The Theory of Supply - Construction Economics: A New Approach - page 71

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The Theory of Supply

In considering the theory of supply, we adopt a similar approach to that of the
previous chapter on the theory of demand and, to some extent, this gives us an
intellectual start. We will not, however, fully appreciate the suppliers' side of the
market until we have worked through the next three chapters. Chapters 6, 7 a nd
8 are particularly significant. Chapter 6 explores the day-to-day relationship of
contractors and clients and Chapters 7 and 8 deal with the theory of the firm.
Before formally commencing with supply it is useful to distinguish between
cost and price. The basic difference arises from the perspective you are considering.
For example, from a supplier's point of view, when a producer sells a good to a
consumer the cost and price should not be the same. Normally, the producer seeks
to make a profit - it is important, therefore, that the cost of the good is less than
the selling price. Consequently, it is quite usual in construction for the cost of a
project to be estimated and a mark-up for profits (risks) and overheads added before
arriving at a price for the job. The contractor's mark-up is the difference between
price and cost. In the present environment in the UK, however, many clients have
become more knowledgeable and powerful; the client (or consultants acting on
behalf of the client) predetermines an acceptable price and the contractor has to try
to meet this figure.
The process is complicated further by the fact that for most construction work
a price needs to be stated before the activity commences - when all the costs are
not yet known. This contrasts with manufacturing: here, the producer does not
have to determine the price until the activity is complete and all the costs have
been revealed. Furthermore, it is important to understand that the most usual
form of price determination in the construction industry is through some form of
competitive tendering . This, in turn, makes it difficult for potential contractors
supplying their services to take advantage of the market, as the lowest price bid is
often seen as the most acceptable. To avoid the obvious problems that this may lead
to, in some countries the practice is to adopt the average or second lowest bid as
clients are aware that competition based solely on the lowest possible price does not
always represent best value. Similarly on large-scale public sector contracts in the
UK it is becoming common practice to add a small percentage to the price of the
winning bid to allow for the unrealistic cost estimates that may have occurred as
ambitious contractors try to submit the lowest possible price at the bidding stage -
this adjustment is known as optimism bias . Competitive tendering seeks to achieve
fair comparisons on a like-for-like basis. What the subsequent chapters will highlight
is the need for the efficient contractor to submit realistic tenders in relation to their
costs and capacity.