Keelvar Blog

How Market Design Can Help Drive Savings in Procurement

January 22, 2014

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How Market Design Can Help Drive Savings in Procurement

The concept of market design has received increased attention in recent years, primarily due to Alvin Roth winning a Nobel prize in Economics in 2012 for research in this area. Since then it’s application is gradually beginning to appear in a raft of different contexts. As this article by Alan Gleeson describes, the exciting news for those in procurement, is that the application of this cutting edge research is now available to all via Keelvar’s sourcing optimization solution. The resultant benefits are significant, with typical additional savings in the region of 10-20% being secured, all without squeezing suppliers. The approach also offers a range of additional benefits; from encouraging SME access (an ongoing public sector requirement), to significantly reducing time spent evaluating procurement exercises, to helping reduce the likelihood of cartels forming.

Market Design

In economic terms, market design describes the use of market based mechanisms to solve problems of economic resource allocation. In layman’s terms, it simply means you should consider the rules under which market participants interact, so you increase the odds of securing the best outcome; be that promoting innovation, or improving pricing.

The attractiveness, of market design in a procurement context primarily relates to the latter benefit, as you can significantly increase the odds of securing more cost efficient outcomes with simple upfront changes as to how you procure. In short, the outcomes of procurement events are significantly impacted by decisions made at the market design stage. And effective market design is the foundation upon which any successful procurement event (or tender exercise) is built. These design decisions include; what auction format you chose to use, whether you allow lotting and whether you look to elicit more expressive bid information from suppliers e.g. whether they are permitted to offer conditional discounts i.e. discounts based on certain criteria such as winning a number of lots etc

The primary benefit from improved market design in a procurement context, is that it can yield surprisingly positive results, particularly when combined with an auction approach that disaggregates demand and encourages suppliers to offer more ‘expressive bids’. With this approach, demand is broken into small units (or lots) and bidders are encouraged to offer discounts based on winning combinations or bundles of attractive lots. These discounts ratchet up as more business is won, and crucially lets all suppliers play to their strengths.

The net effect is that it is possible to elicit additional savings in the order of 10-20% of your total spend, when marrying improved market design and conditional discounting. As the following two examples illustrate a number of additional benefits arise also.

Example 1 : Passenger Transport (Public Sector)

The nature of the passenger transport business is largely local, and the supplier base generally limited to those with a footprint in the area. While the supplier base can be competitive, poor competition design can often reduce the potential of encouraging new market entrants. Similarly, a stagnant market will inevitably result in increased prices due to the lack of competition (a static supplier base will often lead to collusion and price fixing among suppliers). Hence it is important to consider market design elements upfront to ensure the odds of collusion occurring are reduced.

The choice of auction format is one such consideration. And if the procuring body (or purchaser) utilizes a reverse e-auction where prices descend until the end of the auction, it can play into the hands of suppliers looking to collude. Participants can observe the behaviour of other suppliers in a fairly transparent manner enabling them to monitor behaviour ensuring the other colluders ‘play ball’.

However, utilizing a sealed bid format where participants are invited to submit their best considered bids confidentially, the ability of participants to monitor the behaviour of others is removed and hence it acts to mitigate the risk of bidder collusion.

Breaking demand into smaller lots encourages smaller players to participate, so one natural outcome is a richer supplier set competing for business. If suppliers are then invited to offer discounts on lots which they bundle and package as they desire (ratcheting up the discounts on the basis of securing more business), the conditions are ripe to create more efficient outcomes.

New entrants can also be enticed to participate as they can submit conditional bids. In other words, they can bundle up a package of routes and offer a price based on them winning all of the routes in one package. This approach removes the risk they would have had, if they could have won a small number of non contiguous routes which would have been costly to serve, and would have incentivised them to bid higher.

The net effect of the improved competition design invariably leads to a more competitive procurement event, and improved conditions for participants. Efficient market design married with an auction format designed to encourage increased competition and to then elicit discounts from the participants, benefits both purchaser and supplier alike – hence the outcome is invariably a win-win one.

Example 2 : Logistics (Private Sector)

A growing number of companies outsource logistics to haulage companies. In many instances the companies procuring have aggregated their demand believing that they will benefit from significant economies of scale. As a result the supplier base tends to narrow as only the very largest hauliers can bid on the business and the unintended consequences can be significant. If the purchaser is then content to contract with a small number of hauliers (often two), given that they do not want to ‘manage additional suppliers’ the consequences of this reasoning can be significant.

The inherent problems with the above approach is that the procurer has essentially created a duopoly and the suppliers have market power which will typically lead to market abuse over time.

Structuring the Inputs and Outputs to capture Savings

Alternatively, in this example, those procuring could move away from aggregation by region and break demand down into routes (or trucking lanes in this logistics example) encouraging suppliers to bundle and package routes as they see fit. This encourages them to look at backhaul opportunities (whereby an empty truck returning to base picks up supplies en route). Given the Department of Transport in the UK indicates that an astonishing 25% of road transport operations make the return journey empty, the opportunities to operate more efficiently are significant. Of course this more granular approach also means that small regional operators may be able to offer exceptionally competitive rates within their local area. Participants are then encouraged to offer discounts based on winning packages that match their requirements (perhaps contiguous routes that start at their base and return to it by the end of the day).

The net effect of these changes in disaggregating demand and encouraging conditional discounts, can be significant savings and a much stronger and more competitive supplier base. The beauty of applications like Keelvar’s solution is that it offers users (particularly in the private sector) more control, so they could include additional constraints such as ‘I want at least 3 suppliers’ or ‘I do not want any one supplier to manage more than 40% of my business etc

Summary

In summary, the old Henry Ford adage that ‘if you always do what you’ve always done, you’ll always get what you’ve always got’ holds true. However, If you are looking for a different outcome from your procurement exercise, you need to assess what can be done differently to ensure better results while remaining compliant.

Where market design and sourcing optimization was once the exclusive preserve of the largest of enterprises, it is now available to the wider procurement community via Keelvar. And what is most appealing is that the easy to use interface means the time savings for those procuring via Keelvar are also considerable.

Alan Gleeson is the Head of Sales and Marketing for Keelvar.