Pricing approaches in the construction industry

Pricing Approaches in the Construction Industry Akintola Akintoye Martin Skitmore Contractors have to bzd competltlvely for moyt of their work and at the same time deal with the risks and uncertamtles connected wtth bid yubmlrslon Thu article examines the jactors involved tn tender prrcmg and how they interrelate From this, a conceptual model of contractors’ prlcmg strategy IS developed

INTRODUCTION Contract prlcmg 1s not a simple matter The construction industry 1s extremely fragmented and highly competitive, contractors have to bid competltlvely for most of their work and at the same time deal with the risks and uncertamtles connected with bid submlsslon The high level of price competltlon and low capital intensity that characterize the industry often combme to depress profit margins A great deal of current mformatlon 1s needed, together with forecasts of demand, cost, competition, etc , to allow contractors to set bids and adJust them to desired profit levels In commerce, compared with the construction mdustry, much research has exammed mto the processes and stages involved m prlcmg declslons Prlcmg strategy, m Address correspondence to S A Akmtoye. Dept of Surveymg verstty of Salford, Salford M5 4WT, Umted Kmgdom

Industruil Marketuq Manqernenr 21, 3 I 1-3 18 ( 1992) 0 Elsewer Saence Pubhshmg Co , Inc , 1992 655 Avenue of the Americas,, New York, NY 10010

the Uni-

relation to commerce, 1s defined as a reasoned choice from a set of alternative prices (or price schedules) that alms at profit maxlmlzatlon wlthm a planning period m response to a given scenario [l] In relation to marketing, pncmg decision approach mvolves the followmg [2] estabhshmg pricing objectives, consldermg factors influencing pricing declslons, examining pricing strategies and competltlve responses, attention to methods of price determmatlon, tactlcal conslderatlons m setting prices Conceptual models of this type are expected to enhance our understanding of the factors involved m prodect pncmg by construction contractors This article presents a pricing framework for constructlon work m a slmllarly logical and systematic way Methodology The development of the model IS based on an extensive literature search (most of which cannot be reported m this short article) of standard textbooks, materials, proceedings and transactlons of conferences, and referred Journals Figure 1 was developed as an approach to the development of the conceptual model

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Consider PRICING OBJECTIVES The literature relatmg to marketmg actlvltles contmues to report pricing objectives as the logical starting place for price determmatlon A firm’s overall obJectIves determme its prlcmg objectives, which, m turn, estabhsh

PRICINQ

Proflt Proflt

I

maximization satisfrcing

OBJECllVES

rAcroRs

wu##14

I

EnvIronmental

factors

Profltablllty Cost estimating Procurement method

Cost based prwg Market based HIstorIcal price based Standard rate table based Subcontractors’ brds based Cover price

four areas. the parameters of prlcmg pohcles [3] Investlgatlon of firms’ objectives showed the Importance of these objettlves m the firms’ prlcmg policy and method [4] In essence, price should be chosen to achieve a company’s objective [5] Wlthm this field of marketmg, numerous pricing objectives have been identified [6] However, emplrlcal works have specified that the types of prlcmg objectives usually specified by busmessmen or corporations are hmlted to seven [7-91 The three major types of pricing objectives are as follows [2] 1 Cost-oriented ObJectIves-to pursue a target return on investment and recoup costs over a particular time period 2 CornpetItIon-oriented objectives-to retain market share, discourage competltlon, and provide a barrier to entry by other firms 3 Demand-onented objective\-to meet the expectations of clients and the Industry However, It IS claimed that firms’ pricing objectives are related to expected profit levels, and usually concerned with either profit maxlmlzatlon or profit satlsfactlon [IO] EmpIrIcal study found a correlation between the prlcmg ObJectives of construction firms and then pricing strategies, the objectives bemg restricted to target returns on Investment and market share [ 111 This work also recognized that most of the firms with a target return on investment used a cost-based prlcmg strategy Therefore, it may be expected that a firm’s pricing objectives will have different welghted effects on Its bid pnce declslons

FACTORS

INFLUENCING

Environmental

312

Construction

DECISIONS

These entail gathering mformatlon about the various factors to be consldered when making a bid price declslon Four broad areas have been identified

PRICING YODEL I

FIGURE I.

PRICING

Price Determination Approach

Factors

Decision makers often assess a unique set of economic factors m the course of project development These m-

elude Important macroeconomic variables encompassmg a project’s economic, pohtlcal, social, and technological circumstances These factors largely determme the market situation m the construction industry For example, general economic condltlons could determme the chmate for tendermg and market price level [ 121 Slmllarly, the relatlonshlp between economic and social factors has been used to develop constructlon cost mdex [ 131, while some of these factors could be used to forecast changes m the bulldmg market [ 141 The economic, social, or polmcal situation may dictate the level of demand for construction work, the number of constructlon firms registered, and the degree of competition for construction Jobs In times of economic uncertainty, firms may switch from cost-based to marketoriented pricing strategies In boom condmons, construction firms may settle for cost-based pncmg, and therefore make target returns on Investments Envlronmental factors could include any combmatlon of the followmg Geographic location of constructlon demand Competmve market condltlons General state of mflatlon or deflation ’ Local tendering customs Governmental pohcles ’ Capacity and faclhtles available m the mdustry Level of taxation Economic well-bemg of a natron l

l

l

Deslrablhty

of a project

’ Escalations ’ Strategic maneuvering

Estimating

Cost

The first purpose of a cost estimate 1s to provide knowledge of likely cost of constructlon work In the construction industry, a bid price 1s tradltlonally formulated by combmmg this cost estimate with a mark-up value However, the rehablhty of this process has been questloned For example, It has been argued that estimators cannot really estimate costs because they have no reliable means of knowmg what the actual costs are [20] Also, few builders know the accuracy of their cost estimates because of lack of reliable feedback created by a combination of the competltlve tendering system and variable site performance levels [21] However, empirical work suggests that cost estimates continue to provide the basis for most contractors’ tender prlcmg [22] Cost estimate factors consist mainly of design and constructlon variables These determine the project’s level of complexity, the use of plant, and speclficatlons and bulldablhty of construction work, as follows Design varlahles

l

l

l

Plan shape Project size ’ Story height

l

l

How accurate are cost estimates? Profitability Profitablhty m the construction Industry IS generally rather low compared with other mdustrles [ 1.51 At the project level, profitablhty could be described as the tradeoff between wmnmg a tender and makmg a reasonable profit, expected protitablhty on a project bearmg a close relatIonshIp with the mark-up value For example, Runeson and Bennett [ 161 emphasize the Importance of markup m tendermg strategies, while factors mvolved In the constructlon contractors’ mark-up have been ldentlfied [ 17-191 Profitability factors are mainly related to l

l

Level of risk and uncertamty Human error

m a proJect

. . . . . . .

Number of stories Speclficatlon standard General project arrangement (mcludmg layout) Degree of repetition wlthm building Site condltlons Environmental needs (natural dayhght, regulations) Extent of services and external works Construction

. . . . . .

variables

Construction form Degree of repetltlon with building Task complexity Level of interdependence of construction operations System of construction Extent of experience on the type of construction 313

Six approaches relevant construction bids. l

l

l

Contractor’s work program Weather/ground condltlons Time overlap of design and con\tructlon

Procurement Procurement of constructlon These include . . . . . . . . . . . . . . . . .

systems are concerned with the execution contracts and the factors mvolved m this

Tendering procedure Contractual arrangement Intensity of competitlon Contract duration Fmanclal conslderatlon of chent Contractor’s cash flow mampulatlon Quality of project mformatlon Designers involved Quarter of year m which the bid IS submltted Drastic contract provlslons Use of subcontractors Quantity of expected varlatlon on a project Method of cost estlmatmg Level of adequacy of cost data Type of client Contract value Remoteness of project and distance from contractor base

PRICING STRATEGIES To meet specific objectives, and wlthm the content of factors that influence prlcmg declslons, firms have to adopt some type of prlcmg strategy For example, a construction firm could target a particular market by tendermg for such Jobs at a low price level Firms may adopt low-profit prlcmg during economic recesslon to mamtam market share or penetrate a new market [23] Investlgatlon of construction firms’ market-onented prlclng strategies for bid\ suggests that constructlon firms are Interested m what the constructlon market ~111bear whenever they bid for projects [24] Different prlcmg strategies have evolved m other Industnes There are three major strategley are [2, 251 Cost-onented methods based on cost plus mark-up, breakeven, and target rate of return CornpetItIon-onented methods based on competltors’ prices Thl\ mvolves prlcmg m relation to competitor\’ expected reactions Demand-onented methods based mamly on the going price or customers’ perceived value Gabor [26], on the other hand, classified prlcmg pohcles mto two basic approaches+ost-based and market-onented prlcmg Cost-based prlcmg encompasses profit-oriented and government-controlled prices, while

There are many possible frameworks. AKINTOLA AKINTOYE IS a Research Fellow In Construction Prlclng and Estlmatlng and MARTIN SKITMORE IS a Reader of Construction Economics at the Unlverslty of Salford Salford, Unlted Kingdom

314

to

pricing

market-onented prlcmg mcludes customer- and competltlon-onented pricing However, some argue that the structure of the construction industry and the nature of the process are more \ulted to market- than cost-oriented prlcmg [24] Experience and observation of the constructlon mdus-

try indicate that the followmg SIXapproaches are relevant to construction bid prlcmg Two approaches here are relCost-based approach evant cost estimate plus variable mark-up and cost estimate plus flexible mark-up The constructlon hterature has emphasized the importance of market condltlons on mark-up values Market-based approach This relates to a construction firm’s perceptlon of the “gomg price” of a project, consldermg the general level of competltlon, workload m the Industry, the client’s bid price consciousness, etc This IS based Standard rate table-based approach on extracts from standard construction price books such as Spon’s, Laxtons, Wessex database, etc Previous bid Hlstorlcal puce-based approach prices are adjusted for effects of time, locatlon, current economic condmons, variations m design and constructlon, etc This IS more relevant to serial tendering, m which a firm 1s blddmg for a slmdar project executed for the same client m the past, at the same or different site location(s) Subcontractors’ bzds-based approach If a contractor can guarantee the quality and integrity of the subcontractors and the ablhty to adhere to schedule and stay wlthm estimates, subcontractor bids may constitute a huge proportion of the prime contractor’s bid price The contractor may treat these bids as a cost on which to base the mark-up In essence, the more work a contractor subcontracts to others, the lower will be the contractor’s risk and thus the lower the potential mark-up on the total value of the contract [27] Cover price Many reasons prompt a contractor to quote a cover price m competltlve tendering Lack of deslrabdlty of a Job and lack of time to prepare detailed cost estimates or market studies are very Important THE CONCEPTUAL

MODEL

Individual firms’ prlcmg objectives and perceptlon of the factors influencing the prlcmg declslon will to a great extent determme or dictate the pricing pohcy to adopt on bid prlcmg Figure 2 models a general framework for contractors’ pricing strategy This model suggests that pricing ObJectives, which can be broadly categorized as profit maximization and profit satlsfactlon, determme the prlcmg pohcy of firms For example, a firm that adopts target return on investment as a pricing objective could be regarded as satlsficmg rather than maxlmlzmg the profit [28] Such firms set prices by addmg a standard

rl

PRICING OBJECTIVES

dr FACTORS INFLUENCING PRICING DECISIONS

FIGURE 2

General Framework

F.lMROHYWAL F*mRs

for Pricing Strategy

mark-up to costs and are therefore not profit maxlmlzers [29] On the other hand, a firm whose pricing obJective IS sensitive to competmon, workload, and price consclousness of chents could be regarded as a profit maximizer and generally adopts market-oriented prlcmg policy Factors Influencing pricing also influence estlmatlon and allocation of risk and uncertamty To a great extent, project profitability depends on the expected risk and uncertainty Involved m a contract A firm that Intends to spread risk and uncertainty may settle for a subcontractors’ btds-based prlcmg pohcy In essence, the subcontractors’ prlcmg process ~111 be central to the overall pncmg process [30] The procurement system determines the contractual relatlonshlp between chent and contractor The level of confidence a contractor has m this system will determme whether the contractor adopts a flexible or fixed markup prlcmg policy A firm that has httle confidence m a contract procurement system may bid based on a cover price 315

Environmental factors determme the workload avallable for the Industry Turbulent environmental condltlons characterized by sluggish constructlon demand, Intense competltlon, fluctuatmg Interest rates, high corporation taxes, harsh government regulation, etc , lead to quick changes m firms pricing pohcles In essence, prlcmg policies are fine tuned to prevallmg economic condltlons, such that a firm changes from cost-based to marketoriented prlcmg (which pays more attention to envlronmental dynamics) m times of economic uncertamty or when there IS a need to break even or penetrate mto a new construction market Figure 3 proposes a model for construction contractors’ detalled prlcmg strategies It indicates the detailed pricing obJectIves of firms and factors specific to profitabIlIty, environmental condltlons, cost estimating, and procurement systems known to mfluence firms’ prlcmg policy declslons The Model conslders all the stages m the development of prlcmg strategies ldentlfied m Figure 2, and estabhshes the lmks or relatlonshlps among the different stages of price determmatlon For example, Figure 3 shows that cost plus fixed mark-up m tender price determmatlon 15 based on a profit satisfaction ObJeCtlVe It ldentlfies the factors related to cost estlmatmg and mark-up and e\tabhshes a lmk between mark-up and profitablhty, type of work, locatlon, and procurement system For other prlcmg policies (market oriented, subcontractor bids based, hlstorical price based, and cover price based), the lmkmg factors can also be traced in the model In essence, the firm’s prlcmg objective IS central to a pncmg strategy Prlcmg strategies are expected to be flexible and change with the circumstances of a construction project Factors Influencing the prlcmg declslon are Important and provide a pomter to the risk level of a contract

from cost-based to market-onented strategies as the market price of constructlon becomes less certain Although based mamly on a literature review, the conceptual model presented here could be helpful m the development of computer alds for construction contractor prlcmg strategies, while simultaneously enrlchmg our understanding of the prlcmg declslon process of construction firms

REFERENCES I

2

This article describes a conceptual model of construction contract pricing strategies and ldentlfies the lmks between all the stages involved m bid price formation However, rigorous research IS necessary to assess the strength of these relatlonshlps The tender success rates of these strategies need mvestlgatlon, while the contribution of each to project profitability 1s another Important area for study Research 1s also necessary to assess the dynamics mvolved m terms of changes m strategy and strategy type through changing market condmons, company resource levels, etc , and particularly the transltlon 316

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