February 2019

Project Management

EPC/construction contracting—Start with the end in mind

Large capital projects continue to be challenged by budget issues.

Ogunye, S., Praxair; Rentschler, C., Engineering Consultant

Large capital projects continue to be challenged by budget issues. Typically, the central problems are large overruns with construction. Construction is the largest and riskiest portion of an engineering, procurement and construction (EPC) project, and it comes at the end of the project when project optimization, value improvement and/or correction options are limited (FIG. 1). A construction execution strategy must be determined early in the project, even during the front-end engineering design (FEED) phase or at the EPC project bid phase. This article discusses how construction contracting options can be established/determined early in the project, and how this strategy affects the overall project plans and outcome.

FIG. 1. Construction is the largest and riskiest portion of an EPC project. Shown is the construction of process gas air coolers for a steam methane reformer.
FIG. 1. Construction is the largest and riskiest portion of an EPC project. Shown is the construction of process gas air coolers for a steam methane reformer.

Construction contracting is challenging, since both owner and contractor are faced with limiting their risks. This dynamic leads to parties struggling to reach an agreement. Sometimes, the best solution is a blend of contract approaches and early involvement by the contractor. The various contracting options will be discussed, along with the pros and cons of each. The woes that often occur in construction can sometimes be attributed to upstream activities; therefore, all activities should be monitored and assessed on how they may affect the construction contracting approach. Mid-course corrections should always be considered to keep the project on track.

The situation

The construction phase of a major project can represent 35%–50% of the total project cost. For this reason, construction is often a deciding factor on whether a project should move forward, and whether the project budget is adequate. The contracting approach for construction is crucial in efforts to make sure a project stays on track—it is a key driver of the success or failure of a project. This is challenging since most contract approaches must be determined without a complete design. In addition, there are often competing goals between the owner (contracting party) and contractor, which leads to challenges in determining an equitable contracting approach. Defining the best contracting approach, which often involves several types of contracts, is at the heart of driving a successful construction project and is a deciding factor in achieving a win-win between owner and contractor.

The other complicating factor is that the largest portion of an EPC project (construction) is also the riskiest. Engineering and procurement have their risks, but they cannot begin to compare with the magnitude of uncertainties that frequently characterize construction projects. Even with the best outlook for events that may impact a construction project, there are often areas of risks that cannot be envisioned or fully quantified. These “soft” areas can lead to significant cost and schedule impacts in the middle of construction. A large focus of contract development is addressing risks that can potentially affect all parties involved.

The challenge in writing effective construction contracts is to develop a strategy early in the project cycle. This action is particularly challenging, since little design information is known in the early project stages, which could include many different variables. For example, will an EPC firm be engaged, or will the owner serve as the general contractor and engage subs? It is crucial to develop the construction strategy early and to define an appropriate contracting approach in the project development stage. As the design is completed, a detailed construction contract should be put into place. This notion is summed up in the literature: “Construction contracts alone can make or break projects before shovels hit the dirt, depending on whether the terms and conditions of multiple documents are accurate, comprehensive and consistent, and, perhaps most importantly, read and understood by all principal parties.”1

The issues plaguing construction are well documented in literature.2 It is important that these issues are kept in mind as contracts are developed and that appropriate language is considered. For example, it has been well documented that construction productivity improvements have lagged over the years. Since 1995, the global value added per hour has grown at approximately a quarter of the rate of manufacturing. While this is the problem of the contractor, the contracting party should keep this in mind, particularly if a time-and-materials contract is considered.

Projects have become more complicated in recent years. A high potential for unforeseen problems exists, and costs can vary according to conditions. The remoteness or small footprint of construction sites can also be challenging. In addition, construction schedules are often getting tighter. This is due to the need to bring a project online as soon as possible, along with the overall project schedule being over-expended during the engineering and procurement phases. Often, this time crunch leads to beginning the construction phase before all necessary engineering has been completed and before materials have been delivered to the site. While this might appear to save money and schedule time, the premature initiation of construction activities invariably leads to contract concerns, often resulting in change orders.

At present, contract arrangements are often more complex than in past years. All parties in a project want to minimize risks. This can lead to non-preferential contract arrangements for the contractor, or even sometimes for the owner. This is particularly true in cases where a project is competitive and undesirable arrangements must sometimes be accepted to win a project. In general, things may go smoothly until construction problems arise, and then there can be conflicts between the contracting parties. No one wins when there are strains in the mid-course of a project; therefore, every effort should be made to ensure effective contract development at the project’s outset.

Goals

The goals of any construction project should always be focused on achieving the well-known “triangle” requirements of quality, cost and schedule (FIG. 2) to ensure a safe project. To accomplish this, a major focus should be placed on contract development so that each entity is protected. Risks exist with any project. Both the contracting party and the contractor typically spend significant time ensuring that they are protected via contract type and language. While this is important, there should always be an open mind to the situation and the concerns of the other party, and each party should strive for a win-win. This is discussed in a recent two-part article entitled “Creating a ‘win-win’ between construction contractor and project owner,” which was published in the May and June 2018 issues of Hydrocarbon Processing.3 The best outcome of any project is the owner achieving a project that meets the three key project parameters (quality, cost and schedule) and the contractor completing the project at a fair profit—one that enhances its reputation.

FIG. 2. The goals of any construction project should always be focused on achieving the project’s planned quality, cost and schedule. Shown is the construction of a reformer box penthouse for a steam methane reformer.
FIG. 2. The goals of any construction project should always be focused on achieving the project’s planned quality, cost and schedule. Shown is the construction of a reformer box penthouse for a steam methane reformer.

The owner drives the project early in the process and has the responsibility for ensuring that enough project definition exists in scoping the project. This requires some level of engineering during the project’s development phase. To the extent that a contractor can be involved in this early development stage, there is a benefit for both parties as contract development progresses. The contractor can often offer construction techniques and modularization opportunities that will save money, schedule and/or time. Proper construction sequencing is also important and should be determined in the project development phase. While these nuances are fine points of the project, they can have a significant influence on the project and contract development.

The goal is to achieve a project with minimal change orders. Contractors often have the reputation of seeking change orders to bolster their profit, but the truth is that no one wins when there is an ill-defined scope and pervasive change orders. This drives a project away from a win-win outcome and leads to contentious moments. Significant thought must be given to contract type vs. known scope. Often, the best contract approach is a multi-faceted one that uses a time-and-materials approach when the scope is “soft,” and a lump sum or fixed price when the scope is solid. The various contract approaches are discussed in the following section.

Contracting approaches—early project strategy

A “contract” is a written agreement between two or more parties that is enforceable by law.4 A contract is a mutually binding legal relationship obligating the contractor (seller) to furnish the supplies or services and the owner (buyer) to pay for them. Therefore, a contract is expected to set up arrangements that are clear and certain regarding the relationship and performance requirements of the parties (owner and contractor) involved. Choosing the best contract type for a project is aimed at mitigating and apportioning risk between the owner and the contractor.

Several contract approaches/types are implemented in the EPC industry. This work discusses the following popular contract types:

  • Lump sum
  • Guaranteed maximum price (GMP)
  • Time and materials (T&M)/cost reimbursable.

Lump-sum contracts. A lump-sum contract is the traditional means of procuring construction services, and it is still the most common form of construction contracts. Under a lump-sum contract, a single “lump-sum” price for all the work is agreed upon before the work begins. Lump-sum contracts are generally appropriate for projects where the project requirements—including the scope of work and the terms and conditions—are well defined prior to issuance of the request for proposal (RFP) or invitation to bid (ITB) documents to bidders. In choosing this means of contracting, the owner must satisfy itself that significant changes to requirements are unlikely. This means that contractors are able to accurately price the work they are being asked to carry out.

One of the primary advantages of the lump-sum contract is that it gives the owner some certainty about the likely cost of the work. In achieving this goal for the owner, lump-sum contracts apportion more risk to the contractor than some other forms of contract, as there are fewer mechanisms to allow contractors to vary their price. Contractors often add a contingency amount to the contract value to compensate for the increased risk they must carry. One of the major drawbacks of the lump-sum contract is that the bidding process tends to be slower than other forms of contracting, and preparing the proposal documents may be more expensive for the contractor. The cost of proposal preparation is ultimately passed on to the owner through the pricing. In competitive lump-sum contract bidding, the tendency is for the contractors to price for the expressly stated scope while they hope to make additional gains via change orders for the unstated but necessary scope to complete the work. This is what sometimes leads to buy-in tactics (e.g., contractors initially bid very low to win the contract with the hope of making up their costs via change orders). Hence, supply management professionals should be mindful of the rates/prices for changes included in the lump-sum contract.

Lump-sum contracts might be less appropriate where speed is important, or where the nature of the work is not well defined. Other forms of contracts that might be more appropriate in such circumstances include T&M/cost-reimbursable contracts, which are used where the work can be described in reasonable detail, but where the amount and/or the nature of the work cannot be properly defined at the outset. It is often used where an immediate start onsite is required.

It is important to recognize that a truly “fixed-price” contract would not necessarily be in the interest of the owner, as it would require that the contractor price risks over which they may have no control, and which might not arise. It would also give very little ability for the owner to alter project requirements.

GMP contracts. A GMP contract is one in which the contract price will not exceed the agreed upon or specified maximum. In this type of contract, contractors often have responsibility for completing the owner’s design and for carrying out the construction work, so they are in a good position to control costs.

The liability for completing the project on or below the contract price (or budget) lies with the contractor, which estimates a maximum cost, as in a lump-sum contract. Any savings in cost, at the option of the owner, can be split with the contractor. However, that depends on the terms negotiated in the contract. This can create a “pain/gain,” or a target cost agreement, where the contractor is incentivized to make savings, but the owner has the security of a cost cap. The project delivery risk is thereby transferred from the owner to the contractor.

The downside of a GMP contract is that contractors tend to overprice the contract to hedge their risks. This may be acceptable to the owners if their priority is certainty rather than the lowest possible cost (e.g., if the owners have fixed funding available that cannot be exceeded).

In deciding whether to seek a GMP contract, owners should assess the nature of the project, the likely risks and if it is sensible to expect the contractor to bear those risks. If risks are priced by the contractor but do not transpire, then the owner will have paid for nothing. Conversely, if serious unforeseen problems are encountered, the contractor may attempt to find a way out of its obligation or may be at risk of major overruns.

The GMP contract is not a solution to a poorly scoped contract. As discussed in the lump-sum contract section, contractors will take advantage of a poorly written scope, inconsistences and conflicts in the contract documents. Note that any addition or deletion of scope or requirements will result in an appropriate change order that ultimately impacts the initial GMP amount. Although all contracting strategies require some form of oversight from the owner, GMP contracts need an experienced contract resource to manage and ensure that the contract terms and conditions are observed.

T&M/cost-reimbursable contracts. In the US, a T&M contract is a type of construction contract that commits the owner to pay the contractor based on the time spent on the work and the materials used, as well as a markup for profit. In the UK, this type of contract is known as a cost-reimbursable contract (or a cost-plus contract). This type of contract represents an attempt to mitigate some of the liability for project expenses. Several types of cost-plus contract structures exist, including cost-plus-fixed-percentage, cost-plus-fixed-fee and cost-plus-variable-percentage options.

While a T&M contract’s primary advantage is that it allows the owner to quickly mobilize the contractor and probably gain on schedule, it exposes the owner to unknown cost and schedule risks. This is because, in a T&M arrangement, the contractor has little or no incentive to complete the work early, as finishing early will reduce earnings. The contractor has no incentive to improve its inefficiency, since this leads to less money for the contractor. For the owner, a T&M contract requires more supervision, which may not always be possible. Owners should plan to use a T&M contract for short-duration projects. It is also customary to do the front-end work for large projects on a T&M basis and to convert to a lump-sum contract at a pre-agreed point. By this point, the entire scope of the work should be confirmed.

Takeaways

For several reasons, the most challenging part of an EPC project is construction. While the engineering and procurement are mostly carried out under a controlled environment, construction is completed primarily under risky circumstances, such as nature, labor unions and market forces. Having the conclusion in mind is crucial for achieving the owner’s objective in an EPC/construction contracting arrangement. The various options discussed should be weighed and, perhaps, a combination approach considered. The owner should choose the right contracting strategy at the onset of the planning or front-end stage of the project. It is also important that all the disciplines necessary for the success of the project be engaged.

Owners should ensure that they put in place mechanisms to achieve the planning, monitoring and control of all aspects of the contract. Positive motivation of the parties involved is crucial for achieving the contract objectives on time and to the specified cost, quality and performance. More than anything, the parties involved should remain flexible and should understand that circumstances can change throughout a project. Both parties must be ready and willing to change. If the owner and contractor keep in mind that a win-win situation is the desired outcome of any contract arrangement, then there will be enough positive energy to ensure a successful outcome for all. HP

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