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Total Cost vs. Transformational Bidding Faceoff

Posted by jreeves in Sourcing on Aug 13, 2010 1:02:14 PM

Do you use Transformational Bidding or Total Cost Bidding as part of your bidding strategy?  Do you know the differences between the two?  If not, then hopefully this post will clear up confusion you might have.

 

Total Cost

There are factors other than price which impact how a buyer should award business.  Although an item may cost $2000 to buy, it will cost $3,000 to ship it.  In some cases, some suppliers may charge more for shipping based on where they are located.  In addition, there may be taxes charged for both the shipment and the item.  Alternatively, if a buyer switches from an incumbent to a new supplier, then the buyer may have to incur additional costs such as training on the new item or the cost of updating inventory lists.  In these cases, a buyer should determine what their total cost is before awarding a supplier.  This total cost can be turned into a formula such as: Price * Quantity + Shipping + Taxes + Switching.

 

After the buyer has defined total cost, the buyer can determine what strategy to use for the auction.  The buyer could ask suppliers to send the tax rate and shipping cost prior to the auction.  Alternatively the buyer may want to ask for this information during the auction.  In what circumstances should the buyer do one versus the other?  What information should he reveal to suppliers in the auction?  What if the buyer doesn’t want suppliers to know what he is charging them for a switching cost?  What if the buyer knows the Shipping cost will stay constant?  What if taxes are dependent on the amount of quantity he buys?  What if he doesn’t want suppliers to worry about bidding on shipping costs during the auction?  The answers to these questions determine what type of solution the buyer needs.

 

Transformational Bidding

            First, Transformational Bidding’s definition has been typically overloaded.  Transformational Bidding is not total cost as described above, although sometimes has been referenced as such, but it is solution for solving how to model total cost within an auction.  Transformational Bidding is the act of “transforming” a suppliers bid such that a given supplier will see pricing information relative to their own pricing.  In order to transform a supplier’s bid, the following rule applies:  The supplier can only have one cost variable to bid on (in the Transformational Bidding case it is price) and the rest of the costs must be fixed prior to auction start.  I could go into the theory as to why the costs must be fixed in order to transform bids, but my post is already too long.  This limitation means a buyer can not have negotiable factors in a Transformational bid.  This is important because a supplier will not able to adjust their costs during an auction even if they were willing to do reduce them in order to win the business.  A subtle, but important, rule is all costs affecting the rank are supplier specific.  A cost which is the same for all suppliers won’t affect the outcome of the event and need only be entered if this information were being tracked.

            The benefit of Transformational Bidding is the suppliers only need to worry about price.  They do not have to adjust any of the costs during the auction, because they can’t.  In turn this can speed up the supplier decision making and thus speed up how fast the auction runs for.  Another benefit is the ability to mask the impact of the costs from the suppliers.  Because the supplier can only see other suppliers’ prices, they are unable to determine how much of a penalty they are receiving.  If one decides not to reveal supplier bids or the lead bid, then the only thing which is exposed is rank.  This leads us to the blurry line between Total Cost Bidding and Transformational Bidding.

Total Cost Bidding

             Total Cost Bidding is different from Transformational Bidding because it doesn’t have the limitations of collecting costs prior to auction, however one still has this option.  This means a buyer can collect costs and enter in these costs per supplier prior to the auction exactly like Transformational Bidding.  However during a Total Cost Bidding auction the supplier will not see other bids transformed and the supplier can either see the raw total cost of the other bids (or it could be just the lead bid), the raw total cost of their own bid, or their own rank.  Transformational Bidding and Total Cost Bidding are exactly the same in this last case where suppliers can only see their own rank and, more importantly, when there are only supplier-specific costs collected prior to the auction.  Thus at the very essence, where the least amount of information is revealed, these two bidding formats behave in the exact same manner!

            In addition to collecting costs during a Total Cost Bidding auction there are other flexibilities on ranking of bids and revealing of market information.  One option is to rank bids by price, but still collect and calculate total cost for the buyer.  This means a supplier could potentially supply answers to cost terms in a pre-bid (or during the auction), but the supplier would solely compete on price. Thus their ranking would not be impacted by changing their answers to questions which impact the total cost.  The second option is to reveal the raw total cost of their bid and their rank.  This exposes how much of a penalty a supplier gets.  If there are many factors, then this will make it hard to determine how big of an impact it is to change any given factor.  Side Note:  By revealing a supplier’s own total cost before submitting their bid, this gives the supplier the ability to change costs to figure out which ones have the most impact.  In some cases, buyers want to reveal more information about the total cost equation they are using.  Therefore the third option is to expose the “components” of the total cost formula.  With these options, one has the ability to also expose the lead bid as well as other supplier bids.  Thus one can make the Total Cost auction completely “open”.  Revealing this information could have the added benefit to drive their overall cost to the buyer down.  This would require upfront work by the suppliers for them to determine what negotiable costs they could lower.

How is Transformational Bidding done?

Assume Supplier A and B placed bids for the price at $100.  Also assume the buyer collected shipping costs before the auction began and the values for Supplier A are $10 and for Supplier B they are $0.  Thus

Total Cost = Price + Shipping

Supplier A’s Total Cost = $110

Supplier B’s Total Cost = $100

Now if Supplier A is able to see Supplier B’s bid during Transformational Bidding, Supplier A will end up seeing a price of $90 for Supplier B.   Supplier A must improve their overall Total Cost by $10.   If Supplier B saw Supplier A’s total cost, then what would it be?  It would be $110.

Transformational Bidding

Cons:

1)     Negotiable factors that impact rank can not be included other than price during the auction

2)     Information must be collected prior to the auction and entered in manually into the auction

3)     Limited to simple formulas.

4)     Doesn’t make sense to reveal total cost equation to suppliers, nor can you.

 

Benefits:

1)     Supplier is able to solely focus on price

2)     Theoretically speeds up how fast the auction runs.

3)  Buyers can mask the total cost from their suppliers more thoroughly when information other than rank is revealed.

Total Cost Bidding

Cons:

1)     Revealing Total Cost to suppliers may reveal too much information

2)     Adding too many factors can increase the auction time

 

Benefits:

1)     Ability to reveal actual formula to supplier

2)     Suppliers can optionally enter in costs which impact rank or total cost

3)     More information release options, rank on cost, compete on price.

               a. Reveal rank only, compete on cost

               b. Reveal rank only, but compete on price

               c. Reveal Rank and own total cost

               d. Reveal Rank, own total cost, and Total Cost Formula

 

Which one is better?

            Until there is more conclusive information, there is no way to say which one is better.  However, there are some clear choices based on requirements you may have.  If all of the following are true, then Transformational Bidding must be used:

1)     Must expose more information to suppliers other than rank

2)     Can’t expose the raw total cost to suppliers because it has sensitive information in it

3)     Can’t use scoring to hide raw total costs values because it could reveal penalty information

 

If any of the following is true, then Total Cost Bidding must be used:

1)     Must reveal total cost to suppliers

2)     Suppliers must be able to change costs during the auction

 

Do you use Transformational or Total Cost Bidding?  Let us know if this information was valuable or not.

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