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How contractors in Ghana include risk in their bid prices

HOW CONTRACTORS IN GHANA INCLUDE RISK IN THEIR BID PRICES Samuel Laryea and Will Hughes School of Construction Management and Engineering, University of Reading, UK, P.O. Box 219 Reading, RG6 6AW The way that contractors in Ghana establish a bidding
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  HOW CONTRACTORS IN GHANA INCLUDE RISK INTHEIR BID PRICES Samuel Laryea 1 and Will Hughes 2 School of Construction Management and Engineering, University of Reading, UK, P.O. Box 219 Reading, RG6 6AW  The way that contractors in Ghana establish a bidding price, and include allowancesfor risk in their prices is investigated using unstructured interviews and documentaryanalysis. The contextual nature of tendering practices suggested that there may bedifferences in approach between countries. Therefore one objective was to testwhether there are systematic differences between the approaches in different places.Seven contractors were studied to ascertain how they put together a price, and howrisk apportionment influences price. Most of them established their bidding price by building up prices for labour (14%), plant (9%), materials (45%), overhead (15%) and profit (10%). The main determinants of price seemed to be the actual direct costs;level of competition; delivery time of the project; payment regime; and clarity of tender documents. Risk allowances of 5-7.5% were included in the profit margin of some bill item prices. This was based mainly on the direct judgement of the quantitysurveyors who calculated the price, based on their intuition and experience. Noformal and analytical risk models were used. Indeed, none of the contractors indicatedany knowledge of published risk models. The contractors’ risk allowances seemed to be guided by concerns about competition and winning the job rather than the true costof risk. Thus looking at the three systematic processes of formal risk management, itcannot be concluded that contractors in Ghana practice formal risk management;although it is clear that they take account of risks when pricing their work.Keywords: contractor, Ghana, interview and documents, pricing, tendering. INTRODUCTION It is standard textbook knowledge that contractors tend to include a hidden premiumfor risk in their bid prices (see for example, a textbook prepared on behalf of TheAqua Group practitioners by Hackett et al., 2007: 35). A study on the contingencyallocation practices of 12 small-to-medium US contractors by Smith and Bohn (1999:101) explained that such premiums can be thought of as a contractor’s estimated valueof the extraordinary risks they will encounter in a project. Extraordinary risks arenormally project risks that are not covered by bonds, insurance, or the contract (Tah etal., 1993) for which contractors need to self insure using contingency (Smith andBohn, 1999). Most standard estimating textbooks express contractor contingency as afixed percentage of 5-10% of the contract value. However, the severe nature of competition in the construction market indicates that this figure could be high. Threeempirical studies have shown that risk premiums form around 0-5% of a contractor's bidding price (see Neufville and King, 1991 who investigated the risk and need-for-work premium practices of 30 US contractors; Shash, 1993 who studied the bidding practices of 30 US contractors; and Smith and Bohn, 1999 who studied contingencyallocation practices of 12 US contractors). 1   Several formal and analytical models for contractor’s risk analysis at the tender stagehave proliferated since 1971 (summarized in Laryea and Hughes, 2008). Theanalytical approaches assume that contractors include risk contingencies in their bid proposals (see unpublished PhD thesis on the relationship between risk and price intendering by Laryea, 2008a: 60-61). However, the way that contractors actuallycalculate prices and account for risk when bidding is not clearly articulated in theconstruction management literature (see Laryea and Hughes, 2008). In specificrelation to Ghana, the process used by contractors for putting together a bidding price,including how risk is taken into account, is yet to be investigated. The contextualnature of tendering practices suggests that there may be differences in approach between countries. Therefore one objective was to test whether there are systematicdifferences between the approaches in different places. The objectives here are: • To ascertain how contractors in Ghana establish a construction price; and • To ascertain how they include risk in their bid prices.Ghana is a developing country 2 with a growing economy and construction sector (asshown in analysis of the causality links between the growth of the constructionindustry in Ghana and the growth of its macro-economy by Anaman and Osei-Amponsah, 2007). In Ghana, the absence of research of such nature meant that a vitalgap in knowledge about the tendering practices of contractors would be addressed. HOW CONTRACTORS APPROACH RISK IN THE TENDER PROCESS The research literature on how contractors approach risk apportionment in the tender  process is reviewed in Laryea (2008a: 34-63). Furthermore, the research literature onthe relationship between risk and price in tendering, mechanisms used by contractorsfor pricing risk, and formal and analytical risk models in construction is summarizedin Laryea and Hughes (2008). The way that risk pricing is approached in different business sectors such as finance, insurance and construction is articulated in Laryea(2008b). Laryea (2008c) describes public sector tendering processes in Ghana basedon a case study. Therefore, this section of the paper summarizes generally the conceptof risk in specific relation to contractors and contractor risk management practices. Risk in relation to contractors Little attention has been focussed on a precise definition and evaluation mechanismfor project management risk specifically related to contractors. Project ManagementInstitute (2004: 238) define risk as an uncertain event or condition that, if it occurs,has a positive or a negative effect on at least one project objective, such as time, cost,scope, or quality. However, three risk definitions may help to articulate a better understand of risk in the context of construction contractors. First, in developing asystematic influence diagram-based model for contractors risk analysis at the tender stage, Al-Bahar and Crandall (1990: 534) described risk as "an exposure to thechances or occurrences of events adversely or favourably affecting project objectivesas a consequence of uncertainty." Second, a practitioners’ textbook prepared on behalf of the Aqua Group by Hackett et al. (2007: 35) defined risk as "the possibleloss resulting from the difference between what was anticipated and what finallyhappened." Third, a financial analysis and management textbook by Fisher and 2 Human Development Report 2007-2008,  Annual Report  , United Nations Development Programme(2006 data published in 2008  Jordan (1996: 70) defined risk as "the possibility that realized returns will be less thanthe returns that were expected".Thus, risk may be understood in the context of contractors as a positive or negativedeviation to expected profit. This aligns with Chang and Tien’s (2006: 171) definitionof risk as "a measure of the probability and consequence of not achieving a goal."Risk is not the same as risks, although the terms are often used interchangeably in theliterature. Whiles risk is the deviation to an expected outcome, risks are the actualdeviation-causing events. As explained in a financial analysis textbook by Fisher andJordan (1996: 70), forces [risks] that contribute to variations in return constituteelements of risk. Al-Bahar and Crandall (1990) defined risk event as what mighthappen in favour or in detriment of a project. In examining the way software practitioners are taught to perform risk management, Pfleeger (2000: 266) stated threecriteria for identifying a risk event. First, a loss associated with the event, often calledthe risk impact. Second, the likelihood that the event will occur, with risk probabilityoften measured with a number between zero (impossible) and one (certain). Third, thedegree to which the project team can change the outcome, either by mitigating therisk’s causes before they occur or by controlling the risk's effects afterwards. Anexperiential-based textbook by Park (1979: 170) explained 12 risk events contractorsface as: weather, unexpected job conditions, personnel problems, errors in costestimating/scheduling, delays, financial difficulties, strikes, faulty materials, faultyworkmanship, operational problems, inadequate plans or specifications, and disaster. Contractor risk management practices Risk management is mostly defined as a logical process of risk identification, risk analysis and evaluation, and risk monitoring and control (PMI, 2004).Contractors have often been portrayed to be poor at managing risk by for example,authors such as Baloi and Price (2003: 262), Ahmed et al. (2002: 4) and Kangari andRiggs (1989: 126). In developing an analytical model for modelling global risks,Baloi and Price (2003) said: "…many contractors are unfamiliar with these risk factors and do not have the experience and knowledge to manage them effectively. Asa consequence, conflicts, poor quality, late completion, poor cost performance and business...Contractors have traditionally used high mark-ups to cover risk but as their margins have become smaller this approach is no longer effective...Contractors rarelyuse these techniques and tools in practice. More often than not constructioncontractors and other practitioners rely on assumptions, rules of thumb, experienceand intuitive judgement which can not be fully described by prescriptive or normativemodels. Individual knowledge and experience, however, need to be accumulated andstructured to facilitate the analysis and retrieval by others."According to Ahmed et al. (2002), "The construction industry has a poor reputation incoping with risks, many projects failing to meet deadlines and cost targets." Kangari(1989) said: "…the construction industry has a very poor reputation for coping withrisk. Risk analysis is either ignored or done subjectively by simply adding acontingency. As a result many major projects fail to meet schedule deadlines and costtargets with attendant loss to both contractors and owners."However, these assertions may not be true generally. Since general contracting startedin the early parts of the 19th century, contractors have used various means to surviverisks in construction industry. Most contactors resorted to speculative house buildingin the 19th and 20th centuries to sustain labour force and business costs through the peaks and troughs of contracted work. In modern times, there is a growing tendency  for contractors to use their positive cash flows to invest in projects, rather than house building. Most recently, successful contractors are diversifying into businesses whosecycles counteract those of construction (Oxford Encyclopaedia of Economic History,2003:1:511). Contractors are minimising risk by declining work perceived as toorisky, subcontracting large portions of their work to others, and apportioning risk inwage structures. In essence, they are passing on risk to others. A questionnaire surveyof 19 contractors in Australia by Bajaj et al. (1997) identified five of the ways used bycontractors for identifying risk at the tender stage of projects: (1) Risk review (bysenior staff at the start of the tender pricing); (2) Contact (discussions withsubcontractors, architect and client); (3) Research (ascertaining information aboutsubcontractors, client, consultants, economic climate, etc); (4) Site visit (visiting siteto ascertain the access situation, location, obstructions, etc); and (5) Finance (issuesregarding payment and financial obligations). CONTRACTOR INTERVIEWS AND DOCUMENTARYANALYSIS The outcome of exploratory interview and documentary analysis studies with sevenFinancial Class D1 contractors in Ghana are reported. In-depth interviews with theQSs (estimators) who do the actual estimating and pricing and some directors of sevenconstruction firms in Ghana were carried out in 2006 and 2007. Each unstructuredinterviews was recorded with the interviewee’s permission and lasted roughly 95minutes. The contractors, namely those licensed by the Ghanaian Ministry of Worksand Housing to build the largest projects, were chosen for three main reasons: they arelikely to consider prices more carefully because of the risky nature of their complex projects and the professional background of their staff; they are those who often havewell situated offices that can be easily located; and they would be assumed to practiceformal contract administration procedures because of the professional background of their staff and the size of their organization and projects.Table 1 summarizes the interview findings. All the contractors have operated inGhana for at least 15 years doing all types of projects, apart from roads. Their senior estimators have an average of 21 years’ experience. Average turnover for 2006 wasGH¢4.5m (or ~ USD 4.5m). An average workforce of about 950 people is directlyemployed in their offices and construction sites. The workforce comprisesmanagement, professional and administrative staff, artisans and labourers. The natureof the unstructured interviews used in eliciting information from the contractors inGhana and its analysis is similar to how it was applied in the case of UK contractors,as previously described. Some of the documents used in the bidding processes of thecontractors were also collected and examined.TABLE 1 <NEAR HERE>The literature review provided a basic scheme of things to look for, but the main purpose of the approach to interviewing (unstructured interviews) was to allow therespondents to focus on what they felt was important, so the main headings in thecontent analysis emerged from reading the interviews, and indexing them by theissues that were most important to the respondents. This was interpreted from the waythat they described their work. The interviews were analysed by indexing thecontractors’ statements and collating those common to the particular themes in thestudy for a qualitative interpretation. Documents used by the contractors in puttingtheir bids together were also collected and examined / analyzed.  How contractors in Ghana establish a bidding price The results reported here is based mainly on an analysis of documents involving the profit and loss statement for 2005/2006 for one of the firms; labour all-in ratecalculation matrices; and unit rate calculation matrices that were collected. Wherenecessary, the contractors were asked to explain the documents analyzed.  Bidding price components The five elements of a bid price that were mentioned by all the contractors werelabour, plant and equipment, materials, overheads and profit. However, only onecontractor mentioned that they also include a contingency for unforeseen works. Ananalysis of the 2005/06 profit and loss statement of one major contractor showed thatgross profit was 18% of total contract earnings for the year. The ratios of other costsshowed labour (14%), plant (9%), materials (45%) and overheads (15%).  Labour price components The interviews and documentary analyses showed that the common elements thatform the basis for building up labour prices are: basic annual salary (27x12),workmen’s compensation (5%), inclement weather (10 days), redundancy (4 weeks),social security contribution (121/2%), out-of-station allowance (10 days), sick daywith pay (2 weeks), medical facilities, funeral grant, transfer allowance (1 month),tools allowance, leave / travelling days (23 days), height allowance, safety and health,ex-gratia (8 weeks), insurance (11/2%) and a margin for profit and overheads (10%).An observation of these 17 labour price components shows that four of them arestatutory provisions. Eight of the items are Collective Bargaining Agreements (CBA) between the Association of Building and Civil Contractors of Ghana (ABCCG) andthe Construction and Building Materials Workers’ Union (CBMWU) of TUC. Theother five are included by the contractor themselves to cover labour-related risks.  Material price components The contractors also have a common way of calculating material prices. The basicarithmetic is the addition of cost of the material at ex-stock, transportation cost, wasteallowances and overhead and profit margin (5-10%). For both normal and specialistmaterials, they often rely on quotations from their suppliers to build up prices. Overheads margin components A fixed percentage of 15% is often added to the estimated unit cost of resources(plant, labour and materials) to cover the cost of overheads. Most of the contractorsdescribed this as “a charge for the administrative costs of a project”. An analysis of the profit and loss accounts of one of the firms gave an idea of the centres of overheadcosts. Total overhead was 14% of contract earnings for the year 2005. The elements of overhead costs comprised vehicle insurance and licensing (0.06% of total overheadcosts), staff welfare and safety (2.31%), tyres and tubes (4.73%), tender bidding, bonds and guarantees (1.33%), vehicles spares and repairs (10.84%), electricity andwater (2.61%), freight and handling charges (3.34%), rates and licensing (0.15%), fueland lubricants, cube and soil test analysis fees (0.20%), casuals/subcontractors w/tax(5.59%), tools and miscellaneous (0.24%), canteen expenses (4.12%), machineryspares & repairs & maintenance (4.87%), outstation allowance (6.77%), overseastravels (11.18%), hire of transport (1.88%), building maintenance (0.03%) and factoryinspection fees (0.00%).  Profit margin components Profit margins: All the contractors indicated that the profit margin is allocated inconjunction with overheads. The profit is not apportioned as a percentage of the total
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