BUS 640 Week 5 Discussion 1& 2 and Week 5 Assignment

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Competitive Bids and Price Quotes

Learning Objectives

A�er reading this chapter, you should be able to:

Discuss the nature of price se�ng where a buyer calls for compe��ve bids or tenders to supply goods and/or services that are not available "off-the-shelf." Dis�nguish between three different modes of compe��ve bidding: fixed-price, cost-plus-fee, and incen�ve (risk-sharing) bid pricing. Apply the logic of incremental costs and revenues, and thus contribu�on analysis, to the compe��ve bid pricing problem, incorpora�ng into the analysis any opportunity and future costs and revenues. Demonstrate that high search costs induce firms to set compe��ve bid prices using a standard markup over a standard cost base, with varia�ons for nonmonetary considera�ons including aesthe�cs, poli�cs, and risk a�tudes 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 u�liza�on rate, or profit rate, when these are below the levels that best serve the firm's objec�ves.

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When quo�ng a price, sellers take a gamble. They must operate on the mentality of "win some and lose some" but sellers must win o�en enough to cover overhead costs and realize a profit.

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Introduction

This is the fourth chapter concerned with the pricing decision of the business firm or other organiza�on. In this chapter, we will look into compe��ve bidding, a different 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�ons. Compe��ve 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 situa�on 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 compe��ve bids from one or more poten�al suppliers and then compares the value proposi�on offered by each responding bidder. Consumers effec�vely call for compe��ve bids every �me 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 par�cular preferences or requirements. Firms call for compe��ve tenders for sta�onery supplies, new vehicles or machines, component parts, consul�ng advice, new buildings, and so on, both to economize on their �me and to induce lower prices from suppliers who are most keen to get their business. Governments wan�ng roads and dams built, military hardware, fleets of cars supplied, and so on, similarly call for compe��ve bids from poten�al 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 combina�on 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 transac�ons costs). Quo�ng on the whole package also allows the supplier to reduce its profit margin on individual items in favor of winning a rela�vely large contract with an acceptable profit margin.

Each seller should expect that the buyer will ask for a compe��ve bid from other suppliers as well; although, in prac�ce, buyers o�en ask for a single quote and if that seems fair they will accept that price without seeking addi�onal 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 la�er situa�on is known as the

winner's curse.1 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch10introduc�on#ch10txt1) The pricing problem in compe��ve bid markets is that the seller must select a price that is high enough to provide a sufficient contribu�on 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 poten�al sellers, sellers must operate on the basis of "win some and lose some," but win enough to survive and hopefully prosper.

In addi�on to the uncertainty the seller faces concerning the bids of other poten�al sellers, there is uncertainty surrounding the cost of comple�ng the job as specified. Unless the job is completely specified down to the last nut and bolt, and is otherwise straigh�orward, there will be uncertainty about exactly what repairs, services, parts, and labor will be required. Also, since the price is specified ini�ally and the work is done later, weather and other uncontrollable disturbances may add unexpected costs to the project. Thus, compe��ve bidding is a complex pricing prac�ce faced by many firms in the economy and is especially applicable to business-to-business (B2B) transac�ons.

1. The winner's curse applies to a range of situa�ons where the costs of comple�ng the contract are uncertain. If poten�al suppliers each make es�mates of their costs to complete, and one buyer inadvertently underes�mates 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. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch10introduc�on#return1) ]

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10.1 Types of Competitive Bids and Price Quotes

There are two main types of compe��ve bids plus an intermediate (or combina�on) type. First, there is the fixed-price bid where the seller quotes a price and undertakes to complete the job for exactly that price regardless of unexpected varia�ons in the costs of comple�ng the project. In this case, the seller faces the en�re risk of cost variability. 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 par�es agree that the ul�mate price will be the actual costs plus a predetermined profit margin for the seller, and in this case the buyer bears the en�re risk of cost variability. In this case, the buyer may end up paying more than it ini�ally expected the final price to be. In most B2B and B2G situa�ons the buyer retains the right to an audit of the seller's costs, but in B2C situa�ons it is more commonly a "take it or leave it" tender, or the price is subject to renego�a�on 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 varia�ons, inclusions, or exclusions before choosing the winning tender.

Fixed-price bids are more common where the items to be purchased can be priced separately, such as building materials, and where labor costs are more predictable. Alterna�vely, 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 la�er basis because the actual labor �me and parts required only become known as the repair work progresses and a�er the item to be repaired has been at least par�ally disassembled. The buyer's problem with cost-plus bids is that the seller has li�le incen�ve to work fast and efficiently and thus minimize costs. Given that an audit of the seller's costs will be �me consuming and imperfect, due to the asymmetry of informa�on, the final price to the buyer most likely will be higher than if the seller had a strong incen�ve 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 rela�vely 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 rela�ve bargaining power of the buyer. In some B2B and B2G situa�ons 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 por�olio 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, expec�ng 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 perspec�ve: If the buyer rou�nely calls for tenders for similar 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.

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 rela�vely 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 a�tude 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 a�tude 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 rou�nely and repe��vely 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 rou�nely and repe��vely 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�on built into the specifica�ons of the work to be done. For example, if you ask for a quote for new �res on your car, or to fix your transmission, you expect the job to be completed to a par�cular level of quality. You want new �res that comply with road safety regula�ons, or you want your transmission to work properly again. The buyer will typically be happy enough to bear a legi�mate 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 informa�on 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 observa�on 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 informa�on to raise its profit at the expense of the buyer.2 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.1#ch10txt2)

The third type of compe��ve bid provides one such mechanism. It is known as incen�ve bid pricing, and involves the buyer and seller agreeing on the bid price ini�ally, but also agreeing to share any devia�on from the expected cost in an agreed propor�on. The variance of actual costs from the expected costs

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Project management of a compe��ve bid transac�on involves the efficient management of costs, quality, and the �me it takes to complete the project.

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is a cost over-run (if posi�ve) or a cost under-run (if nega�ve). 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 propor�on. In these situa�ons, the seller has a substan�al incen�ve to control costs, since it will have to pay a propor�on 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 por�on of that cost saving. The buyer's incen�ve 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 an�cipated, 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 compe��ve tenders is �me to comple�on. Project management of a compe��ve bid transac�on involves the efficient management of costs, quality, and the �me it takes to complete the project. The buyer will typically want to set a deadline by which �me the job is to be completed, and this deadline will usually be part of the tender specifica�ons. Especially when the project is considered to be urgent, such as comple�ng major road works, bridges, and other public infrastructure (for B2G contracts); comple�ng the manufacture and installa�on of new capital equipment to allow a business to get back in business (for B2B contracts); or comple�ng a car repair or house renova�on (for B2C contracts), the tender specifica�ons might include a clause rela�ng to penal�es for late comple�on, and, conversely, for bonuses if the project is completed before the deadline. Note that such agreements are effec�vely risk sharing agreements as well, since produc�on 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 comple�on, and indeed it may have put in place an incen�ve contract with its own managers and employees to share this bonus with them if the contract is completed 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 wai�ng for the job to be completed. On the other hand, if comple�on of the project is delayed beyond the planned delivery date, the seller's profit will be reduced to the extent of the penal�es imposed and the buyer's opportunity costs will be offset to some degree.

2. By seeking mul�ple quotes, and more detail from each poten�al seller, the buyer is likely to reduce the informa�on asymmetry by gaining more informa�on about the produc�on 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. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.1#return2) ]

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10.2 Incremental Costs and Revenues and the Optimal Bid Price

From the informa�on above, we can deduce that it is very important that the prospec�ve seller carefully calculates the incremental costs that are expected to be associated with comple�ng any contract that it wins through a compe��ve 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 compe��ve 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 comple�ng 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 decision to be made.

Present-Period Explicit Costs

These include the direct and explicit costs associated with undertaking and comple�ng the project. Included are such cost categories as direct materials, direct labor, and variable overheads that are due to the project under considera�on. These may be es�mated on the basis of the firm's experience with comple�ng similar contracts previously, modified to reflect present materials and labor prices, plus a trend factor if comple�on of the project will take several months or years. In addi�on, the contract may require the firm to purchase and deliver to the buyer capital equipment that needs to be purchased by the seller at current prices.

In some cases, the comple�on 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 a�er the contract is completed. If these items have a useful life remaining, it seems unfair to the buyer to charge the en�re cost against the current contract. The appropriate way to deal with this is indeed to charge the en�re 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 represen�ng the net present value of the future revenues and the future costs avoided (which we call "opportunity revenues").

Another considera�on is the capacity u�liza�on rate of the firm. When the firm is at or near to its full capacity rate of output, it must consider the addi�onal incremental costs that will be incurred if it wins the contract, such as over�me labor rates, outside contrac�ng expenses, penalty charges associated with delays on other exis�ng contracts, and new capital equipment that must be purchased to enable the contract to be undertaken and completed.

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 considera�on.3 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.2#ch10txt3) 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 considera�on, then the contribu�on to overheads and profits that these resources could have made must be counted as an opportunity cost for the project under considera�on. For example, a firm producing rela�vely 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, u�lizing its resources more profitably on the contract under considera�on. The contribu�on foregone is an opportunity cost of the contract under considera�on. If the alterna�ve produc�on 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, deteriora�ng labor rela�ons or supplier rela�ons, and legal recourse by dissa�sfied buyers or government prosecutors. Ill will (or ill feeling) toward the seller may manifest itself in the expected present value of contribu�on (EPVC) of future contracts that are lost if this current contract is undertaken. For example, undertaking a difficult or poli�cally conten�ous 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 calcula�on 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 organiza�ons who are sympathe�c to labor unions.

In prac�ce, it is not likely to be worth the search costs required to carefully es�mate every single opportunity and future incremental costs associated with a par�cular compe��ve tender, nor is the bidding firm likely to have the �me required for this informa�on search ac�vity, since RFTs are typically issued with only a short �me for poten�al sellers to respond. More realis�cally the bidding firm will simply add a "cushion" (or safety margin) to its explicit incremental costs to reflect its recogni�on that there are opportunity and future incremental costs involved.

Bid Prepara�on Costs

Even when it avoids the search costs of es�ma�ng opportunity and future costs, the bidding firm will incur significant bid prepara�on costs, which are costs associated with studying the tender specifica�ons and subsequently es�ma�ng the costs of undertaking and comple�ng the project to the required level of quality and within the required �meframe. It may take one or more employees several days to work up an es�mate and to submit the formal tender

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Opportunity revenues are costs that are avoided as the result of a management decision.

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documents, and they may need to buy-in informa�on and exper�se in order to complete and submit their tender. Note that these bid prepara�on costs are incurred before the bid price is submi�ed and are incurred regardless of whether the contract is later won or lost. They are therefore sunk costs as far as the incremental costs of the contract are concerned.

Thus, bid prepara�on costs must be treated as part of the firm's overhead costs that are (hopefully) covered by the contribu�ons to overheads made by the contracts that the firm actually wins. As noted earlier, the firm that engages in compe��ve bidding cannot expect to win every contract it bids on and must con�nue bidding on many contracts in order to win enough to avoid bankruptcy and hopefully also to be profitable. In the following sec�ons, we shall see how the firm plays the probabili�es game in choosing its compe��ve 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 comple�ng 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 produc�on period. Par�cularly in B2B and B2G situa�ons, 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 progress payments at intervals within the contract dura�on, 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 addi�ve 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 compe��ve 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 associated with laying off workers and the later costs of recrui�ng and training new workers.

It might also avoid the cost of having to apply special treatments to idle plant and equipment to avoid deteriora�on of those capital assets—for example, machinery might need to be sprayed with oil or otherwise sealed to prevent rus�ng. In such cases, the equipment will need to be cleaned and serviced before it can be brought back into produc�on again, so the avoidance of these costs would also represent opportunity revenue. Another possible opportunity revenue is the equipment and research and development (R&D) costs that can be avoided if the firm wins the present contract. 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 trea�ng 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�se while also gaining work for the employees and a posi�ve contribu�on to overheads and profits for the firm.

Future Revenues

Winning and comple�ng the present contract may allow the firm to gain exper�se and reputa�on 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 revenue price and be more likely to win the current contract. In prac�ce of course, the search costs of es�ma�ng the future revenues are likely to be prohibi�ve and, instead, the bidding firm will "take a bit off" its bid price in recogni�on that winning the contract will not only generate revenues in the current and subsequent periods but also facilitate the firm poten�ally 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 �me 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.

The Optimal Bid Price

If the firm's objec�ve is to maximize its net present worth, the op�mal bid price will be the price that maximizes the expected present value of contribu�on (EPVC) to overheads and profits. The "expected" in this term implies that we have to mul�ply the present value of the contribu�on 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 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.2#ch10txt4) In Table 10.2, we show the data for a par�cular compe��ve bid situa�on. Suppose the firm has become aware of an RFT and wants to submit a tender. A�er scru�ny of the tender specifica�ons, the managers have determined that the incremental costs, minus the incremental revenues (other than the bid price),

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all expressed in present value terms, are $500,000. In column 2, we show a range of bid prices with the consequent contribu�on levels in column 3. In column 4, we show the es�mated success probabili�es 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 contribu�on at each bid price level mul�plied 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 contribu�on analysis of the bid price Net EPV of incremental costs $000s Possible bid price $000s Contribu�on 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 ma�er 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.

Figure 10.1: Interpola�on of the EPVC to find the op�mal bid price

In this case, the firm should bid at $725,000 which appears to maximize its EPVC. Subsequently it may or may not win this contract, since the success probability is only about 45% (found by interpola�ng between the success probabili�es 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 �me. Indeed the firm will need to bid on many contracts if the success 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.

Aesthe�c, Poli�cal, and Risk Considera�ons

Several nonmonetary considera�ons may also enter the compe��ve bid pricing process. Aesthe�c considera�ons, such as design aspects that generate psychic sa�sfac�on for the bidding firm, might induce the firm to bid higher or lower than the EPVC-maximizing price. If the project is aesthe�cally appealing, delivering psychic sa�sfac�on to the firm's top managers, for example, they might lower the bid price to increase the chances of winning the contract. Conversely, if comple�ng the project is expected to deliver disu�lity 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 disu�lity in the event that they do win the contract.

Poli�cal (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 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 promote) 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 considera�ons, note that the risk of not winning the contract is about 55% in the case examined above. If this contract is representa�ve 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 running out of cash, not winning this par�cular contract would put the firm at extreme risk of insolvency. In this case, the managers

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Poli�cal 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 quo�ng a lower price to recognize the friendship between the person buying and the person selling.

© Jupiterimages/Thinkstock

might not be willing to gamble on a 45% chance of success on this par�cular occasion and will prefer to trade off some contribu�on for a be�er chance of winning the contract, by se�ng 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 aversion 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 disu�lity associated with going through the process of bankruptcy.

Cost-Plus-Fee Bids to Avoid the Risk of Cost Varia�on

As men�oned earlier, in addi�on to the risk of not winning the contract, there is the risk that (if the contract is won) the actual costs of comple�ng 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 varia�on), a cost-plus-fee bid (transferring all the risk to the buyer), or an incen�ve bid that shares the risk of cost varia�on between the buyer and the seller in some agreed propor�ons. 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 es�mate 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 u�lity for a par�cular bidder. This figure depicts a quite risk-averse seller who would be equally sa�sfied with a $725,000 fixed-price bid, a $650,000 incen�ve bid (with 50:50 risk sharing), and a $600,000 cost-plus-fee bid. It presumably also depicts a situa�on in which the poten�al cost varia�on is apparently quite high, since the seller is willing to give up about $125,000 to totally avoid the risk of cost varia�on.

Figure 10.2: The risk–return trade-off for different bidding modes

Note that in Figure 10.2 we have selected the 50:50 risk sharing propor�ons quite arbitrarily. The actual propor�ons are a ma�er for nego�a�on between the buyer and the seller and could occur anywhere along the indifference curve. That is, anywhere between 0% and 100% of the cost-varia�on risk could be borne by the seller with the complementary propor�on 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 varia�on and pay the $725,000 fixed price, whereas if the buyer is highly risk-tolerant it will prefer to pay the substan�ally lower cost-plus-fee price of $600,000 and bear all of the risk of cost varia�on. If the buyer's degree of risk tolerance is somewhere in between, it will prefer an incen�ve (risk- sharing) bid price somewhere in between these extremes and this might then be nego�ated with the seller.

As an example, suppose the state government issues an RFT that calls for the construc�on of a mul�story parking garage. The es�mated cost for construc�on of this parking garage is quite straigh�orward except for the fact that in digging the holes for the concrete foo�ngs, the construc�on firm might encounter rock. If rock is found, it will require blas�ng 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 some�mes they find rock and have lower than expected profit (because of the extra blas�ng costs) and other �mes they find no rock and have higher profit because blas�ng costs are avoided. 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, poten�ally asking for agreement on a risk-sharing arrangement.

If bidding in the cost-plus-fee mode, XYZ Co. can ignore the blas�ng costs, since it will simply pass them along to the buyer. Excluding the possible blas�ng cost, XYZ Co. calculates that the construc�on cost of the parking garage will be $1.5 million, including the firm's es�ma�on of opportunity and future costs

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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 construc�on project. In Table 10.3 we show the EPVC for several bid price levels.

Table 10.3: Expected present value of contribu�on analysis of the bid price Net EPV of incremental costs* $000s Possible bid price $000s Contribu�on 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 blas�ng costs

By interpola�ng 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 contribu�on 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 es�mated the probability distribu�on of blas�ng costs to be as shown in Table 10.4, where you can see that blas�ng 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 blas�ng costs will be borne by the seller, XYZ Co.

Table 10.4: Expected costs of blas�ng if rock is encountered Expected cost of blas�ng ($000s)

Probability (%)

EV of blas�ng cost ($000s)

0 100 200 300 400 500

20 30 20 15 10 5

0 30 40 45 40 25 180

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 contribu�on analysis of the fixed-price bid Net EPV of incremental costs $000s Possible bid price $000s Contribu�on 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

Interpola�ng 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 blas�ng costs, and tender a fixed-price bid of $1.9 million. The buyer will then consider its own degree of risk aversion 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

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.2#ch10txt5)

3. Idle plant and equipment may provide a back-up plan if the breakage of similar equipment would cause a delay in comple�on of a contract and a�ract penalty charges. Also, idle plant capacity (known as excess capacity) allows a firm to increase its produc�on level quickly without wai�ng 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 exis�ng firm(s) did not have any extra produc�ve capacity. In these cases idle equipment does have an opportunity cost. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.2#return3) ]

4. Or more generally, in cases where the bidders submit differen�ated tenders with different bid prices, the lower the likelihood that the firm's bid price will be considered the best value proposi�on from the buyer's perspec�ve and consequently selected by the buyer. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.2#return4) ]

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 blas�ng might be considerably higher than the EV of the blas�ng costs. The higher its degree of risk aversion, the higher it will want its fixed-price bid to be above $1.9 million. On the other side of the transac�on, the buyer's degree of risk aversion will determine how much of the cost-varia�on risk it is prepared to take on. The op�mal risk-sharing agreement will be nego�ated between the two par�es taking into account their rela�ve degrees of risk aversion. We will not show the theore�cal solu�on to this nego�a�on problem here as it is rather complex and in any case assumes that informa�on on the par�es' risk preferences is easily found with zero search costs. For those interested in the theore�cal solu�on, see Douglas, E.J. (1989). "The simple analy�cs of the principle-agent incen�ve contract." The Journal of Economic Educa�on, 20 (Winter): pp. 39–51, for an analogous argument. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec10.2#return5) ]

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10.3 Markup Bid Pricing When Information Is Costly

In earlier chapters, we learned that when informa�on is costly the firm is likely to avoid informa�on 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.

Essen�ally, the firm will adjust its markup rate to ensure that it wins enough contracts to stay in business and hopefully also make sa�sfactory 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 un�l it has excess produc�ve capacity again. You will see that these adjustments are compa�ble with what we said earlier about adjus�ng 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 alterna�ve approaches to compe��ve 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 opera�ng at full capacity (or expects to fall below full capacity by �me 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 subsequent expected profit calcula�ons, the firm must es�mate what its incurred addi�onal search costs would be. If not excessive, due to readily available cost data and condi�ons that ensure rela�vely low cost variability, the firm might choose the EPVC route. Alterna�vely, in par�cular when the RFT has a rela�vely short deadline, the firm might decide to u�lize the markup pricing procedure. Figure 10.3 serves as a useful review of the steps in the bid-pricing process in the two alterna�ve modes. Not stated in Figure 10.3 is the op�on to bid in a different mode—that is, either cost-plus-fee mode or incen�ve (risksharing) mode—if the risk of cost variability is high and one of these other modes would be�er suit the risk preferences of the buyer or the seller.

Figure 10.3: The EPVC model contrasted with the markup bid-pricing model

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Bid Pricing for the Satisficing Firm

O�en we observe that the prac�cing compe��ve bidder appears to exhibit the four basic features of a sa�sficing firm, which is a firm that is content to earn sa�sfactory profits rather than strive to exactly maximize profits (Cyert & March, 1963; Simon, 1979). The first basic feature of sa�sficing firms is that they exhibit bounded ra�onality, or pu�ng boundaries on the informa�on that they will seek due to the search cost of informa�on, and then ac�ng ra�onally (i.e., trying to maximize profit by se�ng MC = MR, or by choosing the markup rate based on es�mated price elas�city) within the boundaries of the informa�on that is available to them. Thus, the sa�sficing compe��ve bidder might calculate only its es�mated incremental costs and decline to search for future costs and probability distribu�ons. Second, the sa�sficing firm prac�ces selec�vity by confining its a�en�on to profit-making opportuni�es that are near at hand and that seem worthwhile to pursue. Thus, the sa�sficing firm will not bid on all RFTs offered, but confines its a�en�on to those that it is most likely to win and for which it has the technology and produc�ve capacity. Third, the sa�sficing firm establishes decision rules, like standard-cost bases and markup rates, to facilitate and expedite its decision-making processes, as we saw above. Fourth, sa�sficing firms establish targets, or sa�sfactory levels for their output and profit rates, and use feedback informa�on from their experience in the market to adjust these targets and decision rules when such ac�on becomes necessary or desirable.

In Figure 10.4 we see a flowchart of the decision-making process for the sa�sficing firm in the context of compe��ve bidding. You can see that it is essen�ally a varia�on of the markup pricing procedure with several ques�ons explicitly posed to help the decision maker decide whether to bid and, if so, at what price to bid.

Figure 10.4: Bid-pricing decision sequence for the sa�sficing firm

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The Value Proposi�on From the Buyer's Perspec�ve

As in most pricing situa�ons, the seller's inten�on is (usually) to offer the best value proposi�on to the poten�al buyer. Thus, a supplier's bid may be accepted even if it is more expensive to the buyer if it is simultaneously a be�er value proposi�on due to its qualita�ve aspects. So sellers might offer above-specifica�on quality at a slightly higher price and might win the tender if this is a superior value proposi�on 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 qualita�ve varia�on, the best value proposi�on will be the one with the lowest bid price, assuming they all meet the quality specifica�ons.

Although most pricing situa�ons involve the supplier firm feeling compelled to bid and maintain a rela�onship with the buyer, this may not always be the case. If the supplier is opera�ng above full capacity, or sees nega�ve aesthe�c, poli�cal, 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 proposi�on facing the buyer, of course.

Illegal Bidding Practices

In the foregoing we have assumed that firms bidding for a par�cular contract do so without the benefit of any interac�on or informa�on flow between the compe�ng suppliers. Doing so would likely cons�tute collusive pricing, which is illegal under federal legisla�on and would result in financial penal�es for the firms and poten�ally 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 rela�vely 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 informa�on that results in, or could reasonably be construed to result in, a higher price to the buyer. Be sure to avoid any contact or informa�on flow between your firm (and its managers) and rival bidders (and their managers) that might be construed, even circumstan�ally, as collusive bidding. Because

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this is o�en a "gray area" of the law, it is useful to take a brief look at the kinds of prac�ces that are likely to a�ract the a�en�on of the compe��on regulators.

Compe�ng suppliers might conspire to submit iden�cal bids, which are exactly the same bid price on a par�cular contract. These firms might ra�onalize that they will set iden�cal bids to avoid the situa�on 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-specifica�on qualita�ve aspects of the tender or on other aesthe�c, poli�cal, or risk considera�ons. Of course, iden�cal bids might be en�rely coincidental, par�cularly where the component materials and services are rela�vely standard and there is a general expecta�on that a par�cular markup or profit rate is standard in that industry. But a prac�ce of se�ng iden�cal bids is likely to a�ract the a�en�on of the regulators, especially if the poten�al buyer feels that the iden�cal bid price is unreasonably high and brings the situa�on to the a�en�on of the regulators.

Another illegal bidding prac�ce is bid rota�on, where the firms conspire to take turns to submit the lowest bid in a situa�on where they bid repeatedly against each other. Thus, it is illegal for firms to "take turns" to be the lowest bidder, by submi�ng 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 par�cular contract and the other firms acquiesce to that by either not bidding on that contract or by submi�ng higher bids than they normally would.

Bid disclosure is the prac�ce 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 a�er the winner is announced, this informa�on 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 expecta�ons, 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 counterproduc�ve to release any informa�on other than who was the successful bidder; although in B2G situa�ons, the public will want to be assured that the bidding process is sufficiently transparent.

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Summary

In this chapter, we have applied the contribu�on approach to the pricing situa�on where firms must make compe��ve tenders for sales to buyers. The relevant cost concept is the incremental cost associated with undertaking and comple�ng the contract, and as long as the bid price exceeds the incremental cost of the project, some contribu�on 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 probabilis�c, such that the appropriate calcula�on is the expected present value of the contribu�on, or EPVC. We noted that varia�ons from this purely monetary figure may be jus�fied on the basis of aesthe�c, poli�cal, or risk considera�ons.

In prac�ce, 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 �me in a pricing situa�on where the tender deadline may be quite soon, and in many B2C situa�ons may be almost immediate. The markup rate u�lized by the firm should be scru�nized periodically to ensure that it is keeping the firm at the desired levels of capacity u�liza�on and profitability.

Both the EPVC approach and the markup approach require an explicit or implicit es�mate of the probability of winning the contract at each possible bid price level. The major factors involved in es�ma�ng these success probabili�es are the probability that compe�tors will bid at a lower level, and the apprecia�on that the buyer will have for qualita�ve differences that the firms might be able to insert into their tender proposals, such that their bid is seen as the superior value proposi�on from the buyer's perspec�ve.

When firms repeatedly engage in compe��ve bidding, and par�cularly when the �me 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 cos�ng formula. By repeatedly 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 contribu�on to overheads in its standard cos�ng formula. We noted that firms in compe��ve bidding markets may adopt a sa�sficing approach by prac�cing bounded ra�onality or selec�vity, using simple decision rules, and se�ng targets for capacity u�liza�on and profitability levels.

Ques�ons for Review and Discussion

Click on each ques�on to reveal the answer.

1. Outline one or more situa�ons in which you have been the buyer in a compe��ve bidding or price quote situa�on. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Perhaps you have asked for a price quote for a repair to your bicycle or car; or to paint a fence or a house; or to fix a broken string in a tennis racket; or to mow your lawn; or to tutor your child in math, and so on. In a business context, perhaps your firm called for tenders to purchase several vehicles; to refurbish the office space; or to install storage space and par��ons in the factory.

2. Make a list of those items that you would expect to enter into the incremental cost calcula�on for a contract to remove the seagulls from the vicinity of a major coastal airport. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Incremental costs might include the costs associated with the capture and reloca�on and/or of culling and disposing of the seagulls; the costs of appeasing animal rights groups; the costs of promo�on and publicity generated to cast your firm in a favorable light; and the costs of future contribu�ons lost due to bad publicity over killing or removing birds from their habitat.

3. In calcula�ng the incremental cost of a par�cular 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 probability distribu�on? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

The incremental cost of a possible future lawsuit should be es�mated in ENPV terms by first es�ma�ng a probability distribu�on of legal costs in each year for, say, the next five years. From this data you would calculate the EV of legal costs in each future year. Any future revenues including costs that will be avoided as a result of the lawsuit would also be expressed in EV terms and ne�ed against the EVs of legal costs in each year. These values would then be discounted back to ENPV terms by mul�plying each one by the appropriate discount factor and finally summing the products.

4. How would you value the goodwill (i.e., expected future business) that is expected to be generated as a result of undertaking a par�cular contract? If there is expected goodwill, would you be prepared to bid lower than otherwise? Why? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

The expected future business an�cipated to be generated from winning a contract in the current period might be valued in ENPV terms by se�ng out a list of the contribu�on levels (to overheads and profit) that are expected to result from this contract, in each year for several years into the future. A�er es�ma�ng probabili�es for each of these outcomes in each period into the future you would calculate the EV of the future business in each year. By mul�plying each of these by the appropriate discount factor and summing the products you would derive the ENPV of the future business that is expected to flow from winning the present contract.

5. Explain why the strategy of choosing the bid price with the highest expected value is likely to generate the greatest contribu�on to overheads and profit over a large number of successful and unsuccessful bids. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

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Over many trials of a gamble, the best strategy is to con�nually choose the alterna�ve with the highest ENPV. Although you will win some contracts and lose some contracts, you can expect to win the propor�on of bids indicated by the probability of success. Any other bid pa�ern is likely to cause you to win some contracts but lose money due to bidding too low, and lose other contracts by bidding too high when you might have won them at a lower but s�ll profitable bid price.

6. Outline the different modes of bid pricing. Why choose one mode of bidding over the others? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

The fixed-price bidding mode offers a fixed price to comple�on regardless of any cost over-runs or under-runs. The bidder (supplier) thus bears all risk of cost varia�on. The cost-plus fee mode offers a fixed fee on top of actual (audited) costs, and thus transfers all the risk of cost varia�on to the buyer. The incen�ve bidding mode shares the risk of cost varia�on between the buyer and the supplier in an agreed propor�on. The mode chosen will depend on the inherent risk involved in the project, and the rela�ve risk aversions of the buyer and the seller.

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 �me give equivalent results as compared to selec�ng the bid price with the maximum expected value of contribu�on. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

A standard mark-up pricing procedure may give equivalent profit results over �me (to the ENPV approach) because it avoids extensive search costs and the mark-up rate can be adjusted or fine-tuned to take into account any recognized factors that are likely to increase or decrease the probability of success in any specific bid pricing situa�on.

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 par�cular bidding situa�on. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

You would reduce the mark-up rate if (i) capacity u�liza�on was currently very low; (ii) if the job promised extraordinary future net benefits; and (iii) if the job promises extraordinary aesthe�c outcomes, poli�cal rewards, or risk reduc�on.

9. Explain how value analysis enters the bid pricing process when buyers call for tenders that poten�ally vary in their qualita�ve aspects, such as a company asking for bids to design and build a new corporate headquarters building. (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Value is equal to quality over price and some contracts call for the bidder to suggest design features that result in higher or lower quality being perceived by the buyer. Thus the best value proposi�on is not necessarily the tender with the lowest bid price. In such bid markets the bidder's first priority is to create a compelling design which, if preferred by the buyer, can be used to secure a more-profitable bid price.

10. Why is collusive bidding illegal? Who does it hurt? (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/boo

Collusive bidding is illegal because it causes a lack of compe��on in the market, and this in turn tends to cause the buyer to pay higher prices and to receive lower quality than it would if the firms competed independently on the basis of their prices and quali�es. It reflects an abuse of market power, to the financial detriment of not only the buyers and their shareholders but also the downstream customers of the buyer who will, as a consequence, have to pay higher prices for lower quality goods and services.

Decision Problems

1. The Billings Prin�ng Company is preparing to bid on a contract to supply half a million 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.

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 contribu�on at each of the bid prices implied by the above markup rates. b. Interpolate between these rates to iden�fy the markup rate, and the bid price, that would maximize expected contribu�on from the contract. c. What assump�ons and qualifica�ons underlie your analysis?

2. Your company, Bright Paints, is one of a dozen companies manufacturing a special reflec�ve paint used for traffic signs. The State Department of Transporta�on has called for tenders to supply 10,000 gallons of blue reflec�ve paint to be delivered within two months. You can foresee fi�ng in a produc�on 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 par�cular 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 rela�ng 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 (%)

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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 contribu�on 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 irriga�on canal. Its prac�ce has been to charge each contract with bid prepara�on costs of $2,000, which is actually about three �mes the actual value of �me 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 following table.

Cost category $

Bid prepara�on 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 condi�ons in the industry have deteriorated recently. You are aware that some of your compe�tors have been opera�ng 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 informa�on given, what bid price would you recommend? c. What factors would you want to inves�gate 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 government contract to build a pedestrian walkway in a na�onal park during the coming winter. The walkway is to be of standard government design and should involve no unexpected costs. Your present capacity u�liza�on rate is moderate and allows sufficient 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 prac�ce is to add between 60% and 80% to your incremental costs, depending on capacity u�liza�on rate and other factors. You expect three other firms to also bid on this contract, and you have assembled the following compe�tor intelligence about those companies:

Issue Rival A Rival B Rival C

Capacity u�liza�on

At full capacity Moderate Very low

Goodwill considera�ons

Very concerned Moderately concerned Not concerned

Produc�on facili�es

Small and inefficient plant Medium sized and efficient plant

Large and very efficient plant

Previous bidding pa�ern

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

Aesthe�c factors Does not like winter jobs or dirty jobs

Does not like messy or inconvenient jobs

Likes projects where it can show its crea�vity

Poli�cal factors Decision maker is a rela�ve of the buyer

Decision maker is seeking a new job

Decision maker is looking for a promo�on

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 contribu�on from this contract? c. Defend your answers with discussion, making any assump�ons you feel are reasonable or are supported by the informa�on provided.

5. A request for tender (RFT) has been issued by Milford Hydroelectric Power Sta�on to repair a turbine generator. Your company's engineers have examined the broken generator and in conjunc�on with your company accountant have established the following costs associated with repairing the generator.

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Cost category $

Bid prepara�on 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 pa�ern Incremental costs plus 60% Full costs plus 15% Full costs plus 40%

Capacity u�liza�on Moderate Very low Near full

Your current capacity u�liza�on is moderate, leaving sufficient capacity to handle this project. Your previous bidding pa�ern 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 informa�on given? c. What other factors would you want to consider before submi�ng your tender?

Key Terms

Click on each key term to see the defini�on.

bid disclosure (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The prac�ce of making public the prices at which compe�ng suppliers have tendered.

bid prepara�on costs (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The costs that a bidding firm will incur due to studying the tender specifica�ons and es�ma�ng the economic costs of comple�ng the project to the required level of quality within the required �meframe.

bid rota�on (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

An illegal bidding prac�ce, where the firms conspire to take turns to submit the lowest bid and otherwise bid at rela�vely high prices such that they do not expect to win the contract.

bounded ra�onality (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

Rather than consider all possible decision alterna�ves, the decision maker limits the decision alterna�ves under considera�on to those on which it can obtain sufficient informa�on at reasonable cost, and for which it has the required resources. In choosing among this limited set, the firm avoids extreme informa�on search costs and addi�onal produc�on costs and may be content to make a sa�sfactory profit (see sa�sficing) rather than maximize its profit.

collusive bidding (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A system where two or more firms conspire to set their bid prices at a rela�vely high level such that the lowest bid price chosen by the buyer is higher than would have happened if sellers had competed independently for the business.

compe��ve bidding (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A price-determina�on system whereby the price paid by the buyer is determined by the lowest bid price tendered by compe�ng sellers, or in the case of differen�ated bids (i.e., incompletely specified quality aspects) where prices bid may differ, the buyer selects the bid that offers the best value proposi�on (considering both quality and price differences).

cost-plus-fee (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A type of compe��ve bidding where the buyer and seller agree that the ul�mate price (upon comple�on) will be the actual costs of comple�on plus a predetermined profit margin for the seller, such that the buyer bears the en�re risk of cost variability.

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fixed-price bid (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A bidding process where the seller quotes a fixed price and undertakes to complete the project for exactly that price regardless of unexpected varia�ons in the costs of comple�ng the project.

iden�cal bids (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

Compe�ng suppliers submit exactly the same bid prices on a par�cular 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, iden�cal bids or nearly-iden�cal bids are likely to draw the a�en�on of the An�-Combines "watchdogs."

incen�ve bid pricing (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

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 (varia�on from the expected cost) in an agreed propor�on. Thus, the par�es agree to share the risk of cost varia�on.

incremental costs of the contract (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

All those costs, expressed in present value terms, that are incurred as a result of winning and comple�ng the contract.

incremental revenues of the contract (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The sum of all revenues (expressed in net present value terms) that are expected to be received as a result of winning and comple�ng the contract. These include present-period explicit revenues, opportunity revenues, and future revenues.

opportunity revenues (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

Costs that are avoided as the result of a management decision. For example, if costs can be avoided by winning a compe��ve bid contract, the magnitudes of the costs avoided (suitably discounted if extending beyond the current produc�on period) are included as opportunity revenues.

present-period explicit revenues (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The actual cash inflows to the selling firm within the current produc�on period.

project management (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The prepara�on and implementa�on work involved in managing people and other resources to bring a project from incep�on to comple�on.

sa�sficing firm (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A philosophy of firms or their managers under which they are content to earn sa�sfactory profits, rather than striving to maximize their profits.