21 November 2021
Low balling is the pricing of a product or service lower than required to produce satisfactory profits
Low balling is a pricing tactic most often used in competitive bidding in the construction industry. But, there are some less ethical examples.
The reason for doing this is tactical; one hopes to win a position that allows clawing back profits through some future means that may not be possible without gaining the entry point. Low balling buys that entry point.
Low balling in competitive tendering
In building construction, typically the buyer seeks quotes (tenders) from a range of suitable contractors to undertake the construction project. This process is called competitive tendering and is used to encourage competition with the aim of finding the lowest price. To allow competing contractors to calculate a price, a detailed specification including architectural plans, specific construction details, required building standards, expected timelines and a variety of details and specific requirements are all listed in a number of documents that often stretch to several volumes. The bidders use these to calculate their estimated cost for construction.
After calculating their best estimate of construction cost each contractor then has a decision to make...
What profit margin should we add to the building cost?
Add too much profit and they risk not winning the bid. Add too little profit and they risk going out of business. This decision is particularly tricky as there is always some risk they have made a mistake in their cost-estimate.
However, experienced contractors know that rarely is any building built strictly to specification because...
- It is simply too expensive to consider every detail and draft a specification document that covers detail down to the last screw and light bulb.
- Mistakes can be made in the specification document that will need to be corrected during construction.
- The requirements might change after the contract has been let and even during construction.
- Specified materials or other items may no be available at construction time and an alternative will need to be found.
- Assumptions have been made about (for example) accessibility to the building site, the precise nature of the construction site (particularly what might be hidden underground), and also the performance of other contractors contributing to the project.
All these potential changes to the original specification provides the building contractor legitimate reasons to charge for these extra items.
Changes to the building specification are called variations.
Variations are always charged at a much higher margin than the original bid price and are an opportunity to increase the overall profitability of the project.
Low balling ensures the building contractor wins the bid and has the opportunity to improve their profit margins on the project through variations. That's the theory.
Practical realities of low-balling
Several things can go wrong with low balling...
- The project proceeds and there are minimal variations. It can happen.
- In a competitive bid all contractors have the option to offer low-ball pricing. This becomes a race to the bottom with some contractors offering prices below cost. If the project goes to plan the winning bidder is guaranteed to make a loss.
- Of course building project owners know about low-balling and know how to manage variations and specify in their building contract how any variations that arise will be handled. However, for every tactic there is a counter tactic which sets-up an adversarial relationship. Ultimately, accepting the lowest bid is no guarantee that the final cost will be cheaper; working with a more ethical builder who takes a reasonable approach to claiming variations may end-up being more cost effective particularly as the project is likely to run more smoothly.
- Building contractors risk getting a reputation for being hard on variations and after a while find that building project owners are less likely to invite them to tender.
- Before the tenders are let building project owners have calculated a benchmark construction cost. Bids well below this benchmark may be viewed as a warning the bidder intends to go hard on variations, or worse risks going broke halfway through construction. Some building project owners have a policy of rejecting the highest and lowest bids and only consider the bids in the middle.
White Paper Marketing - Sprat to catch a mackerel
Leaving aside the building construction industry for a moment, low-balling is also used to gain an entry point to open a new business relationship.
When selling technical products and services (for example business software applications, automation systems, robotics) some technical and business case evaluation is often needed before the customer can make a decision. Technical issues are particularly important for both the seller and the buyer because sometimes a customer's site may not be compatible with the offered technology.
In this situation, many B2B technical sales firms offer to undertake a technical and financial feasibility - sometimes called a white paper. As there is considerable work involved and some risk that the invested time might be wasted, some firms will charge for this work.
However, often the white paper study work is considerably discounted, even to a token level.
Many would think that a better strategy would be to punt the work and do it at no-charge; after all, this is an important pre-sales tool. However, there are reasons to charge...
- It provides at least some cost recovery for the selling firm.
- It weeds-out tyre kickers who would take advantage of the free consulting work.
- It's a form of psychology - people don't value things they haven't paid for.
Low balling - less ethical
Th traditional example of low-balling is demonstrated as a tactic that used to be used in the car industry - but no longer (well, I hope not).
A car would be advertised for an impressively low price to attract people to the dealership. After getting the prospective buyer enthused and ready to sign, the car sales(person) would excuse him/herself to have the deal checked by the sales manager. The salesperson would come back looking crestfallen/embarrassed and explain the car couldn't be sold at that price because it was an optioned-up version and would cost more - or - the advertised car had been sold already - or- it was a mistake.
After having invested time and becoming emotionally committed to the purchase, it wouldn't be hard for the salesperson to close the sale - even if requiring the giving away of a concessionary discount already allowed for in the scam ("sorry for the misunderstanding").
Consumer protection laws (for example, now requiring advertised cars to be clearly identified with a SID Number) make this practice more difficult and theoretically impossible.
Low balling - to get a seat at the table
A customer who has had a long term relationship with a supplier may check their prices with a competing supplier. The competing supply asks for examples of what they have been purchasing from the incumbent. It is then very easy for them to suggest to the customer that they are paying too much - "wow! that's amazing, I don't want to cause any trouble but we'd only charge X for that" usually said with feigned sincerity and mock astonishment.
Even if not part of a conversation, when asked for sample pricing on a range of items, the low-balling technique is to offer conservative pricing to win the business, with the aim of moving rates -up later particularly if the business relationship will include many other items that are not part of the original sample pricing.
However, while low-balling can be seen as a sharp business practice (i.e. not ethical) it shouldn't be confused with Relationship Pricing which essentially contains elements of low-balling but seeks instead to achieve an acceptable average profit from a customer relationship applying a "swings-and-roundabouts" philosophy.