REFLECTIONS ON THE USE OF THE CONTRACT PRICE FLUCTUATION SYSTEM FOR PUBLIC SECTOR WORKS IN HONG KONG Patrick

TI Lam MHKIS Department of Building and Real Estate Hong Kong Polytechnic University E-mail: bsplam@polyu.edu.hk Sai On Cheung FHKIS Department of Building and Construction City University of Hong Kong E-mail: bcsoc@cityu.edu.hk Caroline TW Chan MHKIS Division of Building Science and Technology City University of Hong Kong E-mail: bstwchan@cityu.edu.hk Warren TY Yu Student Member of HKIS E-mail: warren_yu@hotmail.com

ABSTRACT
The Contract Price Fluctuation System (CPFS) has been used for adjusting payments to contractors of public sector works due to changes in material and labour costs for a number of years in Hong Kong and abroad. Whilst the rationale of this system is well recognised as risk-sharing between employers and contractors who enter into construction contracts lasting for long durations, the detail mechanisms of adjustment vary in different contractual jurisdictions. Taking Hong Kong as an example, although the basic principles of the CPFS bear some resemblances to the Formula Rules under the JCT family of contracts in the UK, the exact details of adjustment differ even between work commissioning departments in terms of the scope of work item included and the parameters used. A sample survey of data from recent contracts shows some interesting features, which throw some light on the efficacy of the system. This paper depicts the issues which clients and contractors alike should pay attention to in using the system and highlights the areas for improvement.

KEYWORDS:

Contract Price Fluctuation System, Formula Rules, Indices, Public Sector Contracts, Schedule of Proportions

INTRODUCTION The Contract Price Fluctuation System (CPFS), formerly known as Formula Price Fluctuation Adjustment System, was first introduced in Hong Kong back in 1977 for government civil engineering contracts, and in 1989 for its building contracts. The system, which is used to adjust construction contract sums, is based on changes in labour and material indices complied monthly by the Census and Statistics Department. It was intended to share risks between contractors and the Government resulting from changes in labour and material costs, thus leading to more rational and competitive tendering and lower risk of contractors becoming insolvent due to sudden

and unforeseeable inflation (ETWB, 2003a). The principles of the system bear resemblances with the Formula Rule adjustment for fluctuations in the Joint Contracts Tribunal (JCT) family of contracts in the UK, although the development of the system in Hong Kong has taken a more simplified track. According to NEDO (1969) and Goodacre (1978), it was well beyond doubt that inclusion of fluctuation adjustment provisions in construction contracts could help to relieve contractors of the risk of under-estimating the increase in price, and the client of any additional cost due to over-estimation of the increase in price. This paper focuses on the CPFS applicable to public sector contracts in Hong Kong. Public sector projects include those commissioned by works departments under the Environment, Transport and Works Bureau, such as the Architectural Services Department (ASD) and the Civil Engineering Department (CED), as well as the Housing Authority (HA). The operation of the CPFS in these departments is based on similar principles, whilst details differ, which will be outlined in the subsequent sections. OPERATION OF THE CPFS Schedule of Proportions Only projects with contract durations of more than 21 months will adopt the CPFS. Under the system, tenderers are required to complete Column (3) of a Schedule of Proportions attached to the Form of Tender (Refer to Table 1). All numbers filled in should fall within their respective pre-determined limits as set out in Column (1) and (2), and the sum of column (3) shall equal 100. The numbers filled in reflect a tenderers assessment of the relative proportions of the values of listed materials and composite labour comprising the contract sum. By setting the pre-determined limits, the possibility of speculation by tenderers is supposedly reduced as tenderers are not allowed to assign unreasonably high proportions in one or several items. The tender sums submitted by tenderers contain a unified and pre-determined (inserted by the client) Provisional Sum to allow for the financial effect of the fluctuation adjustment. Before execution of the Articles of Agreement, the clients quantity surveyor has to complete Column (4) by multiplying the figures marked by the successful tenderer in Column (3) by 0.0085, as only 85% of the project cost is subjected to fluctuation adjustment. The products, namely weighted proportions, will then be used in the calculation of the Price Fluctuation Factor (PFF). Price Fluctuation Factor (PFF) Next, the clients quantity surveyor has to determine the base indices, which is the set of published indices of the month upon which the 42nd day prior to the date set for return of tenders falls. The base indices, together with the weighted proportions, remain unchanged for all fluctuation calculations. In each payment, the current indices (the set of indices for the month upon which the 42nd day prior to the last day of the

period to which the payment certificate relates falls) are obtained and an index fraction for each item is calculated by the formula

Current Index Base Index . Base Index

After that, the product of Column (3) and (4) in Table 2 will give a Factor for each item in the list. The PFF for that valuation period can be obtained by adding up all the factors in Column (5). Table 1: Schedule of Proportions (as it appears in Tender Documents)
Item of Labour and Selected Materials applicable to this Contract Percentage of "Effective Value" of the Works LIMITS Max. Min. TENDER (whole number) (Column No.) Composite labour for building contracts Aggregates Portland cement (ordinary) Sand Steel reinforcement Light structural steelwork Timber formwork Hardwood Mosaic tiles Glazed wall tiles GMS pipes PVC pipes (not exceeding 85mm) PVC pipes (exceeding 85mm) Glass All other costs not subject to adjustment TOTAL (1) 40 4 25 2 18 2 12 6 5 5 5 5 5 5 (2) 20 3 17 1 11 1 10 3 2 4 2 1 1 1 100 0.1500 1.0000 (3) Calculated Proportions Index Proportion [0.0085(3)] (4)

Effective Value (EV) Effective Value refers to the amount of work within an interim valuation which is subjected to fluctuation. Its calculation is described in the General Conditions of Contracts (GCC) Clause 89(3)(d), which is the difference between: (1) The total estimated value of works accumulated to the current certificate; and

(2) Value of work and/or material based on actual cost or current price; amount included in respect of nominated sub-contractors including profit thereon and the Effective Value of work and/or material to last certificate.

When both the PFF and the EV have been calculated, the amount payable or deductible for price fluctuation can be obtained by multiplying these two figures together. All these calculations are conducted in the proforma Statement of contract price fluctuations, which is part of the Surveyors Certificate. Table 2: Example of PFF calculation using hypothetical Calculated Proportions
Index Figures Items Base Current Index Fraction (Current-Base) Base Column No. Composite labour for building contracts Aggregates Portland cement (ordinary) Sand Steel reinforcement Light structural steelwork Timber formwork Hardwood Mosaic tiles Glazed wall tiles GMS pipes PVC pipes (not exceeding 85mm) PVC pipes (exceeding 85mm) Glass 79.9 81.0 0.01376721 0.008500 0.00011702 0.003604 87.4 85.3 (0.02402746) 0.008500 (0.00020423) 94.3 105.3 95.7 74.6 81.7 92.7 96.5 106.6 104.5 95.3 88.0 87.0 102.2 93.5 76.5 83.4 93.5 95.8 106.9 107.1 94.3 85.2 (0.07741251) (0.02943970) (0.02298851) 0.02546917 0.02080783 0.00862999 (0.00725389) 0.00281426 0.02488038 (0.01049318) (0.03181818) 0.025500 0.144500 0.008500 0.093500 0.008500 0.093500 0.042500 0.017000 0.034000 0.017000 0.008500 (0.00197402) (0.00425404) (0.00019540) 0.00238137 0.00017687 0.00080690 (0.00030829) 0.00004784 0.00084593 (0.00017838) (0.00027045) (1) 149.1 (2) 152.0 (3) 0.01945003 (4) 0.340000 (5) 0.00661301 Calculated Proportion FACTOR (3) (4)

PRICE FLUCTUATION FACTOR (PFF) (Assumed Base Index Month: Feb 1999 / Current Index Month: August 1999)

OBSERVATIONS ON THE USE OF THE CPFS

In this section, several scenarios based on the possible ways tenderers fill in the Schedule of Proportions are discussed to illustrate the differences in tendering tactics:
Choosing the Right Proportions It has been mentioned that the Schedule of Proportions contains pre-determined limits and tenderers are free to distribute the proportion of works among the different items in Column (3) as long as they are within the individual limits. The Environment,

Transport and Works Bureau has established different sets of pre-determined limits for different types of works (e.g., high-rise, low-rise, alteration works, etc.). Between different works departments, some variations also exist in the list of materials (e.g., the CED list contains bitumen and diesel fuel whereas the ASD list contains teak and bricks, which are not in the HA list). In the following illustration, the PFF of two hypothetical contractors are calculated, using the same base and current index months for both contractors, who insert the respective proportions as shown in Table 3. Table 3: Illustration of different proportions as inserted by hypothetical contractors
Items Composite labour wages Aggregates Portland cement (ordinary) Sand Steel reinforcement Light structural steelwork Timber formwork Hardwood Mosaic tiles Glazed wall tiles GMS pipes PVC pipes (not exceeding 85 mm) PVC pipes (exceeding 85 mm) Glass Limit 40 20 43 25 17 21 18 11 21 12 10 63 52 54 52 21 21 21 Inserts by Contractor X 34 3 25 1 11 2 10 3 2 4 2 1 1 1 Inserts by Contractor Y 20 4 17 2 18 2 12 6 3 5 5 2 2 2

From the way they fill in the proportions, it would appear that the two contractors hold different views as to their genuine estimates of the respective proportions of the values of the items comprising their tender sums, or else Contractor X forecasts a rising trend for labour wages, whereas Contractor Y forecasts a falling trend for the same item during the course of the contract. Table 4 demonstrates that, despite both contractors having the same set of index fraction, the way they allocate the proportions in Column (3) (see Table 3) does have a significant effect in subsequent PFF calculations it is possible to have a change in PFF from negative to positive value or vice versa! In other words, if the Effective Value for an interim certificate is, say $3,000,000, then a sum of $1,872 ($3,000,000 -0.000624) will be deducted from Contractor X while $54,519 ($3,000,000 0.018173) will be payable to Contractor Y, and the difference is $56,391!

Table 4: PFF calculations for two hypothetical contractors

Index Figures Items Column No. Composite labour for building contracts Aggregates Portland cement (ordinary) Sand Steel reinforcement Light structural steelwork Timber formwork Hardwood Mosaic tiles Glazed wall tiles GMS pipes PVC pipes (not exceeding 85mm) PVC pipes (exceeding 85mm) Glass Base (1) 150.6 81.3 93.3 73.1 67.7 82.8 93.3 99.1 102.7 111.4 88.9 85.5 83.8 92.7 Current (2) 149.9 79.1 84.7 68.8 80.4 86.1 95.8 103.0 101.5 111.4 89.4 85.6 83.8 91.9

Index Fraction (Current-Base) Base (3) -0.00464807 -0.02706027 -0.09217578 -0.05882353 0.18934911 0.03985507 0.02679528 0.03935419 -0.01168452 0.00000000 0.00562430 0.00116959 0.00000000 -0.00862999

Calculated Proportion Contractor X (4) 0.2890 0.0255 0.2125 0.0085 0.0935 0.0170 0.0850 0.0255 0.0170 0.0340 0.0170 0.0085 0.0085 0.0085 Contractor Y (5) 0.1700 0.0340 0.1445 0.0170 0.1530 0.0170 0.1020 0.0510 0.0255 0.0425 0.0425 0.0170 0.0170 0.0170

FACTOR Contractor X (3) x (4)

-0.00134329 -0.00069004 -0.01958735 -0.00050000 0.01770414 0.00067754 0.00227760 0.00100353 -0.00019864 0.00000000 0.00009561 0.00000994 0.00000000 -0.00007335

Contractor Y (3) x (5)

-0.00079017 -0.00092005 -0.01331940 -0.00100000 0.02897041 0.00067754 0.00273312 0.00200706 -0.00029796 0.00000000 0.00023903 0.00001988 0.00000000 -0.00014671

PRICE FLUCTUATION FACTOR (PFF)

-0.000624

0.018173

(Base Index Month: January 2002 / Current Index Month: September 2002)

Empirical Observations on the Effects of the Base Month The above illustration only focuses on contractors PFF of a particular month. However, in reality different contracts are tendered for at different time. Hence, their base months are different. To examine the effect of the base month, the PFF curves of eight randomly selected contractors, namely Contractor A to H, whose identities are kept anonymously, are plotted and compared. (See Fig. 1)

From Fig. 1, it is clear that the PFF curves of these contractors are more or less in tandem, i.e., they share the same pattern of movement. This indicates that they generally have similar genuine estimates of proportions or similar predictions of future price trends. This was evidenced by the very similar, if not identical, figures being filled in their Schedule of Proportions for most items. It is worthwhile to pay attention to the position of the PFF curves Contractor As curve is wholly negative, while Contractor Ds (whose base month is just seven months later than Contractor A) PFF curve is shifted upward. A close examination of the material and labour indices revealed that most indices had relatively low values in August 1998, i.e., the base month for Contractor Ds project, resulting in relatively higher index fractions for subsequent months. Another possible reason for the lifting is because Contractor D allocated less proportion for Portland cement, which encountered a greater degree of price fall throughout the period than GMS pipes (Table 5). Table 5: Schedule of Proportions for Contractor A and Contractor D
Items applicable to building contracts Base Month Composite labour Aggregates Portland cement Sand Steel reinforcement Light structural steelwork Timber formwork Hardwood Mosaic tiles Glazed wall tiles GMS pipes PVC pipes ( 85mm)
Max Min.

CONTRACTOR A 1/98 B 5/98 C 6/98 D 8/98 E 1/99 F 5/99 G 10/99 H 3/00

-40 4 25 2 18 2 12 6 5 5 5 2

-20 3 17 1 11 1 10 3 2 4 2 1

20

20

18

17

17

17

17

17

2 1 PVC pipes ( >85mm) Glass 2 1 (Note: Proportions other than those shown are suppressed for confidentiality reason yet they are

quite similar between the 8 randomly sampled contractors)

The above illustration shows that the vertical position of a PFF curve can be altered by filling in different sets of proportions in the same base month. However, empirical observations on these 8 sample data sets suggest the view that contractors usually complete the Schedule of Proportions quite similarly. Therefore the distinction between different contractors PFF curves is mainly affected by the base months, which is outside the contractors control. It is also well demonstrated that a short interval between base months could mean an overall shifting of the whole PFF curve!

Variation of PFF (Contractor A to H)

0.015000

Contractor D
0.010000 0.005000

Contractor C Contractor B

0.000000 Aug-98 Aug-99 Aug-00 Aug-01 Aug-02 Oct-98 Oct-99 Oct-00 Oct-01 Apr-02 Oct-02 Dec-98 Dec-99 Dec-00 Dec-01 (0.005000) (0.010000) Dec-02 Apr-99 Apr-00 Apr-01 Feb-99 Feb-00 Feb-01 Feb-02 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02

Contractor E

PFF

Contractor H
(0.015000)

Contractor F
(0.020000)

Contractor A
(0.025000) (0.030000)

Contractor G
(0.035000) (0.040000)

Fig.1: Comparison of PFF curve of contractor A to H Fig. 1: Comparison of the PFF curves of Contractor A to H

Time

Foresight vs Hindsight Although contractors generally could forecast major trends of building costs, their prediction accuracy is still far from being perfect. To illustrate how perfect foresight could benefit a contractor, the Best and the Worst scenarios created from hindsight of what actually happened to material and labour prices are tabulated (see Table 6) and plotted (see Fig. 2) for comparison with the actual PFF curve, taking Contractor F above as an example.

Table 6: Proportions between actual, best and worst scenarios of Contractor F

Items Composite labour wages Aggregates Portland cement (ordinary) Sand Steel reinforcement Light structural steelwork Timber formwork Hardwood Mosaic tiles Glazed wall tiles GMS pipes PVC pipes (not exceeding 85 mm) PVC pipes (exceeding 85 mm) Limit 40 20 43 25 17 21 18 11 21 12 10 63 52 54 52 21 21 Actual Best 35 3 17 1 11 2 12 6 2 5 2 1 1 Worst 20 4 25 2 18 1 10 3 4 4 5 2 1 1

2 Glass 21 (Note: Actual Proportions filled by Contractor F are suppressed for confidentiality reason)
Best, Actual and Worst scenario of Contractor F
0.010000

0.000000 Jun-00 Aug-00 Jun-01 Aug-01 Apr-00 Apr-01 Dec-99 Dec-00 Dec-01 Apr-02 Feb-00 Feb-01 Feb-02 Oct-99 Oct-00 Oct-01

-0.010000 Best PFF curve -0.020000 Worst PFF curve -0.030000 Actual PFF curve

PFF

-0.040000

-0.050000

Time

Fig. 2 Graph showing a range of possible PFF curves of Contractor F

From Fig. 2, the best combination is simulated by allocating higher proportions to those items that went up and at the same time keeping those proportions for items that went down to their minimum values. This would have improved Contractor Fs situation as the whole PFF curve would be shifted upward. For instance, in March 2000, Contractor Fs PFF could well be adjusted from -0.007159 to 0.003721. If the Effective Value was $3,000,000 for that period, that means a net difference of $21,477! In reality, contractors PFF curves always lie between the best and the worst scenarios. Yet, if the contractor can monitor closely the trend of major material prices, they could still benefit as shown in Figure 3.

PFF Pattern (Contractor 1 to 4)

0.250000

0.200000 Contractor 2 0.150000

PFF

0.100000 Contractor 1 0.050000 Contractor 3 0.000000

Feb-00 Feb-01 Feb-02 Feb-03 Jun-00 Jun-01 Jun-02 Apr-00 Apr-01 Apr-02 Aug-00 Aug-01 Aug-02 Apr-03 Jun-03 Aug-03 Oct-00 Oct-01 Oct-02 Dec-00 Dec-01 Dec-02 Oct-03 Dec-03

Contractor 4

(0.050000) Time

Fig.3 PFF Pattern for 4 randomly selected contractors In Fig. 3, Contractors 1 and 2 experienced sharp rises in their PFFs in recent months due mainly to price rises for reinforcement steel. Contractors 3 and 4 were less fortunate since their contract periods were different. Another possible explanation of the difference in shapes of the PFF curves lies in the pre-determined set of limits in the Schedule of Proportions. Apart from the typical limits, the clients project surveyor can set other limits deemed to be appropriate for the special projects in hand, as derived from an analysis of similar projects where possible (ETWB 2003b). The pre-determined limits set for Contractors 1 and 2 as well as their own inserted limits are shown in Table 7, which, together with the graph showing the trends of steel prices (Fig. 4), can explain the rather unusual shapes of their PFF curves. Table 7: Extracts of significant Proportions for 2 randomly selected contractors CONTRACTOR 1 CONTRACTOR 2 Items applicable to contract Limits Tender Limits Tender Composite labour for 40 20 20 40 20 20 building contracts Steel reinforcement 42 7 42 42 7 42

Changes of Steel Reinforcement Index from 1998 to 2003

140.0

120.0

100.0

Index

80.0

60.0

40.0

20.0

0.0
Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Aug-98 Aug-99 Aug-00 Aug-01 Aug-02 Jun-03 Aug-03 Feb-99 Apr-99 Feb-00 Apr-00 Feb-01 Apr-01 Feb-02 Apr-02 Feb-03 Apr-03 Oct-98 Oct-99 Oct-00 Oct-01 Oct-02 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Oct-03 Dec-03

Time

Fig.4 Trend of price movement for reinforcement steel (Source: Census & Statistics Dept.)
Composite Labour Wages If we compare the annualised curve of the Composite Labour Wages as used in the CPFS with the curve formed by the Real Salary Indices (A) in Building and Construction and Related Trades, it seems that the two curves are not related (Fig.5). The raw data for both curves is extracted from the Census and Statistics Department.

Comparison between the Composite labour wages curve and the Real Salary Index (A) in building, construction and related trades curve
160.0 155.0 150.0 145.0 140.0 135.0 130.0 125.0 120.0 115.0 110.0 105.0 100.0 95.0 90.0 1995 1996 1997 1998 1999

Index figures

Composite labour wages

Real Salary Index (A)

2000 2001 2002

Year
Fig. 5: Comparison between the Composite Labour Wages and Real Salary Index (A) (Source of data: Census and Statistics Dept.)

Although the overall trend of these two curves are the same: rising from 1995 to mid 2000 and then going downward. When the market was booming, the Composite Labour Wage (CLW) curve went up faster than the Real Salary Index (A) curve. On the other hand, when the market contracted, the CLW curve went down slower than the other curve. As an illustration, a 5.6% drop in the Salary Index (A) between 2001 and 2002 was matched by a mere 1.5% drop in the CLW in the same period The above observation is echoed in the briefing document for a consultancy study invited recently by the Environment, Transport and Works Bureau in 2003. Quoting from the document (ETWB 2003a): the problem for material indices is not significant as the cost information is collected independently by the Census and Statistics Department from suppliers. However, the labour wage data are provided by contractors and the matter at issue is that the wage data cannot be readily verified. There have been serious concerns that the labour indices in recent years are apparently not reflecting the market trend of the significant falling wage rates prevailing in most sectors and as generally expected under deflationary condition. The CLW is the only one component in the CPFS that is compiled by data provided by contractors through the submission of Labour Returns. According to the Study Brief, site staff of the client could at best spot obvious and exceptionally high/low wages figures and therefore it is difficult for them to validate the wage data. This problem has yet to be solved.
CONCLUSION This paper depicts the operation of the CPFS and some observations on its use. Essentially speaking, the CPFS is supposed to reduce the pricing risk of contractors in terms of material and labour cost fluctuations. In the long run, it also helps to rationalise building costs for clients. Due to the particular mechanism of adjusting contract price, contractors need to monitor the movements of material and labour prices carefully to enable accurate estimating of their proportions for tender purpose. On the client side, refinement, updating and improvement of the CPFS can ensure the efficient operation of the system in order to achieve the intended objectives. ACKNOWLEDGEMENT

This paper was first published in The Hong Kong Surveyor (Vol. 15, Issue 1, July 2004) by the Hong Kong Institute of Surveyors and is reproduced here with their kind permission.
REFERENCES

(1) ETWB (2003a). Study Brief for Consultancy Study on Contract Price Fluctuation System for Public Works Contracts, Environment, Transport and Works Bureau, Hong Kong SAR Government (2) ETWB (2003b). Technical Circular (Works) No. 21/2003 Contract Price Fluctuation System for Civil Engineering and Building Contracts, Environment, Transport and Works Bureau, Hong Kong SAR Government

(3) Goodacre, PE (1978). Formula method of price adjustment for building contracts. Centre for Advanced Land Use Studies, College of Estate Management, UK (4) HKSAR Government. (1993). General Conditions of Contract for Building Works, Hong Kong Government Printer. (5) NEDO (1969). Formula method of price adjustment. National Economic Development Office, UK