Markup Bid Pricing for Net Worth Maximisation and Target Profits
| Date | 01 May 1986 |
| Pages | 5-11 |
| DOI | https://doi.org/10.1108/eb057439 |
| Published date | 01 May 1986 |
| Author | Evan J. Douglas |
| Subject Matter | Economics,Information & knowledge management,Management science & operations |
Markup Bid
Pricing for
Net Worth
Maximisation
and Target Profits
by Evan J. Douglas
Economics Department, Bentley College,
Waltham, Massachusetts
Introduction
Competitive bidding, or choosing the level of a price quote
in a market situation where a single buyer wants a particular
product or service, is one of the more challenging decisions
confronting the practising manager. The manager will not
typically know the prices quoted by other suppliers, if in-
deed the potential buyer has consulted any. Moreover, the
manager is typically subject to uncertainty on the cost side,
since the product or service to be provided may be unique,
or, at least, may be quite different from recent production
experience.
Bidding (or price quote) markets are not confined to
con-
struction and defence procurement, although they are
predominant in these areas. Repair services for cars,
household amenities and appliances, are typically bidding
markets. Professional services of dentists, lawyers, medical
doctors, government and business consultants, and so on,
are also offered on this basis. In each case, the potential
supplier must select a bid price, or pricing structure, that
covers the range of services potentially required, and allow
the buyer to choose among several potential suppliers on
the basis of both price and perceived quality of the supplier's
product. If the manager selects a price that is too
high,
the
business goes elsewhere, while a price that is too low will
get the job, but it will be less profitable than it might have
been.
There are essentially three types of competitive bids or price
quotes. Fixed price bids are characterised by the a priori
determination of price, regardless of variations in the final
cost of completing the contract. In these markets, the sup-
plier undertakes the entire risk of cost variation, so it is most
commonly found in markets where cost over-runs are not
likely to be a major problem. Cost-plus-markup bids are
characterised by a posteriori determination of the price,
depending on what the work actually costs to perform.
Repair work is typically undertaken on this basis, and the
buyer assumes the entire risk of cost variation. The middle
ground is incentive (or risk-sharing) bids, whereby any cost
over-run or under-run (from the initial estimate of costs) is
shared between the buyer and supplier in a predetermined
ratio.
Bidding for defence contracts in the United States is
now done primarily in this mode.
In this article, the "Expected Present Value" (EPV) model
of competitive bidding is summarised, and its implications
for practical application are examined. In practice, firms lack
the information necessary to apply the EPV model, and in-
formation search costs are typically prohibitive. Instead,
firms tend to arrive at the price decision by applying a
markup to some measure of costs. The EPV model offers
profound guidelines for markup pricing, suggesting a
markup pricing procedure that will serve to maximise the
firm's net worth over its planning horizon. The markup model
is then extended to cover the case of the "satisficing" firm
that pursues a profit target.
Discussion is confined here to the case of fixed price bids,
although the analysis can be extended to the other bid types.
This serves to simplify the discussion, since we can abstract
away from the risk of cost variation from estimated levels,
as well as the relative attitudes of buyer and seller towards
the risk of cost variation.
The Expected Present Value Model
of Competitive Bidding
This model assumes that the supplier has undertaken in-
formation search activity and has derived its best estimates
of all foreseeable costs and revenues associated with the
contract which is up for tender. The firm has also estimated
the probabilities of winning the contract (success prob-
abilities) associated with each of several potential price
levels. The firm's objective is assumed to be the maximis-
ation of its net worth in expected present value terms.
Expected value analysis is necessary since it faces uncer-
tainty, and present value analysis is required if the costs and
revenues associated with the contract extend into the future.
The firm is risk neutral for any one contract, since it tenders
many bids and can let the law of averages work in its favour.
Given these assumptions, the decision rule is to select the
price level that promises the greatest Expected Present Value
of Contribution (EPVC) to overheads and profits. For more
detail,
see Freidman[1], King[2], Livesey[3] and Douglas[4].
Contribution is, of course, the difference between incremen-
tal revenues and incremental costs, or the incremental net
cash flow arising from the pricing decision. Incremental net
cash flows may be either explicit or implicit, and occur in
either the present or in future periods. Incremental revenues
will include the bid price, received either in the present or
in a future period, as well as incremental goodwill and op-
portunity revenues. Incremental goodwill is the EPVC of
future business that is expected to be gained as a conse-
quence of this current decision. Opportunity revenues are
costs that will be avoided if this contract is won, such as
lay-off costs. Incremental costs will include materials, labour
and expenditures on new equipment, ill will generated (the
EPVC of future business lost as a result of the current dec-
ision) and opportunity costs (the contribution forgone as
a result of this decision). Other future costs may be fore-
seen,
such as potential labour strife or legal action. The
value of the decision to the firm is its EPVC; choosing the
bid price that maximises the EPVC of the decision thus max-
imises the value (or net worth) of the
firm.
IMDS • MAY/JUNE • 1986 5
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