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
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said to be fixed at the start of the contract but it may change during its execution if the contract conditions allow cost adjustment. The most common contract conditions that allow cost to be adjusted are variations, latent site conditions, rise and fall, provisional or prime cost items, and clauses for other risks beyond the control of the contract party claiming such cost adjustments. In this scenario, the original contract price will be different (generally less) than the final contract cost. If the principal wants, for example, to fix the contract price of the main contractor for the entire contract period, the principal would need to delete from the contract any conditions that the contractor might otherwise use to claim for cost adjustments. The principals intent is to shift the risk of cost overruns onto the contractor. 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.

While the principal may be able to draft a contract so that the contract price is indeed fixed for the entire project period, the principal may end up paying more for the work in the long run. 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. The problem for the principal is that the principal doesnt know the value of this risk contingency. If it is too high, the principal will clearly pay more for the work. If it is too low, the risk of the contractors financial losses is likely to increase. This event would in turn increase the principals risk of project cost overruns because in the effort to minimise the losses, the contractor would most likely:
compromise the quality of the work force subcontractors on lower subcontract prices, 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.

Fixing a contract price for the entire contract period may not be in the principals best interest. 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.
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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.

4.2.1 Lump-sum contracts

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

4.2.2 Schedule contracts

When the extent of the work (particularly quantities) is unknown even though full documentation is available, the contractor will often tender for the work using a schedule of prices/rates. For example, the quantity of excavated soil is often difficult to measure accurately without knowledge of the precise type of soil found on the site. In this case, the excavating contractor will tender on the basis of firm rates per cubic metre for the excavation of different types of soil. If awarded a contract, 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. In the case of excavation, it is important that the method of measurement of quantities is prescribed in the contract. The terms schedule of rates and schedule of prices are used by different people to describe what are essentially the same schedule. In Australia, a schedule of prices or a schedule of rates may include estimated quantities of the work to be performed. A schedule of prices is sometimes in the form of a priced bill of quantities. Schedule contracts are also fixed price contracts, with the price fixed at the start of the contract. Similarly to a lump-sum price, rates too may be adjusted for variations, latent site conditions, rise and fall, provisional or prime cost items and the like. While it is possible to express the entire contract price in the form of schedule prices/rates, the most common approach is to combine schedule prices/rates and a lump-sum price. The main limitation of schedule contracts is that the total cost of a project is unknown until the work is completed. Since the total project cost is calculated by applying schedule prices to the quantity of the work executed, regular auditing of the contractors claims for payment is necessary for effective cost control. In public sector engineering, schedule of rates contracts are used almost exclusively. It is common to provide a schedule setting out not only the items for which a rate is required but also estimates of quantities. Such a schedule is more accurately
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described as a schedule of estimated quantities and rates but it is more commonly described simply as a schedule of rates. In order to reduce the risk for both contractual parties, some standard conditions of contract stipulate agreed limits of accuracy for estimated quantities.

4.3 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. If the contractor was to allow for everything that might eventuate, the contract sum could be too high. The price to be paid may, at the time of entering into the contract, be left out, and at completion be determined on the basis of the actual cost incurred. Although the contract will have no contract price in the usual sense, it is most important that the basis for determining the cost and the plus is prescribed in the contract. Cost in cost-plus contracts usually comprises direct cost to the contractor of materials and labour. These cost items constitute no risk to the contractor if they are to be fully reimbursed by the principal. Plus is the contractors bid price, which includes contractors overhead and profit. The cost of preliminary items, which includes supervision, plant and equipment, statutory costs and insurances if carried by the contractor, may be part of either cost or plus. The plus can be a lump sum or a rate (e.g. a percentage of the cost) or a combination of both. 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. Sometimes the contractors plus is based on performance criteria. For example, if the total cost of the project is less than an agreed target price, the contractor will be paid a bonus and if it is greater than the target price, the contractors remuneration will be less. Sometimes, particularly in the case of construction management contracts, the cost may be the cost of subcontracting the whole of the design and construction. Usually cost is defined to exclude costs arising from contingencies that are the contractors risk, for example claims by third parties, damages payable to the principal, subcontractors or others on account of defaults of the contractor, and the cost of making good the contractors defective design or workmanship.
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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. It also avoids most arguments over variations. Cost-plus contracts may be used in conjunction with the traditional method of delivery, but their main application is in managed delivery methods. In the traditional method of project delivery, contractors compete for work through a tender process. When the principal decides to award the main contract on a cost-plus basis, because of the unknown nature and extent of the work, the main selection criterion is the tender price or the fee (usually called a management fee), which includes overheads, profit and possibly the cost of preliminary items. The cost-plus contract will be formed between the principal and the contractor while subcontracts will usually be fixed-price. The winning contractor will be paid the fee and will be reimbursed for cost. From the operational point of view, the contractor may initially pay for all the costs as they occur. The contractor will then invoice those costs on a monthly basis to the principal who, after verifying their accuracy, will reimburse the contractor in full. The principal will pay the agreed portion of the fee to the contractor also on a monthly basis. So that the contractor will need the least possible capital to run the project, 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. Since the contractors risk in cost-plus contracts is very low, the principal needs to be aware of the possibility of the contractors complacency, which could have a detrimental effect on the contract performance. In choosing to use a cost-plus contract in combination with the traditional method of project delivery, the principal should:
select tendering only apply, apart from the tender price, other selection criteria such the contractors reputation, quality and quantity of resources both human and physical, financial strength, and the like engage a quantity surveyor or another suitably qualified consultant to monitor the contractors claims for cost consider inclusion in the contract of incentives for the contractor to keep costs low and expedite completion.

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4.3.1 A fixed fee

The principal and the contractor agree on a fee figure to cover the contractors off-site overhead, profit and sometimes the cost of preliminary items and on-site overheads. A fixed fee is usually expressed as a lump sum. A fixed fee remains constant even when costs vary. 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 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. If the actual quantity of work or the actual time proves to be different from that on which the lump-sum fee was based, the principal may be liable to pay extra. The contractors incentive is to do the work quickly and in accordance with the drawings and specification in order to:
reduce the proportion of overheads, which are a factor of the duration of the project satisfy the principal and the principals representative so as to increase the prospects for future work.

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.

4.3.2 A percentage fee

When the project period is difficult to estimate, the contractors fee may be expressed as a percentage of the actual project cost. Under this arrangement the contractors risk is further reduced. The contractor may be seen as profiting from increased expenditure, since the contractors fee rises when project costs rise. Consequently, the principal must either put in place incentives for the contractor to perform (see the next section) or carefully monitor the contractors performance. A cost-plus percentage fee contract can only be satisfactory if the contractor is selected for integrity, ability and financial stability.

4.3.3 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. In theory, this arrangement appears to be simple and easy to
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implement. The contractor will be paid as a bonus an agreed percentage of the saving, if the saving was realised. Conversely, if the final cost is higher than the agreed estimate (also known as a target price or a guaranteed maximum), the contractor would incur a penalty by having the fee reduced accordingly. However, in practice this concept is often difficult to make work. 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. If the guaranteed maximum price is overstated and the contractor is bound to earn a substantial profit, the principal may question its accuracy and relevance as a benchmark for assessing the contractors portion of the bonus. Conversely, if it is understated, the contractor would undoubtedly take defensive action to avoid the payment of a penalty for overrunning on cost. If the actions of the principal cause the contractor to fail to qualify for a bonus, the contractor may have a claim for breach of contract and the measure of damages may be the lost bonus. 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.

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