Competitive Bids and Price Quotes

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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