Deciding on the best way to price contracts
Chau Ee Lee, international construction lawyer at Reed Smith, discusses common ways of pricing construction contracts in the GCC.
It has been widely reported that during the past year, construction costs have increased by more than 100%, with the major contributors for higher prices being cement, steel and diesel.
During this same period, materials prices have shot up by almost 200%. The net effect for contractors is that their profit margins have taken a severe hit.
Most recently, the government has been urged by contractors to look at ways to manage and prevent further escalation of construction materials' prices. An option is for a move towards cost-plus contracts.
It may be opportune to refresh ourselves on common pricing methods to help determine which form of pricing is preferable for specific construction contracts.
Types of pricing methods
There are three pricing methods in construction contracts. There are situations where distinct trade packages in a construction process require different pricing methods.
There is the now less popular remeasureable form, which is adopted in the Fidic 4th Old Red Book. For this method, the employer accepts the risk of variations in the quantities originally estimated and in some cases, for the rates and prices tendered.
At the tender stage, prospective contractors would fill in a proposed unit price or rate for each item and the contract price is calculated by adding the priced items in the bill of quantities.
Payment of the contractor for the value of the works completed is in accordance with the contract. Therefore, the bill of quantities, which consists of a number of items and a certain quantity to each item, is a key contractual and pricing document.
This is particularly true in civil engineering works, where often the quantities are unpredictable given the high content of ground surface work.
The second method is the cost-reimbursable form. The employer accepts the entire risk of carrying out the work and the contractor is reimbursed for the actual cost of carrying it out plus a fee, which in effect is an additional amount of money in respect of profit, head office and risk.
There is no applicable Fidic form for this pricing method. Given its rather special nature, the engineer's powers, for example, in the Old Red Book and the Fidic 1999 New Red Book, will require modification.
It is therefore generally accepted that Fidic forms may not necessarily be appropriate for this pricing method.
Possible forms include cost plus percentage fee, cost plus fixed fee, cost plus fluctuating fee and target price contracts, which could include a Guaranteed Maximum Price (GMP) slant.
The GMP is basically a monetary value which caps payments to the contractor. Arguably, there should be wording in the construction contract to prevent the contractor from asserting other types of claims or damages.
Proponents of a "pure" GMP contract will always insist on having these couple of key aspects addressed, being (a) the cost to the contractor for carrying out the work in terms of how it is calculated and what the work actually entails and (b) what actually constitutes the fee.
If they are not clearly agreed upon with the contractor, it is likely a "pure" GMP contract will be absent.
The third form is the rather commonly used lump sum method, which is very much what the Fidic Yellow and Fidic Silver is about in terms of pricing. The employer accepts the least amount of risk with respect to quantities and the contractor is obliged to carry out all the work included in the contract documents for a fixed-fee tendered specified sum.
It is generally regarded as useful where the quantities are expected to remain unchanged.
In instances when there could be several events that would entitle a contractor to receive an extra payment, particularly where inaccurate drawings and contract documents do not describe the work, a bill of quantities is used.
Assuming that design is in a fairly advanced stage, it is likely that such a pricing method would be adopted.
Lump sum versus GMP
The ultimate aim for both lump sum contracts and GMP contracts is for the consultant to sit down with the employer to discuss a maximum cost for the project. Yet one would invariably find that the difference is almost purely administrative.
In a GMP contract, payment is usually made as the work is completed, based on actual invoices for sub-contractors and materials, while a negotiated lump sum contract means that the price remains fixed, but due to cash flow management or to minimise the administrative aspects, the contractor bills on a preset payment schedule.
Addmittedly, this tends to be used more for professional services than construction work.
Other key issues arise in deciding the appropriate pricing methods to suit the circumstances. For instance, taxation and currency-related matters can also complicate payment terms.
Chau Ee Lee, international construction lawyer, firstname.lastname@example.org, Reed Smith Dubai.