Why the Price Might be Too Good

May 6th, 2010 at 01:40pm TPI

by Dr. David Howie, Director, TPI

Winning bidders in auctions often experience buyer’s remorse, a gnawing sense that they have paid too much for something that they don’t need and perhaps no longer want. Something similar can happen in reverse when a client selects the cheapest service provider in a competitive tender for outsourced services. For example, in today’s tough conditions, many clients are anxious to strike deals that shift fixed components of their cost base onto the provider. But this can exert colossal pressures on the provider’s operating model if the services are not fairly priced and consumption falls.

Buyers typically – and often with justification – worry that the deal will come to strongly favour the provider. Here are the TPI Top 5 reasons why the opposite might be the case:

1. The service provider doesn’t understand the requirement. Buyer’s remorse is often accompanied by a feeling of embarrassment where the buyer thinks, “the other bidders must know something I don’t.” Likewise, a suspiciously low bid might indicate the provider misunderstood the scope of services or the level to which they were to be performed. Service levels can be a culprit here, as small changes in requirements can result in step-changes in cost.

2. The provider underestimates the transition and transformation effort. This is a subset of the first category, but worth mentioning separately because it is so common. Many service providers understand their own cost bases well, yet believe their products, systems and processes to be broadly standardized when, in fact, significant effort is required to adapt them to client processes and systems.

3. The provider is “buying the business.” A service provider might offer an attractive price in order to acquire a capability and client base in an attractive business area. This is rarely to both parties’ advantage and often ends badly if the provider’s expansion plans don’t result in the expected revenues. Similarly, changes in the provider’s management or business direction (or both) will lead to suboptimal behaviours that are typically focused on the provider’s profit and loss rather than service to the client.

4. The provider relies on leveraging the transferred assets. Perhaps the provider wants to subsidize the cost of, say, a data centre in anticipation of winning additional business that can be serviced from the same location. As above, this can benefit both parties, particularly if both recognise it as a fundamental part of the solution. The risk in this approach, however, can be costly if the new business doesn’t materialise or is delayed, or it if can only be won if the pricing assumes yet more growth.

5. Corporate activity. A client was able to extract a low bid from a service provider who had already announced to the market a strategy dependent on winning the business. As with any price reduction that is unrelated to a corresponding reduction in cost, clients should be wary of such an approach, as the provider’s rationale will soon be forgotten once the margins are being reported.

The lowest bid can easily turn out to be the most expensive. At best, the relationship will be strained and the service provider will try to recover costs through a self-serving reading of the contractual obligations; at worst the client might find itself depending on a bankrupt provider.

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Entry Filed under: Outsourcing, Reverse Auctions, Supplier Performance, Supply Management Best Practices, Technology / SaaS