# India: Ending The Continued Destruction By The L1 Contractor

### A New Approach To Choosing Contractors In Public Tenders

Synopsis

General Financial Rules issued by the Department of Expenditure, Ministry of Finance, Government of India, mandate that for awarding of the contracts for public works and store procurement, the notice inviting tender must be published widely, and among the offers received in response, the contract must be awarded to the firm with the valid lowest offer. It is thought that this system ensures transparency and objectivity and ensures best value for the public money.

This paper contends that this system is flawed at the most fundamental level of valuation, and most of the problems of project execution are caused by this method of choosing the L1 offer for awarding the contract. Using the theory of valuation in economics and mathematical probability distribution, an alternative method is derived which is also transparent, objective and gives the lowest cost of the public works when factors like completion time and quality of the works and supplies are taken into account.

Introduction

1.1 The theory of probability says that in any phenomenon that has large number of independently occurring events, most of the events have magnitude close to the mean of all the events. That is, for any event, the probability of the magnitude of the event being equal to the mean of all the magnitudes is the highest.

1.2 Therefore, when the values are plotted on the x axis and the probability of the event of a given value actually occurring is plotted on the y axis, the famous and ubiquitous Bell Curve results. That is, the events with the value close to the mean of the values have higher probability of occurring.

1.3 The Theory of Value in Economics says that the valuation of any economic goods is subjective. Each human being values a given economic goods based on his subjective needs, ideas, and knowledge of the market. All these factors differ from individual to individual, and moment to moment for the same individual. The value of an economic goods we call as its market price is actually the average of all such individual valuations. And even this average which is taken over a very very large numbers of the individuals is continuously changing.

1.4 Cost of public works is estimated based on the prices of its various inputs obtained from the past works or from survey in the market. But this estimated cost is not considered sacrosanct and the bidders are invited to quote their own cost for the work. The bidders are supposed to use their own experience and knowledge of market prices to work out the cost of the work, and offer to do the work at that cost. The lowest of such offer is claimed to be the actual cost of the work.

1.5 The Normal Distribution Curve instead says that such outlier values are rare occurrences and are best discarded for arriving at the best judgement of the value most likely to occur.

1.6 This paper contends that we should follow economics and mathematics, and discard the system of awarding the work to the lowest bidder.

The Flaws In The L1 Approach

2.1 It is accepted that any estimate of the work is not a final cost of that work. That is why department allows the bidders to quote their own cost of the work. This despite the fact that department frames the estimate using prices distilled from a very large number of works, and extensive market surveys.

2.2 The lowest cost quoted however is then accepted as the most accurate estimation of the cost of the work. But this cost is not arrived by the bidder based on his best judgement and estimation of the prices in the market. It is subject to a very strong bias.

2.3 The bidders know that the lowest estimated cost will win the contract. Therefore they do not quote the cost arrived at after market survey of prices and their experience, instead they try to outguess other bidders to arrive at a figure that would win the contract for them.

2.4 The bidders are independent players in the market. If they are not subject to this strong bias to make their offers the lowest, the cost arrived by them would be truly based on the market surveys and their subjective valuation of the expenditure involved in carrying out the work which will be guided by their experience.

2.5 If the bias to make their offers the lowest is not acting upon their minds, as per the theory of the normal distribution 68% of the offer would lie within one standard deviation above or below the mean of all offers, 95% within the two standard deviations, and 99.7% within the three standard deviations.

2.6 Therefore, the best cost estimation of the work will actually be closest to the mean of all the offers if there is no bias acting on the minds of the bidders. This cost estimation will also be closest to the actual cost of the work as per market prices as market prices themselves are nothing but the average of the individual valuations.

2.7 Accepting the lowest offer as the best estimation of the cost of the work thus goes against the theory of prices of economics and against the mathematical deduction that the most accurate estimation will lie very close to the mean of all estimations. This is so because economics says that prices are nothing but the average of the individual subjective valuations of the economic goods, and theory of normal distribution says that most of the values will lie close to the mean. Since prices are themselves already the average of the individual estimations, therefore the most accurate estimated cost of the work will also lie close to the mean of the received offer.

2.8 The system of accepting L1 offer thus scrambles the entire value judgement of the contractors. They suspend their knowledge, their subjective valuations, and arrive at the cost which would win them the contract, not the objectively estimated cost of the work. Instead of market survey of the prices, they try to guess what their competitors are likely to quote, and thus end up quoting the wrong cost of the work.

Consequences of the L1 System

3.1 Almost all the problems we the civil engineers are facing are directly traceable to the system of accepting the L1 offer.

3.2 The contractor quoted not the most accurate estimation of the cost, but the cost that was most likely to be the lowest. But the work will exact its actual market price. The contractor will have to pay the market prices of all the factors: material, labour, transportation, etc., prevailing in the area of the work.

3.3 The prices of all these factors vary seasonally. The contractor would try to pace the work in a way that most of the material is purchased when their prices are lowest in the year, he would do the work only in the months when labour prices are the lowest in the area, and would do the items of work with higher transportation cost in the months when transportation costs are lowest. This delays the work. The date of completion can not be adhered to despite all the efforts as he also keeps spotting any excuses that can be blamed on the department for the delay in the work.

3.4 He tries to change the items of the work. He starts claiming that such and such item is not possible to be executed for reasons beyond his control, or because of the defect in the framing of the bill of quantities by the department, and must therefore be replaced. He stops the work on this pretext which further adds to the delay. The dispute resolution takes very long post the award of the contract, and he then blames entire delay on the failure of the department to resolve the dispute. If department does get convinced that the items need to be changed or quantities need to be worked out, sanction of such variation takes a very long time. This inordinately delays the work and introduces subjectivity and the room for errors is created. Valuation of the post tender variations is very difficult and hence takes a very long time. The contractor uses all this delay to justify all the delays on his part.

3.5 He doesn’t involve himself in the management of the issue of the drawings. He doesn’t alert the department about any pending drawings and then blames the delays in execution on the delay in issuance of the drawings. He doesn’t point the defects in the drawings if any on time and then uses the resulting delay to cover delays on his own part.

3.6 He doesn’t cooperate in locating the hindrances, and refuses to do the work of removing the hindrances discovered at the rates decided by the department. This delays the work, but that is what the contractor wants.

3.7 He procures poor quality material, he employes labour with poor skills, he cuts all the possible corners. All the watch and check by the department have their own limitations. This results in the poor quality of the work. It may become visible immediately or it may affect the durability of the structure. But in either case the contractor leaves happily leaving the department to face the flak.

3.8 Instead of executing the work, the contractor starts creating records of disputes he himself raises, for making claims for the arbitration case he intends to fight to recover the losses he has incurred in becoming the lowest. Thus he concentrates more on record creating than on the work itself. His focus shifts. The work suffers as a result.

3.9 In the race to become the lowest, not much valuation skills are required, only the recklessness. Therefore not the most skilled contractors who can work out the cost of the work most accurately become the lowest, but the careless and ineffective contractors with poor knowledge of the works often become the lowest and win the contract. But they are not able to execute the work leading to failures and cumbersome process of retendering. The delays are caused eroding the faith of the system in civil engineers.

3.10 The system of awarding the work to the lowest bidders has led to situation that now the rates in the civil engineering contracts are mostly unworkable. This is leading to all of the problems listed above at far greater frequency. The cost and time overruns are increasing. Public and economy remain deprived of the works. Funds waste. And blame for all of this is being led on the civil engineers.

The Alternative To The System of L1

4.1 The public works are funded by the public money. The constitutional and legal and moral principles demand that the contracts for all the public works must be awarded through a transparent and objective system which gives equal opportunity to all the eligible entities, and which secures the best possible rates for the works.

4.2 The alternative system being presented here meets all the above requirements. It is transparent, thoroughly objective, and gives the rates which are lowest when the timely completion, quality, and durability of the works are taken into account. It discovers the contractor with the most accurate estimate of the cost of the work. Since the most skilled contractor will get the work, the delays will be minimized, the quality will be excellent and hence the structure will be durable.

4.3 The Theory of the Normal Distribution states that in case of the independent valuations, most of the valuation will converge to the mean of the valuations. That is, mean of the valuations is most accurate. Therefore, once the offers have been received, the mean of all the valid offers must be worked out, and the offer closest to the mean whether above or below it must be awarded the work.

4.4 The advantages of this system are numerous. Once the bidders know that the offer closest to the mean, which is the most accurate estimate of the cost of the work, will get the contract, they will put their best efforts and skills to estimate the cost based on all the factors of the market. So, we will get the most workable offer.

4.5 With the bidder with the most workable rates getting the contract, all the problems listed in the previous chapter will disappear. The projects will get completed on time, with best quality. The public will get to use the works most expeditiously, the works would last long, very long. The shady characters from among the contractors would be weeded out. The race to the bottom of the rates basket will stop. Departments would deal with the competent contractors, not the unscrupulous elements who use L1 route to get the work they are not skilled to do at the rates which are not workable.

4.6 The bids where offers less than three are received would present no difficulty. Since the contractors would use their best valuations as they can not be aware of the numbers of offers likely to be received, the L1 offer in such cases will still have the workable, accurate rates and hence should get the contract.

Conclusion

5.1 The public works are an essential feature of the country. Systems over centuries have evolved based on the needs as they arose. Whereas the formats of the contracts have undergone continuous change, the criterion to choose the contractor from among the bidders has remained unchanged because the public money involved places certain limitations on the discretion that can be allowed to the individuals holding the public offices. This has led to a situation where the public officials find themselves helpless to weed out the undesirable or incompetent contractors, but they get the blame for the failure of the contractors.

5.2 To address this, an elegant, objective, transparent and mathematically and economically correct method has been outlined to choose the bidder to whom the contract for the public work should be awarded.

5.3 Instead of awarding the work to the lowest bidder, the work must be awarded to the one who has given the most accurate estimation of the cost of the work. And that bidder is the one whose offer is nearest to the mean of all the offers received.

5.4 This system will encourage the bidders to acquire more estimation skills, to do more extensive market surveys and to offer the most workable rates. The system meets all the canons of financial prudence. It only requires few modifications in the General Financial Rules. Civil engineers, if they wish to keep their heads held high and deliver the projects with quality and on time, must insist that this system be adopted.

(This writeup was received as a forward. Author unknown.- Editor)