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People in procurement often talk about “value-for-money.” But what does that mean?

It may be easier to understand if we consider a product from the market for financial derivatives.

There is a product called a swap. One basic form of the swap is the interest rate swap in which one party guarantees to pay a counterparty a set of fixed cash flows for a period of time, say five years, in exchange for receiving from the counterparty a set of floating cash flows for the same period of time.

It could be the case that the party paying fixed rates needs to a hedge a broader portfolio liability exposed to the risk of higher rates.

Each set of cash flows (the fixed stream and the floating stream) has a present value at any given moment in time.

Ideally, at the moment the trade is initiated, the present value of the fixed cash flows is equal to the present value of the floating cash flows. This is likely to be the case when Bank A is trading with Bank B. Both banks have complete access to information and liquidity.

But often when banks are dealing with customers who lack this informational advantage, they will pad the trade.

Imagine a case in which Bank A is trading with Acme Tool and Die. Acme wants to lock in a set of fixed rates today because they think the level of interest rates will fall, so Acme wants to receive fixed cash flows in exchange for paying floating cash flows to Bank A. If Acme is right, they will make money over time.

Bank A might pad the situation by offering a stream of fixed cash flows with lower payments, so that the present value of the fixed stream is less than the present value of the floating stream. This creates an upfront mark-to-market profit for Bank A. Bank A makes it more difficult for Acme to make money over the life of the swap.

When Bank A and Bank B trade for zero net present value, this is value-for-money. Both sides are treated fairly. Both sides purchase a product that will help them shape their individual risk profiles in a targeted way.

When Bank A trades with Acme, however, there is the friction of the padding. Economists call this “economic rent.” The extra profit that Bank A locks in for itself is pure gravy.

When we talk about “value-for-money” in a procurement context, it means that the buyer isn’t overpaying beyond what an informed participant would agree is an economically fair price for the supplier.

Generally, we could say that a buyer gets “value-for-money” if they can purchase the good or service at the same economic price that the most favored buyer pays, after normalizing for the size of the order and other relevant factors.

As a buyer, how can you know that you have obtained value-for-money in a procurement context?

The only way you can know for sure is to see what other representative buyers are paying. But most buyers don’t have access to this kind of information.

At EdgeworthBox, we help buyers understand value-for-money two ways. First, we have a database of live and historic RFP data, as well as historic contracts, split into two repositories. The private repository shows what the buyer organization has paid in the past (and what responses they received to prior RFPs). The public repository shows similar information for government agencies who have disclosed this in a public context. The second way we help buyers and suppliers is to connect them to one another with our social networking tools. Too many procurement activities currently take place in the dark; we transform a historically one-buyer-to-many-suppliers context into a many-buyers-to-many-suppliers one.

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Chand Sooran

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