Dear procurement team,
I thought I’d write to give some feedback on your latest tender, specifically about your choice of price change mechanism. Why, oh why, did you chose to apply the % change in the CPI to the total price? Couldn't you see how this would impact on how we would calculate the price to tender? Especially so given that our cost to supply comprises a diverse range of elements, such as labour, vehicle maintenance, fuel and direct overheads.
Now then, our good reputation and quality service, ensures we receive quite a few invitations to tender (ITT). At the time of your invitation we had another two, all with an initial duration of seven-years. However, we didn’t have sufficient capacity to give each the same time and attention, which meant we had to prioritise. To do this we assessed the likely impact of each tender’s price change mechanism over the seven-year duration. Each ITT used a different approach, they were:
1. Negotiate once every 12-months
2. Once every 12-months apply the % change, over the previous 12-months, in the CPI to our total cost to supply
3. Once every 12-months apply the % change, over the previous 12-months, in indices relevant to each element of our cost to supply
Can you guess which tender we gave top priority and ultimately our best price? Unfortunately it wasn’t yours, it was the tender with the last of the above price change mechanisms. We did this because;it allows the price we invoice over the seven-year term to change in a way that closely mirrors changes in our cost to supply. This reduces profit uncertainty more than the other mechanisms, or rather it gives us greater profit certainty. This reduced our need to include risk premiums to self-insure against profit uncertainty, which also gave us more confidence to tender a keener price.
When we receive invitations to tender the first thing we do is asses the amount of inherent uncertainty. Why? Because our cost to supply comprises a variety of different elements, each of which has a cost that changes at a different rate. For example, changes to the cost of fuel can differ quite markedly relative to the cost of labour or overheads or vehicle maintenance. In this context your one-size-fits-all price change mechanism increased rather than minimised uncertainty, which gave us no choice but to self insure against this higher uncertainty, with more and higher risk premiums, and ultimately a much higher price, or we could have declined to tender.
Despite the third price change mechanism giving us greater profit certainty, it didn’t eliminate uncertainty entirely, which is why we had to include risk premiums that self insure against:
Relevance - more accurately the lack of relevance, despite the buyer having paired each cost element with an index that was as directly relevant as it could have been. Therefore, the uncertainty we need to self insure against here is the difference between the % change in the paired index relative to what we will pay. For some cost elements there is a degree of cost certainty through our contracts with suppliers and labour agreements, but uncertainty remains in the differences between expected and actual change. Therefore, we base our risk premiums on informed forecasting or estimating, what members of the public would quite rightly describe as guessing.
Timing- how much time will elapse from when we calculate prices to tender, to when we start supplying services, to when we calculate the first price change, to when we apply (invoice) the new price? For us it can be anywhere between 19 and 22 months, although 24 months is the longest we have experienced. We had to estimate/forecast, guess, how much our cost to supply would change over this time period and factor this and the impact of the price change mechanism into our calculation of the price to tender. Even so, come the end of the contract, we’re still likely to be up to 12 months behind.
Volatility - can you understand how difficult it is to estimate/forecast, up to 20 plus months, likely changes in cost elements that often experience volatility, such as fuel. To provide certainty about this uncertainty, and have a positive impact on prices, we'd suggest using time bound thresholds. For example, if the cost of fuel changes by more than 5% over a three-month period it triggers an immediate price change.
Gaming- don’t try to game price change mechanisms in your favour. There are plenty of tenders with indices that are not the most relevant, simply because buyers anticipate they will gain, at our expense. We not only recognise when this is going on, we also include risk premiums to self insure against future uncertainty, the end result being higher prices and the potential for exploitative behaviour.
Price-cost correlation- a few cost elements within our cost to supply, such as software, are not particularly closely correlated to the price we tendered. Price mechanisms with multiple indices are most effective/attractive when our cost to supply and the price we tendered are closely correlated.
What you, as a buyer, see as perfectly reasonable, we may consider extremely risky. Don’t hesitate to ask for our opinion. We and other potential suppliers are unlikely to be backwards about coming forwards. Ultimately this will give you sensible options to choose from. If you devise a price change mechanism that enables us to mirror changes in our cost to supply in the price we invoice, that is we are confident of profit certainty, then we’ll tender our best price. However, try to game us or ignore how we perceive changes to our cost to supply then we’ll tender prices which include best guess risk premiums that self insure us against future uncertainty.
Your very concerned supplier
PS - thanks for your business
PPS - are your back teeth still there, we’re making a mint from our risk premiums