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Game Theory and the Construction Bidding Process

Contractors are gamblers by nature. They risk their livelihood on a multitude of factors, many of them uncontrollable, such as the weather, commodity prices and the actions of others. Nowhere is this risk better demonstrated than during the competitive bidding process.

A construction estimate’s accuracy is contingent upon the amount of information present during bid time. Determination of scope, estimation of quantities and assumptions of productivity are all formulated to produce a cost, exclusive of overhead and profit to complete the project. Because there are many similarities between contractors in takeoff methods, labor units utilized by estimating programs, and material pricing, the largest projects see surprisingly close bid numbers. Most times they are not, but these differences can be attributed to company experience, labor saving methods and the amounts allocated for overhead and profit.

This article deals with overhead and profit allocation and the decisions that are made when putting the final number to a bid.

An estimator's job

I ask young estimators what their job is, and many times they answer that it is to win the bid. Anybody can win the bid. By making poor assumptions, ignoring the true cost of overhead and leaving out profit, any firm can be successful at bid time. Unfortunately, that success does not always translate to the bottom line.

I tell estimators that it is their job to determine the lowest number their firm can perform the work and earn enough extra to cover overhead and profit. Depending on the circumstances, this number can be raised to become the highest bid that will still get the job. This range between low and high is where crucial decisions are made.

Game theory

Merriam-Webster defines game theory as “the analysis of a situation involving conflicting interests in terms of gains and losses among opposing players.” It was developed from mathematical models by many scientists, including John Nash, who was popularized in the movie, A Beautiful Mind. Game theory looks at the conflict and cooperation between rational decision makers. A classic example is Albert Tucker’s "Prisoner’s Dilemma."

In the Prisoner’s Dilemma two suspects are being interrogated in separate rooms for a crime they are suspected of committing. Each is given an opportunity to confess and betray their partner, something which will result in freedom should their partner not confess. Both prisoners confessing results in a long prison sentence for both, and both prisoners remaining silent results in a short prison sentence for both. If viewed from an optimal outcome standpoint, no prison term is best, and thus, each suspect should confess, but game theory has to do with the cooperation and conflict of parties. In this situation, both suspects realize that keeping silent is best and will accept their short sentence as a reward.

Game theory has been used in the study of construction bidding practices. This is not to say that bidders cooperate as in the above example. Cooperation in a bid situation, otherwise known as collusion, will have its own Prisoner’s Dilemma should it occur. Bidding is most definitely done between conflicting parties, and it is this conflict that brings many of the factors that go into the decision of the final bid number into play.

If contractors spend so much effort obtaining an accurate estimate of the costs involved for the completion of a project, how can any end up underbidding and losing money? Ignoring takeoff or mathematical errors, it comes down to assumptions and the lack of information. It is assumed that true changes in scope will be handled through the change-order process or through litigation. Everything else is looked at as a rational decision.

Theory in practice

Assumptions beyond those affecting labor can include the amount of work a firm currently has, the economic outlook for future work, and a firm’s desire to pursue work for a customer. Do firms lower their bid to keep people working, to stock up on their backlog or to keep a customer? Absolutely. Should they lower them below their true cost? Absolutely not. Yet it is done every day. The examples above can be emotional issues, and this is a part of game theory as well. My only advice is to always have a working knowledge of your true cost and the factors playing on your eventual decision. Sometimes stepping back from an important decision to see what is influencing it can be beneficial.

This article highlights game theory not because it is being studied by electrical subcontractors, the ones playing the game, but because it is being utilized by owners and construction managers, the ones who run the game. There are several scholarly papers on the internet covering this topic, and to be honest, they become very confusing from a mathematical standpoint as more players, or bidders, and factors are added.

Think of your responses to the above questions and assigning a percentage that you would raise or lower your bid to cover for them. Then chart these against your best guess of how your competition would answer them. Game theorists with knowledge of all parties would compute a resultant percentage that each firm should apply, but this is impossible from the standpoint of a player guessing at its competition’s responses. However, there is a way though that a firm can enhance its decision making for future bids.

The lack of information at bid time can cause a firm to raise its price in fear of the unknown or to unwittingly lower its price in its ignorance. There is a term called "the winner’s curse," originally applied to auctions, that applies to the construction bidding process. Investopedia.com defines the winner’s curse as “a tendency for the winning bid in an auction to exceed the intrinsic value of the item purchased. Because of incomplete information, emotions or any other number of factors regarding the item being auctioned, bidders can have a difficult time determining the item’s intrinsic value. As a result, the largest overestimation of an item’s value ends up winning the auction.”

Does this sound familiar?

A construction bid is also influenced by the lack of information. In this instance the lack of information should be limited to ones not dealing with scope but with factors associated with the owner, construction manager or the firm’s competitors. How well do you perform versus the estimate for a particular owner? Do certain construction managers affect your bottom line adversely? Should you track this information? Absolutely. Do you drop your bid after comparing it to a published budget number? Should you drop your bid when offered a last look?

These are your decisions, but you should be aware of your true cost, or intrinsic value, check your emotions, and chart your decisions for future reference. The ones running the game do this. As a player, you should, too.

How low can you go?

One discouraging procurement method in the industry has been the use of online reverse auctions for construction services. This practice is straight out of the game theory book. When confronted with dropping a small increment to secure a bid, like receiving multiple last looks, the tendency is for the low bidder to eventually go below the level it would have in a closed bid situation, perhaps lower than its true cost. Governments and large corporations that spend billions on construction services realize this and have instituted these auctions in certain circumstances. Understanding all of the factors that are confronting a bidder in such a pressured situation may make some firms decide that the best play is not to play.

While game theory has been studied since the 1940’s, the practice of pitting one player against another has been around much longer. The construction bidding process, with its competing players in conflict, separated and non-cooperating, is a perfect example. Many experienced contractors have a gut feeling while bidding, and there is something to say about intuition. Many others agonize over every bid. The ones that are confident in their cost, rationally look at the factors influencing their decisions and keep a cool head when the games begin will have the best chance of lasting the longest. Long may you play.

About the Author

John Kellamis

Freelance Writer

John Kellamis, is Vice President of Lake Erie Electric, Inc., and manages their office in Akron, Ohio.  He has over thirty years of experience in the electrical construction industry and serves as President of the North Central Ohio Chapter of NECA.

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