D.

Payment Mechanisms - Basis of Price

There are three basic methods of defining the price to be paid under a contract:
Lump Sum Remeasurement or Unit Price Cost Reimbursement

In a Lump Sum contract the contractor is paid a predetermined sum for completing a particular stage or the whole contract works. The sum is not adjusted to take into account any change in the extent of work from that estimated by the contractor at the time of contracting. The contractor therefore carries the risk of correctly estimating, at the time of contracting, the extent of work required to be carried out. Lump Sum is the most appropriate payment mechanism for design and construct contracts or construction contracts where the extent of the works are largely determined by the method of construction adopted. The payment mechanism is easy to administer, provided the Owner does not vary the Works. If variations are likely contract terms will need to be incorporated to make provision for establishing an appropriate price on the basis either of a Schedule of Rates, or by negotiation or by reimbursement at cost. Inevitably variations on Lump Sum contracts give rise to many disputes and resolution of the Final Account may take some time. In Unit Price or Remeasurement Contracts the contractor is paid a price or rate for each unit element of work carried out and identified at the time of contracting. The item descriptions for each element of work are normally prepared following sophisticated Standard Methods of Measurement, in a Bill of Quantities. The quantities for each element are estimated by the Owner at the time of tendering. The contractor however is paid the unit price for the quantities actually constructed, usually on a monthly basis based on a monthly valuation. The Unit Price payment mechanism thus places the risk with the Owner, for estimating the extent of the Works at the time of tender. The unit price mechanism is most appropriate where the design responsibility lies with the Owner and the design is to be completed during construction. The advantages for the Owner are that by adopting overlapping phases of design and construction, construction can commence early. The flow of information must be carefully monitored if claims for delay are to be avoided. The overlap of design and construction means that variations to the original outline scheme are likely, but the Unit Price mechanism provides a ready means of pricing the variations. Unit Price contracts can give rise to two types of measurement claims which are unique to this form of contract. First, if the as-built quantities differ from the estimated quantities given at tender, then it may be argued by the contractor that the balance of plant, labour and materials has changed so that this of itself makes the unit prices inapplicable or inappropriate, so that they need to be adjusted. Secondly if there are omissions of item descriptions from the original Bill of Quantities, then the contractor will be entitled to a new appropriate rate for the item description. Such claims depend upon the interpretation of the Standard Method of Measurement. The Owner may reduce the incidence of the second type of claim by amending the Standard method of Measurement. The Owner may for instance define the Extent of the Works by reference to the Drawings and Specifications. He may then state that the Item Descriptions included in the original Bill of Quantities are to be taken as to be conclusive and require the contractor to satisfy himself that he has priced for all tasks required to construct the Extent of Works so defined. Careful drafting is required if claims based on Measurement arguments are to be omitted. One further method of reducing arguments about the make- up of unit prices for variations for instance or quantity claims, is to require the contractor to provide a full make-up of prices before the contract is awarded including major lump sum items such as preliminaries. It is arguable however whether such estimates are relevant to any re-rating exercise. The Unit Price contract is inappropriate where the Owner has completed all the design before a construction contract has been concluded. In that situation the Owner should consider having the contractor take over responsibility for the design and the contract then being a design and construct contract on a lump sum. The contractor will need certain safeguards if this approach is to be successful, such as the opportunity to check the design and to have agreed changes to the design before accepting responsibility.

In Cost Reimbursement contracts the contractor is paid his costs including overheads and preliminaries together with a fee which may be either a percentage fee or fixed. This payment mechanism is appropriate where an early start is required but the project lacks sufficient definition to allow the other two payment mechanisms to be adopted. Cost reimbursement has also been used in projects where the particular physical conditions are considered too variable to allow normal methods of payment to be adopted, and the overriding consideration has been to ensure the full and open cooperation of the contractor to allow the construction problems to be overcome. Indeed cost reimbursement contracts have been adopted where the Owner perceives that he has the necessary construction expertise to make the major decisions relating to method of construction, and only requires the contractor`s resourcing skills. Cost reimbursement contracts create shared risks, even more apparent in target cost forms, and has a major effect on the relationship of the parties. The main part of the financial risk is with the Owner. This means that the contractor more used to the traditional forms of contract will have little incentive - other than repeat business from a large employer - to work efficiently and economically. None of the standard forms of cost reimbursable contract address the fundamental concern of the Owner , which is to encourage the contractor to cooperate in forecasting the final or out-turn costs, so that joint action may be taken to prevent any cost overrun. Two approaches are possible. One is to create a legal relationship which requires the contractor to notify the Owner when he has reason to believe there will be a cost over-run. This is the approach adopted in US, where doctrines of good faith and fair dealing have developed beyond those in England. The second approach is to share the risk of cost between Owner and contractor, and this is achieved by using Target Cost Forms of Contract or Maximum Guaranteed Price. The former is the most common form of Cost reimbursement contract in UK construction. Whilst the summary above is useful as a checklist, and even as a basis for documentation as part of a management system, it does not in practice assist in the practical application of Risk Management in Construction Projects. In the same way that the categories of risk have been defined so as to help to provide a structure for the identification of risks, so the response decisions need to be reduced to answers to fundamental questions. Any structure for response decision will need to be in two parts. The first part relates to questions to be answered in the allocation of risk to participants, and the second part to the measures to be taken to reduce the consequence of a participant rendering defective performance. The second part of the decision process recognises that if a risk event occurs there will be consequences beyond the immediate contracting party required to control the risk. 2. DEFECTIVE FUNCTION RISK A fundamental decision to be made in relation to each participant in the project is the allocation of risk defective function of specific elements of the project. The function of project elements can be defined at different levels. For instance, a requirement that an overhead crane should comply with a particular performance specification would transfer the risk of defective function to the manufacturer, but only in relation to the specification. The risk that the crane satisfying the specification would nonetheless not perform its overall function and achieve the required overall throughput, due to maintenance down-time for instance, would still reside with the specifier. This allocation of risk for function is best viewed therefore on a sliding scale. In the case of a labour-only contract for instance, the only risk function transferred to the supplier is to supply labour who can perform the skills specified. The specifier carries the risk that the specification is sufficient for his needs. In a turnkey project the risk allocation is essentially the same. The risk function transferred to the Contractor is to supply a plant which performs as specified. The specifier carries the risk that his specification is sufficient to allow him to fulfil supply obligations elsewhere. The description of the type of project is only a shorthand for the liabilities and risks allocated, but is not conclusive. It is the actual circumstances, the contract setting, which define the allocation of risk. The risk of defective function is normally defined as "design liability" and raises the familiar problem of fitness

for purpose. It is however, not always apparent what design risk is actually allocated to each party. The nature of construction projects, their attachment to land, means that design cannot be separated easily from method and manner of construction. For instance, the incremental construction of projects may normally result in locked-in-stresses that need to be allowed for in the design of the permanent works. The design of materials, concrete mixes or steel composition, will be an essential part of the design. All these factors can impose methods of construction on the Contractor that may not be anticipated by him at tender stage. The crucial distinction in law appears to be between one who only designs, and another who designs and makes something. In the former case there will normally be no obligation that the result of the design will be fit for its purpose, but in the latter case an obligation as to reasonable fitness for purpose will normally be implied into the contact. This may change with particular circumstances and express terms of the contract and the particular legal system. Good design involves examination of buildability and suitability taking into account both the environment and the capability of potential Contractors/Designers. The division of design liability is not always apparent, and the extent to which statements in contract documents warranty the ease with which construction can be completed is not clear. 3. CONTRACTUAL FRAMEWORK Contract documents are tools for managing risks. They determine the consequence of particular events. A contract framework needs to bring certainty to the allocation of consequences of hazards. It is uncertainty which gives rise to many disputes. The contractual framework is the practical means of managing level risk. The aim is create certainty. It must however be recognised that commercial considerations may lead to contacts in which there is inherent uncertainty: the design may not be fully developed and even in some cases the concept may not be fully defined. In such cases the flexibility of the contract forms is a significant benefit to the participants. In such projects the choice of contract framework is vital. Standard civil engineering forms are an example of such flexible forms. The detail design is carried out whilst the construction is being carried out, so that the quantities actually required are not known. In addition the uncertainties of the physical conditions of the site including the weather are matters which are dealt with flexibly in all forms of contract. It is important to identify the uncertainty before choosing the appropriate form. It is not realistic in commercial projects to have a project fully defined at tender stage. This has led to different procurement methods such as construction management, or reimbursable or target cost contract arrangement. Reimbursable forms are very flexible but have the potential of the contractor having little incentive to deploy his resources efficiently 4. TYPICAL CONTRACTING ARRANGEMENTS
A. Contracts Based on Bills of Quantities

Contracts based on Bills of Quantities remains the traditional pattern for the larger type of contract particularly in the building and Civil Engineering industry. There are two types of arrangement. These are contracts based on firm quantities and contracts based on approximate quantities. Contracts based on firm quantities are in essence lump sum contracts. The advantage of this arrangement is that all tenderers are pricing on the same basis and the quantities risk is transferred from the contractor to the purchaser. The contractor is saved the cost of preparing his own quantities and any discrepancies in tender prices can easily be identified. The other form of quantities contract is the Bill of Approximate Quantities of which the most common standard form of contract is the ICE 7th Edition. Under this arrangement approximate quantities are prepared for tender documentation and the contract price is based upon the actual quantities of work executed which are remeasured during the course of construction. The advantage of this arrangement is that the works do not

have to be fully designed prior to tenders being issued and that again the contractor is not assuming any of the quantities risk. In effect they permit the overlapping of design and construction. There is of course a danger that if the quantities are too approximate the actual quantities will be of little significance ad the bill will become no more than a schedule of rates. In all cases the bill of quantities should only be used as the basis for pricing the contract where there is a clear separation between design and construction.
B. Contracts Based on Schedule of Rates

As with the Bill of Approximate Quantities the contractor, under a schedule of rates contract, is paid for the actual amount of work carried out at the rates contained in the schedule irrespective of the quantity, if any shown in the schedule. One problem with both types of arrangements is that if the final quantities differ markedly from those in the approximate bill or the schedule then the contractor may have an entitlement to a re-evaluation of the rate. A variation of the Schedule of Rates contract is that of a schedule which is issued with the rates already inserted and contractors are then asked to tender on the basis of a plus or minus percentage addition to the actual rates. The use of such "Schedule Contracts" as with "Approximate Quantities Contract" is that they allow the preparation of quantities from preliminary drawings at a very early stage. Whilst the quantities will not be accurate they should be sufficient to give the contractor a reasonable idea of the scope of work to be executed. In all cases the schedule should be prepared so that preliminary items are priced and identified separately and not included within the unit rates.
C. Cost Reimbursable Contracts

In the traditional priced forms of contract or in the design and construct forms there is a high degree of definition of the project at contract award. This permits fairly clear allocations of risks between the parties. In such contracts it is normal to think of contractors carrying the risk in terms of time, cost, quality and liability. The risks carried by the employer are thought of as exceptions to this one-way allocation of risk, as for example:
time - exceptional adverse weather, delays by the Employer; cost - Employer variations quality - unforeseen ground conditions liability - liquidated damages, exclusion of consequential loss

Little attempt is made in such traditional forms to encourage reduction of the Contract Price by the Contractor. In essence in cost reimbursement forms the contractor is paid the prime cost, that is the actual expenditure with an allowance for overheads and profits, normally on a percentage or formula basis. There is little incentive for the contractor to be efficient under such an arrangement and the purchaser has no assurance of the final cost. In addition such arrangements require detailed checking by the purchasers staff. On the other hand such arrangements are advantageous where there is a very short contract programme or where the importance of getting started on site as early as possible is regarded as more vital than obtaining the lowest initial capital cost. Other situations where the use of a cost plus contract would be appropriate are situations where the project cannot be defined in any detail prior to the start of the work and when the purchaser wants to actively participate in the design of the project. When preparing cost plus contracts it is essential that a very detailed schedule of costs elements or schedule of rates is included within the contract documents. Variants of the cost plus form of contract are the "cost plus percentage fee" where the contractor seeks a percentage on top of his prime cost for overheads and profits, "cost plus fixed fee" where the contractor seeks his prime cost and a fixed fee in respect of overheads and profits and "target costs". The latter arrangement differs from the former arrangement in that in the first instance the contractor is reimbursed on the basis of cost plus either a percentage or fixed fee. It is however further provided that if the final payment due on this basis differs from an estimate agreed between the parties by more than a certain margin either up or down then the

contractor will receive a bonus or incur a penalty as the case may be. Accordingly there is a greater incentive for the contractor to economise than there is under the former two arrangements. Cost reimbursable forms of contract involve a radical change in the cosy traditional division of risk. It creates shared risks, even more apparent in target cost forms of contract. This has a major effect on the relationship of the parties. Cost reimbursable contracts place part if not the main proportion of the financial risk with the employer. This means that a contractor more used to the traditional forms of contract will have little incentive - other than repeat business from a large employer - to work efficiently and economically. Standard forms therefore contain express provisions for the contractor to do so. The fundamental concern of the employer under a cost reimbursable form is to encourage the contractor to cooperate in forecasting the final or out-turn costs, so that joint action may be taken to prevent any cost over-run. Two approaches are possible 1. to create a relationship which requires the contractor to notify the employer when he has reason to believe there will be a cost overrun; or 2. to share the risk of cost between employer and contractor; There is one additional factor which is instrumental in creating the co-operative relationship between contractor and employer. This is the adoption by employers of a value-engineering approach. The most significant change that cost reimbursable forms create, is the change in the Purchasers internal audit procedures to allow the adoption of value engineering concepts to solve on-site problems. This involves a highly significant change in the Purchaser's management organisation and reporting procedures. So for instance a site engineer may find that compliance with the Specification will involve significant costs, but that a relaxation of the Specification will allow a change in method of working and cost savings. In the cost-reimbursable form, the site engineer can begin to ask the right questions from the stand point of benefit to the project. He will examine the change in the Specification in terms of: 1. 2. 3. 4. the maintenance costs; safety; the impact on the function of the project; the effect on the completion date of the project

The direct cost saving is therefore weighed against the overall affects that it will have. Most importantly the Purchaser will have given his agent authority to make such judgments, and will be predisposed to approving such value judgments. This is particularly important in larger organisations, which are the type of organisation which use the cost reimbursable form. The Purchasers attitude is therefore not one of ensuring that the project is built to a pre-conceived plan as in traditional forms, but he is pre-disposed to re-examining the plan during implementation using value engineering.
D. Design & Construct Contracts

Fixed price contacts are common in design and construct forms of contract. The major difficulty in the UK construction market has been the control of quality and performance of the contractor. This has manifest itself in the procedures for the client to monitor the design and the quality of the workmanship. A distinction needs to be made between single point contracts and "design and construct" or "turnkey" contracts. A single point contract is one in which there is only one contract for the whole project. Where the Contractor has responsibility for all the design as well as construction the contract is referred to as "design and construct" or "turnkey". Although the term "turnkey" is sometimes used to refer to projects with single point

contracts, the essential feature is the allocation of responsibility for design and construction to the Contractor. The main advantages for the Employer of Design and Construct are, first that there is a single point responsibility for any defects either in materials or performance. The Employer does not need to ascertain whether the defect is due to design or due to workmanship. Secondly this type of contract lends itself to lump sum form of payment, or fixed payment at completion of identified stages. Provided the completion of the various stages is clearly identified then the administration of the contract is simpler than remeasure or unit price forms of contract. The advantages for the Contractor are that he has more control over the whole project, and can adopt designs that suit his own resources and expertise. Design and Construct is the logical method of procurement for many types of project. Although Design and Contract forms have many advantages for the Employer and Contractor, there are specific problems that frequently arise. These are:
Uncertain definition of the contract due to lengthy pre-contract discussions/negotiations. Ambiguity/Discrepancy between Employers Requirements and Contractors Submission. Monitoring the adequacy of the design. Valuation of Variations. Fair cashflow payments. Dealing with Defects.

The selection of a turnkey contractor will preclude payment being made on a unit price or cost reimbursable basis. It will be very difficult for the Owner to ascertain accurately the unit cost of various elements of the work on account that the fact that the critical elements of cost may well be determined by matters of which he has no knowledge such as the contractors specialist know-how and off-site manufacturing processes etc. If it is anticipated that the works will be varied, then it is essential under both conventional and turnkey contracts that a breakdown of the contract price in terms of elements of work and key components is provided in order to assist in the valuation of the variations and, if necessary, interim payments. As there is no bill of quantities in a turnkey contract it is very difficult to allow for progress payments to be made monthly based on the quantity of work actually executed. There is less risk of dispute if payment is to be made in accordance with particular project milestones. For instance, it could be based on percentage completion of various elements of the work or in the case of mechanical and electrical works based upon completion of detailed design, manufacturing, equipment, arrival at site and installation of major equipment. Payments made on the basis of milestones have the advantage of being relatively easy for the Purchaser to administer and offer an incentive for the contractor to execute the works as efficiently and quickly as possible. When drafting a milestone payment schedule it is important to remember that the work is not complete when the plant has been installed therefore a sufficient percentage must be retained to cover the contractors commissioning and start up obligations. So as to avoid unnecessary disputes suitable mechanisms should be drafted into the contract to allow for the contractor to receive reimbursement in the event that he is unable to attain any particular milestone on account of any delay for which the Owner is responsible. In addition it must be remembered that the milestone payments are approximate and do not represent the true value of the work executed at the point of any milestone. Owners ought to be made aware that in the event of termination of the contractors employment the amount paid out against milestones will almost certainly differ from the value cost of the work at that point. . RESPONSE MECHANISMS It is possible to summarise the response decisions that need to be made to define the contractual setting of the project in terms of strategies to be adopted as follows:
Financial Strategy Organisational Strategy

Defective Performance Strategy Contract Strategy

A. Organisational Strategy

One area of risk can arise from the size of the project itself, and requires an appropriate organisational strategy. There are distinct advantages to an Owner in having one single contract for the whole project. The main contractor will be responsible for coordination of the various work packages and the Owner will be protected from claims for disruption between package contractors. On very large projects the finance and expertise required of a single contractor will mean that the Owner will need to deal with consortia of two or more contractors, each with their own expertise. It is usual for each of the consortia members to be severally liable for the defaults of the other members. The owner will then be protected from coordination and disruption claims, he will not have to identify the particular member responsible for the default and indeed will have a choice of defendant in any dispute proceedings. This single point organisational arrangement may not always be practical nor indeed desirable. So for instance enabling works may need to be let before the main works. Engineering considerations and financing arrangements may dictate several discrete contracts, with different contractors or consortia. The Owner may require to have more control of design of certain parts of the project, possibly the more specialist parts. It may be that the Owner will wish to be involved in the selection of the main equipment. The division of the project into manageable packages creates a resultant risk of lack of coordination between different contractors, which may cause delays and disruption and give rise to disputes. This can be reduced by the appointment of a project manager and by clear identification of the interface responsibilities in each contract with well defined procedures for the flow of information.
B. Design Responsibility

Whatever organisational strategy is adopted, it will be necessary to decide the allocation of design responsibility. Design as used here has a very wide meaning and includes the selection or specification of the quality of materials as well as the structural design of components and structures. Since the Owner will always define the project in some way by orientation, performance or function, there will always be some division of responsibility for design of the project. In some projects, selection of the route or of certain materials by the Owner, may impose methods of construction on the Owner which may not be anticipated at tender stage. It is therefore not always apparent what is the design risk allocated to each contracting party. In the case of an equipment manufacture contract, extensive specification by the purchasing contractor may reduce the manufacturer`s design liability to one of complying with the specification only, and not to supplying equipment which will perform at the required production rate. The allocation of responsibility under a contract may not always be clear as shown by the decision of HH Judge Seymour QC in Cooperative Insurance Society Limited v Henry Boot Scotland Limited [2002] EWHC 1270 (TCC). The form of contract was JCT 1980 Private With Quantities amended by the Contractors Design Portion Supplement 1981 Edition revised July 1994. The preliminary issue was whether or not Henry Boot had any design obligation for the design of piled walls which formed part of the works and a concept prepared by Cooperative. Clause 2.1.2 provided that for the purpose of carrying out and completing the works Henry Boot was to complete the design for the Contractors Design Portion including the selection of any specifications for any kinds and standards of the materials and goods and workmanship to be used in the construction of that Portion so far as not described or stated in the Employers Requirements or Contractors Proposals. Judge Seymour held that the obligation of Henry Boot under Clause 2.1.2 was to complete the design of the piled walls which involved developing the conceptual design of Cooperative into a completed design capable of being constructed. He held that the process of completing the design included examining the design at the point at which responsibility was taken over, assessing the assumptions upon which it was based and forming an opinion whether those assumptions were appropriate. When Henry Boot agreed to the obligation to complete a design begun by someone else, they agreed that the result, however much of the

design work was done before the process of completion commenced, would be prepared with reasonable skill and care. The concept of completion of a design of necessity involved a need to understand the principles underlying the work done and to form a view as to its sufficiency. Insofar as the design remained incomplete at the date of the Contract, Henry Boot assumed a contractual obligation to complete it. Accordingly, in order to avoid disputes, the contract needs to state clearly the responsibility for any aspects of the design, including concept designs as well as detailed design and the working up of conceptual designs and its construction or installation. In performance related contracts unless the operating conditions are clearly defined this can give rise to many disputes. Design and construct contracts can however usefully be adopted where the method of construction dictates the design of the permanent works. Where the contractor has responsibility for all the design as well as construction the contract is referred to as "design and construct" or "turnkey". The term "turnkey" is sometimes used to refer to projects with single point contracts, but the essential feature is the allocation of responsibility for design and construction with the contractor. Design and construct contracts have many advantages for the Owner. First there is a single point responsibility for any defects either in materials or performance. The owner does not need to ascertain whether the defect is due to design or due to workmanship. Secondly this type of contract lends itself to lump sum form of payment, or fixed payment at completion of identified stages. Provided the completion of the various stages is clearly identified then the administration of the contract is simpler than remeasure or unit price forms of contract.
C. Civil Code Legal Systems

Common Law legal systems such as English law have continued with the laisser-faire doctrine in construction, which is a freedom to decide whether and with whom to contract and to freely decide the allocation of risk and the payment mechanisms to be followed. Normally in contracts governed by English law, the allocation of risk between the parties can therefore be found in the contract document itself. This is not the case in Civil Code Systems which include German, French and Greek law. In these systems, which in international contracts may be the stated law of the contract , many of the contentious issues which arise in English law are dealt with by specific legislation. Indeed contract terms may be rendered invalid by such legislation. There is no need to provide the detailed contracts seen in English law contracts. English contractors may therefore be misled by the brevity of contracts under Civil Code Systems. In addition these systems operate to exclude allocation of certain substantial risks between the parties. Some systems operate a general principle of good faith against which contract terms are to be interpreted, common practice being taken into account. Contractors should therefore be familiar with the relevant provisions of the Codes and their effect on the allocation of risk, when contracting under Civil Code Legal Systems.