INTRODUCTION TO EPC CONTRACTS Part 6
I will conclude this series of essays on Introduction to Engineering, Procurement and Construction (EPC) Contacts by discussing Cost-reimbursable contracts. In Part 1 we attempted a definition of contract and its key elements. Part 2 emphasized the need for all project key personnel to read and gain thorough understanding of the contract document. Part 3 explained that it is important for contractors to understand that organizations use contracts as risk management measures and select appropriate types of contracts for different types of projects, depending on how much risk they intend to retain or transfer. Thus, a contractor is engaged to assume the risks that the owner is not willing to bear.
Then, we commenced a review of different types of contracts and their application in Part 4, where we examined Fixed Price contracts. Part 5 presented an overview of Time and Materials contracts.
Finally, I intend to end this series by examining Cost-reimbursable contracts. As can be seen in the graphics below, Cost-reimbursable contracts lie at the low end of Project definition, low end of Sellers risk, and High end of Buyers risk continuums. It represents the highest cost risks for the buyer because costs may spiral out of control.
In Cost-reimbursable contracts, the seller or contractor is paid or reimbursed for all legitimate actual costs incurred for completed work, plus a fee or markup representing seller profit and/ or administrative charges. It is used when project definition does not allow estimate accuracy for Fixed Price contract. It sets out the contract sum as well as a ceiling that must not be exceeded without going back to the approval authority or board.
Call-off or manpower supply contracts are common examples of Cost-reimbursable contract in its basic form. The supplier pays the staff all that is specified in the contract – daily rate, housing, transport, medical, etc. – and all other costs, such as mobilization, demobilization etc. At the end of the month, he submits his invoice representing all the costs incurred on the staff and adds the agreed markup – usually a percentage of the actual costs, for reimbursement by the buyer.
Cost-reimbursable contracts may also include financial incentives for achieving or exceeding or staying below selected project objectives (schedule, costs, performance targets, etc.)
As with other types of contracts already considered, Cost-reimbursable contracts come in many variants. They include Cost-Plus Percentage Fee, Cost-Plus Fixed Fee, Cost-Plus Guaranteed Maximum, Cost-Plus Guaranteed Maximum and Shared Savings, Cost-Plus Incentive or Award Fee, etc. However, we will consider only two of the very common variants:
Here the seller or contractor is reimbursed for all allowable costs plus a fixed fee calculated as a percentage of the initial estimated project cost. The cost may vary but the fee is fixed. Fee is received only for completed work and does not change due to seller’s performance, except there is change in project scope.
Although this variant has no incentive for good performance the seller may consider the fixed fee an incentive to complete the work early.
Cost Plus Award Fee contracts are used when it is not possible to determine objective contract incentives. They are used when the contractor or seller meets higher-than-usual levels of performance, quality, responsiveness, or some other broad subjective performance criteria defined in the contract.
The seller is reimbursed for all allowable costs. Fee is based solely on buyer-determined performance criteria, generally not subject to appeals. The award fee plan that explains the award fee criteria for any performance period is specified in the contract. Typically, a contract award fee evaluation board evaluates seller or contractor performance at the end of the period, against award fee criteria.
Because Cost-reimbursable contracts rely on actual costs, it is critical to ensure adequacy of the seller’s or contractor’s accounting system. It must demonstrate transparency of the entire cost accounting process. This will enhance confidence that the client is paying for actual project costs and nothing more. Fuggy accounting systems or lack of integrity and transparency may require the buyer to set up parallel monitoring systems. That will ultimately add significant costs to overall project budget and may defeat the purpose for selecting this contract type.
As I stated in the first part of this series, the objective was to introduce those who have found themselves in project teams, either as members or leaders, without formal project management training, to the basics of Engineering and Construction contracts. I hope that the objective has been achieved.
Of course, I did not intend to provide a substitute for formal education or training, but a top-of-the-wave view of the subject. I hope that this would provide a starting point for deeper individual exploration of the subject matter.
Our EPC Contracts from the Owners’ Perspective course should be a good starting point and a logical next step.
