Does Spot Buying Have a Place Alongside Long Term Contracting?

One of the age old questions in procurement is whether to establish long-term relationships with suppliers through fixed contracts or to purchase on a spot basis. Usually, long-term contracts are the favored approach, given that they reduce risk and often allow for greater negotiating leverage. But a recent study from Standford professors Haim Mendelson and Tunay Tunca shows there’s a place for spot buying as well (you can access the full study here, however registration is required). According to the press release announcing the study, by "strategically using both fixed-price contracts and open market trading, supply chain participants can create greater efficiencies." I admit, there's a lot of jargon in that sentence (but I guess that's what we should expect given that these guys are professors, after all). Still, there's logic in it as well, especially if you look at how the Internet or private networks can combine to create liquidity on a spot basis.

In this regard, the authors note that "just as the stock market summarizes many pieces of information about the performance of a company, business-to-business spot markets can provide up-to-date information about the availability of raw materials, the cost of production, and consumer demand for the end product. Because all of this happens much closer to the time that the end product ships to the consumer, supply chain participants can update their plans to take into account real-time information ... In industries with liquid markets ... manufacturers and suppliers should leave more of the purchasing for the open market. In industries with illiquid markets, they should do more of their purchases through fixed-price contracts early on. But in all cases, both are needed: No matter how efficient electronic spot markets can be, there will likely be a role for long-term contracting."

What are some examples of spot buying today?, First Index, and even Ariba, who could also, in theory, leverage their network for the posting of RFQs and buying requirements, are but a few examples. In many cases, these marketplaces are used by parties for long term contracts, but in some, they're used on more of a spot basis (especially in the case of job-shop type orders).

What's exciting to me about this type model is that it will ultimately allow for the creation of futures and options markets to help both buyers and suppliers reduce risk. Imagine, for example, a machine shop being able to sell a certain amount of future capacity on a weekly or monthly basis. This might provide them with much needed capital to finance equipment purchases or other capital expenditures (or to lock-in a portion of revenue for payroll). But procurement groups could benefit as well. A buying organization might choose to lock-in a portion of their anticipated spend with suppliers using this type of model while floating the rest to get the best possible balance of quality and low prices (without having to commit to procuring specific parts or items at the time of purchasing the capacity-based contract). If you're curious to learn more about this concept, I previously explored the subject in more detail here (and it also formed a basis of a business model that I came up with at FreeMarkets but never implemented at the time).

Postscript: After I wrote this but before posting Michael Lamoureux penned a post on the same topic over at Sourcing Innovation. I would encourage you to check out what he has to say on the subject

Jason Busch

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