Why Construction Arbitration is Complex? (V)

You probably don’t know that the Channel Tunnel contracts agreed on different payment methods.

What happens when a project’s price is not clearly defined?

In construction arbitration, understanding how the contract price was set can mean the difference at the time of settling a dispute.

The complexity of a construction contract may also be determined by the way in which the parties agree and pay the price.

The very complexity of the subject matter of the contract and the sophistication achieved in our days have meant that there could be several systems for determining the price, which can make the contract, at the same time, more or less complex.

Lump Sum or fixed price

It is the simplest way to agree on the price for the construction of the entire work according to an agreed project.

Even in this case, the form of payment can be agreed in different ways: total payment at the end of the work, payment divided into as many installments as the number of months foreseen for the duration of the works, monthly payment of a percentage of the price according to the percentage of completion of the works or monthly payment of the works actually executed in that month.

In this form of pricing the actual cost that the contractor may incur is irrelevant and it is used when the project is simple and well prepared and is not expected to be subject to variations.

The client always has the certainty of what the work will cost and the contractor, on the other hand, assumes the risk of costs rising above the forecast he has made when negotiating and setting the price.

Unit price

Under this system, a price is established for each unit of work into which the work is broken down (unit price).

The price to be paid to the contractor is the result of multiplying the agreed prices for each unit of work by the actual measurement of the units performed.

For example, if the price per cubic yard of concrete is established in the contract, the quantity of cubic yards of concrete used in a period of time, generally one month, is assessed and multiplied by the agreed price per cubic yard of concrete.

This system can be combined with the fixing of a lump sum in which the entire work is valued. In this case, it is used as a means of payment to the contractor for the work done, but with the limit of the agreed fixed price.

This is the system on which the public contracts in Spain are based. The fixed price is offered by the contractor who is awarded the contract and the unit prices multiplied by the amount of work done are used to pay for the work done on a monthly basis.

In this system, in Spain, the final price cannot exceed ten percent of the fixed lump sum price because a certain margin of variation in the measurements is allowed.

With this form of pricing, the client has greater uncertainty about the final cost of the work and the contractor can charge a higher amount if the actual measurement of the work done is higher than expected or if variations must be made to the project.

Cost plus fee

Another way to fix the price is by paying the actual costs incurred by the contractor plus a profit margin. This is called cost plus fee or cost-plus.

This form of pricing is used in projects with special performing difficulties, with innovative designs or using complex engineering techniques that determine that there is a high risk in its execution. In these cases, it is very difficult to calculate the cost in advance to determine the price and therefore it is agreed to pay the contractor the actual costs incurred plus a profit margin.

Target cost

As a variation of the above, the price may also be established by setting a target cost for the performance of the work and, if the actual costs incurred exceed the target cost, the excess is shared between the contractor and the client in the agreed percentages.

In addition, as an incentive for the contractor to reduce costs, it may be agreed that he will receive a bonus by participating in the profit obtained from such a reduction.

This type of pricing mode requires rigorous cost control and full transparency of the contractor with respect to the costs incurred.

In contracts with this pricing system, it is also agreed which costs are acceptable and which are not. If the contractor incurs in the latter (e.g. due to inefficient management), he does not collect them from the client.

These last two forms of pricing are used in some of the forms of the NEC 4 engineering and construction contract that we reviewed in the previous article, with certain variations.

Guaranteed maximum price

This form of pricing is sometimes used in those contracts which complexity does not allow the price to be determined prior to the start of the work because it requires a prior phase of investigation, feasibility study and preliminary design.

The contractor is paid for his work by paying the costs incurred plus a profit margin and, when the project has been proven to be viable and the project has been fully defined, the price is established by means of a lump sum.

Other considerations on pricing

The way of fixing the price depends largely on the type of work to be carried out, its greater or less complexity and the ease of establishing the final price in a certain way from the beginning.

The client's financial possibilities and needs must also be considered. When the client needs to finance the project with external funding, the financial entities usually establish very demanding criteria and requirements so that the price of the works is maintained within the financed amounts and without surprises for the lender.

A practical example of price fixing

We can see an example of different forms of price fixing in the works of the Channel Tunnel between France and England where different methods of price fixing were used depending on the type of work.

I take this example from Jane Jenkins, an American lawyer and author of an excellent book on international construction arbitration law.

• The tunnels were built on a target cost basis.

• The terminal buildings, platforms, electrical and mechanical equipment were paid for on a lump sum basis.

• The rolling stock, on a cost reimbursement basis with a margin.

Interestingly, the largest cost overruns occurred in the electrical and mechanical works, which were paid for on a lump sum basis, due to the large number of variations that were necessary to the initial project for operational and safety reasons, which shows that the price should have been determined differently.

Pros and Cons

Fixed price systems have the disadvantage that, if variations to the project become necessary, the possibility of conflict between the client and the contractor is greater.

However, in cost plus profit margin systems, the discrepancies will arise in determining whether the costs are allowed under the contract.

The main problem in the latter type of contract is that both parties must work with full transparency so that the contractor's actual costs are absolutely known to the client and accepted by the client in order to be paid.

"Open book" systems are often set up so that the costs incurred are fully transparent for both parties, along with the agreement of which costs are allowed and which are not.

The reality is that the construction of large infrastructures has a long duration in time and requires the investment of large amounts of money.

The contractor does not want to finance the project by advancing the money for the purchase of materials and the payment of salaries, so when the construction of infrastructures became widespread and complex, a system of partial payments to the contractor on account of the final price began to be used, so that he would not have to fully finance the execution of the works.

Conclusion: determining the price of the work and the method of payment is another element that contributes to the complexity of construction contracts.

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