Short-term e-procurement strategies versus long-term contracts

SHORT-TERM E-PROCUREMENT STRATEGIES VERSUS LONG-TERM CONTRACTS*

In this paper we compare the following procurement strategies based on their expected costs: strategic partnership, which is based on a long-term relationship with a single supplier; online search, which is a short-term strategy; and a combined strategy, which is some combination of the first two strategies. In addition, we determine for the online search and combined strategy the optimal number of suppliers to contact for a price quote, and analyze how it depends on the various cost and demand parameters. The main contribution of this paper is that it does not assume a single procurement strategy, but rather compares three alternatives.

(E-PROCUREMENT; PROCUREMENT STRATEGIES; SUPPLY CHAIN MANAGEMENT; INVENTORY MANAGEMENT)

1. Introduction

Increased competition, new technologies, and rapidly changing global markets are forcing businesses to identify strategies for continuously improving their productivity and cost management. Web-based procurement emerges as a powerful strategy to attain these goals. For example, Digital Buyer, a solution developed by Digital Market Inc. (now part of Agile Software), offers a comprehensive enterprise application suite for Internet-based sourcing and supply chain optimization for direct materials. By facilitating quote and order transactions, it helps manufacturers speed new product introduction to boost product revenue and enhance customer satisfaction, while at the same time, cut direct material costs to improve profits (Fox, Mackenzie, Walburger, and Wood 1999). Many other online exchanges that focus on connecting buyers with potential sellers for the exchange of indirect materials, such as www.insurance.com (insurance policies), www.bridgepath.com (IT contract staffing), and www.noosh.com (printing services), report of substantial cost savings that their customers have realized by using their services. Research conducted by Aberdeen Group indicates that early adopters of e-procurement strategies have realized significant reductions in purchasing costs, with most user organizations realizing a return-on-investment of greater than 300% in Internet procurement automation within the first year of deployment (Weil 2000a). E-procurement solutions help buyers to reach a large number of potential suppliers and thus negotiate better contract pricing. In addition, automating direct procurement reduces the cycle time, making a manufacturer more responsive to the market. Given the low vendor search cost, implementing an e-procurement strategy is likely to result in higher profits. A recent survey conducted by Deloitte Consulting reports that more than 90% of businesses indicate that e-procurement is a part of their on-going business plan, with more than 30% having already implemented this new capability to some degree (Weil 2000b).

On the other hand, a long-term relationship with a single supplier has its own advantages. Some of them might be harder to quantify, such as a potential for higher quality. But even when decisions are solely cost driven, working with a single supplier might still be valuable; a long-term contract substantially reduces cost uncertainties and provides an incentive for the supplier to lower prices so as to secure the sale. For example, Varian, a manufacturer of semiconductor processing equipment, reports that implementing a value managed relationships strategy where close relationships are established and maintained with a reduced supplier base, has resulted in higher quality and lower costs (Weissman 1992).

In this paper we seek to develop a better understanding of the conditions under which e-procurement strategies are most cost effective. To do that we study three possible strategies a company might choose to follow, namely (1) strategic partnership, in which a company signs a long-term contract with a single supplier, so that future prices are known in advance; (2) online search, in which the Internet is used for selecting the supplier with whom an order will be placed. Unit price in this case is assumed to be random, but its distribution is known in advance, and is assumed to be a function of the number of suppliers contacted for a price quote. (3) A specific Combined Strategy, under which one supplier is used as a long-term partner but a second source might be chosen through the Internet. While in general, sourcing decisions may be based on several concerns, such as on-time delivery, price, and quality, an underlying assumption in this model is that buyer decisions are solely cost driven, and that quality and delivery performance are already certified by some means. Thus, the three strategies are compared based on their resulting expected costs for the buyer.

Our analysis is composed of two main parts; each focuses on a single manufacturer who faces a random demand and must decide what strategy to use for purchasing her material, so as to minimize total expected costs. In the first part, we use a two-period inventory replenishment model to compare the three strategies under the assumption that when an online search is conducted, the number of potential suppliers contacted is a known constant. We obtain expressions for the optimal order quantities and the related expected costs under each of the strategies. We then determine conditions under which each strategy is expected to yield better results, and show that no strategy will always dominate the other two. In the second part of our analysis we allow the number of suppliers contacted to become a decision variable. We determine its optimal value for both the online search and combined strategy, and conduct a sensitivity analysis to analyze how it depends on the various cost and demand parameters. A numerical study is used to compare the three strategies given a variable number of suppliers.