‘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).