The Cost of the Bad Procurement Process [Part 1]
Competitive bidding requires better procurement management.
The use of competitive bidding remains an established procurement management practice.
30-60% of market approach strategies in private companies and up to 90% in public ones involve the RFP process. Any spending above the minimum threshold in many firms involves at least three quotations.
This happens despite the well-known Kraljic matrix recommendation to exercise competitive bidding selectively, e.g., for leverage items.
Let's see how the unconscious following of the corporate procedure may defeat its good purpose and become an example of bad procurement practice.
The transactional cost of the procurement process
The list of suppliers invited for an RFP should be extensive enough to ensure competition but not overly numerous due to transactional costs associated with the tender process.
Typically, the cost of a sourcing process includes
- business case preparation (there shouldn't be any RFP without a budget and business benefits);
- RFP drafting (business, technical, commercial, financial, legal aspects);
- market research to identify potential products/solutions and capable suppliers;
- RFP distribution in the market;
- communications with vendors;
- bid collection, analysis, and evaluation;
- negotiations and contract award.
This table represents a cost estimate of a simple RFP (e.g., with no trials/prototypes, site visits, and the boiler-plate contract requiring minimum drafting.)
At the hourly cost of $36 (an equivalent of $100k per annum,) this model returns the transactional cost of around $6k for the 3-vendor RFP. Each extra vendor adds around $1k.
This estimate doesn't include the "lost opportunity" cost of 115 hours because all stakeholders have been distracted from carrying out their primary duties.
For smaller RFPs with a value of around $100-200k and estimated savings of 3-5%, the transactional cost isn't likely to justify the potential benefits of competitive bidding.
Adding more vendors would raise the minimum reasonable RFP value even higher.
The mathematical model of the procurement process: the economical tender quantity (ETQ) model
The scientific approach to the intuitive problem specified above would employ the ETQ model, which identifies the minimum quantity of suppliers to invite depending on the tender value and price variability.
You may refer to the document linked above to witness the complexity of ETQ computations.
We will only quote the easiest case with uniformly distributed bids:
This simple formula suggests that you must consider both the tendering cost and the spread between the lowest and highest bids to evaluate the optimum number of bidders.
E.g., in our earlier case, any RFP with the spread of bids of $36k or less doesn't make any economic sense.
You may add extra vendor cost and the "lost opportunity" cost to your calculations.
The vendor's cost of procurement process governance
In our earlier considerations, we only looked at the competitive bidding from the budget owner's perspective.
Let's not forget another critical actor in the process - the vendor!
By following this link, you may download the phenomenal research by the University of Reading on the bidder's view of UK construction tenders.
Just a few highlights:
- It takes 483 hours on average to prepare the winning bid instead of 332 hours for losing ones. You have to work 150% compared to others to succeed, which makes the great law of life overall.
- Winning suppliers spend more resources on relationship building and business analysis, making decisions to bid (and not to), managing the bid, and reviewing and learning post-mortem.
- The bidding cost could be as high as 1.2% of the smaller-value project. That indicator, plus the tendering cost and timing advantage, could be the value at stake for teaming up with the strategic partner. We're talking 2-3% savings plus 8-12 weeks of early revenue on smaller projects!
- Most suppliers spend 2-3% of revenue on bidding. Isn't this something that you may negotiate with your strategic partners upfront upon the reasonable decision of not going for an RFP?
Of course, this study applies to the construction sector but won't we take some generic conclusions from it?
Select your procurement process wisely.
This small piece of research isn't meant to discourage you from the competitive procurement process.
It is only supposed to call for a conscious and weighted decision to tender instead of applying the carpet-bombing principle to most of your sourcing projects.
P.S. If you appreciate hundreds of hours invested in researching and writing this blog, you can buy me a coffee or subscribe for the membership by following this link. Thank you!
More information on this and other exciting topics can be found in "The Technology Procurement Handbook." It represents 23 years of experience, billions of dollars worth of successful sourcing projects, and 1000s of hours spent on research, analysis, and content creation for the most demanding professional readers.
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