8.

Construction Pricing and Contracting

8.1 Pricing for Constructed Facilities
Because of the unique nature of constructed facilities, it is almost imperative to have a separate price for each facility. The construction contract price includes the direct project cost including field supervision expenses plus the markup imposed by contractors for general overhead expenses and profit. The factors influencing a facility price will vary by type of facility and location as well. Within each of the major categories of construction such as residential housing, commercial buildings, industrial complexes and infrastructure, there are smaller segments which have very different environments with regard to price setting. owever, all pricing arrangements have some common features in the form of the legal documents binding the owner and the supplier!s" of the facility. Without addressing special issues in various industry segments, the most common types of pricing arrangements can be described broadly to illustrate the basic principles.

Competitive Bidding
The basic structure of the bidding process consists of the formulation of detailed plans and specifications of a facility based on the objectives and requirements of the owner, and the invitation of qualified contractors to bid for the right to execute the project. The definition of a qualified contractor usually calls for a minimal evidence of previous experience and financial stability. #n the private sector, the owner has considerable latitude in selecting the bidders, ranging from open competition to the restriction of bidders to a few favored contractors. #n the public sector, the rules are carefully delineated to place all qualified contractors on an equal footing for competition, and strictly enforced to prevent collusion among contractors and unethical or illegal actions by public officials. $etailed plans and specifications are usually prepared by an architectural%engineering firm which oversees the bidding process on behalf of the owner.

&

The final bids are normally submitted on either a lump sum or unit price basis, as stipulated by the owner. ' lump sum bid represents the total price for which a contractor offers to complete a facility according to the detailed plans and specifications. (nit price bidding is used in projects for which the quantity of materials or the amount of labor involved in some key tasks is particularly uncertain. #n such cases, the contractor is permitted to submit a list of unit prices for those tasks, and the final price used to determine the lowest bidder is based on the lump sum price computed by multiplying the quoted unit price for each specified task by the corresponding quantity in the owner)s estimates for quantities. owever, the total payment to the winning contractor will be based on the actual quantities multiplied by the respective quoted unit prices.

Negotiated Contracts
#nstead of inviting competitive bidding, private owners often choose to award construction contracts with one or more selected contractors. ' major reason for using negotiated contracts is the flexibility of this type of pricing arrangement, particularly for projects of large si*e and great complexity or for projects which substantially duplicate previous facilities sponsored by the owner. 'n owner may value the expertise and integrity of a particular contractor who has a good reputation or has worked successfully for the owner in the past. #f it becomes necessary to meet a deadline for completion of the project, the construction of a project may proceed without waiting for the completion of the detailed plans and specifications with a contractor that the owner can trust. owever, the owner)s staff must be highly knowledgeable and competent in evaluating contractor proposals and monitoring subsequent performance. #n general, negotiated contracts require the reimbursement of direct project cost plus the contractor)s fee as determined by one of the following methods+ &. -. .. /. 0. ,ost plus fixed percentage ,ost plus fixed fee ,ost plus variable fee Target estimate 1uaranteed maximum price or cost

The fixed percentage or fixed fee is determined at the outset of the project, while variable fee and target estimates are used as an incentive to reduce costs by sharing any cost savings. ' guaranteed maximum cost arrangement imposes a penalty on a contractor for cost overruns and failure to complete the project on time. With a guaranteed maximum price contract, amounts below the maximum are typically shared between the owner and the contractor, while the contractor is responsible for costs above the maximum.

Speculative Residential Construction

#n residential construction, developers often build houses and condominiums in anticipation of the demand of home buyers. Because the basic needs of home buyers are very similar and home designs can be standardi*ed to some degree, the probability of finding buyers of good housing units within a relatively short time is quite high.

,onsequently, developers are willing to undertake speculative building and lending institutions are also willing to finance such construction. The developer essentially set the price for each housing unit as the market will bear, and can adjust the prices of remaining units at any given time according to the market trend.

Force-Account Construction
2ome owners use in3house labor forces to perform a substantial amount of construction, particularly for addition, renovation and repair work. Then, the total of the force3account charges including in3house overhead expenses will be the pricing arrangement for the construction.

8.2 Contract Provisions for Ris Allocation

4rovisions for the allocation of risk among parties to a contract can appear in numerous areas in addition to the total construction price. Typically, these provisions assign responsibility for covering the costs of possible or unforeseen occurences. ' partial list of responsibilities with concomitant risk that can be assigned to different parties would include+

5orce majeure !i.e., this provision absolves an owner or a contractor for payment for costs due to 6'cts of 1od6 and other external events such as war or labor strikes" #ndemnification !i.e., this provision absolves the indemnified party from any payment for losses and damages incurred by a third party such as adjacent property owners." 7iens !i.e., assurances that third party claims are settled such as 6mechanics liens6 for worker wages", 7abor laws !i.e., payments for any violation of labor laws and regulations on the job site", $iffering site conditions !i.e., responsibility for extra costs due to unexpected site conditions", $elays and extensions of time, 7iquidated damages !i.e., payments for any facility defects with payment amounts agreed to in advance" ,onsequential damages !i.e., payments for actual damage costs assessed upon impact of facility defects", 8ccupational safety and health of workers, 4ermits, licenses, laws, and regulations, 9qual employment opportunity regulations, Termination for default by contractor, 2uspension of work, Warranties and guarantees.

The language used for specifying the risk assignments in these areas must conform to legal requirements and past interpretations which may vary in different jurisdictions or over time. Without using standard legal language, contract provisions may be unenforceable. (nfortunately, standard legal language for this purpose may be difficult to understand. 's a result, project managers often have difficulty in interpreting their particular responsibilities. ,ompetent legal counsel is required to advise the different parties to an agreement about their respective responsibilities. 2tandard forms for contracts can be obtained from numerous sources, such as the 'merican #nstitute of 'rchitects !'#'" or the 'ssociated 1eneral ,ontractors !'1,". These standard forms may include risk and responsibility allocations which are unacceptable to one or more of the contracting parties. #n particular, standard forms may be biased to reduce the risk and responsibility of the originating organi*ation or group. 4arties to a contract should read and review all contract documents carefully. Three examples appearing below to illustrate contract language resulting in different risk assignments between a contractor !,8:T;',T8;" and an owner !,8<4':=". 9ach contract provision allocates different levels of indemnification risk to the contractor. >&?

!"ample 8-1# A Contract Provision !"ample $it% &ig% Contractor Ris 69xcept where the sole negligence of ,8<4':= is involved or alleged, ,8:T;',T8; shall indemnify and hold harmless ,8<4':=, its officers, agents and employees, from and against any and all loss, damage, and liability and from any and all claims for damages on account of or by reason of bodily injury, including death, not limited to the employees of ,8:T;',T8;, ,8<4':=, and of any subcontractor or ,8:T;',T8;, and from and against any and all damages to property, including property of COMPANY and third parties, direct and/or consequential, caused by or arising out of, in while or in part, or claimed to have been caused by or to have arisen out of, in whole or in part, an act of omission of ,8:T;',T8; or its agents, employees, vendors, or subcontractors, of their employees or agents in connection with the performance of the ,ontract $ocuments, whether or not insured against@ and ,8:T;',T8; shall, at its own cost and expense, defend any claim, suit, action or proceeding, whether groundless or not, which may be commenced against ,8<4':= by reason thereof or in connection therewith, and ,8:T;',T8; shall pay any and all judgments which may be recovered in such action, claim, proceeding or suit, and defray any and all expenses, including costs and attorney)s fees which may be incurred by reason of such actions, claims, proceedings, or suits.6 Comment# This is a very burdensome provision for the contractor. #t makes the contractor responsible for practically every conceivable occurrence and type of damage, except when a claim for loss or damages is due to the sole negligence of the owner. 's a

practical matter, sole negligence on a construction project is very difficult to ascertain because the work is so inter3twined. 2ince there is no dollar limitation to the contractor)s exposure, sufficient liability coverage to cover worst scenario risks will be difficult to obtain. The best the contractor can do is to obtain as complete and broad excess liability insurance coverage as can be purchased. This insurance is costly, so the contractor should insure the contract price is sufficiently high to cover the expense.

!"ample 8-2# An !"ample Contract Provision $it% 'edium Ris Contractor

Allocation to

6,8:T;',T8; shall protect, defend, hold harmless, and indemnify ,8<4':= from and against any loss, damage, claim, action, liability, or demand whatsoever !including, with limitation, costs, expenses, and attorney)s fees, whether for appeals or otherwise, in connection therewith", arising out of any personal injury !including, without limitation, injury to any employee of ,8<4':=, ,8:T;',T8; or any subcontractor", arising out of any personal injury !including, without limitation, injury to any employee of ,8<4':=, ,8:T;',T8;, or any subcontractor", including death resulting therefrom or out of any damage to or loss or destruction of property, real and or personal !including property of ,8<4':=, ,8:T;',T8;, and any subcontractor, and including tools and equipment whether owned, rented, or used by ,8:T;',T8;, any subcontractor, or any workman" in any manner based upon, occasioned by , or attributable or related to the performance, whether by the ,8:T;',T8; or any subcontractor, of the Work or any part thereof, and ,8:T;',T8; shall at its own expense defend any and all actions based thereon, except where said personal injury or property damage is caused by the negligence of ,8<4':= or ,8<4':=)2 employees. 'ny loss, damage, cost expense or attorney)s fees incurred by ,8<4':= in connection with the foregoing may, in addition to other remedies, be deducted from ,8:T;',T8;)2 compensation, then due or thereafter to become due. COMPANY shall effect for the benefit of CON !AC O! a wai"er of subrogation on the e#isting facilities, including consequential damages such as, but not by way of limitation, loss of profit and loss of product or plant downtime but e#cluding any deductibles which shall e#ist as at the date of this CON !AC $ pro"ided, howe"er, that said wai"er of subrogation shall be e#panded to include all said deductible amounts on the acceptance of the %or& by COMPANY'6 Comment+ This clause provides the contractor considerable relief. e still has unlimited exposure for injury to all persons and third party property but only to the extent caused by the contractor)s negligence. The 6sole6 negligence issue does not arise. 5urthermore, the contractor)s liability for damages to the owner)s property3a major concern for contractors working in petrochemical complexes, at times worth billions3is limited to the owner)s insurance deductible, and the owner)s insurance carriers have no right of recourse against the contractor. The contractor)s limited exposure regarding the owner)s facilities ends on completion of the work.

!"ample 8-(# An !"ample Contract Provision $it% )o$ Ris Contractor

Allocation to

6,8:T;',T8; hereby agrees to indemnify and hold ,8<4':= and%or any parent, subsidiary, or affiliate, or ,8<4':= and%or officers, agents, or employees of any of them, harmless from and against any loss or liability arising directly or indirectly out of any claim or cause of action for loss or damage to property including, but not limited to, ,8:T;',T8;)2 property and ,8<4':=)2 property and for injuries to or death of persons including but not limited to ,8:T;',T8;)2 employees, caused by or resulting from the performance of the work by ,8:T;',T8;, its employees, agents, and subcontractors and shall, at the option of ,8<4':=, defend ,8<4':= at ,8:T;',T8;)2 sole expense in any litigation involving the same regardless of whether such work is performed by ,8:T;',T8;, its employees, or by its subcontractors, their employees, or all or either of them. (n all instances, CON !AC O!)* indemnity to COMPANY shall be limited to the proceeds of CON !AC O!)* umbrella liability insurance co"erage'6 Comment+ With respect to indemnifying the owner, the contractor in this provision has minimal out3 of3pocket risk. 9xposure is limited to whatever can be collected from the contractor)s insurance company.

8.( Ris s and *ncentives on Construction +ualit,

'll owners want quality construction with reasonable costs, but not all are willing to share risks and%or provide incentives to enhance the quality of construction. #n recent years, more owners recogni*e that they do not get the best quality of construction by squee*ing the last dollar of profit from the contractor, and they accept the concept of risk sharing%risk assignment in principle in letting construction contracts. owever, the implementation of such a concept in the past decade has received mixed results. <any public owners have been the victims of their own schemes, not only because of the usual requirement in letting contracts of public works through competitive bidding to avoid favoritism, but at times because of the sheer weight of entrenched bureaucracy. 2ome contractors steer away from public works altogether@ others submit bids at higher prices to compensate for the restrictive provisions of contract terms. 's a result, some public authorities find that either there are few responsible contractors responding to their invitations to submit bids or the bid prices far exceed their engineers) estimates. Those public owners who have adopted the federal government)s risk sharing%risk assignment contract concepts have found that while initial bid prices may have decreased somewhat, claims and disputes on contracts are more frequent than before, and notably more so than in privately funded construction. 2ome of these claims and disputes can no doubt be avoided by improving the contract provisions. >-? A

2ince most claims and disputes arise most frequently from lump sum contracts for both public and private owners, the following factors associated with lump sum contracts are particularly noteworthy+

unbalanced bids in unit prices on which periodic payment estimates are based. change orders subject to negotiated payments changes in design or construction technology incentives for early completion

'n unbalanced bid refers to raising the unit prices on items to be completed in the early stage of the project and lowering the unit prices on items to be completed in the later stages. The purpose of this practice on the part of the contractor is to ease its burden of construction financing. #t is better for owners to offer explicit incentives to aid construction financing in exchange for lower bid prices than to allow the use of hidden unbalanced bids. (nbalanced bids may also occur if a contractor feels some item of work was underestimated in amount, so that a high unit price on that item would increase profits. 2ince lump sum contracts are awarded on the basis of low bids, it is difficult to challenge the low bidders on the validity of their unit prices except for flagrant violations. ,onsequently remedies should be sought by requesting the contractor to submit pertinent records of financial transactions to substantiate the expenditures associated with its monthly billings for payments of work completed during the period. 8ne of the most contentious issues in contract provisions concerns the payment for change orders. The owner and its engineer should have an appreciation of the effects of changes for specific items of work and negotiate with the contractor on the identifiable cost of such items. The owner should require the contractor to submit the price quotation within a certain period of time after the issuance of a change order and to assess whether the change order may cause delay damages. #f the contract does not contain specific provisions on cost disclosures for evaluating change order costs, it will be difficult to negotiate payments for change orders and claim settlements later. #n some projects, the contract provisions may allow the contractor to provide alternative design and%or construction technology. The owner may impose different mechanisms for pricing these changes. 5or example, a contractor may suggest a design or construction method change that fulfills the performance requirements. 2avings due to such changes may accrue to the contractor or the owner, or may be divided in some fashion between the two. The contract provisions must reflect the ownersB risk3reward objectives in calling for alternate design and%or construction technology. While innovations are often sought to save money and time, unsuccessful innovations may require additional money and time to correct earlier misjudgment. 't worse, a failure could have serious consequences. #n spite of admonitions and good intentions for better planning before initiating a construction project, most owners want a facility to be in operation as soon as possible once a decision is made to proceed with its construction. <any construction contracts contain provisions of penalties for late completion beyond a specified deadline@ however, unless such provisions are accompanied by similar incentives for early completion, they may be ruled unenforceable in court. 9arly completion may result in

significant savings, particularly in rehabilitation projects in which the facility users are inconvenienced by the loss of the facility and the disruption due to construction operations.

!"ample 8--# Ar ansas Rice .ro$ers Cooperative Assoc. vs. Alc%em, *ndustries ' &DEA court case can illustrate the assumption of risk on the part of contractors and design professionals. >.? The 'rkansas ;ice 1rowers ,ooperative contracted with 'lchemy #ndustries, #nc. to provide engineering and construction services for a new facility intended to generate steam by burning rice hulls. (nder the terms of the contract, 'lchemy #ndustries guaranteed that the completed plant would be capable of 6reducing a minimum of seven and one3half tons of rice hulls per hour to an ash and producing a minimum of /E million BT()s per hour of steam at -FF pounds pressure.6 (nfortunately, the finished plant did not meet this performance standard, and the 'rkansas ;ice 1rowers ,ooperative 'ssociation sued 'lchemy #ndustries and its subcontractors for breach of warranty. $amages of almost G&.0 million were awarded to the 'ssociation.

8.- /,pes of Construction Contracts

While construction contracts serve as a means of pricing construction, they also structure the allocation of risk to the various parties involved. The owner has the sole power to decide what type of contract should be used for a specific facility to be constructed and to set forth the terms in a contractual agreement. #t is important to understand the risks of the contractors associated with different types of construction contracts.

)ump Sum Contract

#n a lump sum contract, the owner has essentially assigned all the risk to the contractor, who in turn can be expected to ask for a higher markup in order to take care of unforeseen contingencies. Beside the fixed lump sum price, other commitments are often made by the contractor in the form of submittals such as a specific schedule, the management reporting system or a quality control program. #f the actual cost of the project is underestimated, the underestimated cost will reduce the contractor)s profit by that amount. 'n overestimate has an opposite effect, but may reduce the chance of being a low bidder for the project.

0nit Price Contract

#n a unit price contract, the risk of inaccurate estimation of uncertain quantities for some key tasks has been removed from the contractor. owever, some contractors may submit an 6unbalanced bid6 when it discovers large discrepancies between its estimates and the E

owner)s estimates of these quantities. $epending on the confidence of the contractor on its own estimates and its propensity on risk, a contractor can slightly raise the unit prices on the underestimated tasks while lowering the unit prices on other tasks. #f the contractor is correct in its assessment, it can increase its profit substantially since the payment is made on the actual quantities of tasks@ and if the reverse is true, it can lose on this basis. 5urthermore, the owner may disqualify a contractor if the bid appears to be heavily unbalanced. To the extent that an underestimate or overestimate is caused by changes in the quantities of work, neither error will effect the contractor)s profit beyond the markup in the unit prices.

Cost Plus Fi"ed Percentage Contract

5or certain types of construction involving new technology or extremely pressing needs, the owner is sometimes forced to assume all risks of cost overruns. The contractor will receive the actual direct job cost plus a fixed percentage, and have little incentive to reduce job cost. 5urthermore, if there are pressing needs to complete the project, overtime payments to workers are common and will further increase the job cost. (nless there are compelling reasons, such as the urgency in the construction of military installations, the owner should not use this type of contract.

Cost Plus Fi"ed Fee Contract

(nder this type of contract, the contractor will receive the actual direct job cost plus a fixed fee, and will have some incentive to complete the job quickly since its fee is fixed regardless of the duration of the project. owever, the owner still assumes the risks of direct job cost overrun while the contractor may risk the erosion of its profits if the project is dragged on beyond the expected time.

Cost Plus 1aria2le Percentage Contract

5or this type of contract, the contractor agrees to a penalty if the actual cost exceeds the estimated job cost, or a reward if the actual cost is below the estimated job cost. #n return for taking the risk on its own estimate, the contractor is allowed a variable percentage of the direct job3cost for its fee. 5urthermore, the project duration is usually specified and the contractor must abide by the deadline for completion. This type of contract allocates considerable risk for cost overruns to the owner, but also provides incentives to contractors to reduce costs as much as possible.

/arget !stimate Contract

This is another form of contract which specifies a penalty or reward to a contractor, depending on whether the actual cost is greater than or less than the contractor)s estimated direct job cost. (sually, the percentages of savings or overrun to be shared by the owner and the contractor are predetermined and the project duration is specified in the contract. Bonuses or penalties may be stipulated for different project completion dates.

.uaranteed 'a"imum Cost Contract

When the project scope is well defined, an owner may choose to ask the contractor to take all the risks, both in terms of actual project cost and project time. 'ny work change orders from the owner must be extremely minor if at all, since performance specifications are provided to the owner at the outset of construction. The owner and the contractor agree to a project cost guaranteed by the contractor as maximum. There may be or may not be additional provisions to share any savings if any in the contract. This type of contract is particularly suitable for turn&ey operation.

8.3 Relative Costs of Construction Contracts

;egardless of the type of construction contract selected by the owner, the contractor recogni*es that the actual construction cost will never be identical to its own estimate because of imperfect information. 5urthermore, it is common for the owner to place work change orders to modify the original scope of work for which the contractor will receive additional payments as stipulated in the contract. The contractor will use different markups commensurate with its market circumstances and with the risks involved in different types of contracts, leading to different contract prices at the time of bidding or negotiation. The type of contract agreed upon may also provide the contractor with greater incentives to try to reduce costs as much as possible. The contractor)s gross profit at the completion of a project is affected by the type of contract, the accuracy of its original estimate, and the nature of work change orders. The owner)s actual payment for the project is also affected by the contract and the nature of work change orders. #n order to illustrate the relative costs of several types of construction contracts, the pricing mechanisms for such construction contracts are formulated on the same direct job cost plus corresponding markups reflecting the risks. 7et us adopt the following notation+ 9H <H BH 'H (H ,H 4H 5H ;H ;i H :H contractor)s original estimate of the direct job cost at the time of contract award amount of markup by the contractor in the contract estimated construction price at the time of signing contract contractor)s actual cost for the original scope of work in the contract underestimate of the cost of work in the original estimate !with negative value of ( denoting an overestimate" additional cost of work due to change orders actual payment to contractor by the owner contractor)s gross profit basic percentage markup above the original estimate for fixed fee contract premium percentage markup for contract type i such that the total percentage markup is !; I ;i", e.g. !; I ;&" for a lump sum contract, !; I ;-" for a unit price contract, and !; I ;." for a guaranteed maximum cost contract a factor in the target estimate for sharing the savings in cost as agreed upon by the owner and the contractor, with F : &. &F

't the time of a contract award, the contract price is given by+ !E.&"

,=++M

The underestimation of the cost of work in the original contract is defined as+ !E.-"
- = A+

Then, at the completion of the project, the contractor)s actual cost for the original scope of work is+ !E.."
A = + +-

5or various types of construction contracts, the contractor)s markup and the price for construction agreed to in the contract are shown in Table E3&. :ote that at the time of contract award, it is assumed that ' H 9, even though the effects of underestimation on the contractor)s gross profits are different for various types of construction contracts when the actual cost of the project is assessed upon its completion. /AB)! 8-1 8riginal 9stimated ,ontract 4rices Type of ,ontract <arkup ,ontract 4rice &. 7ump sum < H !; I;&"9 B H !& I ; I ;&"9 -. (nit price < H !; I ;-"9 B H !& I ; I ;-"9 .. ,ost plus fixed J < H ;' H ;9 B H !& I ;"9 /. ,ost plus fixed fee < H ;9 B H !& I ;"9 0. ,ost plus variable J < H ; !-9 3 '" H ;9 B H !& I ;"9 A. Target estimate < H ;9 I : !93'" H ;9 B H !& I ;"9 C. 1uaranteed max cost < H !; I ;."9 B H !& I ; I ;."9

4ayments of change orders are also different in contract provisions for different types of contracts. 2uppose that payments for change orders agreed upon for various types of contracts are as shown in column - of Table E3-. The owner)s actual payments based on these provisions as well as the incentive provisions for various types of contracts are given in column . of Table E3-. The corresponding contractor)s profits under various contractual arrangements are shown in Table E3.. #t is important to note that the equations in Tables E3& through E3. are illustrative, subject to the simplified conditions of payments assumed under the various types of contracts. When the negotiated conditions of payment are different, the equations must also be modified.

/AB)! 8-2 8wner)s 'ctual 4ayment with $ifferent ,ontract 4rovisions

&&

Type of ,ontract ,hange 8rder 4ayment &. 7ump sum ,!& I ; I ;&" -. (nit price ,!& I ; I ;-" .. ,ost plus fixed J ,!& I ;" /. ,ost plus fixed fee , 0. ,ost plus variable J ,!& I ;" A. Target estimate , C. 1uaranteed max cost F

8wner)s 4ayment 4 H B I ,!& I ; I ;&" 4 H !& I ; I ;-"' I , 4 H !& I ;"!' I ," 4 H ;9 I ' I , 4 H ; !-9 3 ' I ," I ' I , 4 H ;9 I : !9 3 '" I ' I , 4HB

/AB)! 8-( ,ontractor)s 1ross 4rofit with $ifferent ,ontract 4rovisions Type of ,ontract 4rofit from ,hange 8rder ,ontractor)s 1ross 4rofit &. 7ump sum ,!; I ;&" 5 H 9 3 ' I !; I ;&"!9 I ," -. (nit price ,!; I ;5 H !; I ;-"!' I ," .. ,ost plus fixed J ,; 5 H ; !' I ," /. ,ost plus fixed fee F 5 H ;9 0. ,ost plus variable J ,; 5 H ; !-9 3 ' I ," A. Target estimate F 5 H ;9 I : !9 3 '" C. 1uaranteed max cost 3, 5 H !& I ; I ;."9 3 ' 3 , !"ample 8-3# Contractor4s .ross Profits under 5ifferent Contract Arrangements ,onsider a construction project for which the contractor)s original estimate is GA,FFF,FFF. 5or various types of contracts, ; H &FJ, ; & H -J, ;- H &J, ;. H 0J and : H F.0. The contractor is not compensated for change orders under the guaranteed maximum cost contract if the total cost for the change orders is within AJ !G.AF,FFF" of the original estimate. $etermine the contractor)s gross profit for each of the seven types of construction contracts for each of the following conditions. !a" ( H F, , H F !b" ( H F, , H AJ 9 H G.AF,FFF !c" ( H /J 9 H G-/F,FFF, , H F !d" ( H /J 9 H G-/F,FFF , H AJ 9 H G.AF,FFF !e" ( H 3/J 9 H 3G-/F,FFF, , H F !f" ( H 3/J 9 H 3G-/F,FFF, , H AJ 9 H G.AF,FFF #n this example, the percentage markup for the cost plus fixed percentage contract is &FJ which is used as the bench mark for comparison. The percentage markup for the lump sum contract is &-J while that for the unit price contract is &&J, reflecting the degrees of higher risk. The fixed fee for the cost plus fixed fee is based on &FJ of the estimated costs, which is comparable to the cost plus fixed percentage contract if there is no overestimate or underestimate in cost. The basic percentage markup is &FJ for both the cost plus variable percentage contract and the target estimator contract, but they are subject to incentive bonuses and penalties that are built in the formulas for owners) payments. The percentage markup for the guaranteed maximum cost contract is &0J to &-

account for the high risk undertaken by the contractor. The results of computation for all seven types of contracts under different conditions of underestimation ( and change order , are shown in Table E3/ /AB)! 8-- ,ontractor)s 1ross 4rofits under $ifferent ,onditions !in G&,FFF" Type of ,ontract &. 7ump sum -. (nit price .. ,ost I fixed J /. ,ost I fixed fee 0. ,ost I Kar J A. Target estimate C. 1uar. max. cost (HF (HF (H/J9 (H/J9 (H3/J9 (H3/J9 ,HF ,HAJ9 ,HF ,HAJ9 ,HF ,HAJ9 GC-F AAF AFF AFF AFF AFF DFF GCA. CFF A.A AFF A.A AFF 0/F G/EF AEA A-/ AFF 0CA /EF AAF G0-. C-A AAF AFF A&A /EF .FF GDAF A./ 0CA AFF A-/ C-F &,&/F G&,FF. AC/ A&AFF AAF C-F CEF

!"ample 8-6# 7$ner4s Pa,ments under 5ifferent Contract Arrangements (sing the data in 9xample E30, determine the owner)s actual payment for each of the seven types of construction contracts for the same conditions of ( and ,. The results of computation are shown in Table E30. /AB)! 8-3 8wner)s 'ctual 4ayments under $ifferent ,onditions !in G&,FFF" Type of ,ontract (HF ,HF (HF (H/J9 (H/J9 (H3/J9 (H3/J9 ,HAJ9 ,HF ,HAJ9 ,HF ,HAJ9 GA,C-F A,D-A A,EA/ A,E/F A,E&A A,C-F A,DFF GC,&-. C,.-A C,-AF C,-FF C,-&C,FEF A,DFF GA,C-F A,.D/ A,..A A,.AF A,.E/ A,/EF A,DFF GC,&-. A,CD/ A,C.A,C-F A,CEF A,E/F A,DFF

&. 7ump sum -. (nit price .. ,ost I fixed J /. ,ost I fixed fee 0. ,ost I Kar J A. Target estimate C. guar. max. cost

GA,C-F GC,&-. A,AAF C,FAF A,AFF A,DDA A,AFF A,DAF A,AFF A,DDA A,AFF A,DAF A,DFF A,DFF

8.6 Principles of Competitive Bidding

,ompetitive bidding on construction projects involves decision making under uncertainty where one of the greatest sources of the uncertainty for each bidder is due to the &.

unpredictable nature of his competitors. 9ach bid submitted for a particular job by a contractor will be determined by a large number of factors, including an estimate of the direct job cost, the general overhead, the confidence that the management has in this estimate, and the immediate and long3range objectives of management. 2o many factors are involved that it is impossible for a particular bidder to attempt to predict exactly what the bids submitted by its competitors will be. #t is useful to think of a bid as being made up of two basic elements+ !&" the estimate of direct job cost, which includes direct labor costs, material costs, equipment costs, and direct filed supervision@ and !-" the markup or return, which must be sufficient to cover a portion of general overhead costs and allow a fair profit on the investment. ' large return can be assured simply by including a sufficiently high markup. owever, the higher the markup, the less chance there will be of getting the job. ,onsequently a contractor who includes a very large markup on every bid could become bankrupt from lack of business. ,onversely, the strategy of bidding with very little markup in order to obtain high volume is also likely to lead to bankruptcy. 2omewhere in between the two extreme approaches to bidding lies an 6optimum markup6 which considers both the return and the likelihood of being low bidder in such a way that, over the long run, the average return is maximi*ed. 5rom all indications, most contractors confront uncertain bidding conditions by exercising a high degree of subjective judgment, and each contractor may give different weights to various factors. The decision on the bid price, if a bid is indeed submitted, reflects the contractor)s best judgment on how well the proposed project fits into the overall strategy for the survival and growth of the company, as well as the contractor)s propensity to risk greater profit versus the chance of not getting a contract. 8ne major concern in bidding competitions is the amount of 6money left on the table,6 of the difference between the winning and the next best bid. The winning bidder would like the amount of 6money left on the table6 to be as small as possible. 5or example, if a contractor wins with a bid of G-FF,FFF, and the next lowest bid was G--0,FFF !representing G-0,FFF of 6money left on the table6", then the winning contractor would have preferred to have bid G--F,FFF !or perhaps G--/,DDD" to increase potential profits. 2ome of the major factors impacting bidding competitions include+

!"ogenous !conomic Factors

,ontractors generally tend to speciali*e in a submarket of construction and concentrate their work in particular geographic locations. The level of demand in a submarket at a particular time can influence the number of bidders and their bid prices. When work is scarce in the submarket, the average number of bidders for projects will be larger than at times of plenty. The net result of scarcity is likely to be the increase in the number of bidders per project and downward pressure on the bid price for each project in the submarket. 't times of severe scarcity, some contractors may cross the line between segments to expand their activities, or move into new geographic locations to get a larger share of the existing submarket. 9ither action will increase the risks incurred by such contractors as they move into less familiar segments or territories. The trend of market

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demand in construction and of the economy at large may also influence the bidding decisions of a contractor in other ways. #f a contractor perceives drastic increases in labor wages and material prices as a result of recent labor contract settlements, it may take into consideration possible increases in unit prices for determining the direct project cost. 5urthermore, the perceptions of increase in inflation rates and interest rates may also cause the contractor to use a higher markup to hedge the uncertainty. ,onsequently, at times of economic expansion and%or higher inflation rate, contractors are reluctant to commit themselves to long3term fixed price contracts.

C%aracteristics of Bidding Competition

'll other things being equal, the probability of winning a contract diminishes as more bidders participate in the competition. ,onsequently, a contractor tries to find out as much information as possible about the number and identities of potential bidders on a specific project. 2uch information is often available in the .odge ,ulletinL.odge ,ulletin !daily publication", 5. W. $odge ,orp., :ew =ork, :=.M or similar publications which provide data of potential projects and names of contractors who have taken out plans and specifications. 5or certain segments, potential competitors may be identified through private contacts, and bidders often confront the same competitor)s project after project since they have similar capabilities and interests in undertaking the same type of work, including si*e, complexity and geographical location of the projects. ' general contractor may also obtain information of potential subcontractors from publications such as Credit !eports!Credit !eports, Building ,onstruction $ivision, and Bradstreet, #nc., :ew =ork, :.=." published by $un and Bradstreet, #nc. owever, most contractors form an extensive network with a group of subcontractors with whom they have had previous business transactions. They usually rely on their own experience in soliciting subcontract bids before finali*ing a bid price for the project.

728ectives of .eneral Contractors in Bidding

The bidding strategy of some contractors is influenced by a policy of minimum percentage markup for general overhead and profit. owever, the percentage markup may also reflect additional factors stipulated by the owner such as high retention and slow payments for completed work, or perceptions of uncontrollable factors in the economy. The intensity of a contractor)s efforts in bidding a specific project is influenced by the contractor)s desire to obtain additional work. The winning of a particular project may be potentially important to the overall mix of work in progress or the cash flow implications for the contractor. The contractor)s decision is also influenced by the availability of key personnel in the contractor organi*ation. The company sometimes wants to reserve its resources for future projects, or commits itself to the current opportunity for different reasons.

Contractor4s Comparative Advantages

' final important consideration in forming bid prices on the part of contractors is the possible special advantages enjoyed by a particular firm. 's a result of lower costs, a

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particular contractor may be able to impose a higher profit markup yet still have a lower total bid than competitors. These lower costs may result from superior technology, greater experience, better management, better personnel, or lower unit costs. ' comparative cost advantage is the most desirable of all circumstances in entering a bid competition.

8.9 Principles of Contract Negotiation

:egotiation is another important mechanism for arranging construction contracts. 4roject managers often find themselves as participants in negotiations, either as principal negotiators or as expert advisors. These negotiations can be complex and often present important opportunities and risks for the various parties involved. 5or example, negotiation on work contracts can involve issues such as completion date, arbitration procedures, special work item compensation, contingency allowances as well as the overall price. 's a general rule, exogenous factors such as the history of a contractor and the general economic climate in the construction industry will determine the results of negotiations. owever, the skill of a negotiator can affect the possibility of reaching an agreement, the profitability of the project, the scope of any eventual disputes, and the possibility for additional work among the participants. Thus, negotiations are an important task for many project managers. 9ven after a contract is awarded on the basis of competitive bidding, there are many occasions in which subsequent negotiations are required as conditions change over time. #n conducting negotiations between two parties, each side will have a series of objectives and constraints. The overall objective of each party is to obtain the most favorable, acceptable agreement. ' two party, one issue negotiation illustrates this fundamental point. 2uppose that a developer is willing to pay up to G0FF,FFF for a particular plot of land, whereas the owner would be willing to sell the land for G/0F,FFF or more. These maximum and minimum sales prices represent constraints on any eventual agreement. #n this example, any purchase price between G/0F,FFF and G0FF,FFF is acceptable to both of the involved parties. This range represents a feasible agreement space' 2uccessful negotiations would conclude in a sales price within this range. Which party receives the G0F,FFF in the middle range between G/0F,FFF and G0FF,FFF would typically depend upon the negotiating skills and special knowledge of the parties involved. 5or example, if the developer was a better negotiator, then the sales price would tend to be close to the minimum G/0F,FFF level. With different constraints, it might be impossible to reach an agreement. 5or example, if the owner was only willing to sell at a price of G00F,FFF while the developer remains willing to pay only G0FF,FFF, then there would be no possibility for an agreement between the two parties. 8f course, the two parties typically do not know at the beginning of negotiations if agreements will be possible. But it is quite important for each party to the negotiation to have a sense of their own reser"ation price, such as the owner)s minimum selling price or the buyer)s maximum purchase price in the above example. &A

This reservation price is equal to the value of the best alternative to a negotiated agreement. 4oor negotiating strategies adopted by one or the other party may also preclude an agreement even with the existence of a feasible agreement range. 5or example, one party may be so demanding that the other party simply breaks off negotiations. #n effect, negotiations are not a well behaved solution methodology for the resolution of disputes. The possibility of negotiating failures in the land sale example highlights the importance of negotiating style and strategy with respect to revealing information. 2tyle includes the extent to which negotiators are willing to seem reasonable, the type of arguments chosen, the forcefulness of language used, etc. ,learly, different negotiating styles can be more or less effective. ,ultural factors are also extremely important. 'merican and Napanese negotiating styles differ considerably, for example. ;evealing information is also a negotiating decision. #n the land sale case, some negotiators would readily reveal their reserve or constraint prices, whereas others would conceal as much information as possible !i.e. 6play their cards close to the vest6" or provide misleading information. #n light of these tactical problems, it is often beneficial to all parties to adopt objective standards in determining appropriate contract provisions. These standards would prescribe a particular agreement or a method to arrive at appropriate values in a negotiation. 8bjective standards can be derived from numerous sources, including market values, precedent, professional standards, what a court would decide, etc. By using objective criteria of this sort, personalities and disruptive negotiating tactics do not become impediments to reaching mutually beneficial agreements. With additional issues, negotiations become more complex both in procedure and in result. With respect to procedure, the sequence in which issues are defined or considered can be very important. 5or example, negotiations may proceed on an issue3by3issue basis, and the outcome may depend upon the exact sequence of issues considered. 'lternatively, the parties may proceed by proposing complete agreement packages and then proceed to compare packages. With respect to outcomes, the possibility of the parties having different valuations or weights on particular issues arises. #n this circumstance, it is possible to trade3off the outcomes on different issues to the benefit of both parties. By yielding on an issue of low value to himself but high value to the other party, concessions on other issues may be obtained. The notion of 4areto optimal agreements can be introduced to identify negotiated agreements in which no change in the agreement can simultaneously make both parties better off. 5igure E3& illustrates 4areto optimal agreements which can be helpful in assessing the result of multiple issue negotiations. #n this figure, the axes represent the satisfaction or desirability of agreements to the parties, denoted # and ##. This representation assumes that one can place a dollar or utility value on various agreements reached in a multiple3issue negotiation between two parties. 4oints in the graph represent particular agreements on the different issues under consideration. ' particular point may be obtained by more than one contract agreement. The curved line encloses the set of all feasible agreements@ any point in this area is an acceptable agreement. 9ach party has a minimum acceptable satisfaction level in this graph. 4oints on the interior of this feasible

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area represent inferior agreements since some other agreement is possible that benefits both parties. 5or example, point B represents a more desirable agreement than point '. #n the previous example, point B might represent a purchase price of G/DF,FFF and an immediate purchase, whereas point ' might represent a G/C0,FFF sale price and a six month delay. The feasible points that are not inferior constitute the set of 4areto optimal or efficient agreements@ these points lie on the north3east quadrant of the feasible region as marked on the figure.

Figure 8-1 #llustration of a 4areto 8ptimal 'greement 2et

The definition of 4areto optimal agreements allows one to assess at least one aspect of negotiated outcomes. #f two parties arrive at an inferior agreement !such as point ' in 5igure E3&" then the agreement could be improved to the benefit of both parties' #n contrast, different 4areto optimal agreements !such as points B and , in 5igure E3&" can represent widely different results to the individual parties but do not have the possibility for joint improvement. 8f course, knowledge of the concept of 4areto optimal agreements does not automatically give any guidance on what might constitute the best agreements. <uch of the skill in contract negotiation comes from the ability to invent new options that represent mutual gains. 5or example, devising contract incentives for speedier completion of projects may result in benefits to both contractors and the owner. !"ample 8-9# !ffects of different value perceptions.

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2uppose that the closing date for sale of the land in the previous case must also be decided in negotiation. The current owner would like to delay the sale for six months, which would represent rental savings of G&F,FFF. owever, the developer estimates that the cost of a six month delay would be G-F,FFF. 'fter negotiation, suppose that a purchase price of G/C0,FFF and a six month purchase delay are agreed upon. This agreement is acceptable but not optimal for both parties. #n particular, both sides would be better off if the purchase price was increased by G&0,FFF and immediate closing instituted. The current owner would receive an additional payment of G&0,FFF, incur a cost of G&F,FFF, and have a net gain of G0,FFF. 2imilarly, the developer would pay G&0,FFF more for the land but save G-F,FFF in delay costs. While this superior result may seem obvious and easily achievable, recogni*ing such opportunities during a negotiation becomes increasingly difficult as the number and complexity of issues increases.

8.8 Negotiation Simulation# An !"ample

This construction negotiation game simulates a contract negotiation between a utility, 6,<1 1as6 and a design%construct firm, 64ipeline ,onstructors, #nc.6 >/? The negotiation involves only two parties but multiple issues. 4articipants in the game are assigned to represent one party or the other and to negotiate with a designated partner. #n a class setting, numerous negotiating partners are created. The following overview from the ,<1 1as participants) instructions describes the setting for the game+ ,<1 1as has the opportunity to provide natural gas to an automobile factory under construction. 2ervice will require a new sixteen mile pipeline through farms and light forest. The terrain is hilly with moderate slopes, and equipment access is relatively good. The pipeline is to be buried three feet deep. ,onstruction of the pipeline itself will be contracted to a qualified design%construction firm, while required compression stations and ancillary work will be done by ,<1 1as. 's project manager for ,<1 1as, you are about to enter negotiations with a local contractor, 64ipeline ,onstructors, #nc.6 This firm is the only local contractor qualified to handle such a large project. #f a suitable contract agreement cannot be reached, then you will have to break off negotiations soon and turn to another company. The 4ipeline ,onstructors, #nc. instructions offer a similar overview. To focus the negotiations, the issues to be decided in the contract are already defined+

5uration The final contract must specify a required completion date. Penalt, for )ate Completion The final contract may include a daily penalty for late project completion on the part of the contractor. Bonus for !arl, Completion The final contract may include a daily bonus for early project completion. &D

Report Format ,ontractor progress reports will either conform to the traditional ,<1 1as format or to a new format proposed by the state. Fre:uenc, of Progress Reports 4rogress reports can be required daily, weekly, bi3weekly or monthly. Conform to Pending )egislation Regarding Pipeline 'ar ing 2tate legislation is pending to require special markings and drawings for pipelines. The parties have to decide whether to conform to this pending legislation. Contract /,pe The construction contract may be a flat fee, a cost plus a percentage profit, or a guaranteed maximum with cost plus a percentage profit below the maximum. Amount of Flat Fee #f the contract is a flat fee, the dollar amount must be specified. Percentage of Profit #f the contract involves a percentage profit, then the percentage must be agreed upon. C'. .as Cler on Site The contract may specify that a ,<1 1as ,lerk may be on site and have access to all accounts or that only progress reports are made by 4ipeline ,onstructors, #nc. Penalt, for )ate Starting 5ate ,<1 1as is responsible for obtaining right3of3way agreements for the new pipeline. The parties may agree to a daily penalty if ,<1 1as cannot obtain these agreements.

' final contract requires an agreement on each of these issues, represented on a form signed by both negotiators. 's a further aid, each participant is provided with additional information and a scoring system to indicate the relative desirability of different contract agreements. 'dditional information includes items such as estimated construction cost and expected duration as well as company policies such as desired reporting formats or work arrangements. This information may be revealed or withheld from the other party depending upon an individual)s negotiating strategy. The numerical scoring system includes point totals for different agreements on specific issues, including interactions among the various issues. 5or example, the amount of points received by 4ipeline ,onstructors, #nc. for a bonus for early completion increases as the completion date become later' 'n earlier completion becomes more likely with a later completion date, and hence the probability of receiving a bonus increases, so the resulting point total likewise increases. The two firms have differing perceptions of the desirability of different agreements. #n some cases, their views will be directly conflicting. 5or example, increases in a flat fee imply greater profits for 4ipeline ,onstructors, #nc. and greater costs for ,<1 1as. #n some cases, one party may feel strongly about a particular issue, whereas the other is not particularly concerned. 5or example, ,<1 1as may want a clerk on site, while 4ipeline

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,onstructors, #nc. may not care. 's described in the previous section, these differences in the evaluation of an issue provide opportunities for negotiators. By conceding an unimportant issue to the other party, a negotiator may trade for progress on an issue that is more important to his or her firm. 9xamples of instructions to the negotiators appear below.

*nstructions to t%e Pipelines Constructors; *nc. Representative

'fter examining the project site, your company)s estimators are convinced that the project can be completed in thirty3six weeks. #n bargaining for the duration, keep two things in mind@ the longer past thirty3six weeks the contract duration is, the more money that can be made off the 6bonuses for being early6 and the chances of being late are reduced. That reduces the risk of paying a 6penalty for lateness6. Throughout the project the gas company will want progress reports. These reports take time to compile and therefore the fewer you need to submit, the better. #n addition, 2tate law dictates that the ;equired 2tandard ;eport be used unless the contractor and the owner agree otherwise. These standard reports are even more time consuming to produce than more traditional reports. The 2tate 7egislature is considering a law that requires accurate drawings and markers of all pipelines by all utilities. =ou would prefer not to conform to this uncertain set of requirements, but this is negotiable. What type of contract and the amount your company will be paid are two of the most important issues in negotiations. #n the 5lat 5ee contract, your company will receive an agreed amount from CM/ /as. Therefore, when there are any delays or cost overruns, it will be the full responsibility of your company. With this type of contract, your company assumes all the risk and will in turn want a higher price. =our estimators believe a cost and contingency amount of /,0FF,FFF dollars. =ou would like a higher fee, of course. With the ,ost 4lus ,ontract, the risk is shared by the gas company and your company. With this type of contract, your company will bill CM/ /as for all of its costs, plus a specified percentage of those costs. #n this case, cost overruns will be paid by the gas company. :ot only does the percentage above cost have to be decided upon but also whether or not your company will allow a 5ield ,lerk from the gas company to be at the job site to monitor reported costs. Whether or not he is around is of no concern to your company since its policy is not to inflate costs. This point can be used as a bargaining weapon. 5inally, your company is worried whether the gas company will obtain the land rights to lay the pipe. Therefore, you should demand a penalty for the potential delay of the project starting date.

*nstructions to t%e C'. .as Compan, Representative

#n order to satisfy the auto manufacturer, the pipeline must be completed in forty weeks. 'n earlier completion date will not result in receiving revenue any earlier. Thus, the only

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reason to bargain for shorter duration is to feel safer about having the project done on time. #f the project does exceed the forty week maximum, a penalty will have to be paid to the auto manufacturer. ,onsequently, if the project exceeds the agreed upon duration, the contractor should pay you a penalty. The penalty for late completion might be related to the project duration. 5or example, if the duration is agreed to be thirty3six weeks, then the penalty for being late need not be so severe. 'lso, it is normal that the contractor get a bonus for early completion. 8f course, completion before forty weeks doesn)t yield any benefit other than your own peace of mind. Try to keep the early bonus as low as possible. Throughout the project you will want progress reports. The more often these reports are received, the better to monitor the progress. 2tate law dictates that the ;equired 2tandard ;eport be used unless the contractor and the owner agree otherwise. These reports are very detailed and time consuming to review. =ou would prefer to use the traditional CM/ /as reports. The state legislature is considering a law that requires accurate drawings and markers of all pipelines by all utilities. 5or this project it will cost an additional G-0F,FFF to do this now, or GC0F,FFF to do this when the law is passed. 8ne of the most important issues is the type of contract, and the amount of be paid. The 5lat 5ee contract means that CM/ /as will pay the contractor a set amount. Therefore, when there are delays and cost overruns, the contractor assumes full responsibility for the individual costs. owever, this evasion of risk has to be paid for and results in a higher price. #f 5lat 5ee is chosen, only the contract price is to be determined. =our company)s estimators have determined that the project should cost about G0,FFF,FFF. The ,ost 4lus 4ercent contract may be cheaper, but the risk is shared. With this type of contract, the contractor will bill the gas company for all costs, plus a specified percentage of those costs. #n this case, cost overruns will be paid by the gas company. #f this type of contract is chosen, not only must the profit percentage be chosen, but also whether or not a gas company representative will be allowed on site all of the time acting as a 5ield ,lerk, to ensure that a proper amount of material and labor is billed. The usual percentage agreed upon is about ten percent. ,ontractors also have a concern whether or not they will receive a penalty if the gas right3of3way is not obtained in time to start the project. #n this case, CM/ /as has already secured the right3of3ways. But, if the penalty is too high, this is a dangerous precedent for future negotiations. owever, you might try to use this as a bargaining tool. !"ample 8-8# An e"ample of a negotiated contract ' typical contract resulting from a simulation of the negotiation between ,<1 1as and 4ipeline ,onstructors, #nc. appears in Table E3A. 'n agreement with respect to each pre3 defined issue is included, and the resulting contract signed by both negotiators. /AB)! 8-6 9xample of a :egotiated ,ontract between ,<1 1as and 4ipeline ,onstructors, #nc $uration .E weeks 4enalty for 7ate ,ompletion GA,EFF per day

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Bonus for 9arly ,ompletion ;eport 5ormat 5requency of 4rogress ;eports ,onform to 4ending 4ipeline <arking 7egislation ,ontract Type 'mount of 5lat 5ee 4ercentage of 4rofit ,<1 1as ,lerk on 2ite 4enalty for 7ate 2tarting $ate 2igned+ ,<1 1as ;epresentative 4ipeline ,onstructors, #nc.

GF per day traditional ,<1 form weekly yes flat fee G0,F0F,FFF :ot applicable yes G.,FFF per day

!"ample 8-<# Scoring s,stems for t%e negotiated contract games To measure the performance of the negotiators in the previous example, a scoring system is needed for the representative of 4ipeline ,onstructors, #nc. and another scoring system for the representative of ,<1 1as. These scoring systems for the companies associated with the issues described in 9xample E3C are designated as system '. #n order to make the negotiating game viable for classroom use, another set of instructions for each company is described in this example, and the associated scoring systems for the two companies are designated as 2ystem B. #n each game play, the instructor may choose a different combination of instructions and negotiating teams, leading to four possible combinations of scoring systems for 4ipeline ,onstructors, #nc. and ,<1 1as. >0?

*nstruction to t%e Pipeline Constructors; *nc. Representative

#n order to help you, your boss has left you with a scoring table for all the issues and alternatives. Two different scoring systems are listed here@ you will be assigned to use one or the other. #nstructions for scoring system ' are included in 2ection E.D. The instructions for scoring system B are as follows+ 'fter examining the site, your estimator believes that the project will require .E weeks. =ou are happy to conform with any reporting or pipeline marking system, since your computer based project control and design systems can easily produce these submissions. =ou would prefer to delay the start of the contract as long as possible, since your forces are busy on another job@ hence, you do not want to impose a penalty for late start. Try to maximi*e the amount of points, as they reflect profit brought into your company, or a cost savings. #n 4arts . and /, be sure to use the project duration agreed upon to calculate your score. 5inally, do not discuss your scoring system with the ,<1 1as representative@ this is proprietary informationO -.

SC7R*N. F7R P*P!)*N! C7NS/R0C/7RS; *NC. N7/!# :' means not acceptable and the deal will not be approved by your boss with any of these provisions. 'lso, the alternatives listed are the only ones in the context of this problem@ no other alternatives are acceptable. &. ,8<479T#8: $'T9 S,stem A :' F I0 I&F I-F I/F -. ;948;T2 2tate 2tandard ;eport ,<1 ;eports 3-F 30 F F

(nder .A Weeks .A weeks .C weeks .E weeks .D weeks /F weeks

S,stem B :' :' 3&F F I&F I-F

.. 49:'7T= 58; 7'T9:922 !G 49; $'=" 50RA/*7N =>!!?S@ Scoring S,stem A (6 (9 (8 Scoring S,stem B (9 (8 (< F 3 DDD 3& 3& 3& &,FFF 3 &,DDD 333-,FFF 3 -,DDD 3/ 3. 3. .,FFF 3 .,DDD 3A 30 3/ /,FFF 3 /,DDD 3E 3C 30 0,FFF 3 0,DDD 3&& 3D 3C A,FFF 3 A,DDD 3&/ 3&3D C,FFF 3 C,DDD 3&E 3&/ 3&& 8ver E,FFF :' :' :' /. B8:(2 58; B9#:1 9';7= !G 49; $'=" (6 (9 (8 (9 (8 (< F F F F F F / & / A A E . E &F

(< -A F 3& 33. 3/ 30 3A 3C :'

-A -1 F F 3& 3& 333. 3. :'

Scoring S,stem A Scoring S,stem B F 3 DDD &,FFF 3 &,DDD -,FFF 3 -,DDD .,FFF 3 .,DDD /,FFF 3 /,DDD 0,FFF 3 0,DDD

(< -A F / A &F &/

-A -1 / E &&A

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A,FFF 3 A,DDD C,FFF 3 C,DDD E,FFF 3 E,DDD D,FFF 3 D,DDD 8ver &F,FFF

/ 0 A C E

&F &&/ &A &E

&/ &E --A .F

&E -/ -E ..A

--E .A /F /0

0. ,8:58;< T8 49:$#:1 791#27'T#8: !<';P#:1 4#497#:92" A B =es I0 I&F :o I&0 I&F A. 8W 85T9: 58; T 9 4;81;922 ;948;T2 A :' 3-F 3&F 3A C. ,8:T;',T T=49 A 0 I-0

$aily Weekly Bi3weekly <onthly

B F F F F

5lat 5ee ,ost I QJ

B 0 I-0

*f Flat Fee do part 8 and s ip parts < and 1A. *f Cost B CD do parts < and 1A and s ip part 8. E. 57'T 599 !G" A :' I& for each &F,FFF D. #5 ,82T 47(2 QJ A :' I-0F I.C0 I/0F I/C0 I0FF I0-0 I00F IAFF IC-0 IDFF

Below /,0FF,FFF 8ver /,0FF,FFF

B 3&0 for each &F,FFF I- for each &F,FFF B :' :' I.FF I..F I.AF I/FF I//F I/EF I0/F IAFF IEFF

Below AJ AJ CJ EJ DJ &FJ &&J &-J &.J &/J 8ver &/J

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=es :o

&F. 1'2 ,8. 5#97$ ,79;P 8: 2#T9 A F F

B F I&F

&&. 49:'7T= 58; $97'=9$ 2T';T#:1 $'T9 $(9 T8 1'2 ,8<4':= 9;;8; !G 49; $'=" A B F 3 /DD :' :' 0FF 3 &/DD 3A 3&F &0FF 3 -/DD 3/ 3C &0FF 3 ./DD 330 .0FF 3 //DD 3& 3. /0FF 3 0/DD F 3& 00FF 3 A/DD I& F A0FF 3 C/DD II. C0FF or more I/ IA

*nstructions to t%e C'. .as Compan, Representative

#n order to help you, your boss has left you with a scoring table for all the issues and alternatives. Two different scoring systems are listed here@ you will be assigned to use one or the other. #nstructions for scoring system ' are included in 2ection E.D. The instructions for scoring system B are described as follows+ =our contract with the automobile company provides an incentive for completion of the pipeline earlier than .E weeks and a penalty for completion after .E weeks. To insure timely completion of the project, you would like to receive detailed project reports as often as possible. Try to maximi*e the number of points from the final contract provisions@ this corresponds to minimi*ing costs. $o not discuss your scoring systems with 4ipeline ,onstructors, #nc.

SC7R*N. SES/!' F7R C'. .AS N7/!# :' means not acceptable and the deal will not be approved by your boss with any of these provisions. #f you can)t negotiate a contract, your score will be I/0F. 'lso, the alternatives listed are the only ones in the context of this problem no other alternatives are acceptable. &. $(;'T#8: 48#:T2 -A

8ver /F weeks /F weeks .D weeks .E weeks .C weeks F3.A weeks -. ;948;T2 ;equired 2tandard ;eport 6Traditional6 ,<1 1as ;eports

S,stem A :' F II/ I0 IA A II&F

S,stem B 3/F 3&F IIE I&/ I&/ B F F

.. 49:'7T= 58; 7'T9:922 !G 49; $'=" 50RA/*7N =>!!?S@ Scoring S,stem A (6 (9 (8 Scoring S,stem B (8 (< -A F 3 DDD :' :' :' &,FFF 3 &,DDD D C A -,FFF 3 -,DDD &F D E .,FFF 3 .,DDD && &F D /,FFF 3 /,DDD &&& &F 0,FFF 3 0,DDD &. &&& A,FFF 3 A,DDD &/ &. &C,FFF 3 C,DDD &0 &0 &. E,FFF 3 E,DDD &A &0 &/ D,FFF 3 D,DDD &C &A &0 &F,FFF or more &E &A &0 /. B8:(2 58; B9#:1 9';7= !G 49; $'=" A EFFF or more :' CFFF 3 CDDD I. AFFF 3 ADDD IA 0FFF 3 0DDD IE /FFF 3 /DDD I&F .FFF 3 .DDD I&-FFF 3 -DDD I&. &FFF 3 &DDD I&/ F 3 DDD I&0

(< -1 :' . 0 A C E D && &&. &. B 30 33& F I0 IC ID I&. I&C

-A -2 :' F / 0 A C E D &F &&

0. ,8:58;< T8 49:$#:1 791#27'T#8: !<';P#:1 4#497#:92" A B =es I-0 F :o 3-0 :'

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A. 8W 85T9: 58; T 9 4;81;922 ;948;T2 A $aily I/0 Weekly I0F Bi3weekly I.F <onthly :' C. ,8:T;',T T=49 A -0 F

B I0F I.F I&F I0

5lat 5ee ,ost I QJ

B -0 F

*f Flat Fee do part 8 and s ip parts < and 1A. *f Cost B CD do parts < and 1A and s ip part 8. E. 57'T 599 !G" A :' I& for each &F,FFF below 0,FFF,FFF D. #5 ,82T 47(2 QJ A ID0F IEFF ICFF IAFF I00F I0-0 I0FF I/C0 I/0F I/FF I.FF I-FF :' &F. 1'2 ,8. 5#97$ ,79;P 8: 2#T9 A I-F

8ver 0,FFF,FFF F 3 0,FFF,FFF

B :' I& for each &F,FFF below 0,FFF,FFF B ICFF IAAF IA-F I0DF I0CF I00F I0.0 I0FF I//F I.EF I.FF I&FF I&F

Below 0J 0J AJ CJ EJ DJ &FJ &&J &-J &.J &/J &0J 8ver &/J

=es

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:o

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&&. 49:'7T= 58; $97'=9$ 2T';T#:1 $'T9 $(9 T8 (:'K'#7'B79 ;#1 T3853W'=2 !G 49; $'=" A B F 3 &,DDD I&F I. -,FFF 3 .,DDD IE I/,FFF 3 0,DDD IA I& A,FFF 3 C,DDD I/ F E,FFF 3 D,DDD I3&F &F,FFF or more :' 3-F

8.< Resolution of Contract 5isputes

8nce a contract is reached, a variety of problems may emerge during the course of work. $isputes may arise over quality of work, over responsibility for delays, over appropriate payments due to changed conditions, or a multitude of other considerations. ;esolution of contract disputes is an important task for project managers. The mechanism for contract dispute resolution can be specified in the original contract or, less desirably, decided when a dispute arises. The most prominent mechanism for dispute resolution is adjudication in a court of law. This process tends to be expensive and time consuming since it involves legal representation and waiting in queues of cases for available court times. 'ny party to a contract can bring a suit. #n adjudication, the dispute is decided by a neutral, third party with no necessary speciali*ed expertise in the disputed subject. 'fter all, it is not a prerequisite for judges to be familiar with construction proceduresO 7egal procedures are highly structured with rigid, formal rules for presentations and fact finding. 8n the positive side, legal adjudication strives for consistency and predictability of results. The results of previous cases are published and can be used as precedents for resolution of new disputes. :egotiation among the contract parties is a second important dispute resolution mechanism. These negotiations can involve the same sorts of concerns and issues as with the original contracts. :egotiation typically does not involve third parties such as judges. The negotiation process is usually informal, unstructured and relatively inexpensive. #f an agreement is not reached between the parties, then adjudication is a possible remedy. ' third dispute resolution mechanism is the resort to arbitration or mediation and conciliation. #n these procedures, a third party serves a central role in the resolution. These outside parties are usually chosen by mutually agreement of the parties involved and will have speciali*ed knowledge of the dispute subject. #n arbitration, the third party may make a decision which is binding on the participants. #n mediation and conciliation, the third party serves only as a facilitator to help the participants reach a mutually acceptable resolution. 7ike negotiation, these procedures can be informal and unstructured. 5inally, the high cost of adjudication has inspired a series of non3traditional -D

dispute resolution mechanisms that have some of the characteristics of judicial proceedings. These mechanisms include+

Private 8udging in which the participants hire a third party judge to make a decision, Neutral e"pert fact-finding in which a third party with speciali*ed knowledge makes a recommendation, and 'ini-trial in which legal summaries of the participants) positions are presented to a jury comprised of principals of the affected parties.

2ome of these procedures may be court sponsored or required for particular types of disputes. While these various disputes resolution mechanisms involve varying costs, it is important to note that the most important mechanism for reducing costs and problems in dispute resolution is the reasonableness of the initial contract among the parties as well as the competence of the project manager.

8.1A References
&. 'u, T., ;.7. Bostleman and 9.W. 4arti, 6,onstruction <anagement 1ame3 $eterministic <odel,6 Asce 0ournal of the Construction .i"ision , Kol. D0, &DAD, pp. -03.E. -. Building ;esearch 'dvisory Board, +#ploratory *tudy on !esponsibility, 1iability and Accountability for !is&s in Construction, :ational 'cademy of 2ciences, Washington, $.,., &DCE. .. ,onstruction #ndustry ,ost 9ffectiveness 4roject, 6,ontractual 'rrangements,6 ;eport '3C, The Business ;oundtable, :ew =ork, 8ctober &DE-. /. $ud*iak, W. and ,. endrickson, 6' :egotiating 2imulation 1ame,6 A*C+ 0ournal of Management in +ngineering, Kol. /, :o. -, &DEE. 0. 1raham, 4. ., 68wner <anagement of ;isk in ,onstruction ,ontracts,6 Current Practice in Cost +stimating and Cost Control, 4roceedings of an '2,9 ,onference, 'ustin, Texas, 'pril &DE., pp. -FC3-&0. A. 1reen, 9.$., 61etting 8ut of ,ourt 33 4rivate ;esolution of ,ivil $isputes,6 ,oston ,ar 0ournal, <ay3Nune &DEA, pp. &&3-F. C. 4ark, William ;., he *trategy of Contracting for Profit , -nd 9dition, 4rentice3 all, 9nglewood ,liffs, :N, &DEA. E. ;aiffa, oward, he Art and *cience of Negotiation, arvard (niversity 4ress, ,ambridge, <', &DE-. D. Walker, :., 9.:. Walker and T.P. ;ohdenburg, 1egal Pitfalls in Architecture, +ngineering and ,uilding Construction, -nd 9dition, <c1raw3 ill Book ,o., :ew =ork, &DCD.

.F

8.11 Pro2lems
&. 2uppose that in 9xample E30, the terms for the guaranteed maximum cost contract are such that change orders will not be compensated if their total cost is within .J of the original estimate, but will be compensated in full for the amount beyond .J of the original estimate. #f all other conditions remain unchanged, determine the contractor)s profit and the owner)s actual payment under this contract for the following conditions of ( and ,+ &. ( H F, , H AJ9 -. ( H /J9, , H AJ9 .. ( H 3 /J9, , H AJ9 -. 2uppose that in 9xample E30, the terms of the target estimate contract call for : H F.. instead of : H F.0, meaning that the contractor will receive .FJ of the savings. #f all other conditions remain unchanged, determine the contractor)s profit and the owner)s actual payment under this contract for the given conditions of ( and ,.

.. 2uppose that in 9xample E30, the terms of the cost plus variable percentage contract allow an incentive bonus for early completion and a penalty for late completion of the project. 7et $ be the number of days early, with negative value denoting $ days late. The bonus per days early or the penalty per day late with be T dollars. The agreed formula for owner)s payment is+ 4 H ;!-9 3 ' I ," I ' I , I $T!& I F./,%9" The value of T is set at G0,FFF per day, and the project is completed .F days behind schedule. #f all other conditions remain unchanged, find the contractor)s profit and the owner)s actual payment under this contract for the given conditions of ( and ,. /. ,onsider a construction project for which the contractor)s estimate is G.,FFF,FFF. 5or various types of contracts, ; H &FJ, ; & H .J, ;- H &.0J, ;. H AJ and : H F.A. The contractor is not compensated for change orders under the guaranteed maximum cost contract if the total cost for the change order is within 0J !G&0F,FFF" of the original estimate. $etermine the contractor)s gross profit for each of the seven types of construction contracts for each of the following conditions of ( and ,+ &. ( H F, , H F -. ( H F, , H /J 9 H G&-F,FFF .. ( H 0J 9 H G&0F,FFF, , H F /. ( H 0J 9 H G&0F,FFF, , H /J 9 H &-F,FFF 0. ( H -J 9 H GAF,FFF, , H F A. ( H -J 9 H GAF,FFF, , H /J 9 H &-F,FFF

.&

0. (sing the data in 4roblem /, determine the owner)s actual payment for each of the seven types of construction contracts for the same conditions of ( and ,.

A. 2uppose that in 4roblem /, the terms of the guaranteed maximum cost contract are such that change orders will not be compensated if their total cost is within .J of the original estimate, but will be compensated in full for the amount beyond .J of the original estimate. #f all conditions remained unchanged, determine the contractor)s profit and the owner)s actual payment under this contract for the following conditions of ( and ,+ &. ( H F, , H 0J9 -. ( H -J, , H 0J9 .. ( H 3-J, , H 0J9 C. 2uppose that in 4roblem /, the terms of the target estimate contract call for : H F.C instead of : H F.., meaning that the contractor will receive CFJ of the savings. #f all other conditions remain unchanged, determine the contractor)s profit and the owner)s actual payment under this contract for the given conditions of ( and ,.

E. 2uppose that in 4roblem /, the terms of the cost plus variable percentage contract allow an incentive bonus for early completion and a penalty for late completion of the project. 7et $ be the number of days early, with negative value denoting $ days late. The bonus per days early or the penalty per day late will be T dollars. The agreed formula for owner)s payment is+ 4 H ;!-9 3 ' I ," I ' I , I $T!& I F.-,%9" The value of T is set at G &F,FFF per day, and the project is completed -F days ahead schedule. #f all other conditions remain unchanged, find the contractor)s profit and the owner)s actual payment under this contract for the given conditions of ( and ,.

D. #n playing the construction negotiating game described in 2ection E.E, your instructor may choose one of the following combinations of companies and issues leading to different combinations of the scoring systems+ 4ipeline ,onstructors #nc. 2ystem ' 2ystem ' 2ystem B 2ystem B ,<1 1as 2ystem ' 2ystem B 2ystem ' 2ystem B

a. b. c. d.

.-

&F. 2ince the scoring systems are confidential information, your instructor will not disclose the combination used for the assignment. =our instructor may divide the class into groups of two students, each group acting as negotiators representing the two companies in the game. To keep the game interesting and fair, do not try to find out the scoring system of your negotiating counterpart. To seek insider information is unethical and illegalO

8.12 Footnotes
&. These examples are taken directly from ' ,onstruction #ndustry ,ost 9ffectiveness 4roject ;eport, 6,ontractual 'rrangements,6 The Business ;oundtable, :ew =ork, 'ppendix $, &DE-. 4ermission to quote this material from the Business ;oundtable is gratefully acknowledged. -. 2ee ,.$. 2utliff and N.1. Rack, Nr. 6,ontract 4rovisions that 9nsure ,omplete ,ost $isclosures6, Cost +ngineering, Kol. -D, :o. &F, 8ctober &DEC, pp. &F3&/. .. 'rkansas ;ice 1rowers v. 'lchemy #ndustries, #nc., (nited 2tates ,ourt of 'ppeals, 9ighth ,ircuit, &DEA. The court decision appears in CDC 5ederal ;eporter, -d 2eries, pp. 0A030C/. /. This game is further described in W. $ud*iak and ,. endrickson, 6' :egotiation 2imulation 1ame,6 A*C+ 0ournal of Management in +ngineering, Kol. /, :o. -, &DEE. 0. To undertake this exercise, the instructor needs to divide students into negotiating teams, with each individual assigned scoring system ' or B. :egotiators will represent 4ipeline ,onstructors, #nc. or ,<1 1as. :egotiating pairs should not be told which scoring system their counterpart is assigned.

..