Overhead Allocation and Bidding Approaches – More Interesting Than It Sounds!

Why do bids and tenders come in from different suppliers at different prices for what are fundamentally the same goods or services?

I’m not sure that is something we think about that often in day-to-day procurement activities. We might design evaluation processes or rely on negotiation to come to a final decision and final contract, but how often do we really analyse where the differences in process offered by various suppliers come from?

Of course, some buyers will ask for cost breakdowns at varying levels of detail. Whether suppliers give us accurate information or rather tell us what they think we want to hear is however another issue!

We might assume that big price differences come usually from difference in the precise specification of what is being provided. That’s not just true for goods, but also for many services. Simplistically, it is why a big firm consulting partner might be £5K a day and a contractor project manager £500, even if they are going to do what is basically the same work. Or it might be that one firm is genuinely more efficient than the other, because of technical knowledge or economies of scale. That’s fairly standard – although personally I have found that scale economics are often not as major as we might think.

However, another driver of price differences can be overhead allocation. So, while different firms will arrive at a bid price in different ways, in most cases, there will be some sort of cost modelling that informs the final price offered. That will look at the direct costs of what is being supplier, then add on some sort of overhead allocation, and finally a profit margin.

Now in some businesses, overheads may be relatively small compared to direct costs. But in others, depending on aspects such as the level of capital investment in the firm, or the level of marketing and advertising spend, the overhead allocation element might be 20%, 30% or even more of the final bid price.

However, overhead allocation is not a precise art. Do you do it simply on a pro rata basis across all sales? Do you try to allocate overheads in a realistic manner to the particular products, customers or types of business that really benefit from the overheads? The supplier has to make those decisions, but if I am buying a bulk, unbranded product from a manufacturer, why should I pay for any element of their marketing (overhead) spend which relates to their B2C business?

I saw an example in a recent tendering process where one supplier insisted on a full overhead allocation for the work in question,  even though the buyer had a very strong argument that their work should not attract such a cost loading.

But another bidder, one that clearly wanted to win the contract for longer-term strategic reasons, bid at a price that appeared to be basically direct costs plus a bit of margin. Internally, they might have considered that their overhead costs were already covered by existing business, so they could bid aggressively for the new work. The end result was a huge difference in pricing!

However, we need to be cautious. There can be a downside to such an approach – such an aggressive bidding stance might lead to issues during the contract, if the supplier starts feeling that they’re not making a decent return from the work.

So, there is no simple conclusion here. But thinking about these issues, and not being afraid to ask for cost breakdowns in bids, or to ask questions and challenge suppliers to understand how they are approaching their proposals, can lead to better understanding of how they are thinking. And ultimately that should play into better supplier selection decisions, as well as healthier ongoing relationships.

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