Contractual uncertainty and risk allocation

Developed by Alexandru Radulescu

In order to be fulfilled, civil engineering projects usually entail allocation of huge resources of different types. But in the same time, financing large resources for a project means assigning of great responsibilities. So it is common that a single contractor will not take the whole responsibilities corresponding for a big project, but these will be shared through an ample selection from the multitude of existing types of contracts nowadays.

In the same time, sharing the responsibilities represents sharing the risks corresponding to the specific parts of the civil engineering projects. It is of highly interest how construction business deals with risk management, risk identification, risk quantification and a particular emphasis will subsequently be shown towards the manner of how risks are controlled throughout the project and allocated to different parties by means of contracts.

Analyzing different existing types of contracts, how they serve the involved parties and how responsibilities and benefices are shared in order to achieve a common goal, are very important tasks. Hereinafter the choice between basic types of complex contracts (lump sum contract, unit rate contract, guaranteed maximum price contract, pure incentive contract, guaranteed maximum liability contract, percentage fee contract, cost reimbursable contract) will be further discussed.

Introduction

By definition, a contract is a mutually binding agreement that obligates the seller to provide the specified product and obligates the buyer to pay for it. So, in the same time, a contract can be seen as the foremost documentation that defines the duties and responsibilities of each party of the agreement. Furthermore, to make the connection with risk management in civil engineering, this may be translated to the fact that by means of contracts, the owner will be the one that allocates risks to each of the other parties. Hence, the choice of a contract plan becomes crucial, as it represents the primary step in the control and allocation of corresponding risks of a project. This will further allow focusing the attention of project management on early identification of risk and uncertainty and highlight those areas where further design, work development, or clarification is most needed.

Risk in construction business

Risk is defined as the chance of an adverse event to happen depending on the circumstances. Risk and uncertainty are part of all construction work regardless of the size of the project. Some factors that carry risk include, for example: complexity, speed of construction, location of the project, and familiarity with the work. When serious risks occur on projects the effects can be very damaging. In extreme cases, time and cost overruns turn a potentially profitable project into a loss-making venture. Cost and time targets are often missed due to unforeseen events that even an experienced project manager cannot anticipate.

By means of contractual agreement, it is possible that the inherent risk of a specific job to be assumed by another party that has the competence to fairly assess the risk and the expertise necessary to control or minimize it. Shifting tasks to another subcontractors means transferring or sharing the ownership of the risk with them in the following way :

• having a stake in the benefit or harm that may arise from the activity that leads to the risk;

• responsibility for the risk; accountability for the control of risk;

• financial responsibility for the whole or part of the harm arising from the risk should it materialize.

For a better understanding of possible matters in construction projects, different sources of risk will be presented and grouped, function to their possible allocation: to the contractor, to the owner, shared.

Basic types of contracts

Having familiarized with the concept of contracts and risk management and how they bond with each other in civil engineering projects, there will be further presented the three basic types of complex contracts existing: fixed-price contracts, cost-reimbursable contracts, incentive contracts.

Fixed price represents a category of contracts that involves a determined total price for a well-defined product. They transfer most of the risk to the supplier, but even so, he is protected against changes generated from sources beyond its control. To the extent that the product is not well defined, both the buyer and the seller are at risk- the buyer may not receive the desired product or the seller may need to incur additional costs to provide it. These contracts are used when a large amount of information is available, being widespread for the procurement of execution work on site. They may include incentives for meeting or exceeding selected project objectives.

Fee based contracts involve payment to the seller for its actual costs, plus a fee representing seller’s profit. They are used in high uncertainty situations, when it is possible to determine the type of needed resources, but not the required amount. This category of contracts usually represents the base point in procuring architectural and engineering design services. Since there exists place for opportunism of the contractor, usually detailed auditing systems are put in place in case of fee based agreements. Some can argue that this type of contracts may provide insufficient incentives to reduce costs.

Incentive contracts are hybrid types of contractual arrangement that contain aspects of both fixed price and fee based type of contracts. They are structured so that to limit the risk of one of the parties relative to the other, allocating the responsibilities more equally, but also to keep a linearity between the estimated actual cost of construction plus a percentage fee and the actual outturn. The common feature of all incentive contracts is that they try to provide positive stimulus within the contract to motivate supplier performance.

Some recommendations so that incentive contracts to be as productive as possible are further indicated :

• The benefit obtained from improving the performance must be greater than the cost of the incentive.

• The benefit obtained from improving the performance must be greater than the penalties associated with malfunctioning issues.

• The benefit obtained from improving the performance must be greater than the cost involved in measuring performance.

• It should be kept track of gain and losses very accurately.

• Incentive contracts are more suitable for integrated project coalitions.

Figure 1: Basic types of contracts

Finally, a schematic representation of the abovementioned types of contracts, function of the level of uncertainty at the contract formation and each party responsibilities is depicted in Figure 1. It can be noticed once again how the uncertainty increases from a low level, in case of lump sum contract (which is a fixed price contract) to a high level of uncertainty in case of a cost-reimbursable contract. It is to be observed that the incentive contracts are the ones that tend to give an equilibrium in terms of uncertainty during the contract formation and in terms of each party responsibilities. Another remark would be the fact that fee based contracts implies the most responsibilities from behalf of the client, whilst in case of fixed price contracts the responsibilities are allocated mostly to the supplier.

Choosing the appropriate contract type

Lump Sum Contract

Figure 2: Construction contract

Lump Sum Contract belongs to fixed price category type of contracts and consists in assigning all the risks to the contractor. No risk is assigned to the owner. In exchange, the contractor is legitimate to claim for a higher markup in order to cover any unforeseen contingencies. The lump sum contract often includes commitments made by the contractor as submittals to specific requests, such as: specific schedules, quality control plan, etc. Contractors profit depends on the correct cost estimation made in offering phase. If the actual cost is underestimated, the actual profit will be reduced by the underestimation amount. If the actual cost is overestimated, the contractor profit will be increased with the overestimation amount, but this method can lower the chances to win the bid and have the contract. This is the most wide spread type of contractual agreement on small projects or simple projects with a well-defined scope.

There exist some limitations of this type of contract that should be recalled :

• as expected, lump sum contract presents highest risk for the contractor;
• the selection of methods and technologies is at the contractor's will;
• design of the project must be in a great measure completed before starting of activities;
• changes may be difficult to be quantified.

Unit Price Contract

Also a fixed price contract, Unit Price Contract is a type of arrangement that cuts out the risk for inaccurate estimation of key tasks quantities from the contractor. Still, sometimes, when the contractor finds important contradictions between the quantities estimated by himself and the quantities estimated by the owner, he may forward an unbalanced bid. It is depending on the contractor confidence on his estimation correctness and on his susceptibility to risk that the he raises the underestimated tasks unit prices and lowers the overestimated tasks unit prices. The contractors assessments correctness leads to the profit increase for actual bigger quantities of tasks; in the same time, if the contractors assessments are incorrect, the profit resulted will be lower, even loss, for bigger quantities of tasks. Furthermore, an offer which appears to be heavily unbalanced can result in the contractor being disqualified by the owner. Basically, unit prices misestimations caused by work quantities changes will affect the contractor’s profit depending on the markup in the unit prices. Finally, for an accurate unit pricing based on units of completed work, it is most often to meet unit pricing used on public infrastructure projects (e.g., roads, runways), than on private building projects.

Cost plus Fixed Fee Contract

This is a fee based type of contract that guarantees to the contractor the payment of actual job costs plus a fixed fee.

It is also a type of agreement where the owner embraces the risk of actual job costs overrun. The contractor will be interested to reduce work duration, as his profit is fix, no matter how long it takes to complete the job. On the other hand, there exists the risk of mitigating the supplier's profit if the duration of work exceeds the estimated time.

Cost plus Fixed Percentage Contract

In special situations, such as constructions involving new technologies or urgent needs, the owner may be forced to use a cost plus fixed percentage contract. This implies the owner to take all risks of costs overruns and unless there are compulsory or stringent reasons, it is advisable that he may avoid this type of contract. The contractor obtains the actual work cost and a fixed percentage and he is not highly interested to reduce the total costs. Furthermore, in case of urgent needs or pressing requirements to complete the job, the extra costs for workers overtime payment will increase the job cost.

Cost plus Variable Percentage Contract

This type of contract grants to the contractor the cost payment and a reward if the actual job cost is below the estimated cost. Meanwhile, if the actual cost is higher than the estimated cost, the contractor agrees to pay a penalty to the owner. Consequently, the contractor will be highly interested to reduce actual job costs as much as possible. In other words, it can be said that since the contractor takes the risk of cost estimation, he will receive a variable percentage of the direct job cost in return. Incentives may be included in order to make the contractor quite involved in reducing the actual job costs and completion duration.

Guaranteed Maximum Price (Cost) Contract

When it comes to incentive contracts and when the scope of construction is well defined, the owner can ask to the contractor to assume all risks as concerns the actual costs and completion duration. The owner and the contractor agree to a project cost guaranteed as maximum and to the final completion deadline. In this situation the changes asked by the owner during the project completion should be minimum as all performance specifications were provided to the owner at the beginning of the construction. Guaranteed maximum price contract can also include incentives as bonuses or savings to be shared between the owner and the contractor.

Somewhat similar, it is another type of incentive contract, called the Guaranteed maximum liability contract. The difference is that Guaranteed maximum price contract mostly transfers the responsibilities to the supplier, whilst in Guaranteed maximum liability contract cases, the owner is more exposed to risks.

Target Estimate Contract

Target Estimate is also an incentive contract type that introduces bonuses or penalties applied to the contractor function of the final amount of the job actual cost. If the actual final cost is lower than the estimated cost and/or the completion time is reduced, then the contractor will receive a bonus. If the actual final cost is higher than the estimated cost, the contractor will be penalized, for sure. Both savings and overrun percentages are predetermined and stipulated in the contract. Also, some other contractual conditions are stated in the agreement as criteria for bonuses and penalties, all with the same goal: to motivate supplier performance.

Conclusion

While construction contracts serve as a means of pricing construction, they also define the allocation of risk to the various parties concerned. The owner is the one that 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 and to demonstrate in a systematic way how they are anticipated. Without such a risk analysis, it is difficult to reach an agreement satisfactory to all the parties.

Annotated bibliography

• Godfrey, P.S.,(1996) "Control of risk - A guide to the systematic management of risk from construction" : This reference was used in order to introduce the idea of "ownership of the risk".

• Roozbeh, K.,(1995) "Journal of Construction Engineering and Management - Risk management perceptions and trends of US construction" : This reference was used to extract survey data concerning risk allocation.

• Project Management Institute, Pennsylvania USA (2000): "A Guide to the Project Management Body of Knowledge" : This reference was used in order to get information about basic types of contracts.

• Winch, Graham M., Wiley-Blackwell, (2010) "Managing Construction Projects, 2nd edition " : This reference was highly used in order to gain knowledge about basic types of contracts.

• "What Is a Lump Sum Construction Contract?" -extracted from: https://www.thebalance.com/lump-sum-construction-contract-844915 at 12.07.2017 : This reference was used in order to document about lump sum contract.

• "Construction Contracts: The 10 Most Important Terms" -extracted from: http://www.constructionlawtoday.com/2010/01/construction-contracts-the-10-most-important-terms-price/ at 20.07.2017 : This reference was used in order to get additional information about different types of contracts.

• Chris Hendrickson, Tung Au (1998): "Project Management for Construction - Fundamental Concepts for Owners, Engineers, Architects and Builders" : This reference was highly used in order to get knowledge about different types of contracts.