Low Purchase Price Today to Avoid Future Costs

Victor Martínez highlights the value of split-award auctions

09/09/2014 Barcelona

Víctor Martínez de Albéniz
Víctor Martínez de Albéniz, IESE Associate Professor of Production, Technology and Operations Management

Procurement managers face a critical tension at work. On the one hand, they want to find the cheapest supplier for their company. On the other hand, awarding a contract to the cheapest in a winner-takes-all auction might alienate the other bidders that did not win. The latter is a key point when suppliers must be screened to participate in the first place.

To ensure healthy competition in future auctions, a supplier who drops out should be replaced, which comes at a cost when testing, site visits or other screening devices are used. Put simply, a trade-off exists between getting a low purchase price today and avoiding the costs of qualifying new suppliers for future auctions.

"Splitting the business among multiple suppliers can help resolve this trade off," say Aadhaar Chaturvedi of the University of Namur, Damian R. Beil of the University of Michigan and Víctor Martínez de Albéniz of IESE. In their article, Split-Award Auctions for Supplier Retention – published by Management Science – the authors develop a split-award auctions model with very practical applications.

Unlike the winner-takes-all auctions scenario, where the only thing that matters is being cheapest, with split-award auctions the question of "how much cheaper" determines business-award quantities.

This model is meant to optimize auction results for the buyer – taking the long view – and also to benefit the suppliers and the supply chain as a whole. This is what the authors call the "win-win-win" effect.

The importance of auctions with screened participants

Staying abreast of suppliers' costs is tricky – especially in fast-changing industries. To stay current on pricing in components markets, for example, large manufacturers may run quarterly auctions, thus creating a lot of work for procurement managers.

Deciding who is qualified to participate in an auction is an added challenge. The stakes are high, as supply failures can be devastating. Suppliers should undergo pre-qualifying procedures, even if they are relatively time-consuming and costly, with product testing and site visits.

Maintaining a pool of pre-qualified suppliers (a supply-base) to participate regularly in auctions saves a company from having to constantly work to qualify new suppliers. However, running sole-award auctions, where all the business goes to the cheapest supplier, risks alienating qualified participants for future auctions.

The Study Results and Implications

  • For healthy competition in auctions, buyers should qualify suppliers for auctions to reach an optimally-sized supply-base and then maintain that size;
  • Calculating the right-sized supply-base is fundamental. A larger supply-base allows the buyer to cast a wider net and in theory leads to more competitive bidding. However, maintaining this larger pool of suppliers and splitting awards between them effectively makes the bidding less competitive, as each supplier receives a smaller share of the business;
  • The exact allocation of business to each supplier depends on their cost spread. In split-award auctions, suppliers know that they are likely to be awarded some business but not how much, serving as incentive to stay competitive and win a larger share;
  • Split-award auctions are the best option for everyone in fast-changing industries. The buyer avoids many of the headaches and costs of qualifying new suppliers, the system benefits from lower costs and the suppliers win business more often than they would in a winner-takes-all scenario.

However, the authors note that their model would not apply to industries where there is little change in suppliers' costs. Companies in these stable industries are better off holding sole-award auctions and locking the cheapest supplier in to a long-term contract.

For more information, see IESE Insight