8. Construction Pricing and Contracting
8.1 Pricing for Constructed Facilities
Because of the unique nature of constructed facilities, it is almost imperative to have a separate price for each facility. The construction contract price includes the direct project cost including field supervision expenses plus the markup imposed by contractors for general overhead expenses and profit. The factors influencing a facility price will vary by type of facility and location as well. Within each of the major categories of construction such as residential housing, commercial buildings, industrial complexes and infrastructure, there are smaller segments which have very different environments with regard to price setting. However, all pricing arrangements have some common features in the form of the legal documents binding the owner and the supplier(s) of the facility. Without addressing special issues in various industry segments, the most common types of pricing arrangements can be described broadly to illustrate the basic principles.
The basic structure of the bidding process consists of the formulation of detailed plans and specifications of a facility based on the objectives and requirements of the owner, and the invitation of qualified contractors to bid for the right to execute the project. The definition of a qualified contractor usually calls for a minimal evidence of previous experience and financial stability. In the private sector, the owner has considerable latitude in selecting the bidders, ranging from open competition to the restriction of bidders to a few favored contractors. In the public sector, the rules are carefully delineated to place all qualified contractors on an equal footing for competition, and strictly enforced to prevent collusion among contractors and unethical or illegal actions by public officials.
Detailed plans and specifications are usually prepared by an architectural/engineering firm which oversees the bidding process on behalf of the owner. The final bids are normally submitted on either a lump sum or unit price basis, as stipulated by the owner. A lump sum bid represents the total price for which a contractor offers to complete a facility according to the detailed plans and specifications. Unit price bidding is used in projects for which the quantity of materials or the amount of labor involved in some key tasks is particularly uncertain. In such cases, the contractor is permitted to submit a list of unit prices for those tasks, and the final price used to determine the lowest bidder is based on the lump sum price computed by multiplying the quoted unit price for each specified task by the corresponding quantity in the owner's estimates for quantities. However, the total payment to the winning contractor will be based on the actual quantities multiplied by the respective quoted unit prices.
Instead of inviting competitive bidding, private owners often choose to award construction contracts with one or more selected contractors. A major reason for using negotiated contracts is the flexibility of this type of pricing arrangement, particularly for projects of large size and great complexity or for projects which substantially duplicate previous facilities sponsored by the owner. An owner may value the expertise and integrity of a particular contractor who has a good reputation or has worked successfully for the owner in the past. If it becomes necessary to meet a deadline for completion of the project, the construction of a project may proceed without waiting for the completion of the detailed plans and specifications with a contractor that the owner can trust. However, the owner's staff must be highly knowledgeable and competent in evaluating contractor proposals and monitoring subsequent performance.
Generally, negotiated contracts require the reimbursement of direct project cost plus the contractor's fee as determined by one of the following methods:
- Cost plus fixed percentage
- Cost plus fixed fee
- Cost plus variable fee
- Target estimate
- Guaranteed maximum price or cost
The fixed percentage or fixed fee is determined at the outset of the project, while variable fee and target estimates are used as an incentive to reduce costs by sharing any cost savings. A guaranteed maximum cost arrangement imposes a penalty on a contractor for cost overruns and failure to complete the project on time. With a guaranteed maximum price contract, amounts below the maximum are typically shared between the owner and the contractor, while the contractor is responsible for costs above the maximum.
Speculative Residential Construction
In residential construction, developers often build houses and condominiums in anticipation of the demand of home buyers. Because the basic needs of home buyers are very similar and home designs can be standardized to some degree, the probability of finding buyers of good housing units within a relatively short time is quite high. Consequently, developers are willing to undertake speculative building and lending institutions are also willing to finance such construction. The developer essentially set the price for each housing unit as the market will bear, and can adjust the prices of remaining units at any given time according to the market trend.
Some owners use in-house labor forces to perform a substantial amount of construction, particularly for addition, renovation and repair work. Then, the total of the force-account charges including in-house overhead expenses will be the pricing arrangement for the construction.
8.2 Contract Provisions for Risk Allocation
Provisions for the allocation of risk among parties to a contract can appear in numerous areas in addition to the total construction price. Typically, these provisions assign responsibility for covering the costs of possible or unforeseen occurances. A partial list of responsibilities with concomitant risk that can be assigned to different parties would include:
The language used for specifying the risk assignments in these areas must conform to legal requirements and past interpretations which may vary in different jurisdictions or over time. Without using standard legal language, contract provisions may be unenforceable. Unfortunately, standard legal language for this purpose may be difficult to understand. As a result, project managers often have difficulty in interpreting their particular responsibilities. Competent legal counsel is required to advise the different parties to an agreement about their respective responsibilities.
Standard forms for contracts can be obtained from numerous sources, such as the American Institute of Architects (AIA) or the Associated General Contractors (AGC). These standard forms may include risk and responsibility allocations which are unacceptable to one or more of the contracting parties. In particular, standard forms may be biased to reduce the risk and responsibility of the originating organization or group. Parties to a contract should read and review all contract documents carefully.
The three examples appearing below illustrate contract language resulting in different risk assignments between a contractor (CONTRACTOR) and an owner (COMPANY). Each contract provision allocates different levels of indemnification risk to the contractor.
Example 8-1: A Contract Provision Example with High Contractor Risk
"Except where the sole negligence of COMPANY is involved or alleged, CONTRACTOR shall indemnify and hold harmless COMPANY, its officers, agents and employees, from and against any and all loss, damage, and liability and from any and all claims for damages on account of or by reason of bodily injury, including death, not limited to the employees of CONTRACTOR, COMPANY, and of any subcontractor or CONTRACTOR, and from and against any and all damages to property, including property of COMPANY and third parties, direct and/or consequential, caused by or arising out of, in while or in part, or claimed to have been caused by or to have arisen out of, in whole or in part, an act of omission of CONTRACTOR or its agents, employees, vendors, or subcontractors, of their employees or agents in connection with the performance of the Contract Documents, whether or not insured against; and CONTRACTOR shall, at its own cost and expense, defend any claim, suit, action or proceeding, whether groundless or not, which may be commenced against COMPANY by reason thereof or in connection therewith, and CONTRACTOR shall pay any and all judgments which may be recovered in such action, claim, proceeding or suit, and defray any and all expenses, including costs and attorney's fees which may be incurred by reason of such actions, claims, proceedings, or suits."
Comment: This is a very burdensome provision for the contractor. It makes the contractor responsible for practically every conceivable occurrence and type of damage, except when a claim for loss or damages is due to the sole negligence of the owner. As a practical matter, sole negligence on a construction project is very difficult to ascertain because the work is so inter-twined. Since there is no dollar limitation to the contractor's exposure, sufficient liability coverage to cover worst scenario risks will be difficult to obtain. The best the contractor can do is to obtain as complete and broad excess liability insurance coverage as can be purchased. This insurance is costly, so the contractor should insure the contract price is sufficiently high to cover the expense.
Example 8-2: An Example Contract Provision with Medium Risk Allocation to Contractor
"CONTRACTOR shall protect, defend, hold harmless, and indemnify COMPANY from and against any loss, damage, claim, action, liability, or demand whatsoever (including, with limitation, costs, expenses, and attorney's fees, whether for appeals or otherwise, in connection therewith), arising out of any personal injury (including, without limitation, injury to any employee of COMPANY, CONTRACTOR or any subcontractor), arising out of any personal injury (including, without limitation, injury to any employee of COMPANY, CONTRACTOR, or any subcontractor), including death resulting therefrom or out of any damage to or loss or destruction of property, real and or personal (including property of COMPANY, CONTRACTOR, and any subcontractor, and including tools and equipment whether owned, rented, or used by CONTRACTOR, any subcontractor, or any workman) in any manner based upon, occasioned by , or attributable or related to the performance, whether by the CONTRACTOR or any subcontractor, of the Work or any part thereof, and CONTRACTOR shall at its own expense defend any and all actions based thereon, except where said personal injury or property damage is caused by the negligence of COMPANY or COMPANY'S employees. Any loss, damage, cost expense or attorney's fees incurred by COMPANY in connection with the foregoing may, in addition to other remedies, be deducted from CONTRACTOR'S compensation, then due or thereafter to become due. COMPANY shall effect for the benefit of CONTRACTOR a waiver of subrogation on the existing facilities, including consequential damages such as, but not by way of limitation, loss of profit and loss of product or plant downtime but excluding any deductibles which shall exist as at the date of this CONTRACT; provided, however, that said waiver of subrogation shall be expanded to include all said deductible amounts on the acceptance of the Work by COMPANY."
Comment: This clause provides the contractor considerable relief. He still has unlimited exposure for injury to all persons and third party property but only to the extent caused by the contractor's negligence. The "sole" negligence issue does not arise. Furthermore, the contractor's liability for damages to the owner's property-a major concern for contractors working in petrochemical complexes, at times worth billions-is limited to the owner's insurance deductible, and the owner's insurance carriers have no right of recourse against the contractor. The contractor's limited exposure regarding the owner's facilities ends on completion of the work.
Example 8-3: An Example Contract Provision with Low Risk Allocation to Contractor
"CONTRACTOR hereby agrees to indemnify and hold COMPANY and/or any parent, subsidiary, or affiliate, or COMPANY and/or officers, agents, or employees of any of them, harmless from and against any loss or liability arising directly or indirectly out of any claim or cause of action for loss or damage to property including, but not limited to, CONTRACTOR'S property and COMPANY'S property and for injuries to or death of persons including but not limited to CONTRACTOR'S employees, caused by or resulting from the performance of the work by CONTRACTOR, its employees, agents, and subcontractors and shall, at the option of COMPANY, defend COMPANY at CONTRACTOR'S sole expense in any litigation involving the same regardless of whether such work is performed by CONTRACTOR, its employees, or by its subcontractors, their employees, or all or either of them. In all instances, CONTRACTOR'S indemnity to COMPANY shall be limited to the proceeds of CONTRACTOR'S umbrella liability insurance coverage."
Comment: With respect to indemnifying the owner, the contractor in this provision has minimal out-of-pocket risk. Exposure is limited to whatever can be collected from the contractor's insurance company.
8.3 Risks and Incentives on Construction Quality
All owners want quality construction with reasonable costs, but not all are willing to share risks and/or provide incentives to enhance the quality of construction. In recent years, more owners recognize that they do not get the best quality of construction by squeezing the last dollar of profit from the contractor, and they accept the concept of risk sharing/risk assignment in principle in letting construction contracts. However, the implementation of such a concept in the past decade has received mixed results.
Many public owners have been the victims of their own schemes, not only because of the usual requirement in letting contracts of public works through competitive bidding to avoid favoritism, but at times because of the sheer weight of entrenched bureaucracy. Some contractors steer away from public works altogether; others submit bids at higher prices to compensate for the restrictive provisions of contract terms. As a result, some public authorities find that either there are few responsible contractors responding to their invitations to submit bids or the bid prices far exceed their engineers' estimates. Those public owners who have adopted the federal government's risk sharing/risk assignment contract concepts have found that while initial bid prices may have decreased somewhat, claims and disputes on contracts are more frequent than before, and notably more so than in privately funded construction. Some of these claims and disputes can no doubt be avoided by improving the contract provisions.
Since most claims and disputes arise most frequently from lump sum contracts for both public and private owners, the following factors associated with lump sum contracts are particularly noteworthy:
An unbalanced bid refers to raising the unit prices on items to be completed in the early stage of the project and lowering the unit prices on items to be completed in the later stages. The purpose of this practice on the part of the contractor is to ease its burden of construction financing. It is better for owners to offer explicit incentives to aid construction financing in exchange for lower bid prices than to allow the use of hidden unbalanced bids. Unbalanced bids may also occur if a contractor feels some item of work was underestimated in amount, so that a high unit price on that item would increase profits. Since lump sum contracts are awarded on the basis of low bids, it is difficult to challenge the low bidders on the validity of their unit prices except for flagrant violations. Consequently remedies should be sought by requesting the contractor to submit pertinent records of financial transactions to substantiate the expenditures associated with its monthly billings for payments of work completed during the period.
One of the most contentious issues in contract provisions concerns the payment for change orders. The owner and its engineer should have an appreciation of the effects of changes for specific items of work and negotiate with the contractor on the identifiable cost of such items. The owner should require the contractor to submit the price quotation within a certain period of time after the issuance of a change order and to assess whether the change order may cause delay damages. If the contract does not contain specific provisions on cost disclosures for evaluating change order costs, it will be difficult to negotiate payments for change orders and claim settlements later.
In some projects, the contract provisions may allow the contractor to provide alternative design and/or construction technology. The owner may impose different mechanisms for pricing these changes. For example, a contractor may suggest a design or construction method change that fulfills the performance requirements. Savings due to such changes may accrue to the contractor or the owner, or may be divided in some fashion between the two. The contract provisions must reflect the owners risk-reward objectives in calling for alternate design and/or construction technology. While innovations are often sought to save money and time, unsuccessful innovations may require additional money and time to correct earlier misjudgment. At worse, a failure could have serious consequences.
In spite of admonitions and good intentions for better planning before initiating a construction project, most owners want a facility to be in operation as soon as possible once a decision is made to proceed with its construction. Many construction contracts contain provisions of penalties for late completion beyond a specified deadline; however, unless such provisions are accompanied by similar incentives for early completion, they may be ruled unenforceable in court. Early completion may result in significant savings, particularly in rehabilitation projects in which the facility users are inconvenienced by the loss of the facility and the disruption due to construction operations.
Example 8-4: Arkansas Rice Growers Cooperative Association v. Alchemy Industries
A 1986 court case can illustrate the assumption of risk on the part of contractors and design professionals. The Arkansas Rice Growers Cooperative contracted with Alchemy Industries, Inc. to provide engineering and construction services for a new facility intended to generate steam by burning rice hulls. Under the terms of the contract, Alchemy Industries guaranteed that the completed plant would be capable of "reducing a minimum of seven and one-half tons of rice hulls per hour to an ash and producing a minimum of 48 million BTU's per hour of steam at 200 pounds pressure." Unfortunately, the finished plant did not meet this performance standard, and the Arkansas Rice Growers Cooperative Association sued Alchemy Industries and its subcontractors for breach of warranty. Damages of almost $1.5 million were awarded to the Association.
8.4 Types of Construction Contracts
While construction contracts serve as a means of pricing construction, they also structure the allocation of risk to the various parties involved. The owner has the sole power to decide what type of contract should be used for a specific facility to be constructed and to set forth the terms in a contractual agreement. It is important to understand the risks of the contractors associated with different types of construction contracts.
Lump Sum Contract
In a lump sum contract, the owner has essentially assigned all the risk to the contractor, who in turn can be expected to ask for a higher markup in order to take care of unforeseen contingencies. Beside the fixed lump sum price, other commitments are often made by the contractor in the form of submittals such as a specific schedule, the management reporting system or a quality control program. If the actual cost of the project is underestimated, the underestimated cost will reduce the contractor's profit by that amount. An overestimate has an opposite effect, but may reduce the chance of being a low bidder for the project.
Unit Price Contract
In a unit price contract, the risk of inaccurate estimation of uncertain quantities for some key tasks has been removed from the contractor. However, some contractors may submit an "unbalanced bid" when it discovers large discrepancies between its estimates and the owner's estimates of these quantities. Depending on the confidence of the contractor on its own estimates and its propensity on risk, a contractor can slightly raise the unit prices on the underestimated tasks while lowering the unit prices on other tasks. If the contractor is correct in its assessment, it can increase its profit substantially since the payment is made on the actual quantities of tasks; and if the reverse is true, it can lose on this basis. Furthermore, the owner may disqualify a contractor if the bid appears to be heavily unbalanced. To the extent that an underestimate or overestimate is caused by changes in the quantities of work, neither error will effect the contractor's profit beyond the markup in the unit prices.
Cost Plus Fixed Percentage Contract
For certain types of construction involving new technology or extremely pressing needs, the owner is sometimes forced to assume all risks of cost overruns. The contractor will receive the actual direct job cost plus a fixed percentage, and have little incentive to reduce job cost. Furthermore, if there are pressing needs to complete the project, overtime payments to workers are common and will further increase the job cost. Unless there are compelling reasons, such as the urgency in the construction of military installations, the owner should not use this type of contract.
Cost Plus Fixed Fee Contract
Under this type of contract, the contractor will receive the actual direct job cost plus a fixed fee, and will have some incentive to complete the job quickly since its fee is fixed regardless of the duration of the project. However, the owner still assumes the risks of direct job cost overrun while the contractor may risk the erosion of its profits if the project is dragged on beyond the expected time.
Cost Plus Variable Percentage Contract
For this type of contract, the contractor agrees to a penalty if the actual cost exceeds the estimated job cost, or a reward if the actual cost is below the estimated job cost. In return for taking the risk on its own estimate, the contractor is allowed a variable percentage of the direct job-cost for its fee. Furthermore, the project duration is usually specified and the contractor must abide by the deadline for completion. This type of contract allocates considerable risk for cost overruns to the owner, but also provides incentives to contractors to reduce costs as much as possible.
Target Estimate Contract
This is another form of contract which specifies a penalty or reward to a contractor, depending on whether the actual cost is greater than or less than the contractor's estimated direct job cost. Usually, the percentages of savings or overrun to be shared by the owner and the contractor are predetermined and the project duration is specified in the contract. Bonuses or penalties may be stipulated for different project completion dates.
Guaranteed Maximum Cost Contract
When the project scope is well defined, an owner may choose to ask the contractor to take all the risks, both in terms of actual project cost and project time. Any work change orders from the owner must be extremely minor if at all, since performance specifications are provided to the owner at the outset of construction. The owner and the contractor agree to a project cost guaranteed by the contractor as maximum. There may be or may not be additional provisions to share any savings if any in the contract. This type of contract is particularly suitable for turnkey operation.