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The Mechanism Design Theory

The ultimate dominant play for purchasing in the US Auto Industry

Picture Credit: Peter S. Kuo’s creation (2024)


What happened?

I had dinner right before Christmas with the purchasing manager of a prominent Original Equipment Manufacturer (OEM) to discuss the sourcing activities of several incoming battery electrical vehicle (BEV) programs. My company has often lowered our quotations and provided annual cost reduction (ACR) as incentives to win certain strategic parts, leading to the dominant market position in this OEM. Even so, my company could only win one of the five strategically important parts that we targeted, but we picked up another part unexpectedly. This sourcing result certainly was discouraging to us, but I have discovered several crucial pieces of information as follows –

(1) All the prices that we had lowered were shared with our competitors, so our competitors lowered their prices again to match our improved prices.

(2) When I questioned the sourcing criteria, the purchasing manager ambiguously described the supplier base he visualizes and tries to achieve:

a. By product quality and delivery records: he did name a couple of well-known competitors who were excluded from winning any new parts in this run due to their poor performance in delivery and quality. Therefore, he said that even though there were competitive prices of certain parts quoted by these concerned competitors, those prices were shared with other suppliers for matching.

b. By pricing and ACR offers – the cost-leader with the winning bids plus ACR offers still needs to face the challenges from other competitors with all things considered by the purchasing department of this OEM.

c. By the currently existing market share of each supplier – this portion is the one I disagreed with the most; the purchasing department in this Japanese OEM is trying to maintain a similar market share (pie-chart) between the current business and future new business.

(3) Players’ portfolio analysis – this purchasing manager has been working in the same company for longer than 30 years and is looking into his retirement. Therefore, he is very careful, conservative, and obedient to the directions from his headquarters in Japan. We also had meetings with the Japan headquarters last November, and we have learned that the previous buyer in charge just left the group, and there are two new buyers who have just joined this sourcing project. The manager of these two new buyers in the Japanese headquarters does not attend most of the sourcing meetings nor give clear directions to his associates.

The purchasing department of this OEM in the above scenario is consistent with the mechanism design theory – the purchasing department is manipulating who will win what during this sourcing process. The supplier base of each part number in this BEV sourcing program was designed and pieced together based on a pre-visualized blueprint and then backward inducted via each step to the beginning of supplier selection.


What is mechanism design theory?

Mediavilla et al. describe Mechanism Design Theory (MDT) as an advanced form of game theory, where the focus shifts to establishing optimal rules that guide the game. They elaborate that MDT enables a buyer to craft a supplier selection process where multiple qualified suppliers compete in a structured manner for a predetermined reward, thereby aligning supplier decisions with the buyer's interests. Echoing this, SchulzeHorn et al. (2018) highlight that MDT, as the inverse of game theory, strategically tailors the rules to steer negotiations towards a specific desired outcome. Creutzmann (2021) underscores that MDT, while a strategic approach in negotiations, remains underutilized in industry due to a lack of widespread understanding among professionals. This gap in application and knowledge raises questions about MDT's use cases, benefits, limitations, and how it compares to alternative strategies. Creutzmann's qualitative research, involving interviews with eight negotiation and procurement experts, reveals varied interpretations and applications of MDT in the industry. MDT is primarily concerned with shaping the negotiation framework and end goals, rather than focusing on the individual steps of the players involved. It is particularly relevant in Business-to-Business private procurement settings where there is an adequate pool of bidders, a scenario that can be effectively analyzed using the Kraljic matrix. Introduced by Gelderman & Van Weele in 2003, the Kraljic matrix offers a strategic tool for buyers to optimize their supplier base through the application of mechanism design theory, as illustrated in their Figure 1.

The overall goals are to reduce supply risk and increase profit impact once the risk is reduced and managed. The only exception is that the leverage position is abandoned in the search for a more strategic partnership with a supplier. A cooperative strategy is only pursued if the supplier involved is willing and capable of contributing to the firm's competitive advantage. (Gelderman & Van Weele, 2003) revealed that the move from ‘leverage’ to ‘strategic’ should be considered as an exception to the rule.


The applications of mechanism design theory in the US automotive industry

Mediavilla et al. (2015) pointed out that the first step of implementing mechanism design theory for buyers is to gather and qualify a group of potential suppliers who need to be approved as suitable providers in case of winning the award. Once a proper supply base has been established, the auction will begin to award appropriate suppliers quickly to achieve optimum prices. There are different kinds of auctions: in a forward auction, the bidders are buyers, and the auction manager is the seller. In a reverse auction, the suppliers are the ones who do the bidding, and the auction manager is the buyer. A further categorization depends on whether it is ascending or descending and whether the auction manager or bidders make the bid. English, Dutch, and Japanese reverse auctions are all forms of mechanism design theory. One famous example was COVISINT (Encyclopedia.com., 2024), which conducted online auctions for Detroit Three in 2001, claiming to cut the OEMs’ invoice value from $150 a piece down to $15 a piece at the magnitude of one million invoices per year. The example at the beginning of this post also describes the practice of reverse Japanese auction – first, the buyer gathered a group of suppliers, eliminated the suppliers with bad performances, and then started to leverage the qualified suppliers to achieve the ultimate prices.

(Mediavilla et al., 2021) research the application of game theory to design and implement a two-phase supplier selection process, combining a modified Japanese auction with a structured bargaining process and evaluating its impact in the context of complex items. Findings suggest that two-phase processes can enhance the effectiveness of supplier selection by increasing competition and generating better predictions of the outcomes from the negotiation.


Strategies to adopt the Mechanism Design Theory?

For buyers - (Schulze-Horn et al., 2020; Mediavilla et al., 2015; Mediavilla et al., 2019; Mediavilla et al., 2021; Creutzmann, 2021) suggested that applying mechanism design theory in negotiations can reduce costs significantly. Mechanism design theory represents the inverse of game theory. By developing and implementing economic incentives, the so-called mechanisms can promote supplier competition and drive down the selling prices by targeting the desired outcome and designing the necessary rules to achieve this desired outcome (SchulzeHorn et al., 2018). The mechanism design theory is often connected to the Kraljic Matrix, as explained in Figure 1.

For suppliers - (Hebisch et al., 2022; Mediavilla et al., 2015; Schulze-Horn et al., 2020) suggested that suppliers should know the number of their competitors vs. the optimal number of suppliers in their industry as the key negotiation information. Suppliers should also know their own positions by referring to Kraljic's matrix to anticipate the buyer’s strategic moves. Suppliers’ competition plays a crucial role in the negotiation. The degree of product innovation also determines the intensity of suppliers’ competition. (Hebisch et al., 2022; Heese, 2005; Nagarajan & Bassok, 2008; Swinney & Netessine, 2009; Wolters & Schuller, 1997) suggested suppliers could improve negotiation power by forming a coalition, strengthening market position such as gaining size and market share, improving the degree of innovation such as R&D performance, maximizing the scale of economy in production to reduce cost, and leveraging the switching cost and timing. Still, the suppliers need to be careful of the competition from other suppliers outside the coalition and the capability to form such a coalition. However, suppliers have some advantages during the negotiation when the buyers adopt the mechanism design theory. Heese (2005) stated that using the same supplier in each period (single sourcing) maximizes learning effects and increases the scale of economy in production, such as increasing the manufacturing lot size, leading to the lowest possible system cost. It is often impractical for a buyer to work with an emerging supplier in the automotive industry because asset-specific investments in suppliers are quite large, so switching costs are prohibitive. The process of validating the products of new suppliers often takes time.


Conclusion

The intricate dance of mechanism design in the US auto industry underscores a nuanced approach to procurement, transcending traditional cost-focused strategies. While complex, this method offers a comprehensive framework for buyers and suppliers to achieve mutually beneficial outcomes. As the industry evolves with technological advancements and market shifts, applying mechanism design theory will likely become more sophisticated, necessitating all players' continuous adaptation and strategic foresight. Embracing these dynamics and understanding the underlying principles of mechanism design theory can empower companies to navigate the competitive landscape of the automotive sector more effectively and achieve win-win as the ultimate goal.


References:

Creutzmann, J. B. (2021). Strategic relevance and application of the mechanism design theory at the example of selected European private procurement auctions in a B2B-context (Bachelor's thesis, University of Twente).

Encyclopedia.com. (2024, January 21). Covisint. Gale encyclopedia of e-commerce. encyclopedia.com. 8 Jan. 2024. Encyclopedia.com. https://www.encyclopedia.com/economics/encyclopedias-almanacs-transcripts-and-maps/covisint

Gelderman, C. J., and A. J. Van Weele. 2003. Handling Measurement Issues and Strategic Directions in Kraljic’s Purchasing Portfolio Model. Journal of Purchasing and Supply Management 9 (5–6): 207–216. doi: 10.1016/j.pursup.2003.07.001.

Heese, H. S. (2015). Single versus multiple sourcing and the evolution of bargaining positions. Omega, 54, 125–133. https://doi-org.ezproxy.umgc.edu/10.1016/j.omega.2015.01.016

Hebisch, B., Wild, A., & Herbst, U. (2022). The power of alternative suppliers in the automotive industry—A matter of innovation? Industrial Marketing Management, 102, 1–11. https://doi-org.ezproxy.umgc.edu/10.1016/j.indmarman.2021.12.017

Mediavilla, M., Bernardos, C., & Martínez, S. (2015). Game theory and purchasing management: an empirical study of auctioning in the automotive sector. In Advances in Production Management Systems: Innovative Production Management Towards Sustainable Growth: IFIP WG 5.7 International Conference, APMS 2015, Tokyo, Japan, September 7-9, 2015, Proceedings, Part II 0 (pp. 199-206). Springer International Publishing.

Mediavilla, M., Mendibil, K., & Rivera, O. (2019). How to negotiate with dominant suppliers? A game-theory perspective from the industry. Dirección y Organización, 67, 37-45.Patare, S., & Venkataraman, S. V. (2023). Strategies in supply chain competition: A game theoretic approach. Computers & Industrial Engineering, 180. https://doi-org.ezproxy.umgc.edu/10.1016/j.cie.2023.109242

Mediavilla, M., Mendibil, K., & Bernardos, C. (2021). Making the most of game theory in the supplier selection process for complex items. Production Planning & Control, 32(10), 845–860. https://doi-org.ezproxy.umgc.edu/10.1080/09537287.2020.1773560

Nagarajan, M., & Bassok, Y. (2008). A bargaining framework in supply chains: the assembly problem. Management Science, 54(8), 1482+. https://link-gale-com.ezproxy.umgc.edu/apps/doc/A184299037/ITBC?u=umd_umuc&sid=bookmark-ITBC&xid=1264c4cc

Schulze-Horn, I., Hueren, S., Scheffler, P., & Schiele, H. (2020). Artificial Intelligence in Purchasing: Facilitating Mechanism Design-based Negotiations. Applied Artificial Intelligence, 34(8), 618–642. https://doi-org.ezproxy.umgc.edu/10.1080/08839514.2020.1749337

Schulze-Horn, I., Schiele, H., & Pulles, N. (2018). Using mechanism design theory in negotiations to improve purchasing performance. International Journal Procurement Management 11(6), 24.

Swinney, R., & Netessine, S. (2009). Long-Term Contracts Under the Threat of Supplier Default. Manufacturing & Service Operations Management, 11(1), 109–127. https://doi-org.ezproxy.umgc.edu/10.1287/msom.1070.0199

Wolters, H., & Schuller, F. (1997). Explaining supplier-buyer partnerships: A dynamic game theory approach. European Journal of Purchasing & Supply Management, 3(3), 155–164. https://doi.org/10.1016/s0969-7012(97)00011-7



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