CV-457

CV-457
Contract Management
Contract Management

CV-457
CONTRACT MANAGEMENT
Lecture-5 – (Week-5)

Engr. Rafia Nawaz

Lecturer Department of Civil Engineering
GIK Institute
Dr.-Ing Abdur Rehman Nasir
Assistant Professor ofEngineering
of Construction Engineering Sciences & Technology, Topi, Swabi KPK
and Management
1
12.09.2019 NIT (SCEE), NUST H-12, Islamabad
 CV-457
Contract Management

Topics
Different options for Contract Price

Source: PMP Certification All-In-One Desk

2 21.11.2019
 CV-457
Contract Management

Options for Contract Price - 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
determine 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.

3
 CV-457
Contract Management

Options for Contract Price - Introduction

▪ 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.

4
 CV-457
Contract Management

Fixed-Price Contracts

5
 CV-457
Contract Management

Fixed-Price Contracts

▪ In a fixed-price contract, a contract price for specific work and services is ascertained
before any work is carried out. This price is 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, provisional or prime cost items, and clauses for other risks beyond
the control of the contracting party claiming such cost adjustments.

▪ In this scenario, the original contract price will be different (generally less) than the final
contract cost.

6
 CV-457
Contract Management

Fixed-Price Contracts
▪ If the client wants, for example, to fix the contract price of the main contractor for the
entire contract period, the client will need to delete from the contract any conditions that
the contractor might otherwise use to claim for cost adjustments.

▪ The client’s 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 client will not make changes to the brief and the design
– the design consultants are competent.
7
 CV-457
Contract Management

Fixed-Price Contracts

▪ While the client may be able to draft a contract so that the contract price is fixed for the
entire project period, the client 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.

8
 CV-457
Contract Management

Fixed-Price Contracts
▪ In case risk contingency was low, there is a client’s risk of project cost overruns because,
in the effort to minimize 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 client.

9
 CV-457
Contract Management

Fixed-Price Contracts

▪ Fixing a contract price for the entire contract period may not be in the client’s 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.

▪ 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.

10
 CV-457
Contract Management

Fixed-Price Contracts
A. Lump-sum Contracts

11
 CV-457
Contract Management

A. 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.

12
 CV-457
Contract Management

A. Lump-sum Contracts

▪ 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.

13
 CV-457
Contract Management

A. Lump-sum Contracts
▪ 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 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.

14
 CV-457
Contract Management

A. Lump-sum Contracts

▪ 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, and
provisional or prime cost items.

▪ Despite what the contract may say about variations, there cannot be unlimited power
for the client to order variations.

15
 CV-457
Contract Management

A. Lump-sum Contracts

▪ 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 the 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.

16
 CV-457
Contract Management

A. Lump-sum Contracts
▪ 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 lump sum contract should
be based on the extent and accuracy of the information available.

17
 CV-457
Contract Management

Fixed-Price Contracts
B. Schedule Contracts

18 21.11.2019
 CV-457
Contract Management

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 meter for the excavation of different types of soil.

19 21.11.2019
 CV-457
Contract Management

Schedule Contracts

▪ 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.

▪ 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, provisional or prime cost items, and the like.

20
 CV-457
Contract Management

Schedule Contracts
▪ 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 contractor’s claims for payment is
necessary for effective cost control.

▪ In public sector engineering, schedule of rates contracts are used almost exclusively.

21
 CV-457
Contract Management

Schedule Contracts

▪ 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 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
the contract stipulate agreed limits of accuracy for estimated quantities.

22
 CV-457
Contract Management

Cost-Plus Contracts

23
 CV-457
Contract Management

Cost-Plus Contracts

▪ Cost-plus contracts are used where the true nature or extent of the work is 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.

24
 CV-457
Contract Management

Cost-Plus Contracts
▪ 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 labor.

▪ These ‘cost’ items constitute no risk to the contractor if they are to be fully reimbursed
by the client.

25
 CV-457
Contract Management

Cost-Plus Contracts

▪ ‘Plus’ is the contractor’s price, which includes the contractor’s overhead and profit.

▪ The cost of preliminary items, which includes supervision, plant and equipment,
statutory costs, and insurance 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.

26
 CV-457
Contract Management

Cost-Plus Contracts
▪ For the ‘plus’, 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 contractor’s ‘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 contractor’s 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.

27
 CV-457
Contract Management

Cost-Plus Contracts
▪ Usually ‘cost’ is defined to exclude costs arising from contingencies that are the
contractor’s risk, for example, claims by third parties, damages payable to the client,
subcontractors, or others on account of defaults of the contractor, and the cost of
correcting the contractor’s defective design or workmanship.

28
 CV-457
Contract Management

Cost-Plus Contracts
▪ 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.

29
 CV-457
Contract Management

Cost-Plus Contracts

▪ When the client 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 client and the contractor while
subcontracts will usually be fixed-price. The winning contractor will be paid the fee
and will be reimbursed for the ‘cost’.

30
 CV-457
Contract Management

Cost-Plus Contracts
▪ 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 client who,
after verifying their accuracy, will reimburse the contractor in full.

▪ The client 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 client before actually paying
subcontractors and will negotiate terms of subcontract that make the time for
payment of subcontractors after the date on which the client must pay the
contractor.

31
 CV-457
Contract Management

Cost-Plus Contracts

▪ Since the contractor’s risk in cost-plus contracts is very low, the client needs to be
aware of the possibility of the contractor’s 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 client
should:
– apply, apart from the tender price, other selection criteria such as the contractor’s reputation,
quality, and quantity of resources both human and physical, financial strength, and the like

32
 CV-457
Contract Management

Cost-Plus Contracts

▪ Since the contractor’s risk in cost-plus contracts is very low, the client needs to be
aware of the possibility of the contractor’s 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 client should:

– 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.

33 21.11.2019
 CV-457
Contract Management

Cost-Plus Contracts

34
 CV-457
Contract Management

Cost-Plus Contracts
A. Fixed fee

35
 CV-457
Contract Management

Cost-Plus Contracts – Fixed fee

▪ The client and the contractor agree on a fee figure to cover the contractor’s 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.

36 21.11.2019
 CV-457
Contract Management

Cost-Plus Contracts – Fixed 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 client may be liable to pay extra.

37
 CV-457
Contract Management

Cost-Plus Contracts – Fixed fee

▪ The contractor’s incentive is to do the work quickly and in accordance with the
drawings and specifications in order to:
– reduce the proportion of overheads, which are a factor of the duration of the
project
– satisfy the client and the client’s 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.

38
 CV-457
Contract Management

Cost-Plus Contracts
B. A Percentage Fee

39
 CV-457
Contract Management

Cost-Plus Contracts – A Percentage Fee

▪ When the project period is difficult to estimate, the contractor’s fee may be expressed
as a percentage of the actual project cost.

▪ Under this arrangement the contractor’s risk is further reduced.

▪ The contractor may be seen as profiting from increased expenditure since the
contractor’s fee rises when project costs rise.

▪ Consequently, the client must either put in place incentives for the contractor to
perform or carefully monitor the contractor’s performance. A cost-plus percentage fee
contract can only be satisfactory if the contractor is selected for integrity, ability, and
financial stability.
40
 CV-457
Contract Management

Cost-Plus Contracts
C. A Fixed fee / Percentage Fee plus a bonus or penalty

41
 CV-457
Contract Management

C. 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 budget.

▪ In theory, this arrangement appears to be simple and easy to implement. The

contractor will be paid as a bonus an agreed percentage of the saving if the saving was
realized.

▪ 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.

42
 CV-457
Contract Management

C. A Fixed fee / Percentage Fee plus a bonus or penalty

▪ 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 client may question its accuracy and relevance as a benchmark
for assessing the contractor’s portion of the bonus.

▪ Contrariwise, if it is understated, the contractor would undoubtedly take defensive

action to avoid the payment of a ‘penalty’ for overrunning on cost.

43
 CV-457
Contract Management

C. A Fixed fee / Percentage Fee plus a bonus or penalty

▪ If the actions of the client 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 client with the work or progress.

44
 CV-457
Contract Management

C. A Fixed fee Incentive Fee/ Fluctuating (Target cost/gain share)

Fixed Price Incentive Fee (FPIF):

• FPIF contracts establish a price ceiling and build in an incentive fee (profit) for
cost, schedule, or technical achievement. The term “fixed price” can be
misleading here.

• When a buyer is incentivizing cost performance, the buyer & seller establish a
cost target, a target fee, and a share ratio, such as 80/20, 70/30, or something
similar.

• Cost performance below the target cost earns an incentive fee. Cost
performance above the target cost means the seller relinquishes some of the
target fee.
45
 CV-457
Contract Management

C. A Fixed fee Incentive Fee/ Fluctuating (Target cost/gain share)

• When a contract has a share ration for incentive fee, the first number is
what the buyer keeps, and the second number is what the seller keeps.
Both numbers must total 100%.

• A 70/30 ratio share means that if the actual cost comes in under-target
by $20,000, the buyer keeps $14000 (70% of 20,000) and the seller gets
the remaining $6000.

46
 CV-457
Contract Management

▪ The incentive fee would be calculated as follows:

((Target cost – actual cost) x share ratio) + target fee

47
 CV-457
Contract Management

Example:
Say you have a contract with a target cost of $400,000, a price ceiling of $460,000, a target fee of
$40,000, and an 80/20 share ratio. In this case, the price ceiling is the fixed price part. Regardless of the
total cost, the client won’t pay more than $460,000.

However, if the contractor delivers the scope for less than $400,000 (target fee), the seller gets the target
fee of $40,000 plus 20% of the amount less than $400,000 (target fee). However, if the cost is greater than
$40,000 is reduced by 20% of the amount over $400,000.

See how it plays out if the actual cost is $425,000.

48
 CV-457
Contract Management

TMC contract
• Time & Material (T&M) contracts are generally used for smaller contracts
when there is not a firm scope of work, or the work is for an indefinite
period.

• Hourly labor rates and material rates are agreed to upfront (this is the fixed
part of the contract), but the amount of time and material is subjected to the
needs of the job or the buyer.

• Generally, expenses are reimbursed at cost. Many times, this type of contract
is used until the scope of work can be well defined.
• It may include a not to exceed amount.

49
 CV-457
Contract Management

Pricing Risk in Payment contracts

50
 CV-457
Contract Management

Example:
Assume that a GIKI needs a new building for the construction of the works & services
department. The client decided to go for a design and construct approach. What payment
contract would you recommend for this project? Justify your answer.

51
 CV-457
Contract Management

Thank You!
Any queries??

52