On a call with a client today, they asked me how a “lump sum” bid is different from a “unit price” bid. This led to a larger discussion about risk vs. cost in a supply chain and this client team said to me, “You should write an article about this topic.” So here we are, with this article jumping in line ahead of all my other planned topics. You see, lump sum and unit price bids are like airlines. A lump sum bid is like United Airlines. And a unit price bid is like Frontier Airlines. Read on for a discussion of why, how to e-auction different capital project bid types, and how different bid structures fit into the Great Tradeoff in supply chain: risk vs. cost.
There are a variety of ways to structure a bid (or Request for Proposal/RFP), and today we’re going to focus on ways to structure bids for capital projects. I’m also going to attempt to extend the “capital bid types as different airlines,” but as you’ll see that is going to break down rapidly. We will cover five capital project bid types: lump sum, unit price, time and materials (T&M), cost-plus, and not-to-exceed or guaranteed maximum price.
Lump Sum
A lump sum bid is when the supplier is asked for a single price to provide a stated scope of work. To truly be a lump sum bid, there should be a purchase order (possibly a blanket order with milestone payments) and some sort of contract stating only the lump sum price to accomplish all work required. By the time a price is on a purchase order or contract, it should also include all selected options and adders proposed earlier in the bid process. This might involve extra cleanup or additional work that could have been performed by another supplier, in-house, or skipped entirely.
In an e-auction, a lump sum bid would be structured as just one number for the suppliers to enter and is the simplest for a procurement team to run and manage. A lump sum bid also adapts well to multiple e-auction formats, including English/Dynamic, Dutch, Japanese, or a variety of the other options available.
In a lump sum bid, the supplier carries nearly 100% of the risk and also then takes almost all of the reward if that risk pays off. Depending on your business and how you structure the bid, you can even forbid change orders and truly put all of the risk from the bid on the supplier. In the great supply chain exchange, this often makes a lump sum the most costly option because it always costs more to have the other party carry more risk.
In the airline metaphor, a lump sum bid is United Airlines or maybe more Southwest Airlines before they started charging for checked bags. You pay for your ticket to get from one place to another and everything you need to get there is included: your snack, your fare, your carry-on bags. Once you’ve paid your price, you’re done unless you want to buy an alcoholic beverage or something else above and beyond (which would have been included if your “scope of work” called for first class seats).
Unit Price
The unit price bid structure means setting a price for each completed unit in a project. For a utility, this might be a price per pole installed. For a landscaping contract, this might be a cost per plant. Unit price contracts are the most similar to part contracts from manufacturing (“I need 5,000 widgets per year and I’ll pay $5.00 per widget”) and are structured to charge for exactly the work that is completed. These contracts are where efficient suppliers can shine because they can complete more work in less time and for less cost per completed unit than less experienced or less efficient suppliers.
To e-auction a unit price contract, you must have estimated quantities. Each component of the project may vary widely (installing a 30-foot/9.1-meter utility pole vs. installing a 70-foot/21.3-meter utility pole) and will also vary in cost. Savvy suppliers will decrease their costs for lower volume units and increase their costs for higher volume units unless there is some way to include the true total costs for the project with estimated volumes. The key to a good e-auction is getting to a bottom-line number so supplier results have equal comparisons. This kind of bid is probably better suited to an English or Dynamic auction because it’s hard to enter multiple lines into a Dutch or Japanese auction with most e-auction tools (though definitely not impossible).
A unit price bid structure puts most of the risk on the buyer, so it is often used when cost is a strong consideration. The issue with carrying all of the risk is the buyer needs to find a way to audit or check the supplier’s work to avoid error or unscrupulous behavior. When I have a project manager who bids projects with unit prices, I always advise them to appear on the job site periodically, without warning, to watch the work and otherwise check on the supplier. An advantage to the unit price bid is that the supplier is paid for their results. The supplier does carry some risk such as not being able to charge the buyer if they encounter an unexpected obstacle (such as encountering rock while digging a hole) that causes them to take longer than they estimated to complete the work.
In the airline metaphor, the unit price bid structure is Frontier Airlines or another discount airline. Frontier will sell you your fare from one place to another, but then charge for your seat location (or to assign you one at all), your baggage including carry-ons, to talk to a person at a help desk, your snack, and a myriad of other things. If you are a person who flies with little baggage and can manage yourself without help, this can be a low-cost option. But if you need more support, it’s probably not a great choice.
Time and Materials (or Time and Equipment)
A Time and Materials (T&M) or Time and Equipment (T&E) bid structure means paying the supplier for the labor hours used on the project, the equipment needed to build, and the materials used in construction. Many suppliers prefer this structure because it more closely reflects their own costs to build the project and matches how they calculate their expenses. Any changes or extra requests can simply be folded into the project on the fly as the supplier can charge for those added hours as needed. The T&M structure gives the most flexibility for both parties, which can be good or bad because flexibility means costs can more quickly spiral out of control.
Similarly to the unit price structure, a T&M bid must have estimated quantities or at least weights to quantities. This might mean you expect a supervisor for 10 hours per week, an apprentice for 45 hours per week, and a full electrician for 35 hours per week. Or if you did this as weights, it would be 10% supervisor, 50% apprentice, and 40% electrician. Adding up all hourly rates (with equal quantities or weighting) on a T&M contract for comparing bids will result in very expensive apprentices and very inexpensive supervisors (or whatever the job titles are). Suppliers know which positions will be used most and will ensure those positions have the largest profit margins. Quantities can be tricky to calculate, but are almost always worth it.
The risk profile for a T&M structure is more shared than most people realize. While it seems the supplier doesn’t carry much risk because they are charging for actual work, a T&M project can quickly consume unexpected resources without any checks or balances on scope creep. This becomes an opportunity cost for the supplier because they cannot use those resources on other jobs or for other customers.
In the airline metaphor, the T&M bid is probably private jets. When a company has a private jet, they pay the pilot(s) for the hours flying or have one on staff, and they also pay maintenance on the jet. When a company owns a private jet, they’re likely to use that jet more than if they have their executives fly commercial or contract private flights. This is where my airline metaphor is starting to break down.
Cost Plus
The cost plus model is similar to the T&M model in that it pays a supplier based on their actual costs, but requires more transparency and trust. Rather than the supplier setting their prices for certain items with some items having more of a markup than others, the cost plus structure sets the supplier’s profit margins evenly. An example is if a supplier has to pay an apprentice $20/hour and then has another $8 in overhead costs for that apprentice. If the contract allows for a 10% profit margin, the supplier would charge $30.80 per hour for that apprentice’s work. In addition, they would “open their books” to the buyer to show their costs and that the profit margin is justified, which is where the trust comes in. True cost plus relationships are fairly rare because of this level of transparency, but can be useful when a supplier and buyer relationship is strong, when the supplier has extremely high uncertainty, or when market costs are fluctuating rapidly.
Running an e-auction for the cost plus model is difficult, although not impossible. My best advice for doing so is to set a “likely” cost for the supplier and then have each supplier bid their profit margins. In most e-auction tools, this means setting the “quantity” as the expected supplier cost and then having suppliers bid the profit margin as a decimal. For example, in a $1,000,000 capital project, the buyer might estimate the supplier cost as $900,000. They would enter 900,000 as the quantity in the e-auction and then the supplier would bid their 10% profit margin as 0.10. The e-auction would then show $90,000 as the supplier bid, which represents their profit. In auctioning this model, consider letting the supplier enter more decimal places to allow for nuances (such as 10.25%) and be thoughtful about your bid decrement (the amount by which a supplier has to improve their bid in order to bid again). There is more information on bid decrements and other e-auction parameters in my book.
The cost plus bid structure puts almost all risk on the buyer, because it guarantees the supplier their profit margin based on their actual costs. I say almost all risk because the supplier takes a risk by opening up their books and putting that much trust in the buyer.
I cannot come up with a good airline metaphor for the cost plus model. Perhaps if you charter an entire plane, such as for a sports team, that ends up looking like a cost plus model, or perhaps it’s more of a not-to-exceed…
Not-to-exceed or Guaranteed Maximum Price
A not-to-exceed bid structure, also known as a guaranteed maximum price (GMP) structure is a hybrid between lump sum and T&M or unit price. The not-to-exceed structure charges for actual costs on either an hourly or unit basis, but then has a cap on the total project. The cap can mitigate the potential “runaway” nature of the T&M structure as it motivates both parties to not simply add on a bunch of extra work without thoughtful approvals. The not-to-exceed structure also helps the buyer hold the work to a budget and increases certainty.
An e-auction for not-to-exceed should be similar to a lump sum bid. While it is possible to pay less than the not-to-exceed price, the tendency for both supplier and project manager is to simply keep doing work until the not-to-exceed price is reached. Therefore, functionally, the not-to-exceed and lump sum bids are mostly the same for procurement purposes.
In a not-to-exceed bid, the supplier actually takes on slightly more risk than with a lump sum bid. This is because with a lump sum bid, if the supplier manages to finish more quickly or with less work than expected, they keep the extra payment. With a not-to-exceed bid, the supplier still carries all of the risk like in a lump sum project, but doesn’t benefit from that risk as a reward if a project goes well. I see the not-to-exceed model fairly frequently, but I think suppliers should be very careful about agreeing to this model over a lump sum.
I cannot come up with a good metaphor for airlines with the not-to-exceed bids structure. It sure would make a very interesting model, however. If this plane flies on time, pays no late fees to the aviation administration, manages to fill every seat, and sells out its cargo hold, the passengers pay less than their original expected estimate (the “not-to-exceed”). Airlines would lose money often in this model unless their not-to-exceed prices were astronomically expensive or they got to the point where they were much more consistent and efficient. It might be an interesting motivator for airlines and cause consumers to choose airlines based on efficiency more. It’s an interesting thought experiment.
Airlines are not a perfect metaphor for capital project bid structures. But they’re something most of us experience and it can be helpful to frame up how we think about bids. Bid structure is a collaborative activity between the procurement and project management teams, and a strong partnership between those teams can lead to good understanding of the risks, rewards, and options for different bids. If you would like to talk about your capital project bid structure and how to e-auction anything specific, let’s chat. If you’d like to get these articles weekly straight to your inbox and never miss one, sign up for my newsletter.
My book, Transform Procurement: The Value of E-auctions is now available in ebook and paperback formats: https://www.amazon.com/dp/B0F79T6F25
