Const. Mgmt. Chp. 08 - Construction Pricing and Contracting

8/14/2019 Const. Mgmt. Chp. 08 - Construction Pricing and Contracting

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8. Construction Pricing and Contracting

8.1 Pricing for Constructed Facilities

Because of the unique nature of constructed facilities, it is almost imperative to have aseparate price for each facility. The construction contract price includes the direct projectcost including field supervision expenses plus the markup imposed by contractors forgeneral overhead expenses and profit. The factors influencing a facility price will vary bytype of facility and location as well. Within each of the major categories of constructionsuch as residential housing, commercial buildings, industrial complexes and infrastructure,there are smaller segments which have very different environments with regard to pricesetting. However, all pricing arrangements have some common features in the form of thelegal documents binding the owner and the supplier(s) of the facility. Without addressingspecial issues in various industry segments, the most common types of pricingarrangements can be described broadly to illustrate the basic principles.

Competitive Bidding

The basic structure of the bidding process consists of the formulation of detailed plans andspecifications of a facility based on the objectives and requirements of the owner, and theinvitation of qualified contractors to bid for the right to execute the project. The definitionof a qualified contractor usually calls for a minimal evidence of previous experience andfinancial stability. In the private sector, the owner has considerable latitude in selecting thebidders, ranging from open competition to the restriction of bidders to a few favoredcontractors. In the public sector, the rules are carefully delineated to place all qualifiedcontractors on an equal footing for competition, and strictly enforced to prevent collusionamong contractors and unethical or illegal actions by public officials.

Detailed plans and specifications are usually prepared by an architectural/engineering firmwhich oversees the bidding process on behalf of the owner. The final bids are normallysubmitted on either a lump sum or unit price basis, as stipulated by the owner. A lump sumbid represents the total price for which a contractor offers to complete a facility accordingto the detailed plans and specifications. Unit price bidding is used in projects for which thequantity of materials or the amount of labor involved in some key tasks is particularlyuncertain. In such cases, the contractor is permitted to submit a list of unit prices for thosetasks, and the final price used to determine the lowest bidder is based on the lump sumprice computed by multiplying the quoted unit price for each specified task by thecorresponding quantity in the owner's estimates for quantities. However, the total paymentto the winning contractor will be based on the actual quantities multiplied by the respective

quoted unit prices.

Negotiated Contracts

Instead of inviting competitive bidding, private owners often choose to award constructioncontracts with one or more selected contractors. A major reason for using negotiatedcontracts is the flexibility of this type of pricing arrangement, particularly for projects oflarge size and great complexity or for projects which substantially duplicate previous


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facilities sponsored by the owner. An owner may value the expertise and integrity of aparticular contractor who has a good reputation or has worked successfully for the owner inthe past. If it becomes necessary to meet a deadline for completion of the project, theconstruction of a project may proceed without waiting for the completion of the detailedplans and specifications with a contractor that the owner can trust. However, the owner's

staff must be highly knowledgeable and competent in evaluating contractor proposals andmonitoring subsequent performance.

Generally, negotiated contracts require the reimbursement of direct project cost plus thecontractor's fee as determined by one of the following methods:

1. Cost plus fixed percentage2. Cost plus fixed fee3. Cost plus variable fee4. Target estimate5. Guaranteed maximum price or cost

The fixed percentage or fixed fee is determined at the outset of the project, while variablefee and target estimates are used as an incentive to reduce costs by sharing any costsavings. A guaranteed maximum cost arrangement imposes a penalty on a contractor forcost overruns and failure to complete the project on time. With a guaranteed maximumprice contract, amounts below the maximum are typically shared between the owner andthe contractor, while the contractor is responsible for costs above the maximum.

Speculative Residential Construction

In residential construction, developers often build houses and condominiums inanticipation of the demand of home buyers. Because the basic needs of home buyers arevery similar and home designs can be standardized to some degree, the probability offinding buyers of good housing units within a relatively short time is quite high.Consequently, developers are willing to undertake speculative building and lendinginstitutions are also willing to finance such construction. The developer essentially set theprice for each housing unit as the market will bear, and can adjust the prices of remainingunits at any given time according to the market trend.

Force-Account Construction

Some owners use in-house labor forces to perform a substantial amount of construction,particularly for addition, renovation and repair work. Then, the total of the force-accountcharges including in-house overhead expenses will be the pricing arrangement for the

construction.

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8.2 Contract Provisions for Risk Allocation

Provisions for the allocation of risk among parties to a contract can appear in numerousareas in addition to the total construction price. Typically, these provisions assign


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responsibility for covering the costs of possible or unforeseen occurances. A partial list ofresponsibilities with concomitant risk that can be assigned to different parties wouldinclude:

Force majeure (i.e., this provision absolves an owner or a contractor for paymentfor costs due to "Acts of God" and other external events such as war or laborstrikes)

Indemnification (i.e., this provision absolves the indemified party from anypayment for losses and damages incurred by a third party such as adjacent propertyowners.)

Liens (i.e., assurances that third party claims are settled such as "mechanics liens"for worker wages),

Labor laws (i.e., payments for any violation of labor laws and regulations on the jobsite),

Differing site conditions (i.e., responsibility for extra costs due to unexpected siteconditions),

Delays and extensions of time, Liquidated damages (i.e., payments for any facility defects with payment amounts

agreed to in advance) Consequential damages (i.e., payments for actual damage costs assessed upon

impact of facility defects), Occupational safety and health of workers, Permits, licenses, laws, and regulations, Equal employment opportunity regulations, Termination for default by contractor, Suspension of work, Warranties and guarantees.

The language used for specifying the risk assignments in these areas must conform to legal

requirements and past interpretations which may vary in different jurisdictions or overtime. Without using standard legal language, contract provisions may be unenforceable.Unfortunately, standard legal language for this purpose may be difficult to understand. As aresult, project managers often have difficulty in interpreting their particular responsibilities.Competent legal counsel is required to advise the different parties to an agreement abouttheir respective responsibilities.

Standard forms for contracts can be obtained from numerous sources, such as the AmericanInstitute of Architects (AIA) or the Associated General Contractors (AGC). These standardforms may include risk and responsibility allocations which are unacceptable to one ormore of the contracting parties. In particular, standard forms may be biased to reduce therisk and responsibility of the originating organization or group. Parties to a contract shouldread and review all contract documents carefully.

The three examples appearing below illustrate contract language resulting in different riskassignments between a contractor (CONTRACTOR) and an owner (COMPANY). Eachcontract provision allocates different levels of indemnification risk to the contractor. [1]

Example 8-1: A Contract Provision Example with High Contractor Risk


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"Except where the sole negligence of COMPANY is involved or alleged, CONTRACTORshall indemnify and hold harmless COMPANY, its officers, agents and employees, fromand against any and all loss, damage, and liability and from any and all claims for damageson account of or by reason of bodily injury, including death, not limited to the employeesof CONTRACTOR, COMPANY, and of any subcontractor or CONTRACTOR, and from

and against any and all damages to property, including property of COMPANY and thirdparties, direct and/or consequential, caused by or arising out of, in while or in part, orclaimed to have been caused by or to have arisen out of, in whole or in part, an act ofomission of CONTRACTOR or its agents, employees, vendors, or subcontractors, of theiremployees or agents in connection with the performance of the Contract Documents,whether or not insured against; and CONTRACTOR shall, at its own cost and expense,defend any claim, suit, action or proceeding, whether groundless or not, which may becommenced against COMPANY by reason thereof or in connection therewith, andCONTRACTOR shall pay any and all judgments which may be recovered in such action,claim, proceeding or suit, and defray any and all expenses, including costs and attorney'sfees which may be incurred by reason of such actions, claims, proceedings, or suits."

Comment: This is a very burdensome provision for the contractor. It makes the contractorresponsible for practically every conceivable occurrence and type of damage, except whena claim for loss or damages is due to the sole negligence of the owner. As a practicalmatter, sole negligence on a construction project is very difficult to ascertain because thework is so inter-twined. Since there is no dollar limitation to the contractor's exposure,sufficient liability coverage to cover worst scenario risks will be difficult to obtain. Thebest the contractor can do is to obtain as complete and broad excess liability insurancecoverage as can be purchased. This insurance is costly, so the contractor should insure thecontract price is sufficiently high to cover the expense.

Example 8-2: An Example Contract Provision with Medium Risk Allocation to

Contractor

"CONTRACTOR shall protect, defend, hold harmless, and indemnify COMPANY fromand against any loss, damage, claim, action, liability, or demand whatsoever (including,with limitation, costs, expenses, and attorney's fees, whether for appeals or otherwise, inconnection therewith), arising out of any personal injury (including, without limitation,injury to any employee of COMPANY, CONTRACTOR or any subcontractor), arising outof any personal injury (including, without limitation, injury to any employee ofCOMPANY, CONTRACTOR, or any subcontractor), including death resulting therefromor out of any damage to or loss or destruction of property, real and or personal (includingproperty of COMPANY, CONTRACTOR, and any subcontractor, and including tools andequipment whether owned, rented, or used by CONTRACTOR, any subcontractor, or anyworkman) in any manner based upon, occasioned by , or attributable or related to theperformance, whether by the CONTRACTOR or any subcontractor, of the Work or anypart thereof, and CONTRACTOR shall at its own expense defend any and all actions basedthereon, except where said personal injury or property damage is caused by the negligenceof COMPANY or COMPANY'S employees. Any loss, damage, cost expense or attorney'sfees incurred by COMPANY in connection with the foregoing may, in addition to otherremedies, be deducted from CONTRACTOR'S compensation, then due or thereafter tobecome due. COMPANY shall effect for the benefit of CONTRACTOR a waiver of


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subrogation on the existing facilities, including consequential damages such as, but not byway of limitation, loss of profit and loss of product or plant downtime but excluding any

deductibles which shall exist as at the date of this CONTRACT; provided, however, thatsaid waiver of subrogation shall be expanded to include all said deductible amounts on the

acceptance of the Work by COMPANY."

Comment: This clause provides the contractor considerable relief. He still has unlimitedexposure for injury to all persons and third party property but only to the extent caused bythe contractor's negligence. The "sole" negligence issue does not arise. Furthermore, thecontractor's liability for damages to the owner's property-a major concern for contractorsworking in petrochemical complexes, at times worth billions-is limited to the owner'sinsurance deductible, and the owner's insurance carriers have no right of recourse againstthe contractor. The contractor's limited exposure regarding the owner's facilities ends oncompletion of the work.

Example 8-3: An Example Contract Provision with Low Risk Allocation to

Contractor

"CONTRACTOR hereby agrees to indemnify and hold COMPANY and/or any parent,subsidiary, or affiliate, or COMPANY and/or officers, agents, or employees of any ofthem, harmless from and against any loss or liability arising directly or indirectly out of anyclaim or cause of action for loss or damage to property including, but not limited to,CONTRACTOR'S property and COMPANY'S property and for injuries to or death ofpersons including but not limited to CONTRACTOR'S employees, caused by or resultingfrom the performance of the work by CONTRACTOR, its employees, agents, andsubcontractors and shall, at the option of COMPANY, defend COMPANY atCONTRACTOR'S sole expense in any litigation involving the same regardless of whethersuch work is performed by CONTRACTOR, its employees, or by its subcontractors, theiremployees, or all or either of them.In all instances, CONTRACTOR'S indemnity to

COMPANY shall be limited to the proceeds of CONTRACTOR'S umbrella liabilityinsurance coverage."

Comment: With respect to indemnifying the owner, the contractor in this provision hasminimal out-of-pocket risk. Exposure is limited to whatever can be collected from thecontractor's insurance company.

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8.3 Risks and Incentives on Construction Quality

All owners want quality construction with reasonable costs, but not all are willing to sharerisks and/or provide incentives to enhance the quality of construction. In recent years, moreowners recognize that they do not get the best quality of construction by squeezing the lastdollar of profit from the contractor, and they accept the concept of risk sharing/riskassignment in principle in letting construction contracts. However, the implementation ofsuch a concept in the past decade has received mixed results.


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Many public owners have been the victims of their own schemes, not only because of theusual requirement in letting contracts of public works through competitive bidding to avoidfavoritism, but at times because of the sheer weight of entrenched bureaucracy. Somecontractors steer away from public works altogether; others submit bids at higher prices tocompensate for the restrictive provisions of contract terms. As a result, some public

authorities find that either there are few responsible contractors responding to theirinvitations to submit bids or the bid prices far exceed their engineers' estimates. Thosepublic owners who have adopted the federal government's risk sharing/risk assignmentcontract concepts have found that while initial bid prices may have decreased somewhat,claims and disputes on contracts are more frequent than before, and notably more so than inprivately funded construction. Some of these claims and disputes can no doubt be avoidedby improving the contract provisions. [2]

Since most claims and disputes arise most frequently from lump sum contracts for bothpublic and private owners, the following factors associated with lump sum contracts areparticularly noteworthy:

unbalanced bids in unit prices on which periodic payment estimates are based. change orders subject to negotiated payments changes in design or construction technology incentives for early completion

An unbalanced bid refers to raising the unit prices on items to be completed in the earlystage of the project and lowering the unit prices on items to be completed in the laterstages. The purpose of this practice on the part of the contractor is to ease its burden ofconstruction financing. It is better for owners to offer explicit incentives to aid constructionfinancing in exchange for lower bid prices than to allow the use of hidden unbalanced bids.Unbalanced bids may also occur if a contractor feels some item of work wasunderestimated in amount, so that a high unit price on that item would increase profits.

Since lump sum contracts are awarded on the basis of low bids, it is difficult to challengethe low bidders on the validity of their unit prices except for flagrant violations.Consequently remedies should be sought by requesting the contractor to submit pertinentrecords of financial transactions to substantiate the expenditures associated with itsmonthly billings for payments of work completed during the period.

One of the most contentious issues in contract provisions concerns the payment for changeorders. The owner and its engineer should have an appreciation of the effects of changesfor specific items of work and negotiate with the contractor on the identifiable cost of suchitems. The owner should require the contractor to submit the price quotation within acertain period of time after the issuance of a change order and to assess whether the changeorder may cause delay damages. If the contract does not contain specific provisions on costdisclosures for evaluating change order costs, it will be difficult to negotiate payments forchange orders and claim settlements later.

In some projects, the contract provisions may allow the contractor to provide alternativedesign and/or construction technology. The owner may impose different mechanisms forpricing these changes. For example, a contractor may suggest a design or constructionmethod change that fulfills the performance requirements. Savings due to such changes


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may accrue to the contractor or the owner, or may be divided in some fashion between thetwo. The contract provisions must reflect the owners risk-reward objectives in calling foralternate design and/or construction technology. While innovations are often sought to savemoney and time, unsuccessful innovations may require additional money and time tocorrect earlier misjudgment. At worse, a failure could have serious consequences.

In spite of admonitions and good intentions for better planning before initiating aconstruction project, most owners want a facility to be in operation as soon as possibleonce a decision is made to proceed with its construction. Many construction contractscontain provisions of penalties for late completion beyond a specified deadline; however,unless such provisions are accompanied by similar incentives for early completion, theymay be ruled unenforceable in court. Early completion may result in significant savings,particularly in rehabilitation projects in which the facility users are inconvenienced by theloss of the facility and the disruption due to construction operations.

Example 8-4: Arkansas Rice Growers Cooperative Association v. Alchemy Industries

A 1986 court case can illustrate the assumption of risk on the part of contractors and designprofessionals. [3] The Arkansas Rice Growers Cooperative contracted with AlchemyIndustries, Inc. to provide engineering and construction services for a new facility intendedto generate steam by burning rice hulls. Under the terms of the contract, AlchemyIndustries guaranteed that the completed plant would be capable of "reducing a minimumof seven and one-half tons of rice hulls per hour to an ash and producing a minimum of 48million BTU's per hour of steam at 200 pounds pressure." Unfortunately, the finished plantdid not meet this performance standard, and the Arkansas Rice Growers CooperativeAssociation sued Alchemy Industries and its subcontractors for breach of warranty.Damages of almost $1.5 million were awarded to the Association.Back to top

8.4 Types of Construction Contracts

While construction contracts serve as a means of pricing construction, they also structurethe allocation of risk to the various parties involved. The owner has the sole power todecide what type of contract should be used for a specific facility to be constructed and toset forth the terms in a contractual agreement. It is important to understand the risks of thecontractors associated with different types of construction contracts.

Lump Sum Contract

In a lump sum contract, the owner has essentially assigned all the risk to the contractor,

who in turn can be expected to ask for a higher markup in order to take care of unforeseencontingencies. Beside the fixed lump sum price, other commitments are often made by thecontractor in the form of submittals such as a specific schedule, the management reportingsystem or a quality control program. If the actual cost of the project is underestimated, theunderestimated cost will reduce the contractor's profit by that amount. An overestimate hasan opposite effect, but may reduce the chance of being a low bidder for the project.

Unit Price Contract


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In a unit price contract, the risk of inaccurate estimation of uncertain quantities for somekey tasks has been removed from the contractor. However, some contractors may submitan "unbalanced bid" when it discovers large discrepancies between its estimates and theowner's estimates of these quantities. Depending on the confidence of the contractor on itsown estimates and its propensity on risk, a contractor can slightly raise the unit prices on

the underestimated tasks while lowering the unit prices on other tasks. If the contractor iscorrect in its assessment, it can increase its profit substantially since the payment is madeon the actual quantities of tasks; and if the reverse is true, it can lose on this basis.Furthermore, the owner may disqualify a contractor if the bid appears to be heavilyunbalanced. To the extent that an underestimate or overestimate is caused by changes in thequantities of work, neither error will effect the contractor's profit beyond the markup in theunit prices.

Cost Plus Fixed Percentage Contract

For certain types of construction involving new technology or extremely pressing needs,the owner is sometimes forced to assume all risks of cost overruns. The contractor will

receive the actual direct job cost plus a fixed percentage, and have little incentive to reducejob cost. Furthermore, if there are pressing needs to complete the project, overtimepayments to workers are common and will further increase the job cost. Unless there arecompelling reasons, such as the urgency in the construction of military installations, theowner should not use this type of contract.

Cost Plus Fixed Fee Contract

Under this type of contract, the contractor will receive the actual direct job cost plus a fixedfee, and will have some incentive to complete the job quickly since its fee is fixedregardless of the duration of the project. However, the owner still assumes the risks ofdirect job cost overrun while the contractor may risk the erosion of its profits if the projectis dragged on beyond the expected time.

Cost Plus Variable Percentage Contract

For this type of contract, the contractor agrees to a penalty if the actual cost exceeds theestimated job cost, or a reward if the actual cost is below the estimated job cost. In returnfor taking the risk on its own estimate, the contractor is allowed a variable percentage ofthe direct job-cost for its fee. Furthermore, the project duration is usually specified and thecontractor must abide by the deadline for completion. This type of contract allocatesconsiderable risk for cost overruns to the owner, but also provides incentives to contractorsto reduce costs as much as possible.

Target Estimate Contract

This is another form of contract which specifies a penalty or reward to a contractor,depending on whether the actual cost is greater than or less than the contractor's estimateddirect job cost. Usually, the percentages of savings or overrun to be shared by the ownerand the contractor are predetermined and the project duration is specified in the contract.Bonuses or penalties may be stipulated for different project completion dates.


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Guaranteed Maximum Cost Contract

When the project scope is well defined, an owner may choose to ask the contractor to takeall the risks, both in terms of actual project cost and project time. Any work change ordersfrom the owner must be extremely minor if at all, since performance specifications are

provided to the owner at the outset of construction. The owner and the contractor agree to aproject cost guaranteed by the contractor as maximum. There may be or may not beadditional provisions to share any savings if any in the contract. This type of contract isparticularly suitable for turnkey operation.

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8.5 Relative Costs of Construction Contracts

Regardless of the type of construction contract selected by the owner, the contractorrecognizes that the actual construction cost will never be identical to its own estimate

because of imperfect information. Furthermore, it is common for the owner to place workchange orders to modify the original scope of work for which the contractor will receiveadditional payments as stipulated in the contract. The contractor will use different markupscommensurate with its market circumstances and with the risks involved in different typesof contracts, leading to different contract prices at the time of bidding or negotiation. Thetype of contract agreed upon may also provide the contractor with greater incentives to tryto reduce costs as much as possible. The contractor's gross profit at the completion of aproject is affected by the type of contract, the accuracy of its original estimate, and thenature of work change orders. The owner's actual payment for the project is also affectedby the contract and the nature of work change orders.

In order to illustrate the relative costs of several types of construction contracts, the pricing

mechanisms for such construction contracts are formulated on the same direct job cost pluscorresponding markups reflecting the risks. Let us adopt the following notation:

E=contractor's original estimate of the direct job cost at the time of contract award

M =amount of markup by the contractor in the contract

B =estimated construction price at the time of signing contract

A =contractor's actual cost for the original scope of work in the contract

U =

underestimate of the cost of work in the original estimate (with negative value of Udenoting an overestimate)

C =additional cost of work due to change orders

P =actual payment to contractor by the owner

F =contractor's gross profit


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R =basic percentage markup above the original estimate for fixed fee contract

Ri =premium percentage markup for contract type i such that the total percentagemarkup is (R + Ri), e.g. (R + R1) for a lump sum contract, (R + R2) for a unit price

contract, and (R + R3) for a guaranteed maximum cost contractN =a factor in the target estimate for sharing the savings in cost as agreed upon by the

owner and the contractor, with 0 N 1.

At the time of a contract award, the contract price is given by:

(8.1)

The underestimation of the cost of work in the original contract is defined as:

(8.2)

Then, at the completion of the project, the contractor's actual cost for the original scope ofwork is:

(8.3)

For various types of construction contracts, the contractor's markup and the price forconstruction agreed to in the contract are shown in Table 8-1. Note that at the time ofcontract award, it is assumed that A = E, even though the effects of underestimation on thecontractor's gross profits are different for various types of construction contracts when theactual cost of the project is assessed upon its completion.

TABLE 8-1 Original Estimated Contract Prices

Type of Contract Markup Contract Price

1. Lump sum2. Unit price3. Cost plus fixed %

4. Cost plus fixed fee5. Cost plus variable %6. Target estimate7. Guaranteed max cost

M = (R +R1)EM = (R + R2)EM = RA = RE

M = REM = R (2E - A) = REM = RE + N (E-A) = REM = (R + R3)E

B = (1 + R + R1)EB = (1 + R + R2)EB = (1 + R)E

B = (1 + R)EB = (1 + R)EB = (1 + R)EB = (1 + R + R3)E

Payments of change orders are also different in contract provisions for different types ofcontracts. Suppose that payments for change orders agreed upon for various types of


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contracts are as shown in column 2 of Table 8-2. The owner's actual payments based onthese provisions as well as the incentive provisions for various types of contracts are givenin column 3 of Table 8-2. The corresponding contractor's profits under various contractualarrangements are shown in Table 8-3.

TABLE 8-2 Owner's Actual Payment with Different Contract ProvisionsType of Contract Change Order Payment Owner's Payment

1. Lump sum2. Unit price3. Cost plus fixed %4. Cost plus fixed fee5. Cost plus variable %6. Target estimate7. Guaranteed max cost

C(1 + R + R1)C(1 + R + R2)C(1 + R)CC(1 + R)C0

P = B + C(1 + R + R1)P = (1 + R + R2)A + CP = (1 + R)(A + C)P = RE + A + CP = R (2E - A + C) + A + CP = RE + N (E - A) + A + CP = B

TABLE 8-3 Contractor's Gross Profit with Different Contract Provisions

Type of Contract Profit from Change Order Contractor's Gross Profit

1. Lump sum2. Unit price3. Cost plus fixed %4. Cost plus fixed fee5. Cost plus variable %6. Target estimate7. Guaranteed max cost

C(R + R1)C(R + R2CR0CR0-C

F = E - A + (R + R1)(E + C)F = (R + R2)(A + C)F = R (A + C)F = REF = R (2E - A + C)F = RE + N (E - A)F = (1 + R + R3)E - A - C

It is important to note that the equations in Tables 8-1 through 8-3 are illustrative, subjectto the simplified conditions of payments assumed under the various types of contracts.When the negotiated conditions of payment are different, the equations must also bemodified.

Example 8-5: Contractor's Gross Profits under Different Contract Arrangements

Consider a construction project for which the contractor's original estimate is $6,000,000.For various types of contracts, R = 10%, R1 = 2%, R2 = 1%, R3 = 5% and N = 0.5. Thecontractor is not compensated for change orders under the guaranteed maximum costcontract if the total cost for the change orders is within 6% ($360,000) of the originalestimate. Determine the contractor's gross profit for each of the seven types of constructioncontracts for each of the following conditions.

(a) U = 0, C = 0(b) U = 0, C = 6% E = $360,000(c) U = 4% E = $240,000, C = 0(d) U = 4% E = $240,000 C = 6% E = $360,000


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(e) U = -4% E = -$240,000, C = 0(f) U = -4% E = -$240,000, C = 6% E = $360,000

In this example, the percentage markup for the cost plus fixed percentage contract is 10%which is used as the bench mark for comparison. The percentage markup for the lump sum

contract is 12% while that for the unit price contract is 11%, reflecting the degrees ofhigher risk. The fixed fee for the cost plus fixed fee is based on 10% of the estimated cost,which is comparable to the cost plus fixed percentage contract if there is no overestimate orunderestimate in cost. The basic percentage markup is 10% for both the cost plus variablepercentage contract and the target estimator contract, but they are subject to incentivebonuses and penalties that are built in the formulas for owners' payments. The percentagemarkup for the guaranteed maximum cost contract is 15% to account for the high riskundertaken by the contractor. The results of computation for all seven types of contractsunder different conditions of underestimation U and change order C are shown in Table 8-4

TABLE 8-4 Contractor's Gross Profits under Different Conditions (in$1,000)

Type of ContractU=0C=0

U=0C=6%E

U=4%EC=0

U=4%EC=6%E

U=-4%EC=0

U=-4%EC=6%E

1. lump sum2. unit price3. cost + fixed %4. cost + fixedfee5. cost + Var %6. targetestimate

7. guar. max.cost

$720660600600600600900

$763700636600636600540

$480686624600576480660

$523726660600616480300

$960634576600624720

1,140

$1,003674612600660720780

Example 8-6: Owner's Payments under Different Contract Arrangements

Using the data in Example 8-5, determine the owner's actual payment for each of the seventypes of construction contracts for the same conditions of U and C. The results ofcomputation are shown in Table 8-5.

TABLE 8-5 Owner's Actual Payments under Different Conditions (in

$1,000)

Type ofContract

U=0C=0

U=0C=6%E

U=4%EC=0

U=4%EC=6%E

U=-4%EC=0

U=-4%EC=6%E

1. lump sum2. unit price3. cost + fixed

$6,7206,6606,600

$7,1237,0606,996

$6,7206,9266,864

$7,1237,3267,260

$6,7206,3946,336

$7,1236,7946,732


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%4. cost + fixedfee5. cost + Var %6. target

estimate7. guar. max.cost

6,6006,6006,6006,900

6,9606,9966,9606,900

6,8406,8166,7206,900

7,2007,2127,0806,900

6,3606,3846,4806,900

6,7206,7806,8406,900

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8.6 Principles of Competitive Bidding

Competitive bidding on construction projects involves decision making under uncertaintywhere one of the greatest sources of the uncertainty for each bidder is due to the

unpredictable nature of his competitors. Each bid submitted for a particular job by acontractor will be determined by a large number of factors, including an estimate of thedirect job cost, the general overhead, the confidence that the management has in thisestimate, and the immediate and long-range objectives of management. So many factors areinvolved that it is impossible for a particular bidder to attempt to predict exactly what thebids submitted by its competitors will be.

It is useful to think of a bid as being made up of two basic elements: (1) the estimate ofdirect job cost, which includes direct labor costs, material costs, equipment costs, anddirect filed supervision; and (2) the markup or return, which must be sufficient to cover aportion of general overhead costs and allow a fair profit on the investment. A large returncan be assured simply by including a sufficiently high markup. However, the higher the

markup, the less chance there will be of getting the job. Consequently a contractor whoincludes a very large markup on every bid could become bankrupt from lack of business.Conversely, the strategy of bidding with very little markup in order to obtain high volumeis also likely to lead to bankruptcy. Somewhere in between the two extreme approaches tobidding lies an "optimum markup" which considers both the return and the likelihood ofbeing low bidder in such a way that, over the long run, the average return is maximized.

From all indications, most contractors confront uncertain bidding conditions by exercisinga high degree of subjective judgment, and each contractor may give different weights tovarious factors. The decision on the bid price, if a bid is indeed submitted, reflects thecontractor's best judgment on how well the proposed project fits into the overall strategyfor the survival and growth of the company, as well as the contractor's propensity to riskgreater profit versus the chance of not getting a contract.

One major concern in bidding competitions is the amount of "money left on the table," ofthe difference between the winning and the next best bid. The winning bidder would likethe amount of "money left on the table" to be as small as possible. For example, if acontractor wins with a bid of $200,000, and the next lowest bid was $225,000 (representing


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$25,000 of "money left on the table"), then the winning contractor would have preferred tohave bid $220,000 (or perhaps $224,999) to increase potential profits.

Some of the major factors impacting bidding competitions include:

Exogenous Economic Factors

Contractors generally tend to specialize in a submarket of construction and concentratetheir work in particular geographic locations. The level of demand in a submarket at aparticular time can influence the number of bidders and their bid prices. When work isscarce in the submarket, the average number of bidders for projects will be larger than attimes of plenty. The net result of scarcity is likely to be the increase in the number ofbidders per project and downward pressure on the bid price for each project in thesubmarket. At times of severe scarcity, some contractors may cross the line betweensegments to expand their activities, or move into new geographic locations to get a largershare of the existing submarket. Either action will increase the risks incurred by suchcontractors as they move into less familiar segments or territories. The trend of market

demand in construction and of the economy at large may also influence the biddingdecisions of a contractor in other ways. If a contractor perceives drastic increases in laborwages and material prices as a result of recent labor contract settlements, it may take intoconsideration possible increases in unit prices for determining the direct project cost.Furthermore, the perceptions of increase in inflation rates and interest rates may also causethe contractor to use a higher markup to hedge the uncertainty. Consequently, at times ofeconomic expansion and/or higher inflation rate, contractors are reluctant to committhemselves to long-term fixed price contracts.

Characteristics of Bidding Competition

All other things being equal, the probability of winning a contract diminishes as morebidders participate in the competition. Consequently, a contractor tries to find out as muchinformation as possible about the number and identities of potential bidders on a specificproject. Such information is often available in theDodge Bulletin or similar publications which providedata of potential projects and names of contractors who have taken out plans andspecifications. For certain segments, potential competitors may be identified throughprivate contacts, and bidders often confront the same competitor's project after projectsince they have similar capabilities and interests in undertaking the same type of work,including size, complexity and geographical location of the projects. A general contractormay also obtain information of potential subcontractors from publications such as Credit

Reports(Credit Reports, Building Construction Division, and Bradstreet, Inc., New York,

N.Y.) published by Dun and Bradstreet, Inc. However, most contractors form an extensivenetwork with a group of subcontractors with whom they have had previous businesstransactions. They usually rely on their own experience in soliciting subcontract bidsbefore finalizing a bid price for the project.

Objectives of General Contractors in Bidding


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The bidding strategy of some contractors are influenced by a policy of minimumpercentage markup for general overhead and profit. However, the percentage markup mayalso reflect additional factors stipulated by the owner such as high retention and slowpayments for completed work, or perceptions of uncontrollable factors in the economy. Theintensity of a contractor's efforts in bidding a specific project is influenced by the

contractor's desire to obtain additional work. The winning of a particular project may bepotentially important to the overall mix of work in progress or the cash flow implicationsfor the contractor. The contractor's decision is also influenced by the availability of keypersonnel in the contractor organization. The company sometimes wants to reserve itsresources for future projects, or commits itself to the current opportunity for differentreasons.

Contractor's Comparative Advantages

A final important consideration in forming bid prices on the part of contractors are thepossible special advantages enjoyed by a particular firm. As a result of lower costs, aparticular contractor may be able to impose a higher profit markup yet still have a lower

total bid than competitors. These lower costs may result from superior technology, greaterexperience, better management, better personnel or lower unit costs. A comparative costadvantage is the most desirable of all circumstances in entering a bid competition.

Back to top

8.7 Principles of Contract Negotiation

Negotiation is another important mechanism for arranging construction contracts. Projectmanagers often find themselves as participants in negotiations, either as principalnegotiators or as expert advisors. These negotiations can be complex and often present

important opportunities and risks for the various parties involved. For example, negotiationon work contracts can involve issues such as completion date, arbitration procedures,special work item compensation, contingency allowances as well as the overall price. As ageneral rule, exogenous factors such as the history of a contractor and the generaleconomic climate in the construction industry will determine the results of negotiations.However, the skill of a negotiator can affect the possibility of reaching an agreement, theprofitability of the project, the scope of any eventual disputes, and the possibility foradditional work among the participants. Thus, negotiations are an important task for manyproject managers. Even after a contract is awarded on the basis of competitive bidding,there are many occasions in which subsequent negotiations are required as conditionschange over time.

In conducting negotiations between two parties, each side will have a series of objectivesand constraints. The overall objective of each party is to obtain the most favorable,acceptable agreement. A two party, one issue negotiation illustrates this fundamental point.Suppose that a developer is willing to pay up to $500,000 for a particular plot of land,whereas the owner would be willing to sell the land for $450,000 or more. These maximumand minimum sales prices represent constraints on any eventual agreement. In thisexample, any purchase price between $450,000 and $500,000 is acceptable to both of theinvolved parties. This range represents afeasible agreement space. Successful negotiations


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would conclude in a sales price within this range. Which party receives the $50,000 in themiddle range between $450,000 and $500,000 would typically depend upon the negotiatingskills and special knowledge of the parties involved. For example, if the developer was abetter negotiator, then the sales price would tend to be close to the minimum $450,000level.

With different constraints, it might be impossible to reach an agreement. For example, ifthe owner was only willing to sell at a price of $550,000 while the developer remainswilling to pay only $500,000, then there would be no possibility for an agreement betweenthe two parties. Of course, the two parties typically do not know at the beginning ofnegotiations if agreements will be possible. But it is quite important for each party to thenegotiation to have a sense of their own reservation price, such as the owner's minimumselling price or the buyer's maximum purchase price in the above example. This reservationprice is equal to the value of the best alternative to a negotiated agreement.

Poor negotiating strategies adopted by one or the other party may also preclude anagreement even with the existence of a feasible agreement range. For example, one party

may be so demanding that the other party simply breaks off negotiations. In effect,negotiations are not a well behaved solution methodology for the resolution of disputes.

The possibility of negotiating failures in the land sale example highlights the importance ofnegotiating style and strategy with respect to revealing information. Style includes theextent to which negotiators are willing to seem reasonable, the type of arguments chosen,the forcefulness of language used, etc. Clearly, different negotiating styles can be more orless effective. Cultural factors are also extremely important. American and Japanesenegotiating styles differ considerably, for example. Revealing information is also anegotiating decision. In the land sale case, some negotiators would readily reveal theirreserve or constraint prices, whereas others would conceal as much information as possible(i.e. "play their cards close to the vest") or provide misleading information.

In light of these tactical problems, it is often beneficial to all parties to adopt objectivestandards in determining appropriate contract provisions. These standards would prescribea particular agreement or a method to arrive at appropriate values in a negotiation.Objective standards can be derived from numerous sources, including market values,precedent, professional standards, what a court would decide, etc. By using objectivecriteria of this sort, personalities and disruptive negotiating tactics do not becomeimpediments to reaching mutually beneficial agreements.

With additional issues, negotiations become more complex both in procedure and in result.With respect to procedure, the sequence in which issues are defined or considered can bevery important. For example, negotiations may proceed on an issue-by-issue basis, and theoutcome may depend upon the exact sequence of issues considered. Alternatively, theparties may proceed by proposing complete agreement packages and then proceed tocompare packages. With respect to outcomes, the possibility of the parties having differentvaluations or weights on particular issues arises. In this circumstance, it is possible to trade-off the outcomes on different issues to the benefit of both parties. By yielding on an issueof low value to himself but high value to the other party, concessions on other issues maybe obtained.


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The notion of Pareto optimal agreements can be introduced to identify negotiatedagreements in which no change in the agreement can simultaneously make both partiesbetter off. Figure 8-1 illustrates Pareto optimal agreements which can be helpful inassessing the result of multiple issue negotiations. In this figure, the axes represent thesatisfaction or desirability of agreements to the parties, denoted I and II. This

representation assumes that one can place a dollar or utility value on various agreementsreached in a multiple-issue negotiation between two parties. Points in the graph representparticular agreements on the different issues under consideration. A particular point may beobtained by more than one contract agreement. The curved line encloses the set of allfeasible agreements; any point in this area is an acceptable agreement. Each party has aminimum acceptable satisfaction level in this graph. Points on the interior of this feasiblearea represent inferioragreements since some other agreement is possible that benefits bothparties. For example, point B represents a more desirable agreement than point A. In theprevious example, point B might represent a purchase price of $490,000 and an immediatepurchase, whereas point A might represent a $475,000 sale price and a six month delay.The feasible points that are not inferior constitute the set of Pareto optimal or efficientagreements; these points lie on the north-east quadrant of the feasible region as marked on

the figure.

Figure 8-1 Illustration of a Pareto Optimal Agreement Set


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The definition of Pareto optimal agreements allows one to assess at least one aspect ofnegotiated outcomes. If two parties arrive at an inferior agreement (such as point A inFigure 8-1), then the agreement could be improved to the benefit of both parties. Incontrast, different Pareto optimal agreements (such as points B and C in Figure 8-1) canrepresent widely different results to the individual parties but do not have the possibility for

joint improvement.

Of course, knowledge of the concept of Pareto optimal agreements does not automaticallygive any guidance on what might constitute the best agreements. Much of the skill incontract negotiation comes from the ability to invent new options that represent mutualgains. For example, devising contract incentives for speedier completion of projects mayresult in benefits to both contractors and the owner.

Example 8-7: Effects of different value perceptions.

Suppose that the closing date for sale of the land in the previous case must also be decidedin negotiation. The current owner would like to delay the sale for six months, which would

represent rental savings of $10,000. However, the developer estimates that the cost of a sixmonth delay would be $20,000. After negotiation, suppose that a purchase price of$475,000 and a six month purchase delay are agreed upon. This agreement is acceptablebut not optimal for both parties. In particular, both sides would be better off if the purchaseprice was increased by $15,000 and immediate closing instituted. The current owner wouldreceive an additional payment of $15,000, incur a cost of $10,000, and have a net gain of$5,000. Similarly, the developer would pay $15,000 more for the land but save $20,000 indelay costs. While this superior result may seem obvious and easily achievable,recognizing such opportunities during a negotiation becomes increasingly difficult as thenumber and complexity of issues increases.Back to top

8.8 Negotiation Simulation: An Example

This construction negotiation game simulates a contract negotiation between a utility,"CMG Gas" and a design/construct firm, "Pipeline Constructors, Inc." [4] The negotiationinvolves only two parties but multiple issues. Participants in the game are assigned torepresent one party or the other and to negotiate with a designated partner. In a classsetting, numerous negotiating partners are created. The following overview from the CMGGas participants' instructions describes the setting for the game:

CMG Gas has the opportunity to provide natural gas to an automobile factory underconstruction. Service will require a new sixteen mile pipeline through farms and light

forest. The terrain is hilly with moderate slopes, and equipment access is relatively good.The pipeline is to be buried three feet deep. Construction of the pipeline itself will becontracted to a qualified design/construction firm, while required compression stations andancillary work will be done by CMG Gas. As project manager for CMG Gas, you are aboutto enter negotiations with a local contractor, "Pipeline Constructors, Inc." This firm is theonly local contractor qualified to handle such a large project. If a suitable contractagreement cannot be reached, then you will have to break off negotiations soon and turn toanother company.


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The Pipeline Constructors, Inc. instructions offers a similar overview.

To focus the negotiations, the issues to be decided in the contract are already defined:

DurationThe final contract must specify a required completion date.

Penalty for Late CompletionThe final contract may include a daily penalty for late project completion on thepart of the contractor.

Bonus for Early CompletionThe final contract may include a daily bonus for early project completion.

Report FormatContractor progress reports will either conform to the traditional CMG Gas formator to a new format proposed by the state.

Frequency of Progress ReportsProgress reports can be required daily, weekly, bi-weekly or monthly.

Conform to Pending Legislation Regarding Pipeline MarkingState legislation is pending to require special markings and drawings for pipelines.The parties have to decide whether to conform to this pending legislation.

Contract TypeThe construction contract may be a flat fee, a cost plus a percentage profit, or aguaranteed maximum with cost plus a percentage profit below the maximum.

Amount of Flat FeeIf the contract is a flat fee, the dollar amount must be specified.

Percentage of ProfitIf the contract involves a percentage profit, then the percentage must be agreedupon.

CMG Gas Clerk on SiteThe contract may specify that a CMG Gas Clerk may be on site and have access to

all accounts or that only progress reports are made by Pipeline Constructors, Inc. Penalty for Late Starting Date

CMG Gas is responsible for obtaining right-of-way agreements for the newpipeline. The parties may agree to a daily penalty if CMG Gas cannot obtain theseagreements.

A final contract requires an agreement on each of these issues, represented on a formsigned by both negotiators.

As a further aid, each participant is provided with additional information and a scoringsystem to indicate the relative desirability of different contract agreements. Additionalinformation includes items such as estimated construction cost and expected duration aswell as company policies such as desired reporting formats or work arrangements. Thisinformation may be revealed or withheld from the other party depending upon anindividual's negotiating strategy. The numerical scoring system includes point totals fordifferent agreements on specific issues, including interactions among the various issues.For example, the amount of points received by Pipeline Constructors, Inc. for a bonus forearly completion increases as the completion date become later. An earlier completion


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becomes more likely with a later completion date, and hence the probability of receiving abonus increases, so the resulting point total likewise increases.

The two firms have differing perceptions of the desirability of different agreements. Insome cases, their views will be directly conflicting. For example, increases in a flat fee

imply greater profits for Pipeline Constructors, Inc. and greater costs for CMG Gas. Insome cases, one party may feel strongly about a particular issue, whereas the other is notparticularly concerned. For example, CMG Gas may want a clerk on site, while PipelineConstructors, Inc. may not care. As described in the previous section, these differences inthe evaluation of an issue provide opportunities for negotiators. By conceding anunimportant issue to the other party, a negotiator may trade for progress on an issue that ismore important to his or her firm. Examples of instructions to the negotiators appear below.

Instructions to the Pipelines Constructors, Inc. Representative

After examining the project site, your company's estimators are convinced that the projectcan be completed in thirty-six weeks. In bargaining for the duration, keep two things in

mind; the longer past thirty-six weeks the contract duration is, the more money that can bemade off the "bonuses for being early" and the chances of being late are reduced. Thatreduces the risk of paying a "penalty for lateness".

Throughout the project the gas company will want progress reports. These reports take timeto compile and therefore the fewer you need to submit, the better. In addition, State lawdictates that the Required Standard Report be used unless the contractor and the owneragree otherwise. These standard reports are even more time consuming to produce thanmore traditional reports.

The State Legislature is considering a law that requires accurate drawings and markers ofall pipelines by all utilities. You would prefer not to conform to this uncertain set ofrequirements, but this is negotiable.

What type of contract and the amount your company will be paid are two of the mostimportant issues in negotiations. In the Flat Fee contract, your company will receive anagreed amount from CMG Gas. Therefore, when there are any delay or cost overruns, itwill be the full responsibility of your company. with this type of contract, your companyassumes all the risk and will in turn want a higher price. Your estimators believe a cost andcontingency amount of 4,500,000 dollars. You would like a higher fee, of course.

With the Cost Plus Contract, the risk is shared by the gas company and your company.With this type of contract, your company will bill CMG Gas for all of its costs, plus a

specified percentage of those costs. In this case, cost overruns will be paid by the gascompany. Not only does the percentage above cost have to be decided upon but alsowhether or not your company will allow a Field Clerk from the gas company to be at the

job site to monitor reported costs. Whether or not he is around is of no concern to yourcompany since its policy is not to inflate costs. this point can be used as a bargainingweapon.


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Finally, your company is worried whether the gas company will obtain the land rights tolay the pipe. Therefore, you should demand a penalty for the potential delay of the projectstarting date.

Instructions to the CMG Gas Company Representative

In order to satisfy the auto manufacturer, the pipeline must be completed in forty weeks.An earlier completion date will not result in receiving revenue any earlier. Thus, the onlyreason to bargain for shorter duration is to feel safer about having the project done on time.If the project does exceed the forty week maximum, a penalty will have to be paid to theauto manufacturer. Consequently, if the project exceeds the agreed upon duration, thecontractor should pay you a penalty. The penalty for late completion might be related to theproject duration. For example, if the duration is agreed to be thirty-six weeks, then thepenalty for being late need not be so severe. Also, it is normal that the contractor get abonus for early completion. Of course, completion before forty weeks doesn't yield anybenefit other than your own peace of mind. Try to keep the early bonus as low as possible.

Throughout the project you will want progress reports. The more often these reports arereceived, the better to monitor the progress. State law dictates that the Required StandardReport be used unless the contractor and the owner agree otherwise. These reports are verydetailed and time consuming to review. You would prefer to use the traditional CMG Gasreports.

The state legislature is considering a law that requires accurate drawings and markers of allpipelines by all utilities. For this project it will cost an additional $250,000 to do this now,or $750,000 to do this when the law is passed.

One of the most important issues is the type of contract, and the amount of be paid. TheFlat Fee contract means that CMG Gas will pay the contractor a set amount. Therefore,when there are delays and cost overruns, the contractor assumes full responsibility for theindividual costs. However, this evasion of risk has to be paid for and results in a higherprice. If Flat Fee is chosen, only the contract price is to be determined. Your company'sestimators have determined that the project should cost about $5,000,000.

The Cost Plus Percent contract may be cheaper, but the risk is shared. With this type ofcontract, the contractor will bill the gas company for all costs, plus a specified percentageof those costs. In this case, cost overruns will be paid by the gas company. If this type ofcontract is chosen, not only must the profit percentage be chosen, but also whether or not agas company representative will be allowed on site all of the time acting as a Field Clerk,to ensure that a proper amount of material and labor is billed. The usual percentage agreed

upon is about ten percent.

Contractors also have a concern whether or not they will receive a penalty if the gas right-of-way is not obtained in time to start the project. In this case, CMG Gas has alreadysecured the right-of-ways. But, if the penalty is too high, this is a dangerous precedent forfuture negotiations. However, you might try to use this as a bargaining tool.

Example 8-8: An example of a negotiated contract


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A typical contract resulting from a simulation of the negotiation between CMG Gas andPipeline Constructors, Inc. appears in Table 8-6. An agreement with respect to each pre-defined issue is included, and the resulting contract signed by both negotiators.

TABLE 8-6 Example of a Negotiated Contract between CMG Gas andPipeline Constructors, Inc

Duration 38 weeks

Penalty for Late Completion $6,800 per day

Bonus for Early Completion $0 per day

Report Format traditional CMG form

Frequency of Progress Reports weekly

Conform to Pending Pipeline MarkingLegislation

yes

Contract Type flat fee

Amount of Flat Fee $5,050,000

Percentage of Profit Not applicableCMG Gas Clerk on Site yes

Penalty for Late Starting Date $3,000 per day

Signed:

CMG Gas Representative

Pipeline Constructors, Inc.

Example 8-9: Scoring systems for the negotiated contract games

To measure the performance of the negotiators in the previous example, a scoring system isneeded for the representative of Pipeline Constructors, Inc. and another scoring system forthe representative of CMG Gas. These scoring systems for the companies associated withthe issues described in Example 8-7 are designated as system A.

In order to make the negotiating game viable for classroom use, another set of instructionsfor each company is described in this example, and the associated scoring systems for thetwo companies are designated as System B. In each game play, the instructor may choose adifferent combination of instructions and negotiating teams, leading to four possiblecombinations of scoring systems for Pipeline Constructors, Inc. and CMG Gas. [5]

Instruction To The Pipeline Constructors, Inc. Representative

In order to help you, your boss has left you with a scoring table for all the issues andalternatives. Two different scoring systems are listed here; you will be assigned to use oneor the other. Instructions for scoring system A are included in Section 8.9. The instructionsfor scoring system B are as follows:


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After examining the site, your estimator believes that the project will require 38 weeks.You are happy to conform with any reporting or pipeline marking system, since yourcomputer based project control and design systems can easily produce these submissions.You would prefer to delay the start of the contract as long as possible, since your forces arebusy on another job; hence, you do not want to impose a penalty for late start. Try to

maximize the amount of points, as they reflect profit brought into your company, or a costsavings. In Parts 3 and 4, be sure to use the project duration agreed upon to calculate yourscore. Finally, do not discuss your scoring system with the CMG Gas representative; this isproprietary information!

SCORING FOR PIPELINE CONSTRUCTORS, INC.

NOTE: NA means not acceptable and the deal will not be approved by your boss with anyof these provisions. also, the alternatives listed are the only ones in the context of thisproblem; no other alternatives are acceptable.

1. COMPLETION DATE

System A System B

Under 36 Weeks36 weeks37 weeks38 weeks39 weeks40 weeks

NA0

+5+10+20+40

NANA-100

+10+20

2. REPORTS

State Standard ReportCMG Reports

-20-5

00

3. PENALTY FOR LATENESS ($ PER DAY)

DURATION (WEEKS)

Scoring System A

Scoring System B36

3737

3838

3939

4040

41

0 - 9991,000 - 1,9992,000 - 2,9993,000 - 3,9994,000 - 4,999

5,000 - 5,9996,000 - 6,9997,000 - 7,999

Over 8,000

-1-2-4-6-8

-11-14-18NA

-1-2-3-5-7

-9-12-14NA

-1-2-3-4-5

-7-9

-11NA

0-1-2-3-4

-5-6-7

NA

00-1-1-2

-2-3-3

NA

4. BONUS FOR BEING EARLY ($ PER DAY)

Scoring System A 36 37 38 39 40


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Scoring System B 37 38 39 40 41

0 - 9991,000 - 1,9992,000 - 2,9993,000 - 3,999

4,000 - 4,9995,000 - 5,9996,000 - 6,9997,000 - 7,9998,000 - 8,9999,000 - 9,999Over 10,000

0001

2345678

0024

68

1012141618

0246

8101418222630

0246

10141824283236

2248

12162228364045

5. CONFORM TO PENDING LEGISLATION (MARKING PIPELINES)

A B

Yes

No

+5

+15

+10

+10

6. HOW OFTEN FOR THE PROGRESS REPORTS

A B

DailyWeekly

Bi-weeklyMonthly

NA-20-10-6

0000

7. CONTRACT TYPE

A BFlat Fee

Cost + X%5

+255

+25

If Flat Fee do part 8 and skip parts 9 and 10.

If Cost + X% do parts 9 and 10 and skip part 8.

8. FLAT FEE ($)

A B

Below 4,500,000Over 4,500,000

NA+1 for each

10,000

-15 for each10,000

+2 for each 10,000

9. IF COST PLUS X%

A B

Below 6%6%7%

NA+250+375

NANA

+300


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8%9%

10%11%12%

13%14%

Over 14%

+450+475+500+525+550

+600+725+900

+330+360+400+440+480

+540+600+800

10. GAS CO. FIELD CLERK ON SITE

A B

YesNo

00

0+10

11. PENALTY FOR DELAYED STARTING DATE DUE TO GAS COMPANY ERROR($ PER DAY)

A B

0 - 499500 - 1499

1500 - 24991500 - 34993500 - 44994500 - 54995500 - 64996500 - 7499

7500 or more

NA-6-4-2-10

+1+2+4

NA-10-7-5-3-10

+3+6

Instructions to the CMG Gas Company Representative

In order to help you, your boss has left you with a scoring table for all the issues andalternatives. Two different scoring systems are listed here; you will be assigned to use oneor the other. Instructions for scoring system A are included in Section 8.9. The instructionsfor scoring system B are described as follows:

Your contract with the automobile company provides an incentive for completion of thepipeline earlier than 38 weeks and a penalty for completion after 38 weeks. To insuretimely completion of the project, you would like to receive detailed project reports as often

as possible.

Try to maximize the number of points from the final contract provisions; this correspondsto minimizing costs. Do not discuss your scoring systems with Pipeline Constructors, Inc.

SCORING SYSTEM FOR CMG GAS


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NOTE: NA means not acceptable and the deal will not be approved by your boss with anyof these provisions. If you can't negotiate a contract, your score will be +450. Also, thealternatives listed are the only ones in the context of this problem no other alternatives areacceptable.

1. DURATION POINTS

System A System B

Over 40 weeks40 weeks39 weeks38 weeks37 weeks

0-36 weeks

NA0

+2+4+5+6

-40-10+2+8

+14+14

2. REPORTS A B

Required StandardReport

"Traditional" CMG GasReports

+2+10

00

3. PENALTY FOR LATENESS ($ PER DAY)

DURATION (WEEKS)

Scoring System A

Scoring System B36

3837

3938

4039

4140

42

0 - 999

1,000 - 1,9992,000 - 2,9993,000 - 3,9994,000 - 4,9995,000 - 5,9996,000 - 6,9997,000 - 7,9998,000 - 8,9999,000 - 9,999

10,000 or more

NA

9101112131415161718

NA

791011121315151616

NA

689

10111213141515

NA

35678911121313

NA

02456789

1011

4. BONUS FOR BEING EARLY ($ PER DAY)

A B

8000 or more7000 - 79996000 - 69995000 - 59994000 - 49993000 - 3999

NA+3+6+8+10+12

-5-2-10

+5+7


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2000 - 29991000 - 1999

0 - 999

+13+14+15

+9+13+17

5. CONFORM TO PENDING LEGISLATION (MARKING PIPELINES)

A B

YesNo

+25-25

0NA

6. HOW OFTEN FOR THE PROGRESS REPORTS

A B

DailyWeekly

Bi-weeklyMonthly

+45+50+30NA

+50+30+10+5

7. CONTRACT TYPE

A B

Flat FeeCost + X%

250

250

If Flat Fee do part 8 and skip parts 9 and 10.

If Cost + X% do parts 9 and 10 and skip part 8.

8. FLAT FEE ($)

A B

Over 5,000,0000 - 5,000,000

NA+1 for each

10,000below

5,000,000

NA+1 for each

10,000below

5,000,000

9. IF COST PLUS X%

A B

Below 5%5%6%

7%8%9%

10%11%12%13%14%

+950+800+700

+600+550+525+500+475+450+400+300

+700+660+620

+590+570+550+535+500+440+380+300


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15%Over 14%

+200NA

+100+10

10. GAS CO. FIELD CLERK ON SITE

A B

YesNo

+20+5

+100

11. PENALTY FOR DELAYED STARTING DATE DUE TO UNAVAILABLE RIGHT-OF-WAYS ($ PER DAY)

A B

0 - 1,9992,000 - 3,9994,000 - 5,9996,000 - 7,999

8,000 - 9,99910,000 or more

+10+8+6+4

+2NA

+3+2+10

-10-20

Back to top

8.9 Resolution of Contract Disputes

Once a contract is reached, a variety of problems may emerge during the course of work.Disputes may arise over quality of work, over responsibility for delays, over appropriatepayments due to changed conditions, or a multitude of other considerations. Resolution of

contract disputes is an important task for project managers. The mechanism for contractdispute resolution can be specified in the original contract or, less desireably, decided whena dispute arises.

The most prominent mechanism for dispute resolution is adjudication in a court of law.This process tends to be expensive and time consuming since it involves legalrepresentation and waiting in queues of cases for available court times. Any party to acontract can bring a suit. In adjudication, the dispute is decided by a neutral, third partywith no necessary specialized expertise in the disputed subject. After all, it is not aprerequisite for judges to be familiar with construction procedures! Legal procedures arehighly structured with rigid, formal rules for presentations and fact finding. On the positiveside, legal adjudication strives for consistency and predictability of results. The results of

previous cases are published and can be used as precedents for resolution of new disputes.

Negotiation among the contract parties is a second important dispute resolutionmechanism. These negotiations can involve the same sorts of concerns and issues as withthe original contracts. Negotiation typically does not involve third parties such as judges.The negotiation process is usually informal, unstructured and relatively inexpensive. If anagreement is not reached between the parties, then adjudication is a possible remedy.


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A third dispute resolution mechanism is the resort to arbitration or mediation andconciliation. In these procedures, a third party serves a central role in the resolution. Theseoutside parties are usually chosen by mutually agreement of the parties involved and willhave specialized knowledge of the dispute subject. In arbitration, the third party may makea decision which is binding on the participants. In mediation and conciliation, the third

party serves only as a facilitator to help the participants reach a mutually acceptableresolution. Like negotiation, these procedures can be informal and unstructured.

Finally, the high cost of adjudication has inspired a series of non-traditional disputeresolution mechanisms that have some of the characteristics of judicial proceedings. Thesemechanisms include:

Private judging in which the participants hire a third party judge to make adecision,

Neutral expert fact-finding in which a third party with specialized knowledgemakes a recommendation, and

Mini-trial in which legal summaries of the participants' positions are presented to ajury comprised of principals of the affected parties.

Some of these procedures may be court sponsored or required for particular types ofdisputes.

While these various disputes resolution mechanisms involve varying costs, it is importantto note that the most important mechanism for reducing costs and problems in disputeresolution is the reasonableness of the initial contract among the parties as well as thecompetence of the project manager.

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8.10 References

1. Au, T., R.L. Bostleman and E.W. Parti, "Construction Management Game-Deterministic Model,"Asce Journal of the Construction Division, Vol. 95, 1969,pp. 25-38.

2. Building Research Advisory Board,Exploratory Study on Responsibility, Liabilityand Accountability for Risks in Construction, National Academy of Sciences,Washington, D.C., 1978.

3. Construction Industry Cost Effectiveness Project, "Contractual Arrangements,"Report A-7, The Business Roundtable, New York, October 1982.

4. Dudziak, W. and C. Hendrickson, "A Negotiating Simulation Game,"ASCEJournal of Management in Engineering, Vol. 4, No. 2, 1988.

5. Graham, P.H., "Owner Management of Risk in Construction Contracts," CurrentPractice in Cost Estimating and Cost Control, Proceedings of an ASCEConference, Austin, Texas, April 1983, pp. 207-215.

6. Green, E.D., "Getting Out of Court -- Private Resolution of Civil Disputes,"BostonBar Journal, May-June 1986, pp. 11-20.

7. Park, William R., The Strategy of Contracting for Profit, 2nd Edition, Prentice-Hall, Englewood Cliffs, NJ, 1986.


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8. Raiffa, Howard, The Art and Science of Negotiation, Harvard University Press,Cambridge, MA, 1982.

9. Walker, N., E.N. Walker and T.K. Rohdenburg,Legal Pitfalls in Architecture,Engineering and Building Construction, 2nd Edition, McGraw-Hill Book Co., NewYork, 1979.

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8.11 Problems

1. Suppose that in Example 8-5, the terms for the guaranteed maximum cost contractare such that change orders will not be compensated if their total cost is within 3%of the original estimate, but will be compensated in full for the amount beyond 3%of the original estimate. If all other conditions remain unchanged, determine thecontractor's profit and the owner's actual payment under this contract for thefollowing conditions of U and C:

1. U = 0,2. U = 4%E,3. U = - 4%E,

C = 6%EC = 6%EC = 6%E

2. Suppose that in Example 8-5, the terms of the target estimate contract call for N =0.3 instead of N = 0.5, meaning that the contractor will receive 30% of the savings.If all other conditions remain unchanged, determine the contractor's profit and theowner's actual payment under this contract for the given conditions of U and C.

3. Suppose that in Example 8-5, the terms of the cost plus variable percentage contractallow an incentive bonus for early completion and a penalty for late completion ofthe project. Let D be the number of days early, with negative value denoting D dayslate. The bonus per days early or the penalty per day late with be T dollars. Theagreed formula for owner's payment is:

P = R(2E - A + C) + A + C + DT(1 + 0.4C/E)

The value of T is set at $5,000 per day, and the project is completed 30 days behindschedule. If all other conditions remain unchanged, find the contractor's profit andthe owner's actual payment under this contract for the given conditions of U and C.

4. Consider a construction project for which the contractor's estimate is $3,000,000.For various types of contracts, R = 10%, R1 = 3%, R2 = 1.5%, R3 = 6% and N = 0.6.The contractor is not compensated for change orders under the guaranteedmaximum cost contract if the total cost for the change order is within 5%($150,000) of the original estimate. Determine the contractor's gross profit for eachof the seven types of construction contracts for each of the following conditions ofU and C:


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1. U = 0,2. U = 0,3. U = 5% E = $150,000,4. U = 5% E = $150,000,5. U = 2% E = $60,000,6. U = 2% E = $60,000,

C = 0C = 4% E = $120,000C = 0C = 4% E = 120,000C = 0

C = 4% E = 120,000

5. Using the data in Problem 4, determine the owner's actual payment for each of theseven types of construction contracts for the same conditions of U and C.

6. Suppose that in Problem 4, the terms of the guaranteed maximum cost contract aresuch that change orders will not be compensated if their total cost is within 3% ofthe original estimate, but will be compensated in full for the amount beyond 3% ofthe original estimate. If all conditions remained unchanged, determine thecontractor's profit and the owner's actual payment under this contract for thefollowing conditions of U and C:

1. U = 0,2. U = 2%,3. U = -2%,

C = 5%EC = 5%EC = 5%E

7. Suppose that in Problem 4, the terms of the target estimate contract call for N = 0.7instead of N = 0.3, meaning that the contractor will receive 70% of the savings. Ifall other conditions remain unchanged, determine the contractor's profit and theowner's actual payment under this contract for the given conditions of U and C.

8.

Suppose that in Problem 4, the terms of the cost plus variable percentage contractallow an incentive bonus for early completion and a penalty for late completion ofthe project. Let D be the number of days early, with negative value denoting D dayslate. The bonus per days early or the penalty per day late will be T dollars. Theagreed formula for owner's payment is:

P = R(2E - A + C) + A + C + DT(1 + 0.2C/E)

The value of T is set at $ 10,000 per day, and the project is completed 20 daysahead schedule. If all other conditions remain unchanged, find the contractor'sprofit and the owner's actual payment under this contract for the given conditions ofU and C.

9. In playing the construction negotiating game described in Section 8.8, yourinstructor may choose one of the following combinations of companies and issuesleading to different combinations of the scoring systems:

Pipeline Constructors Inc. CMG Gas

a. System A System A


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b.

c.

d.

System ASystem BSystem B

System BSystem ASystem B

10.Since the scoring systems are confidential information, your instructor will notdisclose the combination used for the assignment. Your instructor may divide theclass into groups of two students, each group acting as negotiators representing thetwo companies in the game. To keep the game interesting and fair, do not try to findout the scoring system of your negotiating counterpart. To seek insider informationis unethical and illegal!

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8.12 Footnotes

1. These examples are taken directly from A Construction Industry Cost Effectiveness

Project Report, "Contractual Arrangements," The Business Roundtable, New York,Appendix D, 1982. Permission to quote this material from the Business Roundtable isgratefully acknowledged. Back

2. See C.D. Sutliff and J.G. Zack, Jr. "Contract Provisions that Ensure Complete CostDisclosures", Cost Engineering, Vol. 29, No. 10, October 1987, pp. 10-14. Back

3. Arkansas Rice Growers v. Alchemy Industries, Inc., United States Court of Appeals,Eighth Circuit, 1986. The court decision appears in 797 Federal Reporter, 2d Series, pp.565-574. Back

4. This game is further described in W. Dudziak and C. Hendrickson, "A Negotiation

Simulation Game,"ASCE Journal of Management in Engineering, Vol. 4, No. 2, 1988.Back

5. To undertake this exercise, the instructor needs to divide students into negotiating teams,with each individual assigned scoring system A or B. Negotiators will represent PipelineConstructors, Inc. or CMG Gas. Negotiating pairs should not be told which scoring systemtheir counterpart is assigned. Back

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