Contract pricing

Engineering and construction contracts can be drawn in a great variety of forms, depending on the contract strategy and the financial resources of the contractor. The most successful contracts have at least one element in common: thoughtful and thorough preparation before the contract is let.

Contractual arrangements in construction are becoming increasingly more involved, which leads to the potential for significant added costs. Project complexity and the changing and increasingly costly legal and insurance environments, are major reasons for considering whether better contractual arrangements are possible.

Contracts, of course, must be made early in the life of a project. To do this while simultaneously providing for the risks of uncertainties and gaining improved performance and innovation presents major challenges for owners and contractors alike.

Forms of contract

There are three principle types of contracts: reimbursable, measured (unit price), and lump sum. The following forms of contract are typical of these types:

• Cost Reimbursable (Time & Material);
• Cost Reimbursable with Percentage Fee;
• Cost Reimbursable with Fixed Fee;
• Cost Reimbursable Plus Cost/Schedule Bonus – Penalties;
• Measured Unit Price (Mostly Construction);
• Guaranteed Maximum Price; and
• Lump Sum/Fixed Price.

The objectives of cost, time, quality, risks, and liabilities must be analyzed and prioritized, since trade-offs will probably be necessary in deciding the type of contract to be used.

Reimbursable cost contracts

These require little design definition, but need to be constructed in a way that allows expenditures to be properly controlled. The major advantage of a reimbursable cost contract is time, since a contract can be established during the early stages of a project. This type of contract does present a disadvantage to an owner, however, since poor contractor performance can result in increased costs, and the final costs are the owner’s responsibility. Additionally, the final/total investment level is not known until the work is well advanced.

Reimbursable cost contracts can contain lump sum elements. e.g. the contractor’s overhead charges and profit, which is usually preferable to a percentage basis for calculating these costs. Reimbursements may be applied to salaries, wages insurance and pension contributions, office rentals, communication cost, etc. Alternatively, reimbursement can be applied to all-inclusive hourly or daily rates for time spent by engineers on the basis that all office support costs are built into these rates.

This form of contract is generally known as a fixed fee/reimbursable cost contract and can be used for both engineering and other office services as well as for construction work.

Such arrangements give the owner greater control over the contractor’s engineering work, but the effect of reducing the lump sum content of the contractor’s remuneration is to reduce its financial incentive to complete the work economically and speedily. It also reduces the ability to compare/evaluate competitive bids, since the comparison that can be made between contractor bids involves only a small percentage of the project cost. It is possible that the “best” contractor may not quote the lowest prices.

Requirements

• A competent and trustworthy contractor;

• Close quality supervision and direction by the owner; and

• Detailed definition of work and payment terms covered by lump sums and by “all-inclusive” rates.

Advantages

• Flexibility in dealing with changes (which is very important when the job is not well defined), particularly if new technology development is proceeding concurrently with the design.

• An early start can be made.

• Useful where site problems such as Internal Review (IR) delays and disruptions may be encountered.

• Owner can exercise control on all aspects of the work.

Disadvantages

• Final cost is unknown.

• Difficulties in evaluating proposals--strict comparison of the amount tendered may not result in selection of the “best” Contractor or in the lowest cost of the project.

• Contractor has little incentive for early completion or cost economy.

• Contractor can assign its “second division” personnel to the job and may make excessive use of agency personnel and/or use the job as a training vehicle for new personnel.

• Owner carries most of the risks and faces the difficult decisions.

Target contracts

(Cost and Schedule)

Target contracts are intended to provide a strong financial incentive for the contractor to complete the work at minimum cost and time. In the usual arrangement, the contractor starts work on a reimbursable cost basis.

When sufficient design is complete, the contractor produces a definitive estimate and project schedule for owner review, mutual negotiation, and agreement. After agreement is reached, these become targets. At the end of the job, the contractor’s reimbursable costs are compared with the target and any savings or overrun is shared between the owner and the contractor on a pre-arranged basis.

Similarly, the contractor qualifies for additional payment if it completes the work ahead of the agreed-upon schedule.

The main appeal this form of contract has to the contractor is that it does not involve competitive bidding for the target cost and schedule provisions.

Requirements

• A competent and trustworthy contractor; and

• Quality supervision by owner (both technical and financial).

Advantages

• Flexibility in controlling the work.

• Almost immediate start on the work, even without a scope definition.

• Encourages economic and speedy completion (up to a point).

Disadvantages

• Final cost initially unknown.

• No opportunity for competitive bidding for the “targets”.

• Difficulty in agreeing on an effective target.

• Variations are difficult and costly once the target has been established. Contractors tend to inflate the cost of all variations so as to increase profit potential with “easy” targets.

• If the contractor fails to achieve the targets, it may attempt to prove that this was due to interference by the owner, or to factors outside the contractor’s control; hence, effective control and reporting is essential.

Measured Contracts

(Unit Price)

These require sufficient design definition or experience in order to estimate the unit/quantities for the work.

Contractors then bid fixed prices for each unit of work. The advantage is that the time and cost risk is shared: the owner will be responsible for the total quantities, and the contractors will have the risk of the fixed unit price. A quantity increase greater than 10% can lead to increases in the unit prices.

Requirements

• An adequate breakdown and definition of the measured units of work;

• A good quantity surveying/reporting system;

• Adequate drawings and/or substantial experience for developing the Bill of Quantities;

• Financial/payment terms that are properly tied to the measured work and partial completion of the work;

• Owner-supplied drawings and materials must arrive on time; and

• Quantity-sensitivity analysis of unit prices to evaluate total bid price for potential quantity variations.

Advantages

• Good design definition is not essential - “typical” drawings can be used for the bidding process.

• Very suitable for competitive bidding and relatively easy contractor selection, subject to sensitivity evaluation.

• Bidding is speedy and inexpensive and an early start is possible.

• Flexibility - depending on the contract conditions, the scope and quantity of work can be varied.

Disadvantages

• Final cost is not known at the outset since the Bills of Quantities have been estimated on incomplete engineering.

• Additional site staff are needed to measure, control and report on the cost and status of the work.

 

Lump sum/Fixed price contracts

In this type of contract, the contractor is generally free to employ whatever methods and resources it chooses in order to complete the work. The contractor carries total responsibility for proper performance of the work although approval of design, drawings, and the placement of purchase orders and subcontracts can be monitored by the owner to ensure compliance with the specification.

The work to be performed must be closely defined. Since the contractor will not carry out any work not contained in the specification without requiring additional payment, a fully developed specification is vitally important. The work has to be performed within a specified period of time, and status/progress can be monitored by the owner to ensure that completion meets the contractual requirements.

The lump sum/fixed price contract presents a low financial risk to the owner, and the required investment level can be established at an early date. This type of contract allows a higher return to the contractor for superior performance.

A good design definition is essential, although this may be time-consuming. Further, the bidding time can be twice as long as that for a reimbursable contract bid. For contractors, the cost of bids and the high financial risk are factors in determining the lump sum approach.

Requirements

• Good definition and stable project conditions are essential;

• Effective competition is essential;

• Several months are needed for bidding and appraisal; and

• Minimal scope changes.

Advantages

• Low financial risk to owner; maximum financial risk is on the contractor.

• Cost (and project viability) is known before commitment is made.

• Minimum owner supervision - mostly quality assurance and schedule monitoring.

• Contractor will usually assign its best personnel to the work.

• Maximum financial motivation of contractor - maximum incentive for the contractor to achieve early completion at superior performance levels.

• Contractor has to solve its own problems - and quickly.

• Contractor selection (by competitive bidding) is fairly easy, apart from deliberate low price         

Disadvantages

• Variations are difficult and costly - the contractor, having quoted keenly when bidding, will try to make as much as possible on extras.

• An early start is not possible because of the time taken for bidding and for developing a good design basis.

• The contractor will tend to choose the cheapest and quickest solutions, making technical monitoring and strict quality control by the owner essential; schedule monitoring is also advisable.

• The contractor has a short-term interest in completing the job and may cause long-term damage to local Internal Review (IR) relationships, e.g. by setting poor precedents/union agreements.

• Bidding is expensive for the contractor, so the bid invitation list will be short; technical appraisal of bids by the owner may require considerable effort.

• Contractors will usually include allowances for contingencies in the bid price and they might be high.

• Bidding time can be twice that required for other types of contracts.

Summary

• It is possible to devise a form of contract with appropriate terms and conditions to suit many different circumstances. Some basic considerations leading to the best choice are:

• Clear definition of each party’s contractual responsibilities. Shared responsibilities are unsatisfactory, although they are unavoidable in some circumstances.

• The Lump Sum form of contract provides the best financial risk for the owner, gives the contractor the maximum incentive for early completion, and produces the greatest benefit of competitive bidding. Conversely, reimbursable contracts provide no such incentives. It is dangerous, however, to attempt to use a Lump Sum contract if the essential conditions are not satisfied - notably, a clear and complete definition of the scope of work.

• The owner must have the contractual right to exercise adequate control to ensure the success of the project, but the temptation to assume excessive control should be resisted.

• Control and responsibility go together - the greater the owner’s control, the less the responsibility carried up by the contractor.

 

Thanks to Ignacio Manzanera for providing this book