Managing Uncertainty in Contract Bidding
All bids have uncertainty but how can this be effectively managed to minimise associated risks? In 2012 Dr Linda Newnes, Professor Paul Goodwin and Dr Melanie Kreye of University of Bath with Dr Yee Mey Goh, of Loughborough University, published a paper which addresses this subject and forms the basis of the content in this article with additional input from the author's own experience.
Kreye et al state that companies who have traditionally competed in markets for their products now compete through the provision of service, such as asset availability. Such companies typically design and manufacture long life assets such as aeroplanes and submarines. An example of this is Rolls Royce where 60% of their revenue is achieved from selling services rather than the engine itself.
In my experience it is not uncommon for large Tier 1 O&G service companies to also fall into this category and thus to bid for supply contracts at a single figure profit margin (or even buy the contract at a loss) with the knowledge that they will maintain long term profit and revenue through life of asset field maintenance contracts often 25 years plus in duration. It can also put the company in pole position to win contracts for future phases of field development or extension (although this is not guaranteed).
In any event, through research, Kreye et al state it is shown that companies generally make over optimistic forecasts of profitability in bids, some yielding only 50% of expected profit.
Dennis Lock (2007) in his book Project Management Eighth Edition, states that even in comparative bidding it may not be possible to achieve better than +/-15% accuracy.
This is a huge challenge for companies when considering their bid strategy and it can be taken that the greater the bid uncertainty the lesser the bid accuracy, which is why managing uncertainty in bidding is essential. The pricing decision is influenced by various factors which lead to such uncertainty.
Kreye et al suggest that the decision maker must decide a single point in a given range to communicate as a bid to the potential customer. Too high and you may be underbid by competitors thus loose the business. Too low and it may influence the customers perception of quality therefore be rejected.
Before we go any further it is important to understand the definition of uncertainty and risk according to Kreye et al.
Uncertainty is a potential deficiency in any phase or activity of the process, which can be characterised as not definite, not known or not reliable.
Risk is the possible effect of an uncertain event of situation.
Uncertainty Framework for Competitive Bidding
According to Kreye et al there are four factors on a company's bidding strategy. This is illustrated below.
According to Kreye et al the framework was derived through different empirical studies; two experimental studies and one interview survey. This was undertaken together with industry partners to observe how pricing decisions are made and which influences are taken into account.
During experimental studies two key observations were taken.
Illustrating various ranges of probabilities of future costs was the approach which made decision makers most aware of the uncertainties which influence said future costs
Considerations about competitors are important to companies in making pricing decisions
Interviews then supplemented the above findings by confirming the below.
There is usually enough information available to support this framework.
Factor #1 - Customer
The customer is likely to have a bidding strategy, just like the supplier would. If the supply has worked with the customer previously then it may be possible to use the knowledge of this relationship in their decision making e.g. does the customer tend to use the same strategy? are they more focussed on cost, time or quality? Such inside information can be invaluable in gaining a competitive advantage.
If the customers budget is disclosed it can actually create uncertainty rather than mitigate it. For example some companies will always look for a saving against their budget. In any event a customer may request a discount following submitting the bid. This is particularly prevalent in certain regions of the world. Also some customers would be willing to pay above the budget if the benefits are considered worth it.
There are many other possibilities for the bidding company to consider. Others include the method or process the customer will use for selection; will they down select then provide the bidders opportunity to re-evaluate their bid?
Kreye et al suggest that although there will normally be a criteria laid out in the tender documents trade offs may occur, its a matter of understanding which trade offs will be most appealing to the customer. Another consideration is whether the customer will be open to offering options or an alternative to a particular element of the specification (maybe an upgrade, new superior technology or a cost saving).
Factor #2 - Competitors
It is useful to know how many bidders there are and if possible who they are. If you understand what the competition are likely to offer or what their capabilities are then you can potentially use this to your advantage. For example a company will normally have good information regarding their market competitors such as if they are normally more expensive, if they have better facilities or assets and what their general capabilities are. In cases where companies are located in sector hubs, such as silicone valley in the USA or Bristol in the UK, it is typical to find high migration of personnel between competitors, therefore more likely to hold inside information.
It is always worth considering that the customer may decide to award the work to multiple suppliers. In cases where there are a limited number of key suppliers the customer may purposely spread the work available between their supply base. This is an important strategy to ensure that limited market capability and capacity is not lost.
If there is a capability gap or weakness in the company it may be worth considering a partnership arrangement with a competitor if the customer would allow it. However there are often difficulties in this with aspects such as disclosing information relating to intellectual property but can usually be overcome if there is mutual appetite.
Factor #3 - Internal Company Processes
Internal company processes will determine whether the company has current capability to deliver the required outputs and, according to Kreye et al, can lead to a decision not to bid. As mentioned above, if there are any gaps in capability, or maybe capacity, decision could be taken to partner with a competitor. This can also be a valuable strategy if the contract is strategically important, maybe to take a first foothold with a particular customer or in a particular sector. If the decision to partner with a competitor was deemed unacceptable either to the bidder or customer then an alternative option may be for the bidder to outsource elements of the scope which would normally be kept in house, to their supply chain.
Factor #3 - Service Contract Conditions
Consideration must be made to any specific legislation or specification requirements in the tender e.g. local laws or import regulations of the customers region, or certification requirements such as ISO.
Payment method, contract type and the level of liability held by the bidder, negotiation style or bidding process, warranty arrangements and whether there are any liquidated damages clauses are all important elements which can create uncertainty for the bidder.
Applying the Framework
In applying the framework contract specific considerations must be made, furthermore the four factors can be interlinked. It is important to understand the general contract, product, service and bidding context before applying the framework to the specific situation.
Identify relevant uncertainty factors
Collect input information
Assess internal company processes
Analyse customer requirements & processes
Consider competitor capacity and capabilities
Process the input information
In considering the above bullets the bidding company will need to utilise many mathematical expressions and resulting diagrammatical representations such as probability and uncertainty modelling to model the probability of making a profit and the uncertainty connected to the internal company processes is used. Kreye et al describe the probability of making a profit as the probability that the actual costs are lower than the price bid. This can be expressed as below.
Pprofit = P(p>c)
with Pprofit - probability of making a profit
p - price bid
c - actual cost
The probability of winning the contract is as important as any other assessment to help inform how much effort should be allocated and which other contracts are to be bid.
Probability of winning can be expresses as below.
Pwinning = x * Pacceptance + y * Plead
where, x+y = 1
x = importance of the customer
y = importance of the competitors
The purpose of this uncertainty modelling is to provide suppliers with a tool that supports decision making process for contract pricing. A decision matrix is often a good tool to support this. Many examples can be found on the internet or by visiting the original paper produced by Kreye, Goh, Newnes & Goodwin.
Good luck bidding!
Reference material:
Kreye, M. E., Goh, Y. M., Newnes, L.B. & Goodwin, P., 2012, Approaches of Displaying Information to Assist Decisions under Uncertainty, Omega - International Journal of Management Science, 40(6), 682-689.
Lock, D., (2003), Project Management, Eighth Edition, Gower Publishing Limited, Hampshire, UK.