Potential suppliers hide risk premiums in prices to self-insure against adverse financial impacts. Predominately because of uncertainties they perceive in your invitation to tender. However, it’s not all on you, potential suppliers also use risk premiums to self-insure against their own inability or unwillingness to calculate accurate prices.
It’s at this point you might suggest surely buyers can banish uncertainty and invite only those potential suppliers capable and willing to expend sufficient time, expertise and resource to calculate accurate prices. Now that would be the ideal, as potential suppliers would then feel sufficiently confident to tender a risk premium free price. In simple terms this would be their actual net cost to supply plus a ‘reasonable’ profit.
I think this is a sensible position for further discussion. That's because it does, from a practical and realistic point of view, pose some major issues. However, it also provides us with a way forward. Let’s look at the major issues first, they include:
- Uncertainty - it’s pretty much impossible for potential suppliers to perceive a tender as being free of all uncertainty, no matter how well you think you’ve done. That’s because of the influence of context and subjectivity on perceptions. For example, the best suppliers are likely to be more risk averse having less need to stick their necks out to win business.
- Just-in-case - potential suppliers include just-in-case risk premiums for many reasons, such as self-insuring against you being a ‘difficult’ customer, or because they're indifferent about winning your business; so they simply ‘up’ their price ‘just-in-case’ they do win your business.
- Profit expectations - the profit expectations of potential suppliers often exceed, by a considerable margin, the ‘reasonable’ profit that they think a buyer would accept. So they tender an explicit ‘reasonable’ profit and then hide profit risk premiums to self insure against the remainder. I’ve seen this happen many times when it concerns the public sector, which tends to be irrationally overly sensitive to profit margins often at the expense of the total amount they end up paying
- Accuracy - potential suppliers regularly use risk premiums to self-insure against their inability or unwillingness to expend sufficient time, expertise and resource to calculate accurate prices. They do this using 'rules of thumb’ they derive from their own and their industry’s experiential learning.
- New entrants - start ups or potential suppliers expanding into new areas may use risk premiums to self insure against their relative lack of experience and perhaps capability.
This provides insight into why potential suppliers use risk premiums. Although it’s worth pointing out that the inclusion of risk premiums is often so ingrained, it’s now simply a way of doing business rather than a conscious deliberate act to calculate and hide risk premiums. To find out what risk premiums look like it helps to start with the main elements that make up a price. They include:
- Cost to supply
- Indirect overheads
- Direct overheads
- Direct cost
- % profit margin (explicit)
Risk premiums are likely in all the above elements that comprise a ‘cost to supply’. This shows that risk premiums are plus a % profit, yes that’s right they generate additional profit as £s, not as an explicit increase in the % profit margin. In more detail ….
- Indirect overheads - the allocation of indirect overheads to specific functions is an estimate, more of a guess, educated? perhaps, but potential suppliers use the same approach to allocate overheads to specific contracts. In this context, when you guess, you’re likely to err on the side of caution and as such your guess is almost always likely to be on the ‘high’ side rather than being an accurate proportional allocation. This is why I’d bet good money that, for some potential suppliers, the sum of all indirect-overheads they allocate to current contracts would exceed the total of their actual overheads.
- Direct overheads - commonly the cost of administering the contract and managing/influencing performance. What potential suppliers include depends largely on the service and their approach. It’s more common for the cost of labour to predominate, although there are circumstances when the cost of other elements exceeds this, such as office leases, capital equipment etc. There are many approaches for potential suppliers to use to include or create risk premiums, such as paying lower salaries than tendered which also lowers on-costs £s, squeezing a better deal out of suppliers because they’ve now won the contract, pricing training as though from sub-contractor but then provide it using internal resource (indirect overheads) and likely duplication between indirect and direct overheads.
- Direct cost (fixed)- again depends on what is being bought, but in general terms labour on-costs are a great area to hide risk premiums. For example, suppose a potential supplier tenders £600/employee/year to provide training for 90 employees, a total of £54,000/year, over five-years this is £270,000. Now suppose the successful supplier decides to provide this with internal resource, already accounted for within indirect and/or direct overheads. The £270,000 total, minus some expenses, changes from cost to profit. That’s a particularly generous ‘risk premium’. Other cost elements with potential for risk premiums include tendering lower productivity than capable of achieving, not including retrospective rebates and increasing purchasing power (adding new contract spend to current contracts) for specific items, such as consumables, equipment and specialist services.
- Direct cost (variable)- generally managed by a schedule of rates, with links to productivity, so some of the above applies but it’s more challenging to audit. There can be time pressure and available capacity issues, although this does depend on the degree to which supply is reactive and relevant notice periods, which the successful supplier can emphasise and then suggest substituting additional resource at a higher price to complete the work on time. This is where buyers can fall foul of the extras racket, with higher prices than given in the schedule of rates.
For high spend contracts it doesn’t take much, a percentage point or two here and there, for the successful supplier to boost their profits, and even more so if perceived uncertainties don’t have an adverse financial impact or they have less of a financial impact than original expectations.
Just a quick note - I’ve been using the term ‘potential suppliers’ rather than suppliers. Why? To reinforce the point that risk premiums originate in tenders, that is when those who return tenders are potentially suppliers and don’t become a supplier until you award them a contract.
So what’s the way forward? What can we do to remove the need, a compelling need, for potential suppliers to include risk premiums. Keep in mind we can’t achieve the ideal, no risk premiums at all, but we can strive to minimise their number and magnitude. Some of the things we should/could do include:
- Remove uncertainty - put yourself into the shoes of potential suppliers, consider how they might perceive what you intend to publish, even better, you could share your thoughts with them and ask for feedback prior to publishing, don’t stop asking throughout the procurement prior to them returning tenders. It also helps to use data that are independent of each party’s influence.
- Residual uncertainty - describe how you and the successful supplier will deal with residual uncertainty, that is provide them with certainty about how you’ll both resolve uncertainty. Because of the vagaries of perception and the heavy influence of different contexts and objectives you’ll always have uncertainties to resolve. The idea is to use fairness and transparency to deal with uncertainties outside of the price they tender, by giving potential suppliers fewer reasons to include risk premiums in prices they tender.
- Price transparency and rules - formulate a price model (pro-forma) that makes it easy for potential suppliers to price accurately in the context of the rules of thumb the industry favours when pricing. Feedback from potential suppliers on pricing can be worth its weight in gold. This helps you avoid inadvertently making your tender difficult for potential suppliers to price, because if you do you’re encouraging them to include risk premiums. Don’t try for pricing perfection, a kind of ivory tower type of procurement, dial it back a bit and aim for practicality and relevance, from the perspective of potential suppliers.
- Price risk separately - widely in use for construction contracts, tends to be OTT for many other contracts.
- Avoid unnecessary price certainty - when you strive for price certainty over the duration of a contract, you also encourage potential suppliers to include risk premiums. They have to include them to give you price certainty. When they do include risk premiums they're almost always on the high side. Why? Because they’re having to price uncertainty, and in most instance this means guessing. Finance do love price certainty, it makes their life easier. Although its often far from the best option for your organisation. You’ll almost always pay well over the odds for the privilege of price certainty. Personally I’d accept quite a lot of price ambiguity, in my experience it pretty much always pays off.
Risk premiums are a fact of procurement life. Therefore, we need to do our best to minimise the need for potential suppliers to self insure against uncertainty. To do this successfully:
- Always consider everything from the perspective of potential suppliers
- Continue to solicit feedback before publishing and until return of tenders
- Communicate with certainty how you will resolve uncertainty, prior to and during the contract
- Create transparent price models that use industry norms
- Give potential suppliers sufficient time to complete tenders especially if you’re planning on starting in April
- Use independent data for productivity expectations
- Never push potential suppliers into a corner