Economies of Scale – Bigger Procurement is Not Always Better Procurement

(In this holiday period, when news is somewhat thinner on the ground, we thought we would take a few articles from the Spend Matters archives – even the Procurement Excellence blog archives – and feature them again here, with a touch of editing / updating where necessary. Only those of course that are relevant, so don’t worry, nothing about the latest procurement of horse-drawn carriages! But here is a two-parter that is still totally relevant!)

Why do we assume that bigger is better in procurement terms? That, if I aggregate my spend, if I have more volume to offer the market, then I will get a better deal.  Why should this be so?   It can only be because the supplier benefits from the economies of scale that the greater volume offers them, and they can pass some of that benefit back to me in the form of better value.

There is no natural law that says a supplier must offer lower prices to a bigger buyer.  If their unit cost for every item sold was independent of volume, there would be no reason for them to offer better pricing for more volume.  They must benefit.

This basic belief in economy of scale underpins so much of what goes on in procurement; collaborative initiatives in the public sector, centralisation in large corporates, attempts to standardise specifications.  Yet procurement and organisations generally often don't think very hard about how the concept applies to different markets or suppliers.

"Economies of scale" refers to reductions in unit cost as an organisation's scale of output increases.  And of course, a larger volume on offer will in most cases have some economy of scale benefit. For a start, the sales cost per unit usually decreases; although it may not if a large contract has a very expensive bidding process attached (as is often the case in the public sector!)

Now that benefit to the supplier can come from a number of sources.  It may be a manufacturing economy or procurement economies in terms of buying raw materials for instance; producing thousands of identical cars, or laptops, has obvious scale efficiencies.  So the ultimate customer can exploit that to get better pricing.  But even those economies may depend on how similar the product is; hence why a generic discount from an auto manufacturer to a large fleet buyer, applicable to anything they buy, will fall well short of what they will offer for a firm order for 1000 identical vehicles.

It may be economies in the sales process; the 'manufacturing' cost of software licenses is basically zero, but you can get a great deal for volume purchases because you save the supplier a lot in terms of their marketing and sales effort, which is a major part of their cost base. It could be economies in financial terms; a large firm can get access to funds at a favourable rate to finance investment, which enables them again to pass on some of that benefit to the purchaser.

But procurement often makes the mistake of thinking that economies of scale apply everywhere, and in the same sort of manner.  If I can get a 50% discount for volume from the software firm, why can't I get that from the facilities management provider if I offer them a big enough deal?

The simple answer is that the direct costs of the FM provider, particularly people, are relatively fixed per unit of output.  The cleaning services provider might buy cleaning fluid slightly better as their volume goes up; but 60% of their price to you is direct labour, probably people working at minimum wage.  Their scope to make economies of scale is limited, as therefore is their ability to offer you a better deal in return for volume.

And there are some spend categories or products where we can even see dis-economies of scale; or other factors that mean the buyer with less volume on offer can do a better deal than the big buyer.  We’ll look at some of those cases in part 2 tomorrow and discuss what this means for procurement.

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Voices (3)

  1. Greg:

    The one aspect overlooked, and sadly overused by many Public Sector organisations, is that by consolidating and effectively pushing the unsuccessful players out of the market, they can force better pricing.

    Personally I see this tactic as somewhat unethical and as this article dempnstrates, self defeting as it forces savings that don’t exist and therefore must be recovered by the supplier in another way.

    There is an inaccuracy though, and that is that by giving a lenghty commitment, suppliers are sometimes able to reduce the cost of labour through permanent employees or reduced rates and overheads.

    1. Dan:

      Hi Greg.

      Could you expand on this in more detail? How are savings that don’t exist being ‘forced’ by public bodies? This would only happen if the supplier was lowballing the contract price, hoping to compensate for this through some other way, surely?

      This is unethical, certainly, but on the supplier’s side, not the buyer’s side, and has nothing to do with aggregated buying – it can happen to smaller contracts as well.

  2. Dan:

    I’m looking forward to Colin Cram’s response…

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