In the previous post, we covered the contract classification based on Nature of Transaction and Mode of Project Delivery. Accordingly, we discussed the difference among Supply, Service Contracts & Works Contracts and among EPC, EPCM and Multiple Packages Contracts
In this post, we are going to discuss various kinds of contracts under the broad category called Compensation Method / Method of Payment .
One organization may prefer to pay Lump Sum Price for the entire scope of work. However, other one may choose to pay based on rates agreed for each work item multiplied by corresponding quantities. Yet a third one may like to pay the contractor based on the actual cost incurred plus reasonable profit. Each type has its own merits and demits and no one is absolutely wrong or right.
Based on the Compensation Method, contracts are classified as follows;
A) Lump Sum Contracts
B) Item Rate Contracts
C) Cost plus Contracts
We deal with such contracts very frequently in our work life. The purpose of this post is to understand the significance of each type and eventually know their distinguishing features. This will help to choose the right fit for a given situation.
Let us now discuss above contracts in more details
Classification based on Compensation Payment
A) Lump Sum Contract:
The word lump means to combine, aggregate, bunch or consolidate. The word Lump Sum means Aggregated Amount or Consolidated Amount.
As the name suggests, Lump Sum Contracts consists of Total Consolidated Amount against the given scope of work. In such contracts, Owner defines detailed Scope of Work and/or Materials to be Supplied and/or Services to be rendered by the Contractor and as required to execute and complete the work. And, Owner invites Total Aggregated Price from the bidders for the entire scope of work.
Consolidated Price which include all associated costs for all supplies and services is called Lump Sum Contract Price. Lump Sum Price is a consideration for all liabilities and obligations of Contractor. Also, this lump sum amount is a contractual price between the parties. Consequently, Owner is bound to pay such price as long as the scope of work remains unchanged. Any further break up of Total Price in the form of Price Schedule/Priced Bill of Quantities is to facilitate payment. Existence of item price, sub-component or component price in the Price Schedule does not dilute the essence of Lump Sum Contract
Significance and relevance of Lump-sum Contracts
Lump Sum Contracts are very common industry practice for procurement of engineered products, specialized services and for execution of design-build & EPC/Turnkey Contracts. Owner prefers to obtain lump-sum price so as to ascertain the Total Cost before starting the works. Also, it is easy to compare various offers when received on the basis of Lump-sum Price. By doing so, Owner transfer the risk of quantity variations to the Contractor
Lump Sum Contracts are best fit and most suitable when there is a full clarity on the Scope of Work. This means works items and quantities are known with greater certainty and the probability of scope/quantity change is comparatively less. This mainly happened for execution of works where industry practice is established and when bidders have full understanding of scope and enough prior experience to accurately calculate and quote the Lump Sum Price and successfully perform the awarded works
Contracts Classification based on Compensation Method
B) Item Rate Contracts:
Item Rate means “contract price” for “unit quantity” of each “work item” as defined under scope of work. Sometime it may not be possible for the Owner to ascertain exact quantities for identified work items. This may happen because of the nature of the work, and/or design not fully completed and/or some inputs are missing to ascertain exact quality. So, the Owner stipulates the “estimated quantities” of each work items. Accordingly, the quantities, finally executed by Contractor, may be different. Therefore, in these circumstances, where quantities are likely to change, it is not prudent to invite Lump Sum Price or sign a Lump Sum Contract. Here Item Rates Contract (i.e. unit price contract) seems best fit, as it extend flexibility to address “quantity changes” within certain range (as agreed by parties), without any need to follow lengthy Variation & Variation Order Procedure.
In Item Rate Contracts, Owner defines the comprehensive Bill of Quantities, which consists of detailed description of Work Items, Unit of Measurement and estimated quantities. Accordingly, Owner invites and bidder quote the “Rate/Price” for “unit quantity” of each BOQ Item. Such contracts where different unit price exists for respective BOQ Items are called Item Rate Contracts.
Unit Rates contractually binding, not total price
The Unit Rate mentioned against each work items is the “contract price” for “unit quantity” of such item. Therefore, it is a contractually binding price. However, the item price which is obtained by multiplying the unit price with estimated quantity is a notional price. The actual item-wise price to be paid contractually shall depend upon the actual executed quantities.
Subject to other contract conditions, Owner is bound to pay for actual executed quantities based on the Unit Prices stipulated in the Contract. This is true as long as actual quantities do not vary beyond the prescribed limits. Total Price which is obtained by adding the item price of all BOQ items is again the estimated Total Price rather than Total Contractual Price. Total Contract Price (or Contract Price) as stipulated in the item rate contracts is necessary for the purpose of ascertaining BG or LD Amount. However, it does not dilute the spirit of Item Rate Contracts
C) Cost Plus Contracts:
In certain situation, in view of nature of work, it may not be possible for the Owner to clearly mention work items as well as quantities with greater certainty. So the scope of work is a stipulation of final requirements with a general description of work items and tentative quantities. Also, there is a high probability that the work items and/or the associated quantities may change.
Therefore, in the above circumstances, it would not be possible for the contractor to quote Lump Sum Price or Unit Rates because both work items and quantities are not fixed. Hence, it is prudent to select a reputed contracting organization having versatile experience and enter onto Cost plus Contract. Under such contracts Owner pay the contractor based on actual cost incurred plus reasonable profit.
Significance and relevance of cost plus contracts
Cost Plus Contracts are best fit and most suitable when there is high degree of uncertainty in the scope of work and both work items & quantities are likely to change. This mainly happened for scope of work where:
a) industry practice is not established
b) scope of work is entirely new or some thing totally different
c) work is being executed first time and
d) Owner and/or Contractor have not executed similar work in the past
e) Owners and/or Contractor are not able to estimate the cost with reasonable accuracy