INTRODUCTION TO EPC CONTRACTS Part 5
In Part 4 we examined types of contracts that are applicable when the scope of work is clearly defined, and risks reduced. I continue our discourse of Introduction to EPC Contracts by discussing contracts that are applicable when the project or scope of work is not clearly defined. We begin with Time and Materials (T&M) Contracts. As the graphics below illustrates, T&M contracts lie midway between Fixed Price and Cost Reimbursable contracts. It is a hybrid that combines aspects of both Fixed Price and Cost Reimbursable contracts.
Time and Material (T&M) Contracts are used when it is not possible, at the time of placing the contract, to estimate accurately the extent or duration of the work or to anticipate costs with any reasonable degree of confidence. It is also used when there are no acceptable ways to determine what a fair and reasonable price may be for a particular project. They are often used for staff augmentation, acquisition of experts or any outside support.
Many service contracts are of the T&M type. The buyer agrees the rate with the seller but does not know exactly how many hours of work may be required to complete the task. The buyer pays for the time expended and the resources (Materials) used.
For example, a power plant breaks down, but no one knows exactly what the cause is or how long it might take to uncover the source of the problem and fix it. However, power must be restored as soon as possible. Thus, there is no time to go through a normal contracting process. The buyer consults the expert, agrees on his rate, and pays for any spare parts required. Once the problem is solved the buyer pays for the hours recorded.
T&M contracts resemble cost-reimbursable contracts because they can be open ended; the full contract price and exact quantity of items to be delivered may not be determined at contract award. Thus, the contract price can increase as if it were cost reimbursable. This can expose the buyer to unwanted risks.
To limit risk exposure from a traditional T&M contract, various alternatives or variants have been developed. I discuss some of these below.
- Not-to-exceed time and materials. In this variant the overall budget is limited to a fixed amount, thus preventing uncontrolled cost growth. The buyer can incorporate changes or substitute scope provided he does not exceed the ceiling. However, it requires close monitoring to ensure that hours and materials paid for are actually used in the project. Of course, this can come at a significant cost if integrity and trust are lacking.
- Graduated time and materials. This is a shared financial risk approach. In this arrangement the seller can earn higher hourly rates if he delivers earlier than the contractual dateline. Conversely, late delivery may attract lower hourly rates.
- Early cancellation option. In agile environments, a seller may deliver required functionality or value midway into the scope of work. If the buyer decides that the remaining scope of work is not required or that there is no added value in pursuing the project to completion, he may cancel it by paying a cancellation fee. Thus, the buyer limits budget exposure while the seller earns revenue for services no longer required.
Above is not an exhaustive list of T&M contract variants. But I that should be enough to get started. You may consult the PMBOK 6th Edition, Project Management: A Systems Approach to Planning, Scheduling, and Controlling by Harold Kerzner or other excellent project management literature.
The downside of T&M contracts is that monitoring large or complex projects may require the buyer to set up a full monitoring system. And this may come at significant cost. In fact, one organization warns its contract officers never to use a T&M contract except there is no other option.
Well, as already indicated, there are many cases where T&M contracts are the only way out.
Next, we will examine Cost Reimbursable contracts and when they should be applied.
See you then.
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