December 17, 2008

Auctioning Supply Contracts

Buyers and suppliers can both gain from a procurement strategy that uses an auction to eliminate guesswork.


The Idea

Buyers and suppliers can both gain from a procurement strategy that uses an auction to eliminate guesswork.

The Research

In search of ever-more competitive prices, buyers must frequently seek out new suppliers to secure certain products or raw materials. When buyers have the option of purchasing goods from multiple suppliers, however, they must navigate the market without the benefit of knowing the suppliers’ production cost, which the supplier doesn’t reveal. Buyers, therefore, are limited in their ability to negotiate for the lowest price.

On the other end of such a transaction, suppliers face fierce competition for contracts with buyers and must often pay controversial slotting allowances. Slotting allowances are widespread and are most notably used in grocery stores to guarantee that a new product is placed on shelves or that an older product is given a special promotion. Such allowances can divide the risk associated with introducing a new product between the manufacturer and the retailer. But because slotting allowances are dictated by buyers who can set fees as high as they want, this practice can give an unfair advantage to established suppliers and discourage new, up-and-coming suppliers.

Professor Fangruo Chen developed a mathematical model to devise an optimal procurement strategy through which buyers and suppliers can reap the maximum benefits from an auctioned contract.

Chen’s strategy requires that when soliciting a supplier, buyers present a contract that specifies the minimum and maximum quantity of a product, as well as how much they are willing to pay for different quantities. The contract is then put up for auction, and the supplier who bids the highest slotting allowance wins. (Though the buyer remains unaware of the supplier’s production costs, in order to maximize its profits, the supplier must consider these costs when bidding.)

Also, though buyers traditionally manage inventory, Chen’s contract stipulates that the supplier manages inventory. This benefits the supplier, who decides how much to manufacture and deliver and can take advantage of economies of scale to produce the most cost-effective quantity.

Practical Applications

Buyers, Retailers

You can use this strategy to negotiate the lowest price for a product or raw material, as well as to secure the highest slotting allowance from a supplier. This method also minimizes the controversy associated with slotting allowances, because all suppliers have the opportunity to bid, regardless of a retailer’s preset minimum fee.

 

Suppliers, Manufacturers

You can use this strategy to maximize profits based on what a retailer is willing to pay for different quantities of goods. This strategy puts you in charge of managing inventory by allowing you to determine the most cost-effective quantity of goods to produce and deliver.

 

Read the Research

Fangruo Chen

"Auctioning Supply Contracts"

View abstract/citation  Download PDF  

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