How fixed-cost pricing in public sector tenders affects construction SMEs

Christian Rowe is the managing director of Executive Compass

When bidding into the public sector, small- and medium-sized construction businesses (SMEs) often feel they are at a competitive disadvantage, particularly given that most government contracts employ a fixed-cost pricing model.

“It may be preferable to miss out on a contract due to pricing rather than incur serious financial difficulties”

With smaller labour resources, limited cashflow and fewer supply-chain options compared to larger firms, SMEs may feel they will struggle to stand out compared to larger bidder organisations. Equally, the recent effects of industry inflation have had an outsized impact on construction contractors, leading to nearly 18 per cent of insolvencies in March last year.

Nevertheless, careful planning and prudent, considered ‘bid/no-bid’ decisions will allow construction SMEs to stay afloat and maintain steady growth in a challenging sector.

From the buyer’s perspective, the primary benefit to fixed-cost pricing is a risk transfer from the buyer to the supplier. Such models offer cost certainty, precise timetabling, additional negotiations and simpler pricing schedules compared to open-book contracts.

One study found that buyers use fixed-price models for 80 per cent of construction contracts compared to open-book models. Furthermore, high-priced construction projects (in excess of £1m) are nearly four times as likely as low-value (up to £250,000) to employ open-book contracts, meaning the majority of small businesses will be required to submit a fixed-cost quotation for services.

Inflation and fixed-cost pricing – impacts on SMEs

Although industry inflation has stabilised in comparison to the previous years (topping out at 10.4 per cent in May 2022), the effects remain a pressing issue for SME construction businesses currently engaged in fixed-cost contracts.

  • Energy: The construction industry accounts for nearly 20 per cent of the UK’s fossil fuel consumption, primarily via natural gas. Furthermore, construction management consultancy RG Group estimated that SMEs and subcontractors incurred the largest risk from skyrocketing energy prices, due to their tendency to work on fixed-term contracts.
  • Profitability: Profit margins in construction are among the smallest in any UK sector, averaging between 1.5 and 2 per cent. Whereas larger firms may be better positioned to absorb at-price or even loss-leader pricing, SMEs have neither the flexibility nor project turnover to commit to a calculated loss on contracts.
  • Supply chain: A report from Knight Frank found that build costs have increased 24 per cent in the past three years and materials costs have risen 43 per cent in two years, placing significant strain on smaller construction businesses with fewer supply-chain options.
  • Resourcing: There are approximately 244,000 fewer workers in the construction sector compared to three years ago, and nearly 20 per cent of firms are reporting worker shortages. Salary increases due to inflation and the ongoing cost-of-living crisis add financial pressure on construction SMEs.

The last five-year forecast from BCIS anticipates construction costs to outpace tender prices until Q3 2024, before dipping under from Q4 2024 through to 2028.

What can construction SMEs do?

Although challenges posed by fixed-cost pricing and rampant industry inflation may seem insurmountable, careful and prudent planning will allow small businesses to remain afloat and effectively manage risk in the current climate:

  • Strengthen supply chains: when forming SLAs, negotiate for as long an agreement as possible to preserve any discounts or bulk deals stemming from the contract. Increasing existing stock levels of commonly used parts and materials prone to inflation will further aid in shielding SMEs from future price hikes during fixed-cost contracts.
  • Consider forming a consortium: The benefits of forming a consortium include overcoming minimum turnover thresholds and great operational resourcing and capacity, particularly when contracts are across different workstreams. The Federation of Master Builders has released a report outlining the advantages of several SMEs forming a consortium to strengthen chances of winning public sector contracts.
  • Search and bid for frameworks: Public sector frameworks offer a range of benefits for SMEs, including long contract lifecycles, scalable workstreams and shared risk. Securing a position on a framework agreement can also aid in forming long-lasting relationships with buyers, allowing SMEs to develop a positive relationship for future work opportunities.
  • Price wisely: Try to integrate potential increases to materials costs and cost-of-living pay rises into pricing, ensuring a realistic and comfortable profit margin during the contract term. It may be preferable to miss out on a contract due to pricing rather than incur serious financial difficulties in the medium- to long-term of a business lifecycle.

While there is no quick-fix solution to the current challenges construction SMEs face, the above mitigations can help to prevent overextension and its consequences during this turbulent period.

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