INTRODUCTION TO EPC CONTRACTS Part 4
In Part 3 of this series, I stated that although there are many sources of project risks, the greatest of them, and one that has the greatest influence on contract type is project definition – how clearly the scope of work is defined. Thus, scope of work definition is a key element in the selection of appropriate contract type. Today I begin to discuss different contract types and when they are applicable.
As we have already stated, at the early stages of the project, such as options screening, concept development or feasibility study, when there is very minimal scope definition or details, uncertainties or risks are very high. Since the buyer is not able to define clearly what is required, he carries most of the risk, because sellers or contractors typically assign a price to any uncertainty.
But in the later stages of the project, such as during construction, the scope is almost completely defined, and uncertainties or risks are reduced to the barest minimum. Sellers can bid for the work, and they become responsible for any uncertainties that may come either from the work or from the marketplace.
This is illustrated by the graphics below.
We can see from the figure above that the buyer can choose from Cost Reimbursable contracts (with minimal project definition) through Time and Materials contracts (midway through scope definition) to Fixed Price contract types (when scope definition is almost or totally completed).
Now let us examine different contract types and when they are applicable. We begin with the Fixed Price contracts. According to the PMBOK 6th Edition, this class of contracts involves setting a total price for a defined product to be provided. They should be used when the scope is well defined and no significant changes to the scope are expected.
They may also include financial incentives for achieving or exceeding selected project objectives – schedule, costs, safety, performance targets, etc.
The seller is under legal obligation to complete such contracts, with possible financial penalties if they do not. That is why sellers are usually required to post performance bond which the buyer can cash, if the seller does not complete or abandons the work. Also, the buyer may impose a penalty if the seller does not complete the milestone or project as specified in the contract. The common type of financial penalty is the proverbial Liquidated Damages that compensates the buyer for the inability to use the product.
This type of contract requires that buyers precisely specify the product or service being procured. Changes in scope may be accommodated, but at an increase or decrease in contract price, called variation.
Next is the Fixed Price Incentive Fee (FPIF) contract, another variant of the Fixed Price contract. It gives buyers and sellers some flexibility in that it allows some deviation in performance. Instead of just relying on penalties to ensure that buyers deliver as promised and on time, it also employs financial incentives. The incentives are tied to agreed metrics – cost, schedule, technical or quality performance established at the outset.
Therefore, the final contract price is determined at completion of the scope of work based on seller’s performance. The seller becomes responsible for all costs above the set price ceiling.
The final variant of the Fixed Price contract that I want to consider is the Fixed Price with Economic Price Adjustment (FP-EPA) contract. This is used when the contract runs for many years or when economic conditions are unstable. It combines fixed price with special provision for pre-determined adjustment for inflation, changes in exchange rates, or cost increases for specific commodities. The Economic Price Adjustment clause must relate to a reliable financial index which is used to adjust the price. The aim is to protect both buyers and sellers from external conditions beyond their control.
For example, a manpower supply contract that runs for 3 years may specify that the rates will increase by, say 5% every year after the first year of the contract. This is to accommodate inflationary trends within the country concerned.
Next, we will examine the Time and Materials contracts and when they should be applied.
See you then.
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