INTRODUCTION TO EPC CONTRACTS Part 2
In this second part of our series on Introduction to Engineering and Construction (EPC) Contracts, I intend to further emphasize the need for all project key personnel to be thoroughly familiar with and understand the contract. I will illustrate this with an actual example.
Years ago, I worked with a western colleague, a construction superintendent. I will call him Mike. One day while trying to clarify an issue about the project we were executing, he brought out his own copy of the contract document. I noticed the whole thing was copiously marked up with highlighter and separated with section markers. It was strange to me that a construction superintendent would be so thorough. I am not even sure I had my own copy of the contract at that time.
Why did he do that? He needed to be clear about what the client wanted done; what was included and what wasn’t.
I have also worked with a contractor who did not understand the contract.
In one case, the contract scope of work (SOW) included fabrication and installation of a significant amount of oil and gas piping. But while the contract specified radiography of all the welded pipe joints the contractor priced for only 10%!
Radiography is a major cost item in piping fabrication and installation. They only discovered the blunder when fabrication work started. That misunderstanding, and subsequent underpricing of the contract made him the lowest bidder! But they paid a huge price for it. They went bankrupt shortly after. I wish they had opportunity to attend the EPC Contracts from Owner’s Perspective Course.
To underscore the importance of this point I will repeat something I said in the last post: a contract between a buyer and a seller must clearly describe what it is the seller must provide and how the buyer will pay for it. For this reason, the contractor and all key personnel involved in the contract must study and understand the contract.
That statement outlines two issues that are foundational to all contracts, and particularly to Engineering and Construction contracts, that the contractor cannot afford to be unclear about:
- What the seller must provide – the scope of work.
This describes all that the contractor is obligated to provide or deliver through the contract. The contractor is under obligation to provide whatever it includes. Anything outside it is not part of the contract.
- How the buyer will pay for it – the terms of payment
This does not only specify what the buyer would pay but how he will pay. It includes both the contract price and the terms of payment.
Thus, everyone responsible for any aspect of the scope of work needs to be clear about what that scope includes. This will eliminate unnecessary disputes. If the client or his representative requests to do something, the first thing is to determine that it is included in the scope of work. That is why Mike, the construction superintendent, had his own copy of the contract document handy.
If it is determined that the request is not part of the scope, then the change management process must be followed. Even if at the end of the day the contractor decides to do it for free, it should still be clearly documented because it could provide leverage during negotiation if the need arises.
For example, a client requested a contractor’s construction team to perform a significant amount of extra work – work outside the scope of the contract. It consumed a significant amount of materials and labor. The contractor did it for free but without involving their quantity surveyor. So, the client did not know how much the contractor spent in materials and labor. However, when the contractor missed the completion date and the client imposed the penalty (liquidated damages (LD)), they raised the issue. The client project team was aware of the free work but could not help because there was no documentation.
Understanding the second point, the terms of payment, is equally important because it affects project execution strategy. For example, if the contract specifies monthly progress payment, then you do not have to complete any milestone to get paid. Every piece of work done is carefully measured, aggregated and paid for at the end of the month.
However, if the contract specifies milestone payment, i.e., payment is due only at the completion of a milestone, then the contractor must focus on the completion of those milestones. Any uncompleted work does not qualify for payment.
Related to terms of payment and equally important in Engineering and Construction contracts is the invoice processing time. Most common invoice processing times are 45 and 60 days. In fact, contractors need to read very carefully all the ‘fine prints’ around invoicing and payment. It could mean the difference between heaven and hell for your cashflow.
Finally, there is a widespread practice among contractors: they treat the contract document as a secret or classified document. Consequently, only very few team members get to see it. This secrecy only hurts the contractor at the end of the day.
See you next week as we take this still a step further.
Meanwhile, go here to dig deeper.
