9781118041581

where c is the ultimate cost of the procurement (unknown at the time the

contract is signed). The remaining three variables are specified in the con-

tract: Tis the firm’s target profit, cTis its target cost, and b is its sharing

rate. If the actual cost matches the target cost (c cT), then the firm earns

its target profit: T. For positive sharing rates, the supplier and the

buyer share in cost overruns and underruns. For instance, if b .4, then

each extra dollar of cost is paid 40 percent by the firm and 60 percent by the

buyer. For b 1, the buyer writes a fixed-price contract; the supplier is

responsible dollar for dollar for cost overruns. At b 0, the buyer writes a

cost-plus contract; here the buyer pays for all overruns and the firm is guar-

anteed a fixed profit of T. For sharing rates between 0 and 1, the buyer

writes an incentive contract.

The trade-off between risk sharing and efficient firm selection is at the

heart of determining the “degree of incentive” (i.e., the value of b) in the con-

tract terms. Under a fixed-price contract, the winning supplier bears all costs

and, therefore, has an obvious efficiency incentive (i.e., will strive to keep costs

to a minimum). Since it bears full-cost responsibility, a firm’s price bid will nec-

essarily reflect its likely production cost (plus a provision for profit).

Consequently, by choosing the lowest competitive bid, the buyer also will be

selecting the lowest-cost firm. However, the disadvantage of the fixed-price con-

tract is that it allows no risk sharing. Being risk averse, the winning supplier

will require a much higher profit margin for bearing procurement risk and

will pass this premium on to the buyer via a higher price bid.

At the opposite extreme, a cost-plus contract insures the supplier com-

pletely against uncertainty about program cost. Accordingly, a risk-averse sup-

plier requires a much lower guaranteed profit fee (than with a fixed-price

contract). However, under a cost-plus contract, the firm has no incentive to

minimize cost (since the buyer picks up the tab). Furthermore, if cost-plus

contracts are set, the bidding competition is much less likely to select the most

efficient supplier.

In general, the buyer minimizes its expected procurement cost by fash-

ioning an incentive contract. (That is, neither the fixed-price nor cost-plus

extremes are optimal.) Determining an optimal incentive contract (the “right”

value of b) depends on a basic trade-off among the goals of risk sharing, effi-

cient firm selection, and incentives for cost reductions.

694 Chapter 16 Auctions and Competitive Bidding

Bidding to Televise

the Olympics

Revisited

In light of our analysis of competitive bidding, what conclusions can we draw about the

networks’ fight for the Olympics television rights? First, consider the positions of the bid-

ders themselves. Bidding for the Olympics four or more years before the fact is fraught

with uncertainty. Much of this uncertainty is common to all bidders. A network’s adver-

tising revenues from televising the Olympics depend on the number of viewers advertis-

ers expect. Of course, viewer interest (in particular, American viewer interest) depends

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