Chapter 34
Procurement
Abstract
This chapter covers procurement from the strategy through tender documentation and evaluation, bidder selection, requests for quotations, letters of intent, purchase orders, contract types and documents, subcontracts, conditions of contract, bonds, ascertainable liquidated damages, discounts, monitoring, expediting, inspection, shipping, insurance, incoterms, commissioning and final handover procedures and documentation.
Keywords
ALDs; Bids; Bonds; Contracts; Expediting; Inspection; Procurement; Purchase order; Shipping; Subcontracts; Tender documents
Procurement is the term given to the process of acquiring goods or services.
The importance of procurement in a project can be appreciated by inspecting the pie chart (Fig. 34.1) from which it can be seen that for a typical capital project, procurement represents over 80% of the contract value.
The main functions involved in the procurement process are:
1. Procurement strategy
2. Approved tender list
3. Pre-tender survey
4. Bidder selection
5. Request for quotation (RfQ)
6. Tender evaluation
7. Purchase order
8. Expediting, monitoring and inspection
9. Shipping and storage
10. Erection and installation
11. Commissioning and handover
These main functions contain a number of operations designed to ensure that the desired goods are correctly described and ordered, delivered when and where required and conform to the specified quality and performance criteria.
The functions are described further followed by a more detailed discussion of the types of contracts and supporting requirements.
Procurement Strategy
Before any major purchasing operation is considered, a purchasing strategy must be drawn up which sets out the criteria to be followed. These include:
• The need and purpose of the proposed purchase.
• Should the items be bought or leased?
• Should the items be made in-house?
• Will there be a construction element involved? If yes, it will be necessary to draw up subcontract documentation. If no construction or assembly element, a straight purchase order will suffice.
• Will there be open or selective tendering? This will often depend on the value and strategic or security restrictions. European Union regulations require contracts (subject to certain conditions) over a certain value to be opened up for bidding to competent suppliers in all member states.
• Are there prohibited areas for purchase or restrictive shipping conditions?
• What are the major risks associated with the purchase at every stage?
• What is the country of jurisdiction for settling disputes and what disputes procedures will be incorporated?
• What contract law is applicable, what language will be used, and in what currency will the goods be paid for?
• How will bids be opened and assessed and by whom? With public authorities tenders are usually opened by a committee.
Supply Chain
Every purchaser must bear in mind that most items of equipment contain components that are outsourced by the manufacturer or subcontractor to specialist companies. These companies may themselves subcontract subcomponents to other specialists, so that the original purchaser is utterly dependent on each subcontractor being technically and commercially rigorous and astute to ensure that the basic criteria of reliability, repeatability and sustainability are maintained through the whole supply chain.
The technical failure of any component, or the non-compliance with the relevant environmental and health and safety legislation, can have serious repercussions on the reputation and profitability of the purchaser. The problem has been exacerbated by the globalization of many manufacturing organizations where the inspection of the actual component or manufacturer’s premises may be difficult and costly. A monitoring and reporting mechanism must therefore be set up right through the supply chain to ensure that technical and environmental standards are maintained.
This issue has to be confronted by every manufacturing industry whether it be construction, engineering, electronics, pharmaceuticals, textiles, toys, etc.
Approved Tender List
When the procurement strategy has been agreed, a list of approved (or client-nominated) tenderers can be drawn up.
For many large infrastructure or power plant projects, it is beneficial to obtain the advice of specialist suppliers or contractors during the design stage. This will then inevitably lead to the possibility of reducing the number of competitive bids or even contravening (in Europe) EU procurement laws. In practice, many such projects will be constructed by consortia comprising civil, mechanical and electrical contractors and manufacturers, so that this risk has been transferred from the client/operator to the consortium.
Most major companies operate a register of the vendors who have carried out work on earlier contracts and have reached the required level of performance. These are generally referred to as ‘approved vendor lists’ and should only contain the names of those vendors who have been surveyed and whose capacities have been clearly established.
The use of computers enables such lists to be very sophisticated and almost certainly to contain information on company capacity and performance together with the details of all the work the contractor has carried out and the level of his performance in each case.
Lists are normally prepared on a commodity basis, but they are only of real use if they are constantly updated.
A typical entry against a vendor on such a list includes:
• Company name and address
• Telephone, telex and telefax no.
• Company annual turnover
• List of main products
• Value of last order placed
• Performance rating on:
• Adherence to price
• Adherence to delivery
• Adherence to quality requirements
• Ability to provide documents on time
• Cooperation during design stage
• Responses to emergency situations
Many organizations also keep a second list, comprising companies that have expressed their wish to be considered for certain areas of work, but are not on the approved vendors list. When the opportunity arises for such companies to be considered, they should be sent the pre-qualification questionnaires shown in Fig. 34.2 and, if necessary, be visited by an inspector.
In this way, the list will be a dynamic document onto which new companies are added and from which unsatisfactory companies are removed.
Pre-Tender Survey
The approved vendor list is a useful tool, but it cannot be so comprehensive as to cover every commodity and service in every country of the world. For new commodities or new markets, therefore, a pre-tender survey is necessary. This is particularly important when a contractor is about to undertake work in a new country with whose laws and business practices he is not familiar.
Figure 34.2
The summary should be as comprehensive as possible and the buyer should draw information from every available source. The subject is discussed in more detail later in this chapter under ‘Overseas bidder selection’, but the principles are equally applicable to surveys carried out in the UK or USA.
Bidder Selection
Before an enquiry can be issued, a list of bidders has to be compiled. Although the names of qualified companies will almost certainly be taken from the purchaser’s approved vendor list, the actual selection of the prospective bidder for a particular enquiry requires careful consideration.
During the preparation stage of the equipment requisition, a number of suitable companies may well have been suggested to the buyer by the project manager, the engineering department, the construction department and, of course, the client. While all this, often unsolicited, advice must be given serious consideration, the final choice is the responsibility of the procurement manager. In most cases, however, the client’s and project manager’s suggestions will be included.
The number of companies invited to bid depends on the product, the market conditions and the ‘imposed’ names by the client. In no case, however, should the number of invited bidders be less than 3, or more than 10. In practice, a bid list of six companies gives a reasonable spread of prices, but if too many of the invited companies refuse to bid, further names can be added to ensure a return of at least three valid tenders.
To ensure that the minimum number of good bids is obtained, some purchasers tend to favour a long bidder’s list. This practice is costly and time-consuming, especially if the support documentation, such as specifications and drawings, is voluminous. A far better method is to telephone prospective bidders before the enquiry is sent out and, after describing the bid package in broad terms, obtain the assurance from the companies in question that they will indeed submit a bid when the documents are received. In this way, the list can be kept to a reasonable size. If a vendor subsequently refuses to bid, he runs the risk of being crossed off the next bid list.
While the approved vendor list is an excellent starting point for bidder selection, further research is necessary to ensure that the selected companies are able to meet the quality and programme requirements. The prospective vendor must be experienced in manufacturing the item in question, have the capacity to produce the quantity in time, be financially stable and meet all the necessary technical and contractual requirements.
The buyer who keeps in touch with the market conditions can often obtain useful information from colleagues in other companies, from technical journals and even the daily press on the workload or financial status of a particular supplier. An announcement in the financial columns that a company has obtained an order for 10,000 pumps to be delivered over two years should trigger off an investigation into the company’s total capacity, before it is asked to bid for more pumps. Loading up a good supplier until he is overstretched and becomes a bad supplier is not in the best interest of either party.
When a purchaser lets it be known that a certain enquiry will be issued, the buyer will undoubtedly be contacted by many companies eager to be invited to bid. The information given by the salesman of one company must be compared with the, often contradictory, information from the opposition before a realistic decision can be taken. Only by being familiar with the product and the market forces at the time of the enquiry, can the buyer make objective judgements. On no account should vendors be included on a bid list to keep salesmen at bay or just to make up numbers.
For items not usually ordered by a purchaser, a different approach is necessary. In all probability, no approved vendors list exists for such a product and unless someone in the procurement department, or in one of the other technical departments, knows of suitable suppliers, a certain amount of research has to be carried out by the buyer.
The most obvious sources of suitable vendors are the various technical trade directories and technical indexes available on microfilm or microfiche. In addition, a telephone call to the relevant trade association will often yield a good crop of prospective suppliers. Whatever the source, and whoever is chosen for the preliminary list, it will be prudent to send a questionnaire to all the selected companies, requesting the following details:
• Full company name and address (postal and website)
• Telephone, fax no. and e-mail address
• Company annual turnover
• Name of bank
• Names of three references
• Confirmation that the specified product can be supplied
• What proportion will be subcontracted
• Name of parent company – if any
It is clear from the above that these questions must be asked well in advance of the enquiry date. It is necessary, therefore, for the buyer to scan the requisition schedule as soon as it is issued to extract such materials and items for which no vendors list has been compiled. In other words, the buyer will have to perform one of the most important functions of project management – forward planning.
Request for Quotation
The procurement manager will first of all:
• Produce a final bid list of competent tenderers
• Decide on the minimum and maximum number of bids to be invited
• Ensure that the specification and technical description of goods or services to be purchased are complete
• Decide on the type of delivery and insurances required (ex-works, FAS, FOB, etc.)
• Agree to the programme with delivery dates for information and goods with the project manager
• Decide on the most appropriate general conditions of purchase or contract
• Draft the special conditions of contract (if required)
• Decide the type and number of document requirements (manuals)
• Agree with project manager on the amount of liquidated damages required against late delivery
• Draft and issue the RfQ letter
• Enclose with the RfQ the list of drawings and other data required for submitting bids
It is important to include any special requirements over and above the usual conditions of contract with the enquiry documents. Failure to do so might generate claims for extras once the contract is underway. Such additional requirements may include special delivery needs and restrictions, access restrictions, monitoring procedures such as EVA, inspection facilities and currency restrictions, etc. Discounts and bonus payments are best discussed at the interviews with the preferred supplier/contractor after the tenders have been opened.
The following information must be requested from tenderers in the RfQ:
• Price and delivery as specified
• Discounts and terms of payment required
• Date of issue of advance date technical data, layout drawings, setting plans, etc.
• Production and delivery programme
• Expediting schedule for suborders
• Spares lists and quotation for spares
• Guarantees and warranties offered
• Alternative proposal for possible consideration
Tender Evaluation
The procurement manager must next:
• Decide on bid opening procedure and open bids
• Receive and log the bids as they arrive
• Assess previous experience and check reference contracts or sites
• Check list of past clients
• Set up bidders meetings
• Interview site or installation manager or foreman (if applicable)
• Discuss quantity discounts
• Negotiate early or other payment discounts
• Obtain parent company guarantees when the contract is with a subsidiary company
• Agree the maintenance (guarantee) period
• Discuss and agree bid, performance, maintenance and advance payment bonds
• Produce bid summary (bid tabulation) (Fig. 34.3)
• Carry out technical evaluation
• Carry out commercial evaluation
The following are the main items that have to be compared when assessing competing bids:
• Basic cost
• Extras
• Delivery and shipping cost
• Insurance
• Cost of testing and inspection
• Cost of documentation
• Cost of recommended spares
• Discounts
• Delivery period
• Terms of payment
• Retentions guarantees
• Compliance with purchase conditions
All the vendors’ prices must, of course, be compared with the estimator’s budgets, which will also appear on the sheet.
If the value of the bids (or at least one bid) is within the budget, the bid evaluations can proceed as described below. If, on the other hand, all the bids are higher than the budget, a meeting has to be convened with the project manager at which one of the four decisions has to be taken, depending largely on the overall project programme:
1. If there is time, the enquiry can be reissued to a new list of vendors, spreading the area to include overseas suppliers, provided foreign suppliers are not excluded by the terms of the contract.
2. Review the original design or design standards to see whether savings can be made. While such savings may be difficult to make with equipment items, which have to meet specified technical requirements, it may be possible to effect cost savings in the type of finish, or the materials of construction. For example, a tank that was originally specified as galvanized may be acceptable with a good paint finish.
3. If there is no time to reissue the enquiry it may be necessary to call in the two lowest bidders and either negotiate their prices down to the budget level or ask them to rebid within a few days on the basis of a few quickly ascertainable design changes.
4. If it is discovered that the original budget estimate was too low, the lowest bid (if technically and commercially acceptable) will have to be submitted for approval by the project manager.
These commercial comparisons must be carried out for every enquiry. However, an additional technical assessment must be produced when the material and equipment is other than a general commodity item, which only has to comply with a material specification.
Although the purpose of this evaluation process is to find the cheapest bidder who complies with the specification and contractual requirements, the technical capability of the bidder as well as their track record of timely completion and past relationships (good or bad) with other stakeholders should also be taken into consideration. This may of course be a problem in itself with government contracts, where there can always be accusations of favouritism or even nepotism if the least expensive bidder has not been selected.
Purchase Order
When the selected bid has been agreed, the purchase order or contract document must be issued with all the same attachments, which were part of the RfQ. The only additional documents are those containing the terms and conditions agreed at the bidder’s meeting or other written agreements made during the bid evaluation process. These will include:
• The procedures for payments as set out in contract
• The stages for issuing interim and final acceptance certificates
Any changes to the specification or drawings, etc. after the date of the purchase order will be issued as a variation order and controlled using established configuration management procedures.
As the contract proceeds, the procurement manager must:
• Set priorities from programme and revisions to programme, if necessary
• Set out bonded areas and marking when advance payments are considered
• Arrange to carry out regular expediting and check expediting reports
• Carry out stage inspection and specified tests, and check inspection and test reports
• Carry out route survey (if required)
• Issue final delivery instruction for documents and goods
• Issue packing instructions
• Issue shipping information, sailing times
• Advise on current site conditions for storage
• Gree and finalize close-out procedures
• Obtain details of after sales service
Expediting, Monitoring and Inspection
Between the time of issuing the purchase order or contract documents and the actual delivery of the goods or services, the progress of the production (manufacture) of the goods must be monitored if quality and delivery dates are to be maintained.
The contract documentation will have (or should have) included the appropriate portion of the overall project programme. From this, the contractor or supplier will be required to produce his own construction or manufacturing programme. This should be issued to the main contractor or client within two or three weeks of receipt of order and can be used to monitor progress.
It is beneficial if an expediter or inspector visits the works or offices of the supplier within two weeks of contract award to ensure that:
1. The contract documents have been received and understood
2. The contractor’s or supplier’s own programme has been started or is ready to be issued
3. The supplier or contractor has all the information he or she needs
At regular intervals an expediter will then visit the supplier and check that the supplier’s own programme is being met and, in particular, that sub-orders for materials and components have been placed, bearing in mind the lead times for these items. Any slippage to either the purchaser’s or supplier’s programme must be reported immediately to the project manager so that appropriate action can be taken. Where time is of the essence, a number of options are available to bring the delivery of the goods back on schedule. These are:
1. The purchaser’s programme may have sufficient float (permissible delay) in the delivery string, which may make further action unnecessary, but pressure to deliver to the revised date must now be applied.
2. If there is no float available, the supplier must be urged to work overtime and/or weekends to speed up manufacture. It may be worthwhile for the purchaser to pay for these premium man-hours in full or in part, as even if liquidated damages are imposed and obtained, the financial cost of delay, in addition to loss of prestige or reputation, is often very much greater than the value of any liquidated damages received.
3. If there is no liquidated damages clause in the purchase agreement or contract but delivery by a stated date is a fundamental requirement, the purchaser may threaten the supplier with legal proceedings, breach of contract or any other device, but while this may punish the supplier, it will not deliver the goods. For this reason, early warning of slippage is essential.
Because of the danger from the imposition of damages at large, due to possible delayed delivery, prudent suppliers, and especially contractors, should request that a liquidated damages clause be inserted into the contract, even if this has not been originally provided.
Similarly, an inspector will visit the supplier early on to ensure that the necessary materials and certificates of conformity are either on order or available for inspection.
This expediting and inspection process should continue until all the items are delivered or the specified services are commenced.
Shipping and Storage
To ensure that the materials or equipment are delivered on time and at the correct location, checks should be carried out to ensure that, in the case of overseas procurement, there are no shipping, landing or customs problems. Overland deliveries of large components may require a route survey to ensure that bridges are high or strong enough, roads wide enough and the necessary local authority permits and police escorts are in place.
Special attention must be given to contracts when dealing with the construction industry. Here, the timing of deliveries has to be carefully calculated to ensure that there is sufficient unloading and storage space, adequate cranage is available, there is no interference with other site users and that adequate temporary protective materials are ready.
In the case of urban construction, interference with traffic or the general public must be minimized.
Erection and Installation
Once on site, fabrication, erection and installation work should be regularly monitored using earned value techniques, which are related to the construction programme. Only in this way can the efficiency of a subcontractor be assessed and predictions as to final cost and completion can be made.
As the cost of delays to completion can be many times greater than the losses to production or usage of the facility being constructed, the imposition of liquidated damages (even if possible) will not recover the losses and are at best a deterrent. A far better safeguard against late completion is the insistence that realistic and updated construction programmes are produced, regularly (preferably weekly) monitored and, with the aid of network analysis and EVA techniques, kept on target. Although this may require additional resources and incentives, it may well be the best option.
As most construction contracts will have been placed on the basis of an agreed set of conditions of contracts (whether general or special), it will be necessary to check that the conditions are fully met, in particular those relating to quality, stage completion and health and safety. It is also necessary to ensure that adequate drawings and commissioning procedures are ready when that stage of the contract commences.
Throughout the manufacturing or construction process, documents such as operating and maintenance procedures, spares lists and as-built drawings must be collated and indexed to enable them to be handed over in a complete state when the official handover takes place.
Commissioning and Handover
Before a plant is handed over for operation, it must be checked and tested. This process is called commissioning and involves both the contractor and operator of the completed facility.
Careful planning is necessary, especially if the plant is the part of an existing facility that has to be kept fully operational with minimal disruption during the commissioning process. Integration with existing systems (especially when computers are involved) has to be seamless, and this may require the existing and new systems to be operated concurrently until all the teething problems have been resolved.
In certain types of plants, equipment will have to be operated ‘cold’, i.e., without the operating fluids (gases, liquids or even solids) being passed through the system. Only when this stage has been successfully completed can ‘hot’ commissioning commence with the required media being processed in the final operating condition (temperature, viscosity, pressure voltage, etc.) and at the specified rates of usage (flow, wattage, velocity, etc.).
It is often convenient to involve the operating personnel in the commissioning process so that they can become familiar with the new systems and operating procedures.
After the various tests and pilot runs have been completed and the operating criteria and KPIs have been met to the satisfaction of the client, the new facility can be formally handed over for operation. This involves handing over all the stipulated documents, such as built drawings, operating and maintenance instructions, lubrication schedules and spares lists, as well as commissioning records, test certificates of equipment, materials and operators, certificates of origins and compliance, guarantees and warranties.
A close-out report will have to be written, which records the major events and problems encountered during the manufacturing, construction and commissioning stages. This will be indexed and filed to enable future project managers to learn from past experience.
Types of Contracts
Contracts consist of three main types:
1. Lump sum contracts
2. Remeasured contracts
3. Reimbursable contracts
It is possible to have a subcontract that is a combination of two or even all three types. For example, a mechanical erection subcontract could have design content that is a lump sum fixed fee, a remeasured piping erection portion and a reimbursable section for heavy lifts in which the client wants to be deeply involved. The main differences between the three types are as follows.
Lump Sum Contracts
A prerequisite to a lump sum (a fixed price) contract, with or without an escalation clause, is a complete set of specifications and construction drawings. These documents will enable the subcontractor to obtain a clear picture of the works, assess the scope and quality requirements and produce a tender that is not inflated by unnecessary risk allowances or hedged with numerous qualifications.
The trend in the USA is to have all the designs and drawings complete before tenders are invited and, provided such usual risk items as sub-soil, climatic and seismic conditions are clearly given, a good competitive price can be expected.
Most lump sum contract documents should, however, contain a schedule of rates, so that variations can be quickly and amicably costed and agreed. Clearly, these variations should be kept to a minimum and must not exceed reasonable limits, since the rates used by the subcontractor are based on the tender drawings and quantities and a major change could affect his man-hour distribution, supervision level and site organization. A common rough limit accepted as reasonable is a value of variations of 15% of the contract value.
It must be stated that a variation can be a decrease as well as an increase in scope and although the quantities may be reduced by the client, the reduction in price will not be proportional to that reduction. Indeed, when a subcontract includes a design element, a reduction in hardware (say the elimination of a small pump), may increase the contract value due to costly drawing changes and cancellation charges.
Remeasured Contracts
Most civil engineering subcontracts in the UK are let as remeasured contracts. In other words, the work is measured and costed (usually monthly) as it is performed in accordance with a priced bill of quantities agreed between the purchaser and the subcontractor. The documents that are required for the tender are:
1. Specifications
2. General arrangement drawings
3. Bills of quantities
The bills of quantities are usually prepared by a quantity surveyor employed by the purchaser and are in fact only approximate, since the only drawings available for producing the bills are the general arrangement drawings and a few details or sketches prepared by the designers. Obviously, the more details available, the more accurate the bills of quantities are, but since one of the objectives of this type of contract is to invite tenders as quickly as possible after the basic design stage, full details are rarely available for the quantity surveyor. The subcontractor prices the items in the bills of quantities, taking into account the information given in the drawings, the specification, the preambles in the bills and, of course, the location and conditions of the proposed site.
Although the items in the bills of quantities are often described in great detail, they are included only for costing purposes and do not constitute a specification. In the same way, the quantities given in the bill are for costing purposes only and are no guarantee that they will be the actual quantities required.
As with lump sum contracts, variations, which inevitably occur, must not exceed reasonable limits in either direction, since these could invalidate the unit rates inserted by the subcontractor. For example, if the bills of quantities call for 10,000 m3 of excavation of a depth of 2 m, and it subsequently transpires that only 1000 m3 have to be excavated, the subcontractor is entitled to demand a rerating of this item on the grounds that a different excavator would have to be employed, which costs more per cubic metre than the machine envisaged at the time of tender.
In remeasured subcontracts, it is a common practice to carry out a monthly valuation on site as a basis for progress payments to the subcontractor. These valuations consist of three parts:
1. Value of materials on site, but not yet incorporated in the works
2. Value of work executed and measured in accordance with the method of measurement stated in the bills of quantities
3. Assessed value of preliminary items and provisional sums set out in the bills
The value of materials, which have been paid for in a previous month (when they were delivered, but not yet incorporated in the works), is deducted from the measured works in the subsequent month (by which time they were incorporated) since the billed rates will include the cost of materials as well as labour and plant.
At the end of the contract period, the final account will require a complete reconciliation of the cost and values, so that any overpayments or underpayments will be balanced out.
Reimbursable Contracts
When a client (or purchaser) wishes to place a contract as early as possible, but is not in a position to supply adequate drawings or specifications, or when the scope has not been fully defined, a reimbursable contract is the most convenient vehicle.
In its simplest form, the contractor (or subcontractor) will supply all the materials, equipment, plant and labour as and when required, and will invoice the client at cost, plus an agreed percentage to cover overheads and profit. To ensure ‘fair play’, the client has the right to audit the contractor’s books, check his invoices and labour returns, etc., but he has little control over his method of working or efficiency. Indeed, since the contractor will earn a percentage on every hour worked, he has little incentive in either minimizing his man-hour expenditure or finishing the job early.
To overcome the obvious deficiencies of a straight reimbursable (or cost-plus) contract, a number of variations have been devised over the years to give the contractor an incentive to be efficient and/or finish the job on time.
Most cost reimbursable contracts have two main components:
1. A fee component that can cover design costs, site and project management costs, overheads and profits
2. A prime cost component covering equipment, materials, consumables, plant, site labour, subcontracts and site establishment
In some cases, the site establishment may be in the fee component or the design costs may be in the prime cost portion. The very flexibility of a reimbursable contract permits the most convenient permutation to be adopted.
By agreeing to have the fee portion ‘fixed’, the contractor has an incentive to finish the job as quickly as possible, since his fee and profits are recoverable over a shorter period and he can then release his resources for another contract. Furthermore, since he only recovers his prime cost expenditure at cost, he has absolutely no advantage in extending the contract – indeed, his reputation will hardly be enhanced if he finishes late and costs the client more money.
If the scope of work is increased by the client, the contractor will usually be entitled to an increase of the fixed fee by an agreed percentage, but frequently such an increase only comes into effect if the scope charge exceeds by 10% of the original contract value.
The factors to be considered when deciding on the constitution of the fixed fee and prime cost components are:
1. Time available for design
2. Extent of the client’s involvement in planning and design
3. Extent of the client’s involvement in site supervision and inspection
4. Need to permit operations of adjacent premises to continue during construction. This is particularly important in extensions for factories, hotels, hospitals or process plants
5. Financial interest of the client in the contractor’s business or vice versa
6. Location of site in relation to the main area of equipment manufacture
8. Method of sharing savings or other incentives; it can be seen that if both parties are in agreement a contract can be tailored to suit the specific requirements, but the client still has only an estimate of the final cost
Target Contracts
To counter some of the disadvantages of the straight reimbursable contracts, target contracts have been devised. In these contracts, an estimate of the works has been prepared by the employer (or his consultants) and agreed with a selected contractor. The prime cost is then frozen as a target cost the contractor must not exceed. The fee component is fixed, but it can also be calculated to be variable in such a way that the contractor has an incentive to complete the works below target or on programme or both.
Again, there are numerous variations of this theme, but the following are the more common methods of operation:
1. If the final measured prime costs are less than the target value, the difference is shared between the parties in a previously agreed proportion. If the final costs exceed the target value, the contractor pays the difference in full. The fee portion remains fixed.
2. As in 1, but the fee portion increases by an agreed percentage as the prime cost portion decreases. This gives the contractor a double incentive to complete the contract below the target value and thus increase the fee and ensure savings.
3. As in 1, but the fee portion increases by an agreed percentage for every week of completion prior to the contractual completion date.
4. The employer pays the final prime cost or the target cost, whichever is lower, but the difference, if any, is not shared with the contractor. The fee, however, is increased if there is a saving of prime cost or time or both.
If the contractor is responsible for purchasing equipment as part of the prime cost portion, the procurement costs such as purchasing, expediting and inspection may be reimbursable at an hourly rate (subject to an annual review), but all discounts, including bulk and prompt payment discounts, must be credited to the employer. The contractor still has an incentive to obtain the best possible prices, since the prime cost will be lower.
Design, Build and Operate Contracts
These types of contracts have been developed since 1992 to reduce the financial burden on the public purse. This process is known as private public partnership (PPP). A subset of PPP is private finance initiative (PFI). These new types of contracts have a number of variations as described below, but their main purpose is for the private sector to take most, if not all, of the financial risk and employ their specialist knowledge and commercial experience, not always available in the public sector. Generally, a special service company, known as a special service vehicle (SPV) is formed, consisting of the contractors (building, maintenance and operating) and the financiers (bank or other finance house) to construct, maintain and operate the asset for a contractually agreed period. This company then signs the contract with the public authority (central or local) and arranges any leases with the actual operating organization, such as a prison or hospital.
The big difference between PFI and more conventional contracts is that the contractor finances the whole project from his own resources, and then recoups the cost and profit from the operation revenues or from levies charged on the public sector organization that awarded the contract. The following three examples explain the different types.
Free Standing
A typical example of this type of PFI contract is where the public authority drafts a performance specification for a new bridge and asks a number of large contractors to submit costed schemes. The successful contractor then designs, builds and maintains the bridge for a specified period. During this operating period, the cost and profit are recovered by the contractor/operator from tolls charged for the crossing. The contractor carries the risk that the volume of traffic will not reach the anticipated levels to yield the required revenues, possibly because the end user, the general public, considers the tolls to be too high.
Levies on the Public Sector
An example of such a contract is where the government requires a new prison. The successful contractor designs and builds the prison to the client’s specification and operates it in accordance with the standards laid down by the prison service. As the end users, the prisoners, can hardly be expected to pay rent, an operating levy is charged on the prison service to cover building, financing and operating costs plus profit.
Joint Ventures
Joint venture PFI projects are often used for road construction where there are no toll charges on the road users. Here, the design and construction costs are shared by an agreed amount by the public and private sector, and the contractor recovers his costs by a fee based on a benefit/revenue formula agreed in advance.
In all these types of contracts, the contractor is not chosen on the basis of the cheapest price, but on the viability of his business case, design concept, experience, technical expertise, track record and financial backing. In many cases, the contractor leads a consortium of specialist contractors, design consultants and financial institutions.
Basic Requirements for Success
Whichever formula is agreed upon, it is clear that in any reimbursable contract, the employer retains a measure of control and hence a considerable responsibility. If the employer is also involved in the design process, the release of process information, construction drawings and operating procedures must form part of the programme and should be marked as a series of key dates that must be kept if adherence to the programme is imperative.
The success of a contract (or subcontract) depends, however, on more factors than a well-drawn-up set of contract conditions, and the following points must not be overlooked:
1. Good cost control of prime cost items
2. Good site management
3. Careful planning and programming
4. Punctual release of information to site
5. Timely deliveries of equipment and materials
6. Elimination of late design changes
7. Good labour relations
8. Good relationship between contracting parties
The main types of contracts are summarized in Fig. 34.9.
Bonds
A bond is a guarantee given by third party, usually a bank or insurance company, that specified payments will be made by the supplier or contractor to the client if certain stipulated requirements have not been met. There are four main types of bonds a client may require to be lodged before a contract is signed. These are shown in order of submission:
1. Bid bond
2. Advance payment bond
3. Performance bond
4. Retention bond
Any of these bonds can be either conditional or on-demand. Conditional bonds, which are usually issued by an insurance company or similar financial institution, carry a single charge that is independent of the time the bond is in force and can only be called if certain predetermined conditions have been met. Such a condition might include that the supplier or contractor has to agree that the bond is called (i.e., that the money is paid to the client), or that the client or purchaser must prove loss to the satisfaction of the issuing house due to the default of the supplier. While such a bond may be very advantageous to the supplier, it is often regarded as unacceptable to a purchaser, since the collection and submission of evidence of default or proof of loss can be a time-consuming business.
The on-demand bond, on the other hand, has no such restrictions. As the name implies, it enables the purchaser to call in the bond as soon as and when he or she believes that a default by the supplier has occurred. Such a bond is normally issued by a recognized bank and will be paid without question and without the need for justification as soon as the demand for payment is made by the purchaser. Clearly, the main element of such a bond is trust. Both the bank and the supplier trust the purchaser to be reasonable and honourable not to call the bond until the contractual terms permit it. These bonds cost more than a conditional bond and are only for a fixed duration, usually a particular stage of the project. They can, however, be extended for a further period for an additional fee (see Fig. 34.4).
Apart from the benefit of speedier payment should there be a default by the supplier, another advantage to the purchaser of such a bond is that, as the cost of the bond depends on the bank’s perception of the risk and the supplier’s financial rating, a measure of the supplier’s standing can be obtained. A low bond fee usually means that the supplier is regarded by the bank as reliable and financially stable.
Bid Bond
In major contracts, many overseas clients require a bid bond to be submitted with the tender documents. The purpose of this bond, which is usually an on-demand bond, is to discourage the tenderer from withdrawing his bid after submission. This can be of considerable potential danger to a tenderer who discovers, after the bids have been dispatched, that there was an error in his tender price or that other contractual requirements have been overlooked. Unless his price was originally higher than that of his competitors, the unfortunate tenderer has to decide whether to proceed with a potentially loss-making contract or to forfeit his bond.
The client will undoubtedly argue that the main purpose of the bond is to eliminate frivolous bids and ensure that those bids submitted are not only serious but also firm.
However, there can be considerable financial disadvantages to a tenderer since a bid bond, if issued by his bank, is equivalent to an overdraft, so that the working capital can be greatly reduced for a considerable period. When one considers that it can take between three months and a year to know whether a large contract has been won or lost, the loss in financing facilities and interest charges for the bond can be so great as to deter all but the largest contractors from tendering.
Advance Payment Bond
There are circumstances when a seller requires payments to be made before the goods are delivered. This arrangement is frequently required to finance expensive raw materials. The purchaser may also wish to make advance payments to reserve a place in the manufacturing queue or, as in the case of public authorities, to meet an expenditure deadline.
Until the goods are delivered, however, the purchaser has little or no guarantee that the advance payments will not be completely lost, should the supplier go into liquidation or the directors disappear to South America. To eliminate this risk, the purchaser requires the supplier to deposit with him a bond, usually underwritten by a bank, which guarantees a refund should any of the above misfortunes of the above type occur. The bond usually has a time limit that is often geared to a physical stage of the contract, such as the receipt by the purchaser of preliminary drawings or the arrival of raw materials. The latter stage is often accompanied by a certificate of ownership which vests the proprietorial rights with the purchaser.
Such a certificate is often supplemented by labels, which are affixed to the equipment or materials, declaring that the items marked are the property of the purchaser. This enables the purchaser to recover his goods (for which he has after all paid) should the vendor go into liquidation. The wording of such a notice should be vetted by the purchaser’s legal advisers to ensure that the goods can, indeed, be recovered without further court action.
Where bulk materials have to be protected in this way, it is usual to fence off a ‘bonded’ area and erect notice boards at a number of locations. A typical notice of transfer of ownership is shown in Fig. 34.5.
While an advance payment bond will usually be required for progress payments for work carried out off site, it is not normally required for work on site, since the completed works are the immediate property of the purchaser and could be finished by another subcontractor in the case of bankruptcy or default (see Fig. 34.6).
Performance Bond
This type of bond is more usually associated with subcontracts and is an underwritten guarantee by a bank or other financial institution that the subcontractor will perform his contract and complete the work as specified.
Even if the subcontractor is paid by progress payments, the purchaser may still suffer considerable loss and frustration if the works are not completed due to the subcontractor withdrawing from site.
The performance bond should be of sufficient value to cover the cost of finding and negotiating with a new subcontractor and paying for the additional costs that the new subcontractor may incur. There may, of course, be the additional costs of delays in completing the project, which are often far greater than the difference in price of two subcontractors.
Usually, the value of a performance bond is between 2.5% and 5% of the contract value, which covers most contingencies.
Once the certificate of substantial completion has been issued, the performance bond is returned to the subcontractor. Alternatively, the bond can be extended to cover the maintenance period and thus takes the place of the retention bond (see following section), provided, of course, that the percentage of the contract value is the same for both bonds (see Fig. 34.7).
Retention (or Maintenance) Bond
Many purchase orders and most subcontracts require a retention fund to be established during the life of the manufacturing or construction stage. The purpose of a retention bond is to release the monies held by the purchaser at the end of the construction period and yet give the purchaser the available finance to effect any necessary repairs or replacements if the subcontractor or vendor fails to fulfil his contractual obligations during the maintenance period. The value of the bond is exactly equal to the value of the retention fund (usually between 2.5% and 10% of the contract value), and is issued by either a bank or an insurance company.
When the maintenance period has expired and the final certificate of acceptance has been issued, the retention bond is returned by the purchaser to the subcontractor, who in turn returns it to his bank (see Fig. 34.8).
Letter of Intent
If protracted negotiations created a situation where it is vital to issue an order quickly to meet the overall project programme, it may be necessary to issue a letter or fax of intent. Formal purchase orders, especially if extensive amendments have to be incorporated, can take days if not weeks to type, copy and distribute. A device must thus be found to give the vendor a formal instruction to proceed to enable the agreed delivery period to be maintained.
The letter of intent fulfils this function, but unless properly drafted it can turn out to be a very dangerous document indeed. Invariably, the buyer tends to be brief, restricting the letter or fax to essentials only. The danger lies in the fact that by being too brief, he may underdefine the contract, leaving the position open for an unscrupulous or genuinely confused vendor to lodge claims for extras. To make matters worse, instructions to proceed may have to be given before a number of apparently minor contractual points have been fully agreed, and while the buyer may try to build a safeguard into the letter by a clause, such as: ‘This authority is given subject to final agreement being reached on the outstanding matters already noted’, he has not, in fact, protected anybody.
The following examples show how a letter or fax of intent should not and should be drafted.
Bad Letter
Following our Invitation to Bid and your quotation No. 2687 of …… together with all subsequent documentation, please accept this fax as your instruction to proceed with the works.
This Authority is given subject to final agreement being reached on the outstanding matters already noted.
Good Letter
This fax gives the vendor the right to start work and incur costs which can be recovered by him even if the final negotiations breakdown and the formal contract is not issued. A fax of intent should be drafted on the following lines:
Following an Invitation to Bid of the …… and your quotation No. 2687 of …… together with Amendments Nos. 1, 2, 3 and 4, and Minutes of Meeting of ……, and ……, please proceed with the design portion of the works and the preparation of sub-order requisitions to a max. value of £2000 to maintain a contract completion of ……
The firm order for the remainder of the contract of the agreed value of £59,090 (subject to adjustment) will be issued if the outstanding matters, i.e., amount of liquidated damages and cost of extended drive shafts are agreed by the ……
This fax of intent is undoubtedly longer, but it contains all the essential information and tells the vendor what his limits of expenditure are before the final order is placed. The vendor also knows the scope of supply (including all the agreed amendments) and the date by which the equipment has to be delivered. By releasing the vendor to commence the design and suborder preparation, the delivery date will not be jeopardized, provided, of course, that the stated outstanding issues are resolved.
The vendor realizes that he may, in fact, still lose the order if he does not come to terms with the purchaser, and this gives him an incentive to complete the deal.
The fax also states what the contract sum (subject to the negotiated adjustments) will be and what the items are that are subject to adjustment.
Clearly, the best procedure is to be in a position to issue the formal purchase order as soon as the negotiations have been completed. This can be done provided the buyer works up to the preparation of the purchase order during the negotiation phase. As clauses or specification details are amended and agreed, they are added to the draft purchase order document so that when the final meeting has taken place, any last-minute extra paragraphs can be added and the price and delivery boxes filled in. It should then be possible to send the final draft to the typing section within 24 hours.
Subcontracts
Definition of Subcontracts
The difference between a subcontract and a purchase order is that the subcontract has a site labour content. The extent of this content can vary from one operative to hundreds of men. The important point is that the presence of the man on site requires documents to be included in the enquiry and contract package that set out the site conditions for labour and advise the subcontractor of the limitations and restrictions on the site. While this distinction is undoubtedly true, there are numerous cases where the decision between issuing a relatively simple purchase order or a full set of subcontract documents is not quite as straightforward as it would appear.
For example, if an order is placed for a gas turbine and it is required that the manufacturers send a commissioning engineer to site to supervise setting up and commissioning, does this constitute a site labour content or not? Similarly, if a control panel vendor prefers to complete the wiring of a panel on site (possibly due to programming requirements) and has then to send two or three technicians to site, can this be classed as a subcontract?
There are undoubtedly good reasons why, if at all possible, the issuing of a full set of subcontract documents should be avoided. The cost of collating and issuing what is often a very thick set of contractual requirements, site conditions, specifications, safety regulations, etc., is obviously greater than the few pages that constitute a normal purchase order. Furthermore, the vendor has to read and digest all these instructions and warnings and may well be inclined to increase his price to cover for conditions that may not even relate to his type of work. On the other hand, if a vendor brings a man onto the site who performs similar work to other site operatives but is paid more, or belongs to an unacceptable trade union (or no union), or works longer hours, or enjoys unspecified conditions better than the other men, the effect on site labour relations may be catastrophic. The cost of even half a day’s strike is infinitely greater than a bundle of contract documents.
It can be seen, therefore, that there is a grey area that can only be resolved in the light of actual site conditions known at the time, plus a knowledge of the scope of work to be carried out by the vendor’s site personnel. The following guidelines may be of some assistance in deciding the demarcation between a purchase order and a subcontract, but the final decision must reflect the specific labour content and site conditions.
Typical subcontracts are as follows:
• Demolition
• Site clearance and fencing
• Civil engineering
• Steel erection
• Building work and decorating
• Mechanical erection and piping
• Electrical and instrumentation installation
• Painting
• Specialist tray erection
• Specialist telecommunication installations
• Specialist tank erection
• Specialist boiler or heater erection
• Water treatment
• Effluent treatment
• Site refractory works
• Site cleaning (including office cleaning)
• Security and night watchmen
• Radiography and other non-destructive testing (NDT)
Subcontract Documents
The documentation required for a subcontract can be roughly classified into three main groups:
1. Commercial conditions
2. Technical specification
3. Site requirements
Although all three types of documents are interrelated, they cover very different aspects of the contract and are therefore prepared by different departments in the purchaser’s organization.
The commercial conditions are usually standardized for a particular contract or industry, and if not actually written by the commercial or legal department, are certainly vetted and agreed by them.
The technical specification may be prepared by the relevant technical department and includes the necessary technical description, material and work specifications, standards, drawings, data sheets, etc.
The site requirements originate from the construction department or client and set out the site conditions, labour restrictions, safety and welfare requirements, and programme (sometimes called the schedule).
The subcontract manager’s function is to pull these three sets of documents together and produce one combined set of papers that tell the subcontractor exactly what he must do, how, where and when.
Commercial Conditions – General
The conditions of subcontract, like the general or main conditions of contract, are most effective if they follow a standardized and familiar form. Most civil engineers are conversant with the Institution of Civil Engineers’ (ICE) General Conditions of Contract and NEC3, and every mechanical engineer should have at least the knowledge of MF/1/as published by the Institution of Mechanical Engineers (I.Mech.E.) and the Institution of Electrical Engineers (IEE). In 1993, the ICE published the New Engineering Contract (NEC), called the Engineering and Construction Contract (ECC). This has since been updated and is now known as NEC3. The NEC family of contracts now covers contract conditions for main contractors, subcontractors, professional services, supply and adjudicators. A table of the more important standard conditions of contract, which frequently form the basis of the subcontract conditions, is given in Fig. 34.10, but it is not imperative that any of these standard conditions be used. Many large companies, such as oil companies, chemical manufacturers or nationalized industries, have their own conditions of contract. In turn, many of the contractors, whether civil or mechanical, have their own conditions of subcontract. Generally, the terms and clauses of all these conditions are fairly similar, since if they were unreasonably onerous, contractors would either not quote or would load their tenders accordingly. However, there are differences in a number of clauses a prospective tenderer would be well advised to heed. Such differences are often incorporated by the purchaser in the light of actual unfortunate experiences he has no intention of repeating. One can well imagine the commercial officer writing these conditions and applying the adage that the difference between a wise man and a fool is that a wise man learns from his experience.
The alternative to using standard conditions, whether issued by established institutions or by the purchaser’s organization, is to write tailor-made general conditions for a particular project. This is usually only viable when the project is very large and when a multitude of subcontracts is envisaged. There are considerable advantages for the purchaser or main contractor in tailoring the conditions to a particular project, since in this way the same base documents can be used for every discipline. In other words, instead of the civil contractor being governed by the ICE conditions, the piping erection contractor by model form ‘A’, and the insulation contractor by the Thermal Insulation Contractors Association (TICA) conditions, all the subcontractors must work to the same general conditions written especially for the project. To ensure that the various disciplines can work to one set of conditions, great care must be taken in their compilation. Since most of the clauses must be applicable to all the subcontracts, they should be of a general nature. Clauses specific to a particular discipline or trade are collected together in what are known as ‘special conditions of sub-contract’. These are described later.
Obviously, such a comprehensive set of conditions will contain clauses that are not relevant to some of the disciplines. This problem is overcome by either incorporating a list of non-relevant clauses in the accompanying special conditions, or relying on the common sense of all parties to ignore clauses that are not usually applicable by custom and practice. For example, a clause relating to underground hazards (usually in a civil contract) would be irrelevant in an insulation contract.
The advantages of a common set of general conditions are:
1. There is no confusion at the issuing stage as to which conditions of contract must be used for a specific subcontract.
3. There is no risk of contradiction between certain terms that may have a different interpretation in different standard conditions. A typical example is Clause 24 in the I.Mech.E. model form ‘A’ of general conditions of contract. This clause lists industrial disputes as a reason for granting an extension of time. The corresponding clause in the ICE conditions (Clause 4A) does not list this particular occurrence as a valid claim for extension of time. Clearly, it is highly desirable that such an important factor as industrial disputes has the same implications for all contractors on a particular site.
Special Conditions
As mentioned earlier, one way of advising the tenderer that certain clauses in the general conditions are not applicable to his particular contract is to list all those non-applicable conditions in a special conditions of contract that form part of the package.
Where the general conditions have not been tailor-made for a contract, the special conditions contain all those clauses peculiar to a particular site, especially the labour relations procedures. In theory, general conditions of contract apply to any site in the UK (overseas sites usually require separate conditions), so that particular items such as site establishment requirements, utility facilities, security, site car parking, site agreement notifications and other special clauses must be drawn to the attention of the tenderer in a separate document. Because of the specific nature of these clauses, special conditions of contract usually precede the general conditions in the hierarchy of importance. In other words, a modification or qualification in the special conditions takes precedence over the unqualified clause in the general conditions. Other clauses in the special conditions are terms of payment and, of course, the form of agreement.
Technical Specification
The technical portion of the subcontract document consists of six main sections:
1. Description of work
2. Specification and test requirements
3. Bills of quantities (if applicable)
4. List of drawings
5. List of reports to be submitted and details of cost codes
6. Payments schedule (if related to work packages)
Some organizations also include the planning schedule and insurance requirements in this section, but these two items are more logically part of the site requirements and will be dealt with later.
Description of Work
This section is divided into two parts:
1. Description of the site and a general statement of the objectives relating to the project as a whole
2. Description of that portion of the work relating to the subcontract in question
Thus, part 1 states the purpose of the project (e.g., to produce 1000 tonnes of cement per day using the dry process, etc.). Part 2 describes (in the case of a civil subcontract) which structures are in concrete, which are steel with cladding, the extent of roads, pavings and sewers, and the soil conditions likely to be encountered.
Needless to say, more detailed technical descriptions will appear on the drawings, in the technical specifications and in the bills of quantities, giving, in effect, the scope of the subcontract.
Liquidated Damages (or Ascertainable Liquidated Damages)
Liquidated damages have been defined by Lord Dunedin in a court case in 1913 as ‘a genuine covenanted pre-estimate of damages’, and as such is the compensation payment by a vendor to a purchaser when the goods are not delivered by the contract date. In cases of subcontracts, liquidated damages can be imposed if the contract is not completed by the agreed date.
Liquidated damages are not penalties. They are primarily designed to cover the losses suffered by a purchaser because the goods or services were not available to him by the agreed date. As the amount of liquidated damages was agreed by both parties in advance, the purchaser does not have to prove he has lost money. The fact that the goods are late is sufficient reason for claiming the damages.
Over the years, however, liquidated damages have been assessed in quite an arbitrary way that bears no relationship to the losses suffered. Usually, they are calculated as a percentage of the contract value and vary with the number of days or weeks for which the goods have been delayed.
In most cases the Courts will uphold such a clause, provided the actual amount of liquidated damages is less than the amount that could have been realistically shown as the loss. It is argued that both parties knew at the time of signing the contract that the loss would probably be greater, but agreed to the lower figure. If, on the other hand, the amount is greater than the real loss and the vendor could demonstrate to the Courts that the purchaser was, in fact, imposing a penalty, then the clause would not be enforceable.
A normal figure used for assessing liquidated damages is 0.5% per week of delay with a maximum of 2.5%. This means that the vendor’s maximum liability becomes operative after a 5 weeks’ delay and is limited to 2.5% of the contract value. If the purchaser does not really need the goods, even after five weeks’ delay, he can still claim his 2.5%, which is, in fact, pure profit. On the other hand, if, because of the delay of one item of equipment, the whole plant remains inoperative, his losses could be enormous. The receipt of a miserable 2.5% of the value of one relatively small item is insignificant.
It can thus be seen that the real purpose of liquidated damages is to encourage the vendor to deliver on time, since a loss of 2.5% represents a large proportion of his profit. It is quite naïve to suggest that the vendor should pay the true value of a loss that could be suffered by a purchaser, which could be many times greater than the cost of the goods in question.
If no liquidated damages clause is included in the purchase order, the purchaser may claim damages at large, and may, indeed, recover the full, or a substantial proportion of the full amount of his loss, due to the goods being delayed. For this reason, many vendors actually request that a liquidated damages clause is inserted, so that their liability is limited to the agreed amount.
For large subcontracts, it is prudent to produce some form of calculation for assessing the amount of liquidated damages, since if they are challenged, they must be shown to be reasonable. There are a number of ways these can be assessed:
1. If the whole plant was prevented from producing the desired product, the loss of net profit per week of production can be used as a basis.
2. If the works are nonprofit earning, such as a road or reservoir, the additional weekly interest payment on the capital cost is a realistic starting point.
3. If the delayed items hold up work by another subcontractor, the waiting time for plant and additional site overheads are considered as real losses. To these could be added the standby time of labour, if it cannot be redirected to other work.
Liquidated damages may be imposed on the total contract or on sections. This means that the late delivery of layout or even final drawings could be subject to liquidated damages. The amount of these damages could easily be calculated as the man-hours of waiting time by engineers being held up for information.
After all these calculations have been produced, the total value of the damages must be compared with the contract value of the goods. If the amount is high in relation to the contract value, it must be reduced to a figure that a vendor can accept. At the end of the day, if the purchaser requires the goods, he must find a vendor who is prepared to supply them.
Insurance
Normally a purchaser–contractor requires his goods to be fully insured from the point of manufacture up to the stage when the client has taken over the whole project. In practice, this insurance is affected in a number of stages, which vary with the terms of the main contract between the contractor and his client. The more usual methods adopted are as follows:
1. The manufacturer insures the goods from the time they leave his works to the time they are off-loaded on site. The insurance cover for this stage ceases when the contractor’s crane lifts the goods off the transport. The contractor’s all-risk insurance policy now covers the goods until they are actually taken over by the client.
2. The manufacturer insures the goods as above – the client’s overall site insurance policy covers the goods as soon as they are lifted off the transport. In such circumstances, the goods will be paid for at the next payment stage and will become the property of the client, although they may, in fact, not yet be erected or installed. Depending on the terms of the conditions of purchase, the goods will have become the property of the purchaser when delivered to the site or were paid for, whichever was earlier.
For large capital projects, the second method is the more common for the following reasons:
1. A large site may involve a number of contractors, all of whom have to insure their works. The cost of this insurance will, if provided by the different contractors, have to be paid eventually by the client as part of the contract sum. By taking out his own insurance for the total value of all the various contractors’ works, the client will be able to negotiate far better terms with a large insurance company than if the different works were insured individually.
2. Most contractors require payments for materials delivered or erected in accordance with agreed terms of payment, which form part of the contract. When these payments are made, that portion of the finished works becomes the property of the client. It is reasonable, therefore, for the client to be responsible for the insurance also. It can be seen that if the contractor’s insurance were to cover the goods from receipt on site to the date of payment, a whole series of insurance changeover dates would have to be agreed. The additional administrative problems would be both time-consuming and costly.
3. In many cases, the new works will be constructed on a site close to, or even integrated in, an existing operational plant owned or run by the client. Any damage to the existing plant, due to an accident on the new plant, can be covered by the same insurance policy.
4. The project, though large in itself, may only be a part of an even bigger project, e.g., an onshore oil terminal may be part of a major development of an offshore oil field involving a number of oil rigs. In such a situation, the client will negotiate a massive insurance policy, perhaps with a consortium of insurers, at a really attractive rate.
Needless to say, the goods will only be covered by the client’s policy once they have arrived on the job site. If the goods have to be stored temporarily in an off-site warehouse, the contractor will have to arrange for insurance, even if the goods have been paid for in the form of advance payments.
The exact stage, at which the insurance risk passes from the seller to the buyer, depends on the conditions of the purchaser and the shipping terms. For a more detailed explanation, see the section on Incoterms, which discusses the shipping responsibilities used internationally by all the trading nations.
Discounts
During the pre-order discussions with the prospective supplier, the buyer must try to reduce the price as much as possible. This can be achieved by asking the supplier to give a price reduction in the form of a discount. These, often considerable, reductions can take the form of:
1. Negotiated and hidden discounts
2. Bulk purchase discounts
3. Annual order discounts
4. Prompt payment discounts
5. Discount for retention bond
Negotiated and Hidden Discounts
There comes a stage during most negotiations when all the technical points have been resolved and all the commercial conditions agreed. However, the final price can still be unresolved since the very technical and commercial points discussed have probably affected the original bid. This is the time for the buyer to bring up the question of discounts. The arguments put forward could be:
1. The technical requirements are now to a different specification requiring less material, etc.
2. The commercial conditions are now less onerous.
Both these changes could warrant a price reduction. If, on the other hand, the opposite is the case, i.e., the specification is higher or the conditions harsher, a ‘hidden discount’ can be obtained by insisting that the price remain as tendered. To clinch the deal, the vendor may well agree to this at this stage. A salesman would be very loath to return to his Head Office without an order, having got so far in the negotiations.
It must be remembered that there is no such thing as a fixed profit percentage. Most salesmen are allowed to negotiate between prescribed limits, and it is the buyer’s job to take advantage of these margins. When the bid analysis is prepared, the discounts obtained should be shown separately so that the bid price can be checked against the original tender documents. This is especially important if the bid price is made up of a number of individual prices that have to be compared with those of competitors.
Bulk Purchase Discounts
When large quantities of a particular material have to be purchased, the vendor, in order to make the offer more attractive, may offer a bulk purchase discount on the basis that some of the economies of scale can be shared with the purchaser. If such a discount is not volunteered by the vendor, it can still be suggested by the buyer.
Annual Order Discounts
A vendor may offer (or be persuaded to offer) a discount if the purchaser buys goods whose total value over a year exceeds a predetermined amount. This will encourage a purchaser to order all similar items of equipment, say electric motors, from the same vendor. The items may be of different size or specification, but will still be obtained from the same supplier. At the end of the year, a percentage of the total value of all orders is paid back to the purchaser as a discount.
Prompt Payment Discount
Although the conditions of sale may stipulate payment within 30 days of the date of the invoice (assuming the item has been received by the purchaser in good condition), many companies tend not to pay their bills unless the vendor has issued repeated requests or even threatened legal action. To encourage the prompt payment of invoices, an additional discount is frequently offered. The value of this is usually only a few percent and reflects the financing charges the vendor may have to pay due to late receipt of cash.
Discount for Retention Bond
Most contracts or subcontracts contain a retention clause, which requires a percentage of the contract value to be retained by the purchaser for a period of 6–12 months. To improve the vendor’s cash flow, a retention bond can often be accepted by the purchaser, which guarantees the retention value, but this will deprive the purchaser of the use of these monies during the retention period. To compensate the purchaser for this, a vendor may offer a discount, which in effect is a proportion of the interest charges the vendor would have to pay for borrowing the retention sum from a bank. A usual procedure is to split the interest charges 50:50 between the purchaser and the vendor. In this way, both parties gain by the transaction.
It can be seen that discounts can frequently be obtained from a supplier, especially if it is a buyer’s market. In most reimbursable cost contracts, all discounts except prompt payment discounts must be passed on to the client for whom the goods or services have been purchased. For this reason, all negotiations including the discounts offered must be open and properly documented so that they can stand up to any subsequent audit.
Counter-Trade
Despite the name, this is not meant to refer to trade carried out over a shop counter, although this use of the term is commonly applied to goods collected from a wholesaler’s premises. In the case of international business, the term refers to the payment for goods or services by something other than money. In other words, it is akin to good old-fashioned barter.
The difference between barter and counter-trade is that in barter, one type of goods or services are exchanged for another without money being involved, while in counter-trade, the goods supplied by the buyer are delivered to a third party who sells them (usually at a profit) for the benefit of the seller who then receives cash.
A simple example illustrates how the system works: a potential client in a developing country may need to extend his production facilities. His business may be expanding and highly profitable, but because of government restrictions the company has no access to hard currency. It is in the country’s national interest to encourage industrial growth at home, but not to increase its national debt by borrowing dollars or pounds. A new approach is needed and one solution is to resort to counter-trade. If, for example, the country is rich in some natural resources, such as coal, this may be the most convenient commodity to trade-off against the proposed factory extension. The expanding company will buy the coal from the mine in local currency. The UK supplier will provide the production facility expansion and receive an appropriate quantity of coal as payment.
Incoterms
World trade inevitably requires goods to be shipped from one country to another. Raw materials must be transported from the less developed countries to the developed ones, from which finished goods are sent in the opposite direction. Both movements have to be packed, insured, transported, cleared through customs and unloaded at their point of destination, and in order to standardize the different conditions required by the trading partners, Incoterms (Fig. 34.11) were developed. These trade terms cover 14 main variations and encompass the spectrum of cost and risk of shipments from ‘ex works’ where the buyer has all the risk and pays all the costs, to ‘delivered duty paid’ where the seller contracts to cover delivery costs and insurance.
Ex Works
‘Ex works’ means that the seller’s only responsibility is to make the goods available at his premises (i.e., works or factory). In particular, seller is not responsible for loading the goods in the vehicle provided by the buyer, unless otherwise agreed. The buyer bears the full cost and risk involved in bringing the goods from there to the desired destination. This term thus represents the minimum obligation for the seller.
Free Carrier (Named Point)
This term has been designed to meet the requirements of modern transport, particularly such ‘multi-modal’ transport as container or ‘roll-on roll-off’ traffic by trailers and ferries. It is based on the same main principle as FOB, except that the seller fulfils his obligations when he delivers the goods into the custody of the carrier at the named point. If no precise point can be mentioned at the time of the contract of sale, the parties should refer to the place or range where the carrier should take the goods into his charge. The risk of loss of or damage to the goods is transferred from seller to buyer at the time and not at the ship’s rail. ‘Carrier’ means any person by whom or in whose name a contract of carriage by road, rail, air, sea or a combination of modes, has been made. When the seller has to furnish a bill of lading, waybill or carrier’s receipt, he or she duly fulfils this obligation by presenting such a document issued by a person so defined.
FOR/FOT
FOR and FOT mean ‘free on rail’ and ‘free on truck’. These terms are synonymous since the word ‘truck’ relates to the railway wagons. They should only be used when the goods are to be carried by rail.
FOB Airport
FOB airport is based on the same main principle as the ordinary FOB term. The seller fulfils his obligations by delivering the goods to the air carrier at the airport of departure. The risk of loss of or damage to the goods is transferred from the seller to the buyer when the goods have been so delivered.
FAS
FAS means ‘free alongside ship’. Under this term the seller’s obligations are fulfilled when the goods have been placed alongside the ship on the quay or in lighters. This means that the buyer has to bear all costs and risks of loss of or damage to the goods from that moment. It should be noted that, unlike FOB, this term requires the buyer to clear the goods for export.
FOB
FOB means ‘free on board’. The goods are placed on board a ship by the seller at a port of shipment named in the sales contract. The risk of loss of or damage to the goods is transferred from the seller to the buyer when the goods pass the ship’s rail.
C&F
C&F means ‘cost and freight’. The seller must pay the cost and freight necessary to bring the goods to the named destination, but the risk of loss of or damage to the goods, as well as of any cost increases, is transferred from the seller to the buyer when the goods pass the ship’s rail in the port of shipment.
CIF
Freight Carriage – Paid to …
Like C&F, ‘freight or carriage – paid to …’ means that the seller pays the freight for the carriage of the goods to the named destination. However, the risk of loss of or damage to the goods, as well as of any cost increases, is transferred from the seller to the buyer when the goods have been delivered into the custody of the first carrier and not at the ship’s rail. It can be used for all modes of transport including multi-modal operations and container, or roll-on or roll-off traffic by trailers and ferries. When the seller has to furnish a bill of lading, waybill or carrier’s receipt, he or she duly fulfils this obligation by presenting such a document issued by the person with whom the contracted for carriage to the named destination was signed.
Freight Carriage – and Insurance Paid to …
This term is the same as ‘freight or carriage paid to …’ but with the addition that the seller has to procure transport insurance against the risk of loss of or damage to the goods during the carriage. The seller contracts with the insurer and pays the insurance premium.
Ex Ship
‘Ex ship’ means that the seller shall make the goods available to the buyer on board the ship at the destination named in the sales contract. The seller has to bear the full cost and risk involved in bringing the goods there.
Ex Quay
‘Ex quay’ means that the seller makes the goods available to the buyer on the quay (wharf) at the destination named in the sales contract. The seller has to bear the full cost and risk involved in bringing the goods there.
There are two ‘ex quay’ contracts in use, namely ‘ex quay (duty paid)’ and ‘ex quay (duties on buyer’s account)’ in which the liability to clear the goods for import are to be met by the buyer instead of by the seller.
Parties are recommended to use the full description of these terms always, namely ‘ex quay (duty paid)’ and ‘ex quay (duties on buyer’s account)’, or uncertainty may arise as to who is to be responsible for the liability to clear the goods for import.
Delivered at Frontier
‘Delivered at frontier’ means that the seller’s obligations are fulfilled when the goods have arrived at the frontier – but before ‘the customs border’ of the country named in the sales contract. The term is primarily intended to be used when goods are to be carried by rail or road, but it may be used irrespective of the mode of transport.
Delivered Duty Paid
While the term ‘ex works’ signifies the seller’s minimum obligation, the term ‘delivered duty paid’, when followed by words naming the buyer’s premises, denotes the other extreme – the seller’s maximum obligation. The term ‘delivered duty paid’ may be used irrespective of the mode of transport.
If the parties wish the seller to clear the goods for import but that some of the costs payable upon the import of the goods should be excluded – such as VAT and/or other similar taxes – this should be made clear by adding words to this effect (e.g., ‘exclusive of VAT and/or taxes’).
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