It is quite often an interesting discussion when it comes time to factoring in the risk profile of major construction projects.
The differing terms of each construction contract serve to allocate risk in different ways. Since risk must be factored into price, each method of allocating risk leads to a different price for constructing the same facility.
In principle, the owner has the sole right to select the type of contract to be used for the construction of a specific facility. In addition, the owner can vary from the industry norm by choosing to set out its own proposed terms for the final contractual agreement.
While minor modification to the normal assignment of risk is unlikely to discourage bids, this becomes progressively less true as the extent of such modifications increases.
At some point, a municipality may find that its proposed terms are completely unattractive to the market.
The normal allocation of risk associated with each of the different forms of pricing arrangement is as follows. Under a fixed price contract the owner essentially assigns all of the construction-related risk to the contractor, as a result, such contracts tend to include a higher mark-up than other types of contract in order to allow for unforeseen contingencies.
Usually, such contracts provide for a series of (monthly) progress payments as work is completed on the project. However, the mark-up is highest in the case of a so-called “entire” contract, in which payment is made in one lump sum, following the full completion of the project.
For an inexperienced contractor, fixed price arrangements present the greatest level of risk. If the actual cost of the project is underestimated, the contractor will bear the full burden of the underestimation. For an experienced contractor, the fixed price arrangement allows the greatest opportunity for profit.
Other factors influencing the total amount of risk associated with the execution of the project depend upon the following:
- Has the contractor committed to delivering the project in accordance with a specific schedule with completion to occur no later than a specific date?
- Does the contract allow the contractor an agreed number of working days for completion?
- If there is a working day allowance, how is it determined whether a particular day is a working day?
- What time and expense allowance is provided for unanticipated circumstances?
Fixed price contracts do not limit the price that may be charged where there is a change in the scope of work. Often where there is a problem with design, there will be a change in the scope of work in order to correct that problem.
Under a unit price contract, the risk of inaccurate estimation of uncertain qualities for some key tasks is assumed by the owner rather than the contractor.
Accordingly, unit price contracting is generally used only by owners who have sufficient experience to be able to make a realistic estimate of the number of units of each type of work identified, that are required to carry out the contract.
Where there are discrepancies between the contractor’s estimates and those of the owner, the contractor may submit an “unbalanced bid.”
This allows the contractor to raise the unit prices on the tasks that it believes that the owner has underestimated while lowering the unit prices on other tasks. If the contractor is correct in its assessment, it will increase its profit substantially since the payment is made on the actual quantities of each unit performed. Some owners will disqualify a contractor if the bid appears to be heavily unbalanced.
In my experience working with owners, some have a greater tolerance to assume the risk, while others would be more comfortable transferring all the risk to the contractors. It is always wise to delegate the risk to the person best qualified to handle it.
Stephen Bauld is a government procurement expert and can be reached at swbauld@purchasingci.com. Some of his columns may contain excerpts from The Municipal Procurement Handbook published by Butterworths.
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