Department of Economics

Trading off efficiency versus optimality in the procurement process

In light of the financial crisis of 2008 and the subsequent spending cuts, many large projects are being increasingly scrutinised for their cost effectiveness

Audits of government spending on procurement projects have repeatedly highlighted that lower-cost alternatives to those chosen by the government would have been available at the time of tender.

Insights from a research project by Dr Peter Postl have highlighted that such criticism may be misguided. That is, trying to identify and purchase the lowest-cost option during a public tender may actually result in a higher purchase price for the buyer.

The procurement process: design-bid-build

In the procurement of complex projects (such as construction work, or defence equipment) the exact quality or specification of the project is rarely fully determined by the buyer at the outset. Instead, the purpose of the procurement process is to determine the project specification, along with the price and the identity of the supplier.

Procurement processes, known as two-stage ‘design-bid-build’ tenders, are commonly used by purchasers of construction work.

The procurement process usually consists of two parts:

  • First stage tender - information is collected about the available or technically feasible design specifications from expert contractors (such as architects, engineering consultancies, or defence companies).
  • Second stage tender - any contractor who has participated in the first stage has the opportunity to tender the second stage, where the exact specification and the price of the project will be determined alongside the identity of the supplier.

Peter Postl's research focussed on the second stage of the procurement process.

Modelling the procurement process

 

- Components of a procurement process.

 

The basic question driving this research was how a buyer who cares about the price and the design specification of the project should structure the second stage procurement process when participating firms face cost uncertainty at the time of tender.

Peter Postl proposed a theoretical model in which the tendering firms have only partial information about the cost of providing each of the available design specifications. While the eventual costs of producing a given specification are assumed to be identical across firms, they are unknown to the firms at the time of tender.

Procurement and cost efficiency

The main goal of this research programme was to explore whether the specification with the lowest production cost would also be the cheapest from the buyer's point of view.

Peter Postl's investigation into procurement mechanisms began with the analysis of a specific benchmark procedure (Minimum Price Mechanism - MPM). Under this procedure, the prices quoted by the contractors alone determine the identity of the supplier and the chosen design specification. However the MPM does not always result in the efficient specification choice (that is, the specification whose eventual production cost are lowest).

However, despite its inefficiency, there is a good reason for using the MPM instead of a procurement procedure that guarantees delivery of the efficient specification. The reason is that the MPM typically generates a lower expected purchase price for the project than an efficient procedure. This indicates that there is a trade-off between efficiency and expenditure-minimisation.

Enabling procurers to counter accusations of contract mismanagement

This research has highlighted that whenever the government’s choice of project and supplier must be based on information provided by the firms competing for the contract, it is simply impossible to reconcile the aim of minimising the government’s expected payment with the desire to identify the lowest-cost project.

An understanding of this trade-off between efficiency and expenditure-minimisation allows procurers to counter accusations of contract mismanagement at a time of increased scrutiny of public spending.