Joint venture

At one end of the range is the cost-plus, a fixed-fee type of contract where the company's profit, rather than price, is fixed and the company's responsibility, except for its own negligence, is minimal. At the other end of the range is the lump sum or turnkey type of contract under which the company has assumed full responsibility, in the form of profit or losses, for timely performance and for all costs under or over the fixed contract price. In between are various types of contracts, such as the guaranteed maximum, incentive types of contracts, and the bonus-penalty type of contract. These contracts provide for varying degrees of cost responsibility and profit depending on the level of performance. Contracts that cover the furnishing of consulting services are generally on a per diem basis at one end of the range and on a fixed-price basis at the other end of the range.

There are generally five types of contracts to consider: fixed-price (FP), cost-plus-fixed-fee (CPFF), or cost-plus-percentage-fee (CPPF), guaranteed maximum-shared savings (GMSS), fixed-price-incentive-fee (FPIF), and cost-plus-incentive-fee (CPIF) contracts. Each type is discussed separately.

• Under a fixed-price or lump-sum contract, the contractor must carefully estimate the target cost. The contractor is required to perform the work at the negotiated contract value. If the estimated target cost was low, the total profit is reduced and may even vanish. The contractor may not be able to underbid the competitors if the expected cost is overestimated. Thus the contractor assumes a large risk.

This contract provides maximum protection to the owner for the ultimate cost of the project, but has the disadvantage of requiring a long period for preparation and adjudications of bids. Also, there is the possibility that, because of a lack of knowledge of local conditions, all contractors may necessarily include an excessive amount of contingency. This form of contract should never be considered by the owner unless, at the time bid invitations are issued, the building requirements are known exactly. Changes requested by the owner after award of a contract on a lump sum basis lead to troublesome and sometimes costly extras.

• Traditionally, the cost-plus-fixed-fee contract has been employed when it was believed that accurate pricing could not be achieved any other way. In the CPFF contract, the cost may vary but the fee remains firm. Because, in a cost-plus contract, the contractor agrees only to use his best efforts to perform the work, good performance and poor performance are, in effect, rewarded equally. The total dollar profit tends to produce low rates of return, reflecting the small amount of risk that the contractor assumes. The fixed fee is usually a small percentage of the total or true cost. The cost-plus contract requires that the company books be audited.

With this form of contract the engineering-construction contractor bids a fixed dollar fee or profit for the services to be supplied by the contractor, with engineering, materials, and field labor costs to be reimbursed at actual cost. This form of bid can be prepared quickly at a minimal expense to contractor and is a simple bid for the owner to evaluate. Additionally, it has the advantage of establishing incentive to the contractor for quick completion of the job.

If it is a cost-plus-percentage-fee contract, it provides maximum flexibility to the owner and permits owner and contractor to work together cooperatively on all technical, commercial, and financial problems. However, it does not provide financial assurance of ultimate cost. Higher building cost may result, although not necessarily so, because of lack of financial incentive to the contractor compared with other forms. The only meaningful incentive that is evident today is the increased competition and prospects for follow-on contracts.

• Under the guaranteed maximum-share savings contract, the contractor is paid a fixed fee for his profit and reimbursed for the actual cost of engineering, materials, construction labor, and all other job costs, but only up to the ceiling figure established as the "guaranteed maximum." Savings below the guaranteed maximum are shared between owner and contractor, whereas contractor assumes the responsibility for any overrun beyond the guaranteed maximum price.

This contract form essentially combines the advantages as well as a few of the disadvantages of both lump sum and cost-plus contracts. This is the best form for a negotiated contract because it establishes a maximum price at the earliest possible date and protects the owner against being overcharged, even though the contract is awarded without competitive tenders. The guaranteed maximum-share savings contract is unique in that the owner and contractor share the financial risk and both have a real incentive to complete the project at lowest possible cost.

• Fixed-price-incentive-fee contracts are the same as fixed-price contracts except that they have a provision for adjustment of the total profit by a formula that de pends on the final total cost at completion of the project and that has been agreed to in advance by both the owner and the contractor. To use this type of contract, the project or contract requirements must be firmly established. This contract provides an incentive to the contractor to reduce costs and therefore increase profit. Both the owner and contractor share in the risk and savings.

• Cost-plus-incentive-fee contracts are the same as cost-plus contracts except that they have a provision for adjustment of the fee as determined by a formula that compares the total project costs to the target cost. This formula is agreed to in advance by both the owner and contractor. This contract is usually used for long-duration or R&D-type projects. The company places more risk on the contractor and forces him to plan ahead carefully and strive to keep costs down. Incentive contracts are covered in greater detail in Section 21.7.

Other types of contracts that are not used frequently include:

• The fixed-price incentive successive targets contract is an infrequently used contract type. It has been used in the past in acquiring systems with very long lead time requirements where follow-on production contracts must be awarded before design or even production confirmation costs have been confirmed. Pricing data for the follow-on contract is inconclusive. This type of contract can be used in lieu of a letter contract or cost-plus arrangement.

• The fixed-price with redetermination contract can be either prospective or retroactive. The prospective type allows for future negotiations of two or more firm, fixed-price contracts at prearranged times. This is often used when future costs and pricing are expected to change significantly. The retroactive FPR contract allows for adjusting contract price after performance has been completed.

• Cost (CR) and cost-sharing (CS) contracts have limited use. Cost contracts have a "no fee" feature that has limited use except for nonprofit educational institutions conducting research. Cost-sharing contracts are used for basic and applied research where the contractor is expected to benefit from the R&D by transferring knowledge to other parts of the business for commercial gain and to improve the contractor's competitive position.

Table 21-1 identifies the advantages and disadvantages of various contracting methods that are commonly used.

The type of contract that is acceptable to the client and the company is determined by the circumstances of each individual project and the prevailing economic and competitive conditions. Generally, when work is hard to find, clients insist on fixed-price bids. This type of proposal is usually a burden to the contractor because of the proposal costs involved (about 1 percent of the total installed cost of the project), and the higher risk involved in the execution of the project on such a basis.

When there is an upsurge in business, clients are unable to insist on fixed-price bids and more work is awarded on a cost-plus basis. In fact, where a special capacity position exists, or where time is a factor, the client occasionally negotiates a cost-plus contract with

Contract Type

Advantages

Disadvantages

Cost-plus-fee

Guaranteed maximum-share savings

Fixed price/lump sum

Fixed price for services, material, and labor

Fixed price for imported goods and services, local costs reimbursable

Provides maximum flexibility to owner

Minimizes contractor profits

Minimizes negotiations and preliminary specification costs Permits quicker start, earlier completion

Permits choice of best-qualified, not lowest-bidding, contractor Permits use of same contractor from consultation to completion, usually increasing quality and efficiency

Provides firm assurance of ultimate cost at earliest possible date Insures prompt advice to owner of delays and extra costs resulting from changes Provides incentive for quickest completion

Owner and contractor share financial risk and have mutual incentive for possible savings Ideal contract to establish owner-contractor cooperation throughout execution of project

Provides firm assurance of ultimate cost

Insures prompt advice to owner of delays and extra costs resulting from changes

Requires minimum owner follow-up on work Provides maximum incentive for quickest completion at lowest cost Involves minimal auditing by owner's staff

Essentially same as cost-plus-fee contract

Fixes slightly higher percentage of total cost Eliminates checking and verifying contractor's services

Maximum price assured for high percentage of plant costs

Avoids excessive contingencies in bids for unpredictable and highly variable local costs Permits selection of local suppliers and subcontractors by owner

No assurance of actual final cost

No financial incentive to minimize time and cost

Permits specification of high-cost features by owner's staff Permits excessive design changes by owner's staff increasing time and costs

Requires complete auditing by owner's staff

Requires completion of definitive engineering before negotiation of contract

Requires exact knowledge if what is wanted before contract award Requires substantial time and cost to develop inquiry specs, solicit, and evaluate bids. Delays completion 3-4 months

High bidding costs and risks may reduce qualified bidders Cost may be increased by excessive contingencies in bids to cover high-risk work

May encourage reduction of economic studies and detailing of drawings: produce higher costs for operation, construction, maintenance

Other disadvantages same as cost-plus-fee contract

Same extended time required for inquiry specs, quotations, and evaluation as fixed lump-sum for complete project

Requires careful definition of items supplied locally to insure comparable bids

No financial incentive to minimize field and local costs only one contractor. Another technique is to award a project on a cost-plus basis with the understanding that the contract will be converted at a later date, when the scope has been better defined and unknowns identified, to another form, such as a lump sum for services. This approach is appealing to both the client and the contractor.

As we mentioned earlier, the client frequently has a standard form of contract that is used as the basis of negotiation or the basis of requests for proposals. A company should review the client's document carefully to assure itself that it understands how the client's document differs from what is its preferred position. Any additional duties or responsibilities assigned to your company merit careful scrutiny if the additional legal consequences and increased financial risks are to be evaluated properly.

It is important that you use an adequate and realistic description of the work to be undertaken and a careful evaluation and pricing of the scope of the work to be performed and the responsibilities and obligations assumed. The preparation of a proposal requires a clear understanding between the client and your company as to the rights, duties, and responsibilities of your company. The proposal defines what it intends to do and can do, what it neither intends doing nor is qualified to undertake, and the manner and basis of its compensation. Thorough analysis of these matters before, not after, submission of the proposal is essential.

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Project Management Made Easy

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