CHAPTER 2

Chapter Summary

Discuss how pricing policy is adopted by managers and discuss the major issues
considered to adopt a certain pricing policy

• Identify the pricing arrangements in contracts and discuss what bidding

strategy can be adopted by a firm from a project to maximize wealth.

• For a strategy to be adopted one needs to know the tendering procedures and
the associated issues.

• Determining a firm’s mark-up target

• Discuss the major construction contracts and their risk structure to the
contracting parties .
Introduction

Factors that need to be considered in construction pricing

• Work at hand,
• The geographical areas in which the firm will operate,
• Type of client the organization is to favor, ( private, local
authority, community services, )
• Projected risks and uncertainties of the project,
• Form of the bid: (open, short-listed, pre-qualification, etc.)
 Bid Qualification
Procedure

Competitive Bid Negotiated Bid

Short listed Open Bid

One Stage Procedure Two Stage Procedure

Pre-Qualification Post Qualification

 In a competitive tendering situation, the contracting firm is
constantly facing a tradeoff of submitting a high price for
getting profit and the resulting shortage of work, with that
of a low price for winning the contracts, but allow little
profit margin.
 A bidding pattern could be worked out for his major
competitors.
 An optimum bid could be ascertained by combining the
probability curves (the Z-distribution) and developing a
bidding curve using a linear regression line for this
situation.
Develop a bidding strategy to determine the
OPTIMUM BID
 First step: MAP THE BIDDING PATTERN OF KEY
COMPETITORS
i) Preparation of a database of price quotations
offered by competing bidders
Contract No. Contractor’s Quotation Least Bidder’s Quotation
(Birr) (Birr)

1 500,000 450,000
2 750,000 750,000
3 1,000,000 800,000
4 625,000 600,000
5 850,000 800,000
6 250,000 250,000
7 400,000 350,000
8 1,200,000 1,000,000
9 900,000 875,000
10 1,100,000 950,000
ii) Plot the information on a scattered diagram
1,200,000

1,000,000

800,000
Winner’ Price

600,000
Scattered Diagram

400,000

200,000

0
0 200,000 400,000 600,000 800,000 1,000,000 1,200,000 1,400,000

Contractor’s Own Price

iii) Draw the most likely curve  regression line
1,200,000

1,000,000

800,000
Winner’ Price

600,000
Scattered Diagram

400,000

200,000

0
0 200,000 400,000 600,000 800,000 1,000,000 1,200,000 1,400,000

Contractor’s Own Price

 Y = mX + b
Where: Y: refers to the most likely winning price,
X: refers to contractor’s tender prices
m & b are coefficients of the regression line.
m: The slope of the line
b: The intercept of the line.
n : number of samples.
n xy    x  y 
m  y  x    x  xy 
2

  
n  x 2   x 
2 b
n x    x 
2 2

Furthermore, one has to determine the standard deviations, to

define the probable region of winning a tender.
n 1 2
VARIANCE 
n2

s y  m 2 sx2 
Sy = STDEVA (Y values)

Sx = STDEVA (X values)

Yi  
Z

iv) The final step is to decide the probability of winning
a tender using the normal distribution

Normal Distn
Probability

Z

Yi Price
 = probable cost
 The Standardized Normal
Distribution
Standardized Normal Probability
Table (Portion)  Z = 0 and Z = 1
.0478
Z .00 .01 .02
0.0 .0000 .0040 .0080

0.1 .0398 .0438 .0478

0.2 .0793 .0832 .0871
Z = 0.12
0.3 .0179 .0217 .0255 Shaded Area
Probabilities Exaggerated
 Standardizing Example

Z X    6.2  5  0.12
 10
Normal Standardized
Distribution Normal Distribution

 = 10 Z = 1

 = 5 6.2 X  = 0 .12 Z
Shaded Area Exaggerated
 Determining Probability
Z values: table

Z 0.00 0.01 … 0.09

.. .. ..
1.6 . .
1.9 0.4713 0.4719 … 0.4767
P( Yi ) = 95% 50% 45%

Z = 1.645

 = 615,251 Yi Tender amount

(Birr)
 Example: For the example in (i), suppose the
contractor’s tender sum amounts to 675,000 Birr.
Determine the rebate to be improvised with 95 %
probability of winning the tender.
 m= 0.813, b= 66476.91, Standard deviation = 55509.2
 The most likely winning price, Y = 0.813(675,000) + 66476.91 =
Birr 615, 251.91:- taken as the mean value (µ) with a winning
chance of 50%.
 The Z-values of 95% probability, from the table = 1.645. The
relation between Z and probability in this case is inverse.
 Higher probability is achieved by reducing the bid price and hence
we need to use the negative value of what we read from the table.
 Z= -1.645, µ = 615,251.91 and δ = 55509.2,
 Yi = Birr 523,939.28

 Rebate (R) = 100% -- (523,939.28/675,000) x100%

= 22.38 % (95% probability of wining)

= 8.9% (50% probability of winning)
Procedure for tendering:

i) Decision to Tender

• Production workload,
• Future commitments,
• Market,
• Capital,
• Associated risk,
• Estimating workload,
• Time for preparation of tender,
ii. Collection of Information:
Time scale for tendering with key dates as mentioned in the invitation to bid,
Examination of contract documents, with preliminaries attached with the
tender,
Assessment of client and design team,
Enquiries to suppliers and sub-contractors with a time scale,
Site and locality visit,
Discussion with site management, plant and planning department,
Evaluation of alternatives
Preparation of detailed construction method statement and pre-tender
programme, developed to include production outputs, gang sizes, plant
details, etc.
 iii .Preparation of estimate:
 Iv .The tender:
 V. Action with tender results:
  Mark up can be seen as the sum of general overheads, provision for
risks and profit margin.
 General Overheads
 Costs entailed in administering the company and providing off-site
administration
  Several expenses incurred at the corporate headquarters of a
company cannot be directly traced to any particular project
 Research and development
 publicity and advertisement
 cost of unsuccessful bids
 recruitment of personnel
 security personnel at the head office etc
 Contingency for Risks
Construction projects are risky proposition full of uncertainties and
risks.
In spite of different details known at the tendering stage there are
uncertainties and risks pertaining to :
•timely completion

• budget escalation

• site conditions

• soil characteristics

•labor, and material availability and so on.

In order to safeguard against these eventualities contractors keep certain

contingencies provisions so that should these risks materializes one can
use the contingency.
 Profit
 This is a reward of carrying out the business and thus taking risk.
Risky business carries more profit and vice versa.
 Factors Affecting Mark-Up
 Number of competitors and the intensity of competition
 Size, cost, and intensity of the project;
 Type of projects such as buildings or infrastructure
projects etc.
 Duration of the project
 Location of the project
 Season in which the work is done
 Degree of hazard and difficulty associated with the project
 Name of owner/consultant and designers and date and place of
bid submission;
 Labour availability and productivity
 Material availability and costs;
 Per cent of the work which is to be subcontracted and the bids of
sub- contractors
 Insurance cost and Fringe benefits;
 Supervisory talent availability
 Method of performing the work
 Uncertainty in estimate and historic profit;
 The current and forecasted economic conditions
 The contractor's risk attitudes
-To determine firm’s mark-up target, it is required establish:
i) Return on Capital Employed (ROCE), which is made to
account the following costs:
·      The average weighted cost of capital ( Interest of capital employed)
·        Profit margin (dividends, capital reserves...)
·        Corporate obligations such as taxations and deprecation costs.
·        Contingencies to cover uncertainties ( Risks)
ii) Annual Turnover on contracts. This can be obtained from
the firm’s short-term plan committed or planned for execution
in the current year.
iii) General overhead costs (off-site administration)
Example

Assumptions
Capital Employed: Birr 2,000,000
Turnover on contracts for year: Birr 4,000,000
General overheads: Birr 160,000
Return on Capital Employed 17%
Target: Contracts must contribute (Head office Mark-up)
General overheads Birr 160,000
Return ( ROCE) 17% ( 2,000,000 ) Birr 340,000
Head office Mark-up = Birr 500,000

Production Costs = 4,000,000 – 500,000 = Birr 3,500,000

Mark-up on contracts = (500,000 / 3,500,000) x 100 = 14.3%
 The distribution of markup is also an important decision that a contractor has
to take.
 Example: total value of the project was Br. 500 million and the markup
amount was Br 50 million. Thus the total cost to the contractor for this project
works out to be Br. 450 million. The markup in terms of percentage works out
to be 10% of the value or 11.11% of the total cost. There are different ways to
distribute the markup amount of Br. 50 million. Although it does not affect the
total bid price, the timing of cash receipt plays an important role in easing the
negative cash flow which is usually encountered in the beginning phases of a
project.

 Uniform loading
 Front loading and
 Back loading of Markup
Sl. No. Item Description Bid Total Cost Markup distribution (Total mark up amount = br. 50 million)
Amount In million
In million
Uniform Loading Front Loading Back Loading
Mark up Mark up % Mark up Mark up % Mark up Mark up %
amount amount amount

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

1 Earthwork - All Soils 5 4.5 0.5 11.11 1 22.22 0.25 5.56

2 Concrete works 80 72 8 11.11 10 13.89 6 8.33

3 Formwork 42 37.8 4.2 11.11 7 18.52 3 7.94

4 Reinforcement works 112.5 101.25 11.25 11.11 13 12.84 7 6.91

5 Brickwork 34 30.6 3.4 11.11 4.7 15.36 2 6.54

6 Plastering - All types 15 13.5 1.5 11.11 1.5 11.11 3.05 22.59

7 Painting - All Types 5 4.5 0.5 11.11 0.5 11.11 1 22.22

8 Flooring - All Types 110 99 11 11.11 7 7.07 14 14.14

9 Waterproofing works 12 10.8 1.2 11.11 1.2 11.11 1.2 11.11

10 Aluminum work 13.5 12.15 1.35 11.11 0.5 4.12 2.5 20.58

11 Electrical work 35 31.5 3.5 11.11 1 3.17 6 19.05

12 Sanitary & Plumbing 20 18 2 11.11 1 5.56 1 5.56

works
13 Road Works 16 14.4 1.6 11.11 1.6 11.11 3 20.83

Total 500 450 50 100% 50 100% 50 100%

 Table shows the three ways in which the total mark up has
been distributed.
 In the first case the total mark up is distributed uniformly
across all the activities of the project.
 In the second case, the activities which are likely to be taken
up early in the project carry a higher mark up percent. This
is known as ‘front end rate loading’ and has an effect of
improving the cash flow in the early stages of the contract.
 In the third case, the mark up percent is higher for the items
which are planned to be completed in the final or later
stages of the project. This is referred to as ‘back end rate
loading’
All Pricing arrangements have some common features in
the form of the legal documents binding the owner and
the supplier (s) of the facility.
Common types of Pricing arrangements are:
1) Competitive Bidding
2) Negotiated Contracts
• Final bid
• Reimbursement is direct
submitted on lump
project cost plus the
sum or unit price
contractor’s fee
basis
 All forms of construction pricing arrangements pose
differed level of risk to the parties in the contract.
Hence, it is important to identify the provisions for risk
in contracts.
 Force major : "Acts of God" and other external events such
as war, etc
 Indemnification: third party liability transfers
 Differing site conditions,
 Delays and extensions of time,
 Liquidated damages,
 Occupational safety and health of workers,
 Termination for default by contractor,
 Suspension of work
 etc
In addition to serving as a means of pricing construction,
contracts also structure the allocation of risk to various parties
involved:
I. Lump Sum Contract
All risk assigned to the contractor
  II. Unit Price Contract
 In a unit price contract the owner and the contractor agree as to
the price that will be charged per unit for the major elements of
the project.

Problem: Unbalanced Bid

Description Estimate Unit prices (Birr) Tender Amount ( Birr)
Quantity Contr. A Contr. B Contr. A Contr. B
Masonry Works 50 m3 250 400 12,500 20,000
Re. Bars 5000 kg 8 6 40,000 30,000
52,500 50,000

Description Actual Unit prices (Birr) Actual Amount ( Birr)

Quantity Contr. A Contr. B Contr. A Contr. B
Masonry Works 200 m3 250 400 50,000 80,000
Re. Bars 5100 kg 8 6 40,800 30,600
90,800 110,600
III. Cost + Contracts :negotiated contract b/n contractor and client.
Actual cost+profit+allowance for risk
1. Cost Plus Fixed Percentage Contract
Purpose: for new approach/technology yet to be analyzed
 The owner takes all the risks of cost
overruns
2. Cost Plus fixed fee contract
3. Cost plus variable percentage contract: used for
compromising b/n cost plus fixed fee and Cost Plus Fixed
Percentage Contract.
4. Target Estimate Contract
 Actual costs measured against target estimates of the contractor.
 This is another form of contract which specifies a penalty or
reward to a contractor, depending on
 whether the actual cost is greater than or less than the
contractor's estimated direct job cost.
THANK YOU!

38