There are a number of reasons why senior executives sometimes act against the medium- to long-term interests of themselves and the company's owners and investors in bidding for the right to manage public services.
Bounded rationality - At one level, this is simply a problem of 'bounded rationality' - company executives are human beings, subject to the limitations of the human condition, and they are often obliged to make decisions with little time, drawing upon limited information.
But there are also cultural and systemic explanations for this behaviour.
The winner's curse - These are procurements where the winner always loses money and/or reputation by bidding too low (or too high, depending on the nature of the tender). While the concept has since been adopted by economists, the 'winner's curse' was identified by a group of engineers in the oil industry in the early 1970s.22 It occurs in particular circumstances - where bidders have incomplete information about the good or service for which they are bidding (and thus its true value), and where there is intense competition based heavily on price. Given the complexity of most human services, and the fluid policy environment within which they are delivered, it is almost inevitable that the first of these conditions will exist in competitive tendering for public services. There is only one way of winning a true 'winner's curse' procurement - not bidding.
Sunk costs - When the timetable for a procurement repeatedly shifts to the right, it may be rational for providers to spend additional money on the bid at each new stage, so they remain in the race. If the company has been down-selected to a short-list of two or three, this will often be a better use of scarce bidding resources than starting again in an entirely new tender. If providers had been aware of the total costs at the outset, they might have decided not to bid, but when additional expenditure is demanded incrementally, it may be quite rational to keep spending.
Lack of understanding - In some cases, new entrants may put forward unsustainable prices simply because of their lack of familiarity with the service in question. In several central government markets in recent years, the most optimistic bids were submitted by new entrants and companies that had few alternatives. Procurement teams should be extremely cautious in such circumstances.
First-mover advantage - Some companies have been prepared to bid low and/or take on unmanageable risks for newly-contracted and little-understood services in an attempt to secure first-mover advantage. The argument is that the low margins or potential losses are an investment in R&D, and that, if it wins, the company will have a competitive edge over later entrants. While this is a rational strategy, it fails when the cost of investment is too high and/or where the market fails to expand as anticipated.
In one large contract (where the successful bidder is now losing money), a senior manager instructed the bid team to reduce their price by 20% because of the supposed opportunities which this contract would open up. I was told that the leader of the bid team was ashen when it was announced that the company had won, because he knew that they did not have a solution at that price. The anticipated market never emerged.
Last-survivor advantage - In a market or a procurement that is rapidly thinning due to declining quality, providers might conclude that the survivors will occupy a favoured position with the customer, or that the market will become an oligopoly (so that the remaining suppliers will be able to demand higher prices once again). This is somewhat like a game of chicken, and those that remain are likely to be those with deep pockets and/or those who are prepared to assume the biggest risks.
In one medium-sized procurement, delay resulted in the three short-listed bidders collectively spending almost as much in bidding as the contract was worth. As the tender dragged on, two of the bidders withdrew. An executive from the third company said that as the final bidder, they expected to demand a higher price.
Relational contracting - For a time, based on previous experience with customers who were more forgiving, companies have been prepared to undertake complex tasks that were not fully understood, on the assumption that adjustments would be made as the circumstances were clarified. In a highly contractual market, this is not sustainable, and the author was provided with several examples of this behaviour in recent years.
The prisoners' dilemma23 - The chief executive of one large provider said that companies had no real alternative except to bid low given the expectation that their competitors would be doing likewise. They took the view that they could build up profitability later. Legal constraints on collusive tendering make it impossible for competitors to signal their true intentions in the process of bidding.
Professional bias - Bid teams are often motived to 'close the deal', without due consideration of the impact on colleagues who will be responsible for operating the contract. While financial incentives may exacerbate this problem, professional culture is usually sufficient to encourage bid teams to behave in this way.
People who view the contract as the conclusion and see themselves as solely responsible for getting there behave very differently from those who see the agreement as just the beginning and believe their role is to ensure that the parties involved actually realize the value they are trying to create.24
Some companies have managed this much better than others. In one large corporation, for example, there is no distinction between sales and operations - the executives who will be responsible for ongoing management prepare the bids.
Bid fever - But even when operational teams are deeply engaged in the procurement, they can become caught up in the excitement of the bid and make poor decisions on price and risk. In one prominent central government contract, where the operational team led the bid, the senior responsible executive admitted that he had become over-enthusiastic about winning.
The term 'bid fever' was coined a decade and a half ago by a senior Treasury official in one of the Australian states, who had been responsible for letting a large public transportation contract. One of the successful bidders, a British transport company, eventually walked away after losing well over a hundred million dollars. A senior executive of that company later explained that the bid team was influenced by a short-term focus within the company on growing revenue - but this perverse incentive had been intensified when the procurement team deliberately fed information back and forwards between shortlisted bidders. The Treasury official later acknowledged that in doing this, they had induced bid fever.
Short-term incentives - A senior executive from a provider which was about to be sold, acknowledged that as the prospect of sale grew closer, aggressive bids were submitted as a way of boosting the forward order book. It was expected that the purchaser could not quantify the risk of low profitability in the course of the due diligence.
Reputational incentives - Where a company has held a high-profile contract for many years, senior executives will not want to lose to their competitors, nor will they want to explain to analysts and investors why they have done so. As one survey participant expressed it: 'It takes a lot of steel to hand back a contract or to walk away from a contract you've already had'.
A senior executive working for a large provider advised the company to hold its nerve when bidding for a set of regional contracts, being tendered nationwide. Both the scale and the scope of services were being significantly expanded, and new entrants were being actively encouraged to enter the market. He had a great deal of experience in the sector, and offered to submit his resignation if the company did not win a significant share of the contracts. In the result, it won only a couple of the contracts, although because the company had bid responsibly, these would subsequently prove to be profitable and perform well. The company accepted the executive's resignation.
Expectations of growth - The remarkable success of the large UK public service providers in recent decades resulted in a several of them joining the FTSE 100 and FTSE 250. Some of these companies found it difficult to manage the expectations of investors and analysts who expected historic growth rates to persist. This placed relentless pressure on senior executives to grow, with companies bidding for large and complex contracts they little understood.
A former senior executive in one large firm said that the pressure for growth meant that the company had to keep moving into new, edgy markets, at a faster rate than could be accommodated. In such contracts, he said, you needed 18 months to understand the service and deliver the promised change, but head office wanted the bid margin immediately.
The chief executive of another major provider said that North American investors in particular had unrealistic expectations about margins and adopted a short-term perspective which were dangerous to the traditional business model of UK public service providers.
The dynamics of bidding in low-price public service markets have not been studied, but it seems likely that companies with less exposure to any single customer, either because of international operations, or because of much greater involvement in the private sector, have been better able to resist the race to the bottom. It follows that the move to centralise government procurement, which has made the market more monopsonistic, has increased the risks to providers.
Where government moves to contract new services, companies which specialise in a narrow range of services (such as facilities management, engineering services and business process outsourcing) may have a better grasp of their limitations, and take fewer risks in an aggressive price-based procurement.