RFPs and the Dreaded Winner's Curse

Mar 14

A couple of weeks ago I received another email from Chris Forsman, who had alerted me to an article about movie theater popcorn, which I blogged about here.In this new email, he related this fascinating story.

Good Afternoon Ron:I have been fascinated by pricing models for as long as I can remember and as a salesperson, it is my job to "extract" as much money as humanly possible. I remember being in an opportunity once in which we were competing against several firms in which all of our pricing came in at roughly $750,000 for an end-to-end solution. This number was given to us by the prospect as their desired budget and we all had to "massage" our numbers to fall into this price range. How do you pick the winner when everyone has the same price?One competitor, who had several recent wins in this industry priced their solution at $1,200,000. They understood that their references would be stronger and that would somehow show that they had deeper domain knowledge. It would also insulate the executive from making a bad decision since their peers purchased the same solution. Naturally, they chose this higher priced solution.Best regards,Chris

What a great story! The $1.2M firm separated itself from the competition based on value, not price. We always say, high price tempts, and here's even more empirical evidence.This got me thinking about Requests for Proposals. We at VeraSage recommend that you don't do them, because they subsidize dysfunctional buying behavior, often being used as a club to beat up the current provider by customers who have no intention of changing. Or they are used by price sensitive customers you don't want anyway.We also think you should charge for an RFP. Why not? The customers are asking you to compete, which has value in and of itself. If you charged for an RFP, it might actually be a process that had some value, rather than merely reciting deliverables.That said, we realize many PKFs have to do a certain amount of RFPs. If you do, you should be well versed with what economists call the winner's curse.Never forget that your weapon is made by the lowest bidder.—Law Number 20 of Murphy's Laws of CombatIn auction markets, economists refer to the dreaded winner's curse—whereby the winning bidder is often a loser. In other words, the only RFPs sellers will accept are ones you should not make. One of the ways to avoid the winner's curse is to bid more conservatively when there are more bidders. Thomas Nagle and Reed Holden explain why in their seminal book, The Strategy and Tactics of Pricing:

To understand the curse, imagine first that you are one of two bidders and you win a bid with the lower price. You will probably be quite happy. Now imagine that you are one of ten bidders and you believe that your competitors are sophisticated businesspeople who know how to bid a job. Again you win. Are you still happy? What does it mean that you bid below nine other knowledgeable bidders? Perhaps it means that you were willing to take less profit on the job. On the other hand, it could also mean that you underestimated the cost to complete the work.The more bidders there are, the more likely you will lose money on every job you win, even if on average you estimate costs correctly and both you and your competitors set bids that include a reasonable margin of profit. The reason: The bids you win are not a random sample of the bids you make. You are much more likely to win jobs for which you have underestimated your costs and are unlikely to win those for which you have overestimated your cost.The only solution to this is, in effect, to formalize the principle of "selective participation." You do that by adding a "fudge factor" to each bid to reflect an estimate of how much you are likely to have underestimated your costs if you actually win a bid. Needless to say, adding this factor will reduce the number of bids you win, but it will ensure that you won't ultimately regret having won them (Nagle and Holden, 2002: 225).

RFPs have become more commonplace as competitive bidding has replaced negotiation for price buyers. It is as if dysfunctional buying practices have arisen to counter dysfunctional selling practices.It is important to judge the seriousness of potential buyers going out to bid, as a lot of the RFPs are, in reality, nothing but hammers used against existing suppliers to obtain price concessions. Your company should not waste its resources drafting RFPs to anonymous buyers whose criteria for judging your company's offering are not known to you. It is important to have some contact with the economic buyer, that is, the person who can actually make the decision to hire you, rather than just the procurement department. Establishing relationships and having internal advocates in the customer's enterprise also helps to ensure your value is being considered, not just price.In their book Co-opetition, Adam Brandenburger and Barry Nalebuff offer this sage advice with respect to RFPs:

There seems to be a natural impulse to offer competition for free. After all, that is what business people are supposed to do, is it not? You want a bid? I'll give you a bid...The right question to ask is: How important is it to the customer that you bid? If bidding is so important, then you should get compensated for playing the game. If it is not so important, then you are unlikely to get the business and even less likely to make money. You might want to reconsider bidding at all (Brandenburger and Nalebuff, 1996: 84).

Another strategy with responses to RFPs is: No surprises. Your potential customer should know everything in your proposal before you submit it. Gaining an understanding of your customer's expectations, business model—how they make money—and how your company can add value is imperative to increase your odds of a successful proposal, one that will not suffer from the winner's curse. Search for the differences that will ultimately be weighed in selecting a new supplier. If customers are worth bidding on, they are worth spending some resources on in order to improve your chances.Brandenburg and Nalebuff also discuss the following eight hidden costs of bidding (in bold, with commentary added), which are also worth considering:

There are better uses of your time. Keeping current customers happy may be a better strategic advantage as opposed to chasing after other company's customers. Attracting a new customer can cost three to six times more than holding on to an existing one, and the existing one is most likely less price sensitive.
When you win the business, you lose money. A customer won on price alone is signaling they have no loyalty, and will leave you once they find a lower price. Do not fall into the trap of thinking you can start with a low price and raise it later; the evidence is overwhelming this will not work, as once you set a low price you are rewarding the customer for beating you up in price.
The incumbent can retaliate. If this is a good customer, then your win is someone else's loss. If it is a bad customer, then you have already made a mistake. The incumbent supplier is likely to respond, perhaps by targeting one of your good customers. He may not be successful, but he can force a price concession on your part. If he is successful, you both have achieved nothing but turning two high-margin customers into two low-margin customers—a real lose-lose scenario.
Your existing customers will want a better deal. Lowering your prices within RFPs sends a distinct message into the marketplace that will no doubt find its way to your existing customers. Some will believe you've been overcharging them and may leave; others will demand price concessions. Is winning one job worth the risk?
New customers will use the low price as a benchmark. Once again, sending the wrong signal to all potential future customers.
Competitors will also use the low price as a benchmark. Since your competitors can easily discover your RFP price, they will use this as a reference price in future RFPs, most likely resulting in lower priced RFPs in the future amongst all bidders.
It does not help to give your customer's competitors a better cost position. Your future and that of your customer are naturally linked. If your future is tied to Boeing, you do not want to help Airbus get a lower price. Unless you have very good reason to believe that you can get Airbus' business while keeping Boeing's, bidding for Airbus' business is costly. You help your competitor's customer and thereby hurt your own.
Do not destroy your competitor's glass houses. The notion you win if your competition loses is simplistic and potentially dangerous. If you lower your rival's profits, he now has more reason to become aggressive by going after your accounts with abandon, potentially launching a self-destructive price war. In contrast, the more money your competition is making, the more it has at risk from getting into a price war (Ibid: 86-88).

This is where the firm's value proposition becomes a critical differentiator from its competitive bidders. By offering an unconditional money back service guarantee and competing on total quality service, your firm can maintain a premium over the competition.Do not let the proposal be the first time you test your price, as this can result in a waste of resources going after price buyers who have no intention of considering value.Another effective strategy is to offer various value propositions, in the form of differing options, within the proposal, thereby preventing it from becoming merely a one shot, take-it-or-leave-it option. You can even use Chris Marston's concentric circles to help you, not only to scope a job, but to offer different options.Maintaining your pricing integrity on the RFPs you decide to respond to sends an important message within your firm that pricing is a strategic decision—one based on value—and not just a number to be arbitrarily derived in order to make the next sale.Be sure to maintain a mortality log for proposals submitted but not accepted. Perform post-mortems on lost bids and determine the reasons. This will help you focus on value for future RFPs rather than merely cost and price. The better you know the customer and the more thorough you are at ascertaining both their needs and wants, the higher probability you have of securing your share of profitable RFP work.Keep the winner's curse in mind as you prepare to respond to RFPs and be sure the potential customer is serious about doing business with you and not just using your bid as a way to lower their existing price. Some firms have tested this commitment by charging for a proposal and then offering a full credit if the bid is accepted.Utilizing the above advice could help your firm secure a $1.2 million engagement when everyone else's price was $750,000. That's win-win all the way around.