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Contents

Aim of the module 2

Contract and procurement 3

Post-contract cost control 23

Site and location analysis 30

Advising the client 37

Corporate strategy 48

Property investment economics 62

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Module Aims & Content

1. AIM OF THIS MODULE

The module aim is to introduce new management concepts including development appraisals

and combine and integrate the knowledge and skills learnt in previous modules, thus enabling

students to further develop their knowledge and competence in their subject specialism.

2. BY ENGAGING SUCCESSFULLY WITH THIS MODULE YOU WILL BE ABLE

TO

Apply theory, practice and specialist skills to industry related problems, in a collective

and interdisciplinary team environment.

To research and critically evaluate information from a number of sources and provide

clear advice to the client.

Reflect critically on the project, the group and the individual's performance.

3. THESE ARE EXAMPLES OF THE CONTENT OF THE MODULE

Contract and procurement

Project post-contract cost control

Site and locational analysis

Advising the client

Corporate strategy

Development appraisal and finance

Property investment economics

4. THESE ARE THE MAIN WAYS YOU WILL BE SUPPORTED IN YOUR

LEARNING TO ACHIEVE THESE OUTCOMES

The concept of "Embedding" will be applied enabling clear learning outcomes to be produced

and appropriately linked to valid teaching and assessment strategies. Thus the assessments

are designed to provide both formative and summative feedback. Students can reflect and

learn from the experience and hence have the opportunity to enhance their performance.

Further the concept of "Integration" will be deployed, this will take the form of a case study

project and will provide a vehicle for the bringing together of related taught material.

This empowers students to form "Linkages" and makes the learning process easier.

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1. Contract and procurement

What is Construction Procurement?

The term ‘procurement’ when used in a building context may be defined as the overall

process of acquiring a building. When a client wishes to renovate, extend or construct a new

building he will normally need the services of many construction-related organizations to

achieve the desired end product. There are a number of alternative procurement methods a

client may use to acquire these services. These procurement methods give the client a choice

of various management structures, different contractual arrangements and varying degrees of

client risk. During the late twentieth century, a number of alternative procurement routes

were developed along with alternative options within each procurement routes. As a result it

is difficult to classify the various procurement routes into distinct categories, as they

sometimes share common attributes. The following descriptions provide a broad appreciation

of what procurement routes are potentially available to a client.

Traditional methods

From early in the nineteenth century until about the 1950s, the ways by which building

projects were promoted and carried out in the UK conformed to straightforward and well-

tried procedures. If the project was small, the building owner (or ‘Employer’, as he is often

called) employed a building contractor to design and construct the building for him. Because

buildings generally conformed to a well-defined pattern, contractors had within their

organizations the full range of expertise and skills normally required. In the case of larger

projects, the Employer appointed an architect to design the building, and he then produced

drawings and a specification. If the architect considered it necessary (and the Employer

approved), he then appointed a quantity surveyor to prepare a bill of quantities. Then, on the

basis of either the specification and drawings or the bill, contractors were invited to tender in

competition to carry out the work. Usually the lowest tenderer was awarded the contract.

Since the mid-1940s, the architect’s nomination and/or appointment of the quantity surveyor

has been gradually superseded by appointment by the Employer, sometimes before the

selection of the architect and, in some cases, the latter’s selection is made on the

recommendation of the quantity surveyor. The traditional methods of building procurement

are still widely used and their respective distinguishing characteristics are as described below.

They have gradually evolved during the twentieth and twenty-first centuries to meet changing

circumstances and technological developments, and variants of the main procedures have

been introduced from time to time, but the essential principles still apply.

A. Based on bills of firm quantities

The building owner commissions an architect to prepare a design and, upon virtual

completion of the design, the surveyor prepares a bill of quantities based upon the architect’s

drawings and specification information. Contractors are invited to price the bill and submit

tenders in competition for carrying out the work. The contractor submitting the lowest tender

is usually awarded the contract (the JCT Standard Building Contract with Quantities is

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commonly used). The essential characteristics of this method are (i) that both the quantities

and the unit rates in the bill form part of the contract and (ii) that virtual completion of the

design precedes the signing of the contract. Such a contract is a lump sum contract

(sometimes called a fixed price contract) because a price is stated in the contract as payment

for the work described in the bill.

Advantages

1 Both parties have a clear picture of the extent of their respective commitments.

2 The unit rates in the bills provide a sound basis for the valuation of any variations to the

design.

3 A detailed breakdown of the tender sum is readily available.

Disadvantages

1 The length of time taken in the design of the project and in the preparation of the bills of

quantities.

2 The problem of dealing with those variations which are so fundamental or extensive as to

change the character of the remainder of the work or the conditions under which it has to be

carried out.

B. Based on bills of approximate quantities

This method is largely similar to the preceding one, except that the quantities given in the bill

are approximate only and are subject to later adjustment. The essential characteristics are (i)

that only the unit rates form part of the contract and (ii) the signing of the contract and the

beginning of work on site may proceed before the design is complete. The bill of quantities is

normally specially prepared for the particular project and descriptions of work are as detailed

as in a bill of firm quantities, but the time otherwise required for detailed measurement of the

quantities is saved, the quantities given being estimates of likely requirements. Sometimes the

bill re-uses the quantities which were prepared for an earlier project of a sufficiently similar

kind and size. This method results in a contract (the JCT Standard Building Contract with

Approximate Quantities is commonly used) which is sometimes regarded as a lump sum

contract although it is not strictly so, there being no total price stated in the contract. In effect,

it is very similar to a schedule of rates contract (see D below).

Advantages

1 Construction on site may begin earlier.

2 The extra expense of preparing firm quantities is avoided (although this is offset by the cost

of fully measuring the work as actually carried out).

Disadvantages

1 The bills of quantities cannot be relied upon as giving a realistic total cost at tender stage

and in consequence, the parties to the contract are less certain of the extent of their

commitment.

2 The construction works have to be measured completely as actually carried out, which may

prove more costly than to have prepared bills of firm quantities initially.

3 The architect may feel less pressure to make design decisions which ought to be taken at an

early stage.

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C. Based on drawings and specification

This method closely resembles that described in A above, the difference being that no bills of

quantities are supplied to tenderers, who have to prepare their own quantities from the

drawings provided. This procedure is intended to be used for relatively small works (say

£50,000–£100,000) and for sub-contract works, although it is not unknown for quite large

contracts to be tendered for on this basis. A survey carried out for the RICS showed that a

small number of contracts let on this basis during 2001 were for a contract value in excess of

£10 million.1 The essential characteristics are (i) that tenderers are supplied only with

complete working drawings and a full specification and (ii) that virtual completion of the

design must precede the signing of the contract (the JCT Standard Building Contract without

Quantities is commonly used).

Advantages

1 The time required for the preparation of tender documents is reduced, as the time-

consuming process of preparing bills of quantities is eliminated.

2 Both parties can have a clear picture of their respective commitments at the time of signing

the contract.

Disadvantages

1 No breakdown of the tender sum is immediately available (although the tenderers may be

asked to provide a Contract Sum Analysis, either as a part of their tender submission or

subsequently).

2 The valuation of variations presents problems, as indicated above.

3 There is little, if any, control over the percentage rates for additions for overheads and

profit to the prime cost of labour, materials and plant elements in dayworks (defined on p.

123). Tenderers are normally asked to state percentage rates to be used in the event of

dayworks arising. Where such rates have no effect on the tender sum, there is little incentive

to the tenderer to moderate them.

D. Based on a schedule of rates (sometimes known as measured contracts or measurement

contracts)

This method operates in a similar way to that described in B above, tenders being based upon

a schedule of rates as explained in (i)–(iii) below. A particular advantage arising from its use

is that it allows for a contract to be signed and work to start on site when the design is only in

outline form, and in consequence the pre-contract period is reduced considerably.

(i) Standard schedule

A standard schedule lists under appropriate trade headings all the items likely to arise in any

construction project, with a unit rate against each item. Standard schedules are produced by

both the Property Services Agency of the Department of the Environment2 and NSR

Management.3 Between them these organizations produce schedules for a variety of works,

e.g.:

● Building works

● Mechanical services

● Electrical services

● Painting and decorating

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● Landscape management

● Road works.

Tenderers are asked to tender percentage additions (or deductions) to the listed rates, usually

by sections or sub-sections, thus allowing for variations in construction costs since the date of

the preparation of the schedule used.

Advantage

1 Tenderers using a particular schedule often soon become familiar both with the item

descriptions and the rates, and are able to assess percentage adjustments relatively easily.

Disadvantages

1 In comparing and assessing a range of tenders, the surveyor has the task of gauging the

effect of a series of variables, making the choice of the most favourable tender difficult.

2 The parties are unable to have a precise indication of their respective commitments.

(ii) ‘Ad hoc’ schedule

This is a schedule specially prepared for a particular project and lists only those items which

are appropriate to that project, including any special or unusual items. An ‘ad hoc’ schedule

may be prepriced by the surveyor (in which case the form of the tender will be the same as

when using a standard schedule) or the rate column may be left blank by the surveyor for the

tenderer to insert individual rates against each item. The latter method, because of the

absence of quantities, makes the comparison and assessment of tenders much more difficult.

Advantages

1 Tenderers are only required to concern themselves with a restricted range of items, thus

enabling them to assess rates or percentages more accurately.

2 Tenderers are able to obtain a clearer picture of the scope of the work from the items listed

in the schedule.

Disadvantages

These are similar to those applying to standard schedules.

(iii) Bills of quantities from previous contract

The bill of quantities used will normally be for a comparable type of building of similar

constructional form to the proposed project. It is, in effect, a pre-priced ‘ad hoc’ schedule and

will be used in the same way. This is the method of tendering normally used in serial

tendering.

Advantages

1 The time required to prepare tender documents is reduced to the minimum.

2 Tenderers have to consider only a restricted range of items.

Disadvantages

1 The parties are unable to have a precise indication of their respective commitments.

2 There may be a considerable discrepancy between the successful tender and the real cost of

the work, owing to the approximate nature of the quantities.

E. Based on cost reimbursements (also known as prime cost or cost plus because the method

of payment is reimbursement to the contractor of his prime cost, plus a management fee)

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There are three variants of this type of contract, distinguished by the way in which the fee is

calculated. Each is dealt with separately below (the JCT Prime Cost Building Contract may

be used).

‘Prime cost’ means the total cost to the contractor of buying materials, goods and

components, of using or hiring plant and of employing labour, in order to carry out

construction works.

Of all the types of contract, this produces the most uncertainty as to the financial outcome.

Tenders contain no total sum and it may be very difficult to form any reliable estimate of the

final cost.

It is widely recognized as the most uneconomical type of contract and therefore is one which

normally should be used only in circumstances where none of the other types is appropriate.

Because of the possibility of inefficiency and waste of resources, contracts of this type need

to embody provisions giving the architect some control over the level of labour and plant

employed.

One of the attractions of prime cost contracts is that work on site can commence in the early

stages of design and this may be all-important to the client. There may be circumstances

where, to the client, cost is a less important factor than time. Consequently, a start on site at

the earliest possible time may be financially more advantageous in the long run than a lower

final cost of construction which might have resulted from the use of another type of contract.

It should be noted that no site measuring is necessary other than as checks on the quantities of

materials for which the contractor submits invoices. The process of calculating and verifying

the total prime cost involves a vast amount of investigation and checking of invoices, time

sheets, sub-contractors’ accounts, etc., which can be both tedious and time-consuming. It is

therefore in the interests of the surveyor and the contractor that at the outset a proper system

of recording, verifying and valuing the prime cost is agreed and strictly implemented. In

addition, it is vitally important to define clearly what is intended to be included as prime cost

and what is intended to be covered by the fee. The standard form for the fixed fee variant of

this type of contract does so in the appended schedules. The publication Definition of Prime

Cost of Daywork may be used for this purpose if the standard form is not used, but it will

have to be amended as the authors of the publication advise that the definition is designed to

be used in conjunction with a building contract and should not be used on its own. The

advantages and disadvantages of prime cost contracts over lump sum and schedule of rates

contracts follow.

Advantages

1 The time required for preparation of tender documents and for obtaining tenders is

minimized, thus enabling an early start on site to be made.

2 Work on site may proceed before the detailed design is complete.

Disadvantages

1 The parties have the least precise indication of their respective commitments.

2 The cost of construction to the client is likely to be greater than if other types of contract

were to be used.

3 The computation and verification of the total prime cost is a long and tedious process.

The variants below differ in the way in which the fee for the contractor’s services is

determined. Variants (ii) and (iii) are the consequence of a general acknowledgement that it is

desirable to provide an incentive to economize in the use of resources on the part of the

contractor.

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(i) Cost plus percentage fee.

The contractor is paid a fee equal to an agreed percentage of the prime costs of labour,

materials and plant used in carrying out the work. The outstanding disadvantage (to the

client) is that the more inefficient the contractor’s operations are and the greater the waste of

resources, the higher the fee paid to the contractor will be. To counter this, the agreed

percentage is sometimes made to vary inversely in comparison to the prime cost, i.e., as the

prime cost increases the percentage addition decreases. The following is a simple illustration

of this contractual arrangement, which at the same time will provide a basis for comparison

with the fixed fee form. A contract is assumed where the estimated total cost of materials,

labour and plant was £50,000; the contractor’s overheads were calculated by him as 15% and

he required 5% for profit. He therefore tendered at 20% overall addition to the prime cost as

his fee and his tender was accepted. Assuming that the estimate of prime cost proved at the

completion of the contract to be accurate, the total final cost to the client would be:

If, however, due to uneconomic organization of the contract, inefficiency and excessive

waste, the total prime cost was £55,000 for the same job, then the total cost would be:

As the contractor’s overheads chargeable to this job would still be £7500, it follows that the

real profit would be £3500. The disincentive to the contractor to work efficiently is thus seen

to be strong.

(ii) Cost plus fixed fee.

Under this variant, the fee paid to the contractor is a fixed sum which normally does not vary

with the total prime cost, but is based on an estimate of the likely total. The only ground on

which the fee might be varied is if either the scope of the work or the conditions of carrying it

out were to be materially altered after the contractor tendered. It should be noted that the fee,

if considered in percentage terms, is lower when the prime cost is higher. Using the same

illustration as before, but with the contractor having tendered a fixed fee of £10,000 (made up

of £7500 for overheads and £2500 for profit), the sum paid to the contractor as fee would be

equivalent to 20% if the total prime cost was £50,000. If as before, the prime cost was higher

for the same reasons, the financial picture would be:

The fee is now equal to 18.18% of the prime cost and the profit portion only 4.55%. If the

prime cost rose to £60,000, the fee would equal only 16.67% and the profit portion 4.17%.

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(iii) Target cost.

This variant is really one or other of the two preceding ones with another factor added. As an

incentive to reducing the total prime cost, the agreement provides for a bonus to be paid to

the contractor if the total cost is less than an agreed sum (the ‘target’) and also a penalty to be

paid by him if the total cost exceeds that sum. The bonus and penalty may be a set figure,

e.g., 50% of the difference between the total amounts, or any other agreed percentages.

Alternatively, there may be a sliding scale of percentages to be used depending on how much

below or above the final cost is from the target cost. The target cost is an estimate of the

likely total cost.

Taking the same illustration again, it is assumed that the fixed fee method of payment is to be

used, and that the agreed sum based on an estimate of likely total cost is £60,000. At the end

of the job (assuming the higher cost shown above), the final payment would be calculated

like this:

In effect, the fee has been reduced to £7500, which is only just enough to meet overheads,

leaving nothing for profit. It follows therefore that the contractor will need to be very

satisfied that the ‘agreed sum’ is a realistic estimate of likely cost and the surveyor must give

him every reasonable opportunity and assistance to satisfy himself in that regard. However, if

the contractor were able to reduce the prime cost, say to £48,000, final payment would be

calculated as:

The fee has now increased to £11,000, including £3500 for profit, the overheads remaining at

£7500. As a percentage, the profit is 7.29% of the prime cost. Thus, under this contractual

arrangement, an extra cost or saving is shared between the client and the contractor.

The composite nature of contracts

Although, for convenience, classifications and type labels such as the foregoing are

commonly used, in practice contracts often combine the characteristics of two or more types.

McCanlis has pointed out6 that, for example, a lump sum contract based on bills of firm

quantities often contains items with provisional quantities requiring re-measurement and

therefore such items bear the characteristics of a schedule of rates contract. Also, the

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provisional sums included in the bills for daywork and expended on work, which is not

readily measurable or not reasonably priceable as measured work, form a prime cost plus

percentage fee contract within the main lump sum contract. Thus, many contracts which are

regarded as of the lump sum type are, in reality, a combination of several types. Other

examples of the composite nature of many contracts are given in the reference above.

Circumstances in which the various types of contract may be used

Usually, the circumstances peculiar to a project will indicate which type of contract is most

appropriate. Occasionally, more than one type might be suitable, in which case, the one

which seems to offer the greatest benefits to the client should be chosen, as the client is the

one who will be paying the bill. The suitability of the types of contract discussed earlier may

be related to varying circumstances as follows.

Based on firm bills of quantities

(i) When there is time to prepare a sufficiently complete design to enable accurate quantities

to be measured.

(ii) When the client’s total commitment must be known beforehand, for example, in order to

make adequate borrowing arrangements or when approval to the proposed expenditure has to

be obtained from a finance or housing committee of a local authority, from a central

government department or from a board of directors.

Based on bills of approximate quantities

(i) When the design is fairly well advanced, but there is insufficient time to take off accurate

quantities or the design will not be sufficiently complete soon enough for that to be done.

(ii) When it is desired to have the advantages of detailed bills but without the cost in terms of

time and/or money.

Based on drawings and specification

(i) When the project is fairly small, i.e., up to a value of, say, £50,000–£100,000.

(ii) Where time is short and the client considers it to be less important to have the benefits of

bills of quantities than the early completion of the construction work, while retaining the

advantages of a lump sum contract.

Based on schedule of rates

(i) When the details of the design have not yet been worked out or there is considerable

uncertainty with regard to them.

(ii) When time is pressing. (iii) When term contracts are envisaged. These are appropriate

where a limited range of repetitive work is required to be carried out, such as the external

redecoration of an estate of houses. The contractor tenders on the basis of unit rates, which

are to remain current for the stated ‘term’, usually one year or the estimated period, which the

proposed work will take.

Based on prime cost plus fee

(i) When time is short and cost is not as important as time.

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(ii) When the client wishes to use a contractor who has worked satisfactorily for him before

and whom he can trust to operate efficiently, while being prepared to pay the higher cost

entailed in return for the advantages.

(iii) In cases of emergency, such as repairs to dangerous structures. (iv) For maintenance

contracts.

(v) For alterations jobs where there is insufficient time or it is impracticable to produce the

necessary documentation. The following examples will illustrate some of the foregoing

considerations.

The risk factor

An important element of construction contracting is risk, i.e., the risk the parties take that the

implementation of the contract may be detrimental in some degree to their financial or other

interests.

On his part, the contractor takes the risk that his anticipated profit will be reduced or

converted into a loss as a result of the outworking of the conditions under which the contract

is carried out. On his part, the Employer takes the risk that he will become liable for a greater

total cost than he envisaged when initiating the project. The types of contract described above

carry a varying degree of risk for the parties. Generally speaking, the contractor’s risk

increases as the Employer’s risk reduces and vice versa. Thus, the contractor bears a high

degree of risk where the contract is based on drawings and specification only, for two

reasons. First, as it is a lump sum contract, he must estimate his expected costs as accurately

as possible because any adverse mistake will reduce his profit. Second, there being no bill of

quantities provided for tendering purposes, he must take off his own quantities from the

drawings in order to formulate his tender, and, again, any error he may make in the process

will affect his profit margin. The Employer’s risk is small in the situation just described. He

knows at the outset what his financial liability will be and is under no contractual obligation

to reimburse the contractor for any errors which he may have made in preparing his tender.

At the other end of the spectrum, where a cost reimbursement contract is used, the

contractor’s risk is reduced considerably because he is paid his full costs and a fee in

addition. His only risk is in pitching at the right level the fee which he tenders but, even so,

he is most unlikely to make a loss. On his part, however, the Employer bears the risk of the

prime cost becoming much higher than estimated, owing perhaps to an inefficient site agent

or to wastage of resources. Other types of contract fall within these two extremes, and Figure

1.1 below indicates a ranking of them according to the allocation of risk borne by the parties.

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Figure 1.1: Allocation of risk

Relationships between the parties

In all the traditional types of contract, the pattern of relationships between all the parties is

normally similar. Figure 1.2 illustrates these relationships and indicates the lines of

communication between them. Contractual links exist between

(i) the Employer and each of his professional advisers (architect, quantity surveyor and

consultant engineers);

(ii) Employer and contractor;

(iii) the contractor and each sub-contractor.

There may also be Warranty Agreements between the Employer and sub-contractors if the

Employer wishes (as, for example, by use of Form SCWa/E in conjunction with the JCT

Standard Building Contract).

Figure 1.2: Relationships and communication links

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Alternative methods

Since the early 1960s, various alternative ways of promoting and carrying out construction

projects have been devised with varying degrees of success. The reasons why many building

owners and developers considered that the traditional procedures were no longer satisfactory

were:

(i) The rapidly spiralling cost of construction meant that large sums of money had to be

borrowed to finance projects;

(ii) high interest rates meant that the time occupied by the traditional procedures resulted in

substantial additions to the construction cost;

(iii) clients were becoming more knowledgeable on construction matters and were demanding

better value for money and an earlier return on their investment;

(iv) high technology installations required a higher quality of construction.

Attention has focused on reducing the time traditionally occupied in producing a design and

preparing tender documentation, thus enabling construction work to begin sooner.

Another important factor has been bringing the contractor in at an early stage in the design of

a project. Under the traditional procedures, the contractor rarely played any part until the

tender stage was reached, after virtual completion of the design. The increasing complexity of

projects, however, led to the realization that it was in the interests of clients and architects to

use the vast amount of knowledge and practical experience of contractors early in the design

process, and that this would make a valuable contribution to a successful outcome. The

following are the principal alternative methods of building procurement now in use.

A. Design and build (sometimes called design and construct or package deals)

When first introduced in its modern form, this method usually meant the contractor using an

industrialized building system which was adapted to meet the client’s requirements – usually

straightforward, rectangular warehouse or factory buildings with a minimum of design.

Nowadays the method is applied to a wide range of building types.

Essentially, the contractor is responsible for the design, for the planning, organization and

control of the construction and for generally satisfying the client’s requirements, and offers

his service for an inclusive sum. A proprietary, prefabricated building system may or may not

be used. The procedure is initiated by the client (or an architect on his behalf) preparing his

requirements in as much or as little detail as he thinks fit. These are then sent to a selection of

suitable contractors, each of whom prepares his proposals on design, time and cost, which he

submits together with an analysis of his tender sum. The client then accepts the proposals, he

is satisfied best meet his requirements and enters into a contract (e.g., the JCT Design and

Build Contract is a suitable form of contract) with the successful tenderer. The latter then

proceeds to develop his design proposals and to carry out and complete the works.

The client may use the services of an independent architect and quantity surveyor to advise

him on the contractor’s proposals as to design and construction methods and as to the

financial aspects, respectively. He may also appoint an agent to supervise the works and

generally to act on his behalf to ensure that the contractor’s proposals are complied with.

Figure 1.3 shows the normal pattern of relationships and indicates the lines of communication

between the parties in a design and build contract.

Contractual links exist between

(i) the client and the contractor;

(ii) the contractor and each sub-contractor;

(iii) the client and each of his independent advisers.

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Advantages

1 Single point responsibility is provided, i.e., the contractor is solely responsible for failure in

the design and/or the construction.

2 The client has only one person to deal with, namely, the contractor, whose design team

includes architects, quantity surveyors, structural engineers, etc.

3 The client is aware of his total financial commitment from the outset.

Figure 1.3: Design and build contracts: relationships of the parties

4 Close intercommunication between the contractor’s design and construction teams

promotes co-operation in achieving smoother running of the contract and prompt resolution

of site problems.

Disadvantages

1 Variations from the original design are discouraged by the contractor and, if allowed, are

likely to be expensive.

2 The client has no means of knowing whether he is getting value for money unless he

employs his own independent advisers, which adds to his costs.

3 If the contractor’s organization is relatively small, he is unlikely to be as expert on design

as he is on construction, and the resulting building may be aesthetically less acceptable.

B. Management fee

The management fee procurement route is based upon the client employing a professional

team to advise him on design and cost issues and in addition a management consultant to

advise on and supervise the construction aspects of the project. The construction work is

broken down into individual packages and let out to sub-contractors throughout the progress

of the project as and when design details are finalized. This approach enjoyed a degree of

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popularity from the early 1970s to the end of the 1980s. A survey of usage of various forms

and types of contract carried out in

20017 showed that the use of management fee contracts peaked in 1991 when 27.3% of

projects (by total value) used this form of procurement, but by 2001 this figure had fallen to

11.9%. This fall in usage is possibly a reflection of some client dissatisfaction with this

procurement route and to some extent a change in the economic climate from the 1980s.

There are two main variations of the management fee approach as identified below.

Management contracting

The principal characteristic of management contracting is that the management contractor

does none of the construction work himself but it is divided up into work packages which are

let to

works contractors, each of whom enters into a contract with the management contractor. The

latter is normally either nominated by the client on the basis of the contractor’s previous

experience of management contracting or is selected by competition based upon tenders

obtained from a number of suitable contractors for (a) the management fees and (b) prices for

any additional services to be provided before or during the construction period (unless to be

paid for on a prime cost basis, in which case the tenders will include percentage additions

required to the respective categories of prime cost). The successful contractor will then enter

into a contract with the client (e.g., the JCT Management Building Contract). The

management contractor’s role therefore is that of providing construction management service

on a fee basis as part of the client’s management team – organizing, co-ordinating,

supervising and managing the construction works in co-operation with the client’s other

professional consultants. As part of his service, he provides and maintains all the necessary

site facilities, such as offices, storage and mess huts, power supplies and other site services,

common construction plant, welfare, essential attendances on the works contractors (e.g.,

unloading and storing materials, providing temporary roads and hardstandings and removing

rubbish and debris) and dealing with labour relations matters. Figure 1.4 shows the usual

pattern of relationships and indicates the lines of communication between the parties to a

management contract. Contractual links exist between

(i) the client and each member of the design and management team (including the

management contractor);

(ii) the management contractor and each of the works contractors.

Advantages

1 Work can begin on site as soon as the first one or two works packages have been designed.

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Figure 1.4: Management contracts: relationships of the parties

2 Overlapping of design and construction can significantly reduce the time requirement,

resulting in an earlier return on the client’s investment.

3 The contractor’s practical knowledge and management expertise are available to assist the

design team.

4 Where the nature and extent of the work may be uncertain, as in refurbishment contracts,

the design of later work packages may be delayed until more information becomes available

as the work progresses, without extending the construction period.

5 The contractor, being part of the client’s team, is able to identify with the client’s needs and

interests.

6 Because works contracts are entered into close to the time of their commencement on site,

they can be based on firm price tenders.

Disadvantages

1 Uncertainty as to the final cost of the project until the last works contract has been signed.

2 The number of variations and the amount of re-measurement required may be greater than

on traditional contracts because of the greater opportunity to make changes in design during

the construction period, because of problems connected with the interface between packages,

and because packages are sometimes let on less than complete design information.

Construction management

Construction management is similar to management contracting to the extent that it is a

professional consultant service to the client, provided on a fee basis, with the design and

construction services being provided by other organizations. The construction manager is

responsible for the organization and planning of the construction work on site and for

arranging for it to be carried out in the most efficient manner. The construction work itself is

carried out by a number of contractors, each of whom is responsible for a defined trade

package. All the trade packages together constitute the total project. Each trade contractor

enters into a direct contract with the client.

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The construction manager’s duties normally include any or all of the following:

(i) co-operation and consultation with the other members of the client’s professional team;

(ii) preparation and updating of a detailed construction programme;

(iii) preparation of materials and components flows and arranging for advance ordering;

(iv) determining what site facilities and services are required and their location;

(v) breaking down the project into suitable trade packages in consultation with the other

members of the client’s team and recommending suitable contractors to be invited to tender

for trade packages;

(vi) obtaining tenders from contractors and suppliers;

(vii) evaluating tenders and making recommendations on them to the client’s team;

(viii) co-ordinating the work of the trade contractors to ensure that it is carried out in

accordance with the master programme;

(ix) establishing all necessary management personnel on site with responsibility to manage

and supervise the project;

(x) dealing with any necessary variations to the work, providing the design manager with

estimates of their likely cost and subsequently issuing instructions to trade contractors;

(xi) submitting to the quantity surveyor applications from trade contractors for periodic

payments and all necessary documentation enabling the final accounts of trade contractors to

be settled.

Figure 1.5 shows the normal pattern of relationships between the parties and indicates the

lines of communication between them. Contractual links exist between

(i) the client and the construction manager;

(ii) the client and each of the trade contractors;

(iii) the client and each of his professional advisers (architect, quantity surveyor, engineering

consultants, etc.).

Advantages

1 The construction work is more closely integrated into the management of the project.

Figure 1.5: Construction management contracts: relationships of the parties.

Note: Lines of communication also exist between the architect and quantity surveyor and

each of the trade contractors. To avoid confusion, these lines are omitted.

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2 Close liaison between the construction manager and design manager leads to prompt

identification of and decisions relating to practical problems.

3 Detailed design can continue in parallel with construction, trade packages being let in

succession as the design of each is completed, thus shortening the project time.

4 Privity of contract between the client and each of the trade contractors provides the client

with a readier means of redress in the event of difficulties, such as delays, arising.

Disadvantages

1 The client has one more consultant and a number of contractors with whom to deal instead

of only one main contractor.

2 The client’s financial commitment is uncertain until the last of the works contracts has been

signed.

Management fee overview

There is little difference between the approaches used in management contracting and

construction management. The major difference is that in management contracting all the

works contractors are in a direct contractual relationship with the management contractor,

whereas in construction management the trade contractors contract directly with the client.

Over a period of time, a general opinion has developed stating that for experienced clients the

construction management route is possibly the preferred route of the two. Although

construction management causes the client much more administration and possibly a greater

level of risk by contracting directly with the trade contractors, it is claimed that the closer

arrangement and involvement of the client with the trade contractor is generally beneficial to

the building process. This view is possibly reflected in the 2001 RICS survey8 where, of the

management fee projects captured in the survey, only 15% were management contracts

whereas 85% were construction management contracts (percentage by value).

C. Government procurement routes

During the late twentieth and early twenty-first centuries the government was looking at ways

in which it could improve the procurement of construction works within the public sector

while at the same time encouraging greater efficiencies within the industry as a whole. In

April 2000, government policy had identified three recommended procurement routes:

Design and Build, Private Finance Initiative (PFI) and Prime Contracting. It was

recommended that traditional procurement routes should only be considered where it could

be clearly demonstrated that they provided better value than the three recommended routes.

Private Finance Initiative (PFI)

A definition of PFI is ‘Where the public sector contracts to purchase quality services, with

defined outputs from the private sector on a long-term basis, and including maintaining or

constructing the necessary infrastructure so as to take advantage of private sector

management skills incentivized by having private finance at risk’.10 Although PFI is one of

the preferred procurement routes for government works there are limits as to its suitability. Its

use is recommended where it offers clear value for money, and is considered to be more

appropriate for large projects, i.e., in excess of £20m, and projects that have significant

ongoing maintenance requirements.11 To illustrate the limited use of PFI the government

estimated that it would account for only 11% of its total investment for 2003–2004. There are

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a number of ways in which PFI may operate but perhaps the most common is ‘build own-

operate-transfer’ (BOOT). In this situation contractors would be provided with details of the

client’s requirements, regarding function, facilities, maintenance, etc. and be asked to tender

for the scheme. The successful tenderer (often a consortium of companies) would be

responsible for the design and construction work, and on completion it would continue to be

responsible for the running and maintenance of the works.

This responsibility may run for a set period of time, e.g., 20–30 years where upon the works

revert back to the government or local authority. Also within the PFI agreement is a payment

mechanism to allow the PFI contractor to be reimbursed all its construction, finance and

maintenance costs. The payments will not normally commence until the work is finished and

is operational. Obviously if the PFI contractor performs inefficiently then the payments may

not be sufficient to cover its costs and generate any profit, and that is the risk the contractor

takes. Since its inception PFI has been used to provide numerous facilities: schools, hospitals,

leisure centres, bridges, roads, tram systems and rail links, e.g., the Channel Tunnel Rail Link

was a PFI project valued at £4178m. There are conflicting views as to the benefits of PFI but

from a report prepared by the National Audit Office they found that PFI has been able to

deliver built assets on time and within the expected price.

Prime contracting

Prime contracting has developed to a large extent as a result of reports produced in the 1990s

(Constructing the Team, Sir Michael Latham and Rethinking Construction, Sir John Egan),

which encouraged the use of teamwork and the integration of the whole supply chain into the

construction process. The general principle is that the work will be undertaken by a prime

contractor who will be responsible for bringing together, co-ordinating and managing the

supply chain (i.e., all the organizations necessary for carrying out the works – designers,

engineers, sub-contractors, suppliers, etc.). A prime contractor does not have to be a

contracting organization, the term is used to identify any organization that is capable of

providing the above service, therefore the role may be taken by a designer, project manager,

contractor, etc. The claimed advantage of the system is that the prime contractor will provide

a single point responsibility and should bring to the client’s project a wellestablished supply

chain that has a proven working relationship, an ability to contribute to all aspects of the

project in a harmonious relationship which should lead to a reduction in the client’s capital

and maintenance costs. The system is designed to overcome the traditional fragmented nature

of the UK construction industry and seeks to remove the adversarial approach adopted on

many projects. Prime contracting is not just concerned with the initial provision of a building,

there is also a general expectation that the prime contractor must be able to demonstrate

during the early occupation of the project that the cost and performance requirements can be

met which may well require the prime contractor to employ value management techniques. It

is also recommended that consideration should be given to letting the contract on a target cost

basis with the prime contractor (and the whole supply team) having a financial share in any

savings that may be made but with them also being liable for a share of any overspend

incurred.

E. Project management

Project management is not a procurement system in itself, in that it does not include the site

construction process but only its general supervision. It has been defined as ‘the overall

planning, control and co-ordination of a project from inception to completion aimed at

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meeting a Client’s requirements in order that the project will be completed on time within

authorized cost and to the required quality standards’. A number of project management

organizations came into existence during the late 1970s and 1980s to meet the need for the

management of projects, which were becoming larger and increasingly complex. Many

clients do not have the in-house skills and experience necessary for the successful

management of construction projects and so need to employ an independent project

management company to do it for them. Quantity surveyors, by their training and experience

in financial and contractual matters, coupled with a detailed knowledge of construction

processes, are well qualified to offer a project management service, and a number of

established quantity surveying practices have set up associated companies offering such a

service. Other groups of professionals, such as architects, engineers, and building and

valuation surveyors, are also now filling this role. The project manager, in effect, becomes

the client’s representative, with authority to supervise and control the entire planning and

building operation from acquisition of the site to completion of the project and settlement of

the accounts. The service he provides is essentially one of planning, organizing and co-

ordinating the services provided by surveyors and lawyers in relation to site acquisition; the

architect, engineers and quantity surveyor in relation to project planning and design; and the

contractor and subcontractors in carrying out the site construction work; but does not include

the carrying out of any of their duties himself. Figure 1.6 shows the normal pattern of

relationships between the parties and indicates the lines of communication between them.

Contractual links exist between

(i) client and project manager;

(ii) client and each of his professional advisers;

(iii) client and contractor;

(iv) contractor and each sub-contractor.

F. Partnering

The use of partnering was developed by a number of state authorities in the US during the

1980s and met with a degree of success, and as a consequence during the 1990s the idea of

partnering came to prominence in the UK. Partnering is similar to project management in the

fact that it cannot really be categorized as a procurement route but unlike project management

it does not create a management structure for the delivery of the client’s project. In its

simplest form partnering is a philosophy of introducing trust and teamwork into the

construction process, engendering commitment to common objectives, encouraging a shared

focus on the project and on how it may best be delivered, seeking solutions to problems and

removing adversarial attitudes. The principle of partnering should extend through the whole

supply chain, it should be seen as an alliance between client, consultants, contractor and

subcontractors. If a contractor fails to encourage the same principles between himself and his

suppliers and sub-contractors then the client is unlikely to reap the full rewards of the system.

Where partnering is to be used on a project it is recommended that a project agreement is

drawn up that will identify the partnering principles to be employed throughout the project

and signify the parties’ commitment to those principles. The problem with some early

projects where partnering was tried was that the parties involved were not totally clear on

how the process should operate and there were reports of early projects eventually reverting

back to the old adversarial approach. As a consequence it was claimed that partnering could

not really exist on trust alone, and what was needed was a more rigid structure at the outset

which has led to the publication of at least three standard forms of agreement for partnering,

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PPC 2000 produced by the Association of Consultant Architects, the NEC Partnering

Agreement (Option X12) and the Public Sector Partnering Contract (PSPC) developed by

Knowles Management and the Federation of Property Societies. PPC 2000 is a contract for

the project, which all the partnering members are required to sign. The contract contains

express terms on how the partnering approach is to operate as well as all the normal terms

relating to the administration of a project, e.g., payment, insurance, variations and extensions

of time. The NEC and PSPC partnering arrangements adopt a different approach; they are in

fact optional documents that may be incorporated into standard forms of contract, as such

they are much shorter documents as the bulk of their content is based solely around the

partnering principles.

Figure 1.6: Project management-relationships of the parties

Framework agreements

The advantages of partnering is that it should put the parties in a win/win situation, the site

construction process should run more smoothly, there is scope for increased innovation and

improvement in quality, less waste in time and resources and overall better value for money.

However, these advantages may not be quite so evident in one-off projects and it is claimed

that a client with an ongoing programme of construction works is more likely to benefit from

the accumulation of partnering benefits that may be acquired through strategic alliances.

Similar arguments can also be applied to prime contracting and as a result a number of clients

(e.g., BAA, NHS, the Prison Service) with a large and continuous construction programme

have developed the idea of producing framework agreements. The principle involved is that a

number of key organizations or consortiums within the construction industry (architects,

engineers, surveyors, contractors) are put through a vigorous pre-qualification process which

if successfully concluded results in them becoming the client’s preferred bidders in future

projects. Thus, the framework agreement allows for more continuity within the parties and

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allows the partnering benefits to grow and accumulate. The JCT have produced two standard

forms of framework agreement one binding (FA) and one non-binding (FA/N).

G. Joint venture

This is an arrangement for building procurement which has developed out of the increasing

complexity of construction projects, often with unorthodox methods or sequences of

construction. It is applicable to large-scale projects of, say, £5m value or more, where there is

a higher than normal proportion of engineering and other specialist services. It has been

defined as follows: A partnership between two or more companies covering building,

mechanical and electrical engineering, or other specialist services for the purpose of

tendering for, and executing a building or civil engineering contract, each of the participating

companies having joint and several liability for their contractual obligations to the employer.

The basis of such projects is a single contract to which all the partner companies to the joint

venture are signatories. Any of the standard forms of contract in current use may form the

contract document, and in the publication just quoted the NJCC recommended the use of JCT

standard forms for projects not primarily of an engineering nature. Modifications will need to

be made to cover joint and several liability of the participating companies and to provide for

any performance warranty which the Employer may require. Joint venture has the effect of

making specialist contractors, who under more orthodox arrangements would be sub-

contractors, partners with the building contractor. This does not preclude the use of sub-

contractors (whether, named or listed), a role which is filled by secondary specialist

contractors who are not partners in the joint venture.

Advantages

1 The combined resources of participating companies result in greater economy in the use of

specialist manpower, design and equipment.

2 There is a greater degree of unified action between the contracting parties.

3 Lines of communication between the Employer’s professional advisers and the building

contractor and specialist contractors are shorter and better defined.

4 Improved integration of work sequences results in a shorter contract time and fewer

management problems.

Disadvantages

1 If one JV partner withdraws, the remaining partner or partners must accept total liability to

complete the project.

2 A separate, unified JV bank account must be arranged and maintained by all the partners.

3 Separate insurance policies must be taken out on behalf of all the JV partners, specifically

for the proposed project.

4 A board of management with a single managing director needs to be appointed jointly by

the JV partners to ensure unified actions.

The pattern of relationships in a Joint Venture project and the lines of communication

between the parties are similar to those illustrated in Figure 2, but with the JV partners

together fulfilling the role of ‘Contractor’.

Contractual links exist between

(i) the JV participating companies;

(ii) the Employer and the JV partners collectively;

(iii) the Employer and each of his professional advisers;

(iv) the JV partners and each of the sub-contractors.

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2. Post-contract cost control

Introduction

For the purposes of this text, post-contract cost control is defined as the control of costs after

the contract has been awarded to carry out the building work. The emphasis is on the cost

control from the contractor’s perspective, but the client, the sub-contractors and suppliers are

also looking to control their costs. Mention will be made from time to time about the client’s

cost control mechanisms, as whilst similar, the emphasis can be different especially since the

client is usually looking at much longer period for its returns.

Pareto’s Law

Pareto’s Law states that:

In any series of elements to be controlled, a selected small fraction of items in terms of

number of elements almost always accounts for a large fraction in terms of effect.

Conversely the majority of items are only of minor significance in their overall effect. Simply

put, 20 per cent of your decisions will affect 80 per cent of your business. This is similar in

principle to ‘management by exception’. A typical example to demonstrate this is

approximately 80 per cent of all construction work is carried out by only 20 per cent of the

companies, the remaining 80 per cent carrying out 20 per cent of the work. In other words it

is unproductive to spend an equal amount of time controlling each element, in this case costs,

but rather to concentrate on controlling the key elements. Figure 2.1 illustrates this point.

Figure 2.1: Pareto’s Law

The significance in controlling construction costs is that there are potentially a large number

of cost centres that can be created. The numbers of items in bills of quantities clearly

demonstrates this. If the cost-control system developed and adopted becomes too detailed

then the cost of controlling costs becomes disproportionate to the benefit derived. Therefore

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rather than design a system of cost control which considers every item it is better to

concentrate on the key elements.

The basic needs of a cost-control system for the contractor and client

Any cost-control system used by the contractor must ensure payment for work done by

having automatic triggers built in. It should be able to monitor costs as the work progresses at

least monthly and indicate the amount of losses or gains being made, anticipating any cash-

flow problems. There should be limitations in the system that prohibit any changes to the

work in excess of a given amount without the authority of senior management. Similarly,

certain personnel may have restrictions on the amount they can spend without recourse to a

senior person. It should be transparent and understood by all those whom it affects, whether

in-house, suppliers or subcontractors. The client needs a system that does not permit any

alteration to the tender cost of the contract without authorisation by either the client or

representatives. The client or representatives should agree any changes made which affect the

tender sum above a certain limit before the instruction is given to the contractor. Any likely

overspend from the agreed budget should be highlighted as soon as possible to enable the

employer to have time to finance the excesses or rein back expenditure to the initial budget.

The system should be such that the client can monitor, on a monthly basis, the current

financial state of the project. It should be readily understood by the client, representatives and

the contractor.

Cash Flow

Cash flow is the transfer of money into and out of a company. As indicated previously, the

developer needs to know what financial demands are going to be made during all stages of

the development. Equally, contractors need to know about their predicted cash flow to be able

to cover any deficit in funding. Remember the contractor aims to cut this to a minimum as the

margins on a contract are small and any interest paid on money borrowed will eat into this. In

practice, on a traditional contract using the bills of quantities the timescale is as follows. To

save time the contractor’s quantity surveyor will produce an interim valuation of the work

that has been carried out by the contractor during the month. A meeting then takes place with

the client’s quantity surveyor (PQS) on site at the start of the following month and this

valuation will be agreed. It normally takes one week for the PQS to submit this valuation to

the architect. Usually the architect takes two weeks before issuing a certificate, and

depending on the clause in the contract the employer is obliged to pay the contractor the

agreed amount within 14 days. This can sometimes be 28 days. Generally, from completing

the month’s work the contractor is paid within four to five weeks. It used to be that when the

contractor received this money, the subcontractors would then be paid. However, this practice

on major works has largely died out, as the sub-contractor is entitled under their contract with

the main contractor to receive their payment after a fixed period of time, often 28 days. In

practice this means that by and large the main contractor receives payment at the same time

as it is necessary to pay the sub-contractor. It is important this latter payment is made, as the

sub-contractor has to pay the staff and operatives carrying out the work, many of whom will

be paid hourly which means they are paid the week following the one they have worked.

Withholding this payment could land the sub-contractor in a financially difficult position.

The tightness of the timescale also reinforces the previous discussion on the importance at the

25

decision on whether or not to tender, by the main contractor, in establishing the financial

strength and reliability of the client’s payment record.

Figure 2.2: a) S-curve: client paying the contractor; b) front-loaded S-curve

S-curve

An S-curve is a graph plotting the cumulative income against time. The time scale is

normally in monthly increments to coincide with the way contractors are paid by the client.

The S-curve in Figure 2.2a demonstrates what happens when the client pays the contractor.

At the end of each month, the contractor submits an interim valuation for the sum of work

carried out. However, these monthly valuations will not be paid for another 4 to 5 weeks,

shown by the horizontal line on the steps. The vertical line on the steps represents the interim

payment from the client. If the payment is made within the month then it can be seen that the

main contractor will not have a cash-flow problem. However if the contractor front-loads the

tender by a small amount, then as can be seen in the Figure 2.2b, the contractor receives the

money from the client well before it is necessary to pay the sub-contractors. The cash-flow

deficit probability is then limited to the back end of the contract.

Further refinements

To carry out a full and detailed calculation, there are many more factors to consider. Adapted

from Harris and McCaffer (2001), Table 13.1 shows these factors and indicates how the

calculations are derived. These would be carried out at monthly intervals throughout the

duration of the contract in a similar way to that used in calculating discount cash flow.

26

Table 2.1: Factors affecting cash-flow calculations

27

Figure 2.3: Monitoring trends

Monitoring using the S-curve

one can see what is happening and the results. Figure 2.3a represents the budget forecast of

expenditure and the work actually carried out at a point in time on the project. This graph can

be produced for the project costs or sections, such as materials. In this case the trend is

positive. Figure 2.3b represents the budget forecast as before, but in this case the actual value

of work carried out is less. Any continuing trend in this direction will result in increased

financial problems for the company.

Saw-tooth diagram

Another means of demonstrating the cash flow is by using a saw-tooth diagram. In many

ways this is a better way of demonstrating the position so it can be seen what financing is

required month by month. The cash flow is shown in linearly, plotting negative and positive

cash flows against time. At the start of the contact as shown in Figure 2.4, the interim

payment for the first month’s work is received at the end of the second month

(approximately) as shown by the vertical line and so on throughout the duration of the

project. For simplicity is assumed the expenditure is constant through out each month,

although in practice this may not be the case. In this example, the lowest point of negative

cash flow occurs at month six. This is the maximum cash requirement the contractor has to

provide to fund the project and it would be important to know this at the tender stage

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Figure 2.4: Saw-tooth diagram

If during the course of the contract the position worsened because of delays, then this would

be continually looked at the see what the implications are. At month 12, the defects liability

period commences, the end of which the retention monies are paid. The final profit released

is shown at the end of the defects liability period. It is possible to superimpose the actual

position in terms of valuation or cost on this diagram

Bad practices

There are a number of questionable practices that have arisen over the last few decades which

assist the contractor and sub-contractor to maintain a good cash flow. Since Latham (1994),

and subsequently Egan (1998), there has been a trend and pressure to eliminate such practices

and be more open with the client and those involved in the design and construction processes.

This trend must be continued for the health of the industry especially with the development of

supply chain management and partnering initiatives.

Practices to be avoided include:

• front-loading: not changing the total tender price, but increasing the items constructed early

and reducing those at the end to balance the overall price;

• back-loading: at times of high inflation, loading he latter items to be constructed at the

expense of the earlier ones;

• over measurement: for example agreeing that a floor on a multi-storey reinforced concrete

building is 7/8 complete rather than the 3/4 in reality;

• delaying payments to sub-contractors and suppliers until receiving payment for the client;

this may incur a loss of discount for not paying within the contracted period for payment, but

may still be profitable;

• entering into dispute with the sub-contractor over variations to delay payment;

• disputing the account to delay payment.

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The client’s representatives can employ similar practices:

• entering into dispute with the contractor over variations for work done

• disputing the accounts;

• delaying passing information to the architect for the issuing of interim certificates;

• delay issuing the interim certificates.

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3. Site and Location analysis

Prior to purchasing a building site it is essential to conduct a thorough analysis to ascertain

whether the site characteristics suit the development concept

Aims of Site Analysis

To achieve a successful design, site analysis is a must & should be done carefully.

Site Analysis involves taking an inventory of site elements and analyzing these factors

relative to the clients needs & aims.

To gather relevant information about the site, from it's topography to it's climate, wind

patterns and vegetation.

To analyze these features and incorporate them into the design

Site Analysis: Inventory List

1. Measured Survey and Inspection of existing Buildings

Conduct a Measured Survey to establish site dimensions and levels.

Note suspicious factors such as filled ground, cracks in the ground, subsidence due to

mining and any cracks in the existing and adjacent buildings

2. Old Maps

OS Maps: Refer to old maps, preferably 1890's and 1950's editions to determine

position of ponds, ditches that have been filled in and the location of old mine shafts

etc.

Street Names: Look at street names! Sandy Lane or Bog Street could suggest poor

ground and more expensive foundations.

Past Uses: Consider past uses of buildings as a clue to the possibility of

contamination. Examples such as old tanneries or old garages could result in a costly

clear up. (Contaminated Land Act1991)

3. Subsurface Features

Geology: Geological history of the area, bedrock type & depth etc.

Soil Investigation: Susceptibility to erosion, plasticity of clay, moisture content,

acidity (pH), organic content, bearing capacity etc. Use trial holes and borings to

determine soil quality and water table level

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Trial Pits: Minimum size to provide access for operatives is 1200 x 1200 mm.

Maximum economic depth is 4000mm.

For use on dry ground which requires little or no temporary support to the sides

Also used to expose and / or locate underground services.

Hand Augur Holes: Diameter range is 50 to 150mm. Maximum economic depth is

6000mm.

For use on dry ground but liner tubes could be used if required to extract subsoil

samples at a depth beyond the economic limit of trial holes.

Mechanical Augur: Suitable for depths over 3000mm

A liner or casing is required for most granular soils and may be required for other

types of soil

4. Flood Potential

Refer Environment Agency Flood Maps.

Rainfall charts

Possibilities for drainage of water table

Capping of springs, filling of ponds, diversion of streams and rivers

5. Natural Surface Features

Wildlife: ecology, species etc. The Wildlife and Countryside Act 1981 imposes strict rules as

to what you can and can't do on site. Be wary of badger sets, barn owls, bats and rare pond

life and fauna

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6. Natural Surface Features

Slopes: Gradient,

landforms, elevations,

drainage patterns

Orientation: wind direction,

solar intensity &

orientation,

average/highest/lowest

temperature

Vegetation: Type, size,

location, shade pattern,

aesthetics, ecology etc. Be

very aware of invasive

plants such as Japanese

Knotweed.

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7. Cultural & Man-made Features

Utilities: sanitary, water supply, gas, electrical, broad band etc.

Social Factors: population, intensity, educational level, economic & political factors,

ethnicity, cultural typology etc.

Land use: Usage of site, adjacent use, zoning restrictions, easement etc.

Historic notes: archaeological sites, landmarks, building type, size, condition

Location Analysis

A location analysis allows a client / developer to assess the most important factors affecting

viability and feasibility

It will consider the physical and legal attributes of a project. These are evaluated in relation to

its specific location

Consider the buzzwords: Location, location, location!

Location Analysis & the Immediate Area

The dimensions of the site determines:

Shape of the property

The placement of structures

Consider the number of sides a site possesses:

A multi-sided parcel is more suitable for retail

One-side parcel is more suitable for residential

Consider the functional layout of the facilities on site:

Ease of ingress to and egress from the site

Placement of structures and parking areas

Key to the site’s marketability

Where are the best views?

Location Analysis & Zoning

Consider the zoning in the area.

Contact the local planning

department at an early stage to

discuss your proposal with a

planning officer.

View the structure plan

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Your proposed land use may be at

saturation level or alternatively the

planning department could look at

your proposal favourably.

Consider the degree of “friction”

How well the site is linked to its environment?

What would be the traffic flow inward or outward (goods, services, or people)?

How convenient is access and what would be the level of aggravation ?

What would be the mode of transport for goods?

What is the overall level of access to the site?

Are there any low bridges that could create problems for delivery of materials?

The Situs Factor

What is it?

“Relationship between the surrounding environment and a specific land use on a specific land

parcel over a given time”

A function of time as well as space

Basic theory:

- land uses are interdependent and economic activities are interrelated

- site is physically fixed but economically flexible

Why consider the situs factor?

Economic forces outside the land parcel alter the relationships of its use

Activities conducted on the site and the economic nature of the site can change over

time

Location analysis of a site cannot be separated from the life cycle of a neighbourhood

It links highest-and-best use and market analysis

Situs Analysis: Method

Carry out comprehensive research as to the identification of the key activities

undertaken in the area

Study the nature of the associations between these activities

Analyse the accessibility of the site to the surrounding area

Evaluate the impact of the surrounding area on the site’s use

35

Market Boundaries

Economic activities in the neighbourhood or trade area are separated by:

physical, political, and socio-economic boundaries

time-distance relationships (travel times) to and from common destinations

Identification of Activities

What other activities are carried out in the area.

Major anchor tenants such as 'Tesco plc.' can act as magnets to attract other activities /

customers to an area.

Look at the Neighbourhood:

Who are the major employers?

What are the current recreational facilities?

What are the current services?

Carry out market research:

What do the public feel is missing?

How responsive would they be to your proposal?

What are the associations between the surrounding activities land uses?

Activities may be:

- complementary

- subservient

- competitive

- even repel one another

Land use can be:

- dominant use/subordinate use;

- dominant use/ancillary use;

Aesthetic Factors: These can be

Perceptual: from motor vehicle, by pedestrian, by bike etc.

Spatial Pattern: views of the site, views from the site, spaces existing, potential for

new areas.

Natural Features: significant natural features of the site, water elements, rock

formations, plant materials. Can a feature be created?

Accessibility Analysis

36

Degree of convenience or inconvenience involved in moving people, goods, and

services between different locations of activity

Degree of friction, or inconvenience, measured in terms of time, cost, and

aggravation.

Accessibility on two levels:

Flow of people between one area and another

Entry and exit from the property, and the immediate area of the site

Further reading includes:

Fryer. 1990. The Practice of Construction Management. BSP. Oxford.

Griffith and Watson. 2004. Construction Management Principles and Practice. Palgrave.

Basingstoke.

37

4. Advising the client

How do we communicate?

•CVs, Resumes

•Email, Web site, FAQs

•Letters, Newsletters, Brochures, Articles, Catalogues

•Advertisements, Notice Boards, Pamphlets, Signs, Press Release

•Presentations, multimedia, talks

•Reports, Manuals, Proposals, Books

Why is it important?

•You need to express your ideas / findings so that

the reader or audience understands.

•"I didn't mean that" or "I knew that" is no

excuse.

•It needs to go from your brain to the readers!

Legal Issues

•If you are giving professional advice you need to

agree conditions of engagement.

•this applies to verbal advice as well as written

advice

•If you tell the client something and they act on it,

even though they do not pay you, you can be held

negligent in a court of law and be liable for

damages

•Do not give advice beyond your area of

experience. Your PI insurance may become

invalid.

•Do not give advice to friends and family without

a formal contract

What is a report?

•report (noun) a statement of facts; a formal or official statement, such as of results of an

investigation or matter referred… …

The Chambers Dictionary

38

•A report is a document that is meant to contain material that will be of use and interest to

those reading

MUNROE (2006)

Identify your Audience

•Who is your audience?

Is it an academic report?

Is it a professional report?

Who is the primary reader?

Who is the secondary reader?

•What is the audiences level of knowledge?

This will effect your reporting style and use of technical terms

What do the readers need to know?

•What kind of relationship do you wish to establish between yourself and the reader

Repeat business?

adapted from Wainwright (1984)

39

Define Your Objective

•What are the instructions?

•What is the question or assignment brief?

•For what purpose will the report be used?

•What are you trying to tell your client?

•How will you ensure that they will get satisfaction?

Organise your ideas

•Is there a required format, maximum word count?

•Are photographs needed, relevant?

•Are sketch plans needed?

•Do you need to research your ideas?

•Give your tutors time to answer any queries!

Writing Style

Make sure it is easy to read. Do not over complicate things

Use clear, concise language

Adopt short sentences

Use examples where appropriate to illustrate argument

Do not use information unless you fully understand what it means

Place more important information where it will be seen:

First and last paragraphs in a section

The start of the paragraph

Keep paragraphs simple:

Short paragraphs

Each paragraph should contain one main point

For font size and spacing you should refer to the assignment brief

Do not use too fancy a font style and try not to use any more than 5 different sizes and

5 different colours in your report as a whole

Do not make positive statements unless you are absolutely positive that there is no

doubt. You can be sued for negligence when you think you were being helpful

Use caveats where necessary but avoid repeating the same caveat or using an

unnecessary amount. It will annoy your client

40

41

Photos

•Use photographs where relevant

•A good photo can save many a word

•Do not use blurred or photos of too small a size

•Incorporate photos into the text. They provide interest for the reader

•Avoid putting the photos together in an appendix

•Do not duplicate photos unnecessarily

42

Executive Summary

•Concise summary of the essential elements of the report

•Purpose

•Scope

•Main points

•Conclusions

•Recommendations

43

•Can be read on its own and attached loosely

•Short, only 10-15% of the length of the report (maximumONE side)

Table of contents

•Use the Microsoft word 2010 to automatically create and update your table of contents

•This can also be done for the list of figures and photos.

•Do not forget to update the entire field if you carry out any alteration!

Introduction

•This should state the purposes of the report

•It maybe necessary to repeat the letter of instruction / assignment question.

•State any assumptions you have made and methods used.

•Briefly state the circumstances of the report and any unusual limitations.

•It should not give details that are repeated in the main body of the report

Main Body / Discussion

•This is the area where you need to express your findings research to the reader / target

audience.

•You need to decide upon the format you intend to use. The suitability of a format will

change with the task. A word document is the norm but PowerPoint presentations or video

could also be an option

44

•In the case of a survey you will need to decide if it best suited to a room by room analysis or

on an elemental basis?

•It is possible that the exterior could be covered on an elemental basis and the interior on a

room by room basis. This is relevant where there will be repetition of accommodation such as

a hotel

Presentation

•There is nothing worse that a client paying big money for a report and receiving something

that looks like it has been sat upon and used as a coffee mat. Similarly a tutor will instantly be

put in a bad mood if a piece of work is unbound and has a mistake in the first paragraph.

•Make it look good and think to yourself:"Would I be happy to pay money for what you are

producing?"

Conclusions / Recommendations

•No new material introduced or references

•It should follow logically from the Main Body

•Conclusions section should give:

Key points

It should NOT just be another Executive Summary

Recommendations will not always be appropriate

List areas for further investigation or study

45

References / Bibliography

•You must cite references for all sources of information that you have used including media

•Use Harvard Method of referencing

•Acknowledge in:

Main body of report

In a bibliography or a reference list at end of the piece or work (including

presentations)

•List anything you have read when carrying out your research but haven't actually directly

included in the Bibliography.

•Refer to SHU leaflet or follow link below

•https://staff.shu.ac.uk/lits/documents/Referencing_Leaflet_2008.pdf

Plagiarism

•I didn't know I was cheating is no excuse!

•Refer to SHU publication:

•http://shuspace.shu.ac.uk/webapps/portal/frameset.jsp

46

47

Style and Vocabulary

•George Orwell said:

never use a long word when a short

word will do

if it is possible to cut a word out,

always do so

never use a scientific name, a foreign

phrase or jargon if you can think of an

everyday equivalent

Photo

Conclusion

•You can advise the client in a number of words, not just a written report

•You should know your audience before deciding upon the format

•Your advice should be structured and have an introduction, main body and conclusion

•Do not overcomplicate, No one likes a smart arse

•Be aware of referencing and plagiarism.

48

5. Corporate strategy

Introduction and Objectives

Corporate strategy is concerned primarily with the decisions over the scope of the firm’s

activities, including:

Product scope. How specialized should the firm be in terms of the range of products it

supplies? Coca-Cola (soft drinks), SAB Miller (beer), Gap (fashion retailing), and

Swiss Re (reinsurance) are specialized companies: they are engaged in a single

industry sector. General Electric, Samsung, and Bertelsmann are diversified

companies: each spans a number of different industries.

Geographical scope. What is the optimal geographical spread of activities for the

firm? In the restaurant business, Clyde’s owns 12 restaurants in the Washington DC

areas, Popeye’s Chicken and Biscuits operates throughout the US, McDonald’s

operates in 121 different countries.

Vertical scope. What range of vertically linked activities should the firm encompass?

Walt Disney Company is a vertically integrated company: it produces its own movies,

distributes them itself to cinemas and through its own TV networks (ABC and Disney

Channel), and uses the movies’ characters in its retail stores and theme parks. Nike is

much more vertically specialized: it engages in design and marketing but outsources

many activities in its value chain, including manufacturing, distribution, and retailing.

Business strategy (also known as competitive strategy) is concerned with how a firm

competes within a particular market. The distinction may be summarized as follows:

corporate strategy is concerned with where a firm competes; business strategy is concerned

with how a firm competes. The major part of this book has been concerned with issues of

business strategy. For the next four chapters, the emphasis is on corporate strategy: decisions

that define the scope of the firm. There are three different dimensions of scope – vertical

scope (vertical integration), geographical scope (multinationality), and product scope

(diversification). However, as we shall discover, the key underlying concepts for analyzing

these different dimensions – economies of scope in resources and capabilities, transaction

costs, and costs of corporate complexity – are common to all three.

First we begin by considering the overall scope of the firm. We then focus specifically on

vertical integration, since it takes us to the heart of the determinants of firm boundaries – in

particular, the role of transaction costs. Moreover, vertical integration has been a central issue

in corporate strategy in recent years as outsourcing, alliances, and e-commerce have caused

companies to rethink which parts of their value chains they wish to include within their

organizational boundaries.

By the time you have completed this chapter, you will be able to:

Identify the relative efficiencies of firms and markets in organizing economic activity

and apply the principles of transaction cost economics to explain why boundaries

between firms and markets have shifted over the past two hundred years.

49

Assess the relative advantages of vertical integration and outsourcing in organizing

vertically related activities, understand the circumstances that influence these relative

advantages, and advise a firm whether a particular activity should be integrated within

the firm or outsourced.

Identify alternative ways of organizing vertical transactions – including spot market

transactions, long-term contracts, franchise agreements, and alliances – and advise a

firm on the most advantageous transaction mode given the characteristics and

circumstances of the transaction.

Transaction Costs and the Scope of the Firm

In Chapter 6, we noted that firms came into existence because they were more

efficient in organizing production than were market contracts between independent

workers.

Let us explore this issue and consider the determinants of firm boundaries.

Firms, Markets, and Transaction Costs

Although the capitalist economy is frequently referred to as a “market economy,” in fact, it

comprises two forms of economic organization. One is the market mechanism, where

individuals and firms make independent decisions that are guided and coordinated by market

prices. The other is the administrative mechanism of firms, where decisions over production,

supply, and the purchases of inputs are made by managers and imposed through hierarchies.

The market mechanism was characterized by Adam Smith, the 18th-century Scottish

economist, as the “invisible hand” because its coordinating role does not require conscious

planning. Alfred Chandler has referred to the administrative mechanism of company

management as the “visible hand” because it is dependent on coordination through active

planning.

Why do institutions called “firms” exist in the first place? The firm is an organization that

consists of a number of individuals bound by employment contracts with a central contracting

authority. But firms are not essential for conducting complex economic activity. When I

recently remodeled my basement, I contracted with a self-employed builder to undertake the

work. He in turn subcontracted parts of the work to a plumber, an electrician, a joiner, a

drywall installer, and a painter. Although the job involved the coordinated activity of several

individuals, these self-employed specialists were not linked by employment relations but by

market contracts (“$4,000 to install wiring, lights, and sockets”). What determines which

activities are undertaken within a firm, or between individuals or firms coordinated by market

contracts? Ronald Coase’s answer was relative cost. Markets are not costless: making a

purchase or sale involves search costs, the costs of negotiating and drawing up a contract, the

costs of monitoring to ensure that the other party’s side of the contract is being fulfilled, and

the enforcement costs of arbitration or litigation should a dispute arise. All these costs are

types of transaction costs. If the transaction costs associated with organizing across markets

are greater than the administrative costs of organizing within firms, we can expect the

coordination of productive activity to be internalized within firms. This situation is illustrated

in Figure 5.1. With regard to vertical scope, which is more efficient: three independent

companies – one producing steel, the next rolling the steel into sheet, and the third producing

steel cans – or having all three stages of production within a single company? In the case of

geographical scope, which is more efficient: three independent companies producing cans in

the US, UK, and Italy, or a single multinational company owning and operating the can-

50

making plants in all three countries? In the case of product scope, should metal cans, plastic

packaging, and domestic appliances be produced by three separate companies, or are there

efficiencies to be gained by merging all three into a single company?

Figure 5.1: The scope of the firm: specialization versus integration

The Shifting Boundary between Firms and Markets

The answers to these questions have changed over time. During the 19th and for most of the

20th century, companies grew in size and scope, absorbing transactions that had previously

taken place across markets. Companies that once were localized and specialized grew

vertically, geographically, and across different industry sectors. This trend can be attributed

to a fall in the administrative costs of the firm as compared with the transaction costs of

markets. Two factors have greatly increased the efficiency of firms as organizing devices:

Technology. The telegraph, telephone, and computer have played an important role in

facilitating communications within firms and expanding the decision-making capacity

of managers.

Management techniques. Developments in the principles and techniques of

management have greatly expanded the organizational and decision-making

effectiveness of managers. Beginning with the dissemination of double-entry

bookkeeping in the 19th century,5 and the introduction of scientific management in

the early 20th century,6 the past six decades have seen rapid advances in all areas of

management theory and methods.

Observing this growth in large corporations at the expense of markets, several leading

economists of the late 1960s declared that the market economy had been replaced by a

corporate economy. In 1969, J. K. Galbraith predicted that the inherent advantages of firms

over markets in planning and resource allocation would result in increasing dominance of

capitalist economies by a small number of giant corporations.7 During the 1980s and 1990s,

51

these predictions were refuted by a sharp reversal of the trend toward increased corporate

scope. Although large companies have continued to expand internationally, the dominant

trends of the past 20 years have been “downsizing” and “refocusing,” as large industrial

companies reduced both their product scope through focusing on their core businesses, and

their vertical scope through outsourcing. The result, as shown in Figure 5.2, was that the

largest companies began to play a declining role in the US economy. These changes are

associated with the more turbulent business environment that followed the oil shocks of 1973

and 1979, the end of fixed exchange rates (1972), the invention of the integrated circuit, and

the upsurge of international competition. The implication seems to be that during periods of

instability, the costs of administration within large, complex firms tend to rise as the need for

flexibility and speed of response overwhelms traditional management systems. Let us focus

now on just one dimension of corporate scope: vertical integration. The question we will

consider is this: is it better to be vertically integrated or vertically specialized? To answer this

question, we shall draw in particular on Oliver Williamson’s analysis of transaction costs,

which forms the basis for a theory of economic organization that is particularly useful in

designing vertical relationships.

The Costs and Benefits of Vertical Integration

Strategies towards vertical integration have been subject to shifting fashions. For most of the

20th century, the prevailing wisdom was that vertical integration was generally beneficial

because it allowed superior coordination and security. During the past 20 years there has been

a profound change of opinion and the emphasis has shifted to the benefits of outsourcing in

terms of flexibility and the ability to develop specialized capabilities in particular activities.

Moreover, it has been noted that most of the coordination benefits associated with vertical

integration can be achieved through interfirm collaboration.

However, as in other areas of management, fashion is fickle. In the media sector, vertical

integration between content and distribution has become viewed as a critical

52

Figure 5.2: 500 biggest US companies’ share of total US private sector employment

advantage in the face of rapid technological change. The resulting wave of mergers between

content producers and distributors (TV broadcasters, cable companies, and internet portals)

has transformed the industry. Our task is to go beyond fads and fashions to uncover the

factors that determine whether vertical integration enhances or weakens performance.

Defining Vertical Integration

Vertical integration refers to a firm’s ownership of vertically related activities. The greater

the firm’s ownership and control over successive stages of the value chain for its product, the

greater its degree of vertical integration. The extent of vertical integration is indicated by the

ratio of a firm’s value added to its sales revenue. Highly integrated companies – such as the

major oil companies that own and control their value chain from exploring for oil down to the

retailing of gasoline – tend to have low expenditures on bought-in goods and services relative

to their sales. Vertical integration can be either backward, where the firm takes over

ownership and control of producing its own components or other inputs, or forward, where

the firm takes over ownership and control of activities previously undertaken by its

customers.

Vertical integration may also be full or partial:

Full integration exists between two stages of production when all of the first stage’s

production is transferred to the second stage with no sales or purchases from third

parties.

Partial integration exists when stages of production are not internally self-sufficient.

Among the oil and gas majors, “crude-rich” companies (such as Statoil) produce more

oil than they refine and are net sellers of crude; “crude-poor” companies (such as

Exxon Mobil) have to supplement their own production with purchases of crude to

keep their refineries supplied.

53

Technical Economies from the Physical Integration of Processes

Analysis of the benefits of vertical integration has traditionally emphasized the technical

economies of vertical integration: cost savings that arise from the physical integration of

processes. Thus, most steel sheet is produced by integrated producers in plants that first

produce steel, then roll hot steel into sheet. Linking the two stages of production at a single

location reduces transportation and energy costs. Similar technical economies arise in pulp

and paper production and from linking oil refining with petrochemical production.

However, although these considerations explain the need for the co-location of plants, they

do not explain why vertical integration in terms of common ownership is necessary. Why

can’t steel and steel sheet production or pulp and paper production be undertaken by separate

firms owning facilities that are physically integrated with one another? To answer this

question, we must look beyond technical economies and consider the implications of linked

processes for transaction costs.

The Sources of Transaction Costs in Vertical Exchanges

Consider the value chain for steel cans, which extends from mining iron ore to delivering

cans to food processing companies. Between the production of steel and steel strip, most

production is vertically integrated. Between the production of steel strip and steel cans, there

is very little vertical integration: can producers such as Crown Holdings and Ball Corporation

are specialist packaging companies that purchase steel strip from steel companies on

contracts.

Figure 5.3: The value chain for steel cans

The predominance of market contracts between steel strip production and can production is

the result of low transaction costs in the market for steel strip: there are many buyers and

sellers, information is readily available, and the switching costs for buyers and suppliers are

low. The same is true for many other commodity products: few jewelry companies own gold

mines; few flour-milling companies own wheat farms.

To understand why vertical integration predominates across steel production and steel strip

production, let us see what would happen if the two stages were owned by separate

54

companies. Because there are technical economies from hot-rolling steel as soon as it is

poured from the furnace, steel makers and strip producers must invest in integrated facilities.

A competitive market between the two stages is impossible; each steel strip producer is tied

to its adjacent steel producer. In other words, the market becomes a series of bilateral

monopolies.

Why are these relationships between steel producers and strip producers problematic? To

begin with, where a single supplier negotiates with a single buyer, there is no equilibrium

price: it all depends on relative bargaining power. Such bargaining is likely to be costly: the

mutual dependency of the two parties is likely to give rise toopportunism and strategic

misrepresentation as each company seeks to both enhance and exploit its bargaining power at

the expense of the other. Hence, once we move from a competitive market situation to one

where individual buyers and sellers are locked together in close bilateral relationships, the

efficiencies of the market system are lost.

The culprits in this situation are transaction-specific investments. When a can maker buys

steel strip, neither the steel strip producer nor the can maker needs to invest in equipment or

technology that is specific to the needs of the other party. In the case of the steel producer and

the steel roller, each company’s plant is built to match the other party’s plant. Once built, the

plants have little value without the existence of the partner’s complementary facilities. Once

transaction-specific investments are significant then, even though there may be a number of

suppliers and buyers in the market, it is no longer a competitive market: each seller is tied to

a single buyer, which gives each the opportunity to “hold up” the other.

Hence, where a vertical relationship between companies requires one or both companies to

make investments that are specific to the needs of the other party, a market contract will be

inefficient due to the costs of negotiating and enforcing a contract, plus bargaining,

monitoring, and dispute resolution. The basic case for vertical integration is that by bringing

both sides of the transaction into a single administrative structure, these transaction costs may

be avoided.

Empirical research gives considerable support to these arguments:

Among automakers, specialized components are more likely to be manufactured in-

house than commodity items such as tires and spark plugs. Similarly, in aerospace,

company-specific components are more likely to be produced in-house rather than

purchased externally.

In the semiconductor industry, some companies specialize either in semiconductor

design or in fabrication, while other companies are vertically integrated across both

stages (e.g. Intel, ST Microelectronics). Which is more efficient? Again, it depends on

the characteristics of the transaction between the designer and the fabricator. The

more technically complex the integrated circuit and, hence, the greater the need for

the designer and fabricator to engage in technical collaboration, the better the relative

performance of integrated producers.

If companies recognize that transaction-specific investments give rise to opportunism, why

don’t they write a contract that eliminates the potential for opportunism and misinterpretation

by fully specifying prices, quality, and terms of supply? The problem is uncertainty about the

55

future. When the steel producer and the steel sheet roller are agreeing to build their integrated

plant, it is impossible to anticipate all the circumstances that might arise over the 30-year life

of the plant. Hence contracts are inevitably incomplete.

Administrative Costs of Internalization

Just because there are transaction costs in intermediate markets does not mean that vertical

integration is necessarily an efficient solution. Vertical integration avoids the costs of using

the market, but internalizing the transactions means that there are now costs of

administration. The efficiency of the internal administration of vertical relations depends on

several factors.

Differences in Optimal Scale between Different Stages of Production

Suppose that Federal Express requires delivery vans that are designed and manufactured to

meet its particular needs. To the extent that the van manufacturer must make transaction-

specific investments, there is an incentive for Federal Express to avoid the ensuing

transaction costs by building its own vehicles. Would this be an efficient solution? Almost

certainly not: the transaction costs avoided by Federal Express are likely to be trivial

compared with the inefficiencies incurred in manufacturing its own vans. Federal Express

purchases over 40,000 trucks and vans each year, well below the 200,000 minimum efficient

scale of an assembly plant. (Ford produced two million commercial vehicles in 2005.)

The same logic explains why specialist brewers such as Anchor Brewing of San Francisco or

Adnams of Suffolk in the UK are not backward integrated into cans and bottles like Anheuser

Busch or SAB Miller. Dedicated can-making plants involve specific investments, creating

problems of opportunism that vertical integration can avoid. However, small brewers simply

do not possess the scale needed for scale efficiency in can manufacture.

Developing Distinctive Capabilities

A key advantage of a company that is specialized in a few activities is its ability to develop

distinctive capabilities in those activities. Even large, technology-based companies such as

Xerox, Kodak, and Philips cannot maintain IT capabilities that match those of IT services

specialists such as EDS, IBM, and Accenture. The ability of these IT specialists to work with

many different customers stimulates learning and innovation. If General Motors’ IT

department only serves the in-house needs of GM, this does not encourage the rapid

development of its IT capabilities.

However, this assumes that capabilities in different vertical activities are independent of one

another. Where one capability builds on capabilities in adjacent activities, vertical integration

may help develop distinctive capabilities. Thus, IBM’s half-century of success in mainframe

computers owes much to its technological leadership in semiconductors and software. The

efficiency of Wal-Mart’s retailing operations depends critically on specialized IT and

logistics from its in-house departments.

Managing Strategically Different Businesses

These problems of differences in optimal scale and developing distinctive capabilities may be

viewed as part of a wider set of problems – that of managing vertically related businesses that

are strategically very different. A major disadvantage to FedEx of owning a truck-

manufacturing company is that the management systems and organizational capabilities

56

required for truck manufacturing are very different from those required for express delivery.

These considerations may explain the lack of vertical integration between manufacturing and

retailing. Integrated design, manufacturing, and retailing companies such as Zara and Gucci

are comparatively rare. Most of the world’s leading retailers – Wal-Mart, Gap, Carrefour – do

not manufacture. Not only do manufacturing and retailing require very different

organizational capabilities, they also require different strategic planning systems, different

approaches to control and human resource management, and different top management styles

and skills.

Strategic dissimilarities between businesses have encouraged a number of companies to

vertically de-integrate. Marriott’s decision to split into two separate companies, Marriott

International and Host Marriott, was influenced by the belief that owning hotels is a

strategically different business from operating hotels. Similarly, Britain’s major brewing

companies have all de-integrated: Whitbread plc divested its breweries and specialized in

pubs, restaurants, and hotels; Scottish & Newcastle sold off most of its pubs and hotels to

become a specialist brewer.

The Incentive Problem

Vertical integration changes the incentives between vertically related businesses. Where a

market interface exists between a buyer and a seller, profit incentives ensure that the buyer is

motivated to secure the best possible deal and the seller is motivated to pursue efficiency and

service in order to attract and retain the buyer. Thus, market contracts gives rise to what are

termed high-powered incentives. Under vertical integration there is an internal supplier–

customer relationship that is governed by corporate management systems rather than market

incentives. Performance incentives exist, but these are low-powered incentives – if Shell’s

tanker fleet is inefficient and unreliable, then employees will lose their bonuses and the head

of shipping may be fired. However, these consequences tend to be slow and undramatic.

One approach to creating stronger performance incentives within vertically integrated

companies is to open internal divisions to external competition. As we shall examine more

fully in Chapter 16, many large corporations have created shared service organizations where

internal suppliers of corporate services such as IT, training, and engineering compete with

external suppliers of the same services to serve internal operating divisions.

Competitive Effects of Vertical Integration

Monopolistic companies have used vertical integration as a means of extending their

monopoly positions from one stage of the industry to another. The classic cases are Standard

Oil, which used its power in transportation and refining to foreclose markets to independent

oil producers; and Alcoa, which used its monopoly position in aluminum production to

squeeze independent fabricators of aluminum products to advantage its own fabrication

subsidiaries. Such cases are rare. As economists have shown, once a company monopolizes

one vertical chain of an industry, there is no further monopoly profit to be extracted by

extending that monopoly position to adjacent vertical stages of the industry. A greater

concern is that vertical integration may make independent suppliers and customers less

willing to do business with the vertically integrated company, because it is now perceived as

a competitor rather than as a supplier or customer.

After Disney’s acquisition of ABC, other studios (e.g. Dreamworks) became less interested in

collaborating with ABC in developing new TV programming.

Flexibility

57

Both vertical integration and market transactions can claim advantage with regard to different

types of flexibility. Where the required flexibility is rapid responsiveness to uncertain

demand, there may be advantages in market transactions. The lack of vertical integration in

the construction industry reflects, in part, the need for flexibility in adjusting both to cyclical

patterns of demand and to the different requirements of each project. Vertical integration may

also be disadvantageous in responding quickly to new product development opportunities that

require new combinations of technical capabilities. Some of the most successful new

electronic products of recent years – Apple’s iPod, Microsoft’s X-box, Dell’s range of

notebook computers – have been produced by contract manufacturers. Extensive outsourcing

has been a key feature of fast-cycle product development throughout the electronics sector.

Yet, where system-wide flexibility is required, vertical integration may allow for speed and

coordination in achieving simultaneous adjustment throughout the vertical chain. American

Apparel is probably the fastest growing clothing manufacturer in the US with an

internationally known brand – especially for T-shirts. Its tightly coordinated vertical

integration from its Los Angeles design and manufacturing base to its 160 retail stores allows

a super-fast design-to-distribution cycle. Vertical integration is also a central theme of brand

identity.

Compounding Risk

To the extent that vertical integration ties a company to its internal suppliers, vertical

integration represents a compounding of risk insofar as problems at any one stage of

production threaten production and profitability at all other stages. When union workers at a

General Motors brake plant went on strike in 1998, GM’s 24 US assembly plants were

quickly brought to a halt. When technology or customer preferences are changing quickly it

is especially likely that poor decisions at one stage have knock-on effects throughout the

firm.

Assessing the Pros and Cons of Vertical Integration

Is vertical integration a beneficial strategy for a firm to pursue? As with most questions of

strategy – it all depends. We have observed that there are costs and benefits associated with

both vertical integration and with market contracts between firms. The value of our analysis

is that we are in a position to determine the factors that will determine the relative advantages

of the two approaches to managing vertical relationships. Table 5.1 summarizes some of the

key criteria. Yet, even within the same industry, different companies can be successful with

very different degrees of vertical integration. Thus in low-end fashion clothing, Zara is much

more vertically integrated than either Hennes & Mauritz or Gap, while in designer clothing,

Armani is more vertically integrated than Donna Karan. The key issue here is that, even when

external circumstances are the same, the fact that different companies have different

resources and capabilities and pursue different strategies means that they will make different

decisions with regard to vertical integration.

Designing Vertical Relationships

Our discussion so far has compared vertical integration with arm’s-length relationships

between buyers and sellers. In practice, there are a variety of relationships through which

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buyers and sellers can interact and coordinate their interests. Figure 5.5 shows a number of

different types of relationship between buyers and sellers. These relationships may be

classified in relation to two characteristics. First, the extent to which the buyer and seller

commit resources to the relationship: the arm’s-length nature of spot contracts means that

there is no significant commitment; vertical integration involves substantial investment.

Second, the formalization of the relationship: long term contracts and franchises typically

involve complex written agreements; spot contracts may involve little or no documentation,

but are bound by common law; collaborative agreements between buyers and sellers are by

definition informal, while the formality of vertical integration is at the discretion of the firm’s

management.

Figure 5.5: Different types of vertical relationship

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Table 5.1: Vertical Integration (VI) versus outsourcing: Some key considerations

60

Different Types of Vertical Relationship

Different types of vertical relationship offer different combinations of advantages and

disadvantages. Consider for example the following:

Long-term contracts. Market transactions can be either spot contracts – buying a

cargo of crude oil on the Rotterdam petroleum market – or long-term contracts that

involve a series of transactions over a period of time and specify the terms of sales

and the responsibilities of each party. Spot transactions work well under competitive

conditions (many buyers and sellers and a standard product) where there is no need

for transaction-specific investments by either party. Where closer supplier–customer

ties are needed – particularly when one or both parties need to make transaction-

specific investments – then a longer term contract can help avoid opportunism and

provide the security needed to make the necessary investment. However, long-term

contracts introduce their own problems. In particular, they cannot anticipate all the

possible circumstances that may arise during the life of the contract and run the risk

either of being too restrictive or so loose that they give rise to opportunism and

conflicting interpretation. The inflexibility problems of long-term contracts are

particularly evident in IT outsourcing when the agreement may be for a period of 10

years or more.

Vendor partnerships. The greater the difficulties of specifying complete contracts for

long-term supplier–customer deals, the more likely it is that vertical relationships will

be based on trust and mutual understanding. Such relationships can provide the

security needed for transaction-specific investments, the flexibility to meet changing

circumstances, and the incentives to avoid opportunism. Such arrangements may be

entirely relational contracts with no written contract at all. The model for vendor

partnerships has been the close collaborative relationships that many Japanese

companies have with their suppliers. During the late 1980s, Toyota and Nissan

directly produced about 20 to 23% of the value of their cars, whereas Ford accounted

for 50% of its production value and GM for about 70%. Yet, as Jeff Dyer has shown,

the Japanese automakers have been remarkably successful in achieving close

collaboration in technology, quality control, design, and scheduling of production and

deliveries.

Franchising. A franchise is a contractual agreement between the owner of a trademark and a

business system (the franchiser) that permits the franchisee to produce and market the

franchiser’s product or service in a specified area. Franchising brings together the brand,

marketing capabilities, and business systems of the large corporation with the

entrepreneurship and local knowledge of small firms. The franchising systems of companies

such as McDonald’s, Century 21 Real Estate, Hilton Hotels, and Seven-Eleven convenience

stores facilitate the close coordination and investment in transaction-specific assets that

vertical integration permits with the high powered incentives, flexibility, and cooperation

between strategically dissimilar businesses that market contracts make possible.

Choosing between Alternative Vertical Relationships

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Designing vertical relationships is not just a “make or buy” choice. Between full vertical

integration and spot market contracts, there is a broad spectrum of alternative organizational

forms. Choosing the most suitable vertical relationship depends on the economic

characteristics of the activities involved, legal and fiscal circumstances, and the strategies and

resources of the firms involved. Even within the same industry, what is best for one company

will not make sense for another company whose strategy and capabilities are different. While

most food and beverage chains have expanded through franchising, Starbucks, anxious to

replicate precisely its unique “Starbucks experience,” directly owns and manages its retail

outlets. While most banks have been outsourcing IT to companies such as IBM and EDS, US

credit card group

Capital One sees IT as a key source of competitive advantage: “IT is our central nervous

system . . . if we outsourced tomorrow we might save a dollar or two on each account, but we

would lose flexibility and value and service levels.”

In addition to the factors that we have already considered, the design of vertical relationships

needs to take careful account of the following:

1. Allocation of risk. Any arrangement beyond a spot contract must cope with

uncertainties over the course of the contract. A key feature of any contract is that its

terms involve, often implicitly, an allocation of risks between the parties. How risk is

shared is dependent partly on bargaining power and partly on efficiency

considerations. In franchise agreements, the franchisee (as the weaker partner) bears

most of the risk – it is the franchisee’s capital that is at risk and the franchisee pays

the franchiser a flat royalty based on sales revenues. In oil exploration, outsourcing

agreements between the oil majors (such as Chevron, Exxon Mobil, and ENI) and

drilling companies (such as Schlumberger and Halliburton) have moved from fixed-

price contracts to risk-sharing agreements where the driller often takes an equitystake

in the project.

2. Incentive structures. For a contract to minimize transaction costs it must provide an

appropriate set of incentives to the parties. Thus, unless a contract for the supply of

ready-mixed concrete to construction projects specifies the proportions of cement,

sand, and gravel, there is an incentive to supply substandard concrete. However,

achieving completeness in the specification of contracts also bears a cost. The $400

toilet seats supplied to the US Navy may reflect the costs of meeting specifications

that filled many sheets of paper. Very often, the most effective incentive is the

promise of future business. Hence, in privatizing public services – such as passenger

rail services or local refuse collection – the key incentive for service quality is a fixed-

term operating contract with regular performance reviews and the prospect of

competition at contract renewal time. Toyota and Marks & Spencer’s vendor

partnerships depend on the incentive that satisfactory performance will lead to a long-

term business relationship.

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6. Property investment economics

THE PROPERTY MARKET AND DEVELOPMENT

Taxation and property development

Health warning: It should be noted that taxation law changes at regular intervals.

The Inland Revenue seeks to classify individuals and companies who build and then dispose

of property as follows.

Investors

Investors are individuals or companies who build a property and retain ownership for

approximately five or so years before disposal.

Traders

Traders are individuals or companies who build a property and dispose of it for profit on

completion.

The revenue has several rules of thumb to determine which of the above classifications a

taxpayer belongs to; however, suffice to say that the tax position of investors is far more

favourable than traders who are treated, for taxation purposes, as any trader who produces

goods or products.

Feasibility reports

Whether in the private or public sector, when a new construction project is proposed the first

question early stage in the development process that needs to be addressed by clients and

quantity surveyors alike is: will the proposed project prove feasible? Although public sector

clients may have different interpretations of feasibility, for the purposes of this section

‘feasibility’ generally means: will the capital invested in the project make the required yield

or profit? This question, in turn, depends on many other factors and variables. Construction is

a high risk process – there are so many external influences that can derail the best laid

development plans, for example:

• The general economic situation, including interest rates and employment levels

• Government intervention; for example, planning issues and the release of green belt land for

development

• Demographics and changing needs of the market

• New entries to the market place/increased competition

• Increase in the cost of materials

• Shortages of labour and materials.

In addition to the above, the property market is uniquely inelastic; this means that, following

an increase in demand for a certain type of development, it can take up to two years for

supply to come on stream. The effect of this is a shortage of supply and a rise in prices as

companies and individuals try to secure what limited stocks are available. When advising a

client on the feasibility of a proposed new project, the quantity surveyor must take all of these

factors into account as well as giving some indication of the construction costs – good local

knowledge is an essential part of this process.

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As we can see, there is a range of unknowns and variables which have to be taken into

account when determining the feasibility of a project. The most realistic way to report

information to a client is to include some sort of indication that the figures being reported or

data used in the preparation of the report are likely not to be totally accurate.

Various techniques for reporting probabilities will be discussed later in this section. One of

the industry standards for determining the feasibility of a project is the residual method of

valuation or, as it is sometimes referred to, the developer’s budget. This method of valuation

is only one of a set of five standard methods of valuation, the others being:

• The investment method. Used extensively by general practice surveyors when determining

whether the price being asked for a property (such as an office block) is realistic compared to

the amount of income that is generated (rent paid by the tenants). The value of an investment

property is in no way connected to the cost of the construction or other costs. Rather, it’s

income generated and is calculated as follows:

years purchase is simply a multiplier but can also be used to calculate the number of

years required to pay back the costs of a project

the term ‘net income’ is sometimes used and refers to the income after landlord’s expenses

have been deducted

new developments can expect to have voids, or empty space during the fi rst twelve months

or so, depending on the state of the rental market

• Profits method.

Used to derive rental values from earnings from, for example, a hotel. It involves establishing

the gross earnings for the property and deducting from this all expenses (including profit),

that are likely to be incurred by the tenant. The residual figure is the amount available for

rent. It should be noted that caution is required, as earnings, for a number of reasons, can be

distorted.

• Comparative method.

The most widely used form of valuation, it uses direct comparison with prices paid for similar

properties to the one being valued. The following should be noted:

- properties compared must be similar; e.g. four-bedroomed detached houses

- properties must be in the same area

- the legal status should be the same; i.e. freehold or leasehold

- the property transactions must be recent

- the market must be stable

It is important to bear in mind that rarely are two properties exactly the same and people’s

opinions about property are very subjective.

• Contractor ’s method.

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Used for insurance purposes and for unusual or unique buildings that rarely comes onto the

market. It involves:

- calculating the cost of rebuilding the property, as if new, including fees, etc.

- apply a reduction for depreciation and wear and tear

- add the site value

• Residual method.

Sometimes referred to as the Developer’s Budget, this method attempts to calculate the value

of a completed development. From this value all of the costs associated with the development

are deducted to provide a residual figure that can, among other things, equal the value of the

site to the developer. Of these five methods used for valuation, the quantity surveyor is most

often asked about the Investment and Residual Methods.

Residual method of valuation (developer’s budget)

A developer’s budget or residual method of valuation is generally used to calculate the

amount of money that a developer can pay for a plot of land. This is determined by firstly

calculating the value of the completed development, the gross development value (GDV). All

the costs that need to be expended are then deducted from this figure. The residual figure is

the amount available for the purchase of the land, although in effect the technique can be

used to determine the value of any unknown. That is to say, if the value of the land was

known, how much could be allocated to construction costs? The developer’s budget lends

itself readily to spreadsheet applications, such as Excel and, once set up, can quickly produce

figures relating the financial feasibility of a new project.

Items to be considered:

Value

• The GDV. Can be the total sum from sales or rental income. If rental income, then it will be

necessary to discount estimated future incomes.

Costs

• Site preparation and infrastructure costs including demolition, contaminated land costs,

roads, sewers and main services

• Construction costs. A realistic estimate must be prepared by the quantity surveyor. Usually

a substantial percentage of costs will be in this item. Therefore, it is imperative that, even

though information and details are limited, the forecast of construction costs is accurate.

• Professional fees. These will depend on the complexity of the project and whether services

such as project management or structural engineering are required.

• Finance costs. These costs will be specific to a client and will depend on the amount of

perceived risk involved in the development. In the UK, when providing funding based on an

overdraft, the amount of interest charged by a High Street bank will generally follow the

Bank of England’s base rate, plus a percentage to reflect the perceived risk. There are many

types and sources of project funding. When carrying out appraisal, and the cost and source of

finance is unknown, there is a rule of thumb that is generally used as follows: interest will be

calculated on the total construction costs plus fees for half the construction period. A term

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often used in connection funding is LIBOR (London Inter Bank Offered Rates); that is the

rate at which banks lend each other money. It can be used instead of base rate.

• Disposal costs. Once completed it will be necessary to dispose of a project, either by selling

or letting. The costs associated with this are typically legal costs, advertising, incentives,

stamp duty, agent’s fees.

• Developer’s profit. Most commercial development is carried out for profit and a client will

have decided what level of profit is required for the risk of investing in a new project.

Generally, the greater the risk, the higher the profit.

• Finally, after the costs have been calculated and deducted from the GDV the residual figure

is the sum available to purchase the land. Of course, it may be necessary to finance the land

purchase, and certainly there will be legal costs involved. To cover these costs, another

simple rule of thumb is applied as shown in the following example.

EXAMPLE

A developer is considering the purchase of a city centre site which has outline planning

permission for the construction of a block of offices to provide 10,000 m2 of gross floor area.

When complete it is anticipated that, based on similar developments in the area, it will be let

at £350 per square metre and that the completed development would produce a yield of 7%.

The project costs are as follows:

Construction costs: £1200/m2

Infrastructure costs: £450,000

Professional fees: 10% of construction costs

Disposal costs: 12% of fi rst year’s rent

Interest rate: 10% (base rate plus 8%)

Developer’s profi t: 15% of gross development value

Construction time: 3 years

It is usual for a project of this type to be planned and built by a developer and then, once

completed and fully let, sold to another party for a profit or yield. The proposed project has a

gross floor area of 10,000 m2 – this area must be converted to net lettable floor area before

the process can begin. Typically, the ratio of gross to net floor area is in the range of 80–85%.

It is, of course, important that the ratio is as high as possible in order to maximise the rental

income and the value of the completed project. This can include specifying components that

maximise the floor areas; for example, perimeter heating or air conditioning units should be

fixed at a sufficient height to allow a wastepaper bin to be placed beneath them (see Figure

6.1). This way, the area below the units is deemed to be usable and therefore lettable. It is

also typical with a development of this type that an allowance is made during the first year

for voids; that is, for space that will remain un-let during the initial rental period. A solution

to the above proposal follows.

Gross development value

The GDV can be determined in a number of ways. If the development is to be sold, then the

GDV is the total amount received from sales.

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Figure 6.1: Waste bin test

If the development is an investment property, then the income from rent will form the basis

of determining the value. In the example above, the proposed property is for investment and

therefore the capital value is calculated as follows. To determine the value of the project

when complete the following formula is used:

Year’s purchase is a multiplier and is determined as follows:

10,000 m2 Gross fl oor area × 0.84 = 8400 m2 net lettable floor area; this will then produce

an income, when fully let, of:

8,400 × £350 = £2,940,000 per annum.

This figure is gross income and needs to be adjusted by the deduction of landlord’s expenses

to net income. 5% has been taken in this case, giving £2,793,000 per annum.

For the example under consideration, it has been assumed that the developer is an investor

who intends to retain ownership of the completed development for 4 years without rent

reviews and then dispose of it. For the first year it has been assumed that there will be 40%

voids, or un-let space, giving a rental income for the first year of:

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It is assumed that there will be no increases in rental during this period and this information is

allowed for in the calculations as follows:

Having established the value of the completed development, the cost associated with the

project can be calculated.

As discussed earlier, the costs and values of a project are usually very different. The first step

in the process (Stage A – Appraisal) is to meet with the client and to discover exactly what

the requirements are for the new project. Generally regarded as one of the most difficult and

critical stages of the development process, the task can become even more difficult in the

case of the client who has a number of separate departments or sections, all of which perceive

the project’s deliverables in different ways. In this situation all kinds of hidden agenda can

impinge on the process and make it difficult for the design team to accurately determine the

project objectives.

SOURCES OF FINANCE

Every construction project, whether large or small, requires finance. There are two broad

categories where finance can be raised. These are referred to as:

• Equity, and

• Debt.

Equity refers to the practice of using the client’s own resources to finance the project;

whereas in the case of debt funding, the project is financed by borrowing money from a

variety of financial institutions. In practice most projects, particularly the larger ones, are

financed from a mixture of sources. The ratio between the equity and debt funding is referred

to as gearing; the higher the proportion of debt, the higher the gearing is said to be and vice

versa. The gearing ratio can reflect the perceived risk of the proposed development; the

higher the risk, the more a developer will wish to transfer this risk to the lender by borrowing

as much as possible of the development costs. The accepted gearing for property

development projects is around 90:10 debt to equity. Usually financing is required at two

stages:

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• During the development phase, generally regarded to be the period of highest risk, as

revenue will not begin to fl ow until completion, and

• After completion, when the developer has to repay the money lent for construction plus

accumulated interest, generally regarded to be a period of lower risk.

Finance is generally referred to in terms of:

• Short term – up to five years

• Medium term – five to ten years

• Long term – over 15 years.

Equity

The sources of equity are generally:

• From shareholders’ funds or share capital

• Generating funds from internal sources such as retained profits, funds held in return for

taxation, etc.

Depending on circumstances, the second alternative tends to be a short-term solution only.

Sources of equity

Opportunity cost. If an investor decides to use his or her own capital to fund property

development, then the cost of the capital needs to be considered. Opportunity cost is the

amount of interest forgone by taking capital off deposit and using it to fund a new project.

Forward funding. This funding method involves a financial institution; for example, an

insurance company or pension fund purchases the site and provides the funds for the

construction. At the completion of the project it is sold and the developer paid. From the

developer’s point of view the disadvantage is that the funding institution will have a major

influence in the direction of the development; the advantages include the fact that the

institution bears both the development and disposal risk. In return, the developer’s profit may

be lower than the norm.

Joint venture. A joint venture between two or more financial institutions may be essential

for very large projects or developments and may be confined to UK institutions or cross

border arrangements. The advantages include risk sharing and the potential to obtain

additional expertise or local knowledge that may be essential for the successful completion of

the development.

Lease and leaseback. This arrangement involves the developer leasing the site to a bank or

other institution for a nominal rent. The bank then arranges for the construction of the project

in accordance with the developer’s instructions. On completion, the bank leases the building

to the developer at a rate that includes construction and finance costs. This approach also has

the potential for tax allowances.

Debt finance

As has been stated previously, the big advantage to debt finance is that risk is transferred to

the funder. The amount of interest charged will reflect the perceived risk of the development.

The principal sources of debt finance are banks, both UK-based and overseas. Banks are

generally risk adverse organisations and, as such, tend to lend money on a short-term basis

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with the project/site usually required by the bank as security. Options include fixed rate and

variable rate; variable rate is the most commonly used method:

• The developer approaches a bank and the risk will be assessed based on the nature of the

proposed project, market conditions, etc.

• Having assessed the risk, the bank will determine the interest rate to be charged based on

the London Interbank Offered Rate or LIBOR which is the rate charge between banks when

they lend each other money. An addition percentage will be added to the base rate to reach

the rate to be charged. The higher the perceived risk, the greater the addition.

• Variable rate finance leaves the developer exposed to increases in the base rate that can eat

into profits or risk the total project viability. In the UK, the recent past has seen a period of

reasonably stable base rates at historically low levels, but this has not always been the case!

• Loans are categories into non-recourse, limited recourse and full recourse. These terms refer

to the extent to which the developer guarantees the debt. In the case of a non-recourse loan,

the finance is secured on the development itself. In a case where the bank needs to call in the

debt, then none of the assets of the developer will be at risk. Limited recourse loans refer to

the position where, as well as the development under finance, other assets of the developer

are required as a guarantee. Full recourse loans refer to the situation where the funding is

secured entirely on the developer’s assets, and these will be at risk in the case of project

failure. Banks will, as a general rule, lend up to 70% of the GDV depending on the status and

track record of the developer.

Mezzanine finance

Given that banks will usually lend up to 70% GDV a further cash injection is required in

order to meet the required gearing ratio; this gap can be filled with so-called mezzanine

finance. Mezzanine funding is rather like a second mortgage that ranks below the senior debt.

This means that, in the case of project failure, the senior lender has first recourse to recover

losses. The effect of this is to make mezzanine funding more expensive than senior debt as it

reflects the developer’s inability to secure adequate equity.

Bonds

The bond market offers a source of long-dated debt. Accordingly, as an alternative to the

banking sector, it is now common place for many organisations to consider raising money in

this market, especially if the project concerned is so big that there in insufficient liquidity in

the market. This method of raising finance is ideal for individuals and organisations who:

• Need to raise large sums of capital, £20 million upwards

• Have access to regular guaranteed income for the term of the bond, which can be up to 50

years

• Bonds are in effect an IOU and work as follows:

investors lend the bond issuer a sum of money for a fixed term

in return the investor receives an agreed rate of interest from the bond issuer

on maturity the investor receives back the original investment in full

• Bonds may be either public or private.

Answering the ‘ what if ? ’ question

In order to carry out the developer’s budget, several assumptions have been made and the

next step in the process is to test those assumptions against their sensitivity to change,

brought about by consequences beyond the developer’s control; for example, increase in

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interest rates, increase in construction costs due to material and/ or labour shortages, etc.

There are a number of techniques, ranging from the basic to the sophisticated, which test

various sensitivities and scenarios and thereby attempt to answer the ‘what if?’ question. For

example, if interest rates were to rise by 3%, the cost of financing the above scheme would

increase considerably, thereby reducing the amount available for construction costs or profit

and perhaps threatening the feasibility of the project. The techniques that can be used, listed

in order of accuracy, are:

• Sensitivity analysis

• Monte Carlo simulation.

Regardless of which of the above techniques is used, the import aspect of including this item

in the feasibility report is that it highlights the fact that property development has a number of

inherent risks. These risks must be correctly managed if the project is to be a success. After a

budget has been finalised, market conditions rarely evolve as expected; interest rates change,

materials and labour shortages occur, and so on. The likelihood that these and other myriad

events could negatively impact revenue is known as ‘risk’. While risk cannot be avoided, it

can be mitigated and managed.

Sensitivity analysis

Sensitivity analysis is a method for analysing uncertainty by changing input variables, for

example, and observing the sensitivity of the result. The method can be used either on a

variable-by-variable basis or by changing groups of variables at once using scenario analysis

These closely related techniques offer several advantages over other methods for examining

the affects of uncertainty.

Variable-by-variable analysis.

This approach analyses uncertainty and isolates the affect of change on one variable of the

feasibility study at a time. The approach is as follows:

• List all the important factors that can affect the successful outcome of the project

• For each factor define a range of possible values

• Generally three ranges are proposed: Optimistic, Most likely and

Pessimistic

• Calculate the cost-benefit ratios or net present values for each of the ranges.

A variable-by-variable analysis is based on the assumption that factors affecting a project do

not operate independently of one another. By using software such as Microsoft Excel it is

possible to model various scenarios to answer the ‘what if ?’ question. For example, what

will be the effect on the project feasibility if interest rates were to change from the 10%

assumed in the feasibility report, during the construction period?

This process should be repeated for all key drivers Scenario analysis. A scenario analysis is

based on the assumption that factors affecting cost/benefit flows do not operate independently

of each other as is assumed in the variable-by-variable approach. For example, it is unlikely

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that increases in interest rates and lack of demand for the completed development are

independent factors. Sensitivity analyses have several advantages:

• First, it shows how significant any given input variable is in determining a project’s

economic worth. It does this by displaying the range of possible project outcomes for a range

of input values, which shows the decision makers the input values that would make the

project a winner or a loser. It also helps to identify critical inputs

• Answers the ‘what if?’ question and is a good background and preparation for defending a

project. For example, if the question ‘what will the outcome of the project be if operating

costs increase by 20%?’ is posed, the answer is easily determined

• Does not require the use of probabilities

• Can be used on any measure of project worth

• Can be used where there is little information, resources or time to perform more

sophisticated techniques.

The major disadvantage of sensitivity analysis is that there is no explicit probabilistic

measure of risk exposure. That is, although one might be sure that one of several outcomes

might happen, the analysis contains no explicit measure of their respective likelihoods. A

good way to graphically represent the outcomes of a sensitivity analysis is with the use of a

spider diagram (see Figure 6.1). It is an instant snapshot of the relative importance of several

uncertain variables.

It can be seen from Figure 6.1 that a 5% rise in land costs will impact on the development by

increasing the overall cost in excess of £22 million.

Figure 6.1: Spider diagram

Monte Carlo simulation

Monte Carlo simulation was named after the town on the Cotes d’Azure famous for its

casinos, gambling and games of chance. Despite its exotic name, in reality it is a piece of

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software that models or simulates the probable outcomes of a given scenario. It does this by

the use of probalistic techniques that attempt to mimic what will happen in a real situation. It

is far superior than the sensitivity analyses described above, because not only do the results

illustrate the impact of an input, changing but also they take into the account the probability

that any given event will happen, based upon what has happened in the past in similar

projects.

Whichever of the above techniques are used, it should not be forgotten that these are simply

decision-making tools and should not be used as a stand alone set of facts. It will always be

the case that the quantity surveyor will interpret and review the outcome before reporting

figures to the client.

WHOLE LIFE COSTS

Whole life costs include consideration of the following factors when designing and

specifying:

• Initial or procurement costs, including design, construction or installation, purchase or

leasing, fees and charges

• Future cost of operation, maintenance and repairs, including management costs such as

cleaning, energy costs, etc.

• Future replacement costs, including loss of revenue due to non availability

• Future alteration and adaptation costs, loss of revenue due to non-availability

• Future demolition/recycling costs.

The service life of an element, product or whole building may be viewed in one or more of

the following ways:

• Technical life – based on physical durability and reliability properties

• Economic life – based on physical durability and reliability properties

• Obsolescence – based on factors other than time or use patterns, e.g. fashion.

Common terms used to describe the consideration of all the costs associated with a built asset

throughout its life span are:

• Costs-in-use

• Life cycle costs

• Whole life costs

• Through life costs

• Etc.

There are a number of definitions for whole life costing (WLC), but one currently adopted is

‘the systematic consideration of all relevant costs and revenues associated with the

acquisition and ownership of an asset’.