Economies of Scale – A Procurement Myth? ( Part 2)

We talked about economies of scale yesterday and how they did or do not apply to different organisations; and touched on other factors that may lead to a buyer with less volume on offer can do better than a larger purchaser.  Here are a couple of examples from personal experience.

For many services, there are limited economies of scale; or economies may work but not in a ‘straight line’ fashion. We mentioned yesterday those such as cleaning where low-paid labour is a large part of the equation.  At the other end of the pay scale, professional services is an interesting case.  For many consultancy providers, for instance, economies of scale are principally around the utilisation at a consultant by consultant level.

You will therefore get a much better rate engaging a single consultant full time for a given number of days – say 200 - than for 20 consultants for 10 days each over the same period.  That is one of the reasons why basic day-rate framework rates for consulting firms rarely show much reduction from rate card.  But a major assignment that utilises staff on a close to full time basis has more scope for negotiation.

Another example - ask a large hotel to quote a room rate for 100 rooms; it won't be as good as what you MAY be able to negotiate on the day (if they have surplus capacity). It may not even be as good as the rate they will quote you for 10 rooms.  Logically, if you buy a supplier’s entire output they must charge you an average price that enables them to make an adequate return; hence the rate for 100 rooms may not be as good as you expect. That is not the case if you are buying a small quantity of marginal volume (as in the case of the hotel).

I remember hearing that a buying consortium of airlines found exactly this issue when they tried to do ‘group deals’ with hotels around major airports.  Their combined volume was too much; it eliminated some hotels from the market altogether; it would have stopped others from doing lucrative conference business (as 50% of their rooms would have been taken by the consortium).  If they bid at all, they offered ‘average’ pricing.  Individual airlines, looking for perhaps a few hundred room nights a year rather than thousands, could get a better deal.

A buyer with smaller volumes can also often move more quickly to take advantages of market or supplier movement; and can use smaller providers who may just not be an option for the big buyer.  I once bought a raw material where I was an attractive but not huge buyer in market terms.  We bought very tactically and aggressively using short term contracts of 1 – 3 months (we would have used reverse auctions if the technology had been invented!)

But the really big buyers in this market could not afford to take the risk of buying in this manner; and as they were buying perhaps 50% of the entire output of a production facility, they ended up paying very much a standard market price; we had independent evidence that we bought 10-20% better than our larger competitors.

I heard a similar story last year from one of the biggest private sector energy buyers in the UK; they were just ‘too big’ to get the best deals.

Finally, there is no hard evidence I have ever seen that large buyers habitually get better prices than smaller. Indeed, Wally Johnson of Purchasing Index, who I believe is now retired*, used to write regularly in the media (and usually create a stir when he did) to say that his firm, which had probably done more price benchmarking than any over the last 20 years, had no statistical evidence that larger buyers did better than smaller across a range of commodities.

Now, we're being provoking here.  There are other benefits of aggregating and collaborating in procurement, including a time and cost saving on the procurement side, and using procurement expertise in the best possible way.  Personally, these seem to me at least as strong reasons for the public sector to collaborate rather than the expectation that ‘bigger deals’ will produce significantly lower prices in many spend areas. And for some categories, it will work.  I would far rather approach Microsoft with the potential for 5000 licenses than 50.  I will get a much better deal for 1000 identical specification cars than 10.

But assuming that economies of scale apply uniformly, or that the bigger buyer will always do better than the smaller, is lazy thinking.  We have to look at each category and product on its own merits.

(*  2017 addition - I am not sure if Wally is still around? He could be into his 90s now I suspect).

Voices (2)

  1. bitter and twisted:

    Nope. Scale only ‘wins’ when its matched to a particular capacity.

  2. Serge Milman:

    It is safe to say that there is no such thing as “uniformity” when discussing procurement of products and services along the complexity spectrum.

    However, it is also very safe to say that sourcing 1,000 widgets (defined as products or services) will always result in a better price than sourcing 10 widgets. Why? For many reasons, including the fact that most vendors will not value a 10 widget deal as much as they will value a 1,000 widget deal. There may be isolated exceptions to this, but these will truly be outliers to the truism that scale wins.

    It is true that there are many factors that go into creating value through Strategic Sourcing – scale is a factor, but so is expertise of the Sourcing team. We should be careful to ensure a causal connection when associating factors to results.

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