week 3 assign man econ
10
Competitive Bids and Price Quotes
Learning Objectives
After reading this chapter, you should be able to:
• Discuss the nature of price setting where a buyer calls for competitive bids or tenders to supply goods and/or services that are not available “off-the-shelf.”
• Distinguish between three different modes of competitive bidding: fixed-price, cost-plus- fee, and incentive (risk-sharing) bid pricing.
• Apply the logic of incremental costs and revenues, and thus contribution analysis, to the competitive bid pricing problem, incorporating into the analysis any opportunity and future costs and revenues.
• Demonstrate that high search costs induce firms to set competitive bid prices using a standard markup over a standard cost base, with variations for nonmonetary consider- ations including aesthetics, politics, and risk attitudes of the buyer and seller.
• Explain how the firm can adjust its standard cost base and/or its standard markup rate to raise its success probability, capacity utilization rate, or profit rate, when these are below the levels that best serve the firm’s objectives.
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CHAPTER 10Introduction
Introduction
This is the fourth chapter concerned with the pricing decision of the business firm or other organization. In this chapter, we will look into competitive bidding, a differ-ent type of pricing decision problem that is quite commonly found in business-to- consumer (B2C), business-to-business (B2B), and business-to-government (B2G) transac- tions. Competitive bidding occurs in any market where a single buyer calls for a price quote (or tender) from one or more sellers. It is a single buyer situation in the sense that the buyer wants a special package of goods and services that is not stock standard and, thus, cannot simply or easily be purchased “off-the-shelf” from a supplier. Instead, the buyer calls for competitive bids from one or more potential suppliers and then compares the value proposition offered by each responding bidder. Consumers effectively call for com- petitive bids every time they want their car fixed, their teeth braced, their house painted, or any other kind of repair work or service that is specific to their particular preferences or requirements. Firms call for competitive tenders for stationery supplies, new vehicles or machines, component parts, consulting advice, new buildings, and so on, both to econo- mize on their time and to induce lower prices from suppliers who are most keen to get their business. Governments wanting roads and dams built, military hardware, fleets of cars supplied, and so on, similarly call for competitive bids from potential suppliers. In many cases, some, or even all, of the products required by the buyer are indeed available off-the-shelf, but when the buyer wants a complex combination of products and services it is more efficient if the supplier quotes on the whole package rather than have the buyer separately go around finding out prices and buying them individually (thus avoiding search costs and transactions costs). Quoting on the whole package also allows the sup- plier to reduce its profit margin on individual items in favor of winning a relatively large contract with an acceptable profit margin.
Each seller should expect that the buyer will ask for a competitive bid from other sup- pliers as well; although, in practice, buyers often ask for a single quote and if that seems fair they will accept that price without seeking additional quotes. Seller will realize that if their price quote is too high the business will go elsewhere. Conversely, if their price is too low they will get the job but may end up losing money on the job—this latter situ- ation is known as the winner’s curse.1 The pricing problem in competitive bid markets is that the seller must select a price that is high enough to provide a sufficient contribution to overheads and profit, yet low enough to ensure that it wins enough jobs to maintain a sufficient volume of work to ensure its survival. Sellers cannot expect to win every job they tender for. Since there is only one buyer and several potential sellers, sellers must operate on the basis of “win some and lose some,” but win enough to survive and hope- fully prosper.
1. The winner’s curse applies to a range of situations where the costs of completing the contract are uncertain. If potential suppliers each make estimates of their costs to complete, and one buyer inadvertently underestimates these costs and subsequently bids at a lower level, it is likely to win the contract, but later find out that its actual costs exceed the price tendered and it is forced to take a loss on the contract.
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CHAPTER 10Section 10.1 Types of Competitive Bids and Price Quotes
In addition to the uncertainty the seller faces concerning the bids of other potential sellers, there is uncertainty surround- ing the cost of completing the job as specified. Unless the job is completely specified down to the last nut and bolt, and is oth- erwise straightforward, there will be uncertainty about exactly what repairs, services, parts, and labor will be required. Also, since the price is specified ini- tially and the work is done later, weather and other uncontrolla- ble disturbances may add unex- pected costs to the project. Thus, competitive bidding is a complex pricing practice faced by many firms in the economy and is espe- cially applicable to business-to- business (B2B) transactions.
10.1 Types of Competitive Bids and Price Quotes
There are two main types of competitive bids plus an intermediate (or combination) type. First, there is the fixed-price bid where the seller quotes a price and under-takes to complete the job for exactly that price regardless of unexpected variations in the costs of completing the project. In this case, the seller faces the entire risk of cost vari- ability. That is, if actual costs are higher than expected costs, the seller will make reduced profit (or even take a loss) on the project. The second main type is the cost-plus-fee bid, where the parties agree that the ultimate price will be the actual costs plus a predeter- mined profit margin for the seller, and in this case the buyer bears the entire risk of cost variability. In this case, the buyer may end up paying more than it initially expected the final price to be. In most B2B and B2G situations the buyer retains the right to an audit of the seller’s costs, but in B2C situations it is more commonly a “take it or leave it” tender, or the price is subject to renegotiation if the buyer thinks all the bids are too high. In this case, the buyer might receive the bids and then go back to one or more bidders and ask for variations, inclusions, or exclusions before choosing the winning tender.
©Hemera/Thinkstock
When quoting a price, sellers take a gamble. They must operate on the mentality of “win some and lose some” but sellers must win often enough to cover overhead costs and realize a profit.
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CHAPTER 10Section 10.1 Types of Competitive Bids and Price Quotes
Fixed-price bids are more common where the items to be purchased can be priced sepa- rately, such as building materials, and where labor costs are more predictable. Alterna- tively, cost-plus bids are more common where the degree of uncertainty regarding costs is high. Repair work to automobiles, houses, and industrial plant and equipment typically proceeds on the latter basis because the actual labor time and parts required only become known as the repair work progresses and after the item to be repaired has been at least partially disassembled. The buyer’s problem with cost-plus bids is that the seller has little incentive to work fast and efficiently and thus minimize costs. Given that an audit of the seller’s costs will be time consuming and imperfect, due to the asymmetry of information, the final price to the buyer most likely will be higher than if the seller had a strong incen- tive to keep costs to the minimum.
In Table 10.1, we show the circumstances under which one of these bid types is likely to be preferred over the other. If costs are relatively easy to control, then the buyer will probably demand fixed-price bids and the sellers will need to bid in this mode to be considered by the buyer. Conversely, if costs are harder to control or are subject to unexpected increases, sellers will strongly prefer the cost-plus-fee mode and buyers will generally have to bid in this mode. Of course the bidding mode also depends on the relative bargaining power of the buyer. In some B2B and B2G situations a large and important customer might simply announce that it will only accept fixed-price bids.
Next, we consider the degree of risk aversion of the buyer and seller. If the seller is highly risk-averse, it will prefer not to bid in the fixed-price mode; and oppositely, if the buyer is highly risk-averse it will prefer not to receive cost-plus-fee bids. As we noted in Chapter 2, however, even risk-averse people can afford to be risk-neutral with regard to the next decision if they have a portfolio of risky assets. So, if the seller bids on many tenders over the year, it can afford to be risk-neutral with respect to any one tender, expecting that cost over-runs on one project tender might be offset by cost under-runs on other projects. The same applies from the buyer’s perspective: If the buyer routinely calls for tenders for simi- lar jobs, such as a taxi cab company repairing its cabs, it can afford to be risk-neutral with respect to any one cab repair. This is because some repairs will cost more and others will cost less, and on balance the jobs that cost less than expected will tend to offset the jobs that cost more than expected.
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CHAPTER 10Section 10.1 Types of Competitive Bids and Price Quotes
Table 10.1: Factors influencing choice of fixed-price versus cost-plus bids
Factor Fixed-price bids Cost-plus-fee bids
Degree of cost uncertainty (and/or uncontrollability)
If costs are relatively easy to control, buyers will insist on this mode, and seller must tolerate the risk of cost variability.
If cost uncertainty is high, sellers will strongly prefer this mode, and buyers must tolerate the risk of cost variability.
Seller’s attitude to risk If highly risk-averse, the seller will not want to bid in this mode, unless required to (unless the seller can be risk-neutral due to many concurrent bids, in which case, the seller will tolerate these).
Whatever the degree of risk aversion (unless the seller is risk- neutral) the seller will prefer cost- plus bids since these push all the cost variability risk to the buyer.
Buyer’s attitude to risk If highly risk-averse, the buyer will strongly prefer this mode.
If highly risk-tolerant, the buyer will accept these, and indeed sellers will only want to bid in this mode if cost uncertainty is high.
Many trials of the same risk
If the seller routinely and repetitively bids on similar contracts, it can act as if it is risk- neutral (and submit fixed-price bids), since high-cost jobs will tend to be balanced by low-cost jobs.
If the buyer routinely and repetitively calls for similar tenders, it can act as if it is risk-neutral (and submit cost-plus-fee bids), since high-cost jobs will tend to be balanced by low-cost jobs.
Any request for tender (RFT) by a buyer will have an implicit or explicit quality expecta- tion built into the specifications of the work to be done. For example, if you ask for a quote for new tires on your car, or to fix your transmission, you expect the job to be completed to a particular level of quality. You want new tires that comply with road safety regulations, or you want your transmission to work properly again. The buyer will typically be happy enough to bear a legitimate cost over-run that is necessary to achieve that expected level of quality, even if the extra cost is unexpected. The problem is the asymmetry of infor- mation between the buyer and the seller: The buyer may not be sure that the extra costs charged by the seller are, in fact, necessary to achieve the desired level of quality. Where observation and monitoring of the project by the buyer is unsafe (as in the workshop) or would be expensive (in terms of incurred costs and opportunity costs) there needs to be a mechanism to ensure that the seller does indeed deliver the specified quality without leveraging the asymmetry of information to raise its profit at the expense of the buyer.2
2. By seeking multiple quotes, and more detail from each potential seller, the buyer is likely to reduce the information asymmetry by gaining more information about the production side of the job, including what the job is most likely to involve and what is likely to be the costs of labor, materials, parts, and so on.
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CHAPTER 10Section 10.1 Types of Competitive Bids and Price Quotes
The third type of competitive bid provides one such mechanism. It is known as incentive bid pricing, and involves the buyer and seller agreeing on the bid price initially, but also agreeing to share any deviation from the expected cost in an agreed proportion. The vari- ance of actual costs from the expected costs is a cost over-run (if positive) or a cost under- run (if negative). For example, the share of the cost variance might be agreed to be 50% to each party, or in another case 70:30, with one party taking the larger proportion. In these situations, the seller has a substantial incentive to control costs, since it will have to pay a proportion of any cost over-run and this will reduce its profit from the job. Conversely, any cost under-run will also add to its profit because the seller will receive an agreed portion of that cost saving. The buyer’s incentive to pay more, to cover unexpected cost increases, is to achieve the desired level of quality associated with the job. On the other hand, if the repair is not as extensive as anticipated, or if weather and other uncontrollable factors play nicely, both the buyer and the seller benefit from the unexpected cost savings.
Apart from price and quality, the third major issue with competitive tenders is time to completion. Project management of a competitive bid transaction involves the efficient management of costs, quality, and the time it takes to complete the project. The buyer will typically want to set a deadline by which time the job is to be completed, and this deadline will usually be part of the tender specifications. Especially when the project is consid- ered to be urgent, such as completing major road works, bridges, and other public infra- structure (for B2G contracts); completing the manufacture and installation of new capital equipment to allow a business to get back in business (for B2B contracts); or completing a car repair or house renovation (for B2C contracts), the tender specifications might include a clause relating to penalties for late completion, and, conversely, for bonuses if the project is completed before the deadline. Note that such agreements are effectively risk sharing agreements as well, since production delays might be caused by both controllable factors (such as poor management by the seller) and uncontrollable factors such as bad weather and unavoidable delays in receiving materials. If the seller beats the deadline it receives a bonus for early completion, and indeed it may have put in place an incentive contract
with its own managers and employees to share this bonus with them if the contract is com- pleted prior to the deadline. The buyer will be happy to pay this bonus because it will allow early access to the completed project and the bonus will be less than the opportunity cost associated with waiting for the job to be completed. On the other hand, if completion of the project is delayed beyond the planned delivery date, the seller’s profit will be reduced to the extent of the penalties imposed and the buyer’s opportunity costs will be offset to some degree.
©iStockphoto/Thinkstock
Project management of a competitive bid transaction involves the efficient management of costs, quality, and the time it takes to complete the project.
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CHAPTER 10Section 10.2 Incremental Costs and Revenues and the Optimal Bid Price
10.2 Incremental Costs and Revenues and the Optimal Bid Price
From the information above, we can deduce that it is very important that the prospec-tive seller carefully calculates the incremental costs that are expected to be associated with completing any contract that it wins through a competitive tender process. We saw in Chapter 6 that there are three main categories of incremental costs and revenues, namely present-period explicit costs and revenues, opportunity costs and revenues, and future-period costs and revenues. Let us now consider these in the competitive bid pricing problem.
The Incremental Costs of the Contract The incremental costs of the contract are all those costs, expressed in present value terms, that are incurred as a result of winning and completing the contract. Costs that have been incurred already (sunk costs) and costs that will be incurred whether this contract is won or lost (unavoidable costs) are not incremental costs for the purposes of the pricing deci- sion to be made.
Present-Period Explicit Costs
These include the direct and explicit costs associated with undertaking and completing the project. Included are such cost categories as direct materials, direct labor, and variable overheads that are due to the project under consideration. These may be estimated on the basis of the firm’s experience with completing similar contracts previously, modified to reflect present materials and labor prices, plus a trend factor if completion of the project will take several months or years. In addition, the contract may require the firm to pur- chase and deliver to the buyer capital equipment that needs to be purchased by the seller at current prices.
In some cases, the completion of the contract will necessitate the seller purchasing special machines, tools, or other items of capital equipment that are needed to complete the job but which remain the property of the seller after the contract is completed. If these items have a useful life remaining, it seems unfair to the buyer to charge the entire cost against the current contract. The appropriate way to deal with this is indeed to charge the entire cost of the item as an incremental cost to the buyer, but to also take account of possible future income or cost savings that are likely to be obtained subsequently. These should be counted as incremental revenues to reduce the incremental cost by an amount represent- ing the net present value of the future revenues and the future costs avoided (which we call “opportunity revenues”).
Another consideration is the capacity utilization rate of the firm. When the firm is at or near to its full capacity rate of output, it must consider the additional incremental costs that will be incurred if it wins the contract, such as overtime labor rates, outside contract- ing expenses, penalty charges associated with delays on other existing contracts, and new capital equipment that must be purchased to enable the contract to be undertaken and completed.
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CHAPTER 10Section 10.2 Incremental Costs and Revenues and the Optimal Bid Price
Opportunity Costs
As we know, opportunity costs are the value of resources in their next-most-valuable use. Hence, if plant and equipment are lying idle, they have zero opportunity cost if they are used in the contract under consideration.3 On the other hand, if they are currently employed in a project that must be set aside, delayed, or cancelled to accommodate the contract under consideration, then the contribution to overheads and profits that these resources could have made must be counted as an opportunity cost for the project under consideration. For example, a firm producing relatively low-value items to build up its inventories for supply to wholesale and retail customers may decide to bid on a tender and if successful would stop producing these items, utilizing its resources more profitably on the contract under consideration. The contribution foregone is an opportunity cost of the contract under consideration. If the alternative production is simply delayed and this simply causes revenues from the sale of those items to be delayed, the opportunity cost is simply the interest income foregone on the revenues involved.
Future Costs
Future incremental costs may include the effects of customer ill will, deteriorating labor relations or supplier relations, and legal recourse by dissatisfied buyers or government prosecutors. Ill will (or ill feeling) toward the seller may manifest itself in the expected present value of contribution (EPVC) of future contracts that are lost if this current con- tract is undertaken. For example, undertaking a difficult or politically contentious contract today might come back to haunt the firm if it upsets employees, suppliers, or government regulators. To the extent that such future costs are envisioned, the firm should allow for them in the current calculation of incremental costs. For example, a trucking company that wins a contract to move the city’s garbage during a garbage-workers’ strike may well expect to lose business in the future from people and organizations who are sympathetic to labor unions.
In practice, it is not likely to be worth the search costs required to carefully estimate every single opportunity and future incremental costs associated with a particular competi- tive tender, nor is the bidding firm likely to have the time required for this information search activity, since RFTs are typically issued with only a short time for potential sellers to respond. More realistically the bidding firm will simply add a “cushion” (or safety mar- gin) to its explicit incremental costs to reflect its recognition that there are opportunity and future incremental costs involved.
3. Idle plant and equipment may provide a back-up plan if the breakage of similar equipment would cause a delay in completion of a contract and attract penalty charges. Also, idle plant capacity (known as excess capacity) allows a firm to increase its production level quickly without waiting for new plant and equipment to be installed. This may serve to deter the entry of new firms that might have entered to supply unmet demand if the existing firm(s) did not have any extra productive capacity. In these cases idle equipment does have an opportunity cost.
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CHAPTER 10Section 10.2 Incremental Costs and Revenues and the Optimal Bid Price
Bid Preparation Costs
Even when it avoids the search costs of estimating opportunity and future costs, the bid- ding firm will incur significant bid preparation costs, which are costs associated with studying the tender specifications and subsequently estimating the costs of undertaking and completing the project to the required level of quality and within the required time- frame. It may take one or more employees several days to work up an estimate and to sub- mit the formal tender documents, and they may need to buy-in information and expertise in order to complete and submit their tender. Note that these bid preparation costs are incurred before the bid price is submitted and are incurred regardless of whether the con- tract is later won or lost. They are therefore sunk costs as far as the incremental costs of the contract are concerned.
Thus, bid preparation costs must be treated as part of the firm’s overhead costs that are (hopefully) covered by the contributions to overheads made by the contracts that the firm actually wins. As noted earlier, the firm that engages in competitive bidding cannot expect to win every contract it bids on and must continue bidding on many contracts in order to win enough to avoid bankruptcy and hopefully also to be profitable. In the following sec- tions, we shall see how the firm plays the probabilities game in choosing its competitive bid price to win enough bids to stay alive and make enough profit on those that it does win to stay profitable.
Incremental Revenues of the Contract The incremental revenues of the contract are all those revenues (expressed in net present value terms) that are expected to be received as a result of winning and completing the contract. As discussed earlier, they include present-period explicit revenues, opportunity revenues, and future revenues.
Present-Period Explicit Revenues
If the contract is to be awarded, completed, and paid for within the present period, then there will be present-period explicit revenues that accrue to the seller—these are the actual cash inflows to the selling firm within the current production period. Particularly in B2B and B2G situations, the job to be completed may extend beyond the present period, with large projects being completed years later. In such cases there will typically be prog- ress payments at intervals within the contract duration, and at least one of these is likely to occur in the present period. Other progress payments and the final payment that are to be received in future periods should be discounted using the opportunity discount rate to bring them back to present-value terms and allow them to be additive with present period cash flows.
Opportunity Revenues
Opportunity revenues are costs that are avoided as the result of a management decision. In this case, if costs can be avoided by winning a competitive bid contract, the magnitudes of the costs avoided (discounted if avoided in future periods) are included as opportunity revenues. For example, if the firm wins the contract it might avoid severance costs associ- ated with laying off workers and the later costs of recruiting and training new workers.
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CHAPTER 10Section 10.2 Incremental Costs and Revenues and the Optimal Bid Price
It might also avoid the cost of having to apply special treat- ments to idle plant and equip- ment to avoid deterioration of those capital assets—for exam- ple, machinery might need to be sprayed with oil or otherwise sealed to prevent rusting. In such cases, the equipment will need to be cleaned and serviced before it can be brought back into production again, so the avoidance of these costs would also represent opportunity rev- enue. Another possible oppor- tunity revenue is the equipment and research and development (R&D) costs that can be avoided if the firm wins the present con- tract. Managers might know that they need to upgrade their equipment and conduct R&D to keep up to date in the industry, and that winning the current contract would allow them to do this within the context of that contract, and thus save the expense of doing it separately. By treating this expense as an opportunity revenue the firm can bid at a lower price and be more likely to win the contract and, thus, upgrade its equipment and exper- tise while also gaining work for the employees and a positive contribution to overheads and profits for the firm.
Future Revenues
Winning and completing the present contract may allow the firm to gain expertise and reputation that will lead to other contracts in the future that will generate future profit. Accordingly, the firm can afford to count the EPVC of the future contracts as incremental revenue of the contract under review and, thus, will be able to bid at a lower explicit rev- enue price and be more likely to win the current contract. In practice of course, the search costs of estimating the future revenues are likely to be prohibitive and, instead, the bid- ding firm will “take a bit off” its bid price in recognition that winning the contract will not only generate revenues in the current and subsequent periods but also facilitate the firm potentially winning other contracts in the future.
In the previous discussion, I explained that a lower bid price will make it more likely that the bidding firm will win the bid. It is now time to look at how the probability of winning the bid increases as the bid price is reduced, and how the firm considers the expected value of the contract at each of several bid prices to choose the bid price that maximizes the expected value of profit.
©iStockphoto/Thinkstock
Opportunity revenues are costs that are avoided as the result of a management decision.
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CHAPTER 10Section 10.2 Incremental Costs and Revenues and the Optimal Bid Price
The Optimal Bid Price If the firm’s objective is to maximize its net present worth, the optimal bid price will be the price that maximizes the expected present value of contribution (EPVC) to overheads and profits. The “expected” in this term implies that we have to multiply the present value of the contribution at each price by the probability of winning the contract at that price, as we do in Table 10.2. The higher the bid price the lower will be the success probability, which is the probability that the firm will submit the lowest bid price and be selected by the buyer.4 In Table 10.2, we show the data for a particular competitive bid situation. Sup- pose the firm has become aware of an RFT and wants to submit a tender. After scrutiny of the tender specifications, the managers have determined that the incremental costs, minus the incremental revenues (other than the bid price), all expressed in present value terms, are $500,000. In column 2, we show a range of bid prices with the consequent con- tribution levels in column 3. In column 4, we show the estimated success probabilities at each of the indicated bid price levels. As you can see, the success probability is 90% when price is set equal to the net incremental costs (meaning there is a 10% chance that at least one other firm might bid lower than that) and then falls progressively as the probability increases that at least one other firm will bid lower than that price. The data in column 5 is the EPVC, which is the contribution at each bid price level multiplied by the success probability at that price level. As you can see the EPVC seems to be maximized at $100,000 when the bid price is $700,000.
Table 10.2: Expected present value of contribution analysis of the bid price
Net EPV of incremental costs $000s
Possible bid price $000s
Contribution if winning bid $000s
Success probability
EPVC $000s
500 500 500 500 500 500
500 600 700 800 900
1000
0 100 200 300 400 500
0.90 0.70 0.50 0.30 0.15 0.05
0 70
100 90 60 25
But, note that the possible bid prices were arbitrarily spaced out at $100,000 intervals, and the bid price that maximizes EPVC might be somewhere in between these arbitrary bid levels. It is a simple matter to plot the EPVC data against the bid price and interpolate between these data points—that is, to sketch in the apparent intermediate values of the EPVC between the known data points. We do this in Figure 10.1 and see that the EPVC appears to be maximized at about $101,500 when the bid price is set at about $725,000.
4. Or more generally, in cases where the bidders submit differentiated tenders with different bid prices, the lower the likelihood that the firm’s bid price will be considered the best value proposi- tion from the buyer’s perspective and consequently selected by the buyer.
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CHAPTER 10Section 10.2 Incremental Costs and Revenues and the Optimal Bid Price
Figure 10.1: Interpolation of the EPVC to find the optimal bid price
EPVC $000s
Bid Price $000s
Interpolation using known data points
500 600 700 800 900 1000
110 100 90 80 70 60 50 40 30 20 10 0
In this case, the firm should bid at $725,000 which appears to maximize its EPVC. Sub- sequently it may or may not win this contract, since the success probability is only about 45% (found by interpolating between the success probabilities in Table 10.2). But, if a firm bids for a large number of contracts and always bids at the price that maximizes EPVC, it may win some and lose some, but it should expect to maximize its net present worth over an extended period of time. Indeed the firm will need to bid on many contracts if the suc- cess probability of this project (about 45%) is typical—it will need to bid on more than two contracts in order to win one contract, on average.
Aesthetic, Political, and Risk Considerations
Several nonmonetary considerations may also enter the competitive bid pricing process. Aesthetic considerations, such as design aspects that generate psychic satisfaction for the bidding firm, might induce the firm to bid higher or lower than the EPVC-maximizing price. If the project is aesthetically appealing, delivering psychic satisfaction to the firm’s top managers, for example, they might lower the bid price to increase the chances of win- ning the contract. Conversely, if completing the project is expected to deliver disutility to the managers or employees of the firm, because it is dirty, uncomfortable, or inconvenient in some way, the managers might decide to raise the bid price somewhat to compensate for that disutility in the event that they do win the contract.
Political (i.e., self-serving) behavior by the firm’s managers may also cause the bid price to vary from the EPVC-maximizing level. If the pricing manager wants to impress his or her superiors, the bid price might be lower than the EPVC-maximizing level to increase the
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CHAPTER 10Section 10.2 Incremental Costs and Revenues and the Optimal Bid Price
chances of winning the contract. Similarly, if the pricing manager wants to do a favor for a friend who is seeking a price quote, the price quoted may be set at a lower level to recognize (or pro- mote) the friendship between the person buying and the person selling. Similarly, buying firms may wish to build up goodwill with their suppliers to ensure they will receive supplies in the future when the supplier is really busy.
Concerning risk considerations, note that the risk of not win- ning the contract is about 55% in the case examined above. If this contract is representative of
all other contracts for which this firm tenders, this would mean that the firm would win about 45% of the projects it tenders for. But, if the firm needs income soon to avoid run- ning out of cash, not winning this particular contract would put the firm at extreme risk of insolvency. In this case, the managers might not be willing to gamble on a 45% chance of success on this particular occasion and will prefer to trade off some contribution for a better chance of winning the contract, by setting a lower bid price. We have already considered the opportunity revenues that would accrue if the firm can avoid the costs of laying off workers and dormant equipment, but here we are concerned with the risk aver- sion of the firm’s managers (or their shareholders) and their willingness to avoid the risk of insolvency by reducing their bid price even further to increase their chances of success. Thus, we see firms bid at lower bid prices if their managers or shareholders are more risk- averse and strongly want to avoid the psychic disutility associated with going through the process of bankruptcy.
Cost-Plus-Fee Bids to Avoid the Risk of Cost Variation
As mentioned earlier, in addition to the risk of not winning the contract, there is the risk that (if the contract is won) the actual costs of completing the contract will exceed the expected or projected costs (i.e., the winner’s curse). And, as indicated earlier, the greater the risk aversion of sellers the greater will be their desire for cost-plus-fee bids rather than fixed-price bids. The bidding firm usually has a choice of bidding mode—it may bid either a fixed price (bearing all the risk of cost variation), a cost-plus-fee bid (transferring all the risk to the buyer), or an incentive bid that shares the risk of cost variation between the buyer and the seller in some agreed proportions. Unless the supplier is risk-neutral (which it might be if it bids on many similar bids) it will want to set a higher bid price if tendering a fixed-price bid than it would if (for the same estimate of costs) tendering a cost-plus-fee bid price.
In Figure 10.2, we show an indifference curve linking the fixed-price bid and the cost- plus-fee bid that would provide the same expected utility for a particular bidder. This
©Jupiterimages/Thinkstock
Political behavior can influence a firm’s bid price. For instance, the pricing manager might decide to do a favor for a friend who is seeking a price quote by quoting a lower price to recognize the friendship between the person buying and the person selling.
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CHAPTER 10Section 10.2 Incremental Costs and Revenues and the Optimal Bid Price
figure depicts a quite risk-averse seller who would be equally satisfied with a $725,000 fixed-price bid, a $650,000 incentive bid (with 50:50 risk sharing), and a $600,000 cost- plus-fee bid. It presumably also depicts a situation in which the potential cost variation is apparently quite high, since the seller is willing to give up about $125,000 to totally avoid the risk of cost variation.
Figure 10.2: The risk–return trade-off for different bidding modes
800
700
600
500
0% 50% 100%
Percentage of cost variation
borne by seller
Cost-plus-fee bid
Incentive bid
Fixed-price bid
Bid price
$000s
Indifference curve
Note that in Figure 10.2 we have selected the 50:50 risk sharing proportions quite arbi- trarily. The actual proportions are a matter for negotiation between the buyer and the seller and could occur anywhere along the indifference curve. That is, anywhere between 0% and 100% of the cost-variation risk could be borne by the seller with the complementary pro- portion being borne by the buyer. You can imagine that if the buyer is highly risk-averse it will prefer to bear no risk of cost variation and pay the $725,000 fixed price, whereas if the buyer is highly risk-tolerant it will prefer to pay the substantially lower cost-plus-fee price of $600,000 and bear all of the risk of cost variation. If the buyer’s degree of risk tolerance is somewhere in between, it will prefer an incentive (risk-sharing) bid price somewhere in between these extremes and this might then be negotiated with the seller.
As an example, suppose the state government issues an RFT that calls for the construction of a multistory parking garage. The estimated cost for construction of this parking garage is quite straightforward except for the fact that in digging the holes for the concrete foot- ings, the construction firm might encounter rock. If rock is found, it will require blasting with dynamite, which will increase the cost significantly. XYZ Co. is highly familiar with this kind of work, and plans to submit a tender. Its managers reason that sometimes they find rock and have lower than expected profit (because of the extra blasting costs) and other times they find no rock and have higher profit because blasting costs are avoided.
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CHAPTER 10Section 10.2 Incremental Costs and Revenues and the Optimal Bid Price
Whether XYZ Co. bids in fixed-price mode or cost-plus mode may depend on which mode the buyer asks for. In this case, let us suppose that the buyer has asked for bids in both modes and will choose the price and mode that is most suitable, potentially asking for agreement on a risk-sharing arrangement.
If bidding in the cost-plus-fee mode, XYZ Co. can ignore the blasting costs, since it will simply pass them along to the buyer. Excluding the possible blasting cost, XYZ Co. cal- culates that the construction cost of the parking garage will be $1.5 million, including the firm’s estimation of opportunity and future costs and revenues, and we will assume that this incremental cost is not subject to uncertainty since XYZ Co. is very familiar with this kind of construction project. In Table 10.3 we show the EPVC for several bid price levels.
Table 10.3: Expected present value of contribution analysis of the bid price
Net EPV of incremental costs* ($000s)
Possible bid price ($000s)
Contribution if the winning bid* ($000s)
Success probability
EPVC* ($000s)
1,500 1,500 1,500 1,500 1,500 1,500
1,500 1,600 1,700 1,800 1,900 2,000
0 100 200 300 400 500
1.00 0.80 0.60 0.40 0.20 0.10
0 80
120 120
80 50
*Excluding possible blasting costs
By interpolating between the bid prices in Table 10.3 we would find that the EPVC is maximized (at about $125,000) when the bid price is $1,750,000, allowing a contribution from the winning bid of $250,000. Accordingly, to bid in the cost-plus-fee mode, XYZ Co. simply says its price will be the actual cost (as audited by the seller) plus a fee of $250,000.
Now suppose that XYZ Co. has estimated the probability distribution of blasting costs to be as shown in Table 10.4, where you can see that blasting costs might be somewhere between $0 and $500,000 with an expected value of $180,000. If the contract is awarded on a fixed-price basis, the actual blasting costs will be borne by the seller, XYZ Co.
Table 10.4: Expected costs of blasting if rock is encountered
Expected cost of blasting ($000s) Probability (%) EV of blasting cost ($000s)
0 100 200 300 400 500
20 30 20 15 10
5
0 30 40 45 40
25 180
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CHAPTER 10Section 10.2 Incremental Costs and Revenues and the Optimal Bid Price
To find the fixed-price bid, which transfers all the risk of finding rock to the seller, we need to recalculate the EPVC at each bid price level, since incremental costs will now be $180,000 higher, now totaling $1,680,000 in expected value terms. We show this in Table 10.5.
Table 10.5: Expected present value of contribution analysis of the fixed-price bid
Net EPV of incremental costs ($000s)
Possible bid price ($000s)
Contribution if winning bid ($000s)
Success probability
EPVC ($000s)
1,680 1,680 1,680 1,680 1,680 1,680
1,500 1,600 1,700 1,800 1,900 2,000
–180 –80
20 120 220 320
1.00 0.80 0.60 0.40 0.20 0.10
–180 –64
12 40 45 32
Interpolating between the rows in Table 10.5, you can see that the EPVC-maximizing fixed- price bid appears to be somewhere close to $1,900,000. Since XYZ Co. bids frequently on jobs like this, it can afford to be risk-neutral about these possible blasting costs, and tender a fixed-price bid of $1.9 million. The buyer will then consider its own degree of risk aver- sion and might choose the cost-plus-fee bid (if it is risk-neutral) or the fixed-price bid (if it is highly risk-averse) or a bid price and a risk share somewhere in between (if its degree of risk aversion is somewhere in between the two extremes).5
5. Note that if the seller were risk-averse, rather than risk-neutral as in this example, it would want its fixed-bid price to be higher than $1.9 million, since the actual costs of blasting might be considerably higher than the EV of the blasting costs. The higher its degree of risk aver- sion, the higher it will want its fixed-price bid to be above $1.9 million. On the other side of the transaction, the buyer’s degree of risk aversion will determine how much of the cost-variation risk it is prepared to take on. The optimal risk-sharing agreement will be negotiated between the two parties taking into account their relative degrees of risk aversion. We will not show the theoretical solution to this negotiation problem here as it is rather complex and in any case assumes that information on the parties’ risk preferences is easily found with zero search costs. For those interested in the theoretical solution, see Douglas, E.J. (1989). “The simple analytics of the principle-agent incentive contract.” The Journal of Economic Education, 20 (Winter): pp. 39–51, for an analogous argument.
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CHAPTER 10Section 10.3 Markup Bid Pricing When Information Is Costly
10.3 Markup Bid Pricing When Information Is Costly In earlier chapters, we learned that when information is costly the firm is likely to avoid information search costs and simply apply a markup percentage to its cost base to arrive at its pricing decision. It is completely possible that the firm can arrive at the same bid price using a simple markup pricing procedure. For example, if foreseeable costs had been $1,583,333 and the firm had applied a 20% markup rate, the result would be a bid price of $1,900,000.
Essentially, the firm will adjust its markup rate to ensure that it wins enough contracts to stay in business and hopefully also make satisfactory profits. If it does not win enough contracts, it should reduce its markup rate and, thus, increase its probability of success. If it wins too many contracts and cannot handle the volume of business that it wins, it will raise its markup rate to reduce its success rate, at least for a while until it has excess productive capacity again. You will see that these adjustments are compatible with what we said earlier about adjusting the bid price to take account of the opportunity costs and revenues and the future costs and revenues that are likely to be hard to measure.
Reconciling the EPVC and Markup Approaches In Figure 10.3, we show a flow chart of the two alternative approaches to competitive bid pricing. The first step is to decide whether to make a bid. If the project is within the firm’s competency; if the firm is not already operating at full capacity (or expects to fall below full capacity by time the contract would be undertaken); or if the firm thinks it has a reasonable chance of success, it would typically decide to bid on the contract. It must then decide what search costs it wishes to incur. To implement the full EPVC cost and sub- sequent expected profit calculations, the firm must estimate what its incurred additional search costs would be. If not excessive, due to readily available cost data and conditions that ensure relatively low cost variability, the firm might choose the EPVC route. Alterna- tively, in particular when the RFT has a relatively short deadline, the firm might decide to utilize the markup pricing procedure. Figure 10.3 serves as a useful review of the steps in the bid-pricing process in the two alternative modes. Not stated in Figure 10.3 is the option to bid in a different mode—that is, either cost-plus-fee mode or incentive (risk- sharing) mode—if the risk of cost variability is high and one of these other modes would better suit the risk preferences of the buyer or the seller.
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CHAPTER 10Section 10.3 Markup Bid Pricing When Information Is Costly
Figure 10.3: The EPVC model contrasted with the markup bid-pricing model
Calculate all net incremental costs in EPV terms— include explicit and opportunity costs in the present and future. Deduct EPV of opportunity revenues and future explicit revenues.
Decide whether to incur full search costs.
Decide whether to prepare a bid and incur bid preparation costs.
Estimate the probabilities of success at each of several bid price levels.
Calculate the EPVC for each of these bid prices and identify the bid price that maximizes EPVC.
1. Bid at maximum EPVC price if this type of decision is taken frequently and if there are no aesthetic, political, or other nonmonetary considerations involved; or
2. Bid below the maximum EPVC price if indicated by aesthetic, political, or other nonmonetary considerations involved; or
3. Bid above the maximum EPVC price if indicated by aesthetic, political, or other nonmonetary considerations involved.
If successful this time, no change necessary for next time, unless “too successful” such that full capacity is exceeded (so increase bid in future or expand capacity); if unsuccessful this time, no change necessary for next time unless you are not winning enough contracts (so reduce bid in future or reduce plant size).
Calculate all explicit costs associated with this contract. Add allocated overhead charges and bid preparation costs to arrive at your “standard cost” base.
Apply your standard markup rate to your standard cost to find preliminary bid price.
1. Bid at this level if in the past this practice has kept capacity utilization levels at desired levels, and if there are no extraordinary incremental costs or benefits associated with this contract; or
2. Bid below this level if capacity utilization and profitability are both lower than desired, and/or if there are extraordinary incremental net benefits expected in the future as a result of winning this contract; or
3. Bid above this standard price if capacity utilization is higher and profitability lower than desired, and/or if extraordinary incremental net costs are expected in the future as a result of winning this contract.
If successful this time, no change necessary for next time, unless “too successful” such that full capacity is exceeded (so increase bid in future or expand capacity); if unsuccessful this time, no change necessary for next time unless you are not winning enough contracts (so reduce bid in future or reduce plant size).
EPVC model Markup model
Yes
Yes
No
No Stop
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CHAPTER 10Section 10.3 Markup Bid Pricing When Information Is Costly
Bid Pricing for the Satisficing Firm Often we observe that the practicing competitive bidder appears to exhibit the four basic features of a satisficing firm, which is a firm that is content to earn satisfactory profits rather than strive to exactly maximize profits (Cyert & March, 1963; Simon, 1979). The first basic feature of satisficing firms is that they exhibit bounded rationality, or putting boundaries on the information that they will seek due to the search cost of information, and then acting rationally (i.e., trying to maximize profit by setting MC = MR, or by choos- ing the markup rate based on estimated price elasticity) within the boundaries of the infor- mation that is available to them. Thus, the satisficing competitive bidder might calculate only its estimated incremental costs and decline to search for future costs and probability distributions. Second, the satisficing firm practices selectivity by confining its attention to profit-making opportunities that are near at hand and that seem worthwhile to pursue. Thus, the satisficing firm will not bid on all RFTs offered, but confines its attention to those that it is most likely to win and for which it has the technology and productive capacity. Third, the satisficing firm establishes decision rules, like standard-cost bases and markup rates, to facilitate and expedite its decision-making processes, as we saw above. Fourth, satisficing firms establish targets, or satisfactory levels for their output and profit rates, and use feedback information from their experience in the market to adjust these targets and decision rules when such action becomes necessary or desirable.
In Figure 10.4 we see a flowchart of the decision-making process for the satisficing firm in the context of competitive bidding. You can see that it is essentially a variation of the markup pricing procedure with several questions explicitly posed to help the decision maker decide whether to bid and, if so, at what price to bid.
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CHAPTER 10Section 10.3 Markup Bid Pricing When Information Is Costly
Figure 10.4: Bid-pricing decision sequence for the satisficing firm
Does the firm have, or could it obtain through subcontract without undue problems, the productive capacity (people and plant) to undertake this contract?
Is the probability of success high enough to make it seem worthwhile to prepare a bid?
Is the firm desperate for work or considering diversification into new lines of work?
Yes No
Yes No Yes No
Is it necessary to bid to maintain the relationship with this buyer?
Yes No
Is the capacity utilization target being achieved?
No Yes
Is the profitability target being achieved?
No Yes
Stop
Does the firm have, or could it obtain, without undue problems, the technology necessary to undertake this contract?
Apply the standard markup rate to find the indicated standard price.
Calculate all incremental costs and standard fixed-cost charges for this contract.
1. Adjust bid price downwards if capacity target is not being met; if future benefits seem to be greater than usual; and/or if aesthetic, political, or risk factors indicate a lower bid is preferable.
2. Adjust bid price upwards if profit target is not being met; if capacity utilization is too high and subcontracting presents problems; if future net benefits seem lower than usual; or if aesthetic, political, or risk factors indicate a high bid would be preferable.
Yes No
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CHAPTER 10Section 10.3 Markup Bid Pricing When Information Is Costly
The Value Proposition From the Buyer’s Perspective
As in most pricing situations, the seller’s intention is (usually) to offer the best value prop- osition to the potential buyer. Thus, a supplier’s bid may be accepted even if it is more expensive to the buyer if it is simultaneously a better value proposition due to its qualita- tive aspects. So sellers might offer above-specification quality at a slightly higher price and might win the tender if this is a superior value proposition for the buyer. Similarly, where the seller contributes design quality to the project, the design of one seller might be considered superior and chosen even though that firm’s bid price is higher. Conversely, if the tender is completely specified such that there is no room for design or other qualitative variation, the best value proposition will be the one with the lowest bid price, assuming they all meet the quality specifications.
Although most pricing situations involve the supplier firm feeling compelled to bid and maintain a relationship with the buyer, this may not always be the case. If the supplier is operating above full capacity, or sees negative aesthetic, political, or risk issues with the contract, the supplier may not really want to win the contract and should accordingly set a somewhat higher price that will make it worthwhile if the contract is indeed won. This higher price may cause the tender to not be the best value proposition facing the buyer, of course.
Illegal Bidding Practices In the foregoing we have assumed that firms bidding for a particular contract do so with- out the benefit of any interaction or information flow between the competing suppliers. Doing so would likely constitute collusive pricing, which is illegal under federal legisla- tion and would result in financial penalties for the firms and potentially jail terms for the managers concerned. Collusive bidding is where two or more firms conspire to set their bid prices to the detriment of the buyer or society in general. Colluding firms might agree to set their prices at a relatively high level such that the lowest bid price is higher than would have happened if they had competed independently for the business. They might not agree to the actual prices to be set but simply exchange or provide information that results in, or could reasonably be construed to result in, a higher price to the buyer. Be sure to avoid any contact or information flow between your firm (and its managers) and rival bidders (and their managers) that might be construed, even circumstantially, as collusive bidding. Because this is often a “gray area” of the law, it is useful to take a brief look at the kinds of practices that are likely to attract the attention of the competition regulators.
Competing suppliers might conspire to submit identical bids, which are exactly the same bid price on a particular contract. These firms might rationalize that they will set identical bids to avoid the situation where one firm might place a low bid to win a fully specified contract on the basis of price, and to force the seller to choose the winner on some other basis, which might be the above-specification qualitative aspects of the tender or on other aesthetic, political, or risk considerations. Of course, identical bids might be entirely coin- cidental, particularly where the component materials and services are relatively standard and there is a general expectation that a particular markup or profit rate is standard in that industry. But a practice of setting identical bids is likely to attract the attention of the regulators, especially if the potential buyer feels that the identical bid price is unreason- ably high and brings the situation to the attention of the regulators.
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CHAPTER 10Summary
Another illegal bidding practice is bid rotation, where the firms conspire to take turns to submit the lowest bid in a situation where they bid repeatedly against each other. Thus, it is illegal for firms to “take turns” to be the lowest bidder, by submitting bids that are too high to win except when it is their turn to be the lowest bidder. Or similarly, a firm might make it obvious that it would really like to win a particular contract and the other firms acquiesce to that by either not bidding on that contract or by submitting higher bids than they normally would.
Bid disclosure is the practice of making public the prices at which one or more firms have tendered. Even if there is no collusive agreement, if the suppliers regularly disclose their bid prices after the winner is announced, this information may allow suppliers to predict the bidding behavior of rivals in subsequent tenders and also to confirm whether the other firms did in fact bid according to their prior expectations, and this will likely lead to higher bid prices for the buyer in the future. From the buyer’s point of view, it is therefore likely to be counterproductive to release any information other than who was the success- ful bidder; although in B2G situations, the public will want to be assured that the bidding process is sufficiently transparent.
Summary
In this chapter, we have applied the contribution approach to the pricing situation where firms must make competitive tenders for sales to buyers. The relevant cost concept is the incremental cost associated with undertaking and completing the contract, and as long as the bid price exceeds the incremental cost of the project, some contribution will be made to overhead costs and profits. Note that incremental costs and incremental revenues include opportunity costs and revenues and future costs and revenues, and that winning each bid is probabilistic, such that the appropriate calculation is the expected present value of the contribution, or EPVC. We noted that variations from this purely monetary figure may be justified on the basis of aesthetic, political, or risk considerations.
In practice, most firms use markup pricing over easily obtainable cost measures as a search-cost-avoiding method to arrive at hopefully a similar profit outcome. Not only does markup pricing save search costs, but it also saves time in a pricing situation where the tender deadline may be quite soon, and in many B2C situations may be almost imme- diate. The markup rate utilized by the firm should be scrutinized periodically to ensure that it is keeping the firm at the desired levels of capacity utilization and profitability.
Both the EPVC approach and the markup approach require an explicit or implicit estimate of the probability of winning the contract at each possible bid price level. The major fac- tors involved in estimating these success probabilities are the probability that competitors will bid at a lower level, and the appreciation that the buyer will have for qualitative dif- ferences that the firms might be able to insert into their tender proposals, such that their bid is seen as the superior value proposition from the buyer’s perspective.
When firms repeatedly engage in competitive bidding, and particularly when the time to prepare the bid is short, they will gravitate towards a pricing process that is based on a standard markup over costs calculated using a standard costing formula. By repeatedly
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CHAPTER 10Decision Problems
using this standard cost base and markup rate the firm wins some and loses some, and if winning too few contracts will adjust its markup rate downwards, and if winning too many it will use a higher markup rate or include a larger contribution to overheads in its standard costing formula. We noted that firms in competitive bidding markets may adopt a satisficing approach by practicing bounded rationality or selectivity, using simple deci- sion rules, and setting targets for capacity utilization and profitability levels.
Questions for Review and Discussion
1. Outline one or more situations in which you have been the buyer in a competitive bidding or price quote situation.
2. Make a list of those items that you would expect to enter into the incremental cost calculation for a contract to remove the seagulls from the vicinity of a major coastal airport.
3. In calculating the incremental cost of a particular project, how would you treat the possible future costs of a lawsuit that may occur as a result of this project, where the cost of the lawsuit might range from $10,000 to $500,000 with an associated probabil- ity distribution?
4. How would you value the goodwill (i.e., expected future business) that is expected to be generated as a result of undertaking a particular contract? If there is expected goodwill, would you be prepared to bid lower than otherwise? Why?
5. Explain why the strategy of choosing the bid price with the highest expected value is likely to generate the greatest contribution to overheads and profit over a large number of successful and unsuccessful bids.
6. Outline the different modes of bid pricing. Why choose one mode of bidding over the others?
7. Explain how the strategy of marking up incremental costs by a standard percentage (and subsequently winning some contracts and losing some contracts) may over a period of time give equivalent results as compared to selecting the bid price with the maximum expected value of contribution.
8. Outline the factors that would cause you to use a lower markup rate on incremental costs (as compared with your usual markup rate) in a particular bidding situation.
9. Explain how value analysis enters the bid pricing process when buyers call for ten- ders that potentially vary in their qualitative aspects, such as a company asking for bids to design and build a new corporate headquarters building.
10. Why is collusive bidding illegal? Who does it hurt?
Decision Problems
1. The Billings Printing Company is preparing to bid on a contract to supply half a mil- lion leaflets for a mailbox drop by a major pizza restaurant. Billings has calculated its incremental costs to be $50,000. Past experience with this kind of contract has resulted in the following schedule, which shows the number of contracts tendered and won at each of several markup rates over incremental costs during the past three years.
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CHAPTER 10Decision Problems
Markup rate (%) Contracts tendered at this rate Contracts won at this rate
10 20 30 40 50
53 180 624 110 63
50 130 283 20 4
a. Calculate the expected value of the contribution at each of the bid prices implied by the above markup rates.
b. Interpolate between these rates to identify the markup rate, and the bid price, that would maximize expected contribution from the contract.
c. What assumptions and qualifications underlie your analysis?
2. Your company, Bright Paints, is one of a dozen companies manufacturing a special reflective paint used for traffic signs. The State Department of Transportation has called for tenders to supply 10,000 gallons of blue reflective paint to be delivered within two months. You can foresee fitting in a production run of the blue paint and have decided to bid on the job. You calculate your incremental costs for this job to be $76,200. This particular contract is standard, similar in all respects to hundreds of contracts you have bid on over the past few years. Your pricing policy has been to apply a markup rate to incremental costs to arrive at the bid price. Your markup rate has been higher when you had plenty of orders and lower when you had few or no orders to fulfill. You have assembled data relating the markup rate used and the percentage of contracts won at each markup rate, as follows:
Markup rate (%) Percentage of contracts won at that rate (%)
0 10 15 20 25 30 35
95.9 84.8 65.4 41.3 15.7 3.0 0.2
a. Why would your company have bid with a 0% markup on some past tenders? Why didn’t it win all of those contracts?
b. What is the bid price that maximizes the expected contribution of the contract? c. Why, or why not, is the fixed-price mode of bidding likely to be the best one to
use for this contract?
3. Stenson Steel Fabricators is preparing a bid for a steel watergate to be installed in an irrigation canal. Its practice has been to charge each contract with bid preparation costs of $2,000, which is actually about three times the actual value of time and office supplies spent on each bid, but it is costed this way because Stenson wins only about 33% of tenders it submits, on average. Its bidding policy has always been to add a 15% margin to the incremental and allocated costs, and hence the pricing manager insists that the appropriate bid price for this contract is $138,230 as shown in the fol- lowing table.
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CHAPTER 10Decision Problems
Cost category $
Bid preparation costs Direct materials Direct labor Allocated variable overheads Allocated fixed overheads Profit margin Suggested bid price
2,000 18,600 33,200 14,400 52,000 18,030
138,230
You have recently joined Stenson Steel and are worried that business conditions in the industry have deteriorated recently. You are aware that some of your competi- tors have been operating well below capacity, and you suspect that demand for steel fabricated products is likely to be depressed for the coming 12 months.
a. What is the absolute minimum price you would bid on this contract? Please explain and defend your answer.
b. On the basis of the information given, what bid price would you recommend? c. What factors would you want to investigate and evaluate before choosing the
actual bid price to submit?
4. You operate your own small building company and have decided to bid on a govern- ment contract to build a pedestrian walkway in a national park during the coming winter. The walkway is to be of standard government design and should involve no unexpected costs. Your present capacity utilization rate is moderate and allows suf- ficient scope to undertake this contract, if you win it. You calculate your incremental costs to be $268,000 and your fully allocated costs to be $440,000. Your usual practice is to add between 60% and 80% to your incremental costs, depending on capacity utilization rate and other factors. You expect three other firms to also bid on this contract, and you have assembled the following competitor intelligence about those companies:
Issue Rival A Rival B Rival C
Capacity utilization At full capacity Moderate Very low
Goodwill considerations Very concerned Moderately concerned Not concerned
Production facilities Small and inefficient plant
Medium sized and efficient plant
Large and very efficient plant
Previous bidding pattern Incremental cost plus 35–50%
Full cost plus 8–12% Full cost plus 10–15%
Cost structure Incremental costs exceed yours by about 10%
Similar cost structure to yours
Incremental costs 20% lower but full costs are similar to yours
Aesthetic factors Does not like winter jobs or dirty jobs
Does not like messy or inconvenient jobs
Likes projects where it can show its creativity
Political factors Decision maker is a relative of the buyer
Decision maker is seeking a new job
Decision maker is looking for a promotion
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CHAPTER 10Key Terms
a. What price would you bid if you must win the contract? b. What price would you bid if you want to maximize the expected value of the
contribution from this contract? c. Defend your answers with discussion, making any assumptions you feel are rea-
sonable or are supported by the information provided.
5. A request for tender (RFT) has been issued by Milford Hydroelectric Power Station to repair a turbine generator. Your company’s engineers have examined the broken generator and in conjunction with your company accountant have established the following costs associated with repairing the generator.
Cost category $
Bid preparation costs Direct materials Direct labor Specialized equipment required Variable overheads Allocated fixed overheads
750 115,000 252,000
27,500 42,000 86,750
The specialized equipment required will not be purchased unless the contract is won. If purchased it would be available at no incremental cost for similar repair contracts in the future, if such contracts should be forthcoming. You are aware of three other companies that are likely to bid on this contract—relevant details are as follows:
Detail Company A Company B Company C
Cost structure Similar to yours 10% higher 10% lower
Previous bidding pattern Incremental costs plus 60% Full costs plus 15% Full costs plus 40%
Capacity utilization Moderate Very low Near full
Your current capacity utilization is moderate, leaving sufficient capacity to handle this project. Your previous bidding pattern is to add 25% to your full costs.
a. What is the absolute minimum that you would bid on this contract? b. What would be your actual bid price on the basis of the information given? c. What other factors would you want to consider before submitting your tender?
Key Terms
bid disclosure The practice of making public the prices at which competing sup- pliers have tendered.
bid preparation costs The costs that a bidding firm will incur due to studying the tender specifications and estimating the economic costs of completing the proj- ect to the required level of quality within the required timeframe.
bid rotation An illegal bidding practice, where the firms conspire to take turns to submit the lowest bid and otherwise bid at relatively high prices such that they do not expect to win the contract.
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CHAPTER 10Key Terms
bounded rationality Rather than con- sider all possible decision alternatives, the decision maker limits the decision alter- natives under consideration to those on which it can obtain sufficient information at reasonable cost, and for which it has the required resources. In choosing among this limited set, the firm avoids extreme information search costs and additional production costs and may be content to make a satisfactory profit (see satisficing) rather than maximize its profit.
collusive bidding A system where two or more firms conspire to set their bid prices at a relatively high level such that the low- est bid price chosen by the buyer is higher than would have happened if sellers had competed independently for the business.
competitive bidding A price- determination system whereby the price paid by the buyer is determined by the lowest bid price tendered by competing sellers, or in the case of differentiated bids (i.e., incompletely specified quality aspects) where prices bid may differ, the buyer selects the bid that offers the best value proposition (considering both qual- ity and price differences).
cost-plus-fee A type of competitive bid- ding where the buyer and seller agree that the ultimate price (upon completion) will be the actual costs of completion plus a predetermined profit margin for the seller, such that the buyer bears the entire risk of cost variability.
fixed-price bid A bidding process where the seller quotes a fixed price and under- takes to complete the project for exactly that price regardless of unexpected variations in the costs of completing the project.
identical bids Competing suppliers submit exactly the same bid prices on a particular contract. Although this could happen by chance, or if costs are the same for all suppliers and they all tend to use the same markup percentage, identical bids or nearly-identical bids are likely to draw the attention of the Anti-Combines “watchdogs.”
incentive bid pricing A form of bid pricing that involves the buyer and seller agreeing on the bid price but also agreeing to share any cost over-run or under-run (variation from the expected cost) in an agreed proportion. Thus, the parties agree to share the risk of cost variation.
incremental costs of the contract All those costs, expressed in present value terms, that are incurred as a result of win- ning and completing the contract.
incremental revenues of the contract The sum of all revenues (expressed in net present value terms) that are expected to be received as a result of winning and completing the contract. These include present-period explicit revenues, opportu- nity revenues, and future revenues.
opportunity revenues Costs that are avoided as the result of a management decision. For example, if costs can be avoided by winning a competitive bid contract, the magnitudes of the costs avoided (suitably discounted if extending beyond the current production period) are included as opportunity revenues.
present-period explicit revenues The actual cash inflows to the selling firm within the current production period.
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CHAPTER 10Key Terms
project management The preparation and implementation work involved in managing people and other resources to bring a project from inception to completion.
satisficing firm A philosophy of firms or their managers under which they are content to earn satisfactory profits, rather than striving to maximize their profits.
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