Next level procurement negotiations – using game theory and psychology

Correct procurement decisions are crucial for the success of an organization, and negotiations are an integral part of any procurement initiative. With more than 20 years of procurement experience and with scientific insights from game theory and psychology, we take your negotiations to the next level.

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Negotiations are an integral part of everyday life for procurement

Strategic business sourcing, annual price negotiations, make vs buy decisions, supplier claim management, and many more are all examples of what procurement departments need to tackle on daily basis. Procurement professionals must also negotiate internally with stakeholders from engineering, quality, marketing, and other departments to incorporate their needs and requirements and thus make sure that procurement initiatives achieve a successful outcome.

Our Negotiation Excellence (NEX) is a dedicated team of KGM Strategy negotiation experts who bring game theory and psychological insights to the negotiation table. This expertise ensures the right choice of the overall approach to the negotiation and of the tailored negotiation strategy that takes full advantage of leverage, accommodates business needs, ensures stakeholder collaboration, and proactively addresses challenges.

How we support all aspects of procurement negotiations

We help our clients to choose the right approach ranging from conventional negotiations to auctions and thus including process driven negotiations, which incorporate the best of the two extremes. We develop the tailored procurement negotiation strategy, wargame it with our client, and negotiate together. We also look at the big picture by classifying suppliers and strategically using negotiation timing and negotiated business.

Negotiation approach

Conventional negotiations

Negotiations are run in a conventional way whenever we or our clients are involved in one-on-one discussions with suppliers. These discussions might follow a predefined agenda, but otherwise do not comply with any strict process. Human psychology becomes particularly important, and decision trees help run negotiations in a proactive and not reactive manner.

Process driven negotiations

Negotiations that are driven by a process follow a predefined set of rules and are based on game theory insights. Depending on the business needs, these negotiations might include auctions, exclusive discussions with incumbents or strategic partners, incentivized supplier requotes against strategically chosen target lines, and many more.

Various auctions

Auctions take many shapes and forms. They might be dynamic with several bidding rounds like English or Dutch auctions or static like one-time second-price sealed bid auctions. Depending on the strategic importance of the business, supplier landscape, and our client preferences, we can conduct auctions in person, via email, or using an online platform.

NEGOTIATION JOURNEY

Two people on the streets of London talking about business

Tailored negotiation strategy

No two business situations are ever the same, because needs and requirements differ across industries, clients, markets, products, etc. That is why, we always tailor negotiation strategies and process designs to our clients’ particular business situations.

Strategy wargaming

Wargaming a negotiation strategy means putting yourself in the shoes of those who will be involved in negotiations and conducting a roleplay. Challenging the strategy this way is not only a great pre-negotiation practice, but also one of the best ways to assess its strengths and weaknesses.

Active negotiation support

Actual negotiations are the climax of the overall negotiation journey, and we regularly support our clients in this area, too. It might be only providing background support or negotiating on our clients’ behalf as well as negotiating together with our clients, which is arguably the most efficient way.

NEGOTIATION GAMEPLAN

Supplier classification

Different negotiation strategies need to be used with different suppliers or different classes of suppliers, because this incentivizes suppliers to provide their best offers. Classification might be about incumbents vs. new suppliers or be along other dimensions like past behavior regarding price increases, claim management, etc.

Negotiation timing

Timing matters and can be a decisive factor for the outcome of the negotiation. If suppliers’ existing contracts are coming to an end or the market is uncertain and many of their orders are being cancelled or our clients have a significant new business coming up, then suppliers are in a weaker bargaining position, and it might therefore be a good time to open negotiations.

Negotiated business

It might be tempting to focus only on one piece of business or one topic in negotiations, but it often results in a loss of negotiation leverage. Bundling the upcoming new businesses makes the overall offer more attractive and increases a company’s bargaining power. Negotiations are also an opportunity to leverage new business to get better terms on the existing one.

Any successful procurement negotiation follows the following principles

Principles of negotiations

➔ Competition meets collaboration: Competitive spirit is an intrinsic part of negotiating. It turns negotiating into an exciting process – or even a game. As a rule, however, the “players” in negotiations do not have all the information, they are not aware of the full extent of the other party’s interests and do not know what they could still offer or what might be of interest to the other party,

and vice versa. That is why, the spirit of cooperation is invaluable. Thinking collaboratively will help you get what you want as you give others what they want.

➔ Remember, companies are made up of people: It is as simple and as complex as separating the private and professional parts of everyday life. Businesses are led by people, but if things get personal rather than stay professional, particularly during tough and possibly heated negotiations, people might get into the fight-or-flight mode. This stops them from thinking rationally, makes discussions unproductive, and can ultimately damage business relationships. Being tough on business topics but considerate and respectful with people you are negotiating with will help you get what you want and need.

➔ Choose empathy: Negotiating can be an emotional business. You might think you have to choose between being tough and detached to keep a clear head in negotiations, or being sympathetic to the other party and their feelings, if you want to reach an agreement, but it is not the only choice. You can also choose empathy. It will allow you to assert your interests without being too harsh and to show understanding of the other party’s feelings without having to feel the same way.

➔ Be proactive rather than reactive: It is important to prepare for all potential courses of action if you want your negotiations to succeed. It is not only about having a plan of action, but also about being proactive in preventing unfavorable developments and in steering negotiations in the right direction. The right trade-offs, the right people, the right timing, and the right approaches are the key to success. Thorough preparation will help you to establish what “right” means in your business situation.

➔ Never lie: There are many reasons why lying is a bad idea. It is hard to keep track, both of the bigger picture and of the consistency of your claims. You will look foolish if your lies are discovered, because there is no easy way to justify them. It is a tempting strategy in the short term but detrimental to your reputation in the long term. You might feel you either have to tell the truth or lie, but that is not actually the case - you can simply decide not to share everything.

Game theory and psychology as key elements in negotiations

The strategy game of chess as a metaphor for negotiations

Why does game theory play a key role in negotiations?

Game theory is a study of strategic interactions, and negotiations are an excellent example of those. It provides a structured way to analyze leverage and to find the optimal way to apply it, to anticipate supplier’s reactions and to make offers that achieve the most favorable responses. It can be used to tailor the procurement negotiation strategy and to change the negotiation game to achieve the best outcome. Game theory is also at the core of process driven negotiations, which are a powerful

negotiation approach in competitive environments. Competitive forces might be strong in general, but they do not always work due to procurement challenges like bespoke requirements or complex supplier relationships. That is exactly where the negotiation approach offered by NEX can be of help.

Two procurement experts from KGM Strategy in a conversational situation

How does psychology affect negotiations?

Psychology is the study of human mind and behavior and humans are an inherent part of negotiations. It provides a foundation for understanding why people can influence and be influenced by others and thus why negotiation tactics work in the first place. It can also help successfully apply and rebuff the tactics to achieve the desired outcome. Psychology also becomes indispensable in conventional negotiations when there is no process to hide behind and a lot depends on negotiation skills of the people

involved in negotiations. This is common in monopolistic environments when negotiating with brands or technical giants, and this is exactly where the emotional intelligence and psychological insights offered by NEX can be of help.

PROCUREMENT: LET’S GET REAL!

Interview with our expert Daria Khromenkova on the subject of negotiations in procurement

What is game theory?

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.

How can game theory take negotiations to the next level?

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 KGM Strategy, 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.

Which of the most common problems do process driven negotiations solve?

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.

What role can game theory play in exclusive negotiations?

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.

Bonus/Malus or how to ensure a holistic comparison of suppliers during negotiations?

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 KGM Strategy, 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.

Get to know our procurement negotiation experts

Jürgen Wetzstein

Managing Director

office@kgmstrategy.com Contact

Dr. Daria Khromenkova

Senior Project Manager

daria.khromenkova@kgmstrategy.com Contact

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