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The role of cost modeling in competitive bid procurement

Industrial buyers often create cost models to estimate the costs of potential suppliers and 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, the latter can still be beneficial when it helps the buyer set an effective reserve price. We then analyze how 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. 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.