CONTRACT George Solt 1 PRICE In any competitive business it is crucially important to know how to price the product: a high price means no one will buy it, and the company will fall short of its turnover target and so fail for lack of contribution. A low price means that the company will fail for lack of contribution anyway. This problem is particularly difficult in contracting, for the following reasons: 1.1 Competition Contracting is highly competitive. A contractor needs relatively little capital to start trading - he has no need of land, fixed premises, machinery, or stock. He needs working capital to carry out the work, but only after he has actually obtained contracts. (Remember the cowboy roofing mender who demands money before he can start, so that he can buy materials.) It is relatively easy to start up a contracting company. I know that because I’ve done it. Four partners and I started a company in 1971. It not only survived, but even ended up with people thinking of it as a bit old-fashioned and stuffy. It is still going quite well. In my specialised field the UK used to be an isolated market with four or five well-established contractors. With the advent of the EU, the market has now spread to the entire EU and three of these companies (including my old company) were unified under French ownership to be competitive in this wider area. But they’ve all been closed down - the fact that the huge conglomerate which owned them are in serious trouble won‘t have helped.. Before that happened, however, new competitors started up at about 2-year intervals. Most of them disappeared again after a few years in business, but in effect there was always at least one “cowboy” contractor offering contracts at cut-throat prices1. That' s why it has been said that contracting is the last business area in which there is real competition. With such fierce competition, profitability (i.e. profit as a percentage of turnover) will always stay low, but this is no deterrent when you consider the high potential return on capital (see Table 2.2). On the other hand, low profitability means that the margin for error is small, and contracts can easily swing into loss. In many real-life cases it only takes one or two bad contracts to break a company - even a big one. 1.2 The Unknown No two contracts are the same. Even if the technical content of a contract is the same as that of a previous one, there will be different site conditions, labour conditions, costs may have shifted in the interval, the time of year and the weather play a part, and so on. Compare this to manufacturing, which takes place in a more controlled environment. That makes it easier to give an accurate estimate of the cost of producing the product.


In hard times, even the reputable ones have to quote cut-throat prices just to survive.

the switchgear etc. and this plant is normally designed and purchased by the following route: • • • the main contractor issue enquiries for a price to the boilermakers the boilermakers issue enquiries to the water treatment plant manufacturers the water treatment plant manufacturers issue enquiries to the pressure vessel fabricators. Other manufacturers know the cost of an Escort and design and price their cars to compete with that. so there is bound to be trouble of some kind. because they provide a lot of useful examples. Each of these enquiries yields an offer which is incorporated in the price for the next offer back up this chain. This time everyone in the chain knows that the project is really going ahead and tries much harder.and that could be the result of a mistake. That may be an offer from an incompetent cowboy who isn' t quite up to the task. In theory “Turnkey” means that the contractor does everything up to the point when the client turns the key in the front gate and takes over the finished contract in full running order. Both of them dealt with the 2 construction of new power stations by big contractors with a turnkey contract. It is very hard for them not to go blindly for the cheapest. Materials and labour are the most obvious. In the Netherlands. by contrast. or from the one with a big mistake in the estimate. you look at the competitors' price and work to that. 1. there isn’t enough money to do it properly. but they tend to do it just the same.the building. A lot can go wrong in a system where everyone is trying to undercut everyone else. the generating set. In standard commodities like cars or tins of baked beans. 1. and so on. Companies are not required to go for the cheapest offer. A Contractor prepares cost estimates by breaking down the proposed job into known components. In a project as complex as a power station there are of course dozens such chains . Errors in estimating almost always go one way: something gets forgotten. in the hope of avoiding the disasters which would follow. The main contractors who are bidding for the station put it all together to make their turnkey offers. When the turnkey contract for the power station is signed with the successful contractor. I have done several stints as “Expert Witness” in legal cases. When the order is executed. etc. My concern is always limited to the plant which produces highly purified water for the station’s boiler feed. and so the price tends to be too low. so it happens quite often that the contractor whose offer was used in building up the total contract price fails to get the job in this second round.3 Sub Contractors Contracting involves chains of sub-contractors. the sub-contractor may sub-contract out in turn. etc. the turbine. In competitive tendering this is (theoretically) not the case.C510103 Page 2 of 10 October 2003 1.that is the lower-priced middling sized family five-door car. In the motoring magazines you can read that such and such a car is aimed at the “Escort” market .4 Purchasers buy the Cheapest In Britain public bodies were until recently required by law to select the lowest tender which appears technically satisfactory. all these enquiries go out again. though there are devious means of finding out what the competitors’ prices are. and from time to time I will refer to the two biggest of these. or both. but in addition almost all engineering contracts involve sub-contracting. Each contract is generally placed with whoever offers the lowest price . The practice is much more complicated. 2 . they may go for a middle price.5 The competition is unknown.

We thought we had the contract in the bag. . It can take weeks to study this to make sure you' ve found and understood all the relevant bits. and is legally required for a lot of public work. The tender system can be very harsh. or employ consultants to do so. Much less work went into the latter. the tenders have to be sealed and the enquiry may actually say that the tenders will only be opened on that date. and the flow and quality of purified water needed. and the clients can play some nasty tricks as well. We used to distinguish between those offers when we knew the client was going to place an order. In theory no one sees the competitors’ tenders. leaving the contractor to select what he thinks would be the best solution to the problem. There is usually a date by which the tenders have to be in. but I have never heard of it being done in Britain. may be a three-volume document full of detail. but the client for some reason wanted to place the contract with a competitor. The Dutch are a very sensible nation. in which the biggest single application is for power stations. above). He may write the spec himself. The specification may set out in detail exactly what the client wants. and may well be more expert than the consultant (if there is one). In Europe the specification is generally functional: the client specifies the source of raw water. therefore. I had been doing research in this specific application. it is quite legal. And tendering is an expensive business . In practice there are some ethical and many not-soethical devices by which tenderers can ferret out details of competitors'offers. The contractor is invited to offer a plant on the basis of whatever process he thinks is the best. it has been common practice to specify the process and the plant in very great detail. most of which is usually irrelevant to the particular case. Needless to say this technological inequality is already correcting itself. the contract is likely to go to the offer with the best process. As a result European technology in my field is literally decades ahead of the US. In the 60ies and 70ies the CEGB (the nationalised electricity generating undertaking. A client who wants to commission a large project issues a specification to define what it is that he wants. whereas US contractors have no choice in the content of their tender. Each offer includes this sum.C510103 Page 3 of 10 October 2003 2 THE COMPETITIVE TENDER SYSTEM This is the traditional method of placing contracts. I will talk about alternative systems later. In Europe. He might even have revealed what price he would like to see. whereas in Europe the contractors has to offer plant which out-performs the competitors' . because the contractor is usually more expert in some specialised field than his client. For example. and I knew I had a more economical process than the opposition. The latter option "Design and Build" is gaining ground. and invites contractors to tender. and those where the client was just getting a price (see Chains of sub-contractors. I was consulting to my old company who were bidding for a plant to meet a new application. now broken up into several companies) built so many power stations that for a time they were the biggest single purchaser of industrial water treatment plant in the world. We used to expect to win one tender in four. The reason is clear: the consultants or whoever writes a detailed specification will always play safe with known technology.. If this is done openly.the standard enquiry specification issued by big petrochemical companies. which is then shared out between them out of the winner' s contract price. It was unethical. for example. This 3 In Holland its not uncommon for contractors to club together and agree on a sum which covers the cost of all of them tendering. or we should never have been able to cope. and rely on pricing to get the contract. on the other hand. An interesting sideline illustrates what has happened in my own specialised field of industrial water purification. so he simply passed them the details of my (unpatentable) process and told them to re-tender. In the USA. or it may set out only the function which is to be met. so you should have an idea how the system works. which I think is fairly typical. before you can put together an offer which conforms to the spec. which leaves no incentive for technical innovation. and we got no reward for the work which we put into the other three unsuccessful tenders3. but not actually illegal.

15.. 11. I will now run down the detail. and the CEGB broke them all. so most of the contract consists of equipment like steel tanks. + Contingency @ . % of 1 Plant Design Automation and Control Design SUB-TOTAL 1.. When the had ruined a couple of the UK companies... bought the cheapest and then nailed the contractor to the contract.. +Contribution@. This is old history.... Almost all our contracts included at least some design effort. 4b. . The instrumentation and control gear usually involves expensive detailed design.... pumps..... 4a. Sundry Extras Royalty Insurance Capital Charges Penalties Contribution Adjustment Agents’ commissions Negotiation TENDER PRICE I have not copied certain key percentages which used to feature on this sheet because even after all these years they are still confidential.C510103 Page 4 of 10 October 2003 made the CEGB very powerful.all bought as sub-contracts from their fabricators.4. but shows the main factors which have to be considered . 10.. got into dispute with them. Four major UK contractors dealt with the CEGB over this period. 13..... We all realised that their contract conditions were unreasonable. % of 5. 5.. .. 8... 6. The French company closed down their branch here and the UK industrial water treatment plant industry never recovered properly from the disaster of serving the CEGB. 14. Price Fixing @ ..the bigger the company.. even if other companies might call them by different names and set them out in different groups... 16. Most commonly we worked to a functional specification. The moral is that very powerful clients can do a lot of damage to their contractors. 2.. They won several contracts from the CEGB.. 12. 3 MAKING UP A PRICE Table 1 is a copy of the price make-up sheet which we used in my old company when it only had a turnover of about £m 5. so our offer was based on our own process design. 9.. TABLE 1 – SIMPLIFIED PRICE MAKE-UP SHEET ITEM 1. Tendering can be a lottery.. Remember that this sheet deals with contracts for the design and manufacture of chemical process equipment. 17. but as a virtual monopoly client they could insist on the full terms being met... Remember that this is one company’s sheet The important thing is to recognise the items for which any price make-up has to cater.. following the numbers on the sheet... and is open to abuse. a big French contracting company saw an opportunity to get a foothold in Britain.. pipes and instrumentation and control equipment . 3. Bought-out Costs (“BOC”) Deliveries Buying costs @ . % of 5. and they became quite ruthless. .. the more sophisticated all this gets.. and lost out... It’s fairly basic. valves. and the bigger the individual contracts. They thought he had the skill or the clout to deal with the CEGB.. which can cost more than the design of the hardware..... % of 7.. but I’m sorry to say that our present experience with the big public water companies ( who are also extremely big and powerful) is not uniformly good either.. So much for the background to pricing. They insisted on very harsh contract conditions. .. 7....

because of the specialised nature of our trade. 11. whereas at present these formulae aren' t thought necessary by anyone. but sometimes we had to take out additional insurance because of special risk. and/or to the site. I don' t know why they weren' t included in 1. and the technical effort involved. That is legal only if it' s done openly and with the client' s consent. O & M can be quite expensive. 8. is the cost of getting the stuff to the place where we might be assembling equipment. which has two meanings! What we meant on this in-house form was an additional sum in the tender price if we were to hold the cost fixed rather than tying it to a price escalation formula (which I will describe later). shipping. who might query why the proposed Provision on some specific contract was significantly higher or lower. so it's senseless to speak of profit at this stage. The sensible Dutch do this openly. 6. Is a list of other costs . This is the major difference between contractors and consultants . 3. 9. when in effect we became consultants. 7. That may be high compared with straightforward civil engineering contractors. I hope we won’t get back to high inflation again. A single contract makes no profit. Originally it was a single cost centre. "BOC" stands for "Bought-Out Costs" . 4a & b are the estimated costs of plant and electrical design cost centres respectively. when contractors get together secretly and rig their prices high: the one who gets the contract then pays off the others. but often increased or decreased because of the nature of the job. Be careful with this phrase. when it is completely legal. etc. which is rare in the UK. . which I will explain shortly). The company had a general insurance policy. the cost of items to be purchased or subcontracted out. 10. The contract contingency was calculated using another standard percentage. so we can ignore it. but you never know. but we split it into two because control engineering costs a lot more than standard engineering and therefore demands a higher rate per man-day. 2. or because the client required it. What people generally understand by "Price Fixing" is an illegal practice. whose task is to procure the items costed in 1. got "Design-only" contracts. We occasionally. We often engage the services of a specialist writer of O & M manuals to collate the separate bits and write the complete set. out of which the successful bidder can pay all the unsuccessful ones something to cover their cost in producing the offer. is the sub-total so far. (A cost centre is a way of estimating the cost of work done within the company. and 2. Specialised sub-contractors such as the makers of metering and monitoring instruments charge for their O & M manuals. and totals the costs which can be directly attributed to actually doing the work.packaging. consulting it will be the smallest or used to be around 25%. came into force if we were using a licensed design. is the cost of the "Purchasing" cost centre. and 2. Inflation was high at the time when we used this sheet. Profit isn't mentioned anywhere.that is. When buying a car or a telly you get the instruction book free.C510103 Page 5 of 10 October 2003 1. providing operating and maintenance instructions ("O & M"). The standard number would be a guide to the Auditor. It was generally the biggest single cost item. is of course the key number: When we planned the year' s trading we set the average percentage contribution on planned turnover which would give us the necessary total contribution over the year . In Holland. With specialised plant the O & M manual can cost thousands. the contractors sometimes agree to add a sum to all their offers.

That' s self-explanatory: if there are penalties on performance or on completion date you need extra contingency to cover the risk of going down on them. the contract contained a very high element of sub-contract. is the bottom line: the offer price. Conversely. But do remember that this is not the generally accepted definition. for example.sometimes to as little as 3%. The conditions of payment spell out how this burden is shared and therefore who pays the interest for it. The contractor usually has to have to bear some of that burden and this item served for us to estimate how much it was going to cost. we couldn' t afford to slap our standard contribution on top of the sub-contractor' s . 14. from our standard 20-odd% .) Finance costs (12. is self-explanatory: we often used local agents . 4 . we were in fierce competition with other suppliers. The job therefore involved minimal work or risk. All the work that this entailed was to place an order on the resin manufacturer to deliver direct to site. are: • • • the cost centres (3. which for some reason or other figured as an extra. On the other hand. Or we might particularly want the contract and were prepared to cut our contribution to get it.) and (4.. 15. 16. Most of these other items are obvious and/or not particularly important. Or it might be a job we really didn' t want: then we' d put the price up so if we did accidentally get the contract. or both. if we knew we were going to get the order anyway. The ones which I will discuss in a more detail. which have a limited working life. If we got into serious negotiations he would usually come under pressure to cut the price. 13. In ideal circumstances that comes to the same thing as my definition.) The standard contribution (6. in 14. so we were often asked to tender for the supply of replacement charges to our old contracts.C510103 Page 6 of 10 October 2003 12. is the leeway available for the salesman to negotiate away if necessary. The same applied if there was a large element of standard.when exporting to foreign countries like Scotland. so we added this into our tender price. and that brought the contribution down.a skilled and specialised trade. he was going to do most of the work and take most of the risks. but I myself am not going to say anything about that . we might as well put the price up and make a few more bob on it. Overheads are normally taken to be the costs incurred in operating a company which are not affected by the amount of business it’s the province of the Estimators .) 4 ALLOCATING OVERHEADS I must remind you that I define overheads as: all the company’s costs which you can't allocate to any particular job. 4 risk-free material cost together with a minimum of engineering effort .after all. Many of our plant used of ion exchange resins. The bought-out cost is of course usually the most important one. we would at least be well rewarded. knowing it might have to come out again. 17. If. required us to use our judgment in lowering or raising the contribution. Sometimes we had additional site work to do. This is an extremely important subject about which we are going to talk quite a lot more. Any project takes up capital which has to be raised by the client or the contractor.

the additional mileage will put up the depreciation per year. £pa Depreciation. . In 1996 the mileage rates which various organisations pay for using a privately-owned car on the company’s business varied between about 24 p and 42 p per mile . Some companies say: you' ve got a car and probably do the national average mileage for your private use (a bit over 10. and pricing "Bought-out-cost plus 50%" doesn’t allow for the difference in engineering effort needed by different contracts. 4. Why? Table 2 shows some arbitrary assumptions which I make for the major costs of running a small car. One of our bigger and costlier departments was the engineering office. depending on your assumptions.a Simple (and bad) System In a small company in which I worked in my early days we estimated the BOC (1. but its results were wildly inaccurate. Table 3 shows how this works out.000 miles per year).which is a much higher figure than any I have quoted to you so far.2 Overheads and Pricing . so in practice we compensated for that by adjusting the “BOC + 50" price by sheer guesswork . The system overpriced contracts involving little design work. and you should get a higher mileage allowance. and underpriced the ones with a lot. Also. TABLE 2 – CAR RUNNING COSTS DIRECT COSTS OVERHEADS fuel.C510103 Page 7 of 10 October 2003 4.1 Costs Of Running A Car An easy way of showing the problems of allocating overheads is to calculate the cost of running a car. TABLE 3 – COSTS PER MILE Annual mileage Fuel.5 So. thus saving on insurance and licence. We' re only going to pay you the "marginal" cost of running your car for a few miles over and above that. so they’re "overheads".an old banger costs more to service but less in depreciation. Because the cost of other activitites as well as engineering were treated as overheads. In fact the "fixed" costs aren' t really fixed at all. Real costs might be quite different . and so on. If you use it for work you may need a more expensive insurance. £pa Cost p/mile 5. They can’t be allocated to a particular trip. To this.not a very good way of working out vitally important sums.000 400 400 500 2000 4300 21. and tyres Insurance and road fund licence Depreciation p/mile p/mile £pa £pa 7 2 500 2000 The "direct" costs are only incurred when you actually drive the car. £pa Insurance etc. you' d take it off the road for the winter.) and added 50% to get the selling price. you could reasonably reply that if the company didn' t oblige you to use your car. £pa TOTAL. £pa Service etc. The other two must be paid whether you use it or not. the cost of mileage can be made to be pretty well whatever you want. Very simple. We weren’t so stupid as to allow that to happen. with simple numbers to avoid lots of arithmetic.000 350 100 500 2000 2950 59 10. 10 miles/litre @ 70p/l service. oil. we needed to add 50% to the basic cost estimate to get in the necessary contribution . In fact there is no "true" mileage cost: it depends on your overheads and how you allocate them.000 700 200 500 2000 3400 34 20.

but the latter of course could . specialised designers are skilled professionals. the error becomes relatively smaller. and also the design for actual contracts. As an extreme example. to calculate the cost of each man-hour. For example. Management Accounts systems therefore try to allocate as many of the costs as they can.4 How Cost Centres Work The system of “Cost Centres” used on the price make-up sheet overcomes this difficulty.C510103 Page 8 of 10 October 2003 Similar arguments apply when allocating any other overhead costs to contracts. but if the percentage of overhead in a price calculation is small. in my old company I carried out research and development. Cost Centres reduce the sum of “overheads” as I define them. In the early days our engineering office worked on designs for bids which we were going to make. That in turn would mean that we had to add a larger contribution to a smaller cost base when pricing up our contracts. but train them and keep them as permanent staff. and need to know three things: • • • how do we measure the work done by the engineering office? how much work will the contract need. doesn’t reduce the total costs in any way. and overheads aren' t really fixed anyway. Replacing some overheads by Cost Centres gives a partial solution. to below 25%. .if we could separate the two from one another. and those which didn’t. The uncertainty which results from allocating overheads can never be eliminated. The official definition of overheads leaves some grey area. we have to be able to measure the work involved. Some contracts make more demand on the overhead structure than others. both definitions. because it did not distinguish between those contracts which used a lot of time in the engineering office. without in any way changing the way the company actually operates: they are only a paper exercise. but every real contract would take up a different amount of effort which we had no means of costing. 4.chief engineer. You don' t hire and fire them. "Reducing" the overheads in this context means shifting their cost to another category in the management accounts. and so on. because a majority of bids never produce a contract. and this is how it works. Until we had a more sophisticated accountancy system. trainees. Salaries have to include all associated costs like National Insurance.3 What Cost Centres do. printing and other material costs. the engineering office had to be counted as an overhead. Next. and that is a true overhead . but does give the company’s management a clearer understanding of where their money is going. we tot up the total annual costs of the engineering office .the staff (including those not directly productive . and introduce a measure of inaccuracy. and a more sophisticated system might bring it down even more. I just described the pricing of ion exchange resin for re-charging existing plant. The former activity couldn’t be allocated to any job. I will take the engineering office as an example. To estimate the engineering cost to be allocated to a contract. and what does the unit of work cost? So the first thing we must settle on is a yardstick for measuring design work. We used the engineering man-hours needed to do the job. to some job or other. It brings the necessary contribution down from the 50% which we used in my previous company with its simple system. That makes them seem at first sight to be "overhead costs" in the sense that they are costs which my company had to meet regardless of whether it gets a particular contract or not. What is more. etc. Similar arguments apply to other activities in a company. secretary etc).

or working on old jobs which can' t now be allocated. we split design function into two separate cost centres. The theoretical working year at 37 hrs/week is about 1. and the cost centres are a useful tool. We can' t just take the man-hours in a nominal man-year and multiply by the number of design engineers. to give us a "purchasing" cost in terms of a percentage of the value of goods purchased . the more it will cost to operate. That. which was more than double the engineers’ nominal salary cost. Or. a more sophisticated system might also take into account the cost of the area of office floor space occupied by the engineering cost centre. we must be getting behind schedule. and the actual cost with the estimated cost.time spent sick. and so on.or over-recovering its costs. records from previous contracts allow us to estimate the engineering man-hours expected to be used for a particular contract. My company' s monthly management accounts included a statement for each cost centre which compared the output actually booked in the month with the estimated output. etc. . As you will see. and half-way during the contract period it is expected to have used 600. For example. Our management accounts also compared the (man-hours worked so far) with the (man-hours planned) on individual contracts. I told you before. we will probably over-run on man-hours and ought to find out why. This would show whether each centre was under. too goes into the price make-up sheet.C510103 Page 9 of 10 October 2003 Then we tot up how many allocatable man-hours the office actually turns out per year. from the chief executive down. That would increase the costs per engineering man-hour while reducing the general overheads. or training or in meetings. that when we found that the engineers who were designing instrumentation and control gears were much more expensive than the ones doing layout and piping diagrams.2%. Any serious difference would raise an alarm. The more sophisticated the system. Other cost centres use other units to measure their output. 5 MANAGEMENT ACCOUNTS Cost centres are an important part of management accounts. and decide what units you use to measure the output to treat it as a non-profit-making unit which just recovers its costs Add up all its annual costs and divide them by the attainable output to calculate the cost per unit of output I have quoted some actual numbers to give you an idea of the orders of magnitude involved. The essential elements of creating a cost centre are: • • • to take a part of the company which has an identifiable and measureable output. In 1998 the cost of allocatable man-hour in the engineering office worked out at over £25 per might be around 0. I have worked with a company which made every member of staff. The Purchasing department' s annual output is measured as the value of the goods and services it purchases in the year. depending how sophisticated you think it is worth making the accounting system. Management accounts are therefore essential aids to management. this internal cost per engineering man-hour is continuously checked by the system. That in turn would increase the direct cost in the price make-up. We multiply them by the internal cost per man-hour and can now enter a figure for design cost into the price make-up sheet. Suppose for example a contract is estimated to need 800 engineering man-hours. book all working hours to some allocation or other. so you have to match the complexity of the system to the company' s needs. If we have only spent 200. but reduce the percentage contribution required. but in any particular case the actual numbers depend on how the system is set up. if we have already spent 800. and allowed us to update the costs accordingly if we thought it necessary.800 hours per man per year. but the time you can actually allocate to jobs is a less because of "slippage" . You could go further and allocate the cost of heating and lighting in proportion to the area of office space. Once the system is operating. which I thought was rather silly.1 to 0.

(High inflation since then makes the figures seem amazingly low). This is important in that it might mislead us into underestimating their costs for future work. . and I expect we kept them the same for the last three months of the year and waited until next year before adjusting them. You will see that on paper the cost centres have under-recovered their costs (though only by a small margin). The remedy would be to raise the rates. so on Schedule 6. we were nine months into the year. Our financial year started in October.I can' t actually remember.C510103 Page 10 of 10 October 2003 I have attached some of our old Management Accounts sheets to these notes. But the error in the rates is small. and we might have decided to do that . We shall be looking at Management Accounts in more detail in a later lecture. after all. It' s only a paper exercise.

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