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 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.
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 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 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 client wants, for example, to fix the contract price of the
main contractor for the entire contract period, the client
would 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.
While the client may be able to draft a contract so that the contract
price is indeed 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. The problem for the client is that the client doesn’t know
the value of this risk contingency. If it is too high, the client will clearly
pay more for the work. If it is too low, the risk of the contractor’s
financial losses is likely to increase. This event would in turn increase
the client’s 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 client.
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.
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, and
provisional or prime cost items. Despite what the contract may say
about variations, there cannot be an unlimited power for the client
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.

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.
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.
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.
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. 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 contract stipulate
agreed limits of accuracy for estimated quantities.
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 client.
‘Plus’ is the contractor’s bid price, which includes contractor’s
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
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. 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 making good the
contractor’s defective design or workmanship.
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 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 ‘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 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.
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:
• select tendering only
• apply, apart from the tender price, other selection
criteria such the contractor’s 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 contractor’s claims for ‘cost’
• consider inclusion in the contract of incentives for the
contractor to keep costs low and expedite completion.
A 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. 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.
The contractor’s 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 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.
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.
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 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 client may question its accuracy and
relevance as a benchmark for assessing the contractor’s 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 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.