‘The Lowest
Bidder Wins’, a Lose-Lose Proposition
Attending lectures by scholars and thinkers has been my passion
since my college days. I have been fortunate to meet and attend lectures by three
legendary scientists. For me,
being present when such scientists give a talk is like visiting a temple of the
goddess of knowledge and spending time meditating.
The first legendary scientist I met was Freeman Dyson, a
great mathematician and theoretical physicist, who was a professor emeritus at
the Institute for Advanced Study at Princeton University. I was privileged to
attend his lecture at the University of Washington in Seattle.
Later, I had the opportunity to meet Francis Crick, the one
who discovered the structure of DNA and won a Nobel Prize in Medicine. We
commonly hear his name in conjunction with Watson, as in 'Watson and Crick'. It
was a joyful moment for me to shake hands with him and get his autograph.
Prof. Francis Crick and the author, June 21, 1991,
University of Washington, Seattle.
The third scientist was Robert Aumann. He was 83 years
old when I met him 10 years ago. Prof. Aumann
is a mathematician who has made a deep contribution to game theory. For his work, he won the Nobel Prize in
Economics in 2005. Meeting him came as a
big surprise when one of the engineers in our R&D team told me about a
lecture being given in a college by Prof. Aumann. I knew nothing about him, but
I was sure that I would learn something new. I dropped everything and took
other interested team members with me, and we drove to the college in Pune,
India, where this lecture was to be delivered.
Prof. Aumann talked about game theory, and although it
was interesting, I had no prior knowledge of the subject. I met him after the
talk. What he revealed was profound from the perspective of an organization and
the selection of suppliers based on the method of the lowest bid.
The Prevalent Bidding Process:
For those who have dealt with government organizations,
the bidding process is not new. In such a process, ‘The lowest bidder wins!’
Such a bidding process also exists in public as well as private sectors. From a
buyer’s perspective, it is best to buy something at the lowest cost and yet get
the same quality. However, experience tells us that most often the lowest bids
do not result in the lowest cost to the buyer in the end.
The main objective of the lowest bidder supplier is to
get the project. Once the project starts, the buyer’s organization is all
geared up to complete the project. Any half-done project is hard to complete
for any other supplier. The supplier working on the project always talks about
some proprietary details that they would not reveal to other suppliers. The
supplier makes a case stating that they tried their best, but there were many
changes to the specifications. They accommodated all those. Now they have run
out of the internal budget. They make a case for 30, 40, or 50% of the previous
budget as an additional supplemental cost. These cost overruns can skyrocket to
two or three times the original bid value or so-called the ‘lowest bid’. This
is where the real problem lies. This is nothing but a game being played by two
parties. How can such situations be avoided?
The Art of Negotiations May Pave the Way to Bankruptcy:
There are other interesting aspects to keep in mind. In
2008, there was a major company named Circuit City, the number two US consumer
electronics retailer (1). Circuit City’s purchasing department was getting very
good at negotiating with suppliers. There were many small-sized, tier 1, and
tier 2 suppliers. They were struggling to establish themselves. For early
startups or small businesses, it is imperative to have some big names on the client
list. Such companies often go below one’s costs and try to get the big-name
businesses as clients. The suppliers' only hope is that the losses will be
recovered by either increasing the business volume and/or margins from other
customers. It’s like being in an ever-growing tornado. You need business thus
you cut costs down, and now since you have incurred losses you need even more
business.
While the purchasing department was getting ‘better and
better’ at negotiations, small businesses were hurting more and more. Finally,
the entire supplier network was making losses. They could not sustain. The
network collapsed, and so did the big business. In 2008, Circuit City declared
bankruptcy. This example shows how important it is to take care of the
suppliers.
Selecting the lowest bidder may not be doing justice to the
buyer's own business. By going below suppliers’ costs, buyers may be paving the
way to bankruptcy for both, the buyer and the supplier. As a growing
organization, you want your supplier network to be strong too.
Prof. Aumann’s Solution:
Prof. Aumann has done extensive research in the area of
game theory that gave deep insight into conflict and cooperation, through his
work on repeated games, correlated equilibria, and games with incomplete
information. Just to give a glimpse of
his research work, some of his books are listed in references (2), (3), and (4).
While discussing the bidding process and asking Prof.
Aumann’s views, he suggested a solution that certainly makes one think. Prof.
Aumann suggested changing the rules of the game. Discard the rule ‘the lowest
bidder wins.’ Instead, make it ‘the second lowest bidder wins.’ This paradigm
shift is mind-boggling in the beginning. However, when one starts to think from
a supplier’s way of thinking, it slowly becomes clear.
As a supplier in a group of niche suppliers, one is fully
aware of the cost. One knows the profit margins others add. It does not take
much thinking to bid below the cost price. Such a price is often mind-boggling
to competitors. However, the supplier bids it below the cost price since they
are fully aware that once they start the project, cost overruns will also be
approved. There is another possibility. The supplier would provide low-quality
material and by cutting corners manage within the budget. Even this is
unacceptable from the buyer’s viewpoint.
Now let’s think about the paradigm shift. The contract is
to be awarded to the second lowest bidder. In a fair competition, how can one
go about guessing the lowest bid and then further guessing the second lowest?
This forces everyone to quote a realistic price. The only possible difference in
the quote could be due to the type of material used, the quality of the
service, and/or low overheads.
Additionally, as mentioned earlier in the Circuit City
example, one has to maintain a balance between the symbiotic relationship
between suppliers and producers. If one chooses the lowest bidder,
it may be that the supplier is reducing the cost to the bones thereby suppliers’
long-term survival becomes questionable. This also hints buyers to choose the
second lowest bidder.
On the flip side, the buyer has to come up with an
additional amount to cover the difference between the lowest and the second
lowest. If it is worth paying extra to
reduce potential delays or usage of low-quality material or parts, then one
should go for the second lowest bid.
Awwad and Ioannou (5) did a Monte Carlo Simulation of the
lowest bid option vs the second lowest bid.
They concluded that the second lowest bid is a better method for avoiding
cost overruns, project delays, and quality issues.
Awwad and Ioannou (5) also point out the possibility of unethical
practices. A company may pose someone as a dummy lowest bidder and guess the
second lowest bid. However, often those who qualify for the technical round are
invited to the bidding round. This process of elimination, in a way, precludes
the possibility of having some dummy vendor. Why would a technically competent
company not want to get the contract? Let us also consider the worst-case
scenario that there are two companies in cahoots. They switch the role of being
the lowest and the second lowest. Even that is not going to be easy to do since
one still has to make sure that no third company will be in between the two to
snatch the second-lowest slot.
Prof. Aumann explained his thinking in a short time.
However, it took quite a while for me to sync in various issues such as how
difficult it is to guess the second lowest and why the method of choosing the
second lowest bidder is beneficial to buyers’ organizations, etc. I left the
lecture hall in awe of Prof. Aumann. Such
is the effect of being surrounded by a true thinker and a scholar.
References:
1)
Circuit City, Nov. 11, 2008 https://www.reuters.com/article/idUSTRE4A936V/
2)
Aumann, Robert J., Michael Maschler,
and Richard E. Stearns. Repeated games with incomplete information. MIT Press,
1995.
3)
Aumann, Robert J., and Lloyd S.
Shapley. Values of non-atomic games. Princeton University Press, 2015.
4)
Aumann, Robert J. Collected papers.
Vol. 1., Vol. 2, MIT Press, 2000.
5)
Awwad, Rita, and Photios Ioannou.
"The second low bid method." Proceedings of the CIB W78 2012: 29th
International Conference –Beirut, Lebanon, 17-19 October (2017).
