How to increase your procurement costs: use economies of scale rather than competition

For best value in buying products there are two different approaches:

a) Use the forces of competition

b) Use economies of scale

Supermarkets like Tescos manage to combine both. The size of market it offers makes it possible for its buyers to drive hard bargains. But it would never remove competitive forces. Whether you supply yoghurt or olive oil or 1,000 other products, you know that your product will be sitting on the shelves alongside its competitors. And that ensures you either match market prices or have something damn special about your item to justify any extra cost.

Procurement by government or large companies typically does the opposite. The norm is to offer a prize of sole provider, normally for a number of years (25 years in one large government case) in the hope that this will attract a very cheap offer. Normally combined with a tender that restricts who can apply, it is a deeply flawed approach.

A classic example is Building Schools for the Future (BSF), the last government’s much-needed project to rebuild our school infrastructure. The standard Partnership for Schools approach was to combine all services needed (cleaning, ICT support, facility management, architects and builders) into one massive tender. When I questioned this, I was told it was to make the contract “more attractive to the market”. I found that odd. I have never gone to buy a PC and had the response “we can do it cheaper if you let us provide the cleaning in your house too”. We could have put out contracts for ICT, cleaning and other elements and received dozens of responses – and then put them on annual contracts to ensure they were focused on service.

Instead the combination was so complex, and the process so expensive, that only two companies bid for it. This wasn’t surprising as each had to spend over £1 million on the bidding process. The result is a contract in which the forces of competition play no element and service relies entirely on contractual obligation. It should be no surprise that the resulting service has been dreadful. Indeed I am at a loss as to why Partnership for Schools survived the axe on quangos. If ever any organisation deserved to go, for the billions that were wasted in the way it conducted BSF, it is this one.

Key Points on Losing Value

  • Reducing the number of bidders increases prices (as it reduces competitive forces)
  • Increasing the complexity and cost of bidding increases prices
  • Long contracts reduce the pressure to deliver great service, or to be flexible
  • There is no evidence that passing the cost of administering suppliers to the lead contractor reduces costs

I suggested in my previous blog that, if government were running Tescos, it would carry out a procurement that resulted in one supplier of yoghurt (and fix what type and flavour of yoghurt for at least 5 years). Clearly that would not put any pressure on the supplier for low prices. But that single-supplier approach has been used in 90% of procurements we have been involved in – both in the public and private sector. One effect of this economies of scale method is to drive small businesses out of supplying government. Small business supply to central government fell from 22% to 15% in just one year in the early 2000s, as this approach took hold.

One response of Cameron has been to try to ensure that large business use small companies in supplying government. This completely misses the point. The benefit of small businesses is that they are generally more flexible and offer better value. By making them sub-contractors to large businesses, you lose both advantages.

A confession: I used to be a believer in economies of scale. As a student of development economics I looked at Chinese communes and marvelled at how much more efficient they must make Chinese agriculture, with their shared use of tractors and fertilisers. Economies of scale clearly made sense. At first I could not understand, when the land began to be given back to the peasants, how families working the plots – without any benefits of scale – were far more productive. But the evidence soon proved that they were.

The economies of scale approach to procurement would make absolute sense to anybody who ever believed in the benefits of centrally planned economies – and I freely admit that, in my youth, I was one of those who did. (I even wrote a paper entitled “small is ugly” in my first job as a economic researcher.) But being older and, I hope wiser, I now see that competition (properly regulated) is a key driver of value and service. For procurement departments to seek to remove it as a driving force for suppliers is sheer madness.

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