Bending over backwards when you're buying

When you're trying to create a strategy to lower the category cost of a good or service within for a company it's practically a given that among the first things that is done is to attempt to aggregate demand for a particular good or service. There is the usual tussle between centralizing control and delegating authority out to regions or business units. It's probably no surprise that I tend to come down on the central control side of the argument when it comes to procurement, but what may surprise some is that I attribute less of the value to centralization to aggregated volume than I do to access to information. Experience has proven to me that buyers armed with lots of recent market knowledge routinely will negotiate better deals than buyers armed only with bigger volumes. This post will try to provide a partial justification for that opinion, and it's based on a couple of special cases of supply and demand curves from our friends in economics, the backward bending supply curve and the u-shaped cost curves. I've used material from Wikipedia to help illustrate my points.

Standard supply and demand theory tries to explain how the amount of demand for a good or service and the amount of supply of that good or service interact. In relation to the amount of supply, the more demand there is for something, the higher the market price. The more supply there is in relation to the demand the lower the market price. Here's an illustration from the wikipedia entry.



This is the primary reason why buyers like to aggregate their demand - assuming adequacy of supply the more you buy (the red downward sloping line) the lower your per unit costs should be. Of course, in the real world sales teams don't pay much attention demand curves and will happily charge companies with larger volumes higher prices.

The backward bending demand curve is often used to describe labour markets "As a person's wage increases, they are willing to supply a greater number of hours working, but when the wage reaches an extremely high amount (say a wage of $4,000 per hour), the amount of labor supplied actually decreases". I can't recall ever seeing this behaviour in the market, or at least that couldn't more accurately be described as simply lowering supply and increasing price. It is worth having buyers understand, if only to help them understand that the standard curves don't always apply.




The u shaped cost curve, where the cost of a good or service initially decreases with volume and then begins to increase with additional volume is pretty common in real markets. There are many reasons, the main reason why companies accept a supplier having a u shaped cost curve is that the increased price they pay to a supplier that has a higher cost with more volume is often lower than the company would incur for introducing a new supplier "switching costs". The u shaped cost curve looks like this (don't blame wikipedia for this one).

I've run into this curve several times, usually while negotiating corporate-wide, or nation-wide deals for companies. Here are a few examples:

• Waste removal for a US based national housing REIT
• Travel agency and card services for a global telecommunication firm
• PCs for a national Canadian bank
• Office supplies for a national government
• Airline travel for a global media company
• Facility Management services for a commercial property REIT
• MRO and parts for a military
• Engineering supplies for a continental freight railway
• Food and snacks for a global media company
• Consulting services for a national government
• Packaging supplies for a global manufacturer
• Consumer shopping bags for a national retailer
• Recycling services for a brand-name retailer

And the list could continue. The list of examples is deliberately diverse both in industry served and in category purchased. There are, at least, three similarities. First, in every case the organization was large and geographically dispersed, the second is that the good or service being purchased was not being consumed by a manufacturing process (in other words they are "indirect" goods and services). The final is that none of them are classic "commodities", there are no public traded financial instruments to buy and sell waste removal service "futures".

With time, expertise, and the ability to test the market frequently, buyers can get a reasonable level of understanding of when a price curve for a good or service will begin to curve upwards. Often it is a function of both volume and geographic dispersion. It might cost a supplier more to service one city than another depending on how much business they have in each location. You might find that a supplier has production capacity constraints that you are bumping up against.

You want your buyers to lower the total cost of a category of good or service. They should consciously be aggregating and disaggregating volume to find the optimal "demand" offer to the market. That often means letting them pay a premium for a given geography or range of goods and services if that means an aggregate lower cost overall.

Cheers,
David Rotor