Principles of procurement and contract

The cost of engineering is a relatively small part of the cost of a process plant, say 5–15 per cent, depending not only on the complexity of the plant but also on what activities are included within ‘engineering’ or are included in procured item packages and construction contracts. Most of the cost of the plant, the direct field cost or DFC, is expended on purchasing equipment, materials, and construction. In designing the plant, a lot of effort and skill goes into producing economic and cost-effective designs which are aimed at minimizing the DFC while maintaining functionality and technical standards. Just as much effort and skill need to go into maintaining the interface with suppliers and contractors in the best way, commercially. Arguably, more money is wasted, and more opportunities are lost, by poor technical/commercial interface than by poor design.

The ‘interface’ with a supplier or contractor is governed by a purchase order or a contract, respectively. Although purchase orders and contracts have differences in format and content, they are essentially the same, in that they are both a form of contract which is arrived at by a process of offer and acceptance. The two-sided nature of a contract is often insuffi-ciently understood by engineers – both sides have obligations and can expect to be penalized for non-performance. Even the fundamental process of offer and acceptance is subject to reversal. If an offer is accepted subject to certain conditions or changes, the conditional accept-ance effectively becomes a counter-offer and the roles are reversed. In fact as suppliers’ bids are seldom accepted without qualification, the purchase order or contract issued by the project manager is usually the final offer, and is not binding unless accepted by the supplier or contractor.

The fundamental principle of procurement in a market economy is of course that the best prices are obtained by competition. Competition can be effected in several ways, the most usual (which we will assume as a default case) being that the goods and services to be procured are defined, and competitive bids are solicited.

Alternatively, competitive circumstances can be introduced indirectly, by:

• negotiating with a single supplier, under threat of going to competitive bid if an acceptable deal is not offered;

• agreeing on a price which has already been established by the market; or

• a process of genuine¹ partnership in which participants, who would otherwise relate as suppliers or sub-contractors, share in the overall competitive forces and profitability to which the end product, the process plant, is subject.

However, the development of a commercial relationship or business deals by any means other than fair and open competition is susceptible to corruption, or even the perception of corruption, which can be equally damaging.

One of the basic problems confronting the project manager, since the beginning of the history of projects, has been that of maintaining commercial integrity, to which there are several aspects. The concepts of commercial integrity are based on the cultural values of a particular society and are therefore variable in place and time. The project manager and his team are responsible and accountable for spending large sums of money, and need to understand what practices are expected and what are acceptable in the circumstances, at the risk of being considered guilty of corrupt practice (assuming that is not the project manager’s actual intention!). Procurement procedures therefore tend to be elaborate and subject to external audit and supervision. This is as much in the project team’s defence as it may be a burden, given the tendencies of even some of the most unexpected people and organiza-tions to line their pockets or employ corrupt practices when the oppor-tunity arises. These procedures need to follow the needs of the country and the client, considering that what is regarded as corrupt practice in one society may be acceptable behaviour in another.

How the engineering–commercial interfaces are set up is evidently critical for the planning of the project. The interfaces effectively define

1 This adjective is intended to imply that sham partnership arrangements are common in practice.

the format of much of the outputs of engineering work, the documenta-tion created for purchase. The content and timing of this documentadocumenta-tion must reflect a balance between technical and commercial priorities. For example, it is counter-productive to conduct lengthy engineering studies to minimize the steel tonnage of a structure, when as a result there is so little time for procurement that competitive prices are not obtainable without delaying the construction schedule. The financial gains of reduced mass are likely to be far outweighed by higher unit prices.

It is also counter-productive to technically format a construction bid in a way which is unacceptable to the target market. This can happen, for instance, if lump sums are invited for work which is regarded by the bidders as unquantifiable, which may result in high bid prices because the vendors include high contingencies, or because few bids are submitted.

The engineering costs saved by the simple bid format may be much less than the increase in the direct construction costs.

Before finalizing the engineering plan, it is necessary to agree a procurement plan in which the commercial policies and procedures are recognized, and are given due weighting in relation to their implications.

It is also vital to agree the format of purchase orders and contracts, and to decide on basic contracting relationships, such as whether specific items of construction work will be handled by lump-sum contracts, by rates-based contracts, by direct labour hire, or by the client’s own resources. Such decisions (which will be discussed in Chapter 23) have fundamental implications, such as the way in which site work may be related in sequence to the finalization of design. Failure to do this planning properly – a frequent shortcoming – can result in ten times the amount saved on engineering being lost in procurement and construction.

For a competitive bidding process to be effective, not only must the format and content of the bids be appropriate to the market but also the goods and services purchased have to be accurately defined to make the competition meaningful and the contracts enforceable. Further-more, the purchaser – and that mainly means the engineer – must fully understand his side of the two-way contract, and be ready to fulfil those obligations (in addition to payment) on time, or risk having to settle claims that may nullify the benefits of competition. The obligations in question may include the provision of information (usually drawings), approvals, materials, site access, or third-party activities.

The education of an engineer centres on the understanding and logical application of scientific principles and technology, and inculcates a set of values based on the inherent worth of what is produced.

The thinking and behaviour which appears to be most successful in

commercial dealings or negotiations is radically different, and this needs to be understood by the engineer. Some people or cultures seem to have this commercial ability by intuition. Others never understand it and it costs them dearly: they will never get the best bargain, and they may be ‘robbed blind’. The basis of this ability is possibly manipulative thinking: the ability and the intention to influence people by means other than logical argument or force (both of which are readily under-stood by most engineers). This is supplemented by a mindset in which gain is made by smart trading, or negotiation, rather than by value added inherently – scheming, devious behaviour, or great commercial insight, depending on your point of view. Successful commercial negotiation skills are as essential as engineering skills to the outcome of the project, and much more important in some environments.

The art of negotiation can be learnt. In general, the objectives are to explore matters of common interest between the negotiating parties, identify the basis for agreements which can be beneficial to both parties, and reach actual agreements. Usually, there is an overlap between the minimum terms acceptable to one party and the maximum that the other party would be prepared to concede to reach an agreement. The art to be exercised by the individual negotiator is to recognize and quantify the range of overlap of possible agreement, and ensure that the eventual agreement reflects the best deal for his principals, within the achievable range.

More specifically, if you are buying something, the maximum price that you are prepared to pay (influenced by what you can afford, and what you can get from other sources) is often greater than the minimum price for which the vendor may be willing to sell. Your negotiating aim is to settle on the minimum price.² To do so, you need to know or guess what the vendor’s minimum terms are, and you need to ensure that he does not know your maximum. You may manipulate him, for instance, by frightening him that he may lose the business altogether, and there are various obvious and subtle ways of doing this. The subtle methods are more effective, especially if the vendor does not realize that he is being manipulated. Keeping your own position secure is often a challenge, especially if some witless young engineer – who possibly

2 Originally, the text here was ‘... and pocket the difference.’ This has been amended, on review, to clarify that the author is not advocating the practice (common in certain environments) summarized by ‘5 per cent into my offshore bank account, and the order is yours’.

thinks technology is everything, and negotiating is unfair – passes too much information to the vendor.³

Like so many subjects touched on in this book, negotiation is an art in itself on which several excellent manuals exist. A more detailed discus-sion is beyond our scope, but it is relevant to discuss one aspect, which is that negotiation is ineffective unless the agreement reached is comprehensive of all aspects of the proposed co-operation, for example the full terms of the purchase order and the specification of the goods purchased. Little is likely to be gained if, when agreement is reached on what seems to be a bargain price, there remain other necessary aspects of agreement to be reached, such as technical details. Once the vendor has secured a commitment, there is clearly no further threat of losing the order. Ground lost in the preceding negotiation may well be made up in the addenda!

The ‘price’ of a proposed order or contract is not usually a clear-cut matter. The real cost to the purchaser may be affected by variations in terms of payment, provision for taxes and duties, terms of exchange rate variation, or any one of the myriads of conditions of purchase. The price may also be affected by variations in the scope of supply or in quality requirements. Quite frequently, a vendor will deliberately introduce some vagueness into his offer in order to leave room for negotiation. On the other side of the deal, purchasers may claim to have fixed tendering procedures which allow for no price changes or price negotiations after the submission of bids, but in practice they may effectively negate these stipulations. They may keep the price intact, but negotiate conditions which would affect the price, such as the terms of payment, the technical specification or scope of supply. In order to gain the full benefits of negotiation, all technical and commercial matters, including the handling of anticipated future changes and additions, must be settled before reaching final agreement.

Unless it is ordained in the persons of a separate procurement depart-ment, engineers lacking negotiation skills are well advised to ensure that they receive appropriate help in this regard, or they may well end up being totally outmanoeuvred by somebody who does not know one end of the plant from the other. It is also appropriate to note that as the relationship of contract is fundamentally a legal one and subject ultimately to legal interpretation, professional legal input is necessary in the drawing up and management of contracts. This may be limited to a consultancy role if sufficiently knowledgeable procurement professionals are employed.

3 Possibly over cocktails ... and possibly while our young engineer is being told that he’s

‘the only real engineer in the office’. Manipulation is a two-way process!

Chapter 7