INTRODUCTION TO EPC CONTRACTS Part 1
In this series of essays on Introduction to Engineering, Procurement and Construction (EPC) Contracts, I intend to discuss the basics of Engineering and Construction contracts. I hope they will help you if you are new to project and construction management, and provide fresh insights to experienced project professionals.
If you are new to project management, then this is for you. If you have been part of a project team, or even consider yourself an experienced project professional, but without formal project management training, then this is for you too. If you are one of the proverbial Accidental Project Managers – those leading project teams but without formal project management training, then this is definitely for you.
I hope that this will serve well those who have been assigned to project teams without formal training either in project management or contract management, or even in any of the skills necessary for project delivery. They are expected to ‘pick up’ experience as they go, and at the same time get penalized for the mistakes they make as they learn!
Some of the topics I intend to discuss include Definition of contracts, Contracts as a risk management strategy, Types of contracts and why they are used and when, Contract types and inherent risks, among other topics.
Let us start by answering the question: “What exactly is a contract?” Well, the Project Management Institute (PMI) defines a contract as a mutually binding agreement that obligates the seller (contractor) to provide the specified product or service and obligates the buyer (client) to pay for it. Rita Mulcahy, author and project management expert, on the other hand, says that a contract refers to any legal agreement for the purchase or sale of goods and services. It may include purchase orders, service agreements, etc.
Thus, a contract between a buyer and a seller must clearly describe what the seller must provide and how the buyer will pay for it. That sounds quite simple and easy to understand, doesn’t it? Then how come that buyers and sellers often end up in court trying to resolve how the seller did not quite provide what the buyer wanted, when he wanted it; or how the buyer did not quite pay for the goods or services when and how he should have paid, according to the contract?
In fact, the problems involving buyers and sellers (contracts) have grown so much that an entire industry has developed around it. It therefore defies understanding how anyone would venture into contracts, either as a seller or buyer, without thoroughly educating himself in the subject.
I guess the problem is the fact that many do not understand that a contract is a risk management strategy. In fact, companies use contracts to transfer risks to another company. Perhaps, another company can do the work faster, has more efficient equipment, or has more experience, resulting in a less risky activity and lower cost or time.
Also, organizations use contract terms and conditions to adequately distribute risks between the buyer and the seller. In fact, Rita Mulcahy strongly enjoins that contracts should not be created without a risk analysis. That is to ensure that the party that is more capable takes responsibility for particular risks.
I will use car insurance to demonstrate the use of contracts as a risk management process. Most people who buy brand new cars take out a comprehensive insurance contract to provide full protection against loss. Thus, by paying a premium – a small fraction of the cost of the car, they transfer the risk of loss to the insurance company who is more capable of handling it.
However, as the car gets older, most car owners tend to purchase only Third-Party Insurance to cover the damage done to third parties while they take care of any damage to their old car. In this way they distribute the risk between themselves and the insurance company.
To further illustrate this, let us assume that an old Toyota Corolla has a head-on collision with a brand-new Lamborghini in which the Lamborghini is written off. Police investigation establishes that the Toyota Corolla driver was at fault and is required to replace the Lamborghini. He is in deep trouble, isn’t he? But the insurance company becomes responsible for all the losses of the third party while he only takes care of his Toyota! He has thus used an insurance contract to transfer the risk to the insurance company.
Imagine if the insurance company did not understand the magnitude of the risk they were assuming by that Third-Party insurance contract!
But EPC contractors do this frequently. Many do not take the pains to read the contract thoroughly and make sure that everyone else in their team understands it.
See you next week as we take this a step further.
Meanwhile, go here to dig deeper.
