8.5 Relative Costs of Construction Contracts

Regardless of the type of construction contract selected by the owner, the contractor recognizes that the actual construction cost will never be identical to its own estimate because of imperfect information. Furthermore, it is common for the owner to place work change orders to modify the original scope of work for which the contractor will receive additional payments as stipulated in the contract. The contractor will use different markups commensurate with its market circumstances and with the risks involved in different types of contracts, leading to different contract prices at the time of bidding or negotiation. The type of contract agreed upon may also provide the contractor with greater incentives to try to reduce costs as much as possible. The contractor's gross profit at the completion of a project is affected by the type of contract, the accuracy of its original estimate, and the nature of work change orders. The owner's actual payment for the project is also affected by the contract and the nature of work change orders.

In order to illustrate the relative costs of several types of construction contracts, the pricing mechanisms for such construction contracts are formulated on the same direct job cost plus corresponding markups reflecting the risks. Let us adopt the following notation:

E=contractor's original estimate of the direct job cost at the time of contract award

M =amount of markup by the contractor in the contract

B =estimated construction price at the time of signing contract

A =contractor's actual cost for the original scope of work in the contract

U =underestimate of the cost of work in the original estimate (with negative value of U denoting an overestimate)

C =additional cost of work due to change orders

P =actual payment to contractor by the owner

F =contractor's gross profit

R =basic percentage markup above the original estimate for fixed fee contract

Ri =premium percentage markup for contract type i such that the total percentage markup is (R + Ri), e.g. (R + R1) for a lump sum contract, (R + R2) for a unit price contract, and (R + R3) for a guaranteed maximum cost contract

N =a factor in the target estimate for sharing the savings in cost as agreed upon by the owner and the contractor, with 0 N 1.

At the time of a contract award, the contract price is given by:

(8.1)

The underestimation of the cost of work in the original contract is defined as:

(8.2)

Then, at the completion of the project, the contractor's actual cost for the original scope of work is:

(8.3)

For various types of construction contracts, the contractor's markup and the price for construction agreed to in the contract are shown in Table 8-1. Note that at the time of contract award, it is assumed that A = E, even though the effects of underestimation on the contractor's gross profits are different for various types of construction contracts when the actual cost of the project is assessed upon its completion.

TABLE 8-1  Original Estimated Contract Prices

Payments of change orders are also different in contract provisions for different types of contracts. Suppose that payments for change orders agreed upon for various types of contracts are as shown in column 2 of Table 8-2. The owner's actual payments based on these provisions as well as the incentive provisions for various types of contracts are given in column 3 of Table 8-2. The corresponding contractor's profits under various contractual arrangements are shown in Table 8-3.

TABLE 8-2  Owner's Actual Payment with Different Contract Provisions

TABLE 8-3  Contractor's Gross Profit with Different Contract Provisions

It is important to note that the equations in Tables 8-1 through 8-3 are illustrative, subject to the simplified conditions of payments assumed under the various types of contracts. When the negotiated conditions of payment are different, the equations must also be modified.

Example 8-5: Contractor's Gross Profits under Different Contract Arrangements

Consider a construction project for which the contractor's original estimate is $6,000,000. For various types of contracts, R = 10%, R1 = 2%, R2 = 1%, R3 = 5% and N = 0.5. The contractor is not compensated for change orders under the guaranteed maximum cost contract if the total cost for the change orders is within 6% ($360,000) of the original estimate. Determine the contractor's gross profit for each of the seven types of construction contracts for each of the following conditions.

(a) U = 0, C = 0
(b) U = 0, C = 6% E = $360,000
(c) U = 4% E = $240,000, C = 0
(d) U = 4% E = $240,000 C = 6% E = $360,000
(e) U = -4% E = -$240,000, C = 0
(f) U = -4% E = -$240,000, C = 6% E = $360,000

In this example, the percentage markup for the cost plus fixed percentage contract is 10% which is used as the bench mark for comparison. The percentage markup for the lump sum contract is 12% while that for the unit price contract is 11%, reflecting the degrees of higher risk. The fixed fee for the cost plus fixed fee is based on 10% of the estimated cost, which is comparable to the cost plus fixed percentage contract if there is no overestimate or underestimate in cost. The basic percentage markup is 10% for both the cost plus variable percentage contract and the target estimator contract, but they are subject to incentive bonuses and penalties that are built in the formulas for owners' payments. The percentage markup for the guaranteed maximum cost contract is 15% to account for the high risk undertaken by the contractor. The results of computation for all seven types of contracts under different conditions of underestimation U and change order C are shown in Table 8-4

TABLE 8-4  Contractor's Gross Profits under Different Conditions (in $1,000)

Example 8-6: Owner's Payments under Different Contract Arrangements

Using the data in Example 8-5, determine the owner's actual payment for each of the seven types of construction contracts for the same conditions of U and C. The results of computation are shown in Table 8-5.

TABLE 8-5  Owner's Actual Payments under Different Conditions (in $1,000)

8.6 Principles of Competitive Bidding

Competitive bidding on construction projects involves decision making under uncertainty where one of the greatest sources of the uncertainty for each bidder is due to the unpredictable nature of his competitors. Each bid submitted for a particular job by a contractor will be determined by a large number of factors, including an estimate of the direct job cost, the general overhead, the confidence that the management has in this estimate, and the immediate and long-range objectives of management. So many factors are involved that it is impossible for a particular bidder to attempt to predict exactly what the bids submitted by its competitors will be.

It is useful to think of a bid as being made up of two basic elements: (1) the estimate of direct job cost, which includes direct labor costs, material costs, equipment costs, and direct filed supervision; and (2) the markup or return, which must be sufficient to cover a portion of general overhead costs and allow a fair profit on the investment. A large return can be assured simply by including a sufficiently high markup. However, the higher the markup, the less chance there will be of getting the job. Consequently a contractor who includes a very large markup on every bid could become bankrupt from lack of business. Conversely, the strategy of bidding with very little markup in order to obtain high volume is also likely to lead to bankruptcy. Somewhere in between the two extreme approaches to bidding lies an "optimum markup" which considers both the return and the likelihood of being low bidder in such a way that, over the long run, the average return is maximized.

From all indications, most contractors confront uncertain bidding conditions by exercising a high degree of subjective judgment, and each contractor may give different weights to various factors. The decision on the bid price, if a bid is indeed submitted, reflects the contractor's best judgment on how well the proposed project fits into the overall strategy for the survival and growth of the company, as well as the contractor's propensity to risk greater profit versus the chance of not getting a contract.

One major concern in bidding competitions is the amount of "money left on the table," of the difference between the winning and the next best bid. The winning bidder would like the amount of "money left on the table" to be as small as possible. For example, if a contractor wins with a bid of $200,000, and the next lowest bid was $225,000 (representing $25,000 of "money left on the table"), then the winning contractor would have preferred to have bid $220,000 (or perhaps $224,999) to increase potential profits.

Some of the major factors impacting bidding competitions include:

Exogenous Economic Factors

Contractors generally tend to specialize in a submarket of construction and concentrate their work in particular geographic locations. The level of demand in a submarket at a particular time can influence the number of bidders and their bid prices. When work is scarce in the submarket, the average number of bidders for projects will be larger than at times of plenty. The net result of scarcity is likely to be the increase in the number of bidders per project and downward pressure on the bid price for each project in the submarket. At times of severe scarcity, some contractors may cross the line between segments to expand their activities, or move into new geographic locations to get a larger share of the existing submarket. Either action will increase the risks incurred by such contractors as they move into less familiar segments or territories. The trend of market demand in construction and of the economy at large may also influence the bidding decisions of a contractor in other ways. If a contractor perceives drastic increases in labor wages and material prices as a result of recent labor contract settlements, it may take into consideration possible increases in unit prices for determining the direct project cost. Furthermore, the perceptions of increase in inflation rates and interest rates may also cause the contractor to use a higher markup to hedge the uncertainty. Consequently, at times of economic expansion and/or higher inflation rate, contractors are reluctant to commit themselves to long-term fixed price contracts.

Characteristics of Bidding Competition

All other things being equal, the probability of winning a contract diminishes as more bidders participate in the competition. Consequently, a contractor tries to find out as much information as possible about the number and identities of potential bidders on a specific project. Such information is often available in the Dodge Bulletin<Dodge Bulletin (daily publication), F. W. Dodge Corp., New York, NY.> or similar publications which provide data of potential projects and names of contractors who have taken out plans and specifications. For certain segments, potential competitors may be identified through private contacts, and bidders often confront the same competitor's project after project since they have similar capabilities and interests in undertaking the same type of work, including size, complexity and geographical location of the projects. A general contractor may also obtain information of potential subcontractors from publications such as Credit Reports(Credit Reports, Building Construction Division, and Bradstreet, Inc., New York, N.Y.) published by Dun and Bradstreet, Inc. However, most contractors form an extensive network with a group of subcontractors with whom they have had previous business transactions. They usually rely on their own experience in soliciting subcontract bids before finalizing a bid price for the project.

Objectives of General Contractors in Bidding

The bidding strategy of some contractors are influenced by a policy of minimum percentage markup for general overhead and profit. However, the percentage markup may also reflect additional factors stipulated by the owner such as high retention and slow payments for completed work, or perceptions of uncontrollable factors in the economy. The intensity of a contractor's efforts in bidding a specific project is influenced by the contractor's desire to obtain additional work. The winning of a particular project may be potentially important to the overall mix of work in progress or the cash flow implications for the contractor. The contractor's decision is also influenced by the availability of key personnel in the contractor organization. The company sometimes wants to reserve its resources for future projects, or commits itself to the current opportunity for different reasons.

Contractor's Comparative Advantages

A final important consideration in forming bid prices on the part of contractors are the possible special advantages enjoyed by a particular firm. As a result of lower costs, a particular contractor may be able to impose a higher profit markup yet still have a lower total bid than competitors. These lower costs may result from superior technology, greater experience, better management, better personnel or lower unit costs. A comparative cost advantage is the most desirable of all circumstances in entering a bid competition.

8.7 Principles of Contract Negotiation

Negotiation is another important mechanism for arranging construction contracts. Project managers often find themselves as participants in negotiations, either as principal negotiators or as expert advisors. These negotiations can be complex and often present important opportunities and risks for the various parties involved. For example, negotiation on work contracts can involve issues such as completion date, arbitration procedures, special work item compensation, contingency allowances as well as the overall price. As a general rule, exogenous factors such as the history of a contractor and the general economic climate in the construction industry will determine the results of negotiations. However, the skill of a negotiator can affect the possibility of reaching an agreement, the profitability of the project, the scope of any eventual disputes, and the possibility for additional work among the participants. Thus, negotiations are an important task for many project managers. Even after a contract is awarded on the basis of competitive bidding, there are many occasions in which subsequent negotiations are required as conditions change over time.

In conducting negotiations between two parties, each side will have a series of objectives and constraints. The overall objective of each party is to obtain the most favorable, acceptable agreement. A two party, one issue negotiation illustrates this fundamental point. Suppose that a developer is willing to pay up to $500,000 for a particular plot of land, whereas the owner would be willing to sell the land for $450,000 or more. These maximum and minimum sales prices represent constraints on any eventual agreement. In this example, any purchase price between $450,000 and $500,000 is acceptable to both of the involved parties. This range represents a feasible agreement space. Successful negotiations would conclude in a sales price within this range. Which party receives the $50,000 in the middle range between $450,000 and $500,000 would typically depend upon the negotiating skills and special knowledge of the parties involved. For example, if the developer was a better negotiator, then the sales price would tend to be close to the minimum $450,000 level.

With different constraints, it might be impossible to reach an agreement. For example, if the owner was only willing to sell at a price of $550,000 while the developer remains willing to pay only $500,000, then there would be no possibility for an agreement between the two parties. Of course, the two parties typically do not know at the beginning of negotiations if agreements will be possible. But it is quite important for each party to the negotiation to have a sense of their own reservation price, such as the owner's minimum selling price or the buyer's maximum purchase price in the above example. This reservation price is equal to the value of the best alternative to a negotiated agreement.

Poor negotiating strategies adopted by one or the other party may also preclude an agreement even with the existence of a feasible agreement range. For example, one party may be so demanding that the other party simply breaks off negotiations. In effect, negotiations are not a well behaved solution methodology for the resolution of disputes.

The possibility of negotiating failures in the land sale example highlights the importance of negotiating style and strategy with respect to revealing information. Style includes the extent to which negotiators are willing to seem reasonable, the type of arguments chosen, the forcefulness of language used, etc. Clearly, different negotiating styles can be more or less effective. Cultural factors are also extremely important. American and Japanese negotiating styles differ considerably, for example. Revealing information is also a negotiating decision. In the land sale case, some negotiators would readily reveal their reserve or constraint prices, whereas others would conceal as much information as possible (i.e. "play their cards close to the vest") or provide misleading information.

In light of these tactical problems, it is often beneficial to all parties to adopt objective standards in determining appropriate contract provisions. These standards would prescribe a particular agreement or a method to arrive at appropriate values in a negotiation. Objective standards can be derived from numerous sources, including market values, precedent, professional standards, what a court would decide, etc. By using objective criteria of this sort, personalities and disruptive negotiating tactics do not become impediments to reaching mutually beneficial agreements.

With additional issues, negotiations become more complex both in procedure and in result. With respect to procedure, the sequence in which issues are defined or considered can be very important. For example, negotiations may proceed on an issue-by-issue basis, and the outcome may depend upon the exact sequence of issues considered. Alternatively, the parties may proceed by proposing complete agreement packages and then proceed to compare packages. With respect to outcomes, the possibility of the parties having different valuations or weights on particular issues arises. In this circumstance, it is possible to trade-off the outcomes on different issues to the benefit of both parties. By yielding on an issue of low value to himself but high value to the other party, concessions on other issues may be obtained.

The notion of Pareto optimal agreements can be introduced to identify negotiated agreements in which no change in the agreement can simultaneously make both parties better off. Figure 8-1 illustrates Pareto optimal agreements which can be helpful in assessing the result of multiple issue negotiations. In this figure, the axes represent the satisfaction or desirability of agreements to the parties, denoted I and II. This representation assumes that one can place a dollar or utility value on various agreements reached in a multiple-issue negotiation between two parties. Points in the graph represent particular agreements on the different issues under consideration. A particular point may be obtained by more than one contract agreement. The curved line encloses the set of all feasible agreements; any point in this area is an acceptable agreement. Each party has a minimum acceptable satisfaction level in this graph. Points on the interior of this feasible area represent inferior agreements since some other agreement is possible that benefits both parties. For example, point B represents a more desirable agreement than point A. In the previous example, point B might represent a purchase price of $490,000 and an immediate purchase, whereas point A might represent a $475,000 sale price and a six month delay. The feasible points that are not inferior constitute the set of Pareto optimal or efficient agreements; these points lie on the north-east quadrant of the feasible region as marked on the figure.

Figure 8-1  Illustration of a Pareto Optimal Agreement Set

The definition of Pareto optimal agreements allows one to assess at least one aspect of negotiated outcomes. If two parties arrive at an inferior agreement (such as point A in Figure 8-1), then the agreement could be improved to the benefit of both parties. In contrast, different Pareto optimal agreements (such as points B and C in Figure 8-1) can represent widely different results to the individual parties but do not have the possibility for joint improvement.

Of course, knowledge of the concept of Pareto optimal agreements does not automatically give any guidance on what might constitute the best agreements. Much of the skill in contract negotiation comes from the ability to invent new options that represent mutual gains. For example, devising contract incentives for speedier completion of projects may result in benefits to both contractors and the owner.

Example 8-7: Effects of different value perceptions.

Suppose that the closing date for sale of the land in the previous case must also be decided in negotiation. The current owner would like to delay the sale for six months, which would represent rental savings of $10,000. However, the developer estimates that the cost of a six month delay would be $20,000. After negotiation, suppose that a purchase price of $475,000 and a six month purchase delay are agreed upon. This agreement is acceptable but not optimal for both parties. In particular, both sides would be better off if the purchase price was increased by $15,000 and immediate closing instituted. The current owner would receive an additional payment of $15,000, incur a cost of $10,000, and have a net gain of $5,000. Similarly, the developer would pay $15,000 more for the land but save $20,000 in delay costs. While this superior result may seem obvious and easily achievable, recognizing such opportunities during a negotiation becomes increasingly difficult as the number and complexity of issues increases.