C ERTIFICATION PAPER

Application of Appropriate Project Controls Tools for Contract Type

Lori A. Floyd, CCC
ABSTRACT: There are numerous types of contracts available to implement in the execution of capital projects. These various contract forms all have their advantages and disadvantages and are implemented based on evaluation of the individual project. Many factors can play a role in which contract type will be employed. These include, but are not limited to, schedule constraints, level of project definition, project size, local economic climate/conditions, resources available and company financial status. The key to contract selection is balancing potential risks with potential opportunities and managing these risks and opportunities so that the best possible outcome is achieved. To obtain these results, the proper project control systems must be applied. The project control needs will vary with contracting strategy and will vary between owner and contractor. The project control needs will be discussed as related to the major contract types. These major contract types include, reimbursable and lump sum. Variations of these contracting strategies include bonus/penalty clauses, incentives, and fixed fees. (Although unit rate is a version of lump sum, it will not be discussed in this article as reimbursable and lump sum as these are the two most common types of contracts in North America). The project control needs will be evaluated in reference to owner and contractor, as well as the resources required for performance. Although contracts can include engineering as well as construction, for the purposes of this article, the discussion will concentrate on the issues surrounding construction. Many organizations may deem that "one size fits all" for project controls. This may be especially true in owner organizations. Successful execution of capital projects can only be accomplished with properly implemented project controls functions. Failure to recognize which functions are necessary for a particular contracting strategy can contribute to frustration, dysfunction and possible economic failure of the project.

This delicate balance of schedule cost and quality will help determine the contracting strategy for the project. It is important for the Project Manager to understand how the accountability for the costs and schedule vary with the type of contract. Risks and responsibilities are shown in the following table from James Bent [5]:

Reimbursable Contracting An owner whose schedule requirement outweighs the cost requirement, will most likely chose a reimbursable contract. A reimbursable contract implies that the contractor is reimbursed for actual costs, as well as some type of mark up, fixed fee, or incentives. One of the main advantages of reimbursable contracts is it allows for a fast-track project. That is, the job contract for construction can be let, and construction begun, with a greater overlap of engineering completion allowing for a shorter schedule than would be expected with a lump sum contract. J. Cibinic and R. Nash also imply that reimbursable contracting leads to a less adversarial relationship between owner and contractor [1]. This leads to more attention being paid to the job and less attention being focused on profit/loss issues with the contractor. Inherently this should result in better quality. However, in a cost reimbursable contract, it becomes more difficult to predict the final cost. The responsibility and accountability for cost control and scheduling is placed with the owner. Although, the contractor has an KEY WORDS: Project controls, contracts, contracting, construction, capital projects, and risk obligation for reporting, the owner must have the resources to validate and control the contractor's expenditures and progress. A costs n the engineering and construction Background A successful performance of a construction engineers' task during construction includes industry there are several types of contracts available to facilitate project execution. A project can be measured and controlled with controlling field labor, bulk purchasing, contract is a legally binding agreement by which three qualities as shown in the following from J. subcontracts, field indirects, as well as commissioning and start up. one party agrees to provide a service for another Hackney [3]. party, for compensation. According to James Capital Costhow much the project is Estimating Bent, these contracts fall into two main At an appropriate stage of total engineering going to cost? categories [6]. These two separate strategies are TimeHow soon it will be earning completion, a construction estimate should be cost reimbursable (also called "time and done. The engineering contractor or an owner's money? material") and lump sum (often called "hard ValueHow much it is going to return, as cost engineer are the most likely candidates to money"). Variations of these are numerous and related to the investment and risk involved? accomplish this. At 25 to 30 percent of are dependent upon the risk and opportunities engineering, the appropriate controlling design assumed by either the owner or the contractor. These essential qualities are the basis for documents for the facility would be available. A The owner's selection of a contracting strategy will depend on many factors, but the three project controls plans implemented during budget estimate would be developed from these objectives of cost, schedule, and quality will be construction of a capital project. It is the documents. The estimate would be the responsibility of project management and beginning basis for construction cost control. balanced to influence the decision. Although P. Navarette implies that all project controls to monitor, report and control The owner should take an active role in It will depend on the validation of the estimate. contracts create an adversarial relationship, an these qualities. Since this estimate is developed before effectively managed contract rewards both the contracting strategy implemented as to which owner and the contractor [4]. The key to party, the owner or contractor, will have the cost engineering is complete, it is imperative that, achieving mutual satisfaction is to match accountability for these qualities and what the during the execution of the remainder of the accountability with the party most capable of financial impact to the owner will be. Table 1 engineering, the owner keeps track of cost of the design implications developed during this managing the risks [7]. Thus, defining and helps identify these accountabilities. During the initiation of a Capital Project, phase. A tracking estimate should be implementing the necessary project controls applications to support the contract strategy is all risks reside with the owner of the proposed maintained as scope changes and trends are facility. During development of the project the identified and priced. A rigorous change paramount to managing these risks. owner will analyze the objectives of the project procedure must be implemented during including the schedule requirements, the engineering as well as construction. financial limitations and the business drivers.
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As engineering drawings are finalized, a quantity adjusted budget (or IFC budget) is developed. This budget is determined by actual material take-offs from the construction drawings. Construction contractors apply the appropriate work hour factors to the material take off in order to determine the labor budget. This quantity adjusted budget (QAB) becomes the basis for the construction budget and the tool for control of labor. During a reimbursable project where construction has started before all drawings are complete, this QAB is constantly updated until all the engineering drawings are completed. Planning and Scheduling The first step to controlling costs in the field is reliable planning and scheduling. Planning refers to the determination of objectives, identifying activities to be performed, the resources and methods to be used to perform the tasks. This also includes the assignment of responsibility and accountability and establishing an integrated plan to accomplish the objectives. Scheduling is applying timing, and determining order of the tasks [8]. A detail construction plan should establish a work breakdown structure and accounting codes. It should predict all resources required for completion of the work including temporary facilities, field supervision and management, labor requirements, as well as construction equipment needs for the life of the project. With thoughtful planning, the development of the detail construction schedule is initiated.

Table 1Contracting Risks and Responsibilities The detail construction schedule should be developed using a disciplined critical path method (CPM). The construction schedule should reflect the resources needed to accomplish the individual tasks, including labor requirements, the construction equipment requirements, as well as identifying materials to be installed. The labor and material resources can be determined from the QAB. A contractor on a reimbursable project should be contractually bound to supply a detailed, resource-loaded schedule, in a computer model, that supports the objectives of the owner in regards to completion. Updates and status to the schedule should be made on a regular basis and the owner should be able to verify the accuracy of the reports. Progress Measurement Once a detail construction schedule and a quantity adjusted budget are established, the basis for progress measurement can be established. Progress measurement is the quantifiable calculation of percent complete of a project. Initially, the scheduled percent complete is plotted against time. This typical progress curve is shown in Figure 1. This curve can be developed by allocation of work hours to tasks. The contribution of each activity toward total percent complete is proportional to the

Figure 1Progress Measurement Curve

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percentage of work hours for that activity toward the total work hours. This methodology is called weighted work hour measurement. Progress is usually measured in percent complete and is calculated by dividing the amount of work performed by the total work budgeted. Percent complete = earned work hours /budgeted work hours In reimbursable contracting where the QAB is constantly changing until all construction drawings are available, the progress measurement curve and percent complete are always changing to reflect the current budget. For this reason, it may suit the contractor to use forecasted work hours until the final QAB is established. This makes the reporting less confusing, but care must be taken to ensure that the forecast is realistic and reflects the QAB, in order of magnitude and distribution of hours. In calculating percent complete for activities, the measurement criteria must be available to the owner and completely verifiable. Cost Control The objective of project controls is to forecast the cost and completion of the project during the course of construction. Cost control is the implementation of the functions described above, as well as making forecast of the total cost and, where necessary, determine and facilitate corrective measures when an undesirable trend is identified. In a reimbursable situation, the owner, with ultimate responsibility, must implement these measures. The owner must indicate the measures to be taken and exert pressure upon the contractor to execute them. Forecasting the total cost of the job is more difficult in a time and material contract. Although the owner has accountability, the contractor must be made responsible for accurate reporting of schedule, progress and expenditures. It then becomes the owner's responsibility to validate the results and ensure that the contractor is performing in a cost effective manner. Productivity results from the progress measurement will help foretell the ultimate cost of the job. Productivity index, or cost performance index, is measured by dividing the earned work hours or dollars (budgeted cost of work performed) by actual work hours or dollars (actual cost of work performed), or PI = BCWP/ACWP (In construction, work is often stated in work hours) A number less than one is indicative that more work hours are being expended than was budgeted. This would be a

Figure 2Cost Variance and Schedule Variance Progress Measurement gauge that the total work hours may exceed the Total Cost at Completion = PI * Budgeted at Completion or: budget at the end of the project. Cost variance can be calculated by the EAC = PI*BCAC budgeted cost of work performed - actual cost of This formula assumes that the productivity work performed. does not improve over time. Another way to calculate the estimated cost at completion CV=BCWP-ACWP would be to assume the productivity will Schedule performance index is a improve and return to planned rates from the measurement of the amount of progress current point forward. This calculation would achieved against the progress that was be: scheduled. Again, often this is measured in work hours. Schedule performance index can EAC = (ACWP) + (BAC-BCWP) be stated as budgeted cost of work Both of these methods make an performed/budgeted cost of work scheduled. assumption about the contractor's ability to perform. While there may be reasons to make SI = BCWP/BCWS these assumptions, a way to avoid these Again, a number less than one would assumptions is for the contractor to have indicate that the planned schedule is not being calibration curve indicating the planned productivity over time. A contractor will have achieved. The schedule variance is calculated by history of performance on previous contracts subtracting the budgeted work hours from the indicating the profile of productivity over time. This calibration curve may help alleviate the earned work hours. guess work of assuming the contractor will return to good productivity, or will get worse. SV = BCWP - BCWS Typically, in construction projects, work hours A positive variance indicates favorable per percent complete are high at the beginning of the project, decrease toward the peak of the performance. These indicators are most often used in project, and then slowly taper off again as the reimbursable contracting to measure and work comes to an end. Rarely does productivity forecast the total project costs against the remain constant. A calibration curve is shown in Figure 3. budget. Using the calibration curve along with the Graphically, the relationships between planned progress, the schedule index and the productivity index can help forecast the cost of cost performance index would look like what is the project at completion by taking into consideration the planned productivity. shown in figure 2. Since the greatest risk in reimbursable contracting is in forecasting the total cost of the Change Control/Scope Management In reimbursable contracting, Change project during execution, it is important to use the schedule index and productivity index to control and scope management are a mere help forecast the project. If the trend of either formality to the contractor, as he or she is of the indices is unfavorable, one can easily getting reimbursed for all work performed which can reasonably be considered part of the forecast the cost using the following formula: work.

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Formal or informal instructions taken from anyone on the owner's side can be interpreted as part of the work, whether originally planned or not. This issue becomes essential to the owner to control the scope of the work and bring the project in under budget. A formal process must be initiated by the owner to identify, quantify and verify changes to the work to be performed. The contractor must implement changes only after authorization by select personnel. Lump Sum Contracting Lump sum or hard money contracting lends itself most favorably to projects where cost is the most important aspect of the project. To successfully execute a lump sum project, engineering must be nearly complete before an invitation to bid can be developed. Contractors bid on a project using complete, or near complete design documents and return a proposal that specifies the proposed cost of the project, including the cost of all work to be performed and including the contractor's profit. With this method, the owner has forecast of the total project cost at the earliest opportunity. The contractor also has the most completely defined scope of work. Estimating In lump sum contracting, the contractor has all the risk of controlling the costs. Upon awarding of the contract, the contractor will reevaluate his bid and establish a budget, based on quantities taken off of the design documents. This budget will be used as a control budget for the contractor. This budget and the tasks associated with it will become the basis for progress measurement. Accurate estimating and bidding is essential to the contractor's success in lump sum projects. Planning and Scheduling The detailed budget along with the design documents from which the budgets were produced, will be the foundation for the detailed planning and scheduling that needs to be in place. Although a contractor's main concern is the cost of the project, they must consider the time value of money and pay close attention to completion of the project in a timely manner. As discussed earlier in this article, the detail construction schedule should be developed using a disciplined CPM and should consider the resources needed to accomplish the individual tasks including labor requirements, the construction equipment requirements, as well as identifying materials to be installed. Again, this should be a contractual obligation of the contractor, but when the risk is all on the contractor's side, more likely than not, the detail schedule will be one of the main focuses for the contractor to control his own work.

WORKHOURS PER PERCENTAGE COMPLETE

Figure 3Calibration Curve Productivity Calibration Progress Measurement As with the reimbursable contract, the resource loaded schedule with well-defined tasks, will become the basis for the progress measurement curves. In lump sum contracting, the contractor is less interested in producing documents for the owner to see, than in producing control tools to mitigate the risks he or she owns. Detail progress measurement curves will be generated by discipline, and if the size of the project dictates, areas, sub-areas, or other elements of the work breakdown structure. Progress measurement, along with the schedule, are the only tools the owner will have to judge whether the project is on schedule. The contractor usually will not share the details of the productivity, as that risk is his or hers to control, but the owner should look carefully at the schedule index, (SI = BCWP/BCWS) and the schedule variance. Indicators that the schedule is not in control are a signal for the owner to take command and insist the contractor take corrective measures to correct the slippage. It is not enough to validate that the progress is on schedule, but the owner needs to assure himself or herself that the progress is being earned in the right areas [2]. In order to control costs on the project and validate that the budget was correct, the contractor may apply quantity installation curves for main commodities such as piping spools, electrical cable and cable tray, yards of concrete poured, etc. These curves may look similar to progress curves, but are simply based on quantities as developed for the budget. An unfavorable trend may indicate that the material take offs were poor, or conversely, a positive trend may indicate over estimation. Either way, the contractor will get an indication of the cost of the job, in relation to his price. A commodity curve is shown in Figure 4. Cash Flow An important aspect of a lump sum contract is the manner and timing of payment to the contractor. Whereas, in reimbursable contracting, a contractor submits an invoice for time and materials expended, and gets paid the agreed rate, a lump sum contractor will get reimbursed for work accomplished, regardless of how much is expended. A contractor will usually want to maintain "cash neutrality." That

Figure 4Commodity Curve Spool Installation

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Figure 5 Cash Flow Expenditure Projection September Update is, he or she does not want to be out cash too far in advance of being paid, but the owner does not want to front the contractor too far in advance, risking non-performance. Quite often the contractor will use his progress curve along with a schedule of indirect payments and other expenses to generate a cash flow curve. This curve will resemble the progress curve to some extent, but will consider non-progress items like equipment rental, temporary facilities, and other indirect costs as well. From this curve, the contractor can predict at intervals (monthly), his or her portion of the price, scheduled to be achieved, for the next interval. Ideally, the owner and contractor will agree on this cost, and a payment is made for half of the prediction, as well as the remainder of the payment for the last period's prediction. This basis gives the contractor some money up front, but reduces the risk for the owner of nonperformance. The owner must pay close attention to the schedule and progress curves and verify that the progress and schedule are being achieved as predicted. Cost Control The control of the cost is all the contractor's responsibility and risk in a lump sum contract. Therefore, the owner will not be privy to the details. It is imperative that the contractor uses the tools available, schedule, progress measurement, as well as payroll, and accounts payable, to predict how they are tracking against their price. The main function for the contractor's cost engineer is to see that the expenditures do not exceed the price of the contract and that the contractor is being reimbursed on a fair basis. The cost engineer must also be diligent in analyzing trends and identifying items that are out of scope. A rigorous change order procedure must be implemented and the cost engineer should take responsibility to see that work is not performed that has not been budgeted for. The cost engineer must keep project management informed of the status of the cost expenditures and the forecast. A forecast of gross margin, or profit should be calculated from the cost report each month to alert management to any unfavorable trends. remedial action can be facilitated, regardless of the contracting strategy. N REFERENCES 1. Cibinic, J. R. Nash. CostReimbursement Contracting, Second edition. Washington, D.C., (1993): 2. Hackney, J. Control and Management of Capital Projects, Second edition. New York, New York. McGraw-Hill, Inc. Heinze, K. Cost Management of Capital Projects. New York, NY. Marcel Dekker, (1996): 184. Larew, R,. (ed.) Skills and Knowledge of Cost Engineering. Fouth edition, Morgantown, West Virginia. AACE International. (1999): 18-3. Larew, R,. (ed.) Skills and Knowledge of Cost Engineering. Fourth edition, Morgantown, West Virginia. AACE International. (1999): 18-4. Larew, R,. (ed.) Skills and Knowledge of Cost Engineering. Fouth edition, Morgantown, West Virginia. AACE International. (1999): 18-5. Navarette, P. Planning, Estimating, and Control of Chemical Construction Projects. New York, NY: Marcel Dekker. (1995): 164. Navarette, P. Planning, Estimating, and Control of Chemical Construction Projects. New York, NY: Marcel Dekker. (1995): 179.

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any of the tools used in contracting are the same or similar between lump sum and reimbursable. The differences are in how they are used and by whom, the owner or the contractor. A reimbursable contracting strategy used to expedite project completion, places many of the cost risks with the owner. Although the contractor may have reporting responsibilities, the owner must have adequate and qualified personnel on board to analyze and validate contractor reporting. Forecasting total project costs accurately and consistently is the largest challenge for the owner and must be approached methodically. Using the project controls tools and methods through thorough application and examination must be a priority for the owner in reimbursable contracting. Lump sum contracting facilitates more accurate and earlier forecasting of total project costs, but the contractor must have the personnel and tools to manage its own cost risks. Accurate estimating and bidding are essential, as well as management productivity and schedule progress. The owner must control scope growth and be alert to preventable changes by the contractor. In the end, successful management of projects requires the ability for the party at risk to forecast costs in such a timely manner that

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RECOMMENDED READING 1. Cibinic, J. Nash, R. CostReimbursement Contracting, Second edition. Washington, D.C. (1993).

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Clark, F., and A. Lorenzoni. Applied Cost Engineering. Third edition. New York, New York. Marcel Dekker, Inc., (1997). 3. Construction Industry Institute. Contract Risk Allocation and Cost Effectiveness. Publication 5-3. Austin, Texas. Construction Industry Institute. (1988). 4. Hackney, J. Control and Management of Capital Projects, Second edition. New York, NY. McGraw-Hill, Inc. (1992). 5. Heinze, K. Cost Management of Capital Projects. New York, NY. Marcel Dekker. (1996). 6. Ibbs, C. D. Wall, M. Hassanein, W. Back, J. DeLaGarza, R. Twardock, J. Kim, and S. Schran. Determining the Impact of Various Construction Contract Types and Clauses on Project Performance. Volume I. Source Document 10. UrbanaChampaign, Illinois. Construction Industry Institute. (1986). 7. Ibbs, C. D. Wall, M. Hassanein, W. Back, J. DeLaGarza, R. Twardock, J. Kim, and S. Schran. Determining the Impact of Various Construction Contract Types and Clauses on Project Performance. Volume II. Source Document 11. UrbanaChampaign, Illinois. Construction Industry Institute. (1986). 8. Larew, R,. (ed.) Skills and Knowledge of Cost Engineering. Fouth edition, Morgantown, West Virginia. AACE International. (1999). 9. Navarette, P. Planning, Estimating, and Control of Chemical Construction Projects. New York, NY: Marcel Dekker. (1995). 10. Westney, R. (ed.) The Engineer's Cost Handbook. New York, NYk. Marcel Dekker. (1997). ABOUT THE AUTHOR Lori A. Floyd, CCC, is an associate with PMA Consultants, LLC, of Houston, Tx. She can be reached by e-mail at lfloyd@pmaa2.com.
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Cost Engineering Vol. 46/No. 2 FEBRUARY 2004