Procurement myths: economies of scale and ‘bigger is better’ (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.

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!)  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, now retired I believe, used to write regularly in the media (and usually created 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.

(* There is also a very interesting recent study on reverse auctions which supports the theory that volume does not relate to price – more on that to follow as I have just come across it).

Voices (5)

  1. Guy:

    We ran a reverse auction once on a traded commodity (=average price). Our volumes were not great and the best we hoped for was that we would get somewhere near but just above the trade price. We actually recevied a pricing well below the commodity spot price for that day (I cant recall the actual number but might have been 10%)

    Why?

    – Well, there is value in a relatively guaranteed demand.

    – The bidding companies may have seen it as a good route into trading with a blue chip

    – It may be that our specific quantities and timing matched some spare capacity that the suppliers had and they were able to offer at marginal rates.

    A learning for me here was that we as buyers often underestimate the value and attractiveness of our business

  2. MarketDojo:

    Really interesting article. I suppose there are several key factors that will hint at whether a leveraged deal will be a success or not. Firstly, as alluded to at the beginning of the article, there is the question of what proportion of the spend category is actually negotiable. For high margin products, such as software licences or mobile telecomms, you would have a high degree of confidence that aggregation would generate greater savings potential, and vice versa for low margin products.

    There is also the question on relative value. Would combining spend raise your profile significantly in the supply market, or are the suppliers in the market so large that it makes little difference to them or so small that their best price has already been identified? Alternatively would aggregating spend allow you to bypass the brokers / resellers / agents and deal directly with the producers, thereby eliminating the sub-tier cost margins?

    Strangely enough, in the past I have actually come across suppliers who have turned down additional work. It all comes down to finding the right supply partner who is a perfect fit for your needs. I fully agree that bigger does not equal better!

  3. Jerry E Durant:

    I guess the real challenge that a collaborative buy faces, is logistics. It will erode margin and thus end up with more handling costs. The other factor, is that size really doesn’t matter because it is often a case where you run the payment gauntlet to get your money. That is enough to steer one away from those mega deals.

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