Fixed price contracts

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Common practice is for clients to aim to transfer all risk to contractors via fixed price contracts. Typically, a contract is awarded to the lowest fixed price bid in a competitive tender, on the assumption that all other things are equal, including the expertise of the tendering organizations. Competitive tendering is perceived as an efficient way of obtaining value for money, whether or not the client is relatively ignorant of the underlying project costs compared with potential contractors.

With a fixed price contract, the client pays a fixed price to the contractor regardless of what the contract actually costs the contractor to perform. The contractor carries all the risk of loss associated with higher than expected costs, but benefits if costs turn out to be less than expected.

Under a fixed price contract, the contractor is motivated to manage project costs downward. For example, by increasing efficiency or using the most cost-effective approaches the contractor can increase profit. Hopefully this is without prejudice to the quality of the completed work, but the client is directly exposed to quality degradation risk to the extent that quality is not completely specified or verifiable. The difficulty of completely specifying requirements or performance in a contract is well known. This difficulty is perhaps greatest in the procurement of services as compared with construction or product procurement. For example, it is very difficult to define unambiguously terms like 'co-operate', 'advise', 'coordinate', 'supervise', 'best endeavours', or 'ensure economic and expeditious execution', and it is unrealistic to assume that contractors have priced work under the most costly conditions in a competitive bidding situation.

In the case of a high risk project, where uncertainty demands explicit attention and policy or behaviour modification, a fixed price contract may appear initially attractive to the client. However, contractors may prefer a cost reimbursement contract and require what the client regards as an excessive price to take on cost risk within a fixed price contract. More seriously, even a carefully specified fixed price contract may not remove all uncertainty about the final price the client has to pay. For some sources of uncertainty, such as variation in quantity or unforeseen ground conditions, the contractor will be entitled to additional payments via a claims procedure. If the fixed price is too low, additional risks are introduced (e.g., the contractor may be unable to fulfil contractual conditions and go into liquidation, or use every means to generate claims). The nature of uncertainty and claims, coupled with the confidentiality of the contractor's costs, introduce an element of chance into the adequacy of the payment, from whichever side of the contract it is viewed (Perry, 1986). This undermines the concept of a fixed price contract and at the same time may cause the client to pay a higher than necessary risk premium because risks effectively being carried by the client are not explicitly so indicated. In effect, a cost reimbursement contract is agreed by default for risks that are not controllable by the contractor or the client. This allocation of uncontrollable risk may not be efficient. Client insistence on placing fixed price contracts with the lowest bidder may only serve to aggravate this problem.

The following example illustrates the way the rationale for a particular risk allocation policy can change within a given organization, over the dimension 'hands-on' to 'hands-off eyes-on' (as the use of fixed price contracts is referred to in the UK Ministry of Defence).

Example 16.1 A changing rationale for risk allocation

Oil majors with North Sea projects in the 1970s typically took a very hands-on approach to risk management (e.g., they paid their contractors on a piece or day rate basis for pipe laying). Some risks, like bad weather, they left to their contractors to manage, but they took on the cost consequences of unexpected bad weather and all other external risks of this kind (like buckles). The rationale was based on the size and unpredictability of risks like buckles, the ability of the oil companies to bear such risks relative to the ability of the contractors to bear them, and the charges contractors would have insisted on if they had to bear them.

By the late 1980s, many similar projects involved fixed price contracts for laying a pipeline. The rationale was based on contractor experience of the problems and lower charges because of this experience and market pressures.

The above observations suggest that fixed price contracts should be avoided in the early stages of a project when specifications may be incomplete and realistic performance objectives difficult to set (Sadeh et al., 2000). A more appropriate strategy might be to break the project into a number of stages and to move from cost based contracts for early stages (negotiated with contractors that the client trusts), through to fixed price competitively tendered contracts in later stages as project objectives and specifications become better defined.

Normally, the client will have to pay a premium to the contractor for bearing the cost uncertainty as part of the contract price. From the client's perspective, this premium may be excessive unless moderated by competitive forces. However, the client will not know how much of a given bid is for estimated project costs and how much is for the bidder's risk premium unless these elements are clearly distinguished. In the face of competition, tendering contractors (in any industry) will be under continuous temptation to pare prices and profits in an attempt to win work. Faced with the difficulty of earning an adequate return, such contractors may seek to recover costs and increase earnings by cutting back on the quality of materials and services supplied in ways that are not visible to the client, or by a determined and systematic pursuit of claims, a practice common in the construction industry. This situation is most likely to occur where the supply of goods or services exceeds demand, clients are price-conscious, and clients find suppliers difficult to differentiate. Even with prior or post-bidding screening out of any contractors not deemed capable, reliable, and sound, the lowest bidder will have to be that member of the viable set of contractors who scores highest overall in the following categories:

1. Most optimistic in relation to cost uncertainties. This may reflect expertise, but it may reflect a willingness to depart from implicit and explicit specification of the project, or ignorance of what is required.

2. Most optimistic in relation to claims for additional revenue.

3. Least concerned with considerations such as the impact on reputation or the chance of bankruptcy.

4. Most desperate for work.

Selecting the lowest fixed price bid is an approach that should be used with caution, particularly when:

1. Uncertainty is significant.

2. Performance specifications are not comprehensive, clear, and legally enforceable.

3. The expertise, reputation, and financial security of the contractor are not beyond question.

The situation has been summed up by Barnes (1984):

The problem is that when conditions of contract placing large total risk upon the contractor are used, and work is awarded by competitive tender, the contractor who accidentally or deliberately underestimated the risks is most likely to get the work. When the risks materialize with full force he must then either struggle to extract compensation from the client or suffer the loss. This stimulates the growth of the claims problem.

The remedy seems to be to take factors other than lowest price into account when appointing contractors. In particular, a reputation gained for finishing fast and on time without aggressive pursuit of extra payment for the unexpected should be given very great weight and should be seen to do so.

An underlying issue is the extent to which clients and contractors wish to cooperate with an attitude of mutual gain from trade, seeing each other as partners. Unfortunately, the all-too-common approach is inherently confrontational, based on trying to gain most at the other party's expense, or at least seeking to demonstrate that one has not been 'beaten' by the other party. This confrontational attitude can breed an atmosphere of wariness and mistrust. It appears to matter greatly whether the client is entering a one-off, non-repeating, contractual relationship, or a relationship that may be repeated in the future. To the extent that the client is not a regular customer, the client can be concerned only with the present project and may have limited expertise in distinguishing the quality of potential contractors and bids. Competition is then used to 'get the best deal'. This is often manifested as seeking the lowest fixed price on the naive and rash assumption that all other things are equal. As indicated above, this practice brings its own risks, often in large quantities.

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