Construction Contract Types by Price

The factors influencing a construction contract pricing arrangements are numerous and these always must include your own Organization past experience for a project of similar nature; what went well and what didn′t work and which were the circumstances with regards to your responsibilities, engineering and procurement, construction supervision and project management , the contractor′s performance and the unforeseen events which affected the project delivery.

Another factor to consider is the contracting strategy: one main general construction contractor or several discipline / specialty contractors.

Therefore, there is not a single or fixed set of “key” factors to define the best pricing arrangement. Having said that, all pricing arrangements have some common features. This article briefly describes some basic principles of the most common types of pricing arrangements and which may help to decide the type of construction contract/s on your new projects if you are an owner, or an EPC contractor (in which case the construction contracts are commonly called subcontracts).

Contract Provisions for Risk Allocation

Although the type of pricing arrangement sets out the contract risk allocation, there are many other provisions for the allocation of risk among parties to a contract. Typically, these provisions assign responsibility for covering the time and costs of possible or unforeseen events or unforeseen impacts of foreseeable events. Amongst others, this list contains some risks which typically appear in a construction project:

• Differing site conditions
• Disruption by Authorities
• Changes and its cumulative impact
• Liquidated damages, such as for Delay and Performance
• Permits, licenses, regulations
• Force majeure
• Indemnification for losses and damages incurred by a third party
• Change in Law, including Labor laws
• Termination
• Suspension of work,
• Warranties and guarantees.

Risks on Construction delivery

All owners want quality construction, short delivery time and with reasonable costs, but not all are willing to share risks and/or provide incentives to enhance the quality of construction and reduce the delivery time. It is not uncommon that after awarding reduced contract prices, claims and disputes on contracts are more frequent. Some of these claims and disputes can no doubt be avoided by improving the contract provisions and always accompanied of an effective project management, technically and commercially.

Contract Types by Price

The owner has the sole power to decide what type of contract should be used for a specific facility to be constructed and to set forth the terms in a contractual agreement. It is important to understand the risks of the contractors associated with different types of construction contracts.

Since every project is unique, the contract type should be chosen with care and considering how does success looks for that project. As an example, to build a facility on a fast-track basis the owner's primary goal is the earliest possible completion date. This decision may be based upon the high cost of financing, high inflation, or the high return on investment value of early completion to start operating the facility at the earliest possible time.

Construction Lump Sum Contract

This type of contract is based upon a well defined scope at the time of contracting. Technical specifications and drawings should be essentially complete. This is the most rigid of all contract types with respect to allowable variations or changes in project execution and completion.

Advantages

• Maximum construction efficiency
• Detailed project definition requires minimum change
• Provides an upper boundary on costs
• Contractor bears major portion of risk
• Requires minimum administrative monitoring

Disadvantages

• Poor defined change management and extension of time provisions may lead to numerous claims and dispute.
• Contract price includes the contractor's contingency for risks which may not materialize
• Progress measurement system may lead to uncontrolled project and delivery time.

Unit Price

The unit price contract is a form of fixed price contract which is flexible with respect to quantity changes. It is used where the type and complexity of the work is shown on the drawings, but the quantities for each unit have not been finalized. The risk of inaccurate estimation of uncertain quantities for some key tasks has been removed from the contractor

Advantages

• Quantity prices are established for certain well-defined elements (units) of work,
• If changes in quantities occur during construction, pricing is be based on predetermined fixed unit prices
• Flexibility is increased since modifications to the work can be made as details of the work become available

Disadvantages

• Careful measurement and determination of installed quantities requires additional administration
• Contractors will often argue that units added by changes are different than the units intended
• Much of the risk falls on customer
• Experienced contractors may submit an "unbalanced bid"

Cost Reimbursable

Cost reimbursable contracts are used when contract scope definition is not fully developed; where project risks would cause contractors to include unacceptable contingencies in a fixed price; or when work conditions are such that any form of fixed price will be subject to continual change or claims. Payment is made for the actual costs incurred by the contractor for performing the work, plus a fee, which may be a fixed fee; established target fee; fixed percentage of cost; incentive fee; or a combination of the foregoing.

Advantages

• Flexible in that it allows changes in scope, effort and schedule without adverse effect on the contractor
• Significant control over all aspects of work execution can be retained by the Owner
• Fixed price contingencies are eliminated
• Scope of work need not be fully defined; allows for fast-track construction based on minimum design available during progress of the work

Disadvantages

• Little incentive for the contractor to control costs and even incentive to over spend;  there is only leverage if there is limitation on the contractor's fee (e.g. fixed fee or an incentive/target fee)
• Requires detailed auditing
• There is no maximum limit on the cost of completing the work
• Most of the risk falls on the Owner

Time and Materials Contracts

In this type of contract, labor, equipment and associated items are charged at agreed upon rates, which include factors for overhead expenses and profit. Materials are charged at cost plus a percentage markup. Time and material contracts are used on small simple projects where the contractor is essentially a labor broker.

Advantages

• The Owner is able to exercise close control over contractor's execution methods
• Contractor's focus is on work execution, not contract administration
• Contractor is assured a profit regardless of scope changes
• Administration is easier than cost reimbursable contracts

Disadvantages

• The Owner supervision is required to monitor and measure expenditure of effort against results
• No incentive for contractor to control costs
• Unit rate may serve as an incentive for increasing expenditures

Convertible Contracts

This type of contract is a "two-step" arrangement which begins on a cost reimbursable or unit price basis and continues until the project is more clearly defined and drawings and specifications are fundamentally complete. At this point, based upon an agreed definitive estimate, the contract is converted to a fixed price arrangement.

Advantages

• Early start on design effort
• Construction price is fixed at a time

Disadvantages

• Contractor's bargaining position increases significantly as it executes the work

This article is intended for general guide purposes only and independent professional advice should be sought before applying any information contained herein to specific circumstances.

Fernando Falcon

[email protected]