Have you ever wondered how a cost is agreed between a client and contractor before a construction project begins? Or how the basis of this cost is put together and what any changes to the scope would mean to this agreed cost? Despite being a relatively straightforward concept to understand, parties on construction contracts can often encounter several problems when it comes to working together for the agreed contract sum. To try and prevent such disputes occurring, different types of contracts can be used in which the total cost can either be agreed up front or measured and valued as the project develops on a reimbursement type basis.
Lump Sum Contracts – What do they mean?
Lump sum contracts are contracts where the contract sum is known before work starts on site and the contractor agrees to undertake a defined amount of work for a specific amount. This type of contract is often based on a firm bill(s) of quantities and drawings but can also be common on Design and Build Contracts. Alternatives to lump sum contracts include Measurement Contracts and Cost Reimbursement Contracts.
The key difference between a lump sum contract and the latter types mentioned above is that a lump sum contract is essentially based on a fixed price. A fixed price contract means the client and contractor agree to a set price for a clearly defined scope of works at the onset of a project whereas measurement and cost reimbursement contracts contain mechanisms for the price to be adjusted to reflect the actual time, labour and materials costs incurred by the contractor.
The main benefit of a lump sum agreement to a client is that they can achieve cost certainty when entering the post contract phase of a project. This can be quite an important factor for developers when deciding on the type of procurement route they are going to choose when commencing with a development. Upfront, knowing how much a project is going to cost in total makes it more straightforward for developers when obtaining funding and can make managing the project finances less onerous. However, construction is a risky business and there can be a whole range of factors that can have an impact on a project from a commercial standpoint.
The Matter of Variations
One common issue often centres around potential changes to the project. Construction projects by nature are subject to a wide range of influences and there is nothing abnormal with regular changes to the scope, design, and even the definition of the project. For example, ground conditions or non-availability of specified materials can lead to discussions about how the actual works required bears little to no resemblance to the agreed contractual scope. Such alterations to the scope are commonly known as variations to the contract. Broadly speaking, variations are agreements in which consideration is exchanged to alter the scope of works, whether it be the design, the quantities, or the programme.
The ability to alter the works on a lump sum contract is essential, thus making variations an incredibly important mechanism. The client may want to make a change due to an enquiry from a prospective tenant or a third party stakeholder. Another reason may relate to an error in the pre contact documentation in which their Quantity Surveyor has mistakenly not included an allowance for an item that forms part of the scope of works. Scenarios like this are common on construction projects, especially on lump sum contracts, hence the need for a contractual mechanism to vary the scope of the works.
Whilst, the client can achieve cost certainty when entering the contract, there is added emphasis on ensuring that the budget has been properly calculated and that any allowances for provisional sums, where the design is lacking sufficient detail, are robust enough to handle any obstacles the project will inevitably face.
Therefore, Risk Management is an extremely important factor when producing budgets for projects that are based on a lump sum contract. To mitigate any potential financial pressures, the PQS will normally include a project contingency that forms part of the project budget. However, whether it will be included in the overall contract sum agreed with the successful contractor is left at the client’s discretion. This ‘pot’ of money is normally exclusive from the agreed contract sum.
As part of a contractor’s tender offer, the lump sum contract will usually be broken down into several packages, either in line with a Bill of Quantities or in the form of a contract sum analysis. In either case, one of these packages will be a dedicated preliminaries section. Preliminaries form part of the tender documents and provide a description of the project, enabling the contractor to assess the costs required to start the works. Specific preliminaries costs may relate to items such as site set up costs, welfare facilities, and traffic management measures as well as plant and machinery.
The ‘prelims’ costs form part of the Contractors mobilisation package, which essentially refers to the activity required between winning the tender and getting the project up and running on site. Such mobilisation activities can cover items like the preparation of method statements, organising geotechnical surveys, and publishing a master programme for the client’s approval.
Carrying out these activities requires extensive planning and can represent a significant capital outlay of which the contractor may be able to get paid for up front via a pre-arranged mobilisation fee (not separate from the lump sum contract) with the client. Alternatively, they can include these costs within their first interim application for payment.
If we take the latter instance for example, when making their initial application for payment, a Contractor will include an assessment of the actual costs it has incurred in terms of the mobilisation works it has done to get the project off the ground. This is something that the client must pay as these ‘enabling works’ costs form part of the overall lump sum value and payment is necessary to get the project moving forward. It will usually be the responsibility of the Client’s PQS to value the amount of monies due to the contractor on a fair and reasonable basis for any works undertaken related to mobilisation if a pre-established fee has not been agreed.
What if the Contractor needs money up front for non-mobilisation related matters?
Claiming costs that are not recognised as part of the mobilisation package can lead to issues around the need for advance payments on lump sum contracts. This is very important as contractors can be left substantially exposed from a commercial perspective if certain measures are not incorporated into the contract documents they are a party to.
Using an example, let us assume that a Client’s Architect has specified a rare type of stone cladding that will be installed to the façade of a building. There are only a small number of suppliers of this material, therefore cladding contractors request that 50% payment is made up front as these are the terms stipulated by the suppliers. This can be problematic for a main contractor as the onus may be on them to pay their subcontractor 50% for procuring the cladding before a single panel has been delivered to site, let alone installed.
A Client may not feel obligated to pay anything for this as they may not interpret it as a mobilisation expense and contractually they probably will not need to either. However, this can change if there is a clause expressly inserted into the contract designed to protect the main contractor’s cashflow. Such clauses are known as advance payment bonds. These bonds are mechanisms in which the above scenario can be avoided, as the employer agrees to pay the contractor the total or a pre-agreed amount up front for a specific element i.e. stone cladding material.
Advance payments can be essential for safeguarding a contractor’s financial status on a project and the use of bonds enforces an obligation on the employer to pay the contractor any monies they have had to outlay to source a specific requirement within the scope of works. They differ from mobilisation related payments as they typically involve the procurement of products or services that do not fall into the enabling works category in terms of the overall project scope. Therefore, the argument of needing payment to get the project off the ground cannot be used for something like the procurement of cladding material.
The Post Contract Phase
There are several issues that the client and their PQS need to consider when assessing monies due to a contractor on lump sum contracts. The PQS bears significant responsibility in managing the post contract phase of the project when it comes to valuing the contractor’s applications for payment, as well as any variations included within these applications. The PQS must establish a baseline that is fair and reasonable, meaning they are safeguarding their client’s commercial interest whilst concurrently not inflicting unnecessary pressure on a contractor’s cashflow.
As discussed above, the contractor will submit interim applications claiming what they believe they are due for works completed thus far. Depending on where the project is based, items such as materials on site may also be included in this application. The location is important; in Scotland under the SBC the contractor is unable to claim materials on site unless expressly agreed under a separate purchase agreement. The contract will also dictate a timeline in which the PQS must assess this application and provide an interim payment certificate, normally 5 days after the application due date. To do this, a PQS will normally visit site and conduct a physical valuation of the works to assess what they believe the contractor is fair and reasonably due.
The PQS may need to take a view on monies included within the application for variations that have yet to be agreed in terms of final agreed costs. To overcome potential risks around these items, a PQS may agree to making ‘on account’ payments that can be adjusted at a later date to ensure they are protecting their client whilst recognising that the contractor has to be reimbursed for the works undertaken as part of the variation, despite the final cost not being agreed.
The main purpose of a lump sum contract is to give the client certainty by fixing the price of the works, but the inevitable matter of variations, especially if they are substantial, can often be a contentious topic.
This potential problem was brought to light in a case Mascareignes v Chang Cheng 2016 (Privy Council Hearing in London). This case involved the use of JCT design and build contract for an office block in Mauritius. The client on this project drastically changed the scope of works, and in preparing the final account, the Contractors QS’s valued the bulk of the contract components by measurement and value, after deducting the original prices, whilst leaving the preliminaries and other mobilisation costs unchanged. The client MSC in their appeal argued that this approach was not consistent with a lump sum contract.
However, when considering the radical variations imposed by themselves on the project, the Privy Council had a different view. The Arbitrator was of the opinion that this approach was acceptable as a lot of the items included in the final account constituted additional works that were not of a similar character as defined in the original scope, therefore referring to rates and prices in agreed contract bills was not applicable. The fact that the contract developed into a ‘measure and value’ contract was simply a consequence of the client’s actions.
MSC’s appeal was dismissed as the nature of the project changed in a way that the contractors approach to treat specific project elements on a measure and value basis was acceptable, as their decision to not alter the preliminaries was not inconsistent with that of a lump sum contract.
Lump sum contracts are incredibly popular in the UK construction industry, but there are still numerous parties who are unaware of the ramifications concerning their use and application. In principle, lump sums provide certainty and clarity for the employers, but they need to assess if such contracts are suitable based on their preferred approach to the project in question. If clients are looking for flexibility in the design, then lump sums are probably not going to be the most optimal option.
Image credit: iStock.com/HRAUN
About Chris Williams
Chris is a Chartered Surveyor with 6 years experience in the UK Construction industry, working for a range of clients, undertaking Quantity Surveying, Claims Management and Project Co-ordination roles.