In construction, a contract can take make many forms. Not only are there various ‘Suites of Contract’ such as NEC, ICC, FIDIC etc. but within each of these there are different types such as lump sum/fixed price, target cost and cost reimbursable.
Do you know the different implications of each? And do you know how each of the different types affects your risk on a project? I will discuss each in turn and highlight the key areas that need to be considered.
Lump sum/fixed price
This is probably the most common type of construction contract and often a favourite of the employer when placing orders. This is because it limits their financial risk and places most of this on the contractor. In this arrangement, the contractor will be (or should be) given a defined scope to price. Once the price is agreed between the parties it is fixed and this forms the basis of the contract. If the contractor misses something from his price at tender stage, then he won’t be entitled to claim this back from the employer as tender omissions are generally considered to be the contractors risk. Usually the contractor will seek to include contingency in their price to offset the increased risk.
The obvious benefit of this arrangement to the employer is that it gives them greater cost certainty from the outset. This is only true if the design/specification is sufficiently defined and accurate though. The costs may increase if there is an event which gives rise to a variation under the contract. If the employer has provided the design then a change to this design will likely lead to a variation for the contractor. Only sign a lump sum contract if there is a route to recovery of costs and time in the event of a design or scope change.
Another benefit is that lump sum, fixed price contracts often involve less administration when compared with a target cost or cost reimbursable contract. Payments will usually be assessed on a percentage completion against each item of work.
Reviewing and understanding the work scope is fundamentally important when taking on a lump sum contract. You can read more about things to look out for here.
Whilst there may be more risk for the contractor in this arrangement, there is potentially more opportunity. This is because the contractor will be paid the lump sum regardless of how much it costs him to complete the works. If they are therefore efficient and spend less than anticipated, they stand to make more profit on the project. Furthermore if contingency has been built into the price, but the risks never materialise, then this becomes additional profit for the contractor.
There is an option to make a lump sum contract ‘remeasurable’ and this would usually be adopted where the scope was clear, but the quantities weren’t e.g. surfacing where the road make up was known but the area couldn’t be accurately determined. The rate per m2 would be agreed but the quantity for this rate to be applied to wouldn’t be finalised until the work was complete.
Cost reimbursable does exactly what it says on the tin; the contractor is reimbursed their costs for the project along with a fee. The fee may be a predetermined fixed sum or percentage of the costs.
Obviously in this scenario, the contractor has little risk. They can overspend on the original estimate but still recover their costs, assuming no costs are disallowed by the employer. Careful consideration should be given to what constitutes disallowed cost in the contract, prior to agreeing to carry out work in this format. It would make no sense if any costs disallowed offset the fee you are due to be paid. Furthermore, the contractor’s upside will be limited to their fee. There is no opportunity to make additional profit through construction efficiency, effective procurement, early finish etc.
This type of arrangement will most often be used when the scope is not sufficiently defined to allow an accurate estimate and programme to be developed. An example would be site investigation prior to a construction project commencing. The employer won’t know what they are going to find when they start and therefore cannot know the full extent of the investigation to be carried out. It would therefore be unreasonable to expect the contractor to provide a fixed price. The employer will often cap expenditure to limit exposure and require that the contractor notifies when they have reached, or are about to reach, this limit. They can then decide whether it is necessary to release additional budget.
This arrangement operates like cost reimbursable contract but the key difference is the introduction of a pain/gain share mechanism. This means that a value for the works is agreed up front and this is called the target cost. If the contractor overspends in relation to the target cost, then some of the over-spend will be paid by the employer and the remainder by the contractor. Similarly, if the contractor under-spends, he benefits by recovering some of the under-spend from the employer, who also benefits as he doesn’t have to pay the full target cost. Check how the gain/pain is calculated under the contract and make sure this is a fair split between you and the employer.
The idea of this type of contract is to incentivise the contractor to perform well, keep costs down and innovate to determine more efficient ways of working (although incentivisation is also possible in lump sum and reimbursable contracts through different mechanisms). Additionally, the intention is to create a collaborative, open relationship between the employer and contractor leading to better trust, communication, teamwork and less disputes. In practice, it could be argued this isn’t always achieved. Adversarial relationships are often ingrained in the construction industry and it can be difficult for parties to break away from this way of working.
Unlike a cost reimbursable contract, the scope would still need to be relatively well defined to allow a target cost to be determined in the first instance. The target cost can still be increased through variations and the contractor still has an incentive to maximise these whilst the employer will aim to minimise any increase. This alone can lead to disagreements. Furthermore, the contract requires both parties to be fully transparent to operate the way it is intended but both parties may have reservations about sharing commercial information. If this is the case then a lump sum/fixed price contract may be more suitable.
Additionally, it is worth noting that there is an increased level of administration required on both sides. The contractor will need to keep accurate records of all costs and present these in a suitable way for the employer to review regularly. The total forecast expenditure has to be estimated and accurately represented and the pain/gain will need to be calculated regularly.
What experience do you have with each of these types of contract? Do you prefer to use one over the other? Why?
Please share your thoughts and comments.
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