Bidding in the construction industry

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The aim of this report is to research and discuss the term 'bidding' within the construction industry. Within this piece the writer will look at various theories that demonstrate how bidding is adopted within the construction industry along with the various formats and approaches companies can take when it comes to bidding for a particular project. In conclusion the writer will show his understanding of Mechanism Design Theory and speculate if this particularly new theory is adaptable to the construction industry currently and whether this theory will be beneficial to the industry for years to come.

Bidding Within the Context of Construction

Within a construction contract price includes the direct project cost including field supervision expenses plus the mark-up imposed by contractors for general overhead expenses and profit. 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.

In the private sector, the owner has considerable latitude in selecting the bidders, ranging from open competition to the restriction of bidders to a few favoured contractors. In the public sector, the rules are carefully delineated to place all qualified contractors on an equal footing for competition, and strictly enforced to prevent conspiracy among contractors and unethical or illegal actions by public officials.

The final bids are normally submitted on either a lump sum or unit price basis, as stipulated by the owner. The contractor is permitted to submit a list of unit prices for those tasks, and the final price used to determine the lowest bidder is based on the lump sum price computed by multiplying the quoted unit price for each specified task by the corresponding quantity in the owner's estimates for quantities. However, the total payment to the winning contractor will be based on the actual quantities multiplied by the respective quoted unit prices.

An alternative to competitive bidding is negotiated contracts. Private owners often choose to award construction contracts with one or more selected contractors. A major reason for using negotiated contracts is the flexibility of this type of pricing arrangement, in particular projects of large size and great complexity. An owner may value the expertise and integrity of a particular contractor who has a good reputation or has worked successfully for the owner in the past. If it becomes necessary to meet a deadline for completion of the project, the construction of a project may proceed without waiting for the completion of the detailed plans and specifications with a contractor that the owner can trust.

Negotiated contracts require the reimbursement of direct project cost plus the contractor's fee as determined by one of the following methods:

1. Cost plus fixed percentage

2. Cost plus fixed fee

3. Cost plus variable fee

4. Target estimate

5. Guaranteed maximum price or cost

The allocation of risk among parties to a contract can appear in numerous areas in addition to the total construction price. Typically, these provisions assign responsibility for covering the costs of possible or unforeseen occurrences. All owners want quality construction with reasonable costs, but not all are willing to share risks and/or provide incentives to enhance the quality of construction.

An unbalanced bid refers to raising the unit prices on items to be completed in the early stage of the project and lowering the unit prices on items to be completed in the later stages. The purpose of this practice on the part of the contractor is to ease its burden of construction financing. It is better for owners to offer explicit incentives to aid construction financing in exchange for lower bid prices than to allow the use of hidden unbalanced bids. Unbalanced bids may also occur if a contractor feels some item of work was underestimated in amount, so that a high unit price on that item would increase profits.

Lump Sum Contract

In a lump sum contract, the owner has essentially assigned all the risk to the contractor, who in turn can be expected to ask for a higher mark-up in order to take care of unforeseen contingencies. Beside the fixed lump sum price, other commitments are often made by the contractor in the form of submittals such as a specific schedule, the management reporting system or a quality control program. If the actual cost of the project is underestimated, the underestimated cost will reduce the contractor's profit by that amount. An overestimate has an opposite effect, but may reduce the chance of being a low bidder for the project.

Since most claims and disputes arise most frequently from lump sum contracts for both public and private owners, the following factors associated with lump sum contracts are particularly noteworthy:

* Unbalanced bids in unit prices on which periodic payment estimates are based.

* change orders subject to negotiated payments

* changes in design or construction technology

* incentives for early completion

Unit Price Contract

In a unit price contract, the risk of inaccurate estimation of uncertain quantities for some key tasks has been removed from the contractor. However, some contractors may submit an "unbalanced bid" when it discovers large discrepancies between its estimates and the owner's estimates of these quantities. Depending on the confidence of the contractor on its own estimates and its propensity on risk, a contractor can slightly raise the unit prices on the underestimated tasks while lowering the unit prices on other tasks. Should the contractor be correct in its assessment, it can increase its profit substantially since the payment is made on the actual quantities of tasks; and if the reverse is true, it can lose on this basis. Furthermore, the owner may disqualify a contractor if the bid appears to be heavily unbalanced.

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 labour costs, material costs, equipment costs, and direct filed supervision; and (2) the mark-up or return, which must be sufficient to cover a portion of general overhead costs and allow a fair profit on the investment. Consequently a contractor who includes a very large mark-up on every bid could become bankrupt from lack of business. Conversely, the strategy of bidding with very little mark-up 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 mark-up" 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.

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.

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.

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. publications which provide data of potential projects and names of contractors who have taken out plans and specifications. A general contractor may also obtain information of potential subcontractors from publications

Objectives of General Contractors in Bidding

The bidding strategy of some contractors is influenced by a policy of minimum percentage mark-up for general overhead and profit. 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 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 comparative cost advantage is the most desirable of all circumstances in entering a bid competition.

Principles of Contract Negotiation

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 favourable, 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.

Research and explain the theories in context

Historical occurrence of bidding models

Hatush and Skitmore (1997 a) identified five main elements as common factors in the contractor selection process for all types of procurement arrangements. These are project packaging, invitation, prequalification, short listing and bid evaluation. Hatush and Skitmore (1997a) defined pre-qualification as a pre-tender process used to investigate and assess the capabilities of contractors, hence providing the client with a list of potential contractors to invite to tender. Bid evaluation despite involves similar process it is different in two aspects; it occurs at the post tender stage and it considers both bid amount and the contractors' capabilities. Russel and Skibiniewski (1988) defined bid evaluation as a decision-making process that involves the development and consideration of a wide range of necessary and sufficient decision criteria used to assess the contractors' capabilities.

Holt et al. (1993) have proposed a modified quantitative model for selecting contractors. This model comprises a three-stage process requiring the calculation of what is called P1 scale index to investigate the more general areas surrounding potential bidders. A P2 scale index is calculated for the second stage to assess the contractor further in the light of specific factors. Finally a P3 scale index is calculated to compare the bid prices amongst the invited bidders.

Bid evaluation is used to denote the procedure for strategic assessment to tender bids submitted by pre-qualified contractors. The strategy used for bid evaluation should reflect the client's objectives (Hardy, 1978). Hardy's (1978) criterion, for example, prioritises bids considering the return on the client's investment. Thus bidders should submit a projected cash flow so that clients can determine the present value of bids. Herbsman and Ellis (1992), on the other hand, proposed a time/cost approach to determine the winning bid in the highway construction contracts. By converting the contract time to cost, a straightforward comparison can be made on a single criterion.

Emergence of bidding systems

Application to construction industry

Definition of Mechanism Design Theory

Mechanism Design Theory

The gap in knowledge between buyers and sellers, and costs and consequences for the efficient operation of a market, is at the heart of the groundbreaking research by winners of this year's Nobel Prize in economics.

'The theory allows us to distinguish situations in which markets work well from those in which they do not. It has helped economists identify efficient trading mechanisms, regulation schemes and voting procedures'

That gap in knowledge is known in economics as 'information asymmetry' and it has become one of the most widely studied aspects of discipline.

Sellers have an incentive to seek the highest possible sale price, and buyers have the opposite incentive, and both parties have different levels of knowledge about the overall value of the transaction, the final outcome may not be efficient for the economy as a whole. Mechanism design theory attempts to identify these breakdowns and avoid them where possible.

E.g. UK Government sale of 3G mobile phone licenses in 2000 netted the exchequer more than 22 billion in revenue. Adams, R., (2007)

Revolutionised the way economists think about optimal institutions and regulation when governments don't 'know it all'

Highly abstract construct, technically impressive, perhaps, but with little relevance to policy and everyday life.

Leonid Hurwicz, His key insights, any solution should take into account the incentives of self - interested agents, i.e. the people on whose information the decision relies must find it in their interest to reveal information.

Mechanism design theory is a general framework to study any collective decision problem, once a mechanism is in place, participants effectively 'play a game' (e.g. bid at auction) as a function of their information. The goal is to find a mechanism with an equilibrium decision outcome that is best according to the given measure of quality. The strength of mechanism design lies in its generality: any procedure, market - based or not, can be evaluated within a unified framework.

Mechanism design theory tells us when markets or market based institutions are likely to yield desirable outcomes. It also gives guidance to design such alternative institutions when markets fail.

Maskin and Myerson have heavily contributed. The problem is to decide how to allocate some objects among potential bidders when the value of the object(s) to a bidder is only known to a bidder. The government uses auctions to allocate spectrum, airport slots, oil drilling rights, timber or land. They also use reverse auctions to produce goods/services from the private sector.