The way that the contract price is established (especially in large construction projects) is problematic as adequate and clear guidelines are lacking in many countries. Undefined and ambiguous contractual terms tend to give rise to disputes.
Every construction contract should, above all, define sufficiently how the total contract price is to be created and what it should consist of. In many developing countries, the prices of products were formed artificially within a controlled economy. Prices were perceived as fixed and not influenced by market conditions, inflation, etc. This allowed governments to use fixed prices as indicators for directive planning and as an instrument to regulate public consumption.
Construction projects are typically long-term processes. In the preparation phase or at the beginning of the design or construction works, the participants have only limited knowledge of the potential risk. These risks are typically allocated to the parties by contract, or moved to third parties through insurance policies or securities. Other risks will be dealt with by way of a contractor’s risk surcharge or employer’s financial reserve. If there is no financial reserve in a project and risks are hard to foresee and treat, or the contractor is not able to cope with a loss, the project can be negatively affected and, eventually, prematurely terminated.
Very often, the employer does not have sufficient financial resources and needs a loan or subsidy. The employer has to negotiate the conditions of the loan or subsidy with lenders (mainly banks) or an authority that provides such a subsidy. Lenders and such authorities are then closely engaged in the particular project and supervise if the employer and the contractor are complying with the agreed conditions. Some of the most sensitive issues involve the actual compliance with grant conditions, how the contract price is calculated and the handling of variations and claims.
6.1.1 Project finance
Sometimes what is called project finance is used as long-term financing of infrastructure and industrial projects. Project finance is based upon the projected cash flows of the project rather than the balance sheets of its sponsors. Usually, a project financing structure involves a number of equity investors known as sponsors as well as a syndicate of banks or other lending institutions that provide loans to the operation. These are most commonly non-recourse loans, which are secured by the project assets and paid entirely from the project cash flow, rather than from the general assets or creditworthiness of the project sponsors. Financing is typically secured by all the project assets, including revenue-producing contracts. Project lenders are given a lien on all of these assets and are able to assume control of a project if the project company has difficulties complying with the loan terms.
To satisfy the conditions established by the lenders (the subsidy providers) and to avoid disputes, the appropriate delivery method (including the method of total contract price determination and claim and variation management rules) must be chosen and described in full in the contract.
The contract price is usually one of the employer’s priorities. The lowest price is often the only criterion in public procurement and, for this reason, the contract price frequently becomes a political issue. On the other hand, large construction projects are inherently prone to cost overruns.
To understand the limits of the foreseeability of the total contract price it is important to know how the bids are priced. Pricing methods may vary, depending on the practices used within a particular company. The pricing method which enjoys the widest use is based on a determined unit cost which is then increased by a percentage margin.
The bid price is usually the total sum of the direct costs of equipment, material and labour, site overheads, headquarters overheads, risk and profit surcharge. On the other hand, a claim for additional payment rests only on the documented direct costs plus overheads and profit surcharge. Another method of claim quantification is to use a methodology for variation evaluation, i.e. the rates and prices of a bill of quantities of a particular contract or a similar contract, industry standards or a new calculation for a particular rate or price. The position of the SCL Protocol on the relevance of tender allowances is that the tender allowances have limited relevance for the evaluation of the costs of prolongation and disruption caused by breach of contract or any other cause that requires the evaluation of additional costs.
To illustrate the pricing methods, let’s take a particular product like a bridge. Once again, a problem appears in the uniqueness of such a bridge as a product because every construction project is unique in its own way. The designer, employer, on-site physical conditions, risks and the like are always different. This is why there cannot be any all-embracing, unified bridge pricing methodology.
Having received and considered the tender documentation and bill of quantities, the contractor will determine what items of work (moving earth, bearing structures and the like) they are able to construct by their own means and what other items of work (such as special foundations and formwork) the contractor will have to provide through subcontractors. With this decision made, the contractor will contact the subcontractors for their price quotations.
The items in the former group are subject to internal estimates. A budget is prepared for every individual item which covers the necessary materials complete with shipment, labour costs and a time schedule. All items are then assigned a respective ‘weight’ based on their nature, knowledge of the design, the manufacturing processes and other methods used in general. Regardless of whether internally estimated or received from subcontractors, these costs are identified as direct costs.
Site and headquarters overheads constitute other components of the price. The wages of the project teams (the project manager and their team, the site manager and their team), project team personnel expenses such as for transport, communication, training, and so on are included in the site overheads. The site overheads further cover flat, office and land rentals, cleaning, IT costs, power and water supply costs, and site facilities (including their set-up, removal and maintenance, such as traffic ways, fences, traffic signs and on-site security guards).
Headquarters overheads contain a percentage surcharge covering the cost of contractor headquarters.
The last component of the price consists of the risk surcharge and profit. Overhead items, risk surcharges and profit are usually not subject to any separate item in the bill of quantities and the contractor must add them to the other items that are already defined.
Another major distinction to be drawn in connection with pricing and subsequent submission of claims may be the one between fixed and variable costs. Fixed costs are costs which are not directly dependent on production volumes and remain constant. Variable costs, on the other hand, rise and fall with production volumes.
Within a construction project, production volume depends on the time necessary for completion of the work. Variable costs grow with extensions of time, making it more expensive to run site facilities. However, the price of setting up and removing them remains the same (i.e. fixed) as they are one-time processes. As a part of variable costs, the price of works performance bank guarantees and any insurance must also be extended. Therefore, addendums to original contracts will also grow in response to an extension of time for completion.
The contractor may also submit what are called cover bids. The reasons behind submitting cover bids vary and can include motives such as not wanting to disappoint the employer, maintaining good relationships with other contractors, and so on.
A particular cycle in a market economy also plays a role in valuation. For instance, the risk surcharge is often left out in recessions with the priority being to maintain contractor turnover. Therefore, market economy cycles and project risks are important factors affecting valuation.
Cash flow can play a role as well. Many large construction projects last for a number of years so the contractor may charge higher prices for some items of work to be carried out in the later stages of the project, for example, to adjust for inflation or to incur a loss by the end of the first year of construction for accounting or tax reasons. Another factor may be the contractor speculating on the valuation of items in relation to known errors in the employer’s basic design or foreseeable, necessary variations.
The following contract price determination criteria can be distinguished:
- economic influences (fixed or variable price);
- formation of the ‘total price’, i.e. mainly the content of total price and how the total price is calculated (lump price, re-measurement and cost plus).
6.3.1 Economic influences on the contract price
Unlike variable price, the fixed price does not undergo any adjustments due to inflation, deflation, depreciation, changes in exchange rates, interest rates, economic cycle development trends or to changes in costs in a particular market. Concerning the variable price, individual criteria have to be set out in the contract to allow for adjustments. For example, the FIDIC forms contain Sub-Clause 13.8, Adjustments for changes in cost which reads:
If this Sub-Clause applies, the amounts payable to the contractor shall be adjusted for rises or falls in the cost of labour, goods and other inputs to the Works, by the addition or deduction of the amounts determined by the formulae prescribed in this Sub-Clause. To the extent that full compensation for any rise or fall in costs is not covered by the provisions of this or other clauses, the accepted contract amount shall be deemed to have included amounts to cover the contingency of other rises and falls in costs.
6.3.2 Formation of total contract price
The total contract price is calculated on the basis of re-measurement, lump sum price or the cost plus method. It should be emphasized that these terms are often used inconsistently. Therefore, it is always necessary to define and describe the contract price determination method as precisely as possible in the contract. The above-mentioned basic types of pricing methods can be used in various combinations and with different components to limit (maximum price) or motivate (target price). Larger projects may adopt a combination of the above-mentioned methods including different payment arrangements.
Using the re-measurement method (the measured or unit price contract), the works actually done are measured based on the individual rates and prices offered by the contractor in their bid in the bill of quantities (prepared by the employer). The bill of quantities contains particular items and gives a brief description of the work and quantity. Every individual item and the respective rate or price must be properly contemplated and its content clearly understood to avoid disputes. The contractor will evaluate the rates and prices in the bill of quantities while keeping in mind prices for the materials, products, labour, equipment, plants, and so on (e.g. per cubic metre cost of the pit to be excavated). This process is called estimating and affords a means for the employer of comparing tenders received once they have been priced.
It was mentioned that sometimes estimates are not accurate and they may differ significantly from the actual price. This is especially true where prices have been taken over from past contracts. Works that are specific to the project such as pit excavation, for example, depend on things like subsoil, local hydrogeology and distance to temporary deposits which may be difficult to estimate accurately.
Next to the continuing re-measurement of the works, the contract price is also formed via claims, variations and adjustments based on the particular contractual risk allocation, claims options and variation (and adjustments) procedure.
6.4.1 Methods of measurement
Methods of measurement are standardized processes that facilitate measurement and valuation. Standard methods of measurement specify how virtually all commonly encountered construction activities are to be measured. An example is the Civil Engineering Standard Method of Measurement (CESMM) developed by the Institution of Civil Engineers (ICE). The purpose of CESMM is to set out the procedure by which a bill of quantities should be prepared and priced and the quantities of work expressed and measured. The latest edition (4th edition) was published in 2012. Another example is the Standard Method of Measurement (SMM) published by the Royal Institute of Chartered Surveyors (RICS) in 1988. The SMM is now in its seventh edition (SMM7) and was published in 1998. SMM7 provides detailed information, classification tables and rules to create a uniform basis for measuring building works, in order to facilitate industry-wide consistency and benchmarking, to encourage the adoption of best practice and to help avoid disputes.
Re-measurement contracts without an agreed method of measurement are prone to disputes.
6.4.2 Provisional sum
Bill of quantities may contain various types of items and amounts serving different purposes. Their description and content depend mainly on the contract and the method of measurement used. One such item is the provisional sum. In construction contracts, a provisional sum may have various meanings, but usually it is the sum referred to as a provisional sum in the bill of quantities. The provisional sum is used for the payment of works or services for which the total price is difficult to foresee or there is some uncertainty as to whether the works or services will be performed at all. This is different from the contingency (the employer’s financial reserve) used to cover the financial consequences of either known or unknown hazards or their respective risks that are not insured or secured. Contingency should be subject to confidentiality.
Under Sub-Clause 126.96.36.199 of the FIDIC CONS/1999 Red Book Provisional Sum means ‘a sum (if any) which is specified in the Contract as a provisional sum, for the execution of any part of the Works or for the supply of Plant, Materials or services under Sub-Clause 13.5 [Provisional Sums]’.
Sub-Clause 13.5 further reads:
Each Provisional Sum shall only be used, in whole or in part, in accordance with the Engineer’s instructions, and the Contract Price shall be adjusted accordingly. The total sum paid to the Contractor shall include only such amounts, for the work, supplies or services to which the Provisional Sum relates, as the Engineer shall have instructed. For each Provisional Sum, the Engineer may instruct: (a) work to be executed (including Plant, Materials or services to be supplied) by the Contractor and valued under Sub-Clause 13.3 [Variation Procedure]; and/or (b) Plant, Materials or services to be purchased by the Contractor, from a nominated Subcontractor (as defined in Clause 5 [Nominated Subcontractors]) or otherwise; and for which there shall be included in the Contract Price: (i) the actual amounts paid (or due to be paid) by the Contractor, and (ii) a sum for overhead charges and profit, calculated as a percentage of these actual amounts by applying the relevant percentage rate (if any) stated in the appropriate Schedule. If there is no such rate, the percentage rate stated in the Appendix to Tender shall be applied. The Contractor shall, when required by the Engineer, produce quotations, invoices, vouchers and accounts or receipts in substantiation.
Provisional sums under FIDIC forms are the amounts set out separately by the employer in the budget. These amounts are intended to cover particular works or services where the employer is unsure if they will be used or if the quantity or other attributes of them could not have been exactly known prior to commencement of construction. Such sums can be used for those particular items only.
These works or services are only performed after the instruction of the engineer. The quantity is to be measured and the employer will pay for the works actually done, either within a variation procedure as per Sub-Clause 13.3 or on the cost plus basis. As mentioned above, the provisional sum may have a different meaning in construction than under FIDIC.
A provisional lump sum may be encountered by project participants. This is a firm price for part of the works, with provisional rates to apply to a series of contingencies. For example, a range of potential ground conditions could be separately priced and the rates would simply be applied to match the conditions actually encountered. The employer then knows the ‘worst case scenario’, but will benefit from paying the lower rates if the conditions encountered prove to be straightforward. A provisional lump sum also mitigates potential problems where the design is defined by reference to open-ended or general criteria by allowing alternative design solutions to be priced (Jenkins and Stebbings, 2006).
In the context of procurement law, an option is a right of the employer to purchase products or services on terms and conditions determined in advance which the contractor is obliged to perform on the pre-agreed terms stipulated. Exercise of an option does not constitute a change of the contract but a change pursuant to the contract (directed variation), provided that: (1) the option is sufficiently clear in its description; (2) that the tender contains the price of the option so that the employer may take the option into account, directly or indirectly when awarding the contract; and (3) that the option may be exercised without prior negotiation between the parties. Options also have the commercial advantage of maintaining a fixed lump sum price in competition, i.e. during the tender stage where the contractor fought to win the contract, as compared to changes agreed upon subsequently where the employer often has no alternative but to pay the price asked by the contractor (Hartlev and Liljenbøl, 2013).
Under the lump sum method, a pre-agreed sum (regardless of actual cost incurred) is paid by the employer and the works actually done are not measured but paid against the schedule of payments, mostly once the predetermined sections (or milestones) are finished or when the project is fully completed. The lump sum price is also influenced by claims, variations and adjustments based on the particular contractual risk allocation, claims options and variation (and adjustments) procedure.
The lump sum should be sufficient to cover the anticipated costs, overhead, profit and risk surcharge. The main advantage for the employer is cost certainty and simpler contract administration. This advantage is lost where the surcharge is too high and where the risks of a particular project are hard to quantify. Disputes arise in such circumstances where varied or additional works and claims in a lump sum contract are not solved by pre-defined rules or with a common-sense and fair approach of all participants involved.
An alternative called “detailed lump sum contract” is sometimes encountered for example in Germany. Some authors speak about a “system choice” that is to be made by the employer in this regard. If the employer has decided for the lump sum contract “system” with such detailed description of the contractual services, the contractor need only execute the services which are described in detail under the agreed lump sum. An employer attempt to evade this by adding a completeness clause to the “detailed lump sum contract” would be seen as invalid in Germany (Kus, Markus and Steding, 1999).
Under the cost plus method, the contractor receives from the employer not only the payment for reasonable and properly incurred cost, but also a fee for overhead and profit. This method is more appropriate for high risk projects where a lump sum price (which takes all contingencies into account) would be too high. To encourage the contractor to perform the works for the lowest possible price, some additional mechanisms can be used, for example, the maximum guaranteed price or target price, described below.
Under this arrangement, contractors are usually obliged to maintain comprehensive and contemporary cost records and the employer usually reserves the right to audit the claimed cost to ensure they have been reasonably and properly incurred. The profit and overhead surcharge will be subject to competition in the tender period.
It was already mentioned that the cost plus method is often used for contractual claims quantification. Thus, if the contractor suffers delay or incurs cost under 1999 FIDIC forms in case of employer risk event, they are entitled to a payment of any such cost (including overhead) plus reasonable profit in some situations. Under Sub-Clause 188.8.131.52 ‘cost’ means all expenditure reasonably incurred (or to be incurred) by the contractor, whether on- or off-site, including overhead and similar charges, but does not include profit. Profit is allowed only in specific claims, i.e. usually those where there is an employer default.
The cost plus price is also influenced by claims, variations and adjustments based on the particular contractual risk allocation, claims options and variation (and adjustments) procedure.