Session 12 Competitive Bid Prices and Price Quotes

Session 12 Competitive Bid Prices and Price Quotes Lectured by Prof. Dr. Ferdinand D. Saragih, MA 1

A. Background • Competitive bidding occurs in any market where a number of seller compete for the business of a single buyer. As a result, the buyer will then select the seller offering to complete the contract for the lowest price, if the product are identical, or select the seller offering the combination of price and other features if the seller are able to differentiate their products. • Competitive bid markets are quite common. Consumers enter such a market every time they want their car fixed, house painted, and so on. Firms wanting stationery suppliers, new machines, component parts, consulting advice, and so on, effectively call for competitive bids. Governments wanting roads and damn built, prisoners kept secure, fleets of cars supplied, and so on, similarly call for competitive bids from potential suppliers. Prof. Dr. Ferdinand D. Saragih, MA 2

A. Background • Each seller will recognize that if its price is too high then the business will go elsewhere. If the price is too low, then the seller will get the job but may end up loosing money on the job. This is known as the winner’s curse. • The problem is that the seller must select a price high enough to provide a sufficient contribution to overheads and profit, yet low enough to ensure that a sufficient volume of work is actually obtained. Typically, the seller must choose price in the face of considerable uncertainty, not only with respect to what other seller are simultaneously offering but with respect to what it may cost to complete the job as specified, since the job is typically slightly (and sometimes totally) different from what the firm has supplied before. Prof. Dr. Ferdinand D. Saragih, MA 3

B. Types Of Competitive Bids And Price Quotes B. 1. Fixed-Price Bid Fixed-price bid is a type of tendering bid price, or making a price quote, and undertaking to complete the job for that price regardless of any variation of costs from the expected level. In this type, price is determined ex ante, before the contract is undertaken, and a supplier faces the entire risk of cost variability, which is measured by the standard deviation of the probability distribution of cost around the expected value of cost. Prof. Dr. Ferdinand D. Saragih, MA 4

B. Types Of Competitive Bids And Price Quotes B. 2. Cost-Plus-Fee Bids Cost-plus-fee bids are the opposite case of fixed-price bid, i. e. where the bid price is determined ex post, after the contract is complete, and is equal to the actual costs of the job plus a fee (or profit margin) for the supplier. In this case, the entire risk of cost variability is borne by the buyer, who agrees to pay whatever the actual cost turn out to be plus a fee. The fee may be a fixed amount, or it may be based on the actual cost, in which case it is usually expressed as a markup over costs. The cost-plusfee bids are common where the degree of cost uncertainty is particularly high. Prof. Dr. Ferdinand D. Saragih, MA 5

B. Types Of Competitive Bids And Price Quotes B. 3. Incentive Bids Incentive bids are the type of making buyer and supplier agree beforehand on a bid price but agree to share any deviations from the expected cost level in a given way. In this case, the ex ante bid price is based on the expected costs plus a profit margin for the supplier. A deviation of the actual cost from the expect cost is known as a cost overrun or underrun. If there is a cost overrun, then the buyer pays the ex ante bid price plus a share of the cost overrun, and the supplier’s profit margin is reduced by its share of the cost overrun. Conversely, if there is a cost underrun, then the buyer’s ex post price is the ex ante price less the buyer’s share of the cost underrun, and the supplier’s profit margin is increased by its share of the cost underrun. This type is also known as risk-sharing bids. Prof. Dr. Ferdinand D. Saragih, MA 6

Mathematically Approach To the Types of Competitive Bids And Price Quotes Incentive bids B = Ct + π t + (1 -s)(Ct - Ca) ………………………. …. . (1) π a = π t + s(Ct - Ca) ……………………………. . . (2) where: B = the ex post bid price Ct = the supplier’s target cost (the expected PV) Ct = the actual (ex post) costs s = the supplier’s share of the cost variation π a = the actual profit received by the supplier π t = the target profit (expected PV) received by the supplier Prof. Dr. Ferdinand D. Saragih, MA 7

Mathematically Approach To the Types of Competitive Bids And Price Quotes Fixed-price bid In the fixed-price bid, the risk-sharing collapses when s = 1. Thus, equation (1) and equation (2) become: B = Ct + π t …………………………. . (3) π a = π t + (Ct - Ca) ………………. . . ……………. (4) Prof. Dr. Ferdinand D. Saragih, MA 8

Mathematically Approach To the Types of Competitive Bids And Price Quotes Cost-plus-fee Conversely, the cost-plus-fee exists when s = 0. Thus, equation (1) and equation (2) become: B = Ca + π t …………………………. . . (5) π a = π t ………………. . . (6) Prof. Dr. Ferdinand D. Saragih, MA 9

Mathematically Approach To the Types of Competitive Bids And Price Quotes Notes: a. The fixed-price bid is possible to be implemented when: • suppliers are risk neutral • suppliers undertake many contract of this type as to diversification of risk • suppliers can control the costs so easily that there is little or no cost uncertainty • suppliers do not really care of the cost overrun or underrun • buyer is extremely risk averse (only accept fixed-price bid). Prof. Dr. Ferdinand D. Saragih, MA 10

Mathematically Approach To the Types of Competitive Bids And Price Quotes b. The cost-plus-fee bids are more likely to be implemented when: • buyer is a risk neutral • buyer undertakes many contract of this type as to diversification of risk • buyer attaches low marginal utility to the dollars potentially involved in the cost variance, whether because of the relative triviality of the contract or because of a principal-agent problem • the contacts are speculative and quality is imperative to the buyer, such as defense contracting. Prof. Dr. Ferdinand D. Saragih, MA 11

Mathematically Approach To the Types of Competitive Bids And Price Quotes c. Risk-sharing, or incentive bids are possible to be implemented when: • cost uncertainty is relatively high but there is a perceived need to control the supplier’s spending while ensuring that quality does not suffer • the share of risk borne by each party will be determined by their relative risk aversions, the buyers’ perception of the supplier’s propensity to relax cost control, and competitive pressure from other suppliers willing to take a greater share of the risk at each ex ante bid level. 1 See J. J Mc. Call, The Simple Economics of Incentive Contracting, American Economic Review, 60 September 1967), pp. 834 -46; and F. M. Scherer, Theory of Contractual Incentive for Cost Reduction, Quarterly Journal of Economics, 78 (May), pp. 257 -80. 1 Prof. Dr. Ferdinand D. Saragih, MA 12

D. Incremental Costs, Incremental Revenues, And The Optimal Bid Price D. 1. The Incremental Costs of The Contract a. Per Definition: The. Incrementalcostsofthecontractare those all costs, expressed in expected-present-value terms, which are expected to be incurred as a result of winning and completing the terms of the contract. Costs that have been incurred already (sunk costs) and costs that will be incurred whether this contract is won or lost (committed costs) are not incremental costs for the purpose of the pricing decision to be made. Prof. Dr. Ferdinand D. Saragih, MA 13

D. Incremental Costs, Incremental Revenues, And The Optimal Bid Price b. The Categories of The Incremental Costs b. 1. Present-Period Explicit Costs This category of incremental costs consists of the direct and explicit costs associated with undertaking and completing the project. Included such categories as direct materials, direct labor, and variable overhead (but only those amounts that are expected to be paid for the purchases of materials, labor and suppliers, and services required to complete production and delivery of the specified goods and services). Prof. Dr. Ferdinand D. Saragih, MA 14

D. Incremental Costs, Incremental Revenues, And The Optimal Bid Price b. 2. Opportunity Costs The opportunity cost of underlying and completing a specific project is the value of the resource employed (that is, their contribution) in their best usage). b. 3. Future Costs • Future incremental costs may include the effects of ill will, deteriorating labor relations or suppliers relations, and legal resource by dissatisfied buyers or government prosecutors. Ill will is the expected present value of contribution (EPVC) of future contracts lost as a result of taking the presence contract. There may be longer-term disadvantages, for example, in taking a contract which breaks a strike or which takes advantage of the misfortune of a competitor or other party. Future labor problems may arise if the present contract would cause the firm to operate with congestion of work space and facilities. Prof. Dr. Ferdinand D. Saragih, MA 15

D. Incremental Costs, Incremental Revenues, And The Optimal Bid Price An Illustration of The Incremental Costs The city’s garbage collectors have been on strike for several weeks, and the mayor calls for a one-week contract with an outside firm to move the garbage. Young firm, which is engaged in the construction industry, has the trucks and the personnel necessary, and you calculate your incremental present-period explicit cost to be $ 100, 000 for the week, composed of direct labor, fuel, repairs and maintenance, and so on. You are utilizing your equipment and work force on a day-to-day basis moving landfill to an area that will eventually be a new housing development. The contribution to overhead and profits from this job is $ 10, 000 per week. If you win the contract to move the garbage, you must give up this contribution, and this is, therefore, the opportunity cost of winning the city’s contract. Prof. Dr. Ferdinand D. Saragih, MA 16

D. Incremental Costs, Incremental Revenues, And The Optimal Bid Price If you win the job, you are afraid that there will be a backlash response from a company with whom you currently hold a contract for the annual removal of debris and waste products. Their labor force is strongly unionized and you feel that there is a fifty-fifty chance the firm may decide not to offer you the renewal of that contract. You reason that may do this to avoid labor strife at their own plant, which they think may result if they renew the contract with the firm that helped break the city garbage workers’ strike. Next year’s contract with this firm is expected to contribute $ 20, 000 to overheads and profits if it is renewed. Supposing your opportunity discount rate to be 15% and the cash flow to be one year away, the PV of next year’s contract is $ 20, 000 x 0. 8696 = $ 17, 392. Given your estimate of the probability of losing the contract at 0, 5, the EPV of this future cost, or ill will, is $ 17, 392 x 0. 5 = $ 8, 696. Prof. Dr. Ferdinand D. Saragih, MA 17

D. Incremental Costs, Incremental Revenues, And The Optimal Bid Price Thus the incremental cost of the job is estimated to be the sum of the present-period explicit costs, $ 100, 000; plus the opportunity cost, $ 10, 000; plus the EPV of the future costs, $ 8, 696; or $ 118, 696 in total. Consequently, you would require incremental revenues to be at least this high before you would consider taking the job to avoid making an incremental loss on the job. Prof. Dr. Ferdinand D. Saragih, MA 18

D. Incremental Costs, Incremental Revenues, And The Optimal Bid Price D. 2. The Incremental Revenues of The Contract a. Per Definition: The Incremental revenues of the contract are all those revenues, expressed in expected-present-value terms, which are expected to be received as a result of winning and completing the terms of the contract. These revenues may be considered under the same three categories, i. e. : present period, opportunity, and future revenues. Prof. Dr. Ferdinand D. Saragih, MA 19

D. Incremental Costs, Incremental Revenues, And The Optimal Bid Price b. The Categories of The Incremental Revenues b. 1. Present-Period Incremental Revenues This category of incremental revenues is measured by discounting future period’s payment at the opportunity rate to find the present value of revenues. b. 2. Opportunity Revenues Opportunity revenues includes severance pay and other costs laying off personnel and the subsequent rehiring and retraining costs which would be incurred if the firm were forced to close down and wait until it won another contract before starting up again. Prof. Dr. Ferdinand D. Saragih, MA 20

D. Incremental Costs, Incremental Revenues, And The Optimal Bid Price b. 3. Future Revenues Future incremental revenues may include the goodwill to be generated by the present contract. Goodwill should be regarded as the EPVC which is expected to be received from subsequent contract won as a result of having won and successfully completed the current contract. Prof. Dr. Ferdinand D. Saragih, MA 21

D. Incremental Costs, Incremental Revenues, And The Optimal Bid Price An Illustration of The Incremental Revenues The Universal Lamp Company plans to bid on a contract to manufacture and supply energy-saving fluorescent light bulbs for a government building. At present, Universal has no work to do and will have to lay off workers within a few weeks unless it wins this contract. Universal has never manufactured these new-generation light bulbs before and knows that it must establish its credibility by demonstrating that it can manufacture a high-quality product and that it can meet the delivery schedule proposed. Its proposed bid price is $ 278, 500 which it expects will be at least $ 100, 000 less than the nextlowest bid, given its knowledge of recent contracts awarded and publicized. Universal feels that it must bid this low to win the job–any lower price difference may cause the government purchaser to opt for a more expensive, but established, supplier. If it wins the job, then it is confident that it will produce a high-quality product and, therefore, make itself eligible for future contracts at higher profit margins. Prof. Dr. Ferdinand D. Saragih, MA 22

D. Incremental Costs, Incremental Revenues, And The Optimal Bid Price • • Suppose that Universal will avoid layoff, mothball, and other costs of $ 36, 000 associated with closing down and later reopening this plant if they win this contract. Suppose further that if they win this contract, they expect a 75% chance of a follow-up contract, with contribution of $ 200, 000, to be awarded next year. The PV that contribution (at 15% opportunity discount rate, for instance) is $ 173, 920. The EPVC is, thus, $ 173, 920 x 0. 75 = $ 130, 440. This contract, therefore, promises incremental revenues of the bid price, $ 278, 500; plus the opportunity revenues, $ 36, 000; plus the EPVC of future sales foreseen, $130, 440; or $ 444, 940 in total. Thus, the firm’s incremental costs could be anything up to that figure, and it would still be incrementally profitable for Universal to complete the contract with its bid of $ 278, 500. Prof. Dr. Ferdinand D. Saragih, MA 23

E. The Optimal Bid Price E. 1. Per Definition The optimal bid price will be the price level which maximizes the EPVC to overheads and profits of each bid price. To find the EPV of each bid price, we must multiply its EPVC by the probability of winning the contract at that price level. The higher the bid price, the lower the success probability, or the likelihood that the firm will submit the lowest bid. • Prof. Dr. Ferdinand D. Saragih, MA 24

E. The Optimal Bid Price E. 2. An Illustration of The Optimal Bid Price Suppose that the firm has obtained a reliable set of success probabilities, after consideration of the past bidding behavior and current utilization of all its rivals. In Table 1, we show an assumed incremental cost (in expected-PV terms and net of any incremental revenues other than the bid price) of $ 50, 000. Several arbitrarily chosen bid prices and the resultant contribution and success probability for each bid price are shown in column 2, 3, and 4. The product of column 3 and 4 is the EPVC for each bid price level. The bid price which appears to maximize EPVC is $ 70, 000. But this price was chosen arbitrarily from a spectrum of possible bid prices. By plotting the EPVC against bid prices and interpolating between the points, we would find that the EPVC is maximized when the bid price is approximately n$ 73, 500, as indicated in Figure 1. Prof. Dr. Ferdinand D. Saragih, MA 25

E. The Optimal Bid Price Table 1 Expected Present value Analysis of a bid-Pricing Problem Net EPV Bid Incr. Cost Price Success Contribution Prob. EPVC (1) $50, 000 (2) $50, 000 (3) $ 0. 000 (4) 0. 9 (5) $ 0. 000 50, 000 60, 000 10, 000 0. 7 7, 000 50, 000 70, 000 10, 000 0. 5 10, 000 50, 000 80, 000 30, 000 0. 3 9, 000 50, 000 90, 000 40, 000 0. 15 6, 500 50, 000 100, 000 50, 000 0. 05 2, 500 Prof. Dr. Ferdinand D. Saragih, MA 26

E. The Optimal Bid Price Figure 1 The EPVC Curve EPVC ($000 s) 12 10 8 6 4 2 0 50 60 70 73. 5 80 Bid price ($000 s) 90 Thus the firm must bid at $ 73, 500 to pursue the maximization of its net present worth. 27 Prof. Dr. Ferdinand D. Saragih, MA

E. The Optimal Bid Price E. 3. Aesthetic And Political Considerations It is perhaps unreasonable to expect a decision maker to make a choice simply on the basis of quantifiable cost and revenue considerations. In some cases certain aesthetic considerations enter the bidding process. Suppose the project allude in Table 1 was something other than a straightforward and normal profit. On the one hand, it may appeal to the artistic tastes of the decision maker; on the other hand, it may involve considerable amounts of dirty and uncomfortable work. In the first case we might expect a decision maker to choose a bid price somewhat below the expected value, since the nonmonetary gratification received by decision maker would offset some of the monetary compensation involved in the higher bid price. But if the job is expected to be dirty, uncomfortable, or inconvenient in some nonmonetary way, we might expect the decisions maker’s bid to be somewhat above the $ 73, 500 indicated by the expected-value criterion, since the nonmonetary disutility attached to the job would need to be offset by some additional monetary compensation. Prof. Dr. Ferdinand D. Saragih, MA 28

E. The Optimal Bid Price A further consideration that may cause the decision maker to choose a bid price different from the one with the maximum expected contribution is the possibility that decision maker may see personal gain in bidding at a different price level. Thus individual decision makers within an organization may practice self-serving, or political, behavior. This may be functional political behavior in that it causes certain that at the same time promote organization’s objectives, or it may be dysfunctional in that it serves the decision maker’s objectives but hinders the attainment of the organization’s objectives. • Prof. Dr. Ferdinand D. Saragih, MA 29

E. The Optimal Bid Price Risk Considerations Prof. Dr. Ferdinand D. Saragih, MA 30

E. The Optimal Bid Price E. 3. 1. Cost-Plus-Fee Bids • As indicated earlier in this session, prices in some markets are typically set on the basis of ex post cost plus a fee or markup. As a general rule, the greater the potential variability of cost, the greater the risk aversion of the seller relative to the buyer, and the greater the asymmetry of information regarding costs, the more likely it is that firms will wish to bid on a cost-plus-fee basis. In Figure 2 we show an indifference curve in bid price-risk share space as an illustration. Point A represents the EPVC-maximizing bid price, with all the risk of cost variability being borne by the supplier. The certainty equivalent of that bid price is shown as the point C on the vertical axis, where the risk share borne by the supplier is zero. Thus the cost-plus-fee bid the firm should tender is $ 65, 000, which is indicated by the firm’s certainty equivalent of the EPVC-maximizing price. Prof. Dr. Ferdinand D. Saragih, MA 31

E. The Optimal Bid Price Figure 2 The Bid Price And The Risk of Cost Variation 75 A 70 B 65 C 60 55 0 $67, 500 Risk-sharing bid cost-plus-fee bid (certainty equivalent of A) 20 40 60 80 100 Share of Risk Borne by Supplier (s) (%) Prof. Dr. Ferdinand D. Saragih, MA 32

E. The Optimal Bid Price E. 3. 2. Incentive (Risk-Sharing) Bids In many cases the buyer will require that each tender state an ex ante price and also specify the share of any cost variation that the supplier will bear. The risk-averse supplier may arbitrarily select a value of the risk share, such as 70%, and tender the ex ante price that makes the supplier indifferent between that price and that risk share, and the EPVC-maximizing price with all the risk. In Figure 2 we show this tender as the point B, indicating an ex ante bid price of $ 67, 500. An arbitrary choice of risk share is unlikely to be optimal, however. In general, the optimal tender will be the combination of ex ante price and risk share that best serves the buyer’s objectives. If the buyer’s objective is to maximize net worth without regard to risk, the optimal tender is the lowest bid price regardless of risk share offered. If the buyer considers both net worth and risk, the optimal tender is the one that maximizes the buyer’s utility in risk-return space. We can show the buyer’s indifference curves as in Figure 3, where they are superimposed on the seller’s indifference curve. Prof. Dr. Ferdinand D. Saragih, MA 33

E. The Optimal Bid Price The buyer’s indifference curves must be positively sloped but convex from above, because the buyer will receive increasing marginal disutility from higher bid prices and diminishing marginal utility from larger shares of risk being assigned to the supplier. Thus the buyer’s direction of preference is to the southeast, as indicated by the arrow. Note that the buyer can rank the various tenders in terms of utility generated. Point A, representing the fixed-price bid of $ 73, 500, is on the leastpreferred indifference curve. The buyer prefers point C, the $ 65, 000 cost-plus-fee bid, to the fixed-price bid, but ranks point B, the $ 67, 500 bid with 70% (supplier’s) risk share, over both of the other two. But a bid of about $ 66, 250 with 50% risk sharing going to the supplier (point D) allows the buyer to attain the highest level of utility and is thus the optimal tenders for the supplier to submit. Prof. Dr. Ferdinand D. Saragih, MA 34

the supply E. The Optimal Bid Price 75 Figure 3 The Buyer’s Preferred tender In Risk-Return Space Bid price ($000 s) 70 B 65 60 55 D C A the supply indiffent curve sum of the buyer’s indifferent curve 0 20 40 60 80 100 Share of Risk Borne by Supplier (s) (%) Prof. Dr. Ferdinand D. Saragih, MA 35

F. Competitive Bidding In Practice With an eye to its past pricing practice, modifying this standard markup either up or down depending on current conditions in the market and the industry and with reference to longer-term consideration in some cases. Prof. Dr. Ferdinand D. Saragih, MA 36

F. Competitive Bidding In Practice F. 1. Markup Bid Pricing To Maximize EPVC It is clear that the firm could stumble on the EPVCmaximizing price by using the markup approach. For instance, suppose the firm calculates its cost base to be $61, 150, comprised of direct costs and allocated overheads. A 20% markup on that cost base would result in a bid price of & 73, 500, the same as in the EPVC approach. Of course, this outcome would be sheer good luck. More likely, the firm using the simple (but the inexpensive) markup pricing procedure will submit a bid which is either above or below the EPVCmaximizing price level. Prof. Dr. Ferdinand D. Saragih, MA 37

F. Competitive Bidding In Practice F. 2. The Reconciliation Of Theory And Practice The markup price can be wrong to the extent of the information-search costs that were avoided, and markup percentage, and hence the profit margin, must take into account all net incremental costs (in EPV terms) not considered and not calculated into the cost base for the markup calculation. To the extent that overhead costs, including bid preparation costs, are included in the cost base, the markup percentage will be lower, since the markup will be simply the profit margin, rather than the contribution to overheads and profits. Prof. Dr. Ferdinand D. Saragih, MA 38

F. Competitive Bidding In Practice F. 3. Markup Bid pricing For satisfying Firm The practicing competitive bidder appears to exhibit four basic feature of a satisfying firm. First, the firm exhibits bounded rationality, calculating only its present costs and declining to search for future costs and probability distribution. Second, it practices selectivity by not bidding on all contracts offered but confining its attention, instead, to those it is most likely to win and for which it has the technology and capacity. Third, it establishes decision rules, like standard cost bases and markup pricing, to facilitate and expedite the decision process. Fourth, it establishes targets or satisfactory levels for its most important variables, and it uses feedback information to adjust these targets and decision rules when such action become necessary or desirable. Prof. Dr. Ferdinand D. Saragih, MA 39

G. Optimal Purchasing G. 1. Value Analysis for Optimal Purchasing Let us consider the purchasing decision of a householder who is contemplating having new windows installed in his somewhat older house. He receives three quotes, as shown in Table 4, after inviting representatives from each company to quote on the job. Notice that there is a difference not only in the prices quoted but in the qualitative aspects of the offers. Prof. Dr. Ferdinand D. Saragih, MA 40

G. Optimal Purchasing Table 4 Details of price Quotes on Windows Company A Company B $1, 280 Company C Price $2, 200 $1, 050 Frame Baked enamel on steel Baked enamel on aluminum. Anodized aluminum Glass 2 separate 5 -mm panes Double 5 -mm Thermopane Double 3 -mm Thermopane Warranty 10 years, complete 5 years, complete 3 years, complete Delivery 12 weeks 8 weeks 6 weeks Which quote should consumer accept? The answer obviously depends on a variety of considerations, including the consumer’s financial liquidity, his aesthetic feelings and misgivings about the different types of materials, and construction, the length of time he expects to own the house, and his attitude toward the risk and uncertainty associated with the different warranties. Prof. Dr. Ferdinand D. Saragih, MA 41

The End of this Session Thank you Prof. Dr. Ferdinand D. Saragih, MA 42