The Garrison Report #2007-3

The Psychology in Preparing Construction Bids - Part 1: Scarcity and the Low Bid

Listen to the audio version of this report here

Contractors should be wary of the low-bid environment. Why? Professor Robert Cialdini at Arizona State University reveals the answer in his best-selling book, Influence. He reports, "Almost everyone is vulnerable to the scarcity principle in some form."

He explains that when things are less available, they tend to become more attractive because of their increased scarcity. By their very nature, projects are scarce because each project is unique. However, it's more complex than that. Matt Stevens reports in his book, Managing a Construction Firm, that between 1963 and 2003, the number of contractors increased from 800,000 to 2,600,000, despite the fact that the volume of work in 1963 dollars is approximately the same. This has made construction work significantly scarcer. As the number of contractors has increased over the past four decades, there has been an erosion of contractor profit margins and a decline in wages in real dollars within the construction industry.

Cialdini adds that competition increases the impact of the scarcity principle, because the competition only exacerbates the situation. To show this impact, he reminded readers of the Cabbage Patch doll that sold for $23 in stores when available but would sell for up to $900 at auctions. If you think this phenomenon is limited to irrational parents, think again. Cialdini further illustrates that corporations also fall victim this principle. He offered the example of when ABC paid a record price of $3.3 million for the one-time rights to the highly sought movie The Poseidon Adventure even though this bid was guaranteed to produce at least a million dollars loss. How many contractors bid too low without thinking of the consequences because they desperately desire to get a particular project?

The regular sealed low-bid environment creates enough of a feeding frenzy; however, reverse auction bidding is out of control. At least in the conventional low-bid environment, the contractor determines its bid in the privacy its own office without outside influence. However, in the reverse auction bidding wars, a real agitation runs through the room when the various bidders react to other's bids. I've been told about several examples where the final project results were a total disaster for all stakeholders. These samples demonstrate that the frenzy that creates irrational pricing is harmful. I think the reverse auction bidding process should be avoided because it's the equivalent of financial Russian roulette. However, if you should decide to participate, you should at least pick a cost figure that you will not go below. This will allow you to establish a minimum price before the worst craziness starts.

Of course, some would argue that competition merely forces contractors to sharpen their pencil. I certainly agree with that concept but not when it forces contractors to jeopardize their financial well-being. The Business Week's 2007 Investment Outlook Report indicates the situation is worse than merely competition. The report indicates the return on equity for all U.S. industries is 17.9 percent, while the ROE for the construction industry is a mere 9.7 percent, despite the recent construction boom. This indicates that the psychological impact of the scarcity principle has pushed too many contractors over the edge.

The problem is that there are buyers who are hoping to create a feeding frenzy in order to obtain the proverbial free lunch. Yet usually that free lunch ends being a poor-quality, expensive lunch. Also, there are contractors that believe getting the project at any cost is the name of the game. Unfortunately, after these contractors obtain the bid that is too low, they are forced to beat up owners with change orders and/or beat up the subcontractors to get them to lower their prices in order for the prime contractor to create an higher profit margin for itself.

I've often asked subcontractors why they give in to general contractor's demands to lower their price. The usual answer is, "What choice did I have?" The fear of losing something that someone thinks they already have is a very a strong influence, but too often this influence in not in the best interest of the subcontractor. I've personally experienced situations where the general contractor extracted a lower price from the subcontractor merely on the threat they would lose the job. The concessions were so great, it resulted in the subcontractor actually going bankrupt.

However, I've responded with the question, "How do you know you weren't already the low subcontractor? After all, do you think the general contractor starts with the highest bidder and tries to get that subcontractor to lower his price, or do you think the general contractor starts with the lowest bidder and attempts to get that subcontractor lower its bid further?" This is a process that relies on the scarcity principle to extract unreasonable concessions from the general contractor by the owner then by the general contractor from the subcontractors.

I understand that some market places require contractors to submit the low bid to get the project. I recommend that contractors avoid the low-bid environment as much as possible since virtually all data demonstrates that this arrangement is the least profitable for contractors. However, if you are forced to bid on work, what should you do to avoid being taken advantage of?

Cialdini offers some defense, but he says, "It is easy enough to feel properly warned against scarcity pressures, but it is substantially more difficult to act on that warning. Part of the problem is that our typical reaction to scarcity hinders our ability to think." In other words, our "cognitive processes are suppressed by our emotional reaction to scarcity pressure. In fact, this may be the reason for the great effectiveness of scarcity tactics." I suggest you consider that some buyers of construction services are setting you up in the hope of winning that free lunch.

What options do you have?

There is no silver bullet. However, avoiding the bids where there is intense competition is advisable because even if you aren't caught up in the frenzy, someone else will be and your efforts will be wasted since you really have little or no chance of winning the bid.

Before you prepare your bid, establish the profit margins that you want on this type of project. Assign the right overhead and indirect costs to the bid. Then let the numbers fall out. Don't second-guess your price. I often ask contractors, "Who is sitting in the room when you prepare your bid?" The answer is the competitor. He keeps whispering, "If you want to win the bid, lower your price." Since your competitor doesn't have your best interests at heart, why are you listening?

Seriously, if you get caught up in the frenzy that you must win the bid, then the principles of scarcity will take hold and you may become irrational, in essence bidding $900 for a $23 doll.

The best way to avoid this problem is to simply avoid competing on price. Instead compete on value because there is less pressure and you are less likely to get caught up in a frenzy. The data seem to support this because negotiated work usually produces higher profit margins for the contractor.

In next month's report, I will discuss how you can use the scarcity principle to help you obtain higher margins on the projects you get while at the same time reducing the number of proposals you submit.

 

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