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Introduction to Project Management Unit 9

Sikkim Manipal University Page No.: 179

Unit 9 Project Procurement and Contracting

Structure

9.1 Introduction

Objectives

9.2 Importance of Project Procurement

9.3 Project Procurement ManagementOverview

Operations Procurement and Project Procurement

Project Procurement Management Process

9.4 Types of Contracts

Traditional Lump Sum Fixed Cost/Time

Design (D), Construct (C) Novation and Turnkey (T)

CM, PM and PM/CM

On-Call Contracting

Guaranteed Maximum Price

Full Cost Reimbursable Procurement

9.5 Contract Negotiation Techniques

9.6 Summary

9.7 Terminal Questions

9.8 Answers

9.9 Glossary

9.1 Introduction

Procurement and contracting are vastly interrelated domains. These

domains constitute the single most important strategic planning exercise in

successfully implementing large and complex projects. For example in

executing a power plant, the EPC contractor who is implementing the power

plant, usually outsources the total implementation of the Water Treatment

(WT) plant which is needed to provide de-mineralised water to be fed into

the boiler. This is because the agency to whom this work is outsourced has

the technological expertise to design, assemble, erect, commission (and

even operate and maintain for a pre-agreed period, if desired by its

customer) the WT system. The WT system vendor, in turn, treats the

implementation of the total WT system as a project that has been secured

from the power plant EPC contractor. The WT system therefore involves the

works of design, procurement (involving purchase) and site works for

implementation.

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When a project sponsor awards the work of a project to a project manager

the sponsor himself is procuring the project from the project manager. Inreal terms, the project is a commitment, i.e. a contract between the project

manager and the project sponsorthe commitment is to deliver a product or

service to the sponsor within a specified time, budget and quality

specifications.

Project procurement management can have cost and schedule effects on

the internal targets of an organisation i.e. a cost increase over the budget for

the procured item or a delay in the delivery schedule of the procured item

may have an adverse impact on the profitability of the project for the

performing company.

This makes project procurement a major challenge faced by the project

manager when the project is one of infrastructure, or an industrial plant or a

manufacturing facility.

9.3 Project Procurement Management Overview

Project procurement management is a part of the project management

process. In this process, products or services are acquired or purchased

from outside of the organisation in order to complete the task or project.

9.3.1 Operations Procurement and Project Procurement

The differences between the procurement carried out for the overalloperation of an organisation, and the procurement carried out for a specific

project, are shown in Table 9.1.

Table 9.1: Differences between Operations Procurement and Project

Procurement

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9.3.2 Project Procurement Management Process

The project procurement method varies depending on the category of thecontracted product or service. The broad categories are:

Materials or products

Equipment or tools

Labours

Professional services

Totally engineered systems

Total project

Project Procurement Management generally involves the following:

Deciding to Make or Buy Outsourcing the work for a Buy decision.

Managing risk (although risk management is often addressed

separately, it is noteworthy that contracts are, at their core, risk

management tools.)

All procurement requires some level of planning. The intensity and the effort

required in planning depend on the complexity of the scope of work in the

procurement package.

For a manufacturing company deciding to starts a project, the make or buy

decision forms the first step in the procurement planning. This decision isbased on a cost comparison between make and buy, and the timely

availability of the manufacturing equipment or shop personnel for meeting

deliveries without adversely affecting their other job orders. Several

companies in India exist, wherein; the company or a division of the company

already manufactures a product, and the company is also executing projects

for its clients which require the same product as part of another project

scope. For example, Larsen & Turbo manufactures switchgear, pressure

vessels, heat exchangers etc. These products are also required in several

electrical projects or petrochemical projects that they execute for clients.

Another example, Kamani Engineering manufactures transmission towers,and also executes large power transmission projects for Power Grid

Corporation of India, where the bulk of the transmission towers are their in-

house supply. The Table 9.2 shows the comparison of costs for in-house

development and outsourcing.

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Table 9.2: Comparison of Costs for In-house Development and Outsourcing

The additional investment of Rs 30000 for In-house option will break even if

the software usage is for more than 20 months i.e. (Rs. 3500/month

Rs. 2500/month) x 20 months.

Therefore if you plan to use the software for less than 20 months then go foroutsourcing but if plan to use the software for more than 20 months then go

for In-house development. The market scenario for the product or service to

be procured gives rise to any of the following three conditions:

Sole Source:In this case there is only one qualified seller in the market.

For example, Dow Chemicals under their patent was the only

manufacturer Reverse Osmosis (RO) membranes which was utilised for

desalinating saline water and all water treatment package vendors had

to buy RO membranes only from them or their licensee in a country.

Single Source:This is a case when your organisation prefers to work

with an identified seller, even though other sellers may offer a lower

price. Sometimes companies show a preference for a supplier with a

view to create a long term relationship for a niche product which the

company may require to procure often.

Oligopoly: This is a condition where the providers of the product or

service are so few in number that the actions and pricing of one seller

affect the actions and pricing of the other sellers. Examples of airline

fares, oil prices, and hardware prices can fall in this category.

The Table 9.3 summarises the actual procurement processes involved in

each of the process groups.

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Table 9.3: Procurement Management Processes (As per PMBoK)

The function performed by each process is explained below.

Plan Purchases and Acquisition

Plan Purchases and Acquisitions is the process for deciding what to buy or

acquire and when and how to buy that. It is a process of identifying the risks

involved in each make or buy decision. It also reviews the type of contractwith regard to mitigating the risk by determining what risks can be

transferred to seller.

The outputs of this process are:

Project management plan describing how procurement process will be

managed starting with development of procurement documentation and

culminating in contract closure.

Contract Statement of Work (SOW)2(describes the portion of the project

scope which is included in the particular contract).

2Refer "Information Technology, Project Management, Fifth Edition" Kathy Schwalbe,

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Plan Contracting

This process includes preparation of a procurement document for eachcontract planned. This document is issued to prospective sellers who are

invited to bid. The invitation is termed Invitation To Bid (ITB), Request For

Quotation (RFQ), tender notice, Request For Proposal (RFP), invitation for

negotiation or contractor initial response.

ITB and RFQ (both imply the same type of invitation) are focused on getting

the sellers price, and not his ideas. For example if RFP asks for a price that

means in addition, it necessarily asks for the sellers and ideas on how the

project work should be done, which implies that there is a bit of consultancy

service demanded from the sellers in their response.

Evaluation criteria: The first category of evaluation relates to

prequalification of a firm for receiving the ITB. Here, a prior assessment of

the capability of a firm to perform the intended scope of work is made. For

large value contracts, the ITB is preceded by an invitation to submit a

prequalification offer, in which the seller is asked to submit his experience

list for similar works carried out by enumerating the following:

List of projects completed with contract value, completion period, and

scope of work.

Audited financial statements like balance sheet, Profit and Loss (P & L)

account for the last 3 to 5 years.

Contract completion certificates from his clients.

Firms organisational structure

List of key personnel of the firm

List of construction equipment/production machinery owned.

Any other technical/financial/organisational data considered relevant by

the owner.

This data submitted by all prospective bidders is analysed to arrive at a list

of pre-qualified bidders, eligible to receive the ITB/RFP.

The second category of evaluation criteria relates to evaluating the bidsreceived in response to the ITB/RFP. These may involve price loading

criteria for technical and commercial deviations stipulated by the bidders in

their bids, as well as specific criteria for price loading on utilities

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consumption (electricity, water etc.) where system performance is evaluated

based on system life-cycle costs.Request Seller Responses

While the prospective sellers are expected to submit their bids in response

to the ITB/RFP as issued to them, it is a common practice in large value

contracts to host a bidders conference, where all bidders are present and

are permitted to ask questions concerning the SOW. This method is

followed to ensure that all bidders possess the same information on which to

base their prices and proposals. After satisfactory completion of this step, a

due date for submission of the bid/proposal is communicated to all bidders.

This process is called solicitation.

The output of this process is a bunch of bids proposals from the bidders.

The proposals are the sellers prepared document that describes the sellers

ability to provide the requested products/services at his quoted price.

Select Sellers

This process involves complete evaluation (techno-commercial evaluation

and price evaluation) of the bids received, followed by negotiations with the

bidders. Here the bidders have been pre-qualified following a fairly

extensive evaluation; the final selection of the seller is usually based on the

lowest evaluated price.

The outputs of this process are:

The Contract: This can be a simple purchase order or a complex

document. A contract is a legal document backed by the countrys legal

system (as long as it does not include illegal activities).

Contract Management Plan: This covers contract administration

activities through the life of the contract.

Contract Administration

Contract administration is a process of managing the contract between

buyer and seller. It is also provides:

Regular review of sellers performance in executing the SOW, as well asdocumentation of this performance.

Continuously manage contract related changes.

Provide a basis for future relationship with the seller.

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Contract Closure

Contract closure is a process of completing the contract by resolving allopen items. Sometimes, a contract may be foreclosed or terminated by

mutual agreement between buyer and seller.

Activity 1:

List down the components of procurement contract between a

consultancy (Resources unlimited) and its client (United Technology)

9.4 Types of Contracts

All procurements are carried out based on a contract between buyer and

seller. A contract is a binding agreement between two or more parties for

performing some specified acts in exchange for lawful consideration. A

contract is entered into after a decision is made by the buyer on which seller

to use. The nature of the goods and works that are purchased dictate the

appropriate contract type.

Purchase of standard products for a project like cement, steel, pipes, cables

etc. are usually carried with a simple purchase order (contract). Such a

purchase order usually stipulates a fixed unit price for each item.

Alternatively, if the deliveries are required over a long period of time, the

contract may contain a price variation clause to take care of price variations

in the costs of raw materials used in their manufacture. For example, in caseof copper cables, the government published copper price index can be used

as a basis for arriving at a price variation formula in the contract.

The following major key clauses are incorporated in construction contracts:

Scope of Work

Contractors obligations

Owners obligations

Technical and Commercial specifications

Payment terms

Warranties Performance security

Termination rights

Dispute resolution mechanism

Indemnities

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Project procurement requires a high level of understanding of contracts by

the project manager, although a centralised contract department is presentin many project companies to undertake implementation of large projects.

Contracts in India are governed by the Indian Contract Law 1872.

PMBoK categorises contracts into three broad categories:

Fixed price or lump sum contracts:Here, the product to be supplied

or SOW to be carried out is very well defined and the seller is paid a

fixed price.

Cost-reimbursable contracts: Here the seller is paid for his actual

costs plus a fee to cover his profit. The actual cost includes direct cost

(salaries of full-time project staff) and indirect cost (salaries of

management and support staff indirectly involved in the project plus costof office facilities like rent, electricity etc.). The variations in this category

are:

o Cost-Plus-Fee (CPF) or Cost-Plus-Percentage of Cost (CPPC): The

payment is made for the actual cost plus an agreed percentage of

the actual cost as fee.

o Cost-Plus-Fixed-Fee (CPFF): This is same as CPPC except that the

fee is fixed and does not increase or decrease with the actual cost

unless project scope changes.

o Cost-Plus-Incentive-Fee (CPIF); Here, in addition to the payment as

per the CPPC or CPFF mode, an incentive is paid upon achieving

certain specified performance levels of the project.

Time and Material (T&M) contracts: Here the contract contains the

feature of both cost reimbursable and fixed price contracts. Unit rate

contracts are an example, where the unit rates for specific items of work

are fixed, but the contractor is paid for the actual quantities executed,

since quantities are not known at the time of signing the contract with

the contractor.

To illustrate project procurement contract examples, we look at large

construction projects, where sharing of the risk between the majorstakeholders, like the buyer (owner) and the seller (contractor) is a very

important consideration. For a more comprehensive understanding of

contracting in large projects, we examine seven types of contracts with

varying degrees of risks assumed by these stakeholders as per a review

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conducted and presented in an international publication Procurement

strategies A Relationship based approach by Derek Walker and KeithHampson. Figure 9.1 shows a construction cost continuum for project

delivery.

Figure 9.1: A Construction Cost Continuum for Project Delivery3

The contract types shown in the figure 9.1 range from the traditional fixed

cost/time type (lowest cost risk to owner and designated as 1) at one end to

the fully cost reimbursable type (highest cost risk to owner and designated

as 7) at the other end. The descriptions of the seven types are as follows:

1. Traditional lump sum fixed cost/time

2. Design + Construct or Turnkey

3. Design + Novate + Construct

4. Construction Management (CM), Project Management (PM)

3Adapted from Procurement strategies A Relationship-based Approach by Derek Walker and Keith

Hampson

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Many owners perceive that they may be at the mercy of construction

contractors looking for opportunities to create additional revenue andprofit from such gaps in the tender. This may lead to a confrontational

approach over disputes which may ultimately need to be settled by

arbitration or a court of law.

Notwithstanding these disadvantages, fixed contracts are in vogue

where designs can be more or less frozen prior to tendering for

construction, with some contractual provisions for price variations

incorporated in the contract.

BOO, BOT, BOOT (total package options):

The letters here imply:

BBuild

First OOperate

Second OOwn

TTransfer

Here, an entity exists or an entity is formed which meets the clients project

need. The entity enters into one of these three types of contract with the

client to design, build, operate and own for some period of time (called the

concession period) and transfers the facility to the owner at the end of this

period. The conventional wisdom that is accepted here is that, the

contracting parties i.e. client and the entity individually assume the risk

within whose control the risk most lies. The major function of the contract

assignment is to provide for and agree to the mechanism for the assignment

and management of these risks. Usually the entity is an alliance or joint

venture of firms who provide the facility for the client. The client makes a

concession agreement to fund the facility until the facilitys ownership is

transferred to the client. This mode of contracting is common for

infrastructure projects where the concession permits tolls and other

payments to be made by end users.

The concept of constructability is therefore present to a high degree, as it

covers the life-cycle cost effectiveness. The incentive for minimising the long

term costs and developing a highly cost-effective solution over the life cycle

thus gets in-built into the entity which is responsible for design, construction

and operation/maintenance of the facility. The client therefore has no direct

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cost risk but faces the possible risk that the facility does not meet its needs

or that the concession agreement is not satisfactory. While there have beenexamples of successful BOT projects, there have also been cases of

failures, which mainly arise out of a lack of trust or communication between

contracting parties. As the client is usually a government department,

political bottlenecks regarding land acquisition and politically motivated

decisions like toll rates being decreased in the operation phase have

resulted in failure or inordinate delays in such projects.

9.4.2 Design (D), Construct (C) Novation and Turnkey (T)

Here, a Project Management (PM) or Construction Management (CM) entity

enters into a contract with the client to represent the client in leading the

design team and in the management of the construction process, with asingle point of contact in the PM/CM company. There are two variations in

this mode of contracting, they are:

The PM/CM entity is an Advisor to the client and becomes an internal

design and construction group of the client. The managerial instructions

given to the actual contractors by the entity are therefore persuasive

rather than directive.

The PM/CM can have a contractual arrangement with the client in which

the design and construct type of contracting takes a financial risk. The

Design and Construct type of contracting is usually considered as

falling in this category, especially when the PM/CM entity is a builder by

experience.

In the D + C mode of contracting, the client initially engages a design

consultant to develop concept project solution, which is used as the basis

for obtaining bids from D + C bidders. Thus, each D + C bidder gets the

opportunity to involve his design team in the bid for suggesting innovative

solutions over and above this concept. This increases the chances of the

client finding a most cost effective solution for the project from among the

D + C bids received.

The mode of Novated D + C mode of contracting is developed from theD + C model and is gaining popularity among large commercial and

residential projects in Australia. Novation, as a legal term, implies the

replacement of an existing contract between X and Y by a new contract on

the same terms between X and Z and this requires the agreement of all

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three parties X, Y and Z.. For a novated D + C contract. The novation

parties as per the above referred definition are:X is the Client

Y is the Design consultant

Z is the D + C contractor

The clients cost risk is reduced since the D + C contractor engages the

design consultant and becomes directly accountable to the client with

respect to all the design development, and thus the client cannot make a

claim for extra costs on account of errors or omissions in design.

Here, it is also relevant to briefly discuss the concept of a Turnkey project.

In a turnkey project, the D + C contractor also finances the project. Theclient may opt to make milestone payments or payment after handing over

to the D + C contractor.

9.4.3 CM, PM and PM/CM

In this type of contract, the Construction Management contractor acts as a

consultant bidder and provides advice on the practicality of the design with

respect to the construction methods that can be deployed. He also provides

services of construction planning, coordination and supervision of the

construction work carried out by contractors appointed by the client, and

cost control. The advantages of this type of contract are:

Availability of construction expertise in the design phase.

Less confrontation between the design team and the team responsible

for supervising the construction.

Fewer contract variations.

An extended form of the CM contract is the PM/CM contract where the

PM/CM contractor also takes responsibility for design coordination.

9.4.4 On-Call Contracting

This mode is adopted by the owner in the beginning of the project when the

owner is more familiar with the nature of work than the consultant, but this

balance shifts in the execution stage of the project. Hence, conventional

wisdom in this mode of contracting is that the consultant should assume

most cost risk at the execution stage. This scheme is implemented by the

owner signing a master contract with one consultant at the beginning of the

project, and then dividing the project into Task Orders (TOs) that are

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released to the consultant in stages. Table 9.4 shows the typical

characteristics of on call contracting.Table 9.4: Typical Characteristics of On Call Contracting

9.4.5 Guaranteed Maximum Price

In this contracting mode, the contract calls for a reimbursable fee, i.e.

reimbursement of actual cost plus a fee, but there is a cap to the total

amount paid, which is termed the Guaranteed Maximum Price (GMP). This

mode of contracting is adopted when the design is partially developed at the

time of contracting. The contractor makes his judgment of the cushion he

must provide in fixing his GMP which becomes part of the contract. The

design is however fixed. If the actual cost exceeds the GMP, the contractor

absorbs the excess. If the actual cost is less than the GMP, a portion of the

difference amount is shared with the contractor as an incentive.

This mode is similar to novated D + C as the design development is partial

at the time of contracting. But in the GMP mode, the contractor may or may

not agree to take over the design team and its initial design concept.

9.4.6 Full Cost Reimbursable Procurement

This contracting mode is applicable when the client prefers to retain control

over the design, detailed planning, procurement and the construction

phases of the project, but does not find it feasible to deploy the personnel ofhis own organisation to implement the project. Some large projects where

aspects of safety and secrecy are very important and where client cannot

afford to employ a large contingent of project design and project

management personnel fall in this category. For example in India, Nuclear

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Power Corporation of India Limited (NPCIL) deploys engineering consulting

firms like TCE Consulting Engineers for generating all the civil/structuralpiping drawings for the nuclear power plants being implemented by them.

M.N.Dastur Consulting Engineers were also deployed by Steel Authority of

India Ltd. in the 1950s and 1960s to carry out detailed design and drawings

for steel plants. This full cost reimbursable type of procurement is based on

the clients high degree of trust and confidence in the agency deployed by

him. This type of contract can also apply to projects where design details

are unknown at the time of tendering and/or external influences on project

scope and design are significant, resulting in the clients requirements

undergoing changes frequently during project implementation.

Overview of Types of Contract for Large ProjectsThree teams are primarily involved in the implementation of a large project

like, Client, Design team and Contractor. For large projects or the type of

projects mentioned above, the extent of clients influence over the des ign

and other implementation areas of the project assume importance. The type

of contract which the client selects for such projects thus depends on

whether the client prefers to exert a high influence on the design and

procurement of the project or whether the client permits the contractor to

exercise influence over these processes. At one end of the scale is a project

where the client has a very high level of confidence in his expertise to

control the design, procurement and construction processes; at the otherend is the project (example, BOO or BOOT type), where these processes

are under the contractors control. In the former, the client depends on his

appointed design consulting firms expertise in shaping the project details;

and in the latter, the client depends on the market to provide a total solution

to the project and project delivery. In the middle lie the CM/PM type and the

GMP/Novation types of contract.

Self Assessment Questions

Fill in the blanks:

1. CPF stand for _______ and CPFF stands for _______.

2. The first step in the procurement process is to decide whether to

________ or ______.

3. The document detailing the scope of work in a procurement contract is

called ________.

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4. In a GMP contract, there is a _______ to the total amount paid.

5. In PMBoK, the process of receiving quotations from prospective vendorsis called __________.

State whether the following statements are true or false:

6. The financial risk in a fully reimbursable contract is borne by the

contractor.

7. In on-call contracting, the Master contract keeps the risk with the

contractor.

9.5 Contract Negotiation Techniques

In a large project, for subcontracting a major portion of the project scope theproject manager relies on the personnel in the purchase and/or contract

department of the project organisation. However, the project manager faces

the need to understand and track the negotiating process to ensure that

both the project needs and his organisations needs are met in the outcome

of the contract negotiations with the seller.

Therefore, the needs to become familiar with negotiation techniques as well

as negotiation skills, required in conducting the negotiations. Project

contract negotiation is invariably a two-way street wherein the buyer seeks

to exercise a good degree of control over the sellers performance, as well

as wants to maintain a harmonious relationship.

Negotiating skills comprise a combination of hard skills and soft skills. Hard

skills include product/service/technical knowledge, analytical/financial,

computer literacy and legal aspects of contracting.

The negotiation process itself comprises three phases, each of which

requires careful planning and execution effort like planning the negotiation,

conducting the negotiation and documenting the negotiation/forming the

contract when the negotiation is successful.

Table 9.5 shows the checklists for the buyer and a checklist of contract best

negotiation practices for an overall understanding of the negotiationtechniques.

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Table 9.5: Checklist of Contract Negotiation Best Practices

Buyer Activity

Know what you want lowest price or bestvalue.

State your requirements in performanceterms and evaluate accordingly.

Conduct market resource about potentialforces before selection.

Evaluate potential sources promptly anddispassionately.

Follow the evaluation criteria stated in thesolicitation.

Develop organisational policies to guide and

facilitate the source selection process. Use a weighting system to determine which

evaluation criteria are most important.

Use a screening system to pre-qualifysources.

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Self Assessment Questions

8. The three phases in contract negotiations are ______, _______, and________ the negotiations.

9. Contract negotiation requires ______ skills and ______ skills.

10. The project manager does not require being familiar with the contract

negotiation skills and techniques since contracts are handled by other

departments in the organisation. (True/False)

Activity 2:

List the contract negotiation techniques you will use when dealing with a

construction contractor.

9.6 Summary

Procurement and contracting are vastly interrelated functions and constitute

the single most important strategic planning exercise in successfully

implementing large and complex projects.

Project procurement management is the process of acquiring goods,

services or results needed from outside the project team to perform the work

as well as contract management processes. Procurement is formalised by a

contract between buyer and seller. In large projects, an entire system can

get outsourced to a firm specialising in that identified system.

The procurement method adopted depends on the category of

product/service being contracted. The categories are materials/products,

equipment/tools, labour, professional services, totally engineered systems,

total projects. For a manufacturing/production taking up a project,

procurement starts with the make or buy decision.

For subcontracting a major portion of the project scope in a large project,

the project manager relies on the personnel in the purchase and/or contract

department of the project. Although the personnel of this department usually

carry out contract negotiations in large projects, the project manager should

understand and track the negotiating process to ensure that both the projectneeds and his organisations needs are met in the outcome of the contract

negotiations with the seller.

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Contract negotiating skills comprise a combination of hard skills and soft

skills. The negotiation process itself comprises three phases like planningthe negotiation, conducting the negotiation and documenting the

negotiation/forming the contract when the negotiation is successful.

9.7 Terminal Questions

1. Bring out the meanings of the terms purchase, procurement and

contract.

2. Explain the overall project procurement process using the processes

outlined in the PMBoK of PMI, USA.

3. Explain the types of contracts that are entered into in project

procurement.

4. What are the guidelines which the buyer should keep in mind while

negotiating a contract?

5. What are the factors that both the buyer and seller should understand as

forming a checklist for contract negotiations?

9.8 Answers

Answers to Self Assessment Questions

1. Cost Plus Fee and Cost Plus Fixed Fee

2. Make, buy

3. Statement of Work (SOW)

4. Cap5. Solicitation

6. False

7. False

8. Planning, conducting, documenting

9. Hard, soft

10. False

Answers to Terminal Questions

1. Refer sections 9.1 and 9.2

2. Refer section 9.3.2

3. Refer section 9.44. Refer section 9.5

5. Refer section 9.5

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