Are Fixed Bids Self-defeating?

In Part One of this series, we said:

Some clients, such as government agencies, are required by statute to solicit fixed bids from vendors. Other organizations require fixed bids as a matter of internal policy….In fixed-bid proposals, the object is to come in with the lowest price.

It is argued that a fixed bid is an excellent method to get the best price.

Is this a specious argument?

If we're talking heating oil, or the price of corn, sugar, salt, or ounces of gold, this might model might have some merit. Granted, no one wants to be gouged, but in things that really matter, are we served in the long run if we settle for the cheapest doctor, the cheapest lawyer, the cheapest apartment,

" Well, this is it, the last bastion of pure capitalism left on Earth. Here in New York, they trade everything -- gold, silver, platinum, heating oil, propane, cocoa and sugar, and, of course, frozen concentrated orange juice. Fear, that's the other guy's problem. Nothing you have ever experienced can prepare you for the unbridled carnage you're about to witness. The Super Bowl, the World Series, they don't know what pressure is. In this building, it's either kill or be killed. You make no friends in the pits, and you take no prisoners. One minute, you're up a half-million dollars in soybeans, and the next, boom, your kids don't go to college, and they've repossessed your Bentley.'" - Lewis Winthrop III, "Trading Places.' "

But it's probably fanciful to think it’s the same thing as asking a consulting firm to set a firm price on the creation of a built-to-order website.

As suggested in the earlier part of this series, the bidder, unless he's a riverboat gambler, will choose a price that in higher than the most likely outcome. A rational manager will likely choose set the bid somewhere between one and two sigma.

FIG. 11 Setting the acceptable risk from ±2 sigma to one in four are better.
Are fixed bids "moral?"

Fixed bids are legal, but what is the subtext? As suggested in the earlier article, capitalism does not necessarily produce an equitable outcome.

Again, drawing from the first part of this series, we said:

Looking at it from the client side, as one wag put it, "so long as it's what I want and I get it on time for a fixed price, I don't care what it costs them to build it."

This of course works both ways.

Looking at it from the developer's side: If the vendor can do it for a song, but charge an arm-and-a-leg, the vendor makes a huge profit and the clients say that they don't care. Or do they?

Yes they do. Most client's would be livid if they paid an arm-and-a-leg for a "song."

In reality, either one party pays for work that was not performed, or the other party performs work that is not paid for.

Worse yet, the bid that the rational manager enters will be higher the most likely outcome.

Assume the following hypothetical:

I want to fly a precious cargo over the Atlantic from New York to London. I only have to pay for the fuel. Knowing the cost of jet fuel on the commodities market, and assuming the planes are identical, do I go with the lowest bid?

Low bid on fuel may mean the whole project sinks; doesn't it make more sense to pay for what was actually used? Wiser, more fair, and in the end, the least costly.

Possibly not. Fuel is fuel, but the rational pilot will take on extra fuel in case of stronger than expected headwinds, possible missed approaches, and time on the taxiway, to mention just a few of the exigencies of air travel.

If I do choose the flight with the emptiest tank and I end up with a premature landing in Shannon, Ireland, do I have a right to scream about it, or do I thank my lucky stars?

Does a prudent pilot put in more fuel to handle possible emergencies? Will that pilot lose out in a fixed bid situation?

Actual cost: the alternative to fixed bid.

In the example of the flight, what if the parties agreed that the price would be only for the actual fuel used?

Interestingly as the graphs in FIG. 11 show, in the long run, the actual price will be lower for actual price than for the fixed bid price.

Stepping back to FIG. 8, this is the probability curve generated based on Project 01, described in our earlier blog. A client who is paying for the actual work could end up with a project to the left of the most likely value on the curve.

However, by asking for a fixed price, the bid tosses out the possibility of these savings because a rational manager will bid based on FIG. 10., and will be under no obligation to pass the savings on to the client.