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PhD thesis Chapter 2

PhD thesis Chapter 2
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  Chapter 2: Price formation in constructioncontracts  The way that contractors and their clients negotiate and agree onprice is complex, and not well explained in most of the literature. The process of arriving at a price comprises: how a constructionprice is described, awarded, and documented; procurementstrategies; contractual arrangements; tendering procedures; pricingstrategies of contractors; and governance of the constructionmarket at a policy level. 2.1 Definition of main concepts Bidding price, mark-up, and contingency, are concepts that are notconsistently defined in the literature. For the purpose of this study,they are defined as follows. 2.1.1 Bidding price Liu and Ling (2005) attempted to ascertain the most importantfactors influencing a contractor’s mark-up. In their survey of 29 UScontractors, they defined a bidding price as the direct costs formaterials, labour, and plant, plus overhead and markup. In atextbook based on his experiential knowledge, Smith (1986) defineda bidding price as the net cost of a main contractor’s own measuredwork, i.e. costs of materials, plant, and labour; net cost of thepreliminaries section; value of prime costs and provisional sumstogether with attendances; and the value of domesticsubcontractors’ quotations. However, it is not clear why he termssome things ‘net cost’ and others ‘value’. Indeed, gross costs needto be recouped from successful bids, regardless of value. Thisimmediately highlights the importance of the related concepts of cost, price, and value that are explained shortly. In developing aconceptual fuzzy-based analytical approach to help contractorsprice the risk elements associated with construction projects, Peak et al. (1993) defined a bidding price as actual costs (direct, indirect,  and overhead costs) plus contractor’s profit. A textbook by Fisherand Jordan (1996: 70) stated that the calculation of profit shouldcomprise required return and risk allowance. Bidding price, then, isclearly a price, based on costs with risk and market allowancesadded/subtracted. This is sometimes known as a tender price. 2.1.2 Markup Markup is an addition to costs in order to calculate price. It is madeup of two parts, first contingency for risk, second market premium. This margin may also include a premium for capital employed.Markup is commonly understood in the construction managementliterature as the sum of overheads, profit, and contingencies.However, this view appears to vary slightly among authors. Themain point of departure hinges on whether markup includesoverheads. Most authors such as Shash and Abdul-Hadi (1992),Shash (1998), Tah et al . (1994) and Hughes et al . (2006) definemarkup to include overheads. However, a few others such as Liuand Ling (2005) and Paek et al . (1993) view markup as profit pluscontingencies. Tah et al . (1994: 31) attempts to clarify this byexplaining that “direct costs of a project comprise labour, plant,material and subcontractor costs. Indirect costs consist of siteoverheads, general overheads, profit, and allowances for risks.When indirect costs exclude site overheads they are often termedthe markup.” 2.1.3 Contingency Risk contingencies may influence markup, and subsequently biddingprice, as found in different studies of contractors: 400 UScontractors by Mochtar and Arditi (2001), 12 US contractors bySmith and Bohn (1999), 7 UK contractors by Tah et al . (1994), and30 US contractors by Neufville and King (1991). Smith and Bohn(1999) explained the contractor contingency as “an estimated valueof the extraordinary risks that a contractor is likely to encounter on  a project.” Tah et al . (1993: 284) explain this further, in the contextof contractors, by saying that “extraordinary risks are those that arenot covered by contract clauses, insurance or bonds for which acontractor must self-insure using a contingency allowance. Theremust be safeguard clauses to protect a contractor fromextraordinary risks in order to transfer them to the client.” Tah et al . (1993) identifies the assessment of risk and uncertainty as acomplex task that is itself shrouded in uncertainty. There authorsalso say that there are no standard methods on how to determinecontingency allowances and that the decisions are often influencedby estimators and management’s view of the future, and theirdesire to avoid an overrun situation based on their pastexperiences. However, Murdoch and Hughes (2008: 139, 7-8) pointout that one method used by contractors in calculating riskpremiums is, in theory at least, similar to how insurers examine andcalculate risk premiums, although in most cases a contractor’s needfor work may be stronger than the desire to add a premium for arisky project. Thus, market premium may wipe out or hide the riskpremium especially as estimators deal with costs whereas Directorsdeal with premiums. 2.2 Procurement  The way that construction work is organized, documented andawarded, and how the market is governed at a policy level isreviewed. 2.2.1 Relationships between procurement, contracts,and tendering  The text-book approach to describing the way that the price of aconstruction project established reveals a complex process (forexample, see Murdoch and Hughes 2008: 117-139). This introducesthree inter-related concepts: procurement strategies, contractualarrangements, and tendering procedures. The relationship betweenthese concepts is not always articulated clearly in the construction  management literature, although it is clear that contractualarrangements are often dictated by the procurement strategy. Inbroad terms, procurement can simply be understood as a method of buying goods and services (Hackett et al ., 2007). Procurementmethods in construction may be broadly classified as ‘traditionaland competitive’ and ‘innovative and collaborative’ (Hughes et al .,2006). Risk allocation is often the basis of most procurementmethods (Hackett et al ., 2007). Thus, most people who procuregoods and services may wish to record such transactions usingformal, written contracts just in case things go wrong. The maindistinguishing feature of different types of contractual arrangementin construction is often the extent to which the price is based on afixed estimate provided by the contractor/supplier or costreimbursement. Most contracts in construction are made by tender(Murdoch and Hughes, 2008). Thus, the contract price formationoccurs through a competitive tendering framework that clients oftenuse to obtain the lowest price from the winning contractor. Therefore, the main distinguishing feature of tendering proceduresis often the extent of competition. However, a comprehensivereview of literature on the srcins and practice of tendering theory inconstruction by Runeson and Skitmore (1999) showed that thismechanism does not always help clients to achieve value for moneyon projects. Indeed, Smith and Bohn (1999) for example, observedthat for clients, periods of high competition would yield bid pricesthat would appear on the face of it to be exceptional value.However, ultimately, the lowest bids may not prove to be suchbargains, especially in cases that lead to claims and insolvencies.Given that the three concepts of procurement, contracts, andtendering form the basis of the organizational strategy adopted forprojects (Murdoch and Hughes, 2008), these factors can influencethe extent to which contractors assume and apportion risk in theirbids for construction work.  Murdoch and Hughes (2008: 138) observed that contractors knowabout costs (how much they pay for their resources), price (howmuch they sell their products/outputs for), and value (how much it isworth to the buyer). However, quite often, most of the existingliterature has focused on costs without giving much attention tovalue, which may, in fact, form the basis of a contractor’s tenderpricing strategy. This means that clever contractors would indeedpitch their tender price above cost, but below value in order toimprove their chances of winning a job. This bidding exercise ofteninvolves the ‘estimating’ and ‘adjudication’ processes that areexplained later in the section on how contractors build up prices.Hence, tendering may depend on the level of expertise in thecontractor’s estimating department. However, the elemental micro-economic theory of the behaviour of individual competitive markets(Lipsey, 1979: 93) suggests that the price clients will be willing topay for construction work will depend not only on their availableresources, but also what other sellers (contractors) in the marketare willing to offer the same product for. Thus, tendering may bevery dependent on the market or competitive environment in whichit takes place. Neufville and King (1991: 659) identified ‘need-for-work’ as one form of construction market inefficiency in theirexperimental study of 30 US contractors on risk, and this illustratedthe impact of need-for-work premiums in bidding. In other words,this means that contractors who are hungry for work may undercutthe market price, and in the process influence the subsequentpricing behaviour of their competitors who had lost work because of this. Thus, in recessionary periods, competent contractors who needwork may be forced to pitch their prices very low and exploit other techniques, suchas contract claims, to recover losses that result from accepting risks, as explained in atendering costs survey involving 16 UK contractors by Hughes et al. (2006).
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