Selecting the Right Contract Type

The selection of an appropriate contract type depends on several key factors, including the level of readiness of design drawings, the degree of detail available in the Bill of Quantities (BOQ), the urgency of the works, the client’s required completion timeframe, the method and timing of payments, and the manner in which financial risks are allocated between the contracting parties.

Based on these considerations, the following types of contracts are commonly adopted in the construction industry. 

1. Lumpsum

i. Based on bills of firm quantities

ii. Based on bills of approximate quantities

iii. Based on drawings and specifications

2. Re-measurable (Based on a schedule of rates)

3. Prim Cost/ Cost Reimbursement

i. Target cost

ii. Cost plus fixed fee

iii. Cost plus percentage fee 

1. Lump sum Contract 

A. Based on bills of firm quantities

The Client commissions a Consultant to prepare a design and, upon virtual completion of the design, the quantity surveyor prepares a bill of quantities based upon the Consultant’s drawings and specification information. Contractors are invited to price the bill and submit tenders in competition for carrying out the work. The contractor submitting the lowest tender is usually awarded the contract.

The essential characteristics of this method are (i) that both the quantities and the unit rates in the bill form part of the contract and (ii) that virtual completion of the design precedes the signing of the contract. Such a contract is a lump sum contract (sometimes called a fixed price contract) because a price is stated in the contract as payment for the work described in the bill.

Advantages

1. Both parties have a clear picture of the extent of their respective commitments.

2. The unit rates in the bills provide a sound basis for the valuation of any variations to the design.

3. A detailed breakdown of the tender sum is readily available.

Disadvantages 

1. The length of time taken in the design of the project and in the preparation of the bills of quantities.

2. The problem of dealing with those variations which are so fundamental or extensive as to change the character of the remainder of the work or the conditions under which it has to be carried out.

B. Based on bills of approximate quantities

This method is largely similar to the preceding one, except that the quantities given in the bill are approximate only and are subject to later adjustment. The essential characteristics are (i) that only the unit rates form part of the contract and (ii) the signing of the contract and the beginning of work on site may proceed before the design is complete.

The bill of quantities is normally specially prepared for the particular project and descriptions of work are as detailed as in a bill of firm quantities, but the time otherwise required for detailed measurement of the quantities is saved, the quantities given being estimates of likely requirements. Sometimes the bill re-uses the quantities which were prepared for an earlier project of a sufficiently similar kind and size.

This method results in a contract which is sometimes regarded as a lump sum contract although it is not strictly so, there being no total price stated in the contract. In fact, it is very similar to the schedule of rates contract.

Advantages 

1. Construction on site may begin earlier.

2. The extra expense of preparing firm quantities is avoided (although this is offset by the cost of fully measuring the work as actually carried out).

Disadvantages 

1. The bills of quantities cannot be relied upon as giving a realistic total cost at tender stage and in consequence, the parties to the contract are less certain of the extent of their commitment.

2. The construction works have to be measured completely as actually carried out, which may prove more costly than having prepared bills of firm quantities initially.

3. The Consultant may feel less pressure to make design decisions which ought to be taken at an early stage.  

2. Re-measurable Contract (Based on Schedule of rate) 

Only the unit rates form part of the contract. This is particularly true in civil engineering works, where often the quantities are unpredictable given the high content of ground surface work. The signing of the contract and commencing of work on site can proceed before completion of the design. The Remeasurement Contract contains a Bill of Quantities provided by the employer or his consultant. Quantities are estimated and not final. The contractor will quote against each BOQ item and enter a unit rate or unit price to build up the total contract price on basis of those quantities. During the construction period, the actual quantity of work executed under each BOQ item will be jointly measured and valued at the quoted rate for interim payment purpose, statement at completion and final account.

In case of instructed variation or additional works that are without basis of BOQ rate(s), the contractor can build up new rates for those works for valuation. This type of contract is fairer to both client and contractor because the final contact sum is based on a final re-measurement rather than being based on preliminary quantities set at tender.

Advantages 

i. Construction on site may begin earlier.

ii. The extra expense for preparing firm bills of quantities is avoided.

iii. Fair basis for competition.

iv. The client can introduce variations in the work easily by the Consultant.

v. Lower risk for contractors.

Disadvantages

i. The final value of the project is not known to owner until completion. 

ii. Re-measurement should be carried out at every valuation, which may prove more costly than preparing bills of firm quantities.

iii. Parties to the contract are less certain of the extent of their commitments. 

iv. It is very difficult to determine by which contractor has submitted the most advantageous offer.

3. Cost reimbursements (also known as prime cost or cost plus) 

The method of payment is reimbursement to the contractor of his prime cost, plus a management fee.

There are three variants of this type of contract, distinguished by the way in which the fee is calculated. Each is dealt with separately below (the JCT Prime Cost Building Contract may be used).

‘Prime cost’ means the total cost to the contractor of buying materials, goods and components, of using or hiring plant and of employing labour, in order to carry out construction works.

Of all the types of contracts, this produces the most uncertainty as to the financial outcome. Tenders contain no total sum, and it may be very difficult to form any reliable estimate of the final cost.

It is widely recognized as the most uneconomical type of contract and therefore is one which normally should be used only in circumstances where none of the other types is appropriate. Because of the possibility of inefficiency and waste of resources, contracts of this type need to embody provisions, giving the Consultant some control over the level of labour and plant employed.

One of the attractions of prime cost contracts is that work on site can commence in the early stages of design and this may be all-important to the client. There may be circumstances where, to the client, cost is a less important factor than time. Consequently, a start on site at the earliest possible time may be financially more advantageous in the long run than a lower final cost of construction which might have resulted from the use of another type of contract.

It should be noted that no site measuring is necessary other than as checks on the quantities of materials for which the contractor submits invoices.

The process of calculating and verifying the total prime cost involves a vast amount of investigation and checking of invoices, time sheets, sub-contractors’ accounts, etc., which can be both tedious and time-consuming. It is therefore in the interests of the surveyor and the contractor that at the outset a proper system of recording, verifying and valuing the prime cost is agreed and strictly implemented. In addition, it is vitally important to define clearly what is intended to be included as prime cost and what is intended to be covered by the fee.

The advantages and disadvantages of prime cost contracts over lump sum and schedule of rates contracts follow.

Advantages  

i. The time required for preparation of tender documents and for obtaining tenders is minimized, thus enabling an early start on site to be made.

ii. Work on site may proceed before the detailed design is complete.

Disadvantages 

1. The parties have the least precise indication of their respective commitments.

2. The cost of construction to the client is likely to be greater than if other types of contracts were to be used.

3. The computation and verification of the total prime cost is a long and tedious process.

The variants below differ in the way in which the fee for the contractor’s services is determined. Variants (ii) and (iii) are the consequence of a general acknowledgement that it is desirable to provide an incentive to economize in the use of resources on the part of the contractor.

i. Cost plus percentage fee.

The contractor is paid a fee equal to an agreed percentage of the prime costs of labour, materials and plant used in carrying out the work.

The outstanding disadvantage (to the client) is that the more inefficient the contractor’s operations are and the greater the waste of resources, the higher the fee paid to the contractor will be. To counter this, the agreed percentage is sometimes made to vary inversely in comparison to the prime cost, i.e., as the prime cost increases the percentage addition decreases.

ii. Cost plus fixed fee.

 Under this variant, the fee paid to the contractor is a fixed sum which normally does not vary with the total prime cost but is based on an estimate of the likely total. The only ground on which the fee might be varied is if either the scope of the work or the conditions of carrying it out were to be materially altered after the contractor tendered.

iii. Target cost.

This variant is really one or other of the two preceding ones with another factor added. As an incentive to reduce the total prime cost, the agreement provides for a bonus to be paid to the contractor if the total cost is less than an agreed sum (the ‘target’) and also a penalty to be paid by him if the total cost exceeds that sum. The bonus and penalty may be a set figure, e.g., 50% of the difference between the total amounts, or any other agreed percentages. Alternatively, there may be a sliding scale of percentages to be used depending on how much below or above the final cost is from the target cost. The target cost is an estimate of the likely total cost.

The composite nature of contracts 

Although, for convenience, classifications and type labels such as the foregoing are commonly used, in practice contracts often combine the characteristics of two or more types. For example, a lump sum contract based on bills of firm quantities often contains items with provisional quantities requiring re-measurement and therefore such items bear the characteristics of a schedule of rates contract. Also, the provisional sums included in the bills for daywork and expended on work, which is not readily measurable or not reasonably priceable as measured work, form a prime cost-plus percentage fee contract within the main lump sum contract. Thus, many contracts which are regarded as of the lump sum type are, in reality, a combination of several types.

Circumstances in which the various types of contracts may be used 

Usually, the circumstances peculiar to a project will indicate which type of contract is most appropriate. Occasionally, more than one type might be suitable, in which case, the one which seems to offer the greatest benefits to the client should be chosen, as the client is the one who will be paying the bill.

The suitability of the types of contracts discussed earlier may be related to varying circumstances as follows.

a) Based on firm bills of quantities 

i. When there is time to prepare a sufficiently complete design to enable accurate quantities to be measured.

ii. When the client’s total commitment must be known beforehand, for example, in order to make adequate borrowing arrangements or when approval to the proposed expenditure has to be obtained from a finance or housing committee of a local authority, from a central government department or from a board of directors.

b) Based on bills of approximate quantities

i. When the design is fairly well advanced, but there is insufficient time to take off accurate quantities, or the design will not be sufficiently complete soon enough for that to be done.

ii. When it is desired to have the advantages of detailed bills but without the cost in terms of time and/or money.

c) Based on schedule of rates

i. When the details of the design have not yet been worked out or there is considerable uncertainty with regard to them. 

ii. When time is pressing.

iii. When term contracts are envisaged. These are appropriate where a limited range of repetitive work is required to be carried out, such as the external redecoration of an estate of houses. The contractor tenders on the basis of unit rates, which are to remain current for the stated ‘term’, usually one year or the estimated period which the proposed work will take.

d) Based on prime cost-plus fee 

i. When time is short and cost is not as important as time.

ii. When the client wishes to use a contractor who has worked satisfactorily for him before and whom he can trust to operate efficiently, while being prepared to pay the higher cost entailed in return for the advantages.

iii. In cases of emergency, such as repairs to dangerous structures.

iv. For maintenance contracts.

v. For alterations jobs where there is insufficient time or it is impracticable to produce the necessary documentation.

The risk factor 

An important element of construction contracting is risk, i.e., the risk the parties take that the implementation of the contract may be detrimental in some degree to their financial or other interests. On his part, the contractor takes the risk that his anticipated profit will be reduced or converted into a loss as a result of the outworking of the conditions under which the contract is carried out. On his part, the Employer takes the risk that he will become liable for a greater total cost than he envisaged when initiating the project.

The types of contracts described above carry a varying degree of risk for the parties. Generally speaking, the contractor’s risk increases as the Employer’s risk reduces and vice versa. Thus, the contractor bears a high degree of risk where the contract is based on drawings and specifications only, for two reasons. First, as it is a lump sum contract, he must estimate his expected costs as accurately as possible because any adverse mistake will reduce his profit. Second, there being no bill of quantities provided for tendering purposes, he must take off his own quantities from the drawings in order to formulate his tender, and, again, any error he may make in the process will affect his profit margin.

The Employer’s risk is small in the situation just described. He knows at the outset what his financial liability will be and is under no contractual obligation to reimburse the contractor for any errors which he may have made in preparing his tender.

At the other end of the spectrum, where a cost reimbursement contract is used, the contractor’s risk is reduced considerably because he is paid his full costs and a fee in addition. His only risk is pitching the right level the fee which he tenders but, even so, he is most unlikely to make a loss. On his part, however, the Employer bears the risk of the prime cost becoming much higher than estimated, owing perhaps to an inefficient site agent or to wastage of resources.

Other types of contracts fall within these two extremes, and Figure 2 indicates a ranking of them according to the allocation of risk borne by the parties.