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Price Adjustment System in Ethiopia

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BACKGROUND

The problem of price escalation, especially in the construction industry, is a worldwide phenomenon, and its ripple is normally a source of friction between clients and contractors on the issue of price escalations. If this friction is not properly handled, this could stall the progress of work and may subsequently lead to project abandonment and the actual project will suffer with universal inflations of costs. 5]Although the causes of project cost escalations are well known, the methodology used in handling its evaluation, especially on those aspects relating to price escalations, is very inadequate.

The unprecedented escalation of prices escalations in the construction industry has caused significant financial hardships for unprepared supplier, subcontractors, contractors, and owners. Contract losses suffered, projects delayed, or serious disputes resulting from the efforts of constructions industry players to mitigate, shift or recoup the financial consequences of this sudden and dramatically price escalations.

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Yet, it is certain that profits have been lost, relations have been damaged, projects have been impacted, and construction lawyers have been called upon to look for ways to soften or shift the impact of price escalations on their unprepared constructions client.

[11]

SCOPE

In implementation of data’s indicate that majority of the construction works suffered with an extended delay that lead to the major disputes lots of time and money, and the end user can not use the intended projects on the appropriate time.

And in several instances the dalliance is not the intention for both the client and contractor as it does not help both, either in the performance or in the cash flow. Therefore solving these kinds of claim & disputes during the course of construction will automatically improve quality of work by creating an amicable atmosphere for client, contractor and consultant and save substantial amount of money. [5]

PURPOSE

The problem of price escalation, especially in the construction industry, is a worldwide phenomenon, and its ripples are normally a source of friction between clients and contractors on the issue of price escalations.

If this friction is not properly handled, this could stall the progress of work and may subsequently lead to project abandonment and the actual project will suffer with universal inflations of costs. Although the causes of project cost escalations are well known, the methodology used in handling its evaluation, especially on those aspects relating to price escalations, is very inadequate. The unprecedented escalation of prices escalations in the construction industry has caused significant financial hardships for unprepared supplier, subcontractors, contractors, and owners.

Contract losses suffered, projects delayed, or serious disputes resulting from the efforts of constructions industry players to mitigate, shift or recoup the financial consequences of this sudden and dramatically price escalations. Yet, it is certain that profits have been lost, relations have been damaged, projects have been impacted, and construction lawyers have been called upon to look for ways to soften or shift the impact of price escalations on their unprepared constructions client.

AIM OF THE RESEARCH

The aim of research is to review the cause of price variation and their impact on the progress of constructions industry and also to recommend on possible adjustment system that can be taken as remedial measure with assessing the case of cost escalation in constructions industry. Generally, the aim of the Research is: ? Identifying the cause of price escalations & their impact ? Possible treatments mechanism for price escalations ? Minimizing disputes on price escalation and

RESEARCH METHODOLOGY

The key task in research is to design research process that the information obtained permits the assessment of their impact.

The basic research design was an exploratory research methodology using secondary data. This design was chosen since it enables to asses the magnitude, scope problems and facilitate for the suggestion of solutions. Generally, the research process was designed through defining the research problems and to accomplish these objectives the research was made using the following methodologies. 1. Review the pertinent domestic and foreign literatures, ongoing researches, books, conference proceedings, the internet, leading construction management and engineering journals and relevant practices related to price escalations. . Survey public- sector/Regulatory body MoWUD; Construction Company, Consulting Engineers to determined the cause of construction price escalations & method used to handled price escalations & mitigate. 3. Analyzed the cause of price escalation with their impacts treatment mechanism through questionnaires collected

RESEARCH QUESTION

The research methodology is designed in a way that it enables to collect adequate information to answer the following core research question ? What are causes of price escalations? ? What are the impacts of price escalations in constructions industry? How can we treat price escalations in constructions work?

THESIS OVERVIEW

The research consists of six chapters and appendices. The chapters are summarized as; Chapter 1 Introduction and Background This chapter deals with the back ground of the construction industry, scope, purpose, aim of research, and limitation of the research. Chapter 2 Literature review In this chapter, Price Escalation Definitions, Elements of construction industry prices , Types of construction price index and Method of construction price in the construction industry.

Chapter 3 Method and Strategy of the study In this chapter, method of study, data collection technique, work strategy and data analysis techniques are discussed. Chapter 4 Price escalation clauses In this chapter, Purpose, use and Comparisons of price escalation clauses were discussed. Chapter 5 Analysis and Discussion of Results This chapter deals with analyzing and discussion of results from questionnaire survey on causes, impacts and methods of minimizing price escalation. Chapter 6 Conclusions and Recommendation

This chapter re-visits the research aims, objectives and the identified problems; and the result of this thesis would be recommended for further study in this topic. References:- In general, this paper has focused to contribute knowledge on causes of price escalations their possible treatment in constructions industry through:- Preliminary data for the survey study, collected through a literature review, case study and questionnaire. ? Literature review is done to build a conceptual background of the study. The Questionnaire is prepared and distributed to randomly selected contractors, consultants and project owners: to assess or identify the causes of delay and their impact in the construction industry.

LIMITATION OF THE RESEARCH

It is common that research works face various limitations through the process. And we do also encountered different problems. Some of the major problems are: ? In adequate time for the research ? Unavailability of literature on the subject that are with context of Ethiopia ? The willingness of stakeholders to inspire full information about their organization. Carelessness of some respondents to return the questionnaires on time.

LITERATURE REVIEW

The construction industry is an enormously important part of any economy. Economic growth depends on the physical infrastructure that is delivered by the construction industry and its key participants. Construction, responsible for creating, defining and maintaining the built environment within which most other social and economic activities take place, is by far the most important way in which societies create new value.

It provides a society with delivery mechanisms for many aspects of its needs such as economic, social, political, environmental, public sector reform. The industry’s products are essential to mankind’s physical and social day-to-day existence. [6] The construction industry can be categorized in to three major sectors, namely:- Transport and communication (Road, Railway, Airway, and telecommunication related physical works), Water works and Energy, and Building and other physical infrastructures. Accordingly, their capital budget requirements vary extensively depending on the focus the economical trend requires for the nation development. 15] Construction industry has been realized as one among the most important enablers for social, economical and political development of countries some times it used as an economic regulatory sector. The industry provides significant amounts of fixed investment, contributes considerably to the national output and is a major source of employment; directly and indirectly by its multiplier effect. Studies show that in most countries construction constitutes more than half of capital investment, contributes up to 10% of GDP and employs more than one hundred million people globally which accounts for almost 28% of all industrial employment . 7] Generally the construction industry is labeled as a ‘conservative industry’ which adopts new technologies and practices at a slower rate as compared to other industries such as the IT, manufacturing and the automotive and invests very little in capital, research & development and training . [10] Construction industry are Fragmental, sequential and adversarial in nature, it need (requires) the acquisition and effective utilization of human resource second to agriculture.

The outputs of construction are generally large, heavy, durable, expensive, heterogeneous, and immobile in addition to being required over a wide geographical area. Due to the identity of location of production and location of products, with products immobile, the construction market is mostly restricted to be local. Thus the construction market is dominated by small enterprises that perfectly meet the low-size scale of most sites or the specialization of trade respectively and the geographic market.

Since it is expensive the demand is not fashionable and also usually the demand is driven by other sectors (not controlled by the industry itself) Moreover, the level and type of demand cannot be controlled, manipulated or easily created by the industry itself. Hence unlike most industries where a considerable proportion of effective demand for their products is created and managed by the producers themselves through extensive marketing and application of new technologies, demand for construction products is mainly secondary or derive.

Hence the demand is determined by the demand and output of other goods and services such as investment goods for which the ultimate use is either as a means to further production an addition to or improvement of the infrastructure of the economy a social investment or an investment good for direct enjoyment, which it creates or helps create. [10] In developing countries like our country Ethiopia construction industry is labor intensive, which requires large amount of manpower, this creates good job opportunity for citizens.

This big industry, which is the backbone of the social, economical & political development of a country, needs proper management to meet its targeted goal. This industry is full of uncertainties this make it unique from other industries. Therefore it requires unique management. Generally construction projects are unique (different from one anther). Construction management is distinguished from general management of corporations by the mission- oriented of the projects. [14]

Construction contracts are very long is complex documents, consequently is disagreements or claim & disputes can rise regarding contractual obligation or expectation construction contract involves a promise by one party to provide services or materials to build for another party who promises to pay for the work. When one party feels that the contractual obligation or expectations have not been met, and they feel that deserve monetary and/or time compensation they may submit a claim one of the problems which lead to claims & disputes is price escalation (PE)

Price escalations are caused by shortage of material, unbalanced demand and supply, change in weather condition and so on, then to avoiding or minimizing of claims & disputes requires common understanding of the contractual terms, early no adversarial communication improves, un proper documentation like base price data, un proper procurement and contractual management system, understanding the cause of price escalations, its impact on the construction industry and develop different possible solutions and mechanisms described latter in detail. [16]

PRICE ESCALATIONS DEFINISHIONS

Price escalation according to Guidelines for Contract Price Escalations [1] is defined as: Price Escalation is an increase in the contract price during Contract implementation on the basis of the existence of an event or occurrence or Series of events or occurrences. These will be a contract provision in order to cater in the cost of material, labor etc. , due to continuing price changes over time. [17] For further explanation that Price Escalation & related terms Price Escalation:- Refers to an increase in contract price during implementation on the basis of the existence of “Extraordinary circumstances” [11]

Extraordinary circumstances:-Refers to an event or occurrence or series of events during contract implementations which give/s rise to price escalation. [11] Fortuitous Event: – Refers to an occurrence or happening which could not be foresee or event if foreseen, is inevitable. It is necessary that the contractor or supplier is free from negligence. Fortuitous events may be produced by two general causes: – [11] 1. By nature:- such as but not limited to, earthquakes, storms, floods, fire… 2.

By the act of man:- such as but not limited to, arm invasion, robbery, Governmental prohibition, provide that they have the force of an imposition which the contractor or supplier could have resisted. [11] Extraordinary Inflation or Deflation: – refers to the decrease or increase of the purchasing power of the Ethiopian currency which is unusual or beyond the common fluctuation. Such decrease or increase could not have been reasonably foreseen or was manifestly beyond the contemplation of the parties at the time of the establishment of the obligation. [11] ? WPI.

Refers to the wholesale price index, which measures the monthly changes in the general price level of commodities, usually in large quantities, that flow in to the wholesale trading system. [11] ? CPI. Refers to the consumer’s pries index, which measures the monthly change in the average rental prices of goods and services commonly purchased by a particular group of people in particular area. [11] ? PPI. Refers to the producer price index which measures the average change in the unit price of a commodity as it leaves the establishment of the producer. [11] ? Related to the decrease of the purchasing power of money with time:- i. . most cost estimation is done based on the existing currency & then escalate with the time when the project will be accomplished. [11] ? Used to estimate the future cost of a project:- that is, to escalate current costs into the future or to move the cost to the future by using predictive escalation index for planning and budgeting; [11] ? Used to bring historical costs to the present:- that is to compare the present cost based on the past by using historical escalation index, it will also be associated with escalation concepts of present and future worth. 11] Therefore based on the above ascribed a Price Escalation can be defined as the consideration of a onetime cost or continuing costs due to changing of Technology, Changing availability of materials and labor & changing value of the Monetary (i. e. inflation), rate escalations, & adjustments as they specifically related to the products and service and also used to determine reconstruction costs, original costs, estimates for future costs &cost for budgeting purpose.

ELEMENTS OF CONSTRUCTION INDUSTRY PRICES

The term construction covers a wide variety of activities, these include the construction of dwelling, non-residential buildings, and civil engineering works such as roads, bridges, dams, etc. Construction activity also encompasses repair, renovations, rehabilitations and maintenance of existing structures, etc. The diversity of construction activity is the cause of One of the major problems in the compilation of construction price indices is that of comparability. The items comprising an index and their relative weights are the result of different norms and standards that apply in each country.

Prices have already increased several times in the past year or so, as review the evolving market conditions underlying the present situation of the construction industry. We can see this industry from different point of view for price change/index. The price of the output of construction activity is a function of the following 4major factors which is related with input price; output price & seller price indices. A. Direct inputs: directly rendered to the production of the work. These include materials, labor, equipments or energy, etc.

Direct inputs generally vary in proportion to output. B. Indirect inputs and overheads: These include depreciation, Administrative expenses, etc. These are generally fixed and do not vary directly with the volume of output. The project overheads are the cost of administering a project and providing the general plant, facilities and site based services. C· Productivity: Refers to the efficiency with which inputs are converted into outputs (e. g. through new technical solutions, increased labor productivity, or more effective organization of work).

D. Profit: Is a residual determined by the sales price, service provided and combinations of the three preceding items. Profit varies widely and may be Negative. [17]

TYPES OF CONSTRUCTION PRICE INDEX

There are three main types of construction price indices. These are input price indices, output price indices, and seller’s price indices. [11] 2. 4. 1 Input Price Indices Input price indices measure changes in the price of inputs to the construction process by monitoring separately the cost of each factor.

This generally entails the compilation of a weighted index of the costs of wages and materials. Initially, representative object (e. g. a dwelling of a specific type, size, style, etc. ) is taken and the quantity of labor hours and materials needed for its construction calculated. These quantities are periodically multiplied by the corresponding prices and the outcome totaled. Input price indices only provide a reflection of changes in the prices of construction inputs. The indices produced are production cost rather than production price indices.

These include changes in productivity, profit, and trade margins of the construction contractor, and changes in actual market conditions. 2. 4. 2 Output Price Indices Output price indices measure changes in the prices of what is produced by entities engaged in construction activity. Output price indices cover most of the items normally built into the price paid by purchasers or clients to entities involved in producing the completed output of the construction activity. These generally include materials, labor, equipment hire, land preparation costs, overheads, profits, and trade margins.

Different techniques are used to include all these components. One method involves the inclusion in the index of all (or as many as possible of) the individual factors involved in the construction of a dwelling, non-residential building, etc. These include overheads, profits, trade margins, and any other costs paid by the client or purchaser to the builder. 2. 4. 3 Seller’s Price Indices The term “seller’s price” is used to distinguish it from the “purchasers’ price” as defined in the System of National Accounts SNA (1997). Which is excludes the land component in the ownership transfer.

Seller’s price indices described the total sales price of completed construction, including not only the cost of labor and materials, but also land, direct and indirect selling expenses, and seller’s profit. Seller’s price indices measure changes in the prices of construction output paid by the purchaser or final owner of the output of construction activity. These include both supply factors such as wage rates, material costs, and productivity, and demand factors such as demographic changes, incomes, and the availability of mortgage finance.

These indices are the closest approximations in item coverage to the actual price paid for construction output. [11]

METODS OF CONSTRUCTION PRICES

There are seven main construction price index compilation methods used either currently, or in the recent past (OECD1997). In order to demonstrate the main principles more effectively these descriptions only contain the main elements of each methodology and combinations of the seven compilation methodologies described. [16] A. Prior Breakdown Methods

The starting point for prior breakdown methods is a list of carefully specified factors or components, from which the total input or output costs of a building or construction project are built up. 1. Standard Factors: This method is mainly used for the compilation of input price indices. For any given year a representative construction (or small number of projects) is selected and the quantities of each factor used to build it (e. g. materials, labor, transport, machinery, etc. ) evaluated. Changes in the costs of construction are determined by monitoring the cost of each factor.

The representative building or construction chosen initially is used only to establish the weights. Which yields a construction cost index rather than a construction price index. 2. Component cost method: This approach is used for the compilation of output price indices. It regards construction output as bundles of standardized homogeneous components. These components correspond to the supply of standard operations. Examples would be: the supply and lying of so many square meters of roofing tiles; installation of a hot water tank of a given capacity; construction of so many square meters of brick wall etc.

Price indices are compiled using the prices of these homogenous components. A construction (or number of projects) is also chosen. However, the actual work entailed in its completion is broken down into precisely defined standard services or components. [16] A number of representative construction firms that have recently performed any of these services are surveyed to determine the price they have actually agreed or invoiced for these services. A price index is then created for each standard component.

These indices are then aggregated for the buildings initially defined as the benchmarks. The actual buildings are used only to define a selection of services and the corresponding weights. A variant of this approach involves the re-specification of a number of the representative projects on a cyclical basis. [16] The difference between an index based on input factors and one based on standard components is essentially one of degree, since components are only factors at a more advanced stage of production.

However, the standard component cost index also incorporates productivity gains and changes in profit margins, as it reflects not only the cost of the factors, but also the price of the finished product paid by the customers of the construction firm. [16] Another advantage of this method is that the prices obtained are for components which remain comparable over time. Fluctuations due to differential quality or execution are eliminated. However, while components are more homogeneous than completed buildings it is unlikely that they will be completely identical for different completed buildings.

An advantage of both the standard factor and standard component cost methods is that they can produce different indices merely by changing the weighting of the indices for each component. For example, indices could be compiled by type of work, by trade. [16] B. Subsequent Breakdown Methods ۩a Subsequent breakdown methods involve the use of samples of either actually completed or fictitious construction projects. They entail the collection of prices effectively charged (or what would be charged) by the builder and incorporate changes in productivity and profit margins.

These methods start from the “completed” building or projects which are then broken down into component parts. These methods are used primarily for the compilation of output price indices. The hedonic and matched model methods outlined below are also used to compile seller’s price indices. [16] 1. Quoted prices In this method the problem of comparability of components between construction projects i. s overcome by having respondents quote prices for a standard construction output product (house, apartment, bridge, school, etc. ) whose specifications are kept constant from one period to the next.

The standard construction (house, apartment, bridge, school, etc. ) is updated periodically to reflect changes in materials, styles, etc. to ensure that it is typical of those being constructed at the time. A major problem with this method is that it is difficult for firms to take the process seriously. They are not bidding for real work and there is no bargaining involved. [16] 2. Schedule of prices This method entails the selection of a representative sample of construction projects either taking place, or completed, in a given geographic area, over a specified period of time.

The cost of each technical component (derived from blueprints, work specifications, etc. ) of a given construction in the sample is priced as at the base reference date. This involves the use of a schedule of prices containing the price of each component of the construction at the base period date. [16] By aggregating the prices for all the components a theoretical average price of the entire construction is obtained as though it had been undertaken at the base reference date. The general weighting is obtained from statistics on current construction.

A price index is then obtained by calculating the ratio of the current actual price of the sampled construction to the recalculated price at the base reference period (derived from the sum of its components compiled from the schedule of prices). [16] The role of the schedule of prices is to define a price structure, not the average level of each component. The composition of the schedule of prices may not necessarily reflect the average prices for the base period. Obtaining such an average would require a very large sample.

However, the relative structure of the prices on the schedule reflects market conditions at the time period in question. [16] 3. Matched models: This methodology is used for the calculation of price indices for standard project home construction, as in the case of the price indices for the construction and renovation of privately built houses. The composition of the list of construction projects or “models” to be matched against actual construction projects is subject to continuous review, and is determined by the continued availability of price information relating to a particular model specification.

If the specification of an individual model changes significantly, or if a price is unable to be obtained, then that model is excluded from the calculation of price movement. [16] Price information for the actual finished construction is obtained for each period from a sample of builders/construction firms, real estate organizations, government agencies, etc. They relate to actual sales transacted during the period. 4. Building volume or area For this index the cubic meter is used as a common denominator to compare the costs of a recent construction to costs in a base period.

An index of the value per cubic meter is calculated and adjusted for differences in volume, quality, period, and region. These adjustments enable a price index to be prepared. However, the use of this method requires the construction activity included to be homogenous. The index is valid only for each reference building, etc. as it was originally built. [16] 5. Hedonic method: Regression techniques may be used to construct hedonic indices to measure ‘purchasers’ preferences for the different characteristics of construction work.

This price is set by the market and is reflected in the over-all prices for which different combinations of these characteristics are sold, and where different varieties of the same construction type, each with its own peculiar combination of characteristics, coexist. [16] Using econometric techniques (regression and covariance analysis) weight of each of these characteristics in determining the price is estimated. These weights can then be used to factor out that part of the price change in the next month which is due to changes in the characteristics of the house, etc. old. The coefficients of the regressions are calculated first by means of total construction price information and their characteristics in the current year, and on the basis of information on the same type for a base period. The problem with this method, which is based on just a few elements of construction, is that it is less discerning than the schedule of prices method in detecting qualitative change. If construction quality is enhanced the improvement will tend to be underestimated and thus the actual increase in prices overestimated.

Furthermore, the use of these techniques requires the statistical agency to have access to trained econometricians, as well as specialist knowledge of the construction industry. [16]

PROCESSES TO DEVELOPING CONSTRUCTION PRICE INDEX

The development and compilation of price indices for construction activity is a complex procedure consisting of a long and varied set of operations. The usefulness of the construction indices compiled also depends on having a clear understanding of the purposes of the indices, and the characteristics of the construction industry in the country where it is located. 4] These characteristics include: ? The range of construction activities conducted throughout the country; ? construction techniques commonly used for each type of construction activity, together with an idea of the rate of change in techniques used; ? Types of entities/organizations undertaking construction activity, and their characteristics (e. g. size, industry concentration, etc. ); ? administrative arrangements for the maintenance of building/construction standards; ? Administrative arrangements for government authorization of individual construction projects.

These aspects must be determined before commencement of work on the creation of the index. Relevant characteristics of the country external to the construction industry also need to be identified. These could be economic, demographic, geographic, or administrative. [4] The major processes in the development and compilation of construction price indices using the “model price” methodology outlined above are: ? Selection of a small, representative group of recently constructed buildings, etc. as models. Specification of the hundreds of detailed tasks or component trades in the construction of these model projects & general requirements of the main construction contractor. (Architectural drawings and specifications ,overheads and profit margins) ? Selection of a sample of components. The selection of components within each trade area is based on both money value and the coverage of significant materials and/or products involved. ? Development of specifications for each component to include quantities involved and base-weight unit prices. Selection of a sub-sample of subcontractors and general contractors in the appropriate geographic areas from whom prices are collected. ? Collection of periodic reports for a sample of these components from subcontractors. (Price collection may be done by telephone or mail, generally after an initial personal visit to gain co- operation and discuss reporting problems. ? Calculation of a price index for the construction as a weighted combination of these component prices. This is done by multiplying new price quotations by base period weights, and comparing the result to base period mode prices. Development and implementation of an ongoing process of index review to revise the list of model projects, weights, component items, respondents, etc. It could take as long as year to set up the models, enlist respondents, and begin to collect data.

USES OF CONSTRUCTION PRICE INDICES

Construction price indices are primarily used for analysis of price movements and price formation in the construction industry, Ron Dubois (1973) for price escalation clauses in construction contracts, and for deflation of components of the national accounts. More specifically, the primary uses [4] Measuring the changes of prices of construction materials for construction work. ? Studying the impacts of changing prices over the total construction cost and selling prices of the construction work. ? Measuring the expenditure of consumed materials at constant prices. ? Estimating the short-term evolution of prices. ? To determine replacement values for insurance purposes. ? Realizing price-index readjustments of construction contracts. ? Planning the production of materials and checking the efficiency of entrepreneurial units. ? Deflating components of the national accounts.

SOURCES OF CONSTRUCTION PRICE INDICES

From the perspective of the organization responsible for compiling a construction price index the selection of the most appropriate sources of information used depends on a number of considerations. These include the use(s) to which the index will be put and the type of index required (input, output), data availability, and resources (both financial and skill) available in the organization. The institutional background in which a construction price index will be developed, will to a large extent determine the feasibility and cost of the index, and influence the methodology Bused in its compilation.

The data required to compile an index may be in the form of price information obtained from construction enterprises or materials suppliers. Alternatively, components of the price index may be obtained from administrative agencies charged by law with the responsibility for compiling basic costs indices, or by professional associations for use as benchmarks for contracts in the profession. Information may also be obtained from the client who may be traced through building permits. [4] Input prices for –materials ? Surveys of construction, building material supply, or building material manufacturing enter prices. Associations of quantity surveyors ? Trade associations ? Chambers of commerce ? Other national statistical office collections (e. g. for producer price indices ? Government agencies charged with responsibility of monitoring capital construction works (particularly roads, dams, bridges, etc. ) Input prices for- labor ? Trade unions ? Trade associations ? Collective bargain agreements registered with government ? Government agencies charged with responsibility for regulating wages. ? Enterprise surveys of employers ? Household surveys of employees Transport costs ? Transport associations Surveys of transport enterprises ? Relevant government Weight information ? Construction branch structural enterprise surveys ? Associations of quantity surveyors ? Architectural enterprises/associations

IMPACTS OF PRICE ESCALATION

There are many impacts of the recent material price spiking in the construction industry. They involve both domestic and international market forces, as well as aspects of the construction industry that make it particularly susceptible to average cost increases. All project managers understand that there is uncertainty in contract price and duration.

They also know that there is variation in the price and duration of actual task performance. The impacts of insufficient allowance for escalation may lead to: [3] ? A need to seek additional funding, which in turn causes delays; ? Issues with building functionality due to a reduction in the scope of work; and ? Compromised service provision arising from buildings constructed with a reduced scope of work.

THE MAJOR CAUSES OF PRICE VARIATION

The causes of price escalation can be categorized into two main classes. These are: ?

Avoidable causes ? Unavoidable causes A. Avoidable causes: – are any causes under the control of the employer but because of some management problem and other causes result in price variation. These causes result in price variation. These are:- 1. Incomplete design and design change 2. Variation order –New works ? Increase or decrease quantity of work 3. Inadequate allowance of time 4. Inadequate specification 1. Incomplete Design and Design Changes: – Most of the construction projects were affected by these incomplete design and/or design changes.

The reason why almost all Contractors disappointed is these cause result in higher price variation and they are termed as the main and the leading cause for the actual cost of a project more than the estimated cost. These main cause that result in substantial increase of the project cost by itself caused by:- ? Insufficient time given for design and design review ? Inadequate time given for feasibility study When insufficient time is given for design and design review weren’t given for the selected professional, the prepared design/drawing may result in error in design, omission and the scope change.

These results the actual project cost to exceed the planned cost of the project. [ The time given for feasibility study in most of the construction project is small. Thus the design shouldn’t be prepared with due attention to the actual site condition so that the actual project cost varied to the contract amount because of the discrepancy between the contract drawing and the actual site condition. This discrepancy result in increase or decrease in quantity of work and variation order for new works such additional works.

This result in price variation so that the Employer should compensate the Contractor for additional cost incurred which aren’t the fault of Contractor. [5] 2. Variation order: – A variation order is a written instruction issued by the Engineer to the Contractor on the issues of increase or decrease in quantity of works and new works. The increase or decrease in quantity of work would to imply variation of quantity for items in BOQ. If this variation varies between plus or minus 15%, the price escalation would be based on unit price specified in BOQ (basic price) during tendering.

But if the variation varies out of the specified amount, new unit price rather than basic price will be agreed between the contracting parties. Moreover for the variation more than plus or minus 15%, the Contractor is not obliged to do the work unless the experienced Engineer fix the reasonable unit price. When change of quality of work and change order for specified sequence would result in price change, the Employer should have to compensate the escalated cost for the Contractor. This is the reason why such changes occurred due to the change order issued by the Engineer who is the owner representative.

When such changes don’t have cost implication but requires EOT, the Employer still compensate for price variation resulted within the extended time given for the Contractor by the Engineer. As a result of several events and due to difference between the Contractor drawing/design and actual site condition, additional works, which aren’t specified in BOQ, are occurred in most of the construction project. Such additional works should be agreed with new unit price (basic price) otherwise the Contractor shouldn’t be forced to do out of his willingness.

Therefore, variation order would necessary need cost escalation for the variation affected by such order. Both parties should know a variation order resulted in compensation by specified method of cost escalation. [5] 3. Inadequate Allowance of Time: – The Employer has been highly influential power to specify the contract time in a construction project in Ethiopia. This is why the contract time given in most of the projects was inadequate both for Consultants to prepare the design, specification and BOQ and for the Contractors to finish the construction work within the contract period.

For the Consultant the time gap between the design and the design review, as well as between the design and the commencement of construction work are important factors. If the time gap is short, the Consultant can’t provide realistic design to fit for actual site condition. This is due to insufficient time given for feasibility study that includes preliminary site visit and site investigation to determine the ground facts for determining the scope of the work which is under taken within the contract.

This unrealistic design would result in substantial price variation due to quantity over run or under run and change order which divert the contract agreement. When this problem occurred, the Employer should compensate the additional cost incurred due such problem which isn’t the fault of the Contractor. For the Contractor, the time required to finished the actual construction work should be based on the work breakdown structure (WBS) rather than owner/Employer intended completion time. This WBS for each item of work should be a guide to fix contract period to be reasonable and reliable for both parties in a contract.

Most Contractors said none of the projects were completed within the contract period because Employer/Owner didn’t give sufficient time during tender period. This consequence has still gone to the Employer to spend additional money above the contract sum due price variation in this extended time beyond the contract time. Here, everybody has to remind that most of the contract conditions say the Employer only responsible for justifiable delay which should be given extension of time (EOT).

But the real practice can’t allow this condition to implement because there is a great dispute between two parties unless Employer permits EOT. Therefore, the contract time for the Contractor should be based on WBS and the time required by Consultant to prepare the design, specification and BOQ should be sufficient for the contract agreement to go smoothly among those parties. [5] 4. Inadequate specification: – Change in specification and not detailed specifications for construction project can be a cause for contract price to not to be different from that specified in contract agreements.

Such variation later result in price variation claims. When such claims are accepted by specified professional/Engineer the cost escalation should be given for such affected item for the Contractor. If the claimant doesn’t have reasonable ground to claim and if the claimant doesn’t have the right documentation to raise such claim, they result in dispute or suspension of work. Most of contracting parties say inadequate specification isn’t a major issue to cause price variation in most projects but instead lack of ethics turns into the worst condition to be obstacle for the progress of the work.

If professionals are fair to perform contractual obligation, the interpretation and implementation of specification couldn’t be Contractor’s problem to hold their work. Thus preparation of specification should be the only thing that needs special attention during tender stage in ethical environment not to lead cost increase for both the Contractor who will be given compensation and the Employer who will be given compensation. [5] 5. Employer or Engineers Fault:-Normally faults resulting price variation are caused by one of the following factors:- ? Fault /changes caused by the Engineer ? Fault/changes caused by the Contractor Faults out of both parties which are caused by external factors such unforeseeable circumstance (e. g. adverse climate and undercut), price fluctuation of material and governmental legislations, etc If the change/faults of Employer that result in the actual cost to exceed the planned cost was occurred, it is justified and compensated for the Contractor. The Employer should be responsible to compensate the escalated cost for the Contractor with reasonable financial damage and/or EOT for prolongation costs, idle hour claims, overhead costs and costs due to other factors within the extended time.

Some of Engineer/Employer faults in construction project problem, delayed supply of Engineer to supply the drawings/design failure by the Engineer to supply control points, failure of the Engineer to value the work and failure to give possession site. These all result in the actual cost to be more than the planned cost. Thus the Engineer should give due attention and the administration should be with great care for such fault not to be a major cause for the actual project cost increment.

When the change resulting price variation are caused by the Contractors fault, the additional cost incurred is automatically burden on the Contractor and here the claimant is the Employer for such changes.. Therefore no price escalation is done even this change result in substantial price variation according to any contract condition. But in the real practice, Employer assesses the effect of this substantial price variation on Contractors profit, and then compensates some portion of the escalated cost.

In any way contract parties should avoid any fault not to result in price variation by careful implementation process or by precaution at the pretender stage highly varied items to foresee their effect on contract project in the future. [5] B. Unavoidable causes: – are outside the contractor’s responsibility and not under the control of the employer. The employer should compensate the price increase. These are:- 1. Fluctuation of market condition 2. Genuinely unforeseeable circumstances 3. Change in legislation 1.

Fluctuating market condition: – is analyzed based on these points:- Increased costs related to local currencies for the fuel, cement and steel which may be bought from government enterprise like Mugger, Mesobo, Akaki steel rolling. These three items and bitumen/asphalts are the only items that the government permits cost escalation when the current price differs the basic price (unit price in BOQ). Market fluctuation of adjustment items are major causes for change in cost of construction but this change in cost hasn’t been paid to local Contractors.

The reason why the burden of market fluctuation has left to the Contractor is the government legislation only permit adjustment for cement, fuel, reinforcement bar and bitumen/asphalt. [5] These losses due to the government legislation that result in the stoppage, suspension and even termination of contracts are because of the results of disputes between the Employers and Contractors. These causes affect the local Contractor not to build their capacity because of unbearable great loses due to the additional costs incurred since the market prices are fluctuating from time to time.

Therefore formula method, which is suitable for the varied item and government legislation, should have solution for the local contractor to compensate their losses due to fluctuating market conditions. [5] 2. Unforeseen circumstance:-The contract price changes caused by external factors, which are beyond the control of both contracting parties, are termed as change due to genuinely unforeseen able circumstances. These causes are special risk factors such as:- ? Exceptionally adverse weather condition ? Lack of construction material from the market ? Land slide ? Others such as unexpected soil strata encountered etc

These causes also related to some avoidable factors that are improper or insufficient geological study and insufficient time given for feasibility study. Preliminary site visit and investigation (feasibility study) should be required to determine the ground facts for defining the scope of work which determine the contract price and to minimize the effect of unforeseeable circumstance on contract price variation. And sufficient time should be given for feasibility study to investigate the ground condition thoroughly and to avoid the quantity over run due to the unexpected soil strata encountered.

Since this cause is beyond the control of both parties, the compensation for price variation due to unforeseeable circumstances should be based on the special risk factors. For adverse weather condition, the Employer only give EOT but if the price of material varied in this justifiable time ,financial damage should be given for Contractor for the escalated cost. For the lack of material from the market, Employer permits the Contractor to bring from other source and the unit price difference and the transportation cost should be compensated to the Contractor. 5] 3. Change in Legislation: – Change in legislation during the contract time of the project is one the unavoidable causes of price variation . This additional costs due to changes in legislation are considered during the contract and approved extended completion time. The changes in cost and legislation clause (clause70), in the FIDIC general condition of contract is intended to make provision for possible effect of such matters as variation in the cost of labor end materials arising during the execution of the works.

The issue of the effects of subsequent legislation on the construction project is raised in the basis of sub clause70. 7 of the special condition of contract on old FIDIC, (1987). If the Contractors have incurred additional costs related to increment of sales tax, sur tax, vat and other government and custom taxes during the execution of the contracts caused by subsequent legislation, they are entitled to compensation of some amount to the additional cost incurred. The additional cost incurred due to subsequent legislation should be requested separately in addition to the additional cost due to price escalation. 5]

CHARACTERISTICS OF COST ADJUSTMENT

Cost adjustment for labor and material should normally not apply in construction contracts less than 1year in duration. ? Cost adjustment may be provided in construction contracts of less than 1 year duration in special circumstances, for example if the contract involves substantial materials or plant incorporating price sensitive metals, oils or cement. ? Cost adjustment provisions for labor and materials should be based on the national cost adjustment provision if the country has price index other wise the cost escalation formula can be used. Separate provisions are required for cost adjustment to take account of changes in foreign exchange rate, sales tax, and overseas labor and materials indices.

PHASES FOR PRICE ESCALATION

Two phases of escalation need to be considered: 2. 12. 1. Pre-tender phase escalation – the forecast increase in cost between the time the estimate was produced and the tender date. This allowance is required in all cases where an estimate has been prepared prior to the tender date and requires the following fundamental factors to be identified: Date the estimate was produced; ? Expected tender date; ? Expected escalation rate (%); and ? Length of time allowed for the increase. 2. 12. 2. Contract phase escalation – the forecast increase during the contract phase. (Contract phase escalation may not be required where the contract phase is relatively short, i. e. less than 12 months. ) Where it is likely that costs will increase during the contract phase, an extra allowance should be included. This is an allowance for escalation between the expected tender date and the expected date of practical completion.

Allowing for contract phase escalation is particularly important at times when the costs of building are rising rapidly, and also on large projects where the high value and long contract period are likely to gain significant escalation.

METHODS OF PRICE ESCALATION

In projects of reasonably long duration (say greater than one year) undertaken in areas which suffer price variation , the project owners consider these variations to compensate contractors for losses due to increases in the prices of such specified item in contract agreement.

There are two alternative methods which may be used in order to calculate the amount either due to the contractor for increases in costs or to be deducted from the contractor price for reductions. 2. 13. 1 Proven cost method:-This method is based upon ‘basic prices’ or ‘basic date prices’. It is intended to calculate the actual increases or decreases to the contract sum as a result of changes in cost of construction resource. In this method the determination of the increase/decrease is by way of comparison between the schedule of labor rates and material prices included in the tender.

Increase/decrease in such rates and prices allowed for under the price variation clauses multiplied by the quantity of labor and material utilized on the contract after the date of increase/decrease . Reimbursement of material fluctuation is usually restricted to basic list and there is no normally specific reimbursement for profit and overheads. [6] When this method is used the contractor is required, at tender stage, to list those elements of his costs which he requires to contract price adjustment. In support of this he includes a list of the actual costs and suppliers of the various elements upon which the tender was based.

When the contractor purchases these materials he presents proof of the actual price paid and is compensated for the difference between the biggest of “Basic price” in BOQ or “Basic market price” and the “Actual” invoiced cost of those same items. It is therefore important to ensure that all purchases are from the suppliers identified at the time of the tender. Any change in suppliers is likely to result in an invalid comparison of prices and accordingly overcompensation. A typical month’s contract price adjustment calculation using the proven cost method might be as follows. Item No |Quantity |Basic Price in |Basic market |Current Market |Change in |Addition | | | |BOQ |price |Price |Unit rate |Cost due to | | | | | | | |variation | |Cement |100 |190 |200 |210 |10 |1000 | | |100 |205 |200 |210 |5 |500 | |Fuel |500 |4. 50 |5. 00 |5. 50 |1. 00 |500 | | |500 |5. 25 |5. 00 |5. 50 |0. 25 |125 | |Total price escalation for this month in Birr |2,125 | Table 3. 1 traditional /proven cost method Although this example’s contract price adjustment has only been calculated in one currency i. e. ETB, it would not be unusual for the calculations to be presented in the currencies of payment.

In this case, the contractor would present contract price adjustment schedules in each currency payment. It is important, when using this method, that the client verify the genuineness and reliability of the suppliers and prices quoted as the base prices. Any change in supplier is likely to result in different base prices, which will complicate the calculation of contract price adjustment. Although this is the method generally used on the project in which the contract price adjustment is based on basic price, it is not the preferred method as it has the potential for abuse by: ? Under quoting base prices ? Over invoicing current prices ? Changing suppliers

Since the duration of larger projects extends over several years, it is necessary to have a method of adjusting contract price that is based on price indices to minimize such abuse and to have suitable method . These can be achieved by actual cost method/formula method that will be discussed as follow. [6] 2. 13. 2 Actual Cost Method/formula method:- This method is based on ‘price indices’ with studying changes and considering major components for cost compensations by using adjustment formula. It is recommended method whenever suitable indices can be obtained. The index value shall be deemed to take account of all changes in cost due to price variation. With this method, the works to be taken are mathematically described in a formula.

The formula contains a number of factors representing the various elements of the project at the time of tender and a number of similar factors for the various elements of work at the time that the works are undertaken. By using these factors in the formula a percentage increase in the tender value of work done is obtained and the amount resulting from this represents the contract price adjustment due to the contractor. This is the preferred method, where such factors or indices are available. [6] The formula is usually of the following types: Pn=A + b(Ln/Lo) + c (Mn/Mo) + d(En/EO)+….. Where: Pn is a price adjustment factor to be applied to the amount each specific currency for the payment of the work carried out in the subject month

A is a constant, specified in the appendix to Bid, representing the nonadjustable portion in contractual payments i. e. it has no representative or linked indices; b, c, d, etc. , are weightings or coefficients representing the estimated proportion of each cost element (labor, materials, equipment usage, etc. ) in the works or sections thereof, net of Provisional Sums, as specified in the appendix to Bid. Ln, Cn, En, etc. , are the current cost indices or reference prices of the cost elements in the specific currency for months “n”, applicable to each cost element; and Lo, Co, Fo, etc. , are the base cost indices or reference prices corresponding to the above cost elements at the base date.

Prices and accordingly indices can increase and decrease and Pn can, therefore, be either greater than or less than one. In summary: Amount Due this Month =Value of Work Done this Month x Pn If a price adjustment factor is applied to payments made in a currency other than the currency of the source of the index for a particular indexed input, a correction factor Zo/Zn will be applied to the respective component factor of Pn for the formula of the relevant currency. Zo is the number of units of currency of the country of the index, equivalent to one unit of the currency payment on the date of the base index, and Zn is the corresponding number of such currency units on the date of the current index.

The adjustment formula becomes: Pn=A + b(Ln/Lo)(Zo/Zn) + c (Mn/Mo)(Zo/Zn) + d(En/EO)(Zo/Zn)+….. This method uses a mathematical model (a simplified mathematical description) of a system or process, used to assist calculation and predictions of the construction contract to calculate the contract price adjustment. The Client/Contractor develops the model by identifying the items of greatest expenditure and then combining these with statistically derived indices, which indicate the changes in the cost of those items. Once again this is best explained via an example:

ITEMS TO WHICH COST ADJUSTMENT MIGHT APPLY

Cost adjustment may be applied to the following: I.

Materials costs such as cement, fuel, reinforcement bar, asphalt/bitumen, etc. II. Labor costs III. Equipment costs IV. Currency exchange rates for goods purchased in foreign currency V. Inflation or deflation In normal contracting strategies, cost adjustment provisions should only be applicable to costs, typically long-term costs that might cause bidders to overestimate or uneconomically underestimate contract prices. [14] I. Price Adjustment For Materials The adjustment of materials should be made for principal materials involved in the contract. These materials, which face substantial price variations, are cement, fuel, reinforcement bar, bitumen (asphalt), etc.

The contractor will produce his invoice for those materials from which the quantities and costs can be abstracted. The value will be set against the value of corresponding quantities at the basic prices. Invoice should be called for in respect of all materials appearing in the basic list. The supervisor is responsible for seeing that fluctuation in either direction (either increase or decrease) is adjusted. A point that arises from time to time is whether increased cost can be allowed to a contractor, when there has been an increase in market price, for material which he has himself held in store for some time, and, if so, how it shall be assessed.

Although he does not buy for the job, he must lose money in replacement, if the current market price is higher than that at the time he bought. He has moreover, has the capital outstanding for some time and was forced to provide storage, so that he regards him self as a merchant selling to himself. [14] II. Cost Adjustment For Labor Since some roads contracts especially asphalt road in foreign Financiers support Ethiopia, they used price adjustment clauses in most contract document. Under such a clause, any fluctuation in the official agreed rates of wages or variations in the market price of materials are adjusted. The contract clause usually excludes adjustment for contractor’s overheads or profit.

The contractor may face unexpected expenses, such as increase of insurance contribution. Increases, which are made for the improved value of work, are not chargeable, e. g. the periodical increases given to apprentices, or an increase that may be give to a working foreman as recognition for his service. Care must be taken that there is no overlapping with the rates charged for day work when dealing with price variations. [14] III. Cost adjustment for fluctuations in currency exchange rates Default procurement system standard form contracts provide for cost adjustment for fluctuations in foreign currency exchange rates in respect of substantial items purchased overseas. The provisions may be omitted if desired.

There is no reason why the principal should be in any better position to control this price risk than the contractor. [14] IV. Cost adjustment for taxes: – Default procurement system standard form contracts provide for cost adjustment for customs taxes in respect of substantial items purchased overseas. The provisions may be omitted if desired. There is no reason why the principal should be in any better position to control this price risk than the contractor. [14] V. Cost adjustment for long-term service contracts:- In long-term services contracts; cost adjustment may be applied to rates or prices shown in the contract on an annual or other periodic basis.

For contracts of this nature, it may be convenient to avoid cost adjustment by contracting only for periods up to two years and omitting cost adjustment provisions. [14]

Cost Escalations’ Variables

Cost escalation is a persistent phenomenon in construction projects: Project types, Geographical locations and Historical period. Cost escalation is affected by three variables such as: A. Length of implementation phase measured in years B. Size of the project measured in costs C. Three types of ownership such as: ? Private ? State-owned enterprise ? Public ownership ? Decision-makers and/or project manager should be highly concerned about delays &long implementation phases because they translate into risks of substantial cost escalations.

Construction industry has grown large over time; so large projects have larger percentage cost escalation. [14] A. Cost escalation due to length of implementation phase Projects with longer implementation phases tend to have large cost escalation. Length of project implementation phase is the period from the decisions to build up to construction completed and operations have begun. C

Cite this Price Adjustment System in Ethiopia

Price Adjustment System in Ethiopia. (2018, May 10). Retrieved from https://graduateway.com/price-adjustment-system-in-ethiopia-essay/

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