Next level procurement negotiations – using game theory and psychology

Game theory is an analysis of strategic interactions – of how one party’s decisions affect the outcome for another party and vice versa. Negotiations are the best examples of strategic interactions. Offers and counteroffers, final acceptances and rejections represent decisions made by different parties, which clearly affect the outcome of the negotiation. Game theory provides a structured and systematic way to analyze such interactions.

Firstly, you should always look for best responses. There are many ways in which the other party could respond to an offer. You should always look for the response that would be the best for the other party rather than for yourself. This is not the time for wishful thinking.

Secondly, you should always think from the end. Before making an offer, it is important to think about all potential proposals you could make and how the other party would respond to each of them. That is, you should consider what the other party’s best response to each of the proposals would be. By thinking from the end, you can anticipate what is the likely outcome of making an offer would be, and thus make the offer which would lead to the best possible outcome in given circumstances.

And thirdly, you should always think about ways to change the game in your favor. If the best possible outcome is not good enough, the only other option left is to change the current circumstances or to change the game. This can be done by postponing negotiations, involving other stakeholders, choosing a different negotiation approach, and so on.

Mechanism design is one of the fields of game theory that focuses on developing processes or incentives for the parties involved to achieve the desired objectives. When it comes to negotiations and procurement, the objective is to incentivize suppliers to provide their best offers. At INVERTO, we refer to such negotiations as process driven negotiations. What makes these negotiations the next level is the combination of the advantages the more common mechanisms such as auctions bring and of the room for maneuver to accommodate business needs and stakeholder requirements.

The advantages auctions have over conventional negotiations are transparency of and commitment to the negotiation process. Process driven negotiations are characterized by a predefined number of phases with clear rules for how each of these phases would unfold and how suppliers could win the business. This transparency ensures that suppliers know what they need to do if they want to win the business and commitment to the rules and to the outcome ensures that suppliers must do their best within the predefined process as there is no other way for them to win the business.

Depending on the business needs and stakeholder requirements, the negotiation process could indeed be run as auctions, be it English, Dutch, or any other type. They could also be windows of opportunity for exclusive discussions with incumbents or strategic partner. They could be times for incentivized requotes, for example, against strategically chosen target lines, and many more. The exact structure of the negotiation phases as well as their order is driven by the game theory insights to ensure that suppliers not only have to, but also want to do their best here and now.

As a procurement consultancy, we mostly support our clients’ procurement teams in negotiating with their suppliers’ sales teams. This includes sourcing new business, re-negotiating business with existing suppliers, conducting annual price negotiations, and many more.

One of the most common problems that we unfortunately see is the unbalanced levels of negotiation skills between the negotiating teams. Quite often sales departments undergo longer and more intensive negotiation training than procurement teams do, and thus they tend to be better prepared for negotiations and be more effective at running them as well.

One of the ways to solve the problem is, of course, to intensify negotiation training for procurement professionals, and another is to go for process driven negotiations in which the negotiation outcome is driven by game theory and not the negotiation skills of the involved parties.

Running negotiations according to a predefined process allows you to obstruct from or at least minimize reliance on negotiation skills, influence tactics, and people’s psyche that suppliers sales team often use to their advantage. Game theory is the cherry on top as its application to the process setup means that suppliers not only have to do their best here and now, but also that it is the right process to ensure that suppliers do the very best they can do.

When it comes to exclusive negotiations with an incumbent or a potential strategic partner, suboptimal use of available competition is quite common.

One of the telling examples comes around when a client engages in discussions with the current incumbent about new business opportunities before actively engaging the competition available on the market. What incentives does the incumbent have here? The best response for them is to drag out the discussions as long as possible and then offer the price low enough to prevent the client from going through the hustle and bustle of a tender in the already time constrained environment. Unfortunately, the offered price is often not low at all.

What game theory teaches us is to engage available competition early on on as well as to communicate the negotiation process rules to all eligible suppliers, including the incumbent and competitors, before any exclusive discussions with the incumbent begin. What incentives does the incumbent have now? Well, if they want to avoid the now credible gamble of open competition with the market over the new business, they must make an attractive and timely offer to the client.

Most of the time, it is not only prices quoted by suppliers, but also suppliers’ technical capabilities, product quality, sustainability measures, geographical locations, and so on that play a role for the client. That is why, it is a holistic comparison of suppliers that matters in the end.

At INVERTO, we use Bonus/Malus to evaluate and monetarize differences across suppliers and thus ensure the holistic comparison. Bonus is an artificial improvement of supplier’s business case based on their quoted prices. In procurement, improvement means reduction as it makes the supplier’s offer cheaper and thus more attractive. Malus is an artificial worsening or increase of the supplier’s quoted business case. For example, a supplier with a higher quality product than their competitors could receive Bonus, while a supplier with shorter payment terms than the expectation could receive Malus.

The key advantage of the Bonus/Malus evaluation of suppliers’ differences over scoring systems often used by our clients is monetarization of these differences. The advantage is twofold. For one, monetarization allows for as objective evaluation as possible, and for another, it allows for an immediate comparison of suppliers’ holistic business cases whenever their prices change, which is particularly important in dynamic negotiation environments.

In process driven negotiations, Bonus/Malus also plays another crucial role. It enables negotiations according to a predefined game theory driven process. As all suppliers’ differences relevant for stakeholders are accounted for before any negotiation begins, how the winner of the business is determined complies with stakeholders’ preferences. Therefore, the negotiation outcome does not require any further approval by stakeholders.