Demystifying a Mechanism to Deal with Open Market Vacillations
Demystifying a Mechanism to Deal with Open Market Vacillations
Whenever, the majority of contractors locked into lump sum fixed-priced contracts, open market vacillations are a risk to them, particularly in contracts having long durations. This is not only unfair by the contractor but also unhealthy as an industry in long run. A surge in material costs may considerably affect their bottom lines where profit margins are not as high as they once were. As a result, contractors have been searching for recovery means through claims on their own basis whenever a mechanism to deal with price escalation is absent in the contract. Many contractors use consumer price index (CPI) as the basis of their claims although the purpose of the index is something else.
Indeed, it may be cheaper in long run for the employer to pay for what did happen rather than what the contractor thought might happen in those areas of doubt which the contractor cannot influence. In line with this principle of construction economics, a method to deal with price escalation allows the tenderers to overcome the risk of providing an additional mark-up for unforeseen price variations. The benefit of doubt would then be passed on to the employer in a deflation since any contract price adjustment is applicable in both ways. Since the aim behind any mechanism should be to reasonably reimburse the contractor for those eventualities he could not reasonably foresee in advance, it must eventually reflect an equitable risk sharing between the employer and the contractor. Accordingly, when the cost of construction material exceeds a price range if agreed by the parties, there are many basic adjustment methods such as weighted average method, arithmetic average method and composite method etc., wildly used in many construction sectors.
Similarly, many standard forms of contract provide a mechanism for contract price adjustment due to open market escalation in specified construction inputs such as major building materials, hire charges of plants, and wages for the labor. The choice of those inputs largely depends on the cost significance in the overall share for the quoted tender price. Therefore, the adjustments to the contract price shall be made in respect of not only in rise but also in fall in the cost of materials and other inputs affecting the cost of the execution of the works. Together with the traditional methods in calculating this escalated component using contemporary records, there are formula methods such as NEDO, Osborne, Baxter, Haylett, ICTAD to name a few. In all cases, the fluctuated component is ascertained on the difference between the indices of costs of construction labor and materials at the time of tendering and the current values of those indices at the time of escalation in accordance with a predetermined relative proportion for each cost index.
Although a formula method is fairly straightforward and simple to administer, it is difficult to introduce in countries where there is no promotional entity to publish construction indices acceptable as a single source authentic cost database for budgeting, estimating, bidding and cost validation. Since accurate input proportions and reliable cost indices are integral elements in such a mechanism, a traditional approach in an easy-to-understand manner, (by removing complications) helps in pursuit of a reasonably compensable amount. As such, the first task must be to lay down a couple of parameters, as follows;
For example, the projects the duration of which exceeds one (1) calendar year may only be considered for reimbursement of any price escalation on the assumption that the contractors are in a safer, if not better, position to foresee the likely price escalation at the time of bidding for shorter durations. This can be changed to six months, if necessary and define the projects eligible for price escalation accordingly.
The contract price adjustment will be made only on the selected items in the bill of quantities. Many admin issues such as site delivery, calculating wastage, materials excess, double or multiple handling (on and off site) do not arise whenever the adjustment is made in relation to the physical quantity of permanent work at site in which the fluctuated' materials have been consumed. In case the escalation is ascertained on the material purchase, then it may be case where payment may be made even before they are consumed in the works.
Once the escalation mechanism is connected with the physical quantity of work done instead of materials purchased, it avoids a glaring anomaly where the payment on escalation caused by the increase in prices of certain materials may be made at a time when such materials were not used at all. Also, it avoids over compensation on over purchased materials, materials wastage in transit, usage and in application, and redundant materials at the practical completion.
A couple of specified materials of a selected set of work items can only be considered for price adjustment on the basis of cost significance. As per perato principle, it is usually a 20% of the bill items represent the 80% of the cost on the total project which is true in building projects and not far wrong in civil projects.
The adjustments to the contract price can only be considered in respect of price fluctuations varied by more or less than for instance 10% of the prices which prevailed fourteen days prior to the scheduled date of submission of tenders compared with the prevailing prices at the time of procurement (in accordance with the materials procurement plan as approved by the engineer from time to time). In a price drop the employer will gain the benefit of price reduction once the cut off limit is exceeded. However, if the current price is within a margin of 10% above or below the basic price, then the basic price shall remain unaltered, meaning there will be no claim on price escalation. However, the contractor has to use due diligence in procuring materials in required quantity at the right time and deliver the materials without causing unreasonable wastage, since the burden of any occasional slip may definitely fall on him.
Only the net difference of prices shall be considered in the adjustment exclusive of profit and overheads of the contractor. The whole idea is to prevent profiting out of economic losses but bring the losing party back to the original position financially had there been no fluctuation. Accordingly, the adjustment to the contract price shall be calculated by applying the net difference of prices to the quantity of work done during the period where fluctuated' materials were consumed under respective specified items of permanent works.
The adjustment shall only apply up to the estimated quantities in respect of lump sum contracts (except where the quantity changes have been considered a variation eligible for contract price adjustment) and actual quantities in respect of traditional re-measure contracts.
It can also be reasonably assumed that the rates for varied works are already inclusive of any escalation except those priced with existing bill rates.
The materials incorporated into permanent works shall only be considered for cost reimbursement, partly because temporary works can be in multiple uses in other projects. Therefore, any temporary works, plant and equipment, tools and consumables, as well as small items are not matters under concern.
Omitted works and employer supplied materials can also be taken aside in the adjustment of contract price.
In administering, a detail tender price break-up plays an important role to decide on the price quoted in materials, showing apart the other cost elements such as labor, plant, tools, wastage, site and head office overheads, and profit, as well as trade discounts on bulk purchase. Hence, the purchase price at actual procurement will establish the current rate that excludes the cost on delivery to site.
However, there are mechanisms that mandate the contractors to follow employer supplied fixed rates for selected materials with a list of accredited suppliers. One would argue that accreditation helps in reaching the economic order quantity. EOQ is essentially an accounting formula that determines the point at which the combination of order costs and inventory carrying costs are the least. The result is the most cost effective quantity to order. However, the EOQ model is based on the assumptions that the demand rate is constant, recurrent and known (assumed to continue the same level of demand for an indefinite future time with no random variance). The lead time is constant and known. (lead time from order placement to order delivery is always a fixed number). No stock outs occur and materials are ordered and produced in a lot of batch and the lot is placed into inventory all at one time. The unit cost is constant and no discounts are given for bulk purchases. The purchasing cost per unit is unaffected by the quantity ordered and the carrying cost depends linearly on the average inventory level. This approach to determine EOQ which involves optimizing costs of holding stock against costs of ordering stock has been subject to much controversy. In addition to concerns on validity of some assumptions, more recently, criticisms evolved the underlying rationale of the approach itself. In order to keep EOQ model relatively straightforward, it is necessary to make assumptions related to stability of demand, existence of fixed identifiable ordering cost, and the cost of stock holding and so on. While none of these assumptions is often strictly true, at times these assumptions do pose severe constraints to the model. Although the most fundamental criticism of the EOQ approach comes from Japanese inspired JIT philosophies, the task of construction commercial managers would be too hard to find out representative costs of ordering and stock holding in the light of these cost variables.
Where the forces of supply and demand tolerate the price equilibrium, obligating the contractor to procure materials from sources designated by the employer is not only a gross intervention into contractor's internal transactions which are commercial by nature but also an intervention in the supply chain. Remembering the theory of supply and demand as an organizing principle for explaining how prices coordinate the amounts produced and consumed, it applies to price and output determination for a market on the condition that no buyers or sellers large enough to have price-setting power. Market equilibrium occurs where quantity supplied equals quantity demanded, at a price below equilibrium, and when there is a shortage of quantity supplied compared to quantity demanded, it poses a price hike-up in the accredited sources more than in the open market. According to Milton Friedman and many other monetarists, market economies are inherently stable if left to themselves. Friedman effectively claims that the social responsibility of business should be "to use its resources and engage in activities designed to increase its profits (through) open and free competition without deception." In Adam Smith's view, the ideal economy is a self-functioning market system that automatically satisfies the economic needs of the populace. Smith describes the market mechanism as an invisible hand' that leads all individuals, in pursuit of their own self-interests, to produce the greatest benefit for society as a whole. Demand-and-supply analysis can be used to explain the behavior of any type of market including construction which is obligopolistic in nature for many cost significant items. An intervention in the supply chain by a major construction client (contributing a considerable proportion of the gross domestic product (GDP) through accreditation) is therefore a serious concern. In nutshell, large scale procurement through accredited sources can be detrimental in long run.
Another pitfall in such a mechanism is that the BOQ items with materials supplied by accredited suppliers shall be priced in two different places in the tender document: Supply cost to be priced under a separate schedule and all other cost elements under respective BOQ items. This method of pricing bill of quantities not only changes the standard way of pricing (inter-alia based on pricing preambles) but also makes the evaluation of variations difficult. This is an unnecessary infiltration on to the pricing strategies the contractors may employ from project to project on different basis. Duplication in costing of materials may occur since the cost of a particular material can be included under several bill items, except in very few cases. Instructing the bidders to be careful in duplication would not suffice. Restricting premature ordering from compensation is another drawback, which is again an intervention in the contractor's procurement policy, forgetting the principle of economies of scale where any prudent contractor follows in materials procurement. This restricts benefits on pre mature bulk purchase for many forthcoming projects and in line with replenishment of stocks at site level so that the accredited supplier's price may have gone up than other sources in the market.
Thus, in devising a defect free mechanism, care must be taken not to disturb the freedom of business'. For instance, the contractor has the liberty to procure materials from his own choice while the employer also reserves the right to specify the source of procurement in some instances. It is the duty of the contractor, not the employer, to establish the basic prices against the specified materials under specified bill items forming part of the tender. Prices could be ex-factory, imported or open market as the case may be, and it is a pre-tender function of the consultant to specify the materials, compute the input proportions and list them in the tender document and verify the base prices with a tender price break-up in support. Care must also be taken in specifying materials eligible for compensation since the use of materials may differ on the type of project. A reference list of the construction material would be that in residential building projects the steel, cement, concrete, sand and stone whereas in infrastructure projects the steel, cement, concrete, timber material, sand and stone, bridge columns, expansion joints, asphalt products, drainage pipes, pre-fabricated concrete components, etc. Therefore, price adjustment clauses must be approached with care and should be diligently drafted, specifically identifying the individual building materials most at risk for price fluctuation. The consultant should also check the authenticity of the escalation information as a post-contract function. Also, the consultant must keep records for variance in prices so that a claim for contract price adjustment in a deflation can be made on the employer's behalf. Once the price difference has been identified, it shall be a separate claim in its own right.
Contract rates are not subject to change due to price escalation, meaning that the rates shall not be revised depending on the level of fluctuation. Also, a claim on price escalation is separate from a claim for liquidated damages by the employer since a delay in procurement due to delay in progress is a knock-on effect that does not prejudice the contractor's eligibility for contract price adjustment on open market price escalation. On the same token, the contractor reserves the right to claim on price escalation even during the extended period/s since they have been excused for completion at a new date.
Equally important is the notification procedure to hold the contractor responsible for notifying the employer of a price increase and its impact on the contract sum and vice versa. The Contractor shall upon the occurrence of any event which may or may be likely to give rise to adjustment of the contract price give notice to the engineer and shall keep such invoices, accounts, documents or records as are necessary to enable adjustment. Also, the contractor shall keep the engineer informed in advance of the procurement of such specified materials at the most economical prices available at the time of purchase to be made in compatible with the procurement plan and actual progress.
However the importance of deciding an optimum contingency level can not be compromised on the sophistication of the price escalation mechanism in place. Usually being a 10% of the total of quoted sums for billed items, contingency is an allocation for unforeseen events during the currency of works. Price escalation is one such phenomenon where the contingency allocation is used without recalling additional funds. Therefore, it is important to decide on the level of contingency in a rational way as a pre tender function of the consultants. However, qualitative forecasting methods utilize managerial judgment, experience, intuition, thumb rules and guesswork so that the decision model is basically implicit and subjective. Trend projection techniques may be appropriate in situations where the consultant is able to infer, from past behavior of a variable, something about its future impact on inventory, scheduling, seasonal variations and cyclical patterns.
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