The role of cost modeling in competitive bid procurement

Date, Time, Venue

20th July 2012, Friday at 10.30 AM

Room 2.10

Engineering Front Building

University College London


Many firms increasingly rely on suppliers for intermediate and finished goods. Some companies (e.g., CISCO) even eliminated in-house production capabilities. While production outsourcing is often cost-effective, firms also lose some manufacturing and technical capabilities that are relevant to estimate production cost. One way to address this is creating cost models to estimate the costs of potential suppliers so that the firm can use the information to negotiate an attractive price with suppliers. However, in settings where the buyer wishes to negotiate a contract price by soliciting competitive bids from multiple suppliers, the benefit of cost modeling is not clear since the bidding competition among suppliers can itself reveal cost information. In this paper, we examine this interplay, and examine if and when cost modeling should be used prior to competitive bidding.

We show that although bid competition sometimes duplicates the information gleaned by cost modeling, cost modeling can still be benefit the buyer by helping the buyer to tighten a reserve price. We then analyze under what situations the buyer can gain the most benefit through cost modeling. Specifically, we characterize which supplier(s) to learn about, which portion(s) of the costs to learn, and how deeply the buyer should learn.  We then apply these results to design the optimal learning strategy when the buyer has multiple supply bases. Interestingly, learning about the supplier whose cost is the most uncertain is not necessarily optimal, nor is learning about the cost portion that contributes most to the total cost. We also show that conventional intuition that the benefit of additional information has a diminishing rate of return does not always apply when it comes to cost modeling.


Hyun-soo Ahn is an associate professor of Operations Management at the Ross School of Business at the University of Michigan. He received his PhD in Industrial and Operations Engineering from University of Michigan at 2001. Prior to joining Michigan, he taught at the University of California at Berkeley and worked at Intel. Hyun-soo’s research interests are in the design and analysis of production and service systems, supply chain management, and revenue management with operational considerations. His papers are published in Operations Research, Manufacturing and Services Operations Management, Journal of Applied Probability, Advances in Applied Probability, and Queuing Systems. His research has been funded by multiple government and private agencies including National Science Foundation. He has worked with more than 20 companies including J&J, 3M, CISCO, Safeway, GE, Medtronic, Ametek, and Boeing. At Ross, He has been teaching BBA, MBA, Global MBA, and Executive MBA courses in Statistics and Supply Chain Analytics.  He has been awarded the Teaching Excellence Award (also known as Professor of the Year voted by graduating class) at the Ross School (in 2006 for BBA, 2011 for MBA, and 2012 for Exec MBA), and his teaching was featured in an article in Business Week.