Chapter 2: Price formation in construction contracts

The way that contractors and their clients negotiate and agree on price is complex, and not well explained in most of the literature. The process of arriving at a price comprises: how a construction price is described, awarded, and documented; procurement strategies; contractual arrangements; tendering procedures; pricing strategies of contractors; and governance of the construction market at a policy level.

2.1 Definition of main concepts

Bidding price, mark-up, and contingency, are concepts that are not consistently 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 important factors influencing a contractors mark-up. In their survey of 29 US contractors, they defined a bidding price as the direct costs for materials, labour, and plant, plus overhead and markup. In a textbook based on his experiential knowledge, Smith (1986) defined a bidding price as the net cost of a main contractors own measured work, i.e. costs of materials, plant, and labour; net cost of the preliminaries section; value of prime costs and provisional sums together with attendances; and the value of domestic subcontractors quotations. However, it is not clear why he terms some things net cost and others value. Indeed, gross costs need to be recouped from successful bids, regardless of value. This immediately highlights the importance of the related concepts of cost, price, and value that are explained shortly. In developing a conceptual fuzzy-based analytical approach to help contractors price the risk elements associated with construction projects, Peak et al. (1993) defined a bidding price as actual costs (direct, indirect, and overhead costs)

plus contractors profit. A textbook by Fisher and Jordan (1996: 70) stated that the calculation of profit should comprise required return and risk allowance. Bidding price, then, is clearly a price, based on costs with risk and market allowances added/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 made up 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 management literature as the sum of overheads, profit, and contingencies. However, this view appears to vary slightly among authors. The main point of departure hinges on whether markup includes overheads. Most authors such as Shash and Abdul-Hadi (1992), Shash (1998), Tah et al. (1994) and Hughes et al. (2006) define markup to include overheads. However, a few others such as Liu and Ling (2005) and Paek et al. (1993) view markup as profit plus contingencies. Tah et al. (1994: 31) attempts to clarify this by explaining that direct costs of a project comprise labour, plant, material and subcontractor costs. Indirect costs consist of site overheads, general overheads, profit, and allowances for risks. When indirect costs exclude site overheads they are often termed the markup.

2.1.3 Contingency
Risk contingencies may influence markup, and subsequently bidding price, as found in different studies of contractors: 400 US contractors by Mochtar and Arditi (2001), 12 US contractors by Smith and Bohn (1999), 7 UK contractors by Tah et al. (1994), and 30 US contractors by Neufville and King (1991). Smith and Bohn (1999) explained the contractor contingency as an estimated value of the extraordinary risks that a contractor is likely to encounter on a project. Tah et al. (1993: 284) explain this further, in the context of contractors, by

saying that extraordinary risks are those that are not covered by contract clauses, insurance or bonds for which a contractor must selfinsure using a contingency allowance. There must be safeguard clauses to protect a contractor from extraordinary risks in order to transfer them to the client. Tah et al. (1993) identifies the assessment of risk and uncertainty as a complex task that is itself shrouded in uncertainty. There authors also say that there are no standard methods on how to determine contingency allowances and that the decisions are often influenced by estimators and managements view of the future, and their desire to avoid an overrun situation based on their past experiences. However, Murdoch and Hughes (2008: 139, 7-8) point out that one method used by contractors in calculating risk premiums is, in theory at least, similar to how insurers examine and calculate risk premiums, although in most cases a contractors need for work may be stronger than the desire to add a premium for a risky project. Thus, market premium may wipe out or hide the risk premium especially as estimators deal with costs whereas Directors deal with premiums.

2.2 Procurement
The way that construction work is organized, documented and awarded, and how the market is governed at a policy level is reviewed.

2.2.1 Relationships between procurement, contracts, and tendering

The text-book approach to describing the way that the price of a construction project established reveals a complex process (for example, see Murdoch and Hughes 2008: 117-139). This introduces three inter-related concepts: procurement strategies, contractual arrangements, and tendering procedures. The relationship between these concepts is not always articulated clearly in the construction management literature, although it is clear that contractual arrangements are often dictated by the procurement strategy. In

broad terms, procurement can simply be understood as a method of buying goods and services (Hackett et al., 2007). Procurement methods in construction may be broadly classified as traditional and competitive and innovative and collaborative (Hughes et al., 2006). Risk allocation is often the basis of most procurement methods (Hackett et al., 2007). Thus, most people who procure goods and services may wish to record such transactions using formal, written contracts just in case things go wrong. The main distinguishing feature of different types of contractual arrangement in construction is often the extent to which the price is based on a fixed estimate provided by the contractor/supplier or cost reimbursement. Most contracts in construction are made by tender (Murdoch and Hughes, 2008). Thus, the contract price formation occurs through a competitive tendering framework that clients often use to obtain the lowest price from the winning contractor. Therefore, the main distinguishing feature of tendering procedures is often the extent of competition. However, a comprehensive review of literature on the origins and practice of tendering theory in construction by Runeson and Skitmore (1999) showed that this mechanism does not always help clients to achieve value for money on projects. Indeed, Smith and Bohn (1999) for example, observed that for clients, periods of high competition would yield bid prices that would appear on the face of it to be exceptional value. However, ultimately, the lowest bids may not prove to be such bargains, especially in cases that lead to claims and insolvencies. Given that the three concepts of procurement, contracts, and tendering form the basis of the organizational strategy adopted for projects (Murdoch and Hughes, 2008), these factors can influence the extent to which contractors assume and apportion risk in their bids for construction work. Murdoch and Hughes (2008: 138) observed that contractors know about costs (how much they pay for their resources), price (how much they sell their products/outputs for), and value (how much it is

worth to the buyer). However, quite often, most of the existing literature has focused on costs without giving much attention to value, which may, in fact, form the basis of a contractors tender pricing strategy. This means that clever contractors would indeed pitch their tender price above cost, but below value in order to improve their chances of winning a job. This bidding exercise often involves the estimating and adjudication processes that are explained later in the section on how contractors build up prices. Hence, tendering may depend on the level of expertise in the contractors estimating department. However, the elemental microeconomic theory of the behaviour of individual competitive markets (Lipsey, 1979: 93) suggests that the price clients will be willing to pay for construction work will depend not only on their available resources, but also what other sellers (contractors) in the market are willing to offer the same product for. Thus, tendering may be very dependent on the market or competitive environment in which it takes place. Neufville and King (1991: 659) identified need-for-work as one form of construction market inefficiency in their experimental study of 30 US contractors on risk, and this illustrated the impact of need-for-work premiums in bidding. In other words, this means that contractors who are hungry for work may undercut the market price, and in the process influence the subsequent pricing behaviour of their competitors who had lost work because of this. Thus, in recessionary periods, competent contractors who need work may be forced to pitch their prices very low and exploit other techniques, such as contract claims, to recover losses that result from accepting risks, as explained in a tendering costs survey involving 16 UK contractors by Hughes et al. (2006).

2.2.2 Procurement strategies in construction

As previously mentioned, procurement can be simply understood as a method of buying construction goods and services (Hughes et al., 2006). A textbook by Brook (2004) categorizes procurement methods in construction as: traditional, integrated, management-oriented, and

partnering. The traditional method of procurement favours the completion of design before construction thereby separating design from construction. The completeness of tendering documents increases the certainty of a tender price because the full scope of works is significantly known. Methods that integrate design and construction have the benefit of speedy construction (Brook, 2004). However, incomplete documents are often a source of uncertainty and difficulty for both client and contractor in predicting cost. Some major procurement methods include: general contracting, design and build, construction management, management contracting, private finance initiative, partnering, and performancebased contracting (Hackett et al., 2007). According to Murdoch and Hughes (2008: 88-93), the most important criteria for choosing procurement methods are: Involvement of the client in the construction process. Separation of design from management. Reserving the clients right to alter the specification. Clarity of clients contractual remedies. Complexity of the project. Speed from inception to completion. Certainty of price.

Since the early 1970s, new procurement methods (for example, partnering, value management, extended arm contracting, new engineering contract, private finance initiative, public private partnership, housing grants, construction and regeneration ACT 1996, and performance-based contracts) emerged in anticipation of improved services to clients, relationships and performance, and speed of construction. Some of these developments were mainly a consequence of the Latham Report (1994), a joint governmentindustry review of procurement and contractual arrangements in the UK, and of the Egan report (1998), which came to the conclusion that

the UK construction industry was under-achieving and too many of the industrys clients were dissatisfied with its overall performance. The reports called for a radical reform of the processes used to deliver project, with a view to eliminating waste and increasing value. There were initial speculations by industry actors and regulators that collaborative ways of working might lead to decreased tendering costs and perhaps lower construction costs. However, research by Hughes et al. (2006), involving contractors; subcontractors; and clients, showed no evidence that the presence or absence of collaboration influenced tendering costs. Given the introduction of innovative and collaborative procurement methods in the UK construction industry since the early 1970s, Hughes, et al. (2006) sought to quantify the commercial costs associated with the implementation of the most significant procurement methods based on four main parameters: marketing, agreeing terms, monitoring of work, and resolving disputes. The main aim was to examine whether different procurement approaches are associated with differences in procurement costs. The authors derived a method of classifying procurement methods based on six variables: source of funding, contractor selection method, price basis, responsibility for design, responsibility for management, and extent of sub-contracting. The authors found that tendering costs varied between 0-9% depending on the position in supply chain and nature of the work involved. For contractors, it was found that the total cost of obtaining work is high: -1% for traditional contracts and 2-3% for those involving PFI. They discovered that it was typical for contractors and consultants to be winning one in six contracts bid for and one in four for complex projects, meaning that the total costs of obtaining work were 3-6% for traditional work and 8-12% for complex work. Anonymity of competition, excessively long tender lists, diverse prequalification practices, and poor quality and timing of information for bidders were identified as wasteful practices in tendering. If such

Fixed price

Traditional with quantities

Schedule of rates

Cost reimburseme nt

CLIENT'S RISK design quantiti es prices design quantiti es prices

design quantitie s prices

CONTRACTOR' S RISK

design quantiti es prices

wasteful practices can be removed, it might be possible to lower tendering costs. Most contractors indicated that prices had to be pitched sufficiently low enough to stand a chance of winning competitively tendered work. They had very low margins on their work, largely because their profit is more closely connected with their cash flows than with overall mark-up. Interim payments are generally received before having to pay for their supplies and this reduces the amount they need to invest in a project, often to a point that contractors cash-flows are positive for most if not all of the project duration. Indeed, given the use of this cash for the duration of a project, it is no surprise to find that contractors can make money even when mark-up is zero or negative.

2.2.3 Contractual arrangements in construction

Contractual arrangements are formed between contractors and their clients, and other members of the supply chain, when they enter into agreements that satisfy the following six features: offer, acceptance, mistake, consideration, privity of contract, and form (Murdoch and Hughes, 2008: 118-128). Generally, the principles of law apply in

construction but also, Part II of the Housing Grants, Construction and Regeneration Act 1996 lays down rules for documenting contractual agreements for construction work. Different types of standard contracts are often used in construction for example, JCT Suite of Contracts; ICE Conditions of Contract; FIDIC Conditions of Contract; GC/Works/1 Contract; and NEC 3 Engineering and Construction Contract (Murdoch and Hughes, 2008: 101-115). Indeed, Brook (2004: 34-37) indicated that these standard forms of contract help to identify roles and responsibilities of the parties and provide rules to protect and direct the parties should things go wrong. Figure 2.1 shows the extent of risk ownership for both clients and contractors in different types of construction contracts in relation to design, quantities and prices (Brook, 2004: 15). Contracts are often intended to help allocate risk, with the main risk being the responsibility for who takes the risk of actual design, quantities, and price differing from what was estimated. Hence, construction prices may conveniently be analysed as fixed price or cost reimbursement (Hackett et al., 2007). Fixed or lump price bids are paid for on the basis of a contractors predetermined estimate, including risk and market premiums whereas cost reimbursement or unit rate bids are paid for on the basis of what the contractor actually spends in carrying out the work (Murdoch and Hughes, 2008: 86). Contractors tend to bear maximum risk in fixed price contractual arrangements whereas their risk is least in cost reimbursement. Thus, risk and market premiums in contractor bids may be influenced by the concept of fixed and cost reimbursement prices. Although contractual arrangements are often dictated by procurement strategies, Murdoch and Hughes (2008: 129) observed that there is not always a direct relationship between tendering procedures and contractual arrangements

2.2.4 Tendering procedures in construction

Theoretically, the tendering process marks the beginning of a contractual relationship. Based on the experiential knowledge of a group of architects and quantity surveyors, Hackett et al. (2007) described tendering as a procedure that helps clients to obtain an acceptable tender from contractors, at an appropriate time and circumstances. Tendering theory has existed for around 50 years now (Friedman, 1957) and it focuses mainly on the best use of market characteristics to achieving best price. Thus, traditionally, clients have believed that the best price can be gained by making contractors bid for work, so that the lowest price gets the job. To understand a potential dissatisfaction with tendering theory, Murdoch and Hughes (2008: 130) distinguish the difference between lowest tender price and actual price. This means that a contractor who bids too low, in order to be sure of winning the job, may find that the job actually loses money once the works are finished. The main mechanisms used by clients for awarding work to a contractor include open tendering, selective tendering, and open book accounting/negotiation (Brook, 2004). Open tendering often involves public invitation of interested contractors to tender for a job (Brook, 2004). Cost is often the allimportant factor, making it usual for the lowest bidder to win work. This system is often considered to have the advantage of guarding a client against exorbitant pricing but Smith and Bohns (1999) interviews with 12 small-to-medium contractors in the US found that such periods of high competition can yield bid prices of exceptional value on the surface, yet such bargain bids may not prove to be bargains in the end. A contractor who wins the contract may not be able to deliver the project successfully because of unrealistic quotations triggered by excessive competition. Thus, the degree of competition ought to be regulated tactically for meaningful bids. For example, a study by Shash (1992) showed that in Saudi Arabia, the

strategy used by government organizations involves a competitive system where the clients intention of selecting the lowest responsible bidder to deliver a project is announced in the appropriate media. Contractors who are interested will purchase the tender documents and prepare a bid for submission, in a sealed envelope, to the owner or his representative according to the normal procedures. The individual bidding prices are announced when the bids are opened and the obvious lowest bidder is declared. However, a routine bid evaluation process is performed and the job is usually awarded to the lowest responsible bidder. Selective tendering is an alternative tendering procedure designed to help overcome some shortcomings of open tendering (Smith, 1999). Some form of market competition is kept among contractors while unsuitable bidders are eliminated from the process. This is a common arrangement that entails drawing up a list of reputable firms and restricting bidding to them (Brook, 2004). Price remains a decisive factor although less competition among firms could lead to higher pricing levels. The formal recognition and apportionment of risk in contractor bids could be significant under a selective tendering scenario. A client may have considered other factors outside price as important to warrant the selection of reputable contractors. For example, the study by Shash (1992) showed further that in Saudi Arabia, semi-government organizations do not follow an entirely competitive system. One organization invites all contractors to submit a set of specified documents for qualification. Some of the contractors are then qualified and requested to submit technical and price bids / proposals in two different sealed envelopes. The technical bid contains the contractors plan of utilizing its resources to accomplish the works. The price bid contains the contractors consideration for doing the specified job. The technical bid is opened first and evaluated against established criteria. A contractor who receives points that are greater than a set of cut-off point remains in the

competition. The price bid of the technically qualified contractors will then be opened and the job will be awarded to the lowest price. A second semi-government organization uses a closed competitive bidding system where a number of contractors are selected randomly from a list. There is no explanation in the study on how this list is prepared but the selected contractors are then requested to submit a set of specified documents for qualification. The ones who qualify are invited to submit bids for the project, and the job will be awarded to the lowest price. Private organizations generally chose between either open or closed bid systems. Occasionally, some of the firms will proceed to negotiate prices with three or four of the contractors with the lowest prices. Because of the competitive framework that is employed by clients, bidders who are keen on winning a job especially when there are a large number of bidders may assume more risk than usual (Smith and Bohn, 1999). Thus, tendering procedures may influence bidding contingencies. Negotiated tendering usually involves the selection of a contractor based on their past performance, recommendation, familiarity with work or previous experience with the client or those advising the client (Brook, 2004). Sometimes, having started the competition, it would suit a client to dispense with the elements of competition altogether and approach only one contractor who is considered to be the most suitable under the circumstances and negotiate a price for the job (Smith, 1986). Contractors may apportion higher risk margins in negotiated tenders. However, there is a common understanding between the parties, which results in the negotiation option where each party comes to the table with significant strengths and goodwill. Negotiation involves the two main activities of agreeing a price and terms of contract between parties (Aqua Group, 1999). Pre-contract and post-contract negotiation of construction prices can be done depending on timing of events. Pre-contract negotiation may be done on a fixed price basis or open book cost reimbursement basis.

Post-contract negotiation involves known costs. If there are no comparable contract rates, this can involve an open book approach where the contractor, in justifying an entitlement on variations submits invoices, dayworks charges, etc. Negotiated tenders could lead to higher prices than competitive because of the omission of a market factor (Brook, 2004).

2.2.5 Governance of the construction market

Policies and ethics are often formulated to discourage unfair competition and promote fairness and equal opportunity in construction tendering (Brook, 2004). Contract bidding has traditionally been characterized by providing competing contractors the same information (Harris and McCaffer, 2005). There are, however, some conventions: contractors negotiate prices independently in open bidding; no consultation is usually allowed among competing contractors but they can revise their bid within the bidding time; contractors are allowed to submit only one bid in sealed bidding; all forms of negotiation are barred between the client and competing contractors; moreover, competing contractors are not allowed to discuss bids until they all receive them at a specified date, time and venue in sealed envelopes. Brook (2004: 96-97) discusses various forms of competition legislation in the UK designed to ensure that businesses compete fairly by outlawing certain types of anti-competitive behaviour such as collusion, covering and bid-rigging. These instruments revolving around competition law are often enforced in the UK by the Office of Fair Trading (OFT) using legislation like the Competition Act 1998, Enterprise Act 2002 and Company Directors Disqualification Act 1986. According to Whish (2003), another name used to describe this is in the US is antitrust law, and the law has three main elements: prohibiting agreements or practices that restrict free trading and competition between business entities; banning abusive behaviour by a firm dominating a market, or anti-competitive practices that tend to

lead to such a dominant position; and supervising the mergers and acquisitions of large corporations, including some joint ventures. A questionnaire survey of 46 building contractors, 14 subcontractors, 19 architects, and 107 QSs in Australia was conducted by Ray et al. (1999) to ascertain the extent to which ethical behaviour is supported and practised in the tendering process. The study addressed issues like withdrawal, bid cutting, cover pricing, compensation of tendering costs and collusion. The results showed that 77% of respondents claimed to follow a standard code of ethics in their everyday work oriented towards their professional training. Different standards and codes were found in use but the majority were satisfied with the requirements of these codes. On bidding ethics, 88% of respondents defended the right to withdraw offers before the closing of tenders; 59% of respondents believed that asking subcontractors to lower pretender quotes was a fair and practical method for winning tenders; 67% of main contractors thought this practice is okay if the subcontractor does not complain. There was a good amount of evidence of bid cutting in the industry. The majority of respondents rejected the theory of covering, although 46% of contractors had practiced it. 64% of respondents claimed knowledge of other companies who use a cover price. 67% of contractors also knew of others who used a cover price. The electrical industry was particularly exposed here. A third of all respondents and half of the contractors admitted to practicing cover pricing although they believed it was unethical. This shows a gap between theory and practice. In addition, 55% of contractors believed they should be reimbursed for tendering costs, although 79% of all respondents, including 77% of contractors, thought that builders should not be compensated for unsuccessful estimating services otherwise many builders would turn themselves into professional losing tenderers. Respondents argued that compensating for estimating costs would lessen competition, as some would become only professional tenderers, intentionally pricing their

work too high and living off on the compensation. On collusive tendering, 46% of respondents believed that competing tenderers should be allowed to discuss with each other certain matters of importance to the submissions. 50% of contractors also agreed but said such discussions should not cover prices and rates. 82% of respondents and 88% of building contractors believed that clients have the right to know what had been included in a tender. One QS believed that clients should have the right to understand the scope of works although matters such as profit, overheads and prices should not be the principals business although collaborative practices like partnering would require a full disclosure of costs. 27% of all respondents claimed knowledge of practices of collusive bidding in the industry compared to only 8% of building contractors who knew or were prepared to admit to knowing of any such arrangements. Some clients were found to practice unethical behaviour especially in instances where the projects would not proceed, tender information is incomplete, disclaimer clauses are inserted in the contract, and tender evaluation was unfair. The acceptance of the lowest price did not necessarily result in quality of work, and turned out to be more expensive in some cases. Sometimes, clients were involved in shopping bids to other contractors (Ray et al., 1999). Therefore, there is the need for more effective mechanisms of governing the construction markets at both policy and operational levels so that contractors compete for work more fairly. The relationship between main contractors and subcontractors has seen the introduction of some form of governance mechanism, particularly in the way subcontractors are invited to tender for work packages. Following the construction industry boards introduction of a Code of Practice for the selection of subcontractors in 1997, and the enactment of the Housing Grants, Construction and Regeneration Act in 1996, the Constructors Liaison Group, that represents most specialist and trade contractors, carried out a survey involving 700

firms to ascertain the extent of implementation of the Code in actual practice (Greenwood, 2001). The author examined data provided by one piling subcontractor on 175 invitations from 99 different main contractors. Of the 175 invitations to tender, only 16% had involved preliminary enquiries. Tender periods were found to be less than 3 weeks in 91% of cases. Only 11% of invitations indicated the selection criteria. 7% indicated that selection will not be solely on price basis. 86% of invitations included the proposed conditions of contract. 81% also indicated payment terms that would apply. 42% gave information regarding proposed start and finish dates. 49% of tenders were based on standard form conditions of contract, 34% involved amended standard forms, 6% involved main contractors own forms, and in 7% of cases, the subcontract form was not known. Comparing these results with proposals in the Code of Practice, Greenwood (2001) observed three main areas of strong agreement between practice and the Codes recommendations: indication of number of competitors, proposed conditions of contract, and payment terms. However, non-compliance was found in six other areas: preliminary enquiry, tender periods, selection other than price, indication of selection criteria, start and finish dates, and use of industry standard forms. Thus, it is clear that more effort is needed to ensure better governance of the tender-stage relationship between main contractors and their subcontractors.

2.3 Pricing
The way that contractors calculate and decide construction prices is reviewed.

2.3.1 How contractors build up prices

Several experiential-based textbooks and materials on the estimating, tendering, and bidding processes of contractors were identified in the literature for example, Brook (2004); Buchan et al. (2003); Hinze (1993); Skitmore (1989); Smith (1986); Geddes (1985);

Wood (1982); Enterkin and Reynolds (1978); Wainwright and Wood (1977); Hall (1972); and Willis (1929). However, since the study was primarily aimed at ascertaining how risk analysis impacts on tenders and is accounted for by contractors at the tender stage, empirical studies on how contractors actually price their work generally, and risk specifically, at the tender stage were sought. However, only a few questionnaire and interview-based studies on some aspects of what contractors do were identified (see Table 2.1). These did not seem to articulate sufficiently what contractors actually do about risks in the process of putting a bid together. Table 2.1 Empirical studies in journal on how contractors price work
Authors Uher Neufville and King Mak and Raftery Shash and Abdul-Hadi Shash Kodikara et al. Kodikara and McCaffer Tah et al. Skitmore and Wilcock Lowe and Skitmore Edwards and Edwards Ming et al. Uher Shash and Al-Amir Bajaj et al. Shash Shash Ray et al. Smith and Bohn Akintoye Akintoye and Year 199 1 199 1 199 2 199 2 199 3 199 3 199 3 199 4 199 4 199 4 199 5 199 6 199 6 199 7 199 7 199 8 199 8 199 9 199 9 200 0 200 0 Journa l CME JCME CME CME CME CME CME CME CME CME CME CME ECAM CME CME CME JCEM CME JCEM CME CME Vol. 9 117 10 10 11 11 11 12 12 12 13 14 3 15 15 124 124 17 125 18 18 Issu e 6 4 4 5 2 4 5 1 2 5 6 3 1/2 2 4 3 2 2 2 1 2 Pages 495508 659673 303320 415429 111118 261269 341346 31-36 139154 423431 485491 253264 83-95 187200 363369 219225 101106 139153 101108 77-89 161172 Aspect(s) of bid pricing Risks Risk and need for work Errors Markup tendering / markup BOQ Estimatin g data Indirect costs Item pricing Estimator Services Profit Estimatin g practices Processin g, use of IT Risks Bidding practices Pricing decisions Ethics Risks Estimatin g Cost estimatin Research method Q. Survey Experiment and interview Experiment Q. Survey Q. Survey Interview Interview Q. & I. Survey Q. Survey Interview Documents Documents Q. & I. Survey Q. Survey Q Survey Q. Survey Q. Survey Q. Survey Interview Survey Q. Survey Data point s 47 30 62 71 85 8 10 7 8 10 15 221 10 93 19 30 30 60 12 84 84 Country Australia US UK Saudi Arabia UK Sri Lanka Sri Lanka UK UK UK Australia Australia Australia Saudi Arabia Australia US US Australia US UK UK

Fitzgerald Mochtar and Arditi Asaaf et al. Wong and Hui Chan and Au 200 1 200 1 199 6 200 7 CME IJPM CME IJPM 19 19 24 25 4 5 4 6 405415 295303 425438 615626

g Pricing strategy Risks Risks Weather risks Survey Q. Survey Q. Survey Q. Survey 400 38 38 60 US Hong Kong Hong Kong Hong Kong

Note: CME: Construction Management and Economics; ECAM: Engineering, Construction and Architectural Management; JCEM: Journal of Construction Engineering and Management; IJPM: International Journal of Project Management

The few empirical studies on some aspects of how contractors build up prices showed significant differences between theory and practice. For example, Skitmore and Wilcock (1994) asked the estimators of 9 contractors in the UK to price 36 of the items in a typical bill of quantities taken from the ground work, in situ concrete work and masonry sections. Only half of the items were priced according to the methods described in the prescriptive literature. The rest was priced mainly by experience. The main factor that influenced the rating method was the item total. The amount of detail and effort put into tender preparation depended on how much a contractor wanted the work. Some estimators studied the drawings prior to pricing. Then, a subjective allowance was included in the item rates to cover the complexity of work. Others studied them after preparing the initial estimate. Then, they adjusted the estimate for complexity by including an arbitrary lump sum in the preliminaries. Contrary to the formalized approaches often described in the literature, one risk identification method used by one of the estimators interviewed by Skitmore and Wilcock was to just drive past a site to look if there was anything of obvious interest to price in a tender. Each item was usually priced to include profit and overheads. Most of the estimators thought that for example, an item such as the attendance on nominated subcontractors can be best rated with experience and luck. One pricing strategy in practice was that estimators rated preliminary items based on what might eventually be wanted rather than what was actually specified. A study involving seven projects on

how contractors plan for claims at the tender stage confirmed this result (Rooke et al., 2004). A survey of 84 UK contractors by Akintoye and Fitzgerald (2000) did not dwell on how contractors build up prices per se. However, it showed that a standard estimating procedure is used by most contractors, where the costs of construction (labour, plant, materials, and subcontractors) are first established and then an allowance is added for overheads and profit. This aligns with Mochtar and Arditi (2001) whose survey of the top 400 US contractors showed that costbased pricing is more dominant in the construction industry than market-based and other pricing mechanisms. Skitmore et al. (2006) provide a comprehensive review of literature on construction price formation mechanisms and theories. Majority of the 84 contractors stated that the bid prices of relatively smaller projects are usually left to the discretion of the chief estimator, whereas larger projects require the approval of management before submission. None of the contractors used any mathematical modelling technique in cost estimating practice, as also found in several studies of contractors elsewhere for example, Tah et al. (1994); Smith and Bohn (1999); Mochtar and Arditi (2001); Ahmed et al. (2002); and Wong and Hui (2006). A survey on how six UK contractors price the indirect costs of a project showed that, to begin with, the contractors had different perceptions of indirect costs (Tah et al., 1994). However, they agreed that general overheads, risk margins and profits are part of the indirect costs. Most of them used a checklist to price site overheads after calculating the total direct cost. The general overheads amount was often priced by expressing the budgeted annual overheads as a percentage of budgeted turnovers, and by applying this as a proportion of the cost of individual contracts. Two of the firms, who had a policy of apportioning the general overheads charge as a fixed percentage of the tender estimate, said that they were successful at

achieving their annual turnover targets. The fixed percentage applied to all projects. But adjustments could be made to the calculated percentage based on an observation of the yearly sales. Three ways were used by the contractors to include the general overhead charge in this bid: (1) some of the contractors spread it over all the bill items including the preliminary bill except provisional sums and prime cost items; (2) others included it partly as a lump sum in the preliminary bill and the remaining is spread over the measured work; and (3) another distributed it as a percentage of the contracts direct cost excluding prime cost. Tah et al.s (1994) study also showed that, in pricing risk, the contractors classified it into two categories quantifiable and unquantifiable. When the risk is quantifiable, the estimator subjectively included the appropriate cost of the risk in the estimate. When it is unquantifiable, the amount added was based on managements perception of the situation. The four ways of apportioning risk were: as a percentage in the profit margin; as a separate percentage in all costs; as a lump sum in the preliminary bill; and as a percentage in a bill if the risk is in that bill alone.

2.3.1 Pricing strategies

Best (1997) categorized the pricing strategies in construction into cost-based and market based approaches. Thus, in the former approach, the price of a product is established by adding a profit margin to the total cost of the product. Otherwise, the price of the product is based on a required size of market to achieve a certain level of profit. Mochtar and Arditi (2001) used the same terminologies to describe these pricing philosophies of contractors. Skitmore et al. (2006) rather referred to these pricing approaches as full-cost pricing and neoclassical micro-economic pricing. However, it may be appropriate to view these approaches as pricing models or methods of arriving at a price rather than pricing strategies

per se. A survey of the top 400 US contractors by Mochtar and Arditi (2001: 410) showed that 11 factors that influence a contractors pricing strategy are: project size/complexity, financial goals of company, companys strengths and weaknesses, expected future project from the owner, need-for-work, owners characteristics, project location, demand/economic conditions, competition, owners consultant characteristics, and subcontractors characteristics. In terms of pricing strategies, some of the ones that contractors use in practice for the purposes of winning work, ensuring a healthy cash flow, or achieving a reasonable profit are revealed in studies by Tah et al. (1994), Skitmore and Wilcock (1994), Shash (1998), Rooke et al. (2004) and Murdoch and Hughes (2008). These include back-end loading and front-end loading where in the former, contractors can artificially reduce the rates for work at the beginning of the project and add a corresponding proportion to the rates for work later on in the project. Alternatively, they can increase the rates at the beginning of a project with a corresponding decrease in the rates at the end (Murdoch and Hughes, 2008: 139). A survey of nine smaller builders in Australia by Skitmore and Wilcock (1994) found that some contractors tried to limit their tender preparation costs by reducing pre-tender planning and risk appraisal to an absolute minimum. This would reduce the bid price and increase competitiveness. They also found that contractors would rate preliminary items based on only what they felt the architect would eventually want on site rather than what was actually specified in the bills of quantities. The study also showed that some of the contractors actually limited their tender preparation costs by using experience to price certain items rather than a detailed rate analysis. A study involving seven construction projects and interviews with contractors by Rooke et al. (2004) showed that contractors bid at prices that reflect the expectation that the ultimate price of the job

will be inflated by claims. Such claims are planned carefully and the value of the expected return is calculated with a degree of accuracy that allows the contractor to bid at prices that, if quantities were to remain unchanged, would render a negative profit. A survey of 30 specialty contractors in Colorado, US by Shash (1998: 223) found some general contractors negotiate prices with subcontractors after they are awarded a contract. They will include a given subcontractors quotation in their bids but, in an effort to increase their own profit, they tend to persuade the subcontractor to reduce their prices. In response, in subsequent invitations, subcontractors either avoid working for such a contractor or inflate their quotations by 5-10%. When they take the job because they need it, (1) they would reduce, if at all possible, the amount of equipment needed at any given time; (2) rework the specifications to allow for an alternative; (3) reduce their work force; (4) manage the project more efficiently; and (5) assign some more skilled labour to improve productivity.

2.3.2 Estimating and tender preparation

According to Hall (1987: 7-8), each price build-up comprises the cost of materials (based on quotations from suppliers and merchants), unloading (including allowances for unloading), waste (2.5%-15%), labour, plant, and sundry items. Murdoch and Hughes (2008: 128129) explain the factors that contractors should take account of in calculating a contract price as the conditions of contract, risk premium, contract drawings, and the bill of quantities (if used). A bill of quantities (BQ) specifies the material and method of work to be used as well as the quantities of the work to be done including all the information that will affect the price (Brook, 2004). BQs are often prepared in conjunction with a standard method of measurement (SMM). According to Wainwright and Wood (1977: 7), building contracts can be based on BQs or not. Contracts without quantities are often minor works where the contract documents comprise

drawings (the plans, elevations, sections, and large scale details of the proposed building), specifications (detailed descriptions of the materials and methods for the works), and the form of agreement (legal documents signed by both parties, which states that the builder contracts to erect the building in accordance with the drawings and specifications and while client also agrees to pay the contract sum). A contract based on bill of quantities has the drawings, BQ and a form of agreement as the contract documents (Brook, 2004). Tender preparation traditionally involves the building up of unit rates and taking off of quantities for the project (Wainwright and Wood, 1977: 13). Buchan et al. (1993) explain that on receipt of the instructions, specifications, drawings, bill of quantities, and standard form of contract from the client, the contractors estimating task is to price the project and produce an estimate. Wood (1982: 13) defines a unit rate as the total overall cost of a specific item description for a quantity of one unit measured in accordance with the SMM. A unit rate should include the cost of all labour, material, plant, fuel, contractors own subcontractors, overheads, on-costs and contractors profit (gross and net profit). Unit rates for materials often include the direct cost of the materials, cutting waste, application waste, stockpile waste, residue waste, transit waste, and theft and vandalism. Therefore, risks may be included in unit rates. This literature shows that contractors may actually include risk in the calculation of unit prices of the construction items. Smith (1986: 53) outlines the traditional steps involved in tender preparation as: 1. The establishment of all-in rates for key items such as labour, gang costs, and plant rates. 2. The use of these all-in rates together with prices per unit for materials in order to calculate unit rates for each item in the bill.

3. The determination of the value of preliminaries once the measured items within the work sections have been priced. 4. The addition of PC and provisional sums contained in the BQ together with any general and special attendance items which may have been priced. 5. The addition of domestic subcontractors quotations for work to be sublet. The work may initially be divided into the individual sections to be priced. If there is a BQ, the divisions would have been done. Sections to be done by subcontractors will be identified by the estimator who will price for the labour, plant, materials, 2007 CDM regulations on health and safety, overhead and profit. These estimating processes are also described in Enterkin and Reynolds (1978: 4-6). A common method of inviting tenders is a BQ consisting of a detailed schedule of the work that the builder or contractor is needed to price (Geddes, 1985).

2.3.3 The estimating process

Harrison (1981) used his 30 years experience in estimating to explain some of the basic features, areas of uncertainty, and conflicts in relation to the theory and practice of estimating and tendering. The author brought together a group of estimators with a collective experience of over 100 years. Their number was not stated. However, the group of estimators defined an estimate as: "a reasonably accurate calculation and assessment of the probable cost of carrying out defined work under known conditions." The estimate involves both calculation and assessment, and often both scientific fact and human judgement of circumstances and probabilities must be brought together in its production (Harrison, 1981). The main difference between an estimate and a tender is highlighted in a textbook definition by Smith (1986: 34): "an estimate is the preliminary assessment of the net cost of carrying out a

specified amount of work whereas a tender is the final price offered to the client by the contractor and is the sum of money for which the contractor is prepared to carry out the work and will include not only the estimate but also a margin for overheads and profit." Thus, the estimate comprises the net cost of the contractors own measured work, the net cost of the preliminaries section, the value of PC and provisional sums together with attendances, and the value of the domestic subcontractors quotations. This amount is exclusive of management costs, overheads, profit, allowances for risk and other required tender adjustments. It is when the latter charges are added that the estimate converts into a tender (Smith, 1986; Brook, 2004). Harrison (1981) described a tender as "an offer to carry out defined work under stated conditions for a stated reimbursement." Converting an estimate into a tender is a delicate task that is often undertaken by management at an adjudication meeting because a decision often has to be made on the markup that produces a bid that is both competitive and profitable to the contractor (Brook, 2004). Geddes (1985: 3) described estimating as a largely mechanical and technical exercise involving the calculation of labour, material, plant and other operating costs. Enterkin and Reynolds (1978) describe estimating as a system of building-up or compiling notes to facilitate competitive tendering and is the technical process of predicting the costs of construction. Brook (2004: 66-84) described the different methods of estimating as single rate approximate estimating unit of accommodation, floor area and building volume methods; multiplerate approximate estimating elemental cost plans; approximate quantities; analytical estimating; and operational estimating.

2.3.4 The estimator and elements of a construction project price

The elements of a construction price are summarized in the next sections. Traditionally, the estimator prepares the work estimates

and prices (Smith, 1986: 1). The estimators job involves producing an estimate of the net cost to his company of carrying out a specified quantity of building work within a given period of time. To achieve this, they must be able to use their skills, experience and judgement to assess the extent of likely future costs (Harrison, 1981). The estimating process is often shrouded in an atmosphere of doubt and uncertainty. Therefore, some amount of guesswork is inevitable in the estimators work. Estimates are necessarily a matter of opinion, arbitrary and subjective (Smith, 1986). Unfortunately, the accuracy of an estimate may only be known after the project is complete, by which time it is too late to take any corrective action (Brook, 2004). Both Harrison (1981:2) and (Brook, 2004: 103-106) agree that the estimators role includes some managerial aspects. For example, the estimator may work with a team whose size depends on the size of the job. Estimators often coordinate input from different departments namely: operations; procurement; planning; commercial; and clerical/administrative. There are five elements of a price: Costs: Contractor bids often include direct and indirect costs as described from the practical experiences of Carr (1988). Direct costs are physically traceable to the activity in an economic manner, and not counted if the activity is not performed for example, labour, plant, materials. Indirect costs are mainly business costs that are not physically traceable, and counted even if the activity is not performed for example, job-site superintendent and tower crane. Direct cost estimates are theoretically assumed to be risk-free, (Tah et al., 1993: 282), where a risk free estimate described as the most likely estimate of the known scope of works (Mak and Picken, 2000: 131). Project costs may also be classified into variable and fixed costs (Carr, 1988). If a cost changes in proportion to a change in volume or quantity, it is variable for example, project insurance, building permit, project supervision, security, crane,

and job-site offices. If a cost remains unchanged in total despite wide fluctuations in volume or quantity, it is fixed for example, installation of electric and phone service to the job site and installation of shops, hoist, parking, and warehouse facilities. Most construction activities have a mixture of variable and fixed costs. Lump sum bids give an owner fixed prices whereas unit rate bids give owners a set of variable costs. Using a typical building estimate, Brook (2004: 109) broke down the elements of a project estimates as: labour (23%), plant (5%), materials (28%), and subcontractors (44%). However, this may vary between projects. Overheads: according to Harrison (1981: 3): overheads are: "those costs incurred in the operation of a business which are not directly related to the individual items of production." There are two main types of overheads. First, site overheads, which include site supervisory staff, site buildings, temporary roads and services. Second, head office (general) overheads, which include all costs incurred by the business as a whole which cannot be related directly to an individual contract. They include head office staff and buildings and a wide range of other costs including those relating to personnel. Profit margin: Harrison (1981: 3) defines profit as "the amount by which the excess of the assets of a company over its liabilities grows over time." In this case, growth in real terms was considered as distinct from that resulting from inflation. Profit may be in the form of assets, such as buildings. A profitable company may go into liquidation if sufficient assets are not in the form of or easily convertible into cash. Contingency allowances: Willis (1929: 13) explains that, when pricing, "besides the usual sum of money inserted in the bill of quantities for contingencies, many surveyors or

estimators are in the habit of inserting provisional measured quantities additional to the measurements made from the drawings. Such a half-hidden contingency sum may in some cases be justified by a rough and incomplete nature of the drawings from which the quantities have been prepared, but it is more often a confession by the surveyor of lack of skill or confidence in his work." This emphasizes that estimators may apportion risk in their unit rates and quantities to compensate for their own errors and inaccuracies. According to Hackett et al. (2007), there is a hidden premium in every contractors tender intended to charge the client for risk borne. A study by Smith and Bohn (1999: 106) involving 12 small-to-medium US contractors showed that the contractors may indeed "buffer" their bids whenever they feel uncertain about the cost of an individual work item. They did not view this as contingency but as an adjustment to working conditions. The contractors also suggested that, in addition to adjusting unit rates to account for anticipated work difficulties and risks, contingency was a percentage added to the total project cost. The only contractor who indicated the use of contingency in bids tried to pitch it to a sufficiently low value in order to be competitive. 11 out of 12 contractors claimed that they do not price visible contingencies in bids because of competition. Preliminaries: Preliminaries are certain items of expense, usually termed project overhead, which cannot be satisfactorily distributed among the unit rates (Brook, 2004). These are often calculated as lump sums and placed in the preliminaries bill which includes cost incurred in connection with elements such as cost of watching and lighting the work, controlling traffic, site offices, water, building fees, hoarding, temporary roads and contract guarantees (Geddes, 1985: 4).

2.3.5 Adjudication
The adjudication or consideration of the tender by senior management involves adding to the estimate a further element for overheads and profit (Smith, 1986: 54). The process may often appear to be a technical exercise. However, management often considers all factors affecting the companys wellbeing. The factors considered in adjudicating a bid include the accuracy and confidence regarding estimators work; workload to avoid overstretching the companys resources; market competition consciousness of other bids from competitors; project reports conditions of contract, terms of quotations from suppliers and subcontractors, assessment of risk; and resources required for the project (scheduling the firms resources efficiently). The estimator may suggest to management to reduce the allowances added for risk based on the confidence obtained from knowing that the estimate has been made to a high degree of accuracy (Harrison, 1981: 2). Based on his 30 years of experience as an estimator, Harrison (1981: 2) noted that there were companies which spent much time compiling statistics of their own and their competitors relative competitive positions and took heed of this information in their tendering. However, as the potential number of competitors rose, the difficulty and cost of obtaining and maintaining such information tended to become greater than any potential benefits. He argued that based on his many years involvement with the finalization of tenders for a wide range of types and sizes of contracts, it seemed that decisions on the final tender price were rarely as logical and reasoned as those who based tender decisions on past records would have others believe. This dispels the common belief underlying the maintenance of such records namely that tendering is a logical and rational process.

2.3.6 Pitching the tender price

A final tender price has to be decided once the estimate has been completed and risks have been assessed (Harrison, 1981). Three major factors are considered: 1. The probable cost of carrying out the works and the extent to which this could vary depending on circumstances which can be foreseen but the likelihood of which cannot be assessed with any accuracy, i.e. what is the extent of risk? 2. The minimum price at which this contract is likely to benefit the company; 3. The price level at which the firm will (a) certainly get the work; or (b) is likely to get the work. The critical and logical evaluation of (2) above should often inform the minimum price at which the tender should be submitted even if the price under (3) is lower. If, however, the price assessed in (3) is greater than that in (2), a decision will need to be made as to whether it is more advantageous to be almost certain to obtain a contract at a lower price, or have less likelihood of winning it a higher price. A fine subjective judgement of the situation will often be required at this stage, and management experience can play a vital role (Harrison, 1981).

2.4 Theoretical and empirical work on price formation

This Chapter dwelled mainly on five areas of importance to how contractors and their clients establish a construction price: procurement methods, contractual arrangements, tendering procedures, how contractors build up prices, and tender preparation. Several experiential-based studies on how contractors price their work were identified. However, just a few empirical studies on some aspects of what contractors actually do when it comes to pricing a bid were identified. This lack of a comprehensive material on the whole

process of how contractors actually arrive at a bidding price has been, perhaps justifiably, attributed to the reluctance of contractors to participate in such studies because of the commercially sensitive nature of the information involved. Nevertheless, without sufficient empirical knowledge of what contractors actually do, it would be difficult to find the appropriate understanding to guide analytical developments intended to help contractors. Thus, this gap in the exiting literature will be addressed in this study. The next chapter reviews the existing literature on risk and risk analysis and apportionment in construction.