Chapter 19 Auctions and Competitive Bidding Mc GrawHillIrwin

Types of Auctions Types Characteristics Winning Bid Most common form; price is successively raised until only one bidder remains Auctioneer calls an initial high price, and then lowers the price until one bidder accepts the current price The highest bid, but the winner pays the lowest winning price First-price sealed bid auction Competitors submit bids secretly, or sealed. The highest bid when English auction Dutch auction Mc. Graw-Hill/Irwin The highest bid competing for goods; the lowest bid when competing to offer a service © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Types of Auctions Characteristics Second-price sealed bid auction Competitors submit bids secretly, or sealed The highest bidder, but pays the price of the second-highest bidder Reserve-price auction A reserve price is set by the seller Reverse-price auction The price declines at a regular interval The first bid during the price decline Types Mc. Graw-Hill/Irwin Winning Bid The highest bidder, if above the seller=s reserve price © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Types of Auctions • The English auction – The most common form, the one in which the highest bidder among potential buyers, or the lowest bidder among potential sellers is the winner – Can be closed or open – Requires bidders to be present, susceptible to rings of bidders Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Elements of Auctions • Participants – A seller offers a right or an object to prospective buyers who are invited to bid – The auctioneer or auction house conducts the auction and receives a commission from the seller based on the price paid; the auctioneer also receives a commission paid by the winning bidder (buyer’s premium) Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Elements of Auctions • Scarcity – Typically there are limited quantities of the object available for sale – Auctions provide an opportunity to determine the market value of scarce objects, in contrast to mass-produced and mass-merchandised goods and services that are offered for sale at a fixed price Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Why Auctions Work • Reasons for holding auctions üUncertainty as to what price to post, or the value that buyers may place on an asset üOccurs when products are not standardized or market prices are not stable üThe formality of the procedure provides a perception of legitimacy that may not be obtained in other forms of asset transfer Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Why Auctions Work • Information asymmetry – The sellers do not know who will attend and bid in the auction, or what each bidder’s value and price limit is for the object – The bidders do not know if the seller has set a reserve price that reflects the seller’s value for the item, or what the competitor bidders have set as their caps for the item Auction houses are most successful when they can find the largest number of bidders who value the objects to be auctioned more than other bidders Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Fixed-Price Competitive Bidding • The theory of fixed-price competitive bidding covers such situations as – 1. Deciding what price to bid when the number of competitor bidders is known and when the identity of the competitors is known – 2. Deciding what price to bid when the number and identity of competitors are unknown – 3. Deciding whether to submit a bid at all – 4. Deciding how many contracts to bid on simultaneously when a company cannot afford to win them all Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Fixed-Price Competitive Bidding ü The decision problem is to submit a bid that will help the firm achieve its objectives and be lower than the competing bids ü What to bid depends on the objectives of the firm ü Assumes the bidder’s objective is to maximize expected immediate profits Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Fixed-Price Competitive Bidding • The firm must estimate ØThe probabilities of winning the contract at various prices ØThe number of bidders submitting a bid since the probability of winning a bid is a function of this number ØWhat competitors are likely to bid since competitors will keep their intentions secret Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Fixed-Price Competitive Bidding • Prebid analysis – By being selective in its bidding, a company can save time and money that would be spent on bid activities such as cost estimation, engineering proposals, purchasing, and printing the bids • Determine bid objectives – The objective may be the typical economic objective of profit maximization, either in terms of return on investment or absolute profits, or it may be to keep labor busy, gain an entree into a new business, or overcome a survival crisis Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Fixed-Price Competitive Bidding • Developing evaluation criteria § § § Necessary labor skills and engineering capability Available plant capacity Possibility of follow-up orders Amount of the job’s design content Number and identity of probably competitors Degree of familiarity the firm has with the bid project § Ability to deliver the project on time § Possibility of cost savings due to experience curve Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Fixed-Price Competitive Bidding • Develop a screening procedure – Assign a weight to each of the evaluation criteria, quantify these values, and then compare the score to other previous bids or to a predetermined minimum acceptable value • Cost estimation – The firm should avoid arbitrary cost-estimating formulas, and instead prepare careful cost estimates based on realistic activity levels Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Fixed-Price Competitive Bidding • Estimating the probability of winning v. The winning bid approach simply uses the history of competitors' winning bids v. The average-opponent approach uses the history of competitors' winning and losing bids to represent the bidding behavior of an average opponent v. The specific-opponent approach uses the past bidding behavior of specific competitors Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Fixed-Price Competitive Bidding • Problem of determining reasons for a winning bid • The bid-taker may be attempting to maximize the perceived value of the decision by tradingoff price with other product service attributes • Conjoint analysis • The salespeople involved with the buying company need to try to determine reasons why the bid was lost; or the firm can conduct interviews with clients to elicit information about the bid selection and the reasons for the selection of the winning bid Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Fixed-Price Competitive Bidding • Determining the best bid • The optimal bid is the bid that offers the highest expected contribution to profit and overhead • The expected contribution of a bid E(B) is determined by multiplying the probability of winning with a bid, P(B), by the difference between the bid price and the estimated direct costs (B-C): • E(B) = (B - C) x P(B) Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Fixed-Price Competitive Bidding • Contingent contracts are used when neither the bidding firm nor the bid-taking organization has complete information about either the costs of performing the service or developing and providing the product or the value to be derived from receiving the service or using the product • Cost-plus contract- used to determine the amount of “guaranteed” profit for the performing organization • Incentive or risk-sharing contract • Contingency-value contract- the bidding firm uses the amount of the incentive they build into the bid as a signal of their performance capabilities Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Fixed-Price Competitive Bidding • Bidding with capacity constraints 1. When operating at or near full capacity, the firm is in a position to allocate its resources to maximize contributions per resource unit 2. When capacity constraints exist, the bidding firm should substitute the contribution per resource unit criterion for contribution margin in the analytical procedures developed in this chapter and then proceed as usual Mc. Graw-Hill/Irwin © 2003 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.