Procurement update: Uncertain markets

01 / Introduction

The construction industry is inherently tied to the UK’s economic confidence and performance. One vulnerability of the sector is its exaggerated reaction to changes in sentiment and the economic cycle. This has been highlighted in recent weeks by the release of Office for National Statistics figures showing the construction industry technically in recession, despite the wider economy still seeing growth.

The industry is successful and healthy when it has confidence in its future pipeline of work and is able to invest in its contracts, people, tools and systems. While uncertainty from the Brexit result may have robbed the industry of some security for now, it may also hold significant opportunities to improve performance.

The macroeconomic environment and resulting demand/supply balance in the construction sector are usually the predominant factors in shaping the nature of procurement activity. The industry is still recovering from the damaging impacts of lowest lump-sum procurement during the last economic cycle and the associated race to the bottom. A worsening of market conditions creates the risk of repeating past mistakes.

At the same time, the viability of many projects has been challenged by high cost levels that are often the result of layer upon layer of allowances for overhead, profit and risk within the supply chain. The shifting landscape of uncertainty and concerns of an economic wobble are now a catalyst for those in the industry to re-evaluate procurement approaches and, for some, an opportunity to “reset the dial” in relation to both the aims and outcomes of the process.

This article explores procurement in the context of a deeply uncertain market and what approaches might be considered.

02 / The need for different procurement approaches

The EU referendum was a watershed moment for the industry, drawing the cycle in play to a premature end. Key risks and issues that pre-existed will influence the post-referendum industry. They include:

• An overheated but cooling market

  Strong demand, particularly from the commercial, residential and infrastructure sectors, emerged in mid-2014 leading to significant growth in tender prices, in excess of 9% for a time. However, data as well as market anecdotes suggested that momentum in the market was steadily falling from the end of 2015, demonstrated by slowing tender price growth in early 2016.

• Capacity constrained industry

  The industry permanently lost 250,000 employees during the last recession. The heating of the market in 2014 and the years that followed laid bare resulting capacity challenges that emerged in the supply chain as they struggled to meet market demand. On top of high prices, resource constraint has led to problems in two-stage tendering; for example, where a lack of value added during the procurement process has led clients to question the benefits of early supply chain engagement.

• Viability challenges for clients

  High construction prices, with increased on-costs a major source of the issue, have led to significant viability challenges for many schemes, leading to reconfiguration, delay or cancellation.

• Low levels of trust

  Levels of “relationship capital’’ between clients and the supply chain have been very low; partly a legacy of difficult times during the last recession and more recently a result of high price growth, with many in the industry wishing that prices would fall.

• Low productivity

  All tiers of the supply chain have much more to offer than simply pricing provided information. The industry depends on the supply chain’s value-adding skills and expertise, more now than ever. Productivity has been falling across the developed world since the global financial crisis. UK productivity is behind that of other developed nations and construction in particular lags behind other sectors.

  This offers the industry the potential for significant improvements.

  In the post-referendum industry, key risks and issues that have flowed from the pre-referendum environment include:

• Eroded margins

  A return to strong demand in 2014 provided the opportunity for the supply chain to boost margins after years of low or no profitably. This recovery has, however, been interrupted by the EU referendum. It was also already adversely affected by rising input costs as a result of a depreciating pound, intense labour shortages and some rebounding in dollar-denominated commodity prices in the first half of 2016.

• Financial fragility

  As a result of historic capacity challenges and low profitability, financial fragility in much of the supply chain is evolving as a key risk. Tighter lending conditions and falling new orders are increasing the challenges associated with cash flow management. Recently, isolated examples of supply chain failure have highlighted the problem.

• Delayed decision making

  With low investor and consumer sentiment, decision making is being delayed. Many investors have no confidence that they can earn a higher rate of return by investing and believe deflation is either coming or is already here. There is a danger that this prophecy becomes self-fulfilling – creating further financial challenges for the supply chain.

  Pessimistically, we can view these risks of falling investment, slowing pipeline, rising input costs and low profitability as a potential “perfect storm’’ for the sector. But investment in several sectors, such as infrastructure, is likely to continue and the long-term need for housing expansion will not go away.

  The strengthening of headwinds makes it tempting for parties to revert to past procurement approaches, such as single-stage, lump-sum bidding, perceived to provide greater certainty of cost and risk transfer. The flaw with many of these approaches is that they often do not actually generate reliable outturn costs, drive innovation or maximise value for money. In fact, they can often lead to disputes and fail to deliver the best outcome.

  The construction industry and its clients should see the post-Brexit business environment as a trigger for a step-change in the way it does business – focusing on innovation, boosting productivity, improving value for money and maintaining industry capacity. What procurement approaches could help here?

03 / Considerations in the uncertain market

Think twice before reverting to traditional procurement The main intended feature of traditional procurement approaches is that the concept design process is separate from the construction process, though often further design work involving the supply chain is required. Lump sums for construction are submitted by the supply chain, giving perceived cost certainty. In uncertain times this sounds attractive. However, it relies on the design being fixed and completed to a consistent level of detail, typically not the case, and results in extended tender periods and/or variations, as well as reduced flexibility and value.

Because many options for design development have been closed off before the supply chain is engaged, there may be little opportunity for it to ”buy in” and contribute expertise and innovation. In reality, the entry price promised by a lump-sum tender process is rarely achievable because of change or risk transfer.

We know from the last downturn that the supply chain may ”buy” work with sub-economic tender prices in the hope that it can claw back losses later through subcontract procurement, contract changes or disputes. This led to a ”race to the bottom”, resulting in lower quality work, an absence of innovation, escalating costs, distressed suppliers, disputes and outcomes that might have been better under other arrangements.

Many contractors and their suppliers have put in place better governance processes to prevent destructive bidding practices, but these have not been tested. Faced with falling workloads, contractors may still choose to ”buy” turnover rather than lose capacity. Clients’ design of their procurement events will play a significant role in determining contractor behaviour.

Don’t discount two-stage Two-stage design and build procurement has propagated widely. In most cases the approach has been successful and delivered the outcomes sought by clients. In several cases it has evolved. Key successful evolutions have included:

• Longer, pre-planned market engagement periods to position projects more effectively to the first and second-tier supply chain
• Clients retaining two contractors during an abbreviated second stage, but reimbursing a proportion of bidding costs to the unsuccessful contractor
• Clients procuring key packages directly, benefiting from earlier input into design and so on, then reversing these into the main contract
• Timing of package procurement being more closely aligned to commencement dates, reducing inflation risk and providing longer to complete detailed design work.

Focus on agility In today’s uncertain environment, maintaining flexibility and an exit strategy throughout procurement is key. This means maintaining the opportunity to react to any significant demand/supply events that emerge or keeping the door open for possible benefits from price movements. Each project or programme will have different drivers and influences such as joint venture partners or funding conditions that will inform the optimum procurement strategy.

Re-evaluate the procurement breakdown This can include separating a project into “super packages“, for example: demolition, basement box, shell and core and fit-out, and so on. Specific procurement routes can be adopted for each. The timing of the procurement can therefore be optimised to suit the market and the option of flexing the strategy maintained for longer. Inflation modelling of specific trades could accompany such an approach to inform timing of procurement. This approach can be expanded for procurement on a programme-wide, rather than project-only basis.

Proactively manage foreign exchange risk The significant depreciation of sterling and increased risk of supply chain failure urge a re-evaluation of sourcing strategy. Switching sources of supply could offer the potential of better value or greater assurance. Where you cannot source from within the UK, consider approaches to manage foreign exchange risk. These can include hedging, though the level of uncertainty is likely to increase costs. Deliberately fast-paced negotiation is another option, as is the pre-purchase or pre-allocation of currency. Another might be to adopt a floating currency approach to payment.

04 / Procurement approaches to consider

TARGET COST ARRANGEMENTS

Target cost arrangements are designed to encourage collaboration, cost reduction through shared incentivisation, and increased levels of productivity improvement. They have been used widely in the infrastructure sector for many years where they have assisted in the delivery of complex projects with high levels of risk that rely on innovative solutions.

Target cost contracts are cost reimbursable and introduce the concept of pain-share and gain-share. This serves to incentivise the whole project team to work collaboratively, innovatively and productively to deliver the project in line with or below the target cost set in the contract. The most well-known target cost contract is the New Engineering Contract Third Edition (NEC3), widely used in the infrastructure sector, but the approach can also be taken under a Joint Contracts Tribunal agreement.

Advantages

• Provides contractors and subcontractors with an incentive to improve performance, drive innovative approaches and productivity improvements and enables all parties to secure a share of the benefits of a well-managed project.
• Encourages active and equitable risk sharing, based on a clearly defined allocation of risk agreed at the outset of the project and proactively managed throughout the contract.
• Target costs provide incentive for the effective and timely administration of change control mechanisms.

Disadvantages

• Relies heavily on administration best practice and competent management.
• If the target cost level is not right in the first place or breached, typically both, the supply chain and client endure pain as a result.
• Client and supply chain must share gain and pain if the full benefits are to be secured. The client may have greater exposure to cost risk.

Tips for implementation

• Deal with the learning curve. Cultural changes associated with incentivised contracts are substantial; training is recommended for effective implementation.
• Focus on shared risk management. With incentivised contracts, the commercial outcomes for the client, contractor and supply chain are entwined to a greater extent, necessitating more proactive and integrated risk management.
• Manage the schedule transparently. The schedule is central to understanding earned value, progress against the target and in the valuation of change. Periodic reviews of the programme as an integrated project team will promote smooth management of costs, giving the intended benefits of the contract the best chance of success.

TWO-STAGE OPEN-BOOK NEGOTIATION

Clients invite the supply chain to bid on the basis of an initial brief and maximum price level. A variety of contractors will compete for the project in the first stage, with selection criteria based on their capability, capacity, track record, quality of their proposal and submitted commercial terms, including levels of overheads and profit.

Progressing to the second stage, the selected contractor develops the solution further in line with the client’s requirements and pre-agreed cost ceiling on an ”open book” basis. Construction start gets the go-ahead when the design is finalised and a lump sum or target cost agreed.

Advantages

• Collaborative working from early on in the process encourages innovation and improved quality of the solutions designed and constructed.
• The approach can lead to risk and cost savings.
• Can enable faster mobilisation to construction phase through collaborative and integrated working.

Disadvantages

• The client cannot access a further ”upside” from the market after the first stage, which may also insulate them from falling returns on the value side.

Tips for implementation

• Planning to deadlines and sticking to them is central to keeping the process on track and benefiting from its aims around speed of mobilisation and momentum in innovation and cost reduction.
• Pre-agreement of prices and risk profile before commencement of the construction phase is important in avoiding misunderstandings or disputes.

CLIENT AND SUPPLY CHAIN JV PARTNERSHIP

Collaborative arrangements involve a commercial union between the client and the supply chain that enables the parties to share risk and reward in the delivery of a development project or programme. This approach has been highly successful in the residential sector, for example, where the balance of contribution between the parties in respect of land, construction and finance is well understood and where the product is relatively easy to specify.

In a residential scheme, the objectives of the parties can be aligned through tying financial reward to the end performance of the entire development rather than just the construction element. Different arrangements will be needed on other schemes where there is no asset disposal or where construction delivers a relatively small share of overall asset value. Typically, an output-based performance specification forms the basis of the project, leaving the joint venture parties to develop innovative solutions and collaborate to decide how best to achieve the best outcomes in the most efficient way.

Advantages

• The alignment of objectives and commercial destinies of the named parties has significant potential to drive value for money, innovation and efficiency in delivery.
• Joint venture arrangements can allow the optimisation of resources through shared access to expertise, including potentially specialist expertise that may be in short or limited supply.
• Joint venture partners sometimes have established or patented technologies. Ready access to these, particularly in some technology-driven sectors, can offer benefits in time, cost and competitive advantage, for example in the waste sector where the approach has been used with original equipment manufacturers.

Disadvantages

• Requires significant adjustment to value and risk profiles for participating parties. Contractors take on development risk and clients give up development value on the premise that with better outcomes overall it will pay off.
• The inevitable variety of differing cultures, management styles and working relationships that prevail in each partner company can create challenges for the effective working of the joint venture model.
• It can be challenging to both measure performance and also set appropriate performance targets, particularly against any change that takes place.

Tips for implementation

• An aligned route to profit and shared incentives drives the need for forming, sharing and propagating a shared vision and ethos across all partner organisations.
• Structure, resourcing and governance must be clear to all participants from the start, with structured mechanisms for managing these aspects in place early on to avoid unnecessary disruptions or disputes.

COMPETITIVE DIALOGUE

Competitive dialogue is most suited to major projects with high levels of complexity, aimed at developing alternative proposals in response to a client’s fixed set of outline requirements and usually delivering a lump sum or target cost contract.

This approach has traditionally been associated with the public, defence and infrastructure sectors, but there are examples of competitive dialogue being used in major commercial developments, too, where solution enhancements, rather than price enhancements have won the day. A client would adopt this approach where the disadvantages of reduced competitive tension are outweighed by the advantages of focused commitment, innovation and expertise in the development of a solution for a project, where it has been difficult previously to define or has required flexibility.

Advantages

• The supply chain owns the design solution and is commercially incentivised to invest in the most effective and attractive solution.
• All parties benefit from better information flows throughout the process, mitigating misinterpretation.
• Both the client and the supply chain have greater confidence in the quality of the solution and the submission, particularly if it has been progressively tested during the dialogue process.

Disadvantages

• The process can take a significant amount of time, making it only worthwhile for significantly complex and large projects.
• The approach involves the parallel development of at least two design and construction solutions and as a result is resource heavy.
• Total costs are potentially higher for both the client and the supply chain (but value is also potentially higher). In the current environment, clients might consider reimbursing bidder costs to drive engagement and higher quality bids.

Tips for implementation

• At first glance, competitive dialogue appears to require less preparation by the client, but thorough preparation must be undertaken so that the client can fully brief participants and respond appropriately to bidders’ proposals during the dialogue. Clients should avoid changing their requirements so as not to disrupt the process.
• A tenderer’s opportunity to develop solutions as part of the dialogue is one of the benefits of the process, but the requirement to protect confidentiality and prevent information sharing between competing parties introduces issues of discipline. Formal confidentiality policies that will establish what information should be shared need to be put in place.
• Ensure the dialogue process maintains momentum through planning of sessions, identifying topics, those involved and outputs required. The client must be equipped to respond promptly to proposals or change.
• Competitive dialogue introduces the need to assess different solutions using the same criteria. Well-defined, output-based assessment schemes should provide the most consistent assessment.

05 / Critical success factors of procurement approaches in uncertain times

Whether a traditional procurement approach or an alternative is adopted, there are several critical success factors that will apply:

Strong, effective leadership of the procurement process Ensuring that the procurement aligns to corporate objectives, that communication is clear and consistent, that the right environment required to drive value for money.

Understand the market and build relationships Maintaining a detailed understanding of market conditions, capacity, capability and structure will enable faster identification and resolution of supply chain disruptions.

Have an exit strategy The exit strategy should be defined early in the procurement cycle. The needs and considerations embedded therein can be incorporated into the workings of the entire procurement process. Uncertainty means there is significant potential for outlier events. The exit strategy should, therefore, consider continuity of procurement, knowledge, data, the costs incurred and the impacts on people involved should the procurement process be disrupted.

Effective engagement between client and supply chain Effective engagement consists of open, transparent and equitable two-way communication carried out efficiently but over an extended period – even before a specific opportunity. Benefits include consistency, reduced waste of effort and improved quality of outputs, and the building of trust – the key ingredient of collaborative working.

Process excellence Procurement process excellence is reached when the policies, processes and procedures that are implemented are as lean as possible for the task in hand.

Strong due diligence and assurance regime Elevated risks around financial fragility in the supply chain means tender submission quality must be comprehensively assured, with robust due diligence regimes, including the use of third-party audit where appropriate. Strong assurance can be used to offset adapted profiles of risk transfer and competitive tension under different procurement approaches.

Disciplined change management Change under non-lump sum procurements can unpick complex deals: risk transfer can be invalidated and this needs to be considered in a structured way. Change management needs proactive management to avoid disproportionate delays associated with it and resulting costs.

Sensible allocation of risk Risk is often pushed too far down the supply chain, costing money and hampering effective risk management. While the desire to transfer risk in this way is understandable, a more measured approach may drive both better management and value. Complete transparency of risk, pragmatic assessment of which parties are best placed to manage risks and, therefore, where they should sit commercially, collaborative development of mitigation plans and frequent risk review meetings as integrated teams are all activities that could help better allocate and manage risk. For example, through a shared risk register, joint risk review meetings and jointly undertaken mitigation plans.

Keep costs of tendering down The appetite of the procurement process for time and resource should be made as lean as possible. Short bid lists and simplified pre-qualification, together with provision of design information completed to a consistent level of detail are all potential steps. Procurers should consider reimbursing at least a proportion of bidding costs, which might be done for a smaller number of bidders, for example, but is likely to attract higher quality bids. Appropriate use of technology may also assist.

Use technology when appropriate Technology has the potential to impact positively upon the procurement process. Explore the potential of BIM and e-tendering.

Avoid ‘one size fits all’ approaches Flexibility will be key in the uncertain market: mix and match approaches on projects, look at pre-procured packages, main contract elements and delayed procurement of finishes.

06 / Conclusion

With a shift in the economic, political and social landscape, uncertainty has taken hold and there is the prospect of increasingly challenging business conditions. This has exposed significant risks to construction, including falling investment, fewer projects, rising input costs and low profitability.

In responding it can be tempting for the industry to return to flawed commercial practices such as single-stage lump-sum bidding.

The potential long-term impacts of the Brexit vote necessitate a change of approach, but one that is focused more on flexibility, collaboration and pragmatic allocation of risk and balanced commercial terms.

Some procurement approaches that clients might consider include the use of target cost contracts, joint venture partnership models and competitive dialogue.

Regardless of the choice, there are a range of critical success factors. Strong leadership, deep understanding of the market, maintaining an exit strategy, engaging effectively with strong processes, disciplined change management and assurance and having flexibility of approach to suit the project in question will all help ensure success.

Ultimately, for clients that are in a position to invest and progress their construction plans, there is opportunity to drive for improved value for money, innovation, increased productivity and, ultimately, better outcomes through a change in approach.

In doing so, they will be supporting the construction sector longer-term in relation to sustaining capacity and promoting an intelligent and innovative construction sector.