Introduction
In this article, you could be able to learn about, The main types of contracts (including lump sum, unit rate contracts (Measure and pay), target cost, and cost-reimbursement contracts), identify the characteristics, advantages, and disadvantages of each type of Contract and identify the situations where the use of an individual contract type would be appropriate
What Does Mean “Types of Contracts”?
If you are working in the construction industry, you could hear about the types of contracts. The meaning of “Types of Contract” is the way of making payments to the Contractor. Contracts have different types based on their payment systems. Two main payment systems exist:
- Price-based contract types
- Cost-based contract types
Price-based Contract Types
These involve lump sum and unit rate (Measure and pay /admeasurement) contracts. The Contractor submits prices in his tender.
Cost-based Contract Types
Cost-reimbursement and target cost contracts, both are under the cost-based Contract. In these types of Contracts, the actual costs of the Contractor will be reimbursed (Contractor’s actual expenditure) with a fee for Contractor’s overheads and profit.
What Does Mean The Fixed Price and Firm Price?
Many people who are working in the construction industry do not know the precise and accurate terminology to describe how the contract sum is due under the Contract.
Let’s understand the following popular terminologies related to the types of contracts.
The meaning of “A fixed price” is the amount is fixed at the initiation of the Contract. As you know, the Contractor’s work is generally listed in the BOQ, which is to be priced by the bidder. At the time of the tendering period, the bidding Contractor put his price into BoQ. After tendering and negotiations, that priced BOQ becomes a main element of the Contract document. Those agreed prices and unit rates in the Contract are fixed. Then the Client pays the estimated fixed price for the scope of work, regardless of what the Contractor spends actually.
However, these fixed prices/rates may be subject to certain changes sometimes depending on the situation and according to the provisions in the Contract such as variations, changes in legislation, and price fluctuations. Therefore, this contract type is known as a Fixed-priced contract, even though it may have some cost-reimbursable elements such as price fluctuations, which are often related to actual changes in market price.
The meaning of “A Firm price” is that there will be no claims for extra payments. Furthermore, It means that the Contractor has no provision for passing on increases in the cost of work and materials to the employer. In other words, price fluctuations are not allowed. However, in a fixed-price contract, there may be price fluctuations.
In conclusion, both ‘measure and pay’ and ‘lump sum’ contract types are ‘fixed priced’ in nature, but they may be subject to adjustments as per the provisions in the Contract.
1. Lump-sum Contract Type
What is a lump sum contract?
In a lump sum contract, the parties are bound by the contract price, which is determined based on the scope of work. A Bill of Quantities (BOQ) specifying detailed quantities is not necessary for a lump sum contract. Even if a BOQ is included in the contract, the contractor is obligated to complete the agreed-upon scope of work for the contract price, regardless of the quantities and items specified in the BOQ. The BOQ, however, will be used for the purpose of progress payments. If there are no changes to the scope of work, the final contract sum will be the same as the initially accepted contract sum.
Characteristics Of A Lump Sum Contract
A Lump Sum Contract type is based on a single tendered price for the whole work. But, It does not mean a single payment for the Contractor. Payment may be staged at intervals of time or related to the achieved milestones (a milestone refers to a defined stage of progress). The use of the word “milestone” usually means that payment is based upon progress in completing what the Client wants.
A high degree of tender competition may be achieved for this contract type.
However, in the lump sum contract, parties do not measure after completing the work. According to the BOQ fixed rates and quantities, payment will proceed.
Advantages of Lump Sum
- There is a high level of certainty about the final price.
- Contract administration is easy, provided there is no or little change.
- The Client’s management resources are freed for other projects.
Disadvantages of Lump Sum
- It is unsuitable when change is expected.
- There is a possibility that the low bidder may find he is in a loss-making situation, especially where considerable risk has been placed with the Contractor. It may lead to cost-cutting, claims, and in extreme bankruptcy.
- The client and design organization have minimal opportunity for involvement in the management of construction.
Uses of Lump Sum
- A lump-sum contract type shall be used to provide an incentive for the Contractor to perform when the design is complete at the tender, and it is little, or no change or risk is envisaged.
- It can be adopted if the Client wishes to minimize the resources involved in contract administration and might want to place all or most of the risks with the Contractor.
- This type of Contract is rarely used for main civil engineering contracts; however, it is more common in process plants.
What is the Form of Contracts used in Lump-sum contract projects?
If design and documentation are greater in certainty, (Compared to measure and pay), a lump sum may be used. However, if your procurement system is Design and Build, the contract type must always be a lump sum. In the Design and Build procurement path, the Contractor is responsible for both design and build. Therefore, the design is done by the Contractor. If the contract type is the measure and pay, he can manipulate the design for more payments. Therefore the design and build projects are not suitable for the measure and pay contracts.
FIDIC – the yellow book is published for the plant, and design-build projects and payment method is lump-sum. Also, we can use the FIDIC red book for lump sum contracts with some modifications. (Especially clauses 12 & 14)
If your Procurement system is EPC (Engineering, Procurement, and Construction) or Turnkey, the FIDIC silver book is meant for turnkey lump sum contracts.
For more information, see Procurement Systems in Constructions.
2. Unit Rate Contract Types (Measure and Pay Contract/Admeasurement)
What is a remeasurement contract?
In this type of contract, the quantities provided in the Bill of Quantities (BOQ) are approximate and will be reevaluated based on the actual work completed. As a result, the initial accepted contract sum may differ from the final contract sum, as the employer assumes the risk associated with the quantities in this contract type.
Characteristics Of A Unit Rate Contract
A Unit Rate Contract is based on Bills of Quantities in which terms of work are specified with quantities. Bidding contractors put the unit rates or prices against each item of BoQ.
Measure and pay is a unit rate contract type. Measure and Pay Contract type is also called re-measurement or measure and value contract. In this type of Contract, Parties measure the quantities after completing the work. Those quantities will be multiplied by the particularly fixed price rates in the BOQ or new rates negotiated from tender rates and made the payments. The Contractor usually submitted the monthly interim payment application (IPA).
Mechanisms are provided for adjusting both price and time in the likely event of changes. This facility to introduce a limited amount of variation is frequently abused, and design may only be partially complete at the tender. Extensive change and delay will generate claims from the Contractor for additional payment and (/or) time. Consequently, the final contract sum is always different from the tender total.
Measure and Pay vs Admeasurement
There is a slight difference between Measure and Pay and Admeasurement. Measure and pay is the whole process of re-measuring the quantity of work done. But, Admeasurement measures the only difference between the estimated quantity and the actual quantity.
Form of Contract for Unit Rate Contract Types
FIDIC Red Book is generally used for the measure and pay contracts. The term “admeasurement” is considered to be derived from the ICE Conditions of Contract.
Advantages of Unit Rate Contract
- It is a well-understood, widely used type of Contract among the other types of Contracts.
- Flexibility for a design change.
- Overlap of design with construction.
- Good competition at the tender.
- The total amount of tender provides a good sign of the final contract sum, where the probability of variations( changes), disruption, and risks are low.
Disadvantages of Unit Rate Contract
- Claims resolution is difficult; It is an adversarial and quantity-based Contract.
- Limits to flexibility; new items of work are difficult to price.
- There are some limits to the involvement of the Client in the management.
- The final price may not be determined until long after the works are complete, especially when considerable change and disruption have occurred and major risks have materialized.
Uses of Unit Rate Contract
- It can be used with a separate organizational structure. It requires that the design is complete but can accommodate changes in quantity.
- We can use it on many public sectors civil engineerings projects like roads and bridges where little or no change to the program is expected, and the level of risk is low and quantifiable.
- Sometimes, it is used on high-risk contracts where considerable change and disruption are expected, but the Client’s procedures and regulations prevent the use of a cost-based contract. In such circumstances, the Client is advised to proceed with caution and note the deficiencies of traditional BoQ in evaluating extensive change and particularly disruption to the program.
Difference Between Lump Sum contract and Remeasurement contract
| Lump Sum Contract | Remeasurement Contract | |
|---|---|---|
| Parties bound by | Total contract price | Unit rates of the BOQ |
| Initial contract price | Fixed and based on the agreed scope of work | Approximate and subject to adjustment |
| Obligation of contractor | Complete entire scope of work within contract price | Perform work based on unit rates in the BOQ |
| Quantity Risk | With the contractor | With the employer |
| Adjustment of contract price | Not typically allowed | Based on actual work performed |
| Measurement errors | Not covered separately | Contractor may be entitled to payment for some items |
| Miscellaneous items | Not paid separately | Included within another item and not paid separately |
Note: The above points highlight the general characteristics and distinctions between lump sum contracts and remeasurement contracts. Specific contract terms may vary, and it is important to consult the actual contract documents for precise details and obligations.
3. Cost Reimbursement Contract
What is a Cost Reimbursement Contract?
A cost reimbursement contract is a type of contract where the contractor is reimbursed for the actual costs incurred for labor, equipment, materials, and other expenses. In addition to the reimbursed costs, a fee is also paid to the contractor for their services. This contract structure, where both the actual costs and a fee are covered, is commonly referred to as a “Cost-Plus” contract.
What is The Meaning of Prime Cost?
Prime cost refers to the actual cost incurred by a contractor for labor, equipment, materials, and other goods and services required to carry out construction works. In cost-reimbursement contracts, the prime cost is reimbursed to the contractor along with a fee.
Characteristics Of A Cost Reimbursement Contract
Cost reimbursement items are not fixed prices. Those items are paid for based on what the Contractor spends in executing the work. Therefore, the payment of the Contractor is based on his actual expenditure. It includes labour, material, plants, sub-contracting cost, and other direct costs. Then the Contractor has to submit a load of invoices to demonstrate his actual cost. And also he will be paid an agreed fee for his overhead and profit.
The Contractor’s cost accounts are open to audit by the Client (Open-Book Accounting). It is a little contractual incentive for the Contractor to perform, and the final price will depend both on the extent to which risks materialize and on the efficiency of the Contractor.
There are no BOQs in this type of Contract. Then the Client didn’t know the final contract sum. Then it is a very high-risk form of contracting method. The Client carries the risk and, therefore, is required to participate in contract management.
Subcategories Of Cost Reimbursement Contracts
Mainly, three types of Cost reimbursement Contracts exist in the construction industry as follows.
- Cost Plus Fixed Fee Contract
- Cost Plus Fixed Percentage Contract
- Cost Plus Fluctuating Fee Contract
- Cost Plus Fixed Fee with a Guaranteed Maximum Price Contract
As discussed before, the Contractor will be entitled to cost plus an agreed fixed fee or profit percentage for the above three methods. In the third method, the Contractor shall conform with the Client for a maximum price contract, and he can execute the work not exceeding the agreed amount.
What is a Cost Plus Fixed Fee Contract?
A cost-plus fixed fee contract is a type of contract where the fee paid to the contractor is a predetermined fixed amount, which typically does not fluctuate based on the total prime cost. Instead, it is based on the estimated total cost of the project.
For example, let’s consider a construction project with an estimated prime cost of 100 million units, and the agreed fee for the contractor is set at 10 million units. In this case, the fee remains constant regardless of whether the actual prime cost ends up being more or less than the initial estimated cost of 100 million units.
It’s important to note that the prime cost is tentatively established based on available project information and past data from similar projects. This allows for the determination of a reasonable fee that avoids excessively high or low fees, ultimately benefiting both the contractor and the employer.
What is a Cost Plus Percentage Fee Contract?
A cost-plus percentage fee contract is an arrangement where the fee charged is based on a fixed percentage of the prime cost. Unlike a cost-plus fixed fee contract, where the fee amount remains constant, in a cost-plus percentage fee contract, the fee is determined by a fixed percentage of the total cost.
To illustrate, let’s consider an example: Agreed fee percentage: 10% of the actual cost
In this case:
- If the actual cost is 50 million, the fee would amount to 5 million.
- If the actual cost is 100 million, the fee would be 10 million.
- If the actual cost is 150 million, the fee would be 15 million.
In summary, in a cost-plus percentage fee contract, the fee is calculated based on a predetermined percentage of the actual cost, rather than a fixed fee amount.
What is a Cost-plus Fluctuating Fee?
A cost-plus fluctuating fee is a type of contract where neither the fee nor the percentage of the fee is fixed. Instead, the fee percentage varies in relation to the value of the prime cost. Logically, the relationship between the fee percentage and the prime cost should be inverse, meaning that as the prime cost increases, the fee percentage decreases, and vice versa.
The target cost contract is one example of a cost-plus fluctuating fee contract. In this type of contract, if the total cost is less than the agreed target cost, the fee is increased as a bonus. Conversely, if the total cost exceeds the target cost, the fee is reduced as a penalty. This concept is often referred to as gain (bonus) and pain (penalty). The specific percentage for gain and pain is agreed upon by the parties at the beginning of the contract.
What is a Guaranteed Maximum Price (GMP) Contract?
A Guaranteed Maximum Price (GMP) Contract is a type of target cost contract where an agreed-upon maximum price cannot be exceeded. If there are any savings on the guaranteed maximum price, they are typically shared between the contractor and the employer.
Form of Contract for Cost Reimbursement Contract
NEC contract Option-E is a cost-reimbursable form of Contract.
Advantages of Cost Reimbursement Contract
- Provide extreme flexibility.
- Allow and require a high level of client involvement.
- They facilitate joint planning.
Disadvantages of Cost Reimbursement Contract
- There is little incentive for the Contractor to perform efficiently.
- There is no estimate of the final price at the tender.
- Administrative procedures may be unfamiliar to all parties. In particular, the Client must provide cost accountants or cost engineers, who must understand the nature of a contractor’s business.
Uses of Cost Reimbursement Contract
- The scope of the work to be carried out cannot be properly defined at the outset, as the scope of work is very risky such as emergency work (for example, urgent repairing work)
- When the work is innovative, and productivities are unknown. (e.g., involving research and development)
- When the work is of exceptional organizational complexity. (e.g., when there are multi-contract interfaces, to the extent that definition of a target cost is impossible)
- Where a contractor is required to rescue or complete a project that has been subject to extensive disruption.
FAQ Related to Cost Reimbursement Contract
What are the advantages of a cost-plus percentage fee contract compared to a cost-plus fixed fee contract?
In a cost-plus fixed fee contract, the fee is predetermined and fixed, based on an accurate estimation of the prime cost. However, if the actual prime cost significantly deviates from the estimated cost, the fixed fee may not reflect the true value of the services provided. This can lead to disputes. On the other hand, a cost-plus percentage fee contract eliminates this issue by basing the contractor’s fee on a percentage of the actual cost. This ensures that the fee adjusts accordingly, reflecting the accurate value of the services rendered.
What is the disadvantage of a cost-plus percentage fee contract?
A disadvantage of a cost-plus percentage fee contract is that the contractor’s fee is directly tied to the actual cost of the project. This may create an incentive for the contractor to increase project costs through unnecessary expenses. Since the fee increases proportionately with the cost, there is a potential risk of inflated costs if the contractor does not act in a cost-conscious manner.
Why is a cost-plus fixed fee contract not preferable?
A cost-plus fixed fee contract may not be preferable because, even though the contractor may not intentionally increase the actual cost as they would in a cost-plus percentage fee contract, they lack the motivation to eliminate unnecessary costs. In other words, there is no incentive for the contractor to minimize project costs. Since the fee is fixed, the contractor would receive the agreed-upon fee regardless of the actual prime cost value, which may lead to inefficiencies and potentially higher costs.
What is the advantage of a cost-plus fluctuating fee contract?
The advantage of a cost-plus fluctuating fee contract is that the inverse relationship between the fee percentage and the prime cost creates a motive for the contractor to minimize unnecessary costs. The contractor has an incentive to ensure value for the client’s money by actively seeking ways to reduce project costs.
What are the practical issues with Guaranteed Maximum Price Contracts?
There are a few practical issues associated with Guaranteed Maximum Price Contracts. Firstly, it can be challenging to establish a realistic guaranteed maximum price. The accuracy of this target price is crucial for the contract’s success. Additionally, if there are any changes or variations in the project scope, the established target may need to be revised to accommodate these modifications.
4. Target Cost Contract type
A Target Cost Contract involves the setting and agreement of a probable Target Cost for the completion of the work, which may subsequently be adjusted for major changes in the work and cost inflation. The Contractor’s actual costs are monitored and reimbursed as in a Cost Reimbursement Contract.
The Client and Contractor share any difference between actual cost and target cost in a specified way. There is a separate fee covering overheads and profit. Target cost contracts have been successful in achieving a high intensity of collaboration between the parties.
Advantages of Target Cost
- It provides a high level of flexibility for the design change.
- There is an identity of interest: both parties have a common interest in minimizing actual costs. Fewer claims result and the settlement is easier.
- There is client involvement. The Contract offers an active management role for the Client or his agent. Joint planning aids integration of design and construction, efficient use of resources, and satisfactory achievement of objectives.
Disadvantages of Target Cost
- Client involvement is essential, and he must take a different attitude from that adopted on the price-based contracts
- This type of Contract involves unfamiliar administrative procedures and a probable small increase in administration costs. In addition to cost accountants, Client will require some measurement engineers for purposes of target adjustment. The initial target cost provides no greater certainty about the final price than the tender total in an admeasurement contract.
Uses of Target Cost
- When there is an inadequate definition of work at the time of tender owing to the emphasis on early completion or an expectation of substantial variation in work content, Target cost would be recommended.
- If the work is technically or organisationally complex, It can be used.
- When the work involves major unquantifiable risks, We can go for a target cost contract.
- If the Client wishes to be involved in the management of the project or wishes to use the Contract for the training of his staff or the development of a local skilled construction labour force, This contract type is suitable.
Conclusion
Finally, you have to understand your Contract, although you called a measure and pay Contract, it is not one hundred percent measure and pays. It is a combination of other types also. The only majority would be measured and pay. You may have other types of Contracts also.
Let’s take, for example, as Day works. In a re-measurement contract, you have dayworks. The engineer is instructed to do a task on a day work basis. In the Day work bill / Schedule, some material rates are not given at the time of tendering. Then the Contractor will be paid on the actual price of the material with his overhead and profit. The Contractor has to submit a cost breakdown for that new rate with material invoices. It is not the measure and pay. As we discussed earlier, it is a cost-reimbursement contract.
In a lump sum contract, you have a provisional sum bill in the BOQ. So items that are in the provisional sum, you have to make the payment on a measure and pay basis.
Re-measurement and lump sum are both types of contracts that are usually with variations clauses. But Price fluctuation clues, you may have a possibility with or without it. Always, Adjustment for changes in legislation clause should be there in both contracts. Because of government may change some legislation such as vat percentage.
No contract type is perfect in all scenarios. They all have advantages and disadvantages. You need to analyze the project conditions and the Client’s requirements to be able to identify an appropriate contract type.
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