g. materialising in
sliding-price clauses for raw materials, were also considered.
With the TVO framework, internal discussions at Hamstadt
about potentially switching suppliers became structured,
objective and target-oriented. Whenever a discussion about
a potential switch moved up to the executive board, the
discussion was held and the decision made based on the
TVO framework. For example, an exception was made to
grant a premium to a special long-term development part-
ner, with the direct approval of the executive board.
Hamstadt also used the TVO framework externally with
suppliers, often involving bilateral pre-negotiations about
individual aspects of the framework. Discussing the TVO
framework with suppliers generated concessions from
some suppliers about terms and conditions, such as pay-
ment terms and signed liability clauses, and raised the
sense of competition among the suppliers.
Discussing the TVO frame-
work with suppliers gen-
erated concessions from
some suppliers about terms
and conditions, such as
payment terms and signed
liability clauses, and raised
the sense of competition
among the suppliers.
Table 2 Example of a total-value-of-ownership comparison
Source: Arthur D. Little analysis
Price
supplier A
Premium 5 ?
Penalty 7 ?
90 ?
97 ?
95 ?
100 ?
Price
supplier B
“Comparison prices”
Effective procurement negotiations in the downturn
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Prism / 1 / 2009
73
Rule 3: Empower the procurement depart-
ment to both negotiate and decide
The combined use of the competition matrix and the TVO
framework enables you to let price negotiations go hand-in-
hand with potential supplier switching discussions. The TVO
framework in particular shows all preferences and decision
criteria for all of the suppliers concerned.
Furthermore, the use of an approved TVO framework
allows you to empower the procurement department to
decide about switching suppliers even during a negotiation.
No other argument will bestow as much negotiating power
on the procurement department as this mandate to take
decisions. Only when a supplier is certain that a conces-
sion granted during negotiation will decide the deal in his
favour will he be prepared to offer his best price.
Rule 4: Choose the negotiation and decision
mechanism that is best suited to the
bidding situation
Having established “comparison prices” with the TVO
framework, you can start negotiating with your suppliers
in an effort to lower prices and/or improve performance. A
diverse range of effective negotiation mechanisms exists
(see box).
Which particular mechanism is the most appropriate de-
pends on the competitive characteristics of the situation
at hand. Explaining which mechanism is optimal in which
situation is beyond the scope of this article. Factors that
play a role in making the choice of mechanism include
the number of bidders, the bidders’ aversion to risk, the
cost level of the bidders, the likelihood of collusion among
bidders, the bidders’ history with auctions and the level of
product complexity. “Mechanism design theory” provides
a full explanation about these choices (see reference at the
end of this article). Let’s use the Hamstadt case to give
some practical examples.
Hamstadt suppliers C and D (see the competition matrix
in Table 1) are active suppliers that might like to take over
each other’s business. In a situation like this, the “prison-
er’s dilemma” mechanism could be used as a negotiation
tool. However, in on-going business the use of this mecha-
nism contains a risk: it will lead to nothing if both suppliers
Basic Procurement Negotiation and
Decision Mechanisms
English auction:
Suppliers underbid each other in a bidding process with
more or less transparent prices until all bidding stops.
The business is awarded to the bidder that placed the
lowest bid.
English ticker auction:
The buyer reduces the price in prede?ned steps until
only one vendor remains who accepts that price.
Dutch auction:
The buyer increases the price in prede?ned steps until a
?rst vendor accepts.
Second price sealed bid:
Every bidder places a one-shot offer. The business is
awarded to the bidder with the lowest bid at the price
offered by the second lowest bidder.
First price sealed bid:
Every bidder places a one-shot offer. The business is
awarded to the bidder with the lowest bid at the price he
offered.
Chain of take-it-or-leave-its:
A ?rst supplier is asked to accept a very low price. If he
accepts, the business is awarded to him. If he declines,
a second bidder is asked to accept the price, and so on.
Prisoner’s dilemma as negotiation element:
Two suppliers are asked to reduce their prices on run-
ning business.
Factors that play a role
in making the choice of
mechanism include the
number of bidders, the
bidders’ aversion to risk,
the cost level of the
bidders, the likelihood of
collusion among bidders,
the bidders’ history with
auctions and the level of
product complexity.
Effective procurement negotiations in the downturn
74
Prism / 1 / 2009
75
act defensively and ?nd it more important to retain the
status quo than to compete for more business. Neither of
the two will lower its prices (or at best, by a tiny bit) and
both will retain their business.
After evaluating the behaviour of suppliers C and D and
taking the uncertain economic climate into consideration,
Hamstadt concluded that the risk of the two suppliers
employing defensive strategies was extremely high. Both
suppliers had to be put under pressure to lower prices.
Furthermore, an internal decision called for only one single
supplier for all customer projects, i.e. either supplier C or
supplier D.
To that effect, Hamstadt gave supplier C a target price
for all projects concerned. If it did not accept this price,
supplier D would be presented with the same target price
adjusted by the premium established by the TVO frame-
work. If supplier D were to reject the price as well, supplier
C would in turn be presented with a slightly higher target
price. This procedure is basically a Dutch auction with a
minor advantage for supplier C.
Rule 5: Use the negotiation and decision
process systematically
Applying the negotiation mechanisms described in rule 4
looks like a straightforward process. Unfortunately, unex-
pected challenges do occur. For instance, a supposedly
aggressive supplier suddenly appears to lose interest in
a deal, and vice versa. In such situations it is up to the
negotiator’s skill to adapt and interpret the mechanism
prescribed.
In these cases it is important to stick to once-communicat-
ed decision mechanisms as far as possible. In the context
of its yearly price negotiations for 2009, Hamstadt man-
aged to apply all prede?ned decision mechanisms. It was
able to establish a reputation for reliable decision-making.
Effective procurement negotiations in the downturn
Case study 2
As part of its contract to supply an OEM’s upcoming production
run, a tier-one electronic control supplier needed to contract a tier-
two ASIC (Application Speci?c Integrated Circuit) supplier. Based
on technical considerations, the electronic control company’s de-
sign department identi?ed a preferred ASIC supplier, negotiated
a seemingly attractive price and recommended that the procure-
ment department execute a contract.
Procurement immediately recognised an opportunity to reduce
its purchase price by increasing competition between suppliers
(rule 1). They then identi?ed three additional quali?ed tier-two
suppliers to participate in the negotiation process. The design
department’s initial preference was re?ected as a premium in the
TVO framework (rule 2).
Each of the four suppliers found the opportunity to be very attrac-
tive, due to the volume - € 60 million over seven years - and the
credentials conferred by providing ASIC technology to the auto
industry. Procurement began negotiations with all four suppliers,
quickly reducing its purchase price level signi?cantly below the
starting point. Bearing this in mind and after the preferred tier-
two supplier had been granted an adequate premium, the design
department was prepared to let procurement make the ?nal
decision between the four tier-two suppliers (rule 3). Thus procu-
rement found itself in a position to hold a ?nal round of negotia-
tions in which the decision was made.
For this ?nal negotiation, procurement conducted a Dutch auction
with all four suppliers. Mechanism design theory recommends a
?rst-price-type auction, when at least one supplier can be ex-
pected to bid for the business at a very low strategic price (rule
4). The electronic control supplier successfully used the Dutch
auction (which is a special ?rst-price-type auction) to reduce its
purchase price by 35 per cent, or about € 20 million below the
initial level.
After the auction the losing bidders were interviewed about their
calculations and bidding intentions (rule 5). Bidders revealed that
if the tier-one supplier had used a standard approach such as an
English auction, a reduction of only 15 per cent would probably
have been achieved. The structured approach used here resulted
in incremental savings of 20 per cent or € 12 million.
The various auction and
bidding mechanisms help
companies get the best
prices.
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Prism / 1 / 2009
77
To have a reputation for reliable decision mechanisms
means that your suppliers know when they have to reduce
prices in order to in?uence your decision (see case study 2
in side text). Consistently applying rules 1-4 creates sus-
tainable negotiation power.
The bene?ts of applying the above ?ve rules systemati-
cally rather than using a traditional procurement approach
are better, faster and sustainable results (see Table 3 for a
comparison).
Effective procurement negotiations in the downturn
Table 3 Comparison of the five rules with the traditional procurement approach
Source: Arthur D. Little analysis
1
2
3
4
5
Rule Main advantages Traditional procurement
Classic material group strategies often
reduce shiftability and competition
between suppliers. This happens when a
"target supplier portfolio" is defined
without consideration of dynamic
negotiation results.
No systematic choice of negotiation /
decision mechanism. Procurement results
depend on negotiation skills of buyers.
The competition matrix summarises the organisa-
tion's objective assessment of its own negotiating
power and of realistic ways to strengthen that
power.
Every negotiation has its own competition
scenario for which an individual negotiation and
decision mechanism will be the optimum choice.
At this point the current situation of the suppliers
in their respective markets is taken into special
consideration.
Create compe-
tition between
your suppliers
State-of-the-art procurement considers a
"total view" on all relevant decision criteria
in a complex, multidimensional
comparison scheme, but without direct
link to price negotiations. In particular,
usually no discussions with the suppliers
about single decision criteria take place.
The price-performance ratio of alternative
suppliers is compared using a total-value-of-
ownership framework. With it, internal
discussions about switching suppliers become
structured, objective and target-oriented. Openly
discussing the framework with suppliers easily
generates success and creates an impression of
real competition among the suppliers.
Use total-value-
of-ownership to
compare
suppliers’
offerings
Procurement has to reduce prices, but
supplier decisions are taken by internal
stakeholders ahead of the negotiations.
A cross-functionally aligned bonus system makes
it possible to provide procurement with a decision
mandate in negotiations. No other argument will
generate as much negotiating power as this
mandate to decide.
Empower the
procurement
department to
both negotiate
and decide
Choose the
negotiation and
decision mecha-
nism that is best
suited to the
bidding situation
Occasional usage of certain negotiation
tricks. In extreme cases, a negative
reputation for non-reliability of promises
made by certain buyers may be observed.
The relevant goal besides reducing prices in
the short run is to create a reputation for
reliable decision-making in the negotiation
process. This will secure sustainable success
in negotiations.
Use the nego-
tiation and
decision process
systematically
Insights for the executive
Declining market demand and over-capacity drives ?nished
product manufacturers to put price pressure on their sup-
pliers, i.e. the manufacturers of sub-assemblies. This forces
the latter in turn to re-negotiate contracts with their suppli-
ers. Given the brutal nature of the current economic crisis,
it is crucial to extract important price concessions from
suppliers fast, yet without harming the long-term prospects
of vital suppliers.
The traditional procurement approach is ill-suited to that chal-
lenge. It relies too much on the negotiation skills of individ-
ual buyers, leads to adversarial relations with suppliers and,
most importantly, does not achieve the best price-perform-
ance results. In our experience, you will achieve excellence
in procurement if you obey the following ?ve rules:
• Create competition between your suppliers. Even if
you already have alternative suppliers, expand the range
of suppliers from which you can invite bids. Make your
alternative suppliers and the switching options visible
for your most important materials.
• Use total-value-of-ownership to compare suppliers’
offerings. Start with the initial prices quoted by your
suppliers. Then deduct a premium as a function of the
performance of the supplier on your evaluation criteria,
with the magnitude of the premium depending on the
value of the performance to your business.
• Empower the procurement department to both
negotiate and decide. Allow the procurement depart-
ment to decide about switching suppliers even during
a negotiation, as long as they stay within boundaries
prescribed by the total-value-of-ownership framework.
• Choose the negotiation and decision mechanism
that is best suited to the bidding situation. Instead
of relying on the personal negotiation skills of the buy-
ers, prescribe upfront which formal negotiation mecha-
nism (English auction, Dutch auction, etc) you will use
as a function of the competitive characteristics of each
speci?c situation.
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Prism / 1 / 2009
79
• Use the negotiation and decision process systemati-
cally. Be transparent toward suppliers about the nego-
tiation and decision mechanism that will be applied, and
stick to it as much as possible. Revise and adapt the
prescribed mechanism only by exception.
The approach presented in this article is grounded in mechanism
design theory. For more information about the application of this
theory in price negotiations, please see Gregor Berz, “Game Theory
Bargaining and Auction Strategies” (“Spieltheoretische Verhand-
lungs- und Auktionsstrategien”), Schäffer-Poeschel Verlag, Stutt-
gart, 2007.
Effective procurement negotiations in the downturn
Gregor Berz
… is a Principal in Arthur D. Little’s Munich of?ce and mem-
ber of the Operations Management Practice. He specialises in
(reverse) pricing and strategy development in sales and procure-
ment.
E-mail: [email protected]
Andy Dvorocsik
… is a Director in Arthur D. Little’s Houston of?ce where he
leads the Americas Chemical Practice. He specialises in strategy,
pricing, and procurement.
E-mail: [email protected]
Daniel Deneffe
… is a Director in Arthur D. Little’s Brussels of?ce and member
of the Strategy and Organisation Practice. He specialises in the
area of marketing strategy, margin management and pricing
excellence.
E-mail: [email protected]
Ralf Gampfer
… is CEO of the Institut für Angewandtes Mechanism Design,
Munich, and cooperation partner of Arthur D. Little. He spe-
cialises in the application of game theory in practice.
E-mail: [email protected]
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