Contract Strategies in Construction Projects
© Daniel Atkinson 2001 15 November 2001 - Updated 3 May 2006
SUMMARY
The
Response Mechanisms can be summarised as Financial, Organisational,
Defective Performance and Contract Strategies.
The nature of construction projects, their attachment to land,
means that design cannot be separated easily from method and manner of
construction. Good design involves examination of buildability and suitability taking
into account both the environment and the capability of potential
Contractors/Designers. The division of design liability is not always
apparent, and the extent to which statements in contract documents warranty
the ease with which construction can be completed is not clear.
Contract documents are tools for managing risks. They determine the
consequence of particular events. A contract framework needs to bring
certainty to the allocation of consequences of hazards. It is uncertainty
which gives rise to many disputes.
It is possible to summarise the response decisions that need to be made
to define the contractual setting of the project in terms of strategies to
be adopted as follows:
- Financial Strategy
- Organisational Strategy
- Defective Performance Strategy
- Contract Strategy
One area of risk can arise from the size of the project itself, and
requires an appropriate organisational strategy. There are distinct
advantages to an Owner in having one single contract for the whole project.
The main contractor will be responsible for coordination of the various work
packages and the Owner will be protected from claims for disruption between
package contractors. On very large projects the finance and expertise
required of a single contractor will mean that the Owner will need to deal
with consortia of two or more contractors, each with their own expertise. It
is usual for each of the consortia members to be severally liable for the
defaults of the other members. The owner will then be protected from
coordination and disruption claims, he will not have to identify the
particular member responsible for the default and indeed will have a choice
of defendant in any dispute proceedings.
This single point organisational arrangement may not always be practical
nor indeed desirable. So for instance enabling works may need to be let
before the main works. Engineering considerations and financing arrangements
may dictate several discrete contracts, with different contractors or
consortia. The Owner may require to have more control of design of certain
parts of the project, possibly the more specialist parts. It may be that the
Owner will wish to be involved in the selection of the main equipment.
The division of the project into manageable packages creates a resultant
risk of lack of coordination between different contractors, which may cause
delays and disruption and give rise to disputes. This can be reduced by the
appointment of a project manager and by clear identification of the
interface responsibilities in each contract with well defined procedures for
the flow of information.
Whatever organisational strategy is adopted, it will be necessary to
decide the allocation of design responsibility. Design as used here has a
very wide meaning and includes the selection or specification of the quality
of materials as well as the structural design of components and structures.
Since the Owner will always define the project in some way by orientation,
performance or function, there will always be some division of
responsibility for design of the project.
In some projects, selection of the route or of certain materials by the
Owner, may impose methods of construction on the Owner which may not be
anticipated at tender stage. It is therefore not always apparent what is the
design risk allocated to each contracting party. In the case of an equipment
manufacture contract, extensive specification by the purchasing contractor
may reduce the manufacturer`s design liability to one of complying with the
specification only, and not to supplying equipment which will perform at the
required production rate.
The allocation of responsibility under a contract may not always be clear
as shown by the decision of HH Judge Seymour QC in Cooperative Insurance
Society Limited v Henry Boot Scotland Limited [2002] EWHC 1270 (TCC).
The form of contract was JCT 1980 Private With Quantities amended by the
Contractor’s Design Portion Supplement 1981 Edition revised July 1994. The
preliminary issue was whether or not Henry Boot had any design obligation
for the design of piled walls which formed part of the works and a concept
prepared by Cooperative. Clause 2.1.2 provided that for the purpose of
carrying out and completing the works Henry Boot was to complete the design
for the Contractor’s Design Portion including the selection of any
specifications for any kinds and standards of the materials and goods and
workmanship to be used in the construction of that Portion so far as not
described or stated in the Employer’s Requirements or Contractor’s
Proposals. Judge Seymour held that the obligation of Henry Boot under Clause
2.1.2 was to complete the design of the piled walls which involved
developing the conceptual design of Cooperative into a completed design
capable of being constructed. He held that the process of completing the
design included examining the design at the point at which responsibility
was taken over, assessing the assumptions upon which it was based and
forming an opinion whether those assumptions were appropriate. When Henry
Boot agreed to the obligation to complete a design begun by someone else,
they agreed that the result, however much of the design work was done before
the process of completion commenced, would be prepared with reasonable skill
and care. The concept of completion of a design of necessity involved a need
to understand the principles underlying the work done and to form a view as
to its sufficiency. Insofar as the design remained incomplete at the date of
the Contract, Henry Boot assumed a contractual obligation to complete it.
Accordingly, in order to avoid disputes, the contract needs to state
clearly the responsibility for any aspects of the design, including concept
designs as well as detailed design and the working up of conceptual designs
and its construction or installation.
In performance related contracts unless the operating conditions are
clearly defined this can give rise to many disputes. Design and construct
contracts can however usefully be adopted where the method of construction
dictates the design of the permanent works.
Where the contractor has responsibility for all the design as well as
construction the contract is referred to as "design and construct"
or "turnkey". The term "turnkey" is sometimes used to
refer to projects with single point contracts, but the essential feature is
the allocation of responsibility for design and construction with the
contractor.
Design and construct contracts have many advantages for the Owner. First
there is a single point responsibility for any defects either in materials
or performance. The owner does not need to ascertain whether the defect is
due to design or due to workmanship. Secondly this type of contract lends
itself to lump sum form of payment, or fixed payment at completion of
identified stages. Provided the completion of the various stages is clearly
identified then the administration of the contract is simpler than remeasure
or unit price forms of contract.
Common Law legal systems such as English law have continued with the laisser-faire
doctrine in construction, which is a freedom to decide whether and with whom
to contract and to freely decide the allocation of risk and the payment
mechanisms to be followed. Normally in contracts governed by English law,
the allocation of risk between the parties can therefore be found in the
contract document itself. This is not the case in Civil Code Systems which
include German, French and Greek law. In these systems, which in
international contracts may be the stated law of the contract , many of the
contentious issues which arise in English law are dealt with by specific
legislation. Indeed contract terms may be rendered invalid by such
legislation. There is no need to provide the detailed contracts seen in
English law contracts. English contractors may therefore be misled by the
brevity of contracts under Civil Code Systems. In addition these systems
operate to exclude allocation of certain substantial risks between the
parties. Some systems operate a general principle of good faith against
which contract terms are to be interpreted, common practice being taken into
account. Contractors should therefore be familiar with the relevant
provisions of the Codes and their effect on the allocation of risk, when
contracting under Civil Code Legal Systems.
D. Payment Mechanisms - Basis of Price
There are three basic methods of defining the price to be paid under a
contract:
- Lump Sum
- Remeasurement or Unit Price
- Cost Reimbursement
In a Lump Sum contract the contractor is paid a predetermined sum
for completing a particular stage or the whole contract works. The sum is
not adjusted to take into account any change in the extent of work from that
estimated by the contractor at the time of contracting. The contractor
therefore carries the risk of correctly estimating, at the time of
contracting, the extent of work required to be carried out. Lump Sum is the
most appropriate payment mechanism for design and construct contracts or
construction contracts where the extent of the works are largely determined
by the method of construction adopted. The payment mechanism is easy to
administer, provided the Owner does not vary the Works. If variations are
likely contract terms will need to be incorporated to make provision for
establishing an appropriate price on the basis either of a Schedule of
Rates, or by negotiation or by reimbursement at cost. Inevitably variations
on Lump Sum contracts give rise to many disputes and resolution of the Final
Account may take some time.
In Unit Price or Remeasurement Contracts the contractor is paid a
price or rate for each unit element of work carried out and identified at
the time of contracting. The item descriptions for each element of work are
normally prepared following sophisticated Standard Methods of Measurement,
in a Bill of Quantities. The quantities for each element are estimated by
the Owner at the time of tendering. The contractor however is paid the unit
price for the quantities actually constructed, usually on a monthly basis
based on a monthly valuation. The Unit Price payment mechanism thus places
the risk with the Owner, for estimating the extent of the Works at the time
of tender. The unit price mechanism is most appropriate where the design
responsibility lies with the Owner and the design is to be completed during
construction. The advantages for the Owner are that by adopting overlapping
phases of design and construction, construction can commence early. The flow
of information must be carefully monitored if claims for delay are to be
avoided. The overlap of design and construction means that variations to the
original outline scheme are likely, but the Unit Price mechanism provides a
ready means of pricing the variations.
Unit Price contracts can give rise to two types of measurement claims
which are unique to this form of contract. First, if the as-built quantities
differ from the estimated quantities given at tender, then it may be argued
by the contractor that the balance of plant, labour and materials has
changed so that this of itself makes the unit prices inapplicable or
inappropriate, so that they need to be adjusted. Secondly if there are
omissions of item descriptions from the original Bill of Quantities, then
the contractor will be entitled to a new appropriate rate for the item
description. Such claims depend upon the interpretation of the Standard
Method of Measurement. The Owner may reduce the incidence of the second type
of claim by amending the Standard method of Measurement. The Owner may for
instance define the Extent of the Works by reference to the Drawings and
Specifications. He may then state that the Item Descriptions included in the
original Bill of Quantities are to be taken as to be conclusive and require
the contractor to satisfy himself that he has priced for all tasks required
to construct the Extent of Works so defined. Careful drafting is required if
claims based on Measurement arguments are to be omitted.
One further method of reducing arguments about the make- up of unit
prices for variations for instance or quantity claims, is to require the
contractor to provide a full make-up of prices before the contract is
awarded including major lump sum items such as preliminaries. It is arguable
however whether such estimates are relevant to any re-rating exercise.
The Unit Price contract is inappropriate where the Owner has completed
all the design before a construction contract has been concluded. In that
situation the Owner should consider having the contractor take over
responsibility for the design and the contract then being a design and
construct contract on a lump sum. The contractor will need certain
safeguards if this approach is to be successful, such as the opportunity to
check the design and to have agreed changes to the design before accepting
responsibility.
In Cost Reimbursement contracts the contractor is paid his costs
including overheads and preliminaries together with a fee which may be
either a percentage fee or fixed. This payment mechanism is appropriate
where an early start is required but the project lacks sufficient definition
to allow the other two payment mechanisms to be adopted. Cost reimbursement
has also been used in projects where the particular physical conditions are
considered too variable to allow normal methods of payment to be adopted,
and the overriding consideration has been to ensure the full and open
cooperation of the contractor to allow the construction problems to be
overcome. Indeed cost reimbursement contracts have been adopted where the
Owner perceives that he has the necessary construction expertise to make the
major decisions relating to method of construction, and only requires the
contractor`s resourcing skills.
Cost reimbursement contracts create shared risks, even more apparent in
target cost forms, and has a major effect on the relationship of the
parties. The main part of the financial risk is with the Owner. This means
that the contractor more used to the traditional forms of contract will have
little incentive - other than repeat business from a large employer - to
work efficiently and economically. None of the standard forms of cost
reimbursable contract address the fundamental concern of the Owner , which
is to encourage the contractor to cooperate in forecasting the final or
out-turn costs, so that joint action may be taken to prevent any cost
over-run.
Two approaches are possible. One is to create a legal relationship which
requires the contractor to notify the Owner when he has reason to believe
there will be a cost over-run. This is the approach adopted in US, where
doctrines of good faith and fair dealing have developed beyond those in
England. The second approach is to share the risk of cost between Owner and
contractor, and this is achieved by using Target Cost Forms of Contract or
Maximum Guaranteed Price. The former is the most common form of Cost
reimbursement contract in UK construction.
Whilst the summary above is useful as a checklist, and even as a basis
for documentation as part of a management system, it does not in practice
assist in the practical application of Risk Management in Construction
Projects. In the same way that the categories of risk have been defined so
as to help to provide a structure for the identification of risks, so the
response decisions need to be reduced to answers to fundamental questions.
Any structure for response decision will need to be in two parts. The
first part relates to questions to be answered in the allocation of risk to
participants, and the second part to the measures to be taken to reduce the
consequence of a participant rendering defective performance. The second
part of the decision process recognises that if a risk event occurs there
will be consequences beyond the immediate contracting party required to
control the risk.
A fundamental decision to be made in relation to each participant in the
project is the allocation of risk defective function of specific elements of
the project. The function of project elements can be defined at different
levels. For instance, a requirement that an overhead crane should comply
with a particular performance specification would transfer the risk of
defective function to the manufacturer, but only in relation to the
specification. The risk that the crane satisfying the specification would
nonetheless not perform its overall function and achieve the required
overall throughput, due to maintenance down-time for instance, would still
reside with the specifier. This allocation of risk for function is best
viewed therefore on a sliding scale. In the case of a labour-only contract
for instance, the only risk function transferred to the supplier is to
supply labour who can perform the skills specified. The specifier carries
the risk that the specification is sufficient for his needs. In a turnkey
project the risk allocation is essentially the same. The risk function
transferred to the Contractor is to supply a plant which performs as
specified. The specifier carries the risk that his specification is
sufficient to allow him to fulfil supply obligations elsewhere. The
description of the type of project is only a shorthand for the liabilities
and risks allocated, but is not conclusive. It is the actual circumstances,
the contract setting, which define the allocation of risk.
The risk of defective function is normally defined as "design
liability" and raises the familiar problem of fitness for purpose. It
is however, not always apparent what design risk is actually allocated to
each party. The nature of construction projects, their attachment to land,
means that design cannot be separated easily from method and manner of
construction. For instance, the incremental construction of projects may
normally result in locked-in-stresses that need to be allowed for in the
design of the permanent works. The design of materials, concrete mixes or
steel composition, will be an essential part of the design. All these
factors can impose methods of construction on the Contractor that may not be
anticipated by him at tender stage.
The crucial distinction in law appears to be between one who only
designs, and another who designs and makes something. In the former
case there will normally be no obligation that the result of the design will
be fit for its purpose, but in the latter case an obligation as to
reasonable fitness for purpose will normally be implied into the contact.
This may change with particular circumstances and express terms of the
contract and the particular legal system.
Good design involves examination of buildability and suitability taking
into account both the environment and the capability of potential
Contractors/Designers. The division of design liability is not always
apparent, and the extent to which statements in contract documents warranty
the ease with which construction can be completed is not clear.
Contract documents are tools for managing risks. They determine the
consequence of particular events. A contract framework needs to bring
certainty to the allocation of consequences of hazards. It is uncertainty
which gives rise to many disputes.
The contractual framework is the practical means of managing level risk.
The aim is create certainty. It must however be recognised that commercial
considerations may lead to contacts in which there is inherent uncertainty:
the design may not be fully developed and even in some cases the concept may
not be fully defined. In such cases the flexibility of the contract forms is
a significant benefit to the participants.
In such projects the choice of contract framework is vital. Standard
civil engineering forms are an example of such flexible forms. The detail
design is carried out whilst the construction is being carried out, so that
the quantities actually required are not known. In addition the
uncertainties of the physical conditions of the site including the weather
are matters which are dealt with flexibly in all forms of contract. It is
important to identify the uncertainty before choosing the appropriate form.
It is not realistic in commercial projects to have a project fully
defined at tender stage. This has led to different procurement methods such
as construction management, or reimbursable or target cost contract
arrangement.
Reimbursable forms are very flexible but have the potential of the
contractor having little incentive to deploy his resources efficiently
A. Contracts Based on Bills of Quantities
Contracts based on Bills of Quantities remains the traditional pattern
for the larger type of contract particularly in the building and Civil
Engineering industry. There are two types of arrangement. These are
contracts based on firm quantities and contracts based on approximate
quantities.
Contracts based on firm quantities are in essence lump sum contracts. The
advantage of this arrangement is that all tenderers are pricing on the same
basis and the quantities risk is transferred from the contractor to the
purchaser. The contractor is saved the cost of preparing his own quantities
and any discrepancies in tender prices can easily be identified.
The other form of quantities contract is the Bill of Approximate
Quantities of which the most common standard form of contract is the ICE 7th
Edition. Under this arrangement approximate quantities are prepared for
tender documentation and the contract price is based upon the actual
quantities of work executed which are remeasured during the course of
construction. The advantage of this arrangement is that the works do not
have to be fully designed prior to tenders being issued and that again the
contractor is not assuming any of the quantities risk. In effect they permit
the overlapping of design and construction. There is of course a danger that
if the quantities are too approximate the actual quantities will be of
little significance ad the bill will become no more than a schedule of
rates.
In all cases the bill of quantities should only be used as the basis for
pricing the contract where there is a clear separation between design and
construction.
B. Contracts Based on Schedule of Rates
As with the Bill of Approximate Quantities the contractor, under a
schedule of rates contract, is paid for the actual amount of work carried
out at the rates contained in the schedule irrespective of the quantity, if
any shown in the schedule. One problem with both types of arrangements is
that if the final quantities differ markedly from those in the approximate
bill or the schedule then the contractor may have an entitlement to a
re-evaluation of the rate.
A variation of the Schedule of Rates contract is that of a schedule which
is issued with the rates already inserted and contractors are then asked to
tender on the basis of a plus or minus percentage addition to the actual
rates. The use of such "Schedule Contracts" as with
"Approximate Quantities Contract" is that they allow the
preparation of quantities from preliminary drawings at a very early stage.
Whilst the quantities will not be accurate they should be sufficient to give
the contractor a reasonable idea of the scope of work to be executed. In all
cases the schedule should be prepared so that preliminary items are priced
and identified separately and not included within the unit rates.
C. Cost Reimbursable Contracts
In the traditional priced forms of contract or in the design and
construct forms there is a high degree of definition of the project at
contract award. This permits fairly clear allocations of risks between the
parties. In such contracts it is normal to think of contractors carrying the
risk in terms of time, cost, quality and liability. The risks carried by the
employer are thought of as exceptions to this one-way allocation of risk, as
for example:
- time - exceptional adverse weather, delays by the Employer;
- cost - Employer variations
- quality - unforeseen ground conditions
- liability - liquidated damages, exclusion of consequential loss
Little attempt is made in such traditional forms to encourage reduction
of the Contract Price by the Contractor.
In essence in cost reimbursement forms the contractor is paid the prime
cost, that is the actual expenditure with an allowance for overheads and
profits, normally on a percentage or formula basis. There is little
incentive for the contractor to be efficient under such an arrangement and
the purchaser has no assurance of the final cost. In addition such
arrangements require detailed checking by the purchaser’s staff. On the
other hand such arrangements are advantageous where there is a very short
contract programme or where the importance of getting started on site as
early as possible is regarded as more vital than obtaining the lowest
initial capital cost. Other situations where the use of a cost plus contract
would be appropriate are situations where the project cannot be defined in
any detail prior to the start of the work and when the purchaser wants to
actively participate in the design of the project. When preparing cost plus
contracts it is essential that a very detailed schedule of costs elements or
schedule of rates is included within the contract documents.
Variants of the cost plus form of contract are the "cost plus
percentage fee" where the contractor seeks a percentage on top of his
prime cost for overheads and profits, "cost plus fixed fee" where
the contractor seeks his prime cost and a fixed fee in respect of overheads
and profits and "target costs". The latter arrangement differs
from the former arrangement in that in the first instance the contractor is
reimbursed on the basis of cost plus either a percentage or fixed fee. It is
however further provided that if the final payment due on this basis differs
from an estimate agreed between the parties by more than a certain margin
either up or down then the contractor will receive a bonus or incur a
penalty as the case may be. Accordingly there is a greater incentive for the
contractor to economise than there is under the former two arrangements.
Cost reimbursable forms of contract involve a radical change in the cosy
traditional division of risk. It creates shared risks, even more apparent in
target cost forms of contract. This has a major effect on the relationship
of the parties.
Cost reimbursable contracts place part if not the main proportion of the
financial risk with the employer. This means that a contractor more used to
the traditional forms of contract will have little incentive - other than
repeat business from a large employer - to work efficiently and
economically. Standard forms therefore contain express provisions for the
contractor to do so.
The fundamental concern of the employer under a cost reimbursable form is
to encourage the contractor to co-operate in forecasting the final or
out-turn costs, so that joint action may be taken to prevent any cost
over-run. Two approaches are possible
- to create a relationship which requires the contractor to notify the
employer when he has reason to believe there will be a cost overrun; or
- to share the risk of cost between employer and contractor;
There is one additional factor which is instrumental in creating the
co-operative relationship between contractor and employer. This is the
adoption by employers of a value-engineering approach. The most
significant change that cost reimbursable forms create, is the change in the
Purchaser’s internal audit procedures to allow the adoption of value
engineering concepts to solve on-site problems.
This involves a highly significant change in the Purchaser's management
organisation and reporting procedures. So for instance a site engineer may
find that compliance with the Specification will involve significant costs,
but that a relaxation of the Specification will allow a change in method of
working and cost savings. In the cost-reimbursable form, the site engineer
can begin to ask the right questions from the stand point of benefit to the
project. He will examine the change in the Specification in terms of:
- the maintenance costs;
- safety;
- the impact on the function of the project;
- the effect on the completion date of the project
The direct cost saving is therefore weighed against the overall affects
that it will have. Most importantly the Purchaser will have given his agent
authority to make such judgments, and will be predisposed to approving such
value judgments. This is particularly important in larger organisations,
which are the type of organisation which use the cost reimbursable form.
The Purchasers attitude is therefore not one of ensuring that the project
is built to a pre-conceived plan as in traditional forms, but he is
pre-disposed to re-examining the plan during implementation using value
engineering.
Fixed price contacts are common in design and construct forms of
contract. The major difficulty in the UK construction market has been the
control of quality and performance of the contractor. This has manifest
itself in the procedures for the client to monitor the design and the
quality of the workmanship.
A distinction needs to be made between single point contracts and
"design and construct" or "turnkey" contracts. A single
point contract is one in which there is only one contract for the whole
project. Where the Contractor has responsibility for all the design as well
as construction the contract is referred to as "design and
construct" or "turnkey". Although the term
"turnkey" is sometimes used to refer to projects with single point
contracts, the essential feature is the allocation of responsibility for
design and construction to the Contractor.
The main advantages for the Employer of Design and Construct are, first
that there is a single point responsibility for any defects either in
materials or performance. The Employer does not need to ascertain whether
the defect is due to design or due to workmanship. Secondly this type of
contract lends itself to lump sum form of payment, or fixed payment at
completion of identified stages. Provided the completion of the various
stages is clearly identified then the administration of the contract is
simpler than remeasure or unit price forms of contract.
The advantages for the Contractor are that he has more control over the
whole project, and can adopt designs that suit his own resources and
expertise. Design and Construct is the logical method of procurement for
many types of project.
Although Design and Contract forms have many advantages for the Employer
and Contractor, there are specific problems that frequently arise. These
are:
- Uncertain definition of the contract due to lengthy pre-contract
discussions/negotiations.
- Ambiguity/Discrepancy between Employer’s Requirements and Contractor’s
Submission.
- Monitoring the adequacy of the design.
- Valuation of Variations.
- Fair cashflow payments.
- Dealing with Defects.
The selection of a turnkey contractor will preclude payment being made on
a unit price or cost reimbursable basis. It will be very difficult for the
Owner to ascertain accurately the unit cost of various elements of the work
on account that the fact that the critical elements of cost may well be
determined by matters of which he has no knowledge such as the contractor’s
specialist know-how and off-site manufacturing processes etc. If it is
anticipated that the works will be varied, then it is essential under both
conventional and turnkey contracts that a breakdown of the contract price in
terms of elements of work and key components is provided in order to assist
in the valuation of the variations and, if necessary, interim payments.
As there is no bill of quantities in a turnkey contract it is very
difficult to allow for progress payments to be made monthly based on the
quantity of work actually executed. There is less risk of dispute if payment
is to be made in accordance with particular project milestones. For
instance, it could be based on percentage completion of various elements of
the work or in the case of mechanical and electrical works based upon
completion of detailed design, manufacturing, equipment, arrival at site and
installation of major equipment. Payments made on the basis of milestones
have the advantage of being relatively easy for the Purchaser to administer
and offer an incentive for the contractor to execute the works as
efficiently and quickly as possible. When drafting a milestone payment
schedule it is important to remember that the work is not complete when the
plant has been installed therefore a sufficient percentage must be retained
to cover the contractors commissioning and start up obligations. So as to
avoid unnecessary disputes suitable mechanisms should be drafted into the
contract to allow for the contractor to receive reimbursement in the event
that he is unable to attain any particular milestone on account of any delay
for which the Owner is responsible. In addition it must be remembered that
the milestone payments are approximate and do not represent the true value
of the work executed at the point of any milestone. Owners ought to be made
aware that in the event of termination of the contractor’s employment the
amount paid out against milestones will almost certainly differ from the
value cost of the work at that point.
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