When bidding within the public sector, small- and medium-sized construction businesses often feel they are at a disadvantage. With smaller labour resources, less flexible pricing models and smaller supply chain options than larger firms, SMEs are particularly disadvantaged when tendering for contracts with a fixed-cost pricing structure.
When dealing with fixed-cost models, it can be tempting to submit the lowest possible price, especially for bids where pricing constitutes a large portion of the overall score. However, serious and significant consequences can result from ‘loss-leading’ pricing in bids, including insolvency. The construction industry accounted for nearly 20% of all insolvencies for the first half of 2022, with inflation cited as the primary business concern.
Defining fixed-cost pricing
Although fixed-cost pricing within construction tendering sounds rigid, there are significant variations to the model, such as:
- Firm/lump sum: A single price is agreed between the buyer and supplier(s) before works begin, with no further negotiations or adjustments. Typically, the supplier is required to bear any excess if the project runs over budget – however, if the project is delivered under budget, the supplier will reap the benefits of cost savings. Firm/lump sum variations are often employed for relatively short-term projects.
- Fixed-cost with prospective redetermination: The contract is agreed to as a fixed-price contract, with allowances for suppliers to submit an adjustment to pricing for reasons outside of their control, such as a drastic increase in materials cost. In this form, adjustments are often made collaboratively every 12 months over the contract duration, and are more favourable to the supplier.
- Fixed-cost with retrospective redetermination: An adjustment can be applied to the overall contract price following the completion of the project. Retrospective adjustments are relatively rare in construction, and are more applicable to surveying works or the initiation phase. Adjustments are unlikely to be substantial.
Fixed-cost pricing is generally defined in opposition to what buyers term ‘open book contracts’, where suppliers are reimbursed based on work invoices completed, often with an incentivised target cost to keep pricing under control.
Why is fixed-cost pricing favoured by purchasing authorities?
Recent studies indicate that buyers are continuing to favour fixed-price contracts, employing them for 80% of projects compared to open book contracts. SMEs are at a further disadvantage, as high-priced projects (in excess of £1 million) are nearly four times as likely as low-value (£0–250k) projects to employ open book contracts, meaning the majority of small businesses will be required to submit a fixed-cost quotation.
The reasons why purchasing authorities favour fixed-cost pricing over more variable models are relatively simple, including the following:
- Cost certainty: Across the industry, an estimated 69% of construction projects exceed their budgets, with the remaining 31% only delivering works within 10% of their initial quotation. Purchasing authorities can achieve greater cost certainty and mitigate potential budgetary concerns if fixed costs constitute part of the tendering process.
- Precise timetabling: Fixed-cost pricing often comes with a carefully planned timeline inclusive of budget milestones, avoiding arbitrary and unexpected cost overruns. Projects with a firmly defined scope of works can benefit from this feature, but when variations occur suppliers will frequently encounter increased budgeting constraints.
- A firm pricing model: When producing a formal quotation, suppliers will be contractually required to adhere to their initial estimate, thereby eliminating another round of negotiations once a preferred supplier has been identified via the tender process.
- Simpler pricing schedules: In lieu of pricing each part/repair individually (which can sometimes range in the thousands), a Schedule of Rates (SOR) can be generated, where bidders will apply a percentage adjustment to quoted prices. One common example is the M3NHF (SOR) (version 7.2 is the most current edition), employed by 635 social housing associations across the UK. SORs are often utilised on contracts where work is of an undetermined quantity during the tendering stage.
From the buyer’s perspective, the overall benefit of fixed-cost pricing is the risk transfer from the buyer to the supplier. However, as any budget overruns are then borne by the supplier, any slippage in budgeting for labour, materials and overhead can threaten the health of the business, even leading to bankruptcy.
The case of Carillion is instructive for construction SMEs, demonstrating that no business is ‘too big to fail’. It also illustrates the dangers of underbidding on fixed-cost price contracts, and neglecting appropriate levels of cashflow for the sake of high turnover.
The effects of inflation
Already buffeted by the additional administrative burdens of Brexit and wide-ranging changes to statutory working practices during the COVID-19 pandemic, the construction industry is now tasked with responding to challenges stemming from worldwide inflation – making fixed-cost pricing contracts less suitable than ever.
According to the Tender Price Index (a quarterly measure of supplier pricing levels created by the Building Cost Information Service), supplier quotations for fixed-cost pricing models rose 7.6% between Q4 2021 and Q4 2022. A five-year forecast indicates tender prices could increase to as much as 20% by Q2 2027. However, this far exceeds the current inflation figures of both energy and materials borne by construction suppliers.
Energy
Including consumption for the creation of building materials, the construction industry accounts for nearly 20% of the UK’s fossil fuel consumption, primarily natural gas. Although the government did submit an energy relief scheme for businesses in September, with additional support recently extended until March 2024, this has been deemed insufficient and ‘not material’ by many industry outlets.
Construction management consultancy RG Group estimated that SMEs and subcontractors incurred the largest risk from skyrocketing energy prices due to their tendency to work on fixed-term contracts. Although wholesale energy appears to be reverting to normal pricing ranges, small businesses remain the least likely to adjust to new norms of energy expenditure, with 96% reporting that energy bills are a significant concern.
Materials
Inflation of materials costs has fared no better than energy. The Building Cost Information Service reported that average material prices rose 22.3% in Q2 2022 compared to Q2 2021, while wholesale prices of timber and steel rose over 75% in the same timeframe. Due to the consistent rise over the past 21 months, 25% of construction businesses are citing difficulties in procuring materials within budget.
The effects of inflation forecasts are austere – an estimated 6,000 insolvencies are expected over 2023, correlating with a 3.9% decrease in overall construction output, with an outsized effect on small- and medium-sized businesses.
Inflation impact on SMEs
Over 80% of SMEs believe that the effects of inflation are more detrimental for business than the COVID-19 pandemic. The inflationary period has caused small businesses to bear the brunt of decreased profit margins, supply chain shortages and labour resourcing which afflict the sector.
Profitability
As previously stated, due to the competitive nature of fixed-cost pricing, SMEs may feel increased pressure to submit a pricing schedule that is at-cost or even at a loss, even in the current inflationary period. Reasons for under-pricing may include the following:
- Gaining entry onto more profitable projects from the same buyer
- Maintaining organisational turnover/need-to-work rates
- Building or preserving relationships with key buyers
- Penetrating a previously inaccessible or untapped market.
Profit margins in the construction industry are among the smallest in the UK, averaging between 1.5% and 2%. Whereas larger firms may be better positioned to absorb at-price or even loss-leader pricing, SMEs have neither the flexibility nor project turnover to make a calculated loss on contracts.
Supply chain
Already squeezed by supply chain shortages and lengthy lead times during the COVID-19 pandemic, SMEs are now grappling with severe fluctuations in trading prices due to supply and demand. With the average levels of cash in the bank reduced by more than 50% in the last 12 months, small businesses are struggling to effectively resource current projects and contracts.
Labour resourcing
The ONS has estimated there are now 244,000 fewer workers in the construction sector compared to Q4 2019, due to early retirees and a loss of EU workers. Due to the severe industry labour shortage and wage inflation due to the cost-of-living crisis, SMEs may find it difficult to submit a competitive fixed-cost tender, particularly if the contract would result in hiring additional employees.
Due to the effects of inflation, an increasing number of SMEs are in ‘critical financial distress’ compared to larger, more established firms, with an estimated 632 construction businesses owing more than £5,000 at the end of 2022.
What can SMEs do?
The challenges posed by fixed-cost pricing and rampant industry inflation may seem insurmountable. More than 80% of construction SMEs say that the current inflationary period is worse for business than COVID-19 shutdowns. However, careful and prudent planning will allow small businesses to remain afloat and effectively manage risk in a less-than-ideal tendering climate.
To mitigate the risk inherent to fixed-cost pricing, consider the following during the tender process:
- Ensure sufficient labour resources: Due to the shortages in the sector, it is critical to ensure you can effectively resource any tendered contract or framework; confirm there is sufficient contingency as part of your business continuity plan. Furthermore, if you need to hire additional labour for the contract, verify the offered salary will be competitive, as other employers will be aggressive in procuring both skilled and unskilled labourers.
- Strengthen supply chains: When forming service level agreements, negotiate for as long an agreement as possible to preserve any deals or discounts which form the contract. Communicate early and often with suppliers, particularly during contract mobilisation, and determine if they can advise if they are expecting a shortage of certain materials. Increasing existing stock levels of materials prone to inflation (such as timber) will also aid in shielding SMEs from future price hikes. Lastly, as 13% of all construction materials go directly to landfill, ensure any partly used materials are returned to depots for use on future projects, thereby reaping direct cost savings.
- Consider forming a consortium: The Federation of Master Builders has released a report outlining the advantages of several SMEs forming a consortium to strengthen the chances of winning public sector work. Benefits include overcoming minimum turnover thresholds (a common element of PQQs/selection questionnaires) and additional labour resourcing, allowing them to demonstrate suitability for a wider variety of projects. Consortia are particularly relevant for framework opportunities, where buyers are often cautious about operational capacity to delivery when evaluating tenders.
- Search and bid for frameworks: In spite of the caution exercised by framework evaluators, public sector frameworks offer a range of benefits for SMEs, such as long contract life cycles, scalable workstreams, and shared risk. Securing a place on a framework can also aid in forming long-lasting relationships with buyers, allowing SMEs to develop a positive partnership for future work opportunities.
- Price wisely: When tendering for a contract, consider all elements of the cost base. This includes not only the cost of labour and materials, but also overhead costs, such as vehicle maintenance, office space and depot leases. Furthermore, try to integrate increases in materials cost and cost-of-living pay rises into pricing, thereby ensuring a realistic and comfortable profit margin for the contract duration. It may be preferable to miss out on a contract due to pricing rather than incur serious financial difficulties in the medium- to long-term of a business life cycle.
While there is no ‘quick fix’ solution to the current challenges construction SMEs face, the above mitigations can help to prevent overextension and its consequences during this turbulent period.
Future directions for tendering
Towards the end of 2022, Construction News raised the possibility that the overwhelming pressures of fixed-cost pricing for contracts would signal the end of such pricing models for construction tenders. However, given the ubiquity of the model in both the public and private sector, change is unlikely to come overnight, and SMEs must grapple with the possibility of continuing to remain competitive within the confines of fixed-cost pricing models.
Bid writers Executive Compass, propose that one way forward could be a fixed-price model pegged to indices (such as the Tender Price Index or Construction Cost Index), which works in a similar manner to pension funds. Although rarely applied in construction, such contracts are common in commodity-based markets, such as gas. If introduced into the sector, volatility could be mitigated and reduced, with less risk incurred on SME suppliers.
Although Arcadis is reporting that inflation has now peaked, it is clear SMEs must be proactive in adapting to inflation within fixed-cost pricing models. The main priority for a quarter of construction SMEs is now survival – without adequate planning and consideration during the tendering process, more and more businesses risk slipping into insolvency.
