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Procurement Methods in Construction

April 14, 2015

Table of Contents
1. Introduction....................................................................................................................3
1.1. Procurement methods in Saudi Arabia.................................................................3
1.2. Procurement framework........................................................................................5
Figure 1.1 General procurement strategy and framework (Al-Hazmi &
McCaffer, 2004)...............................................................................................................6
2. Design Build Finance and Operate..............................................................................6
Figure 2.1. The DBFO Model (Abou-bakr, 2013)...............................................7
Figure 2.2. Advantages and disadvantages of the DBFO model (Spackman,
2002)................................................................................................................................9
3. Partnering relationship...............................................................................................10
4. Effects of Cost risk on method of procurement........................................................11
Figure 4.1. Procurement methods and cost risks (Milazzo & Hook, 2014)......12
5. Conclusions...................................................................................................................13
References.........................................................................................................................15

1. INTRODUCTION
Procurement in construction refers to the methods used to obtain funding, goods, and
services, for construction activities. Project owners such as the governments and private
enterprises have finite funds, equipment, labour, and other resources at their disposal. The
limitation acts as a constraint for completing infrastructure, social development, or development
projects. Hence, the government uses different procurement methods, by involving private
enterprises to participate in the project. Private enterprises invest in the project, deploy their
resources and expertise, and complete the project as per the requirement. In return, they obtain
reimbursement, and if the government has sufficient funds, it raises a tender in which different
contractors participate as per the contract terms. Several types of procurement methods are
available. These include custom build, design and build, design build finance and operate,
emerging cost contracts, lump sum contract, partnering, and many others (Ashworth, 2011). This
paper examines important types of procurement methods. The paper also discusses other
important terms related to procurement, costs, and risks.

1.1. Procurement methods in Saudi Arabia


Saudi Arabia and the Middle East have seen a very large amount of construction activity.
A number of world famous and iconic buildings such as the Al Bhurj Khalifa, Kingdom Tower,
Diamond Tower, Makkah Clock Royal Tower, and many infrastructure development projects
have been constructed in the kingdom. In 2014, Saudi Arabia has planned construction projects
worth more than $75 billion (Saudi Gazette, 2014). While the oil rich nation has sufficient funds,
project owners use different procurement methods for the construction projects. Procurement
methods and government regulations are different for domestic and foreign contractors. Some of
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the methods used are planned design, engineering procurement and construction agreements
(EPC), and build only agreements (Jaweed, 2004).

Lesser restrictions are placed on Saudi contractors, and these include capital requirement,
owning equipment, relaxation for the number qualified engineers directly employed, and so on.
International contractors must obtain a foreign investment license; they must form different
corporate structures such as Temporary Commercial Registrations, LLCs, or Joint Stock
Company. Contractors are placed different grades such as Grade A, Grade B, and so on up to
Grade D. Grade A is at the highest level, and Grade D is at the lowest. Other classifications
include Class I, Class II, Class II, Class IV, and Class V. These grades are based on the size and
number of projects completed, number of full time workers employed, and certifications
obtained by the contractors such as ISO 9001, ISO 14001, and OHSAS 18001, etc. Another very
important aspect of procurement method is the project financing. International banks and
financial institutions offer financing to construction projects by using conventional financing
projects. Local Saudi banks mandate that Sharia compliant financing methods for private sector
project (Al-Hazmi, 2009).

Some examples of procurement methods for public and private sector projects are
discussed as follows. The Aldara Hospital project worth SAR 404 million was initiated through a
joint venture between UAE government and a Greek contractor. The King Khalid International
Airport, Terminal 5 project worth SAR 1.5 billion was completed as a joint venture between the
Saudi government and a Turkish contractor. Jeddah Corniche, a mega project worth SAR 1,73
billion was taken up as a joint venture between Amias Real Estate Group and the UK based

Lamar Investment and Real Estate Development Company. The King Fahad Medical City
Hospital project worth SAR 522 million was taken up as a partnership venture between UK
based Drake & Scull and Habtoor Leighton Specon. The Abraj Kudai Development project with
SAR 13 billion was awarded to the Saudi Binladin Group on a design and build basis (Husein,
2014). A large number of smaller projects use similar procurement methods.

1.2. Procurement framework


This section provides a brief discussion about the procurement framework. The
framework is applicable to all methods of procurement, which will be discussed in the next
sections. The procurement strategy is closely aligned with the project objectives and framework.
The procurement strategy has four steps, where a number of activities are carried out. The steps
are initiated in the evaluation and definition phases of a project. The four steps are data
gathering, preliminary screening, procurement options analysis, and the recommended delivery
model and procurement method (Al-Hazmi & McCaffer, 2004). The following figure illustrates
the procurement strategy and framework for all types of projects.

Figure 1.1 General procurement strategy and framework (Al-Hazmi & McCaffer,
2004)

2. DESIGN BUILD FINANCE AND OPERATE


The design-build-finance-operate (DBFO) model, also called the public private
partnership (PPP) model, or the Public Finance Initiative (PFI), is one of the procurement
methods used by the government. In this model, the government is the project owner and it floats
a contract inviting private firms to participate in the project. The government may provide part of
the funds by using special purpose vehicles, or bonds, funds, and through lotteries. The private

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party funds either the whole amount or the balance; it designs the project, builds it as per the
specifications, and then operates the completed infrastructure for a fixed amount of time. During
the time when it operates the infrastructure, the private party earns income from the project, to
recoup its investment. After the fixed tenure expires, the project reverts to the government. UK
uses this model extensively and some examples of PPP projects are the Chunnel Tunnel Link, the
London Underground system, many NHS projects to build hospitals, toll roads on the highways,
Stoke on Trent schools, Blackburn Hospital, and many others (Abou-bakr, 2013). The following
image illustrates the manner in which the DBFO model works.

Figure 2.1. The DBFO Model (Abou-bakr, 2013)

The DBFO model starts with a contract between the private party and the public sector.
The terms of the contract can vary, but they generally indicate that the risk in designing the
project as per the requirement, constructing the facility, and operating it, rests with the private

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party. The government helps by obtaining all the necessary clearances, transferring the property
and assets, obtaining project subsidies, and other help. In case the project is very expensive, or
the risks are very high, then the government may decide to provide a onetime grant. Either the
private party obtains revenues through annual payments from the government, or it levies
charges from the taxpayer for using the facilities (Spackman, 2002).

When the project cost is very high, then the private party and sometimes the government,
float a special company called as the special purpose vehicle (SPV). The SPV is used to develop,
construct, maintain, and operate the project for the project duration. In some cases when the
government provides some funding, it receives equity and a share in the SPV. Several banks can
be involved in funding the projects by providing secured debt. These institutions may receive an
additional allotment of the equity. SPV is useful since it is an independent entity, with all
decision-making powers. By involving banks, there is a further dilution and transfer of risks, and
a better assurance that the private party cannot declare insolvency midway through the project
(Zheng & Lewis, 2008).

Advantages to the government are that it transfers the full responsibility and risk of the
project to the private party. It does not have to deploy any resources, other than a team to monitor
the progress. The disadvantages are that if the private enterprise goes bankrupt or if it faces
technical and funding problems, then the whole project can stop. In many cases, the terms of the
agreement can extend to 30 years or more. If the public continues to pay for using the facilities,
then a backlash is created, leading to rescinding the contract, and lengthy lawsuits (Spackman,

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2002). Some of the benefits and possible risks that emerge from such methods are illustrated in
the following figure.

Figure 2.2. Advantages and disadvantages of the DBFO model (Spackman,


2002)

While many DBFO projects have seen success, some of them are considered as
problematic. One of them is the iconic Chunnel Project, completed in 1993. For this project,
costs were underestimated at 1.2 billion GBP, while the final costs rose to more than 4.1 billion
GBP. The traffic was overestimated at 21 million passengers per annum, and in 2012, the number
of passengers was less than 10 million, leading to loss of income. The project complexities, the
advent of low cost airlines, and the other unpredictable factors created these problems (ADBI,
2014). However, this is an isolated incident, and the majority of DBFO projects in UK are
successful. Hence, the recommendation is that Old Cross Borough Council, Department of

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Community Services, should consider this method of procurement, after carefully studying the
project requirements.

3. PARTNERING RELATIONSHIP
Patterning relationship, partnering, or alliance, is another procurement method used in
construction projects. The method indicates a collaborative approach where two or more parties
collaborate to design finance, construct, and operate a public or private project. When two or
more entities take up partnership agreements, then the skills and expertise of both entities are
used. Partnership implies more than a financial arrangement, and it is sustained through trust and
personal friendships. One party may have expertise in design, while the other has expertise in
construction and material supply. The project efficiency, quality, control over cost and schedule,
is improved, when diverse skills are brought together. Trust, teamwork, commitment, common
objectives, and communication between the partners are very important. Attempts by one party
to dominate over the other, can result in the partnership breaking off. Strong and clear contracts
are essential for the partnership to succeed. Risks and rewards are shared between the project
partners on equitable business (Bygballe et al. 2010).

Contracts and costs are managed on an open book basis, with the project estimates
approved by all parties. The partners can either share the costs equally, or distribute the costs, as
per their funding capacity. Managing the project is done either jointly or by sharing the
responsibilities. A project manager oversees and manages all the project activities. The nature of
the project is important in deciding on the revenue sharing arrangements. For example, in a large

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commercial complex construction project, the partners may decide to obtain a share in the
income obtained from selling or leasing the space. In addition, each partner is given a certain
amount of the real estate, which he can sell or lease. In other cases, a partnership firm is formed,
and the partners obtain equity, equal to the investment (Roe & Jenkins, 2003).

Several advantages and disadvantages are evident in this type of procurement method.
The advantages are that there is a pooling of resources, and each party contributes in the form of
funds, design and project management expertise. The project has flexibility, in terms of project
scope, features, design changes, procurement methods, and other aspects. The main
disadvantages are that the whole project depends on trust and close relationship between the
partners. If there is fallout between the partners, or if one partner becomes insolvent, the project
will come to a standstill. Unless the contract terms are clear, liabilities of a partner are transferred
to the project. This means that if a partner goes insolvent, then the creditors can claim a transfer
of the partnership in the project. Partnership projects can develop a lenient attitude and censure,
penalties in case a partner delays executing the assigned responsibilities are not enforced. The
method is not cost efficient since there is no competition for the services offered. A partner can
inflate the costs and other partners often accept the inflated prices. This can prove detrimental in
the end (ECI, 2014).

4. EFFECTS OF COST RISK ON METHOD OF PROCUREMENT


Other than the technical and functional aspects of a project, one of the constraints is the
project cost, and the risk that it places on the procurement method. Construction projects face a

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number of risks and these include design risks, construction cost and quality risks, risks to
schedule, and risks of operating and maintaining the facility. Each type of procurement has its
own risk, and cost is a major factor in determining the risk. If the contractor underestimates the
costs, then there is a major cost risk, and unless the contract allows for cost escalations, the
contractor bears the risk (Ashworth, 2011). The following figure indicates the different types of
costs risks that each procurement method faces.

Figure 4.1. Procurement methods and cost risks (Milazzo & Hook, 2014)

The main reason for adopting a procurement method is to bring in external expertise into
the project. Risk transfer is an added benefit, and the project owner should not force a high cost
risk project on a contractor, since such practices end up in failure. From the figure, it is clear that
the least cost risk appears in the alliance type of procurement method, since each partner shares
the risk. Therefore, each partner is tasked with the successful completion of the project. The
highest risk is seen in the PPP type of procurement, since the private partner assumes the major

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cost risk, while the project owner, typically the sovereign, can remain on the sidelines. The
benefits from PPP projects are rewarded solely to the private partner, along with the risk. Hence,
the financial viability and appetite for risk become the main determinants in PPP projects
(Masterman, 2006).

In design and construct projects, the contractor bears all the risks. Depending on the
contract conditions, the project owner may agree to cover certain risks such as increase in
material costs and other factors. However, the final offer from the contractor becomes binding
and he bears all the risks. In construct only methods, the project owner and contractors share
some of the risks, for the completion schedule. Generally, the contractor has to bear the risks of
labour and equipment costs. The project owner bears the risks of material costs, or changes in
regulations. In construction management method, the contractor bears all the risks, while the
project owner is exposed to some latent risks. However, in managing contractor procurement
method, the contractor bears all the risks (Chitkara, 2005).

An important determinant of costs risks is the project duration, and the involvement of
sub contractors. Large projects with duration of more than a year face higher cost risks. The main
contractor who bids for the project, sub contracts the work to smaller contractors. In such an
arrangement, both the contractors share the revenue. However, the sub contractor has less
bargaining power, and if often squeezed to offer better margins, and the cost risks for the main
contractor are high (Ashworth, 2011).

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5. CONCLUSIONS
The paper extensively discussed important construction methods, and the cost risk effects
on different methods. DBFO projects are popular in Europe and other areas, where the
governments do not have sufficient funds and resources to take up public sector projects. The
private partner assumes all the risks and responsibilities for design funding, and construction,
while obtain returns from operating the facility. The other types of procurement methods such as
partnership would require substantial outlay from the borough in terms of funding, and skilled
resources. Hence, the DBFO method of procurement is recommended for Old Cross Borough
Council, Department of Community Services, since the borough does not have to obtain funding
from the government, and all the expertise if provided by the partner. However, the borough
must carefully define the requirements, estimate the budget, identity the right type of partner, and
ascertain the burden placed on the community.

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