QUESTION

Types of Contract:

Contracts are nothing but agreements between two or more parties. One or more party (contractor) may provide product/ services to the other party (principal or owner) in return of some incentive.

Lump Sum Contract

Lump Sum Contract is a specific type of contract where contractor has to complete the work described in contract document to fulfill the obligation. There is a schedule of price included in the contract document, which is used as the basis of payment schedule. This type of contract is also called “Fixed Fee Contract”. This type of contracts is suitable for the projects where the scope and schedule are defined in such manner that enables consulting engineer to estimate costs of the project.This is the simplest type of contract and is also called fixed price contract. The main advantage of such contract is that total costs associated with the project are known beforehand.

In lump sum contract, generally the contractor is paid a flat amount after the completion of the project work. For example, an architect firm is paid all its dues once the firm has delivered the blueprints (in accordance to the contract and acceptable to the owner) to the principal/ owner.

The construction projects often engage in this type of contract. In most of such cases, the owner or the principal signs a lump sum contract with the contractor. The contractor may enter into separate agreements with subcontractors such as electricians, plumbers or framers. If such case arises, then the responsibility of paying to subcontractors lies with the contractor not with the owner.

As a rule, contractor is not entitled for higher payments than the contract stipulates. However in some cases, a lump sum contract may allow for fee adjustments. For example, if the labor costs or raw material costs rise or fall substantially, the amount to be paid to the contractor may be adjusted accordingly. For allowing such adjustments, a clause specifying such details must be included in the contract agreement.

Measure and Value Contract

Measure and value contract is another type of contract where principal pays the contractor on the basis of work completed. The measured quantity of work is determined by the engineer and the payment is derived based on the schedule of the price. Such contract is also called “unit price contract”. Contractor has to complete the work described in contract document to fulfill the obligation.

The engineer needs to give advance notice to the contractor for measuring any part of the work described in contract document. Contractor or any agent representing the contractor is entitled to attend the measurement activity being carried out by the engineer.

In such contracts, before the start of the project the tender prices are based on the estimates but the payments during or after the work are based on the actual quantities.

Generally, such contracts are suitable for construction projects and supplier projects where the various varieties of the items, not the quantity can be accurately identified in the contract agreement. For example, such contract can be utilized for pile driving project where piles are to be driven ‘to refusal’ not to some definite quantity. The unit price to drive would be determined beforehand but the payment to the contractor is done based on the actual amount of piling. Sometimes, lump sum contract or other types of contract are combined with measure and value contract for part or parts of the project.

Cost reimbursement Contract

Cost reimbursement contract is a contract where contractor is reimbursed with the costs incurred in the work prescribed by contract document along with an allowance for profit. The additional amount is calculated according to the method prescribed in the special conditions of the contract document. Contractor has an obligation to complete the work in accordance of contract document. Some of such contracts based on the different ways of calculating additional amount are given below:

• Project Costs + Fixed Percentage Contract
• Project Costs + Fixed Fee Contract
• Project Costs + Fixed Fee + Guaranteed Maximum Price Contract
• Project Costs + Fixed Fee + Bonus Contract
• Project Costs + Fixed Fee + Guaranteed Maximum Price + Bonus Contract
• Project Cost + Fixed Fee + Agreement for Sharing Any Cost Savings Contract

Such contracts are desirable when the estimation of project cost is not feasible or cost estimation cannot be carried out with accuracy. These conditions may arise due to uncertainties involved with the project work. Cost reimbursement contract is helpful for such instances because both the parties associated with the contract need not to pay attention to the cost estimation during the preparation of contract document. Therefore cost reimbursement contracts are generally used for exploratory projects.

Conclusion

There are various types of contract based upon the responsibility of the contractor about the costs of performance and the incentives offered to the contractor. Selecting the correct type of contract for any business agreement is an important decision as this step determines the potential risks associated with business agreement.

Liquidated Damages

For some critical projects, the on time completion of work described in contract document holds the highest importance. For such projects principal wants to have a solution for the possibility when something might go wrong. In case of delay or performance failure, contractor has to pay liquidated damages in excess to general damages (un-liquidated damages).  For the calculations of the extent of such damages, a liquidated damage clause is added to the contract document. These damages are also called liquidated and ascertained damages. If the damages are not assessed in advance, than the amount to be recovered is called to be ‘at large’. This ‘at large’ amount is agreed or determined by a court in the event of breach of contract.

There are two conditions that must be met for a liquidated clause to be upheld.

1)     The amount of damage assessed must be rough approximation of the damages likely to fall upon the party that is seeking the benefits from the clause.

2)     Sufficient uncertainty must be associated with the damages at the time contract is formed so that the clause will help both the parties to avoid difficulty of estimating damages in future.

It is very important that the anticipated loss in the event of performance failure or delay should be arrived with the genuine estimate. The onus lies with the principal to predict or estimate such losses. There are various benefits from such clause, which are explained below:

• Contractor is put under commercial stress for performance and/ or for on time delivery of the work described under contract document.
• Both the parties associated with the contract become aware of the financial cost related to the delay in the work.
• Non-defaulting party gets benefits by making a recovery without having the hassle of proving actual loss.
• Such a clause helps in reducing legal hassles and recovering the compensation.
• Contractual obligations are reinforced, as there is higher financial risk associated with breach of contract.
• The amount of damages is agreed upon in advance therefore the principal/ owner need not to calculate and prove the actual losses. It also helps contractor to concentrate on finishing the project on time.

Liquidated damages may vary in LAD provision. According to Graeme Roberts, LAD provisions are usually expressed as a certain amount payable for each day, or part of week or week by which completion is delayed.  Other types are straight lump sum, a fixed percentage of the contract amount or a maximum rate that reduces as parts of the project are finished.

A disadvantage of having a liquidated damage clause in contract agreement is that the clause many affect the relationship between the owner and the contractor. As the owner can not gain the benefits of liquidated damages clause if he/ she is the main cause behind the delay, contractor generally resort to sending accusatory letters to the owner if the contractor feels that there is a deviation from the schedule and this deviation can be associated with the actions of the owner. Many critics have asserted that liquidated damage clause foster finger pointing between the owner and the contractor, resulting in an antagonistic relationship between the parties from the start of the project.

NZS 3910: 2003

NZS 3910: 2003 is a form of contract that describes standard conditions of contract for Building and Civil Engineering Construction. A group that included representatives from central and local government, contractors, professional and consulting engineers, and many others developed this standard. This is considered as one of the fairest among many forms of contract in use. This was prepared specifically for the construction industry in New Zealand.

NZS 3910 is used widely in its standard form for small and large projects, and for complex projects that include design and build. Its usage results in fewer contractual arguments, especially when used in standard form.It helps clients in achieving project objectives with certainty. Some of the characteristics of NZS 3910: 2003 are given below.

• It is the primary document that is used for civil works where an engineer is appointed to look after the project. It offers clarity, simplicity, fairness and flexibility.
• It has been developed to satisfy the current and future requirements in a form of contract that is used in all varieties of construction (vertical and horizontal).
• It is developed in compliance with the requirements stated by Construction Contracts Acts 2001. Besides it prescribes payment processes that are in accordance with the Construction Compliance act 2002.
• Insurance forms are included in the NZS 3910 form of contract. These forms provide outlines for insurance cover that is associated with the contract.
• It accommodates multi disciplinary contracts. Besides, it is supported by substantial case law.
• It provides extensive and modern dispute resolution procedures.

Conclusion

From the discussion, it is evident that adding a liquidated damages clause helps both the parties in avoiding any potential future legal hassles.

Estimation Techniques

Before starting any project, it is important for the principal to generate estimation of various costs associated with the project work. A cost estimate establishes the base line for the project cost at various stages of development of the project. In some cases (cost reimbursement contract), cost estimation is a necessity for preparing contractual agreement. There are various estimation techniques available that can be utilized for such purposes. These techniques vary in complexity and time consumption. The main difference among these various types of estimation techniques lies with the accuracy of estimation. For example preliminary estimate provides estimation of cost that lies within 20% (plus or minus) of actual costs while definitive estimate provides cost estimation with only 10% (plus or minus) variation from actual costs.

Top Down

In top down estimation technique, project is partitioned into multiple low level components and the cost estimation is reached from the global properties of the project. In practice, the estimation is completed based on the similar project’s cost estimation. This method is also called Macro model. This method utilized the following details:

• The actual data from previous projects is used for estimated.
• Partial work breakdown structure.
• Analogy is drawn from historical projects to the current work.
• Internal of external expert are asked for opinion in estimating the work.
• Parametric modeling with one or more basic components.

Sometimes to reduce the uncertainty level, work is divided into smaller projects and only the most current project is estimated while later projects are given a vague estimate. Various advantages associated with this approach are listed below:

• This estimation technique requires minimal project details and therefore is faster and easier to implement.
• The cost is estimated using the low level components; therefore the estimation does not miss the low level functions in cost estimation.

There is some criticism to this method because it provides no detailed basis as justification for estimates.

Bottom Up

In bottom up approach, costs of various low level components of WBS are estimated and all the results are combined to arrive at project cost.This approach enables easy reporting and tracking of costs through higher levels of WBS.Besides, this method relies on input from the people who are supposed to perform the relevant tasks; thereby enhancing their commitment to complete the tasks within budget. This method is more balanced because estimation errors in various components have a probability to balance each other. There are some disadvantages associated with this method, which are listed as under:

• The estimation may be inaccurate because necessary information may not be available at the time of estimation.
• The approach is more time consuming. Sometimes this approach is not feasible due to lack of time or lack of human resource.

It is evident from the discussion that this method is difficult to apply early in the life cycle of the project due to lack of necessary information. But it is a often more reliable technique to estimate the cost of remaining project, once the initial phase is completed.

Preliminary Estimate

This estimation technique is generally used by the Construction Manager utilizing the volume, area or other conceptual estimation techniques. This estimation can be done only when the principal (owner) has identified the project requirements and the architect has prepared basic design criteria. For performing this estimation technique, the project is decomposed into production equipment items and major structural systems.

Preliminary estimates are produced with a minimum amount of detailed engineering and these estimates provide a first look at project costs. When preliminary estimates are prepared, various details must be taken into account such as type of project, complexity of project, geographical location, and other special considerations if applicable. Preliminary cost estimation is generally based on the information available from past project experience or based on the standard per square foot costs. According to Louise Sabol, preliminary estimates, unlike those prepared during later stages, are created using concepts (e.g. “corporate space standards require x sq. ft. for this project” or “hospitals cost $ x/sq. ft.”), and avoid counting of individual pieces. This technique is also called cost indicator because it is used at a very early stage of project design. Formal quotations from suppliers (equipment manufacturers) are not necessarily obtained for calculations purposes.

Definitive Estimate

This is among the most accurate estimation techniques but requires a great deal of time and effort for estimation. Definitive estimate requires work breakdown structure, a decomposition of project scope according to deliverables.

Definitive cost estimation is a full-fledged exercise that is undertaken to produce an accurate cost estimate (plus or minus 10% or better) or to produce a competitive bid submission. Therefore this estimation can be performed by the client/ principal for getting cost estimates or by the contractor for bidding against the civil works project.

Conclusion

For any specific project, estimation technique should be selected based on the project environment. Accurate cost prediction is a critical issue for good management decisions; therefore various advantages and issues associated with the estimation techniques should be considered in detail before finalizing the method.

Evolved Estimation Techniques

The estimation techniques provided above re simple and easy to use but they provide the estimation with greater variation (10-20% plus or minus from actual figures). There are various other sophisticated estimation techniques that provide estimates with much less variations. For large projects involving huge amounts of costs and much uncertainty, such evolved techniques are used for costs estimation. Generally such projects have an estimation team comprising of engineers representing various groups of project development. Some of such techniques are explained below.

Delphi Method

This method was developed by RAND Corporation, California in 1950s. This method was developed for forecasting through feedback mechanism. It used surveys and questionnaire for that purpose. With the method, one can achieve quantitative as well as qualitative results. In this method results of first survey are shared with participants of second survey. The feedback helps the participants to converge at a possible value. The three main characteristics of Delphi method are Structuring of information flow, regular feedback and Anonymity of the participants. These characteristics must be sustained for the success of the method.

This method was initially used for forecasting in science and technology projects. But later it was successfully applied in business forecasting yielding high accuracy. For example Basu and Schroeder (1977) reported a case where Delphi method successfully predicted the sales amount of a new product for first two years with inaccuracy of only 3-4% against the actual sales. These results were far better than produced by quantitative methods (error of 10-15%) and unstructured forecast methods (error of about 20%).

In 1970s Barry Boehm and John A Farquhar, introduced the wideband variant of Delphi method. It was named wideband Delphi method because it involves more communication and greater interaction among the participants as compared to simple Delhi method. Later Neil Potter and Mary Sakry developed a variant of the wideband Delphi method. The new variant used work breakdown structures for estimation. The steps for this method are given below.

• Principal/ owner selects an estimation team with 3 to 7 members and a moderator. The team has representatives from every engineering group involved in project development work.
• A kickoff meeting is called for generating work breakdown structure, brainstorming on assumptions and deciding on the units for estimation.
• Afterwards, every member individually prepares the initial estimates for tasks in WBS and documents missing assumptions if any.
• Another meeting is called to reach consensus about the estimates. Here iterative steps are followed to resolve issues and to revise estimates. At the end of the meeting, mutually agreed range for estimation is generated.
• The estimates are collected and compiled into final task list, assumptions and estimates. These results are later review by the estimation team and the owner.

Ratio Method

A ratio describes the relationship between two or more parameters/ things in amount, size or quantity. Ratio method is generally used while preparing preliminary cost estimates. There are two popular methods “Rule of Six tenths” and use of cost indices in adjustment of historical costs to current prices for estimating the cost.

The basis of ratio method lie with the fact that costs can be estimated if the costs of a similar item of different capacity or size are known. “Rule of Sixth tenths” provides satisfactory results regarding costs estimation with 20% (plus or minus) variation. It is assumed that this method was evolved in public domain after large amount of data related to project costs was analyzed retrospectively.

Another popular method utilizes cost indices for estimation. There are various cost indices that can be used for estimation. But the most widely known index is CPI (Consumer Price Index) generated by government. There are various other specific indices that can be utilized for the same purpose such as Marshall and Swift Equipment Cost Index. This method is more useful when the cost estimation is based on prices other than current prices. The index is used to convert the historical prices into proportional current prices by multiplying the cost with the ratio of present day index to the historical index.

Three Point Method

This estimation technique is used to construct and approximate probability distribution that represents the outcome of future events. In this method, three figures are produced for every distribution that is needed,based on the prior experience or best guess. These figures are called the best-case estimate, the most likely estimate and the worst-case estimate. These figures are further utilized for estimation. This is generally handled by computer software such as PERT. This technique has following benefits.

• The estimates are on average approximately 30% faster.
• Degree of uncertainty is documented and there are not any un-interpreted estimates.
• Statistical methods can be applied to calculate path sigma or a total cost sigma from single estimates.

Conclusion

From the discussion, it is evident that evolved estimation techniques have benefits over simple estimation methods. But these techniques involve more time, effort or sophisticated software that may not be available for estimation of a small project.

Reference List:

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• Bennett F. Lawrence. (2003). The Management of Construction. Burlington: Elsevier.
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• Sabol Louise. (2008). Challenges in Cost Estimating with Building Information Modeling. Washington: Design + Construction Strategies.
• Viscarello Kenneth A. (March 2006). The use of Liquidated Damages Clause in Construction contracts [online]. Available at: <http://www.sheehan.com/publications/good-company-newsletter/The-Use-of-Liquidated-Damages-Clauses-in-Construction-Contracts.aspx> [Accessed on 24 May 2012].
• Whitesides Randall W. (2012). Process Equipment Cost Estimating by Ratio and Proportion [online]. PDH Course.Available at: <http://www.pdhonline.org/courses/g127/g127content.pdf> [Accessed on 24 May 2012].

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