Does It Matter If Suppliers Don’t Make Money?

Is it the buyer’s responsibility to identify if a firm bidding to win a contract has bid “too low” – that is, at a price which will not prove profitable for the potential supplier if they win the contract.  And is it feasible for the buyer to do that, even if they want to?

If the answer to those two questions are “yes”, then what should the buyer do about it if they discover that the bidder has put in an “unprofitable” bid?

These are the fundamental questions that lie behind the dilemmas faced by many buyers, not just in the public sector (where the issues have perhaps been more obvious) but also the private sector. Customers in both have been affected by the collapse of Carillion, for example, which you can certainly trace back in part at least to the firm taking on contracts that proved to be unprofitable.

It appears that as Carillion found itself with cash flow issues, it became more desperate to win new work to shore up the balance sheet, so that vicious circle kicked in as it desperately tried to win new contracts at (almost) any price.

Looking back, many people were surprised when a National Audit Office report of 2013 identified that major contractors to the public sector weren’t “ripping off the taxpayer” in terms of making excessive margins. Indeed, that report looks very prescient now, as it showed the big service providers (Serco, Capita, G4S and Atos) losing considerable amounts on quite a few contracts.

Perhaps that should have sounded warning bells – although you might also argue it demonstrated that public sector buyers have got more savvy over the years and weren’t letting suppliers get away with excessive profits.

Going back to the initial questions though, they highlight the problem here. It’s easy to say “yes” to question one – we should know if the bid or proposal is robust and not over-optimistic financially.  We feel like we should want to know if a supplier is making or losing money on the contract.

But why?  If we’ve run an effective competitive process, surely economic theory says we will arrive at a “fair” price, and the best offer (if we’ve run the competition well). But I want to understand the economics because it might be important to know if the supplier isn’t making any money, as that is a risk, and also understanding the finances helps in the contract management process – if we have to negotiate changes, for instance.

That leads on to the tricky questions two and three though. Is it even feasible to know if a bid is financially viable? Let’s say a supplier tells us that the direct costs of running this contract will be 70% of the revenue (the amount they will charge us). Overheads will be 25% and profit 5%.

But … how accurate is the 70% number anyway? How much analysis on that does the buyer need to do to be confident? And what about the 25% overheads number?  How has the bidder allocated overheads?  What about financing costs? And if the profit margin quoted is only 5%, the margin of error is tight – how can the buyer know that the 5% profit won’t in practice turn into 0% or worse?

Question three – what should we do about it - is even more difficult. Let’s say that the buyer’s analysis suggests there is a real risk that the contract won’t make any money for the bidding supplier. What happens next?  Are we really saying that the contract shouldn’t go to that firm – instead, we offer it to another bidder who has quoted a higher price and is proposing to make a higher margin? That cannot work, surely – you can imagine the push-back and indeed the legal challenge that would almost certainly win from the firm that bid lower!

No easy answers here, and some of the ideas being put forward post Carillion frankly don’t stand up to much scrutiny. More thought needed, we fear …

Voices (5)

  1. Bluebell:

    The onus must be on the qualitative aspects of the tender surely?
    None can run without checking and inspection, which is why I’m a little surprised the likes of Carillon were not called to account earlier. Where was the due diligence on the contracts awarded in the last few months?
    Other than that it is not possible to assess individual contracts as the company may legitimately be buying market share either to get in to a new market or to dominate an existing one.

  2. Mr Grumpy:

    The bigger question is the budget and forecasting upfront realistic and accurate? If a contract is being offered out there in mind there is no margin at all for suppliers, then likelihood and logic tells you there is only going to be one outcome.
    Whilst some suppliers don’t help themselves under-bidding on contracts or bidding on contracts they know have no margin,but the customers sometimes don’t help themselves with unrealistic budgets and forecasts.

  3. Dan:

    As far as the public sector goes, a partial answer (unusually) lies in the Regulations. The requirement there is to investigate… and that’s it. The bid can still be accepted if the authority wishes to. It just forces the authority to be aware of the situation and, hopefully, will consider its actions and the options available to it.

    The problem though, is the sheer scale of some contractors. It may be supplying to a good number of buyers, but one or two unprofitable contracts can bring the whole thing crashing down. The buyer may consider that it is an acceptable risk for themselves, but they are unable to assess this for their fellow public bodies.

    In the case of Carillion, for example, one of the buyers – for example Network Rail, may have deemed it to be an acceptable risk as a joint venture partner would step in, They couldn’t, however, be able to assess what this would do to a profitable contract being done, for example, for the MOD.

  4. bitter and twisted:

    I think the issue is: if a public sector contract is too big too fail, surely it must be done in-house instead ?

  5. Mark Lainchbury:

    Depends on the type of contract. A one-off purchase, that’s a problem for the supplier not me, as long as I not being milked on the maintenance & consumables, down the line.

    Any of the big 5 under bidding for a long term service contract. I would suspect they have market synergies I am unaware of, or are trying to shut out a competitor and are happy to take a “hit” in exchange for a guaranteed revenue stream and the chance of accruing more activity down the line.

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