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Fundamentals of Construction Contracts

Presentation · October 2017

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Mohamed Darwish
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 10/9/2017

Construction Contracts

By:
Dr. Mohamed Darwish

•A contract is simply an agreement between two

or more people in which one person agrees to
perform a specific task or provide goods or a
service to another in exchange for something in
return.

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•The contract type chosen, like the delivery

method chosen, is important to the owner for
its ability to address project risk.

•Three basic types of contracts will be discussed:

single fixed price, unit price, and cost plus a fee.

LUMP SUM CONTRACTS

•In a lump sum contract, also called a single
fixed price, the contractor agrees to provide a
specified amount of work for a specific sum.

•In this contracting method both parties try to

fix the conditions of the project as precisely as
possible. Once the contract is signed, both
parties must live with its terms.

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LUMP SUM CONTRACTS

•The advantage of this contract is that the
owner knows before the work begins what the
final cost of the project will be.

•This contracting method is usually used in the

traditional delivery method.

LUMP SUM CONTRACTS

•The designer will prepare a complete set of
contract documents, which the owner then
either bids out or negotiates with a contractor.

•A final contract amount is agreed to and the

work begins.

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Disadvantages
1. The risk that the owner takes in this
contracting method is that the contract is
only as good as the accuracy of the contract
documents - if the scope of the project
changes or if errors exist in the
documentation, the contract will need to be
renegotiated, possibly exposing the owner to
increased financial risk.

Disadvantages
2. To allow a fixed price contract to be
negotiated, a complete set of contract
documents must be prepared.

– This takes time and prevents the construction of

the project from beginning until the design work
is complete.
– This negates the possibility of a fast-tracked
project.

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In summary,
•This contracting method combined with a
traditional delivery method allows the owner to
define and commit to an agreed-upon project
description and dollar amount before the work
begins.
•For owners who want to minimize risk on a project
that can be clearly defined (i.e., that has minimal
unforeseen conditions), this type of contracting
method works well.
•The owner must understand that the process will
take longer and that changes caused by mistakes,
unknowns, or changes in owner requirements will
jeopardize the agreement.

Unit Price Contract

•In a unit price contract the owner and the
contractor agree as to the price that will be
charged per unit for the major elements of the
project.
•The owner/designer will typically provide
estimated quantities for the project, then ask
contractors to “bid” the job by calculating unit
prices for these items and calculating a final
price.

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Unit Price Contract

•Contractor overhead, profit, and other project
expenses must be included within the unit prices
that are provided.
Bidder 1 Bidder 2
Estimated
Work Items Unit Unit Bid Unit Bid
Quantity
Price Amount Price Amount
Soil Excavation CY 10,000 5.50 55,000 2.00 20,000
Rock Excavation CY 3,000 25.00 75,000 25.00 75,000
6” Pipe LF 600 17.00 10,200 18.00 10,800
Crushed Stone Fill CY 4,000 21.00 84,000 20.00 80,000
Fill Material CY 6,000 14.00 84,000 20.00 120,000
Top Soil 4” Deep SY 400 5.00 2,000 6.00 2,400
Total $310,200 $308,200
Bidder 2 wins the job with the $308,200 total price

Advantages
1. In many projects (heavy engineering projects
being a perfect example), it is difficult to
accurately quantify the work necessary.
–In excavation work it is often difficult to accurately
quantify the actual amount of rock versus soil that must
be excavated.
–To eliminate risk to both the owner and the bidders, the
designers will estimate quantities and then ask the
bidders to provide a unit price for each type of
excavation and bid the job.
–Actual payments will be made on the basis of
multiplying the actual quantities excavated by the unit
price provided.

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Advantages
2. Provides the owner with a competitive bid
situation, allowing for a fair price for the
work.
3. It eliminates the risk of getting a fixed price
and then having to renegotiate because of
differing site conditions, as explained before.
4. Work can also begin before the design is
completed, speeding up the completion of
the project.

Disadvantages

1. If estimated quantities are significantly

different from the reality of the situation,
the financial commitment of the owner may
be greater than planned.

2. Mistaken estimates also expose the owner

to what is called an unbalanced bid,
increasing the project's costs to the owner.

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Unbalanced Bid (Example)

Estimated Actual Amount
Work Items Bid Price
Quantity Quantity Paid
Soil Excavation 10,000 20,000 8,000 16,000
Rock Excavation 3,000 75,000 3,000 75,000
6” Pipe 600 10,800 600 10,800
Crushed Stone Fill 4,000 80,000 4,000 80,000
Fill Material 6,000 120,000 7,000 140,000
Top Soil 4” Deep 400 2,400 400 2,400
Total $324,200
Assume Bidder 2, in the last figure, knew that the soil excavation
quantity provided was high and the fill material provided was low.
By providing a low unit price for soil excavation and a high unit
price for the fill material, Bidder 2 earns an additional $16,000.

Disadvantages

3. Actual quantities must be measured in the field,

requiring an owner presence on site to work with the
contractors.

4. Delivery tickets and other invoices must be checked

and validated.

5. Final contract price is not known until the last item of

work is measured and invoiced by the contractor.

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In summary

•Heavy engineering projects such as

infrastructures are often accomplished by a unit
price contract since the quality of the work can
be defined, but the actual quantities are difficult
to determine in advance.
•The risk that the owner runs on this type of
contract is that the actual price is not known
until the work nears completion, but can be
minimized by good design support.

In summary
•An owner presence in the field must also exist
to verify quantities and authorize payments.

•Once a good estimate is made of the actual

quantities and funding is deemed adequate,
work can begin before final design is complete,
saving project time.

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Cost plus a fee Contracts

•In a cost-plus contract arrangement, also called
a reimbursable contract or a time and mate-rials
contract, the contractor (or, sometimes, the
designer) works on the project and is
reimbursed by the owner for its costs, plus is
paid either an additional agreed upon fee or is
paid a fee which is a percentage of those costs.

•It is important for the owner to spell out clearly

in advance what costs will be reimbursed and
which costs are to be covered by the fee.
•This contract makes sense when the scope of
the project may be difficult to define or when it
is important to fast-track the project.

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Advantages

1. By using this type of contract the contractor

can start work without a clearly defined
project scope since all costs will be
reimbursed and a profit guaranteed.
2. This type of contract also allows the
contractor, designer, and owner to work
together early in the designing/building
process in a non-adversarial fashion,
encouraging value engineering and good
esti-mating and scheduling support.

•A variation of this type of contract is called a

guaranteed maximum price (GMP).

•In this type of contract the contractor is

reimbursed at cost with an agreed-upon fee up
to the GMP, which is essentially a cap; beyond
this point the contractor is responsible for
covering any additional costs within the original
project scope.

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Disadvantages
1. The risk to the owner in using this type of contract is
that, even with a GMP, the project is started with
considerable unknowns.
2. By using a GMP the project costs may be capped, but
the quality and scope may become sacrificed at the
expense of the GMP.
– If a GMP is not used, the scope and quality of the project
may be solid, but the cost and schedule may increase.
3. This type of contract requires a reputable contractor
or construction manager, since tremendous trust
needs to be placed with this participant.

Example:

•Assume that the contractor believes that your

project will wind up costing just about $10
million to build.

•The next three graphs show the price to you

and the profit or loss to the contractor for the
three kinds of contracts at three different actual
final cost levels.

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• At point a at each diagram, the contractor

has shaved $500,000 from the anticipated
cost.

• At b, costs have run as expected.

• At c, there has been a cost overrun of

$500,000.

Price is fixed at $ 10,300

c
Final Price

$ 10,300 b
a
Contractor
Final Cost Profit %
Profit
$ 9,500 a = $ 800 8.42%

$ 10,000 b = $ 300 3.00%

$ 10,000

$ 10,500
$ 9,500

$ 10,500 c = $ -200 - 1.90%

Final Cost

Lump-Sum Contract

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Price = cost of work + fixed fee of $500

With a maximum price of $10,500

$ 10,500 c
Final Price

$ 10,000 b

Contractor
a Final Cost Profit %
Profit
$ 9,500 a = $ 500 5.26%

$ 10,000 $ 10,000 b = $ 500 5.00%

$ 10,500
$ 9,500

$ 10,500 c=$0 0.00%

Final Cost

Guaranteed-Maximum-Price Contract

Price = cost of work + 5%

$ 11,025

c
$ 10,500
Final Price

b
$ 9,975
Contractor
Final Cost Profit %
a Profit
$ 9,500 a = $ 475 5.00%

$ 10,000 b = $ 500 5.00%

$ 10,000

$ 10,500
$ 9,500

$ 10,500 c = $ 525 5.00%

Final Cost

Time-and-Materials Contract

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•Basically, with a lump sum, the contractor gets

all the savings and takes all the risks.
•With time-and-materials, the owner gets the
savings and takes the risk.
•And with guaranteed-maximum-price, the
owner gets the savings and the contractor takes
the risk.
•It is not unusual to include in this contract an
incentive clause which specifies that the
contractor will receive additional profit for
bringing the project in under the GMP.

In summary,

•The cost-plus type of contract makes sense

when the owner needs to complete a project
quickly or when the project is difficult to define
accurately upfront.
•The project needs a qualified and reputable
designer and builder, as well as an active owner
organization.

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•The risks to the owner are clear: because the work

often begins before the project is completely
defined, the costs may very well exceed the figures
that were defined upfront.
•A GMP can provide a cap, but this cap may be
protected by the contractor at the expense of
quality and scope.
•This type of contract is used in both the
construction project management and design-build
delivery methods.

Contract Changes
Contract changes occur for three main reasons:

1. Because of a change in owner requirements, the

scope of the project changes.
2. Because of conditions unforeseen at the time
the contract is signed, the work must be
performed differently.
3. Due to omissions or design features that cannot
be built as specified, the design must be
adjusted.

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•The impact that the change has on the contract

depends on which type of contract is in place
and what the reason is for the change.
•A cost-plus contract can accommodate all of
the above contingencies without a change in the
contract except for possibly the case of a GMP.
•If a GMP is in place, it may have to be
increased, depending on the terms of the GMP
clause between owner and contractor.

•In the case of a fixed price contract, all the

three reasons will probably lead to a change in
the contract between parties.
•All of the above generally lead to increased
costs and time which need to be fairly adjusted.
•In the case of a unit price contract, the reasons
listed before may or may not lead to a contract
change.
•In the case of an excavation project an increase
in rock would be covered by the unit price
submitted, whereas an unexpected decision to
prohibit blasting would require a change in the
contract.

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•Contract changes are a reality on construction

projects, although from the perspective of most
parties they can be disruptive and should be
avoided.
•As illustrated before the type of contract
chosen can either increase or decrease the
number of changes that need to be negotiated.
•In general, fixed price contracts require the
most, and cost plus a fee the least.

•Owners need to recognize that changes cost

the project money since in negotiating a change
with a contractor they will generally not get as
good a price as if they had included the change
item in the original project, where the work may
have been competitively bid.

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