ISSUE III : Building and engineering contracts: Pricing them right!

Building and Engineering Contracts: pricing them right!

Introduction

Infrastructure has become the focus of the Indian economy. As development of infrastructure is a precursor for growth, the government has tried to emphasize its importance in its plans and policies with every passing year. The main players are the various government departments and building and construction companies. Every relationship in this sector stems from a contract. From the initial phases of a project till its completion, every aspect is governed primarily by a “building or engineering contract”. In India, the principal law governing all such contracts is the Indian Contract Act, 1872 (“the Act”).

The development of an infrastructure project involves detailed planning of various important aspects with the pricing mechanism being of utmost importance. The pricing mechanism is usually related to the manner in which the work is to be executed. Therefore, disputes can arise on account of payment under the contract related to different factors ranging from whether the contract has been properly executed or not, arguments over variations, loss or damages or expense claims, defects in the quality of the deliverable or delay in completion of the project. In other words, the manner in which the Employer1 agrees to pay the Contractor2 and the scope of work covered by it has been the cause of dispute with numerous judicial precedents. Thus, the pricing mechanism of a contract plays an important role in the ultimate success or failure of an infrastructure project.

This bulletin focuses on the common modes by which building or engineering contracts are priced and their suitability in different situations.

1. Types of Building and Engineering Contracts

The contractual mode of payment has a direct impact on the distribution of responsibility or risk as well as the cost of raw material, labour, etc. Therefore, building and engineering contracts may be classified into three broad categories based on the manner in which a contract is priced. These include: (i) Lumpsum, (ii) Measurement, and (iii) Cost-Plus Contract(s) and are discussed below:

1.1 Lumpsum

A lumpsum contract may also be referred to as a “fixed price” contract i.e., a contract where the buyer agrees to pay the seller a definite and predetermined price. According to the Eighth edition of Garner’s Black’s Law Dictionary, this price is fixed regardless of an increase in the seller’s cost or, the buyer’s ability to acquire the same goods in the market at a lower price.

There are certain defining features of a lumpsum contract, namely; (a) the contract is for a defined or specified scope of work, (b) a lumpsum amount is payable to the Contractor for the performance of such work, (c) it is a contract consisting of reciprocal promises, and

(d) it is an “entire” contract. This means that under such a contract, the Contractor takes on the obligation to complete or perform work that may be specified in drawings or specifications, for a lumpsum amount payable to him upon completion of the “entire” work.

The Act contains provisions that explain “reciprocal promises” under a contract. As per section 51 of the Act, when a contract consists of reciprocal promises that are to be performed simultaneously, the promisor is not required to perform his promise unless the promisee is ready and willing to perform his reciprocal promise. Further, when the contract clearly specifies the order in which the reciprocal promises are to be performed such promises must be performed in the specified order. If, however, the order of performance is not so specified, the promises must be performed in the order that is contemplated by the nature of the transaction.3 In light of the aforesaid provisions, in case of a lumpsum contract, as the principle of reciprocal promises applies, the Employer or Contractor will not be obligated to perform their part of the contract unless the other party is ready and willing to perform their part of the bargain. Thus, generally the Employer is not required to make payment until the Contractor has completed the work as defined under the contract.

A lumpsum contract can contain provisions for milestone payments. Usually, payments may be made by the Employer in fixed installments at various stages of completion of the work. Such a contract does not usually contain a break up of the actual cost incurred in carrying out the specified work. The Contractor agrees to a lumpsum amount bearing in mind all future eventualities, expenses, rise or fall in costs. If his actual costs are less than the lumpsum he makes a profit, if not, he ends up in a loss. Thus in such contracts, the Contractor does take a risk as far as future contingencies are concerned.

Finally, a lumpsum contract is also considered an “entire” contract i.e., it is one and indivisible. Not only does this mean that the obligation of one party arises only when the other party has fully carried out all its obligations under the contract, it also has certain implications as far as sales tax is concerned. This was examined by the Supreme Court in State of Madras V. Gannon Dunkerley & Co. (Madras) Ltd.4 In this case the Supreme Court expressed the opinion that in case of a building contract under which work is to be executed for a lumpsum, there is no contract for sale, as such, of materials used in the works. The contract is for a lumpsum and cannot be broken into components to say that there is a sale of the materials used. Accordingly, in a building contract which is one and entire and indivisible, there is no sale of goods. Therefore, a tax on the supply of materials used in executing the construction work under the contract would not be permissible.

1.1.1 Possibility of dispute

Where the project is based on a lumpsum contract, the usual cause of dispute is either that, (i) the Contractor ends up carrying out some additional work, or (ii) the

Contractor is unable to complete the work. In big construction projects, it is often difficult to define the exact amount of work that will need to be carried out. In such a situation, it is essential that certain clauses are included in the contract. A general practice is to make the “fixed sum” subject to certain limited and specific adjustments. This is often done by appending a schedule of rates to the main contract. The schedule must provide for the adjustments that are permissible under the contract i.e., the amount that can be added or deducted from the fixed sum in case some additional work is either carried out or some work is not carried out by the Contractor. Here it is important that the permissible adjustments are clearly defined, leaving no scope for a further dispute.

1.2 Measurement Contracts

As against a fixed price contract, a measurement contract may also be referred to as a “fixed rate” contract where the Contractor agrees to carry out the work at “fixed rates”. The amount he is entitled to receive depends upon the quantity of work done, the kind of work done and the material supplied. These contracts are commonly used where the quantities of the construction inputs is unknown at the time of execution of the contract. Measurement contracts may be item rate or percentage rate contracts. In item rate contracts, the work that is to be carried out is divided into a number of items and a rate as well as a unit of measurement is fixed for each item. This is usually in the form of a schedule which contains the estimated quantity of each item, the unit which each item is to be measured in and the rate per unit. In such contracts, the Employer pays the Contractor for the actual quantity of work done multiplied by the rate of the specific item.

The only difference between an item rate contract and a percentage rate contract is that in the latter, the Employer also provides and estimated rate for every item and the Contractor bidding for a tender provides the Employer with a percentage range by which the estimated rates are to be increased or decreased should his bid be accepted.

Another important feature of measurement contracts is that, unlike lumpsum contracts, these are severable in nature. This means that the contract can be severed into two or more parts and each part can be enforced separately. Accordingly, failure to perform one of the promises by one party does not justify a total repudiation of the contract by the other. As the contract is not an entire contract, the obligation of the other party does not arise only when all the work under the contract is completed by the other party. In a measurement contract, payment is made to the Contractor on a measurement of the items completed by him. If he does not complete any item as per the contract the Employer has the option of claiming damages from the defaulting Contractor. Therefore, unlike a lumpsum contract, if the Contractor is unable to carry out the work under any one item, it will not automatically amount to a breach of the entire contract on his part.

In such contracts the possibility of dispute generally arises with respect to the actual work covered by the rate quoted by the Contractor for each item. Such disputes can be avoided if the item rate quoted by the Contractor clearly indicates whether or not it includes the cost of executing all ancillary or contingent work that may be necessary for completion of an item or clearly specifies what the rate includes and what it does not.

1.3 Cost-Plus Contract (“CPC”)

Simply put, a CPC is one where payment is based on a “fixed fee” or “percentage fee” added to the actual cost incurred.5 In other words, the Employer pays the Contractor a mutually agreed fixed amount or percentage over and above the actual cost incurred by the Contractor. The term “Cost” usually includes the cost of materials transported to the site or godown, the labour cost, machinery and equipment cost on a given day. This is also known as the “prime cost”. This amount does not include items like supervision charges, overheads and profits. Such items are covered by the fixed or percentage fee.

The manner in which the fixed or percentage fee is calculated varies based upon the agreed mode of payment between the parties. In practice it is generally calculated using the following formulas:

  • Prime Cost + Fixed fee: The Employer agrees on a fixed sum to be paid to the Contractor in addition to the actual cost incurred by him. The fixed sum covers all the other overheads incurred by the Contractor as well his profits.
  • Prime Cost + Percentage fee: The Contractor charges a percentage of the prime cost. Thus, the Contractors profits are usually carved out of the percentage he charges over and above the prime cost. The drawback in such case is that as the Contractor is guaranteed to get a percentage over and above the prime cost he does not consider it necessary to try and reduce or minimize costs. Further, since the percentage is calculated on the prime cost, the higher the prime cost, the more the Contractor is likely to receive. As a consequence, such a method provides no incentive to the Contractor to economize the cost of construction.
  • Prime Cost + Fluctuating fee: The fee is paid on a sliding scale. In other words, the more the prime cost the lower is the fee paid in addition to it and vice-versa.

Target Cost:  A pre-estimated target cost is mutually agreed upon by the Employer and Contractor. The Contractor and Employer agree to a (Prime Cost + percentage of the Prime Cost) minimum amount payable to the Contractor (“minimum price payable”). The purpose of agreeing upon a “target cost” is to provide the parties with an additional incentive. The usual practice is that if minimum price payable is lower than the target cost, the Employer parts with a percentage of the amount saved (target cost – minimum price payable) in favour of the Contractor. On the other hand, if the minimum price payable exceeds the target cost, the Contractor allows the Employer to deduct a percentage of the excess amount from the minimum price payable to him. For e.g., if the target cost is Rs. 500 and the minimum price payable amounts to Rs. 300, in such a situation the saving is 500-300 = 200. The Contractor is given a percentage of this amount of Rs. 200 as an additional incentive. On the other hand, if the minimum price payable was Rs. 600 thereby exceeding the target cost by Rs. 100, the Contractor would stand to loose an amount equivalent to a mutually agreed percentage of the excess amount i.e., Rs. 100 which would be deducted from the minimum price payable to him. In this manner, the target cost acts as an incentive for the Contractor to keep his costs as low as possible, aiding the Employer to ensure efficiency and cost effectiveness.

Conclusion

In practice, the nature and size of a project plays a key role in determining the right pricing mechanism. Additionally, the abilities and financial capabilities of the parties must also be factored in. Lumpsum contracts are better suited for smaller projects as the consideration is paid in one go. Similarly, the item rate contract is more suited in cases where the exact quantity of input is difficult to ascertain. While this leaves scope for the Contractor to increase his quantities to achieve a higher profit, it is commonly used in larger projects. Thus, in every case the parties must weigh the circumstances and decide upon the appropriate pricing mechanism, best suited to the project at hand.

Authored by: Tanya Mehta

1 In this Bulletin, the “Employer” is “the building owner” or “Owner” for whose benefit the work is carried out
2 Similarly, the “Contractor” is the “Builder” who carries out the work
3 Section 52 of the Act
4 AIR 1958 SC 560
5 Eighth edition of Garner’s Black’s Law Dictionary

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