‘They’ll both get a slice of the pie’

The win-win situation is something we all aspire to, with sometimes even the smallest changes making the biggest difference. In a recent research paper, Dr Chen revealed that optimising the sequence of key activities in a buyer’s procurement process can create win-win for both the buyer and suppliers. 

The result? The prospect of millions of dollars in savings on both sides. The secret? A new procurement process that performs strikingly well. The research, ‘Procurement Mechanisms with Post-Auction Pre-Award Cost-reduction Investigations’, is based on a simple approach.

“Fundamentally, it’s about how to optimise the procurement process to enhance performance and lower costs,” says Dr Chen, who teaches operations management at LBS. “If you think about it, the buyer’s whole procurement process involves many interactions with the suppliers. This allows the buyer to gather a lot of useful information. By optimising the sequence of such interactions, the buyer can influence when and what information becomes available, and leverage this to make more informed procurement decisions.” 

For many years, buyers have been using a Bid Award Investigate (BAI) supplier-selection process. Here, the firm will collect pricing bids from a range of suppliers, choose the one with the lowest bid, then award that supplier a contract. It is only after the contract has started that the buyer will investigate ways to help the supplier reduce costs. 

All change

Dr Chen and his co-authors, Damian R Beil and Izak Duenyas from the Stephen M Ross School of Business, University of Michigan, believe the BAI approach is a missed opportunity for buyers, who could make much more informed supplier-selection decisions if they knew the suppliers’ cost-saving potential before signing a contract. To this end, they propose a restructuring of the BAI process. Dr Chen says, “After getting the suppliers’ initial bids, instead of going with the lowest price, the buyer could spend some time visiting the suppliers’ plants and investigating their production plans to see how they will carry out the contract. The buyer would then be able to evaluate any cost savings they could help the supplier achieve. 

“For example, after reviewing a supplier’s proposed production method, the buyer may realise that the supplier could change certain aspects of their intended production process and thereby reduce production costs. 

“The buyer can combine this cost-saving information with the supplier’s initial pricing bid to figure out the projected total cost with that supplier, then decide who to award the contract to,” Dr Chen points out. “We call this approach BIA – Bid Investigate Award. We want to help the buyer find the best supplier, and this ‘best’ isn’t only based on their initial bid, but also on potential cost savings down the line.” 

This way, the buyer finds the most cost-effective supplier to perform the contract and reduce the total cost of the supply chain. The resulting gains – also known as “total welfare” or “slice of the pie” – will be allocated to both parties and create a win-win.

Driven by industry

The research project was originally motivated by the automobile industry in Michigan, US, where Dr Chen earned his doctoral degree at the same business school as his co-authors. Prior to this, he acquired a bachelor’s degree at the Department of Automation at Tsinghua University in Beijing, China. 

“My background is in engineering,” he says, “and Michigan is a big automobile hub with lots of car manufacturers. During my PhD, my co-authors and I got involved in a consulting project with some practitioners and we looked into the processes they used to run their procurement, supplier management and so on. They source input components from their suppliers and then supply sub-assemblies to the big three US car manufacturers – Ford, General Motors and Chrysler. The problem they faced was managing their costs effectively. This project was motivated by that context – a tier one manufacturer’s procurement problem.” 

Key features of the automotive industry made it the perfect context for the researchers’ BIA approach, says Dr Chen. “You’re buying complex products that require an engineering effort, so the buyer can ask the supplier, What kind of engineering approach do you propose to make particular parts? How much tolerance do you want to put into your production process when you do the casting and machining, etc. How will you run your production plant to do this? Do you want to run make-to-order or make-to-stock? 

“These factors have huge cost implications that the companies can leverage when choosing a supplier.”

Dr Chen is always looking at ways to structure and optimise the procurement process. It has, he says, evolved into a more and more strategic function over the

years, involving many considerations including cost, quality, sustainability and now geopolitical viewpoints.

At his “day job” at LBS, the first thing he teaches his students is that every organisation they look at needs to be viewed as a process. He reveals, “I tell my students to think about all the resources and activities that facilitate an organisation’s value-creation process. If possible, you want to avoid putting yourself in a position where the information that’s relevant to your key decision at an earlier stage arrives at a later stage.”

Long process

Writing research papers can be a long and drawn-out process, especially when co-authored remotely between London and Michigan. Inspired by the consulting project six years ago, Dr Chen’s paper was a lengthy affair – although the timeframe enabled a few surprises to emerge.

“Two main things really took me by surprise,” he says. “The first was that, when we ran numerical studies, our seemingly small change in the process would lead to substantial savings.

“The second surprise came when we investigated the ‘theoretically optimal’ way of structuring a cost-reduction mechanism. This optimal mechanism turned out to be a very complex one with complicated contract payment rules, and for many reasons cannot be implemented in practice. But we found that our proposed BIA approach, which is not too complex, achieves the majority of benefits that are offered by the theoretically optimal approach.” 

In his spare time, Dr Chen enjoys learning about emerging issues in the business world. And he has already embarked on a new procurement research project – this time on a policy level. “I’m trying to understand some of the mechanisms that governments can leverage to engage small- and medium-sized businesses in government contracts,” he explains. “There are lots of opportunities out there for these businesses to get engaged, but also a lot of red tape and cost. How can we facilitate these businesses’ involvement in the government procurement process in order to reduce inefficiencies and red tape? I believe operations management can play an important role here.” 

Meanwhile, Dr Chen’s co-authors have been making connections and holding discussions with practitioners back in Michigan who are showing interest in implementing their new ideas. He says, “If I think about the implementation of our process in the future, one of the challenges I can see for buyers is the need to acquire good data. An analytical model will help their decision-making, but they’ll need to get relevant data to calibrate the model to make useful predictions.”

Huge rewards

Dr Chen is convinced that, if the buyers can access the data they need, the rewards on offer will be huge. He concludes, “Based on the consulting project that initiated this paper, we did some benchmarking and validating and found that, on a year’s contract, we could see savings on both sides in the range of millions of dollars.” 

George Chen is Assistant Professor of Management Science and Operations at London Business School