Introduction
A number of contract types exist and these can be awarded to contractors based on the circumstances that surround the kind of work to be done. According to Lenahan (1999), a complex project may consist of a combination of two or more contract types. When awarding contracts, it is critical to understand all the circumstances that surround the contract.
This paper presents a discussion on three types of contracts and looks at their features, benefits, and drawbacks from different perspectives. As will be seen later, each of the contracts has distinct features the separate it from the rest.
Fixed Price Contracts
Fixed price contracts enable clients to transfer all the risks of a contract to a contractor. Typically, a contract will be 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 and the extent to which they are motivated to look after the client’s best interests. The client is expected to pay a fixed price to the contractor regardless of what the contract actually costs the contractor to perform (Chapman & Ward, 2003). 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 costs down. 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. However, the client is directly exposed to quality degradation risk to the extent that quality is not completely specified or verifiable.
According to Lenahan (1999), one of the greatest benefits of a fixed price contract is the fact that most things are fixed and variation is to a very limited degree. These include both costs and duration which, once agreed on, are not expected to change. Under fixed price contracts, it is the mandate of the contractor to make sure that delivery is effective and based on the terms of the agreement. Generally, drawbacks of fixed price contracts result from how they are managed and, apparently, this comes with numerous challenges. The client must, therefore, be equipped with excellent management as well as coordination skills (Lenahan, 1999).
From the stand point of the contractor, a fixed price contract has the potential for a satisfactory profit, if the project is well managed and costs are properly controlled. Usually, it is the contractor who wields this control. In addition, the need for detailed cost records for the owner’s use does not exist. As a result, the contractor does not need to prove costs in order to receive payment. Another potential benefit to the contractor is the prospect of profit from changes in the work after the contract is signed. However, a poorly managed or unlucky job can lead to problems, due to the fact that payments are not adjusted if the contractor gets into difficulties. Furthermore, each contractor must prepare a detailed cost estimate and tender, even though only one such tender will lead to a contract.
Cost Reimbursement Contracts
Cost reimbursement contracts are generally preferred for high risks projects where fixed price contracts may fail to yield the expected benefits. Even though fixed price contracts will initially appear attractive to the client, benefits soon disappear along the way. Under cost reimbursement contracts, the contractor requires what is regarded by the client as an excessive price to shoulder the risk on behalf of the project.
For some sources of uncertainty, such as variation in quantity or other unforeseen conditions, the contractor will be entitled to additional payments via a claims procedure. If the fixed price is too low, additional risks are introduced, for example, the contractor may be unable to fulfill contractual conditions and go into liquidation. The nature of uncertainty and claims, coupled with concealment of the contractor’s costs, also introduce an element of chance into the adequacy of the payment for the contract. 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 since risks effectively being carried by the client are not explicitly indicated (Sweet, Schneier & Schneier). In effect, a cost reimbursement contract is agreed upon by default for risks that are not controllable by the contractor or the client. Client insistence on placing fixed price contracts with the lowest bidder may only serve to aggravate this problem.
Single Contractor Managed Contracts
This is regarded as the simplest contract and is usually managed by one single individual or firm that takes full responsibility to deliver as expected by the client. A contractor is paid a pre-agreed fixed amount of the project. Ordinarily, the amount is paid without regard for the actual costs experienced by the contractor. For single contractor managed contracts, the project must be completely defined by the contract documents prior to receipt of proposals, selection of contractor, and formation of contract (Bennett, 2012).
Ideally, the stated price should include all direct costs of labor, materials, equipment and subcontractors, as well as indirect costs such as field supervision, field office, and equipment attendance. In essence, the contractor guarantees efficient delivery for the stipulated price.
Table 1 shows the features, benefits, and drawbacks of the three types of contracts.
Table 1: Features, Benefits, and Drawbacks of Contract Types
Conclusion
Although a number of contract types exist and an individual or a firm may choose one that appears to effectively address the problems at hand, it is vital to ensure that the right type of contract is chosen in order to realize the agreed upon objectives. The pros and cons of the different contracts may form a good basis for selecting a contract type that will yield greater benefits.
References
Bennett F. L. L. (2012). The Management of Construction: A Project Lifecycle Approach. New York: Routledge.
Chapman, C., & Ward, S. (2003). Project Risk Management: Processes, Techniques and Insights. West Sussex: John Wiley & Sons.
Lenahan, T. (1999). Turnaround Management. Woburn, MA: Butterworth-Heinemann.
Sweet, J., Schneier, M. M., & Schneier, M. M. (2008).Legal Aspects of Architecture, Engineering and the Construction Process. Stanford, CT: Cengage Learning.