Procurement – on savings and incentives

This summer our department at work published a global guideline on procurement. A colleague of mine did great work on managing a project where existing rules, guidelines, processes and tools were brought together, harmonized and supplemented. The result is a guideline that helps all company employees in procurement activities, whether it is about doing a demand and a supplier market analysis, preparing a tender, negotiating a contract or improving collaboration with existing suppliers.

In the following weeks after the publication, I gave trainings to colleagues from other departments on the most relevant policies and rules, available tools and the benefits of using the provided tools and processes. I was also contacted by some colleagues who were in need of procurement support, e.g. asking for help in initiating a supplier search. Being able to refer to the new guideline and the tools was a huge help for me. It reduced my workload immediately, and the people contacting me were happy to have such a clear guide on what to do and how to do it.

After these experiences, I was obviously convinced that soon we would have more of our colleagues buying more professionally and spending less. After all, procurement is something we do everyday in our personal lives: we buy food, bus tickets, plan buying a house, compare prices and so on. Still, companies have dedicated procurement departments. If procurement is so easy and intuitive, why doesn’t it work in larger companies the way it works in our private lives? Why do sensible people spend money less sensibly, when they are spending company money?

I think there are multiple factors here at play, at least two:

  • Lack of experience and information
  • Lack of incentives

Of these two, I find the latter to be the more convincing one, since it also contributes to the first one, but I’ll first briefly discuss the first point. When we do our everyday shopping, we have experience on what the goods usually cost, who are the market players and what is the quality we should expect. We are also usually quite able to define what we want. For example, I roughly know what a kilogram of apples costs in the nearby grocery stores so I know the market. I also know, what to expect from first class apples, so I am aware of the standard product quality. I can also define my preferences regarding apples, e.g. whether I like sweet or the more sour ones.

When you work for a company, you might often need external goods or services. If you do not purchase the same goods or services often, you lack market knowledge, including prices and the usual quality of the goods. For example, if you need a tax consultant, your knowledge on the competitive situation between consultants, their regular service spectrum and potential services might be unknown to you. Thus, even if you can define in detail what you want and what you are prepared to pay for it, you do not know if that is a good deal on the market. And should you be unable to define your needs and not know what kind of opportunities the market provides, you might be lured by a slick salesman in to buying some nearly related good or service that does not fulfill your needs or contains features you do not need at all. Continuing with the previous fruit analogy, you might not be able to define whether you want pears, prunes or apples and might end up leaving the farmer’s market with a cucumber in your bag.

A logical question is then, why we don’t dig out the necessary information and gather the experience. This is, of course, a matter of cost. The learning curve in the beginning is quite steep, and if you are, for example, a research engineer, the opportunity cost for learning the intricacies of the market for different sensors, for example, might be too high. Thus, we have dedicated procurement functions. But this leads to another question, namely, why do we see maverick buying, that is, people not using selected suppliers and the services of the centralized procurement function to gain market knowledge with smaller opportunity costs? Or why might it be that people do not use provided self-service tools that make tendering and offer comparison much easier, reducing the opportunity cost for the company significantly?

I get a penny, I lose a penny

Even if the most evident opportunity cost of getting competing offers from suppliers and doing solid offer comparisons is reduced, the added benefit for the single employee is not necessarily very high. In the case of the research engineer, getting to know the supplier market for sensors has the opportunity cost of doing research and development work that might lead to new products and income sources for the company. For the engineer there is an opportunity cost of potential bonus if the new products can be patented.

With a centralized procurement function the opportunity cost of the research engineer’s time may be reduced from the company’s perspective, if the engineer can quickly do an offer comparison and thus save a few thousand or more when buying the sensor. The generated savings would compensate the lost time in development work. However, for the engineer there might be nearly no benefit from doing this offer comparison. Assuming he is working on a new product and expecting to get additional remuneration from a potential patent, by doing offer comparisons he is not working towards his expected bonus for patent. Even if he reaches savings in excess of a thousand dollars, his payoff is practically zero, since those savings are either flowing in to the company’s profits or divided between all employees. In a very large company, dividing a thousand dollars between all employees, results in pennies per person.

On the other hand, our development engineer also does not suffer very much from using excess funds for buying the sensor. If he uses a couple of thousand dollars too much, this is again divided between all the company employees, incurring an effective loss of less than a dollar per person in a very large company. This leads us to a free-rider problem, where no one has the incentive to be the one to generate the savings and has therefore little reason not to spend excessively.

The problem here is that employees are not incentivized to use company money as if it were their own, since they usually do not see the effect of personally generated savings: it does not increase their salary or their bonus. Of course, excess saving, and lack of investments, today can endanger a company’s existence tomorrow, so we also a have a temporal problem. This kind of situation is also familiar in game theory, where certain games pose the question, under what circumstances people forego today’s added benefit for the anticipated future payoffs. Unsurprisingly, the present value of the future payoffs have to be large enough in comparison to the temptation created by the payoffs one would receive today. This is a question of time-preferences and the nominal values of the future payoffs.

In order to have employees use company money more effectively and efficiently, we need mechanisms that incentivize such behavior. Procurement professionals are sometimes paid based on achieved savings, but this might also be too naive a solution. For example, if the savings are measure against initial supplier offers, we can be quite sure that the procurement manager always comes with astronomically high initial offers, just to seal the deal with significant price reductions that conveniently guarantee him a good pay.

A mechanism to generate savings

The previously presented problem of aligning the incentives of the company and its employees is a principal-agent problem that can be solved with mechanism design. The principal, or the company, designs the mechanism, in this case the salary or the bonus structure of the employees, in such a way that each employee has the incentive to generate savings. Here it is assumed that the achieved savings exceed the potential opportunity costs for the company and for the single employee. After a quick Google-search I did not find any literature on this specific topic, but the principal-agent problem and mechanism design are broadly studied areas in game theory.

Concluding the previous discussion, a good mechanism that incentivizes all company employees to use the company money responsibly, should have at least the following features:

  • When a person generates savings, he profits from them more than other employees do per head;
  • Compensation for generated savings is at least as high as the employees opportunity cost, e.g. expected patent remuneration fees;
  • Compensation for generated savings is at least as high as the employees The net savings for the company are at least as high as the opportunity cost for the company, e.g. delay in new product development and market launch;
  • Generating long-term savings is more profitable for the individual than quick wins, thus arbitrary reduction of profitable investments is discouraged;
  • Savings are not measured against the initial supplier offer.

Doing the impossible daily

Two weeks ago, I posed my colleagues with the “Do the Impossible” –challenge, based on a LYL blog post. I first told my colleagues about LYL and explained the passionate work framework and the role of “doing the impossible” in it. The challenge is to do the personal impossible for one month, after which we will have a feedback session to discuss how the challenge went, how it felt and what we might have learnt from it

My colleagues were very keen on participating and after the first few days some already told me, how they got new spark for a project they had started earlier this year but had fallen out of their radar recently. For example, one colleague got new motivation to keep training for an upcoming half-marathon.

For myself I set the challenge of meditating five minutes each evening. Doing already a fair amount for sport very regularly, I decided that trying to balance that out with some relaxation would be beneficial. Meditating regularly is also a challenge for me, since cutting back on exercise and using more time for recovering is something I tend to omit. So far I am doing well, taking small steps and doing the impossible every day of the challenge. Announcing it here is also a good test of whether my colleagues are reading my blog or not.

I was very happy to give my colleagues an introduction on LYL, setting the challenge and seeing how LYL gets people excited, gets them try and do new things, impossible things. I also noticed how sharing my experiences and giving my knowledge forward is a central part of my calling, the work I am passionate about. Delivering this training was for me one step further in becoming a self-expert and doing passionate work.

Signaling – Show that you can, show that you mean it

My previous post was about complete and incomplete information and about revealing your advantages to your opponents to gain an even bigger advantage. I finished with a short discussion on signaling: How to credibly differentiate yourself from others to gain a higher payoff?

In his course on game theory, Ben Polak represents a good example on signaling by using a simplified model of the job markets. Here I represent it, with possibly different figures, but the idea holds:

  • There are two types of workers only: good and bad
  • 10% of all workers are good, 90% are bad
  • a good worker produces 50 dollars worth of goods per day a bad worker produces only 20 dollars worth of goods
  • employers cannot tell the difference between a good and a bad worker before hiring them
  • the two types of workers are otherwise identical, just their output is different
  • this game lasts only one day, to keep the calculations simple

On average, an employee produces 23 dollars worth of goods, so the average salary level is also 23 dollars. Therefore, the bad workers earn slightly more than they produce, and the good workers a lot less than they produce: a good employee would earn 50 dollars if he could signal credibly to the employer that he is a good worker. Of course, a bad worker would also want to earn 50 dollars instead of 20 or 23. Thus we need something to differentiate between the two, we need a signal.

A signal that differentiates the good workers from bad workers, or any types from one another in general, has to be such that good workers will always give the signal and bad workers will never give the signal. For a signal to be credible, it’s costs obviously have to be such, that they reduce enough the net salary of a bad worker, but do not reduce too much the net salary of a good worker: this way the bad workers will not be willing to give the signal while the good workers will always give the signal.

As an example of a signal, Mr. Polak mentions the possibility of dancing on the table in a job interview and singing a song about how good an employee you would be. Such a signal is obviously costly, being humiliating at the very least, but it does not help differentiate the two types of workers. After all, it is equally humiliating for both types, so even if a good worker would have the incentive to give the signal, the bad worker would have the same incentive, in order to be identified as a good worker and thus receiving the salary of 50 dollars. Clearly not all costly signals can separate the worker types from one another.

Education as a signal

It turns out that education is a form of signaling and conversely, among other things education has a role as a signal giver at the job market. Let’s introduce a two-year MBA that either type of worker can take. The costs of tuition are the same for both and so are those for housing, transport and food. We might argue that the two types have different opportunity costs in taking an MBA instead of working, but both types would earn 23 dollars since we do not yet have a signal to separate them at the job market. So why does the good worker do the MBA and the bad worker doesn’t, as I am proposing? The difference in the costs is the effort, the mental work, hours of sitting in lectures doing homework and assignments. For the bad worker the required effort to finish the MBA degree is much higher than for the good worker. So much, that receiving an MBA would reduce his net salary below current levels, even below 20 dollars.

Of course, in this example the figures can be forced to be in such a relation to one other that the signaling works. E.g. if we make the total costs of an MBA, including the effort, to be 10 dollars per year for the good worker and 20 dollars per year for the bad worker, it is obvious that the good worker will do the MBA and receive a net salary of 30 dollars after being identified as a good worker and hired by an employer. Conversely, the bad worker will not take the MBA, since his net salary for doing an MBA and being identified as a good worker is 10 dollars, which is below the 20 dollars he would receive otherwise.  In addition, the employers have to believe that good workers, and good workers only, take an MBA. Otherwise the good workers might, regardless of their MBA, be identified as bad workers reducing their incentive to take an MBA.

Even if the figures in the above example are arbitrary, the main point is that the signaling mechanism has to be such that it will provide reliable signals and no type has the incentive to deviate. Thus, when creating the mechanism, the related figures actually have to be chosen in such a way that the signaling is reliable and adjusts the payoffs properly. In our MBA example a one-year MBA would not suffice, since a bad worker would do the MBA and receive a net salary of 30 dollars, instead of the 20 dollars he would receive otherwise. On the other hand, a one-year MBA could be made a lot harder and work-intensive, so that the per-year costs are increased and, again, only the good workers go for the education.

Signaling in other areas of life and work

Signaling is not only useful and used in employee-employer relationships. For example, buyer-seller interactions might also require, or at least benefit from, signaling.

For example in the case of used cars information imbalance between the buyer and the seller can lead to all goods in the market being of poor quality. In such a case, the potential sellers of higher quality products would have to be able to reliably signal this quality to the potential buyers. The buyers do not have to signal their preferences, since a buyer looking for higher quality products will buy one, if he gets more value from it, and nobody will pay for a good more than the value received from buying and possessing the good. Thus, we do not have the potential problem of customers looking for low quality products suddenly hoarding all the high quality products.

Another interesting realm where signaling can be applied is the one of procurement. At least larger companies often have a centralized procurement function that is responsible for managing the main suppliers, conducting supplier selection and awarding contracts. When looking for a supplier, the procurement function has to create competition between the candidates to find out the best one for the given quality and specifications. However, a potential supplier must invest resources in the bidding process without any certain revenue or supply contract. If the potential supplier thinks that the expected payoff from the contract is low, he will not put too much effort in to the bidding. This might lead to the customer company receiving only a few offers or the offers being of poor quality and difficult to compare against one another. To increase the number and quality of the offers, the customer company would have to signal, in a reliable way, that the potential contract has a guaranteed, maybe even high value. The way to do this is to commit, before the bidding starts, to awarding the contract to one bidder and to one bidder only, and beforehand abstaining from any cherry picking between offers. This of course requires that a large enough pool of bidders is invited and that the background research on them has been done, since procurement will have to commit to one of the invited bidders. Therefore, their capabilities have to match the requirements well enough, so that in principle any solution could be accepted.

As we see, tying your hands or incurring costs to show your commitment and capability are some ways to reliably signal who you are. Consequently signaling can help you leverage those advantages that might otherwise go unnoticed. Information is power, and shared information can be overpower.

Incomplete and complete information – Strengthen your advantage by revealing it

I have nearly finished the Open Yale course on game theory. Just the final exam is still to be done. Although my exam won’t be graded, I’ll use the opportunity to tackle those problems with the new tools and mind-set and see, what I have learned and understood.

The last topics in the course were about incomplete information and signaling. In game theory incomplete information refers to games, where at least one player is uncertain of the other players’ so called types. A type describes a player’s preferences, available strategies and payoffs. For example, in a real life negotiation we often have incomplete information, being uncertain how tough the opponent is and how he values the potential outcomes. A related concept, imperfect information, we have already encountered when a player does not know, which strategy his opponent has played, although he knows all the potential ways the game could be played and the related preferences and payoffs.

Incomplete information is a realistic condition and thus often encountered when modeling real world phenomena. Often incomplete information is also seen as an asset from the informed party’s point of view: for example, a company knowing both its own and its competitor’s cost structure is intuitively thought to have an advantage, since it knows more, and information is power, as the cliché goes. But what exactly is the benefit of knowing your competitors’ costs and how valuable is it? A further question, with an even less intuitive answer, is, whether such a better-informed company would actually profit from making its own cost structure public. In the following, I will answer these questions from the perspective of the Cournot duopoly model, but taking it a bit further from the standard treatment.

The following is based on the Open Yale course Econ 159a Game Theory and on Strategies and Games: Theory and Practice, 1999 by Prajit K. Dutta.

Incomplete information in a Cournot duopoly

In the standard Cournot duopoly two profit-maximizing companies manufacture substitute products with identical constant marginal cost and serve the same market. The outcome of the model is that in equilibrium both companies produce the same amount of goods, in total more than the monopoly quantity but less than the quantity in free-market competition. Consequently, the companies also get higher than free-market prices and profits, but not the monopoly prices or profits due to the competition between the two rivals.

In an incomplete information Cournot duopoly at least one company (I will only consider this case in the following) has its marginal cost different from those of its competitor’s and this exact cost is unknown to the competitor, while the competitors marginal cost is known by both parties. On average, the company with non-public marginal cost has the same marginal cost as its competitor and the competitor knows this. In equilibrium, the company with the unpublicized marginal cost produces more, reducing the market price, and gets higher profits when its marginal cost is lower than the average. If its marginal cost is above the average, its produced quantity, the price and its profit move to the opposite directions. Somewhat surprisingly, if the company can without costs and credibly reveal its lower marginal cost to the competitor, it will benefit even more, while a company with above average marginal cost would suffer even more.

In table 1 I have summarized the produced quantities, prices and profits to show that revealing its lower than average cost structure in a Cournot duopoly is indeed beneficial for a company. The intuition is the following. When the low-cost producer (company 2) does not reveal its marginal costs, the competitor (company 1) reacts based on the average marginal cost, producing the standard Cournot-quantity. This is the logical reaction, since on average company 2 has the same marginal cost as company 1. However, company knows its own cost structure and produces more than the standard Cournot-quantity, since this is profitable due to the lower than average marginal cost. Likewise, a high-cost company 2 would produce less than the standard Cournot-quantity, but would not suffer from its competitor’s producing more than its standard Cournot-quantity, since again company 1 is reacting as if company 2 had the average marginal cost.

If company 2 could credibly make its lower than average marginal cost public, company 1 would know that company 2 can and will produce more due to its lower marginal cost, driving the price down. In this case company 1 would react to the actual lower than average marginal cost of company 2, not on company 2’s expected average marginal cost. Consequently, company 1 will produce less to counter the price erosion and maximize its margins in this situation. Also, knowing the reaction of company 1, company will produce more, making also higher profits than in the case of incomplete information. Correspondingly, a high-cost producer will also suffer more if its cost structure becomes public, so it will try to keep this information secret.

Table 1 summarizes the Cournot-quantities, prices and profits in different cases of a Cournot duopoly, with companies 1 and 2, company 2 being the low- / high-cost producer who always knows company 1’s constant marginal cost. In the table I have used the following notation:

  • P = a – bQ > 0, where P is the unit price a and b are non-negative constants
  • Q = Q1 + Q2, where Q1 and Q2 are the quantities produced
  • c is the average marginal cost
  • ε is the difference of the low-/high-cost company’s from the average marginal cost
  • c + ε > 0
  • a low-cost company 2 has ε < 0, a high-cost company 2 has ε > 0

I have also used P’, P’’ and similar expressions for the quantities to separate the cases of standard Cournot duopoly from those of incomplete and complete information with company 2 having lower or higher than average marginal cost.

Cournot_table

From table 1 it becomes clear that profits for company 2 increase (decrease) for negative (positive) values of ε, when we move from the standard Cournot duopoly to a duopoly with different marginal costs between companies with incomplete and finally complete information. Thus, a cost advantage is strictly profitable and making it public increases the profit. The profits of company 1 decrease (increase) for negative (positive) values of ε,  when moving from the standard Cournot duopoly to a duopoly with different marginal costs between companies with incomplete information. Thus, a cost disadvantage of one company is strictly profitable for the other companies and their profits increase with this cost disadvantage. With some algebra, it can be shown that company 1’s profits in the case of complete information are lower than in the case of incomplete information and that the difference is (ε/6)*(a + c + 2ε), which is negative (positive) for negative (positive) values of ε.

Information cascading and revelation

As argued previously, a low-cost producer in a Cournot duopoly has the incentive to make its cost structure public to maximize its benefits, i.e. profits. More precisely, the producer with the lowest marginal cost has this incentive, since non-disclosure would lead the competition treating the company as an average-cost producer. Therefore, the producer with the lowest marginal cost will reveal its costs. Now, if there are more competitors in the market, the producer with the second lowest marginal cost also has the incentive to reveal its costs, although they are higher than those of the cost leader. If the producer with the second lowest marginal cost did not reveal its costs, it would now be treated as an average producer in the remaining group of companies: the lowest cost producer has now been excluded from the average, since its cost structure is known. But being treated as an average-cost producer is clearly sub-optimal, if a company’s marginal cost is below the average. Thus, the producer with the second lowest marginal cost will also reveal its costs. This logic can be followed right to the last company on the market, to the one with the highest marginal cost.

When one company, the one with the lowest marginal cost, reveals its costs, this leads to information cascading, since the companies with the next lowest costs now want to differentiate from competitors with higher marginal cost, even if they have costs above the average over all companies at the market. This makes the marginal costs of all companies public, or at least their relation to one another. The last company is evidently going to be the one with the highest costs, since it wishes to stay hidden among the masses and has thus not yet revealed its costs. It follows that the last company does not have to reveal its costs; the competition will be able to infer, that the last company has the highest marginal cost and will react accordingly, even if not knowing the exact costs.

The dog didn’t bark – the value of undisclosed information

The previous exercise shows an important, broader real-world application of revealing information. The absence of evidence or the absence of information can be a substantial piece of information. If a company does not want to reveal its cost structure, it is likely due to its high (marginal) costs, at least in the context of the Cournot duopoly model. But not all markets are like the Cournot model, so the implications are not completely generalizable. But still, even in a free market where all companies are price takers, revealing your costs might help you; not in gaining market share, since your produced quantities do not affect the prices, but in keeping competitors from entering price wars. By revealing your costs, you can potentially indicate that you have the largest margin and can thus come out on top, should a competitor start a price war. But by revealing your costs, you may be able to keep your opponents at bay, since they know in advance that their chances of winning a price war are slim.

The difficulty in revealing the costs and gaining the associated advantage is that it is not always evident, which company has the lowest costs. Therefore, companies may restrain from revealing their costs, even if they would benefit from their low costs more when if became public. But without knowing that it is a low-cost producer a company risks becoming disadvantaged, should it in fact be a high-cost producer.

In the case of very similar consumables and bulk goods (e.g. oil, agriculture products) good estimates on the relative costs among competitors may be made and thus own cost advantages can be made public to keep the competition from starting a price war. For highly specialized and small-series products with small markets, revealing a cost advantage would give the power to affect the demand, prices and quantities produced, but finding out who is the low-cost producer might be more difficult. Specialty products often enjoy higher margins, so that product prices are poor indicators of true costs.

In conclusion, revealing information to your rivals may give you an advantage, and not revealing information already conveys information about your situation. Furthermore, even if you are not in the best position in a group of competitors, being able to separate yourself from the even weaker ones may give you an advantage, and to do this you must credibly signal that you have an advantage over some of the competitors. This will then lead to all with a relative advantage to revealing this information.

Signaling is yet another topic in game theory and discusses how different types of players, e.g. good and bad workers, can credibly be identified: an employer has an incentive to get the good and, presumably, more productive good workers, and the good workers have the incentive to reveal themselves in hopes of a higher salary. But the bad workers also have an incentive to be taken for good workers, due to the potential higher salary. Therefore, if the higher workers are to earn more and employers are to pay “correct” wages to the two types of workers, we need a credible signal that the good worker can and will give, but the bad worker cannot or does not want to give. I will return to this topic in my next post.