Traditional Methods for Project Delivery | Cost | General Contractor

CHAPTER 4

OPTIONS FOR CONTRACT PRICE

4.1 INTRODUCTION
The decision made on the most appropriate option of project delivery will be closely followed by a decision on the most appropriate option for the contract price. The price payable under the contract to members of a project team for specific work and services may either be pre-ascertained in the form of a lump sum or price rates, or determined when a project has been completed. The former approach is known as a fixed-price contract while the latter is usually cost-plus. These two options for a contract price will now be discussed in more detail. There are other options that are used less often. In some forms of contract, for example BOOT, the price may depend on the earnings from the completed project or on a lease arrangement or another formula quite unrelated to the cost of construction. In these types of contract, there is usually no provision for progress payments for the construction work, and the contract price is often payable by the contractor to the principal.

4.2 FIXED-PRICE CONTRACTS
In fixed-price contracts a contract price for specific work and services is ascertained before any work is carried out. This price is
60 Pre-construction contract administration

The principal’s intent is to shift the risk of cost overruns onto the contractor. If it is too low. It is also worth noting that this practice is likely to lead to the development of an adversarial relationship between the parties to a contract. If it is too high. provisional or prime cost items. the principal will clearly pay more for the work. the principal would need to delete from the contract any conditions that the contractor might otherwise use to claim for cost adjustments. If the principal wants. In this scenario. The problem for the principal is that the principal doesn’t know the value of this risk contingency. the contractor would most likely: • • compromise the quality of the work force subcontractors on lower subcontract prices. This event would in turn increase the principal’s risk of project cost overruns because in the effort to minimise the losses. While the principal may be able to draft a contract so that the contract price is indeed fixed for the entire project period. • • Fixing a contract price for the entire contract period may not be in the principal’s best interest. and clauses for other risks beyond the control of the contract party claiming such cost adjustments. rise and fall.said to be fixed at the start of the contract but it may change during its execution if the contract conditions allow cost adjustment. This is because the contractor will estimate the likely cost of the risk of sustaining a fixed-price contract and will add it to the tender price in the form of a risk contingency. latent site conditions. the risk of the contractor’s financial losses is likely to increase. to fix the contract price of the main contractor for the entire contract period. the original contract price will be different (generally less) than the final contract cost. for example. This practice may be justified in some situations but only when: • • • • • the project risk is very low the brief is complete the design documentation is accurate the principal will not make changes to the brief and the design the design consultants are competent. the principal may end up paying more for the work in the long run. which in turn will further increase the risk of achieving poor-quality work in addition to the possibility of subcontractors becoming insolvent delay payments to subcontractors and suppliers proceed to develop a claim against the principal. The most common contract conditions that allow cost to be adjusted are variations. 61 Options for contract price .

Fixed-price contracts consist either of a single sum or the aggregate of various prices or rates in the form of a schedule prepared by the bidding general contractor or prepared by the principal and priced by the bidding contractor. sufficient time must be set aside for the accomplishment of the design stage. overheads. Since formulation of a lump-sum price is dependent on the availability and accuracy of full project documentation. Although contractors will usually be compensated under the contract for variations. rise and fall. too many variation orders may delay progress and cause additional costs. Examples of such contract conditions are variations. This may trigger contractors’ claims to recover such additional costs. bearing in mind the nature of the contract. risk contingencies and profit. specifications and sometimes a bill of quantities. A lump-sum price should cover all costs. Variations must be reasonable.1 Lump-sum contracts A lump-sum contract is the simplest form of contract. It may also be of a questionable value if the project is exposed to a high level of risk. 4. the contract conditions may provide relief to contractors for risks that are beyond their control. latent site conditions. tends to increase the overall project lifecycle period. however. 62 Pre-construction contract administration . However. there cannot be an unlimited power for the principal to order variations. It fixes the price to be paid for carrying out the work. The main benefit of a lump-sum price option is knowledge of the contract price in advance. The preparation of a lump-sum price requires access to full project documentation including drawings. and provisional or prime cost items.2. this is of questionable value if derived from inaccurate and incomplete documentation since it might have to be adjusted for the cost of errors and omissions. Contractors and subcontractors must ascertain the extent and the quantity of the work. Despite what the contract may say about variations. They should assess the level of risk involved and price its likely impact in the form of a risk contingency. Contractors and subcontractors are commonly required to bid for work on the basis of lump-sum tender prices. before the start of the contract. Although contractors appear to carry considerable risk under a lump-sum contract. which contractors may find difficult to assess and accurately price in the risk contingency. This requirement.

the contractor will often tender for the work using a schedule of prices/rates. the quantity of excavated soil is often difficult to measure accurately without knowledge of the precise type of soil found on the site. the excavating contractor will tender on the basis of firm rates per cubic metre for the excavation of different types of soil. Schedule contracts are also fixed price contracts. rates too may be adjusted for variations.Lump-sum contracts are not restricted to the activities of contractors and subcontractors. In Australia. Such a schedule is more accurately 63 Options for contract price . regular auditing of the contractor’s claims for payment is necessary for effective cost control. a schedule of prices or a schedule of rates may include estimated quantities of the work to be performed. the contractor would be paid the sum calculated by application of the agreed schedule of prices/rates to the actual quantity of the excavated soil. latent site conditions. While it is possible to express the entire contract price in the form of schedule prices/rates. schedule of rates contracts are used almost exclusively. Consultants such as project managers or even designers may be engaged on lump-sum contracts. The decision on whether or not to engage consultants on a lumpsum contract should be based on the extent and accuracy of the information available. Since the total project cost is calculated by applying schedule prices to the quantity of the work executed. Similarly to a lump-sum price. The terms ‘schedule of rates’ and ‘schedule of prices’ are used by different people to describe what are essentially the same schedule. In this case. the most common approach is to combine schedule prices/rates and a lump-sum price. In the case of excavation. A schedule of prices is sometimes in the form of a priced bill of quantities. 4. with the price fixed at the start of the contract. In public sector engineering. rise and fall. it is important that the method of measurement of quantities is prescribed in the contract. It is common to provide a schedule setting out not only the items for which a rate is required but also estimates of quantities.2. For example. provisional or prime cost items and the like. The main limitation of schedule contracts is that the total cost of a project is unknown until the work is completed. If awarded a contract.2 Schedule contracts When the extent of the work (particularly quantities) is unknown even though full documentation is available.

64 Pre-construction contract administration . Although the contract will have no contract price in the usual sense. and the cost of making good the contractor’s defective design or workmanship. some standard conditions of contract stipulate agreed limits of accuracy for estimated quantities. at the time of entering into the contract. for example claims by third parties. 4. The ‘plus’ can be a lump sum or a rate (e. subcontractors or others on account of defaults of the contractor. The price to be paid may. In order to reduce the risk for both contractual parties. ‘Plus’ is the contractor’s bid price. which includes supervision. which includes contractor’s overhead and profit. Sometimes the contractor’s ‘plus’ is based on performance criteria. the contractor’s remuneration will be less.described as a ‘schedule of estimated quantities and rates’ but it is more commonly described simply as a schedule of rates. the contractor will be paid a bonus and if it is greater than the target price. For example. and at completion be determined on the basis of the actual cost incurred. the contract sum could be too high. ‘Cost’ in cost-plus contracts usually comprises direct cost to the contractor of materials and labour. the cost may be the cost of subcontracting the whole of the design and construction. may be part of either ‘cost’ or ‘plus’. The cost of preliminary items.g. A lump sum alone is usually only appropriate in small projects where the limits of the project in terms of cost and time can be fixed. it is most important that the basis for determining the ‘cost’ and the ‘plus’ is prescribed in the contract. plant and equipment. if the total cost of the project is less than an agreed target price. particularly in the case of construction management contracts. If the contractor was to allow for everything that might eventuate. be left out.3 COST-PLUS CONTRACTS Cost-plus contracts are used where the true nature or extent of the work are unknown and where the risk or contingency factor is high. statutory costs and insurances if carried by the contractor. Usually ‘cost’ is defined to exclude costs arising from contingencies that are the contractor’s risk. a percentage of the ‘cost’) or a combination of both. These ‘cost’ items constitute no risk to the contractor if they are to be fully reimbursed by the principal. Sometimes. damages payable to the principal.

the main selection criterion is the tender price or the fee (usually called a management fee). Since the contractor’s risk in cost-plus contracts is very low. The winning contractor will be paid the fee and will be reimbursed for ‘cost’. From the operational point of view. When the principal decides to award the main contract on a cost-plus basis. other selection criteria such the contractor’s reputation. apart from the tender price. the principal should: • • select tendering only apply. after verifying their accuracy. In choosing to use a cost-plus contract in combination with the traditional method of project delivery. Cost-plus contracts may be used in conjunction with the traditional method of delivery. profit and possibly the cost of preliminary items. The contractor will then invoice those costs on a monthly basis to the principal who. the principal needs to be aware of the possibility of the contractor’s complacency. and the like engage a quantity surveyor or another suitably qualified consultant to monitor the contractor’s claims for ‘cost’ consider inclusion in the contract of incentives for the contractor to keep costs low and expedite completion. which could have a detrimental effect on the contract performance.One distinct advantage of cost-plus contracts is that construction can begin on site before design work is complete and without the usual preliminary arrangements. The cost-plus contract will be formed between the principal and the contractor while subcontracts will usually be fixed-price. So that the contractor will need the least possible capital to run the project. but their main application is in ‘managed’ delivery methods. quality and quantity of resources both human and physical. which includes overheads. will reimburse the contractor in full. the contractor will usually invoice the principal before actually paying subcontractors and will negotiate terms of subcontract that make the time for payment of subcontractors after the date on which the principal must pay the contractor. In the traditional method of project delivery. contractors compete for work through a tender process. the contractor may initially pay for all the costs as they occur. It also avoids most arguments over variations. The principal will pay the agreed portion of the fee to the contractor also on a monthly basis. because of the unknown nature and extent of the work. • • 65 Options for contract price . financial strength.

The risk can be reduced for both parties by including in the contract agreed limits of cost and time beyond which the lump sum will not apply. 4. A cost-plus percentage fee contract can only be satisfactory if the contractor is selected for integrity.3. the contractor’s fee may be expressed as a percentage of the actual project cost. If the actual quantity of work or the actual time proves to be different from that on which the lump-sum fee was based. A fixed fee remains constant even when costs vary.4. The contractor’s incentive is to do the work quickly and in accordance with the drawings and specification in order to: • • reduce the proportion of overheads.3. since the contractor’s fee rises when project costs rise.3. A fixed fee is usually expressed as a lump sum. which are a factor of the duration of the project satisfy the principal and the principal’s representative so as to increase the prospects for future work.2 A percentage fee When the project period is difficult to estimate. The risk with this arrangement is that the lump sum for the fee must be fixed with a particular quantity of work and time in mind.3 A fixed fee/percentage fee plus a bonus or penalty This type of arrangement is used to offer incentives to the contractor to facilitate better performance and to keep the project cost and time within the overall budgets. Under this arrangement the contractor’s risk is further reduced. The contractor does not profit by increased expenditure unless the nature of the work is substantially altered. which could provide the grounds for renegotiation of the fee. the principal may be liable to pay extra. profit and sometimes the cost of preliminary items and on-site overheads. 4. the principal must either put in place incentives for the contractor to perform (see the next section) or carefully monitor the contractor’s performance. this arrangement appears to be simple and easy to 66 Pre-construction contract administration .1 A fixed fee The principal and the contractor agree on a fee figure to cover the contractor’s off-site overhead. In theory. The contractor may be seen as profiting from increased expenditure. Consequently. ability and financial stability.

Conversely. Conversely. The contractor will be paid as a bonus an agreed percentage of the saving. in practice this concept is often difficult to make work. if the saving was realised. if it is understated. the contractor would incur a ‘penalty’ by having the fee reduced accordingly. If the actions of the principal cause the contractor to fail to qualify for a bonus.implement. the contractor may have a claim for breach of contract and the measure of damages may be the lost bonus. the principal may question its accuracy and relevance as a benchmark for assessing the contractor’s portion of the bonus. if the final cost is higher than the agreed estimate (also known as a ‘target price’ or a ‘guaranteed maximum’). The main problem lies in the difficulty of agreeing on the value of the guaranteed maximum price at the start of the project when only limited design information is available. However. Therefore a contract provision for a bonus is only efficient where there is very little risk of interference by the principal with the work or progress. the contractor would undoubtedly take defensive action to avoid the payment of a ‘penalty’ for overrunning on cost. 67 Options for contract price . If the guaranteed maximum price is overstated and the contractor is bound to earn a substantial profit.

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