If neither the negotiation design nor the competition intensity of a tender can explain the high price marks-ups in renegotiations, what can?

In our last article, we challenged the intuitively appealing hypothesis that competitive tenders lead to tougher price renegotiations and therefore result in higher overall costs. We argued that neither industrial nor behavioural economic theory can explain the high price mark-ups in renegotiations seen after tenders with competitive negotiation designs. But if neither the negotiation design nor the competition intensity of a tender can explain the high price marks-ups in renegotiations, what can?

Changes in bargaining power after nomination

One of the main reasons why sellers can demand significant price increases in renegotiations is that the bargaining positions of buyer and seller reverse after nomination. During the initial negotiation, the seller must compete with other sellers for the tender. The bargaining power thus lies with the buyer. After nomination, however, the buyer depends on the winning seller to supply the ordered product/service and cannot easily move to another seller (lock-in effect). As the seller now has a quasi-monopoly for the remainder of the contract duration, their bargaining power increases.

In addition, the seller has more information than the buyer (information asymmetry), in particular regarding their cost structure, which gives the seller a significant advantage during renegotiations. Both the lock-in effect, as well as information asymmetries, lead to a change in bargaining positions after nomination in favour of the seller. Thus, once renegotiations become feasible, the seller can exploit their increased bargaining power to impose higher prices.

When renegotiations become necessary

Why are prices regularly renegotiated in the first place? Renegotiations become necessary when contracts are incomplete. An incomplete contract is a contract that is defective or uncertain, i.e., has gaps, missing provisions, or ambiguities that must be completed via renegotiations. In Procurement, a contract may be incomplete because the specification of the product/service is not fully available before sourcing, it is expected that the product/service characteristics might change after the nomination, or the needed quantity of the negotiated product/service is uncertain.  In these instances, any post-nomination change must be negotiated with the winning seller, typically leading to significant price mark-ups due to the before-mentioned reasons.

Strategies to prevent high price mark-ups in renegotiations

These issues exist regardless of whether initial prices were negotiated in a competitive setting or not. However, competition can be used as a remedy. In order to prevent having to renegotiate prices post nomination and under lock-in with the winning seller, we suggest to pre-negotiate change management rules and set incentives for information sharing during the initial negotiation.

Incentivise sellers to reduce their post-awarding change management costs

Introducing project-specific change management rules in the initial negotiation allows the buyer to create competition on sellers’ change management, by using a competitive negotiation design and giving sellers an advantage in the final awarding for accepting and committing to change management rules. Sellers can be incentivised to reduce their post-awarding change management costs prior to the awarding. For instance, in case major post nomination changes are likely and can already be specified, the buyer could pre-negotiate prices for these changes with all potential sellers and include differences in change management costs in the awarding decision. If many minor changes are expected, the buyer could classify potential changes into different “tickets” (e.g., according to their commercial implications, frequency, and type) and pre-negotiate flat rate prices for these tickets.

Improve the quality of information given by sellers

Similarly, in order to address the issue of information asymmetries, buyers can use a competitive negotiation design to improve the quality of information given by the sellers. By giving sellers who, for instance, offer detailed cost breakdowns an advantage in the final awarding via a monetary bonus that will be included in the decision basis, buyers can incentivise cost transparency and information sharing. This in turn strengthens the buyer’s bargaining position in renegotiations after the awarding and thus reduces additional cost claims. Naturally, these approaches can lead to additional efforts having to be made in preparation for the final awarding process. However, making sure the competitive negotiation design includes change management rules and sets the right incentives for information sharing not only increases the transparency in renegotiations but also reduces the high price mark-ups that are often seen in renegotiations.

Conclusion

In the first article of this series, we have argued that neither industrial nor behavioural economic theory can explain the high price mark-ups in renegotiations seen after tenders with competitive negotiation designs. Instead, the high mark-ups in renegotiations are more likely to be caused by changing bargaining powers after nomination due to a lock-in effect, as well as information asymmetries. These issues are not specific to tenders that are awarded in a competitive setting but apply to all negotiations. Rather than competition being the culprit, we argue that competition is the remedy: By using competition in the initial negotiation to pre-negotiate changes and to improve the information quality of sellers’ cost structures, buyers can improve their bargaining power and prevent cost increases after nomination.