3. The Prime Contract—An Overview
Key Words and Concepts
- Owner–architect/engineer contract
- Owner–CM contract
- Owner–contractor contract
- Design only
- Construct only
- Design–construct
- Turnkey
- Fast-track
- Construction management
- Agency relationship
- Commercial terms
- Risk of performance
- Cost-reimbursable commercial terms
- Fixed-price commercial terms
- Cost plus a percentage fee
- Cost plus a fixed fee
- Cost plus an incentive fee
- Target estimate
- Guaranteed maximum price
- Relationship of risk to profit
- Lump sum contract
- Schedule-of-bid-items contract
The prime contract is the start of the construction contract’s hierarchical chain. It is from this contract that subcontracts and sub-subcontracts are derived as well as many of the related secondary contracts discussed in Chapter 1. All construction-related prime contracts are not the same, or even necessarily similar, although as pointed out in Chapter 2, they all contain the three essential elements of offer, acceptance, and consideration that are fundamental to their formation.
What are the generic types of construction-related prime contracts, and what are the major distinguishing features between them? This chapter examines these questions from the standpoint of the identity of the contracting entities, the nature of the contractual services provided, and the commercial terms under which these contracts operate.
The Parties to Construction-Related Prime Contracts
Construction-related prime contracts involve owners, architect/engineers, construction managers, and construction contractors. In each case, the owner typically contracts with one of the others, depending on the particular purpose to be accomplished by the contract.
Owner–Architect Contracts and Owner–Engineer Contracts
As discussed in Chapter 1, architect/engineers (A/Es) are entities that typically design projects, prepare drawings and specifications for the construction contract, and in some instances perform field inspection services and administration of the construction contract. Architectural firms and engineering firms provide similar types of services. The difference between them is that architects deal with residential, commercial, and institutional buildings, whereas engineering companies deal with engineered structures such as highways, dams, bridges, tunnels, and heavy industrial buildings and structures. Prime contracts between owners and architects are called owner–architect contracts, whereas such contracts with engineers are called owner–engineer contracts.
Owner–Construction Manager Contracts
Construction managers (CMs) are distinctly different entities from A/Es. Their role is to manage the construction aspects of a project on behalf of the owner, usually as the owner’s agent. A prime contract between an owner and a construction manager is called an owner–CM contract.
Owner–Contractor Contracts
The fourth and final construction-related prime contract party is the construction contractor, the actual builder who determines the means, methods, techniques, sequence, and procedures and directs the actual construction operations. Contracts between owners and construction contractors are called owner–contractor contracts.
The Nature of the Contractual Service Provided
Another way to separate or distinguish one prime construction-related contract from another is by the nature of the contractual services that each involves.
Design Only Services
One obvious category of services is design only, which pertain to owner–A/E contracts. The use of the modifier “only” distinguishes this category of contract service from another called design–construct (design–build). The creation of drawings and specifications is a necessary part of the design process. Thus, design only is normally understood to include the preparation of a complete set of drawings and specifications used to secure bids and to construct the project. Design only contracts may also include assisting the owner in obtaining and evaluating bids for the purpose of awarding a construction contract, providing general inspection services during construction, and providing monthly certified estimates of construction work satisfactorily performed. These estimates are the basis of monthly progress payments and final payment to the construction contractor. Such contracts seldom require continuous on-site presence of the designer during construction or exhaustive site inspections to ensure compliance with the drawings and specifications. Only such inspection services necessary to reasonably assure general compliance are normally required under a design only contract.
Construct Only Services
The second obvious kind of contractual service is construct only, pertaining to owner–contractor contracts. This is the typical service provided by construction contractors. It includes assuming full contractual responsibility to perform the work according to the requirements of the drawings and specifications. Again, the modifier “only” is used to distinguish pure construction contracts from design–construct contracts.
Design–Construct Services
Recently, a hybrid form of contract has become prominent, where the contractual services of design only and construct only contracts are incorporated into design–construct contracts, sometimes called design–build contracts. In this form of contract, the architectural or engineering design work, creation of the drawings and specifications, and actual construction work are all performed by a single entity. Therefore, the owner enjoys the advantage of dealing throughout with only one party that has complete responsibility. A number of companies furnish complete design–construct services using their own forces. Other companies market design-construct services as joint ventures or by using a subcontract to provide part of the required services. An A/E may form a joint venture with a construction contractor or enter into a subcontract with a construction contractor for the construction portion of the overall project. More commonly, reciprocal arrangements are made with the construction contractor in the lead role.
Design–construct contracts can be very large and complex. One such contract in the heavy engineering field was the North Fork Hydroelectric Project on the Stanislaus River in central California completed for the Calavaras County Irrigation District in the late 1980s. This $450-million project consisting of a complex of dams, tunnels, and powerhouses was built by a joint venture of two large construction contractors who entered into a subcontract with a prominent A/E to provide the extensive design engineering services required. An even larger ($1.2 billion) design–construct contract was undertaken to design and build a rapid transit system for the City of Honolulu. The contract consisted of three phases for preliminary design, final design and construction, and an initial period of system operation. The contracting parties were the City and County of Honolulu and a joint venture of four large engineering and construction companies.[1]
Turnkey and Fast-Track Design–Construct Services
The two buzzwords often used in connection with design-build contracts are turnkey and fast-track.
Turnkey refers to a type of design-construct contract in which the contractor performs virtually every task required to produce a finished, functioning facility. This includes, in addition to the normal design–construct duties, procuring all permits and licenses and procuring and delivering all permanent machinery or equipment that may be involved. It would not be unusual for an owner who had contracted on a design–construct basis for a complete hydroelectric power station to furnish the turbines, generators, transformers, and switchgear, requiring the contractor to design and construct the balance of the facility (including furnishing all other necessary equipment and materials) around this owner-procured permanent equipment. Such a contract would be a design–construct contract, but it would not be a turnkey contract. If the contractor also furnished the equipment items just listed, the design-construct contract would also be a turnkey contract. All turnkey contracts are necessarily design–construct, but many design–construct contracts are not turnkey.
A fast-track project is one in which the construction phase is started at a point when only limited design work has been completed. For example, site grading and structure excavation begin when foundation design work is complete, but design work for all subsequent elements of the project, although in progress, is incomplete. This approach has the obvious advantage-on paper, at least-of shortening the overall delivery period for the completed facility, as Figure 3-1 illustrates. Since “time is money,” fast-track project delivery offers considerable potential savings to an owner. However, several severe risks accompany the fast-track approach that can erode the potential savings. The foremost risk is that after construction is in place a problem may develop with subsequent design that requires costly and time-consuming changes to work already completed. At the very least, the owner loses the flexibility to make relatively inexpensive changes reflecting new and unexpected requirements, an advantage enjoyed throughout the design phase of a non-fast-track project.
Sometimes, the fast-track approach is used when the design and construction entities are not the same, each operating under separate contracts with the owner. This creates even greater risk for the owner, particularly if the design phase is not carefully managed. Errors, changes, or delays in design that impact construction are almost certain to result in claims from the construction contractor for additional compensation and time for contract performance.
Construction Management Services
The final type of contract service involved in construction-related contracts is construction management, pertaining to owner–construction manager contracts. A distinction should be made between this use of the term construction management as an administrative service performed for an owner and the meaning of that term as it relates to the direct management of construction operations by a construction contractor’s organization. Although many of the same professional qualifications are required, the two activities are distinctly different. When services are being furnished on a construction management contract, the construction manager (CM) normally furnishes purely professional services as an agent of the owner and does not perform significant actual construction work—that is, an agency relationship is created between the CM and the owner. Although performing no actual construction, the CM may provide such “general conditions” items as utilities, sanitary services, trash removal, and general elevator or hoisting services for the benefit of the construction contractor or contractors. The CM’s role as a provider of professional services is not unlike that of the NE, who also provides professional services with the aim of serving the owner’s interest.
CMs may be involved in the very early stages of a project, even the predesign phase, to assist the owner in planning the project and in preparing a predesign conceptual estimate of the probable project cost. This involvement may continue through the design and preparation of the contract documents phase, where the CM will provide constructability advice, evaluations of alternate designs, and assistance in obtaining and evaluating bids for the construction of the project. During construction, the CM provides general administration authority, performs inspection services to ensure compliance with the plans and specifications, and assists in closing out the contract.
A CM acting as the owner’s agent is normally precluded from performing any actual construction work. However, in one form of CM contract, the agency relationship is partly replaced by the more normal owner-construction contractor relationship, where the CM’s interest is separate from the owner’s. Under this form of CM contract, the CM is part general contractor and does perform part of the construction work in addition to previously described CM services.
Although both entities are agents of the owner, CM and A/E services are essentially different. Figure 3-2 compares typical A/E and CM services. An A/E who has designed the project may also serve the owner as a CM. The same A/E entity may have two separate contracts with the owner, one for design services and another for CM services, or a single contract that provides for both.
Commercial Terms
Another major difference in construction-related prime contracts centers on commercial terms. This part of the contract establishes the method of payment to the party providing the services and defines where the financial risk of performance lies. The two broad classes of commercial terms for construction-related contracts are cost-reimbursable terms (cost-reimbursable contracts) and fixed-price terms (fixed-price contracts). A cost-reimbursable contract is one performed almost entirely on the owner’s funds. As the provider of the contract services incurs costs in providing the services, the owner periodically reimburses the provider for these incurred costs, usually on a monthly basis. The provider thus has little or no funds tied up in the contract and the payments received from the owner are directly dependent on the costs of the services provided. In contrast, there is no relation between the costs that the provider of services may be incurring and payment received from the owner on fixed-price contracts. The owner pays the fixed price stipulated in the contract regardless of what costs the provider is incurring. The fixed price is normally paid in a series of progress payments, usually monthly, as the services are provided.
Although there is basically only one form of fixed-price commercial terms, there are a number of different forms of cost-reimbursable terms.
Cost Plus Percentage Fee Terms
The simplest form of cost-reimbursable commercial terms is the cost plus percentage fee (CPPF) basis of payment, sometimes referred to as a cost plus or a time and materials basis. Many owner–A/E and owner–CM contracts operate on this form as do many small construction contracts. The owner agrees to reimburse the costs incurred by the provider of the services and, in addition, to pay a fee equal to a fixed percentage of incurred costs that is stipulated in the contract. Aside from the practice of professionalism and the desire of the provider to protect his or her reputation for fair dealing in order to secure additional business, there is no incentive for the provider to control costs. Theoretically, the more money spent, the more earned. In the case of construction contracts, this form of commercial terms has a particularly great potential for abuse.
Cost Plus Fixed Fee Terms
Because of the potential for abuse of cost plus percentage fee terms, the cost plus fixed fee (CPFF) form of commercial terms evolved. This form of payment is often used in federal government contracts for military-related construction when war or the threat of war has created conditions where firm pricing is not feasible. It is also broadly used for owner-A/E and owner-CM contracts and for private construction contracts when for one reason or another the drawings and specifications are not definitive enough to permit firm pricing. In this form of commercial terms, the owner reimburses all of the service provider’s costs and pays a fee that is fixed at the beginning of the contract. This fee will not change unless the scope of the services provided is expanded by change order to the contract. The determination of the fee is usually based on an estimate of the probable cost of the services to be provided or, sometimes in the case of owner-A/E or owner-CM contracts, on a percentage of the estimated construction cost of the project involved that is agreed to by the parties prior to entering into the contract. This form of commercial terms ensures that, if the costs overrun the original estimate without a change in scope, the provider of the services will not benefit by an increased fee as is the case under CPPF terms.
Target Estimate (Cost Plus Incentive Fee) Terms
A more sophisticated form of cost-reimbursable commercial terms is the target estimate form, sometimes called cost plus incentive fee (CPIF) terms. The target estimate is an estimate agreed upon by the parties prior to entering into the contract, as the most probable cost of providing the contemplated services. A fee as payment for the services is also agreed to, based on the magnitude of the target estimate, with the proviso that the parties will share the benefits or penalties of any underruns or overruns in the actual costs incurred in providing the services compared to the target estimate. The exact formula for the sharing of the underruns or overruns must also be agreed to at the onset and can vary widely depending on the particular contract. For instance, the formula could provide that the parties split underruns or overruns 50-50. It is not unusual for the provider of services to insist that the formula set a cap on the provider’s share of any overruns, the cap usually being equal to the amount of the agreed-upon fee. In all of the previously discussed forms of commercial terms, the provider of the services bears none of the financial risk of performance. In the target estimate arrangement, however, the provider does assume part of this risk, depending on the exact formula agreed upon. Ordinarily, the target estimate approach requires that fairly definitive information about the services to be provided be known at the onset. As a result, the target estimate will be relatively more accurate than the initial estimate for a cost plus fixed-fee contract, although probably not as accurate as an estimate for a fixed-price contract.
Guaranteed Maximum Price Terms
Another form of cost-reimbursable commercial terms is the guaranteed maximum price (GMP) arrangement. This form is similar to the target estimate form in that the parties agree on an initial estimate for the cost of the contemplated services and on a fee for the provider based on this estimated cost. The agreed-upon estimate for the cost of providing the services and the agreed-upon fee, usually along with an allowance for contingencies, are then added together to yield the guaranteed maximum price which, as its name implies, is a price that the provider contractually guarantees will be the owner’s maximum financial exposure for the services received. The owner then reimburses the provider for all costs of the services as they are incurred and makes pro rata payments of the agreed-upon fee as would be the case for CPFF and target estimate contracts. The difference is that once the owner has paid out funds equal to the GMP, no further payment is made. The provider must then continue to perform at his or her own expense until all of the agreed-upon services have been performed according to the contract terms. If a point is reached when all services have been provided according to the contract terms and the owner’s financial outlay is less than the GMP, the owner receives the total benefit of the savings. The GMP form of commercial terms has gained enormous popularity in recent years, particularly for contracts in the field of residential and commercial building construction. Obviously, unless the GMP is set at an inflated level compared to a reasonable estimate of the cost of providing the services, the provider assumes a considerable risk of performance under this form of commercial terms.
Fixed-Price Contracts
All of the proceeding forms of commercial terms apply to cost-reimbursable contract situations. The one other broad class of contract is the fixed-price contract, also called a firm-price contract, or sometimes a lump sum, or hard money contract. All four terms mean that the provider will be paid an agreed fixed price for providing the contractually stipulated services. There is no relationship between the payment received from the owner and the costs incurred by the provider. The financial risk of performance is borne entirely by the provider of the services. Fixed-price commercial terms require a particularly definitive mutual understanding of the scope of services to be provided. In the case of construction contracts, such an understanding is difficult to attain unless a complete and accurate set of plans and specifications is available, upon which the fixed price can be determined and agreed.
In any form of contracting, there is a definite relationship of risk to profit. When the commercial terms of any performance contract require that the performer or provider assume the entire financial risk of performance, that performer is taking a far greater risk than under other commercial terms. It follows that the provider is entitled to greater profit than would be the case if less risk were assumed. Therefore, the profit potential in fixed-price contracting is much greater than for other forms of contracting, particularly for construction contracts. The fixed-price or hard money contract is the traditional form around which today’s construction contracting industry evolved. The underlying philosophy of this form of contracting has been whimsically described by construction contractors as a matter of “what you bid and what you thought” v. “what you did and what you got.”
Fixed-price contracts in construction take one of two different forms. The first is a true lump sum contract, where payment is made in a total fixed monetary amount called the lump sum contract price. Usually, a breakdown of the lump sum price agreed to by the owner and the contractor is used as the work progresses to determine the appropriate part of the lump sum price to be paid monthly for work performed that month. The sum of the monthly payments will equal the lump sum contract price. Unless the scope of the work specified in the contract is changed, the lump sum price will not change.
The second form of fixed-price contract is the schedule-of-bid-items contract. In this type of contract, work is broken down into a series of bid items, each for a discrete element of the project work. Each bid item contains a title or name that describes the particular element of work involved, an estimated quantity and unit of measurement for the units of work in the item, an agreed fixed unit price, and finally, an extension price for the bid item consisting of the product of the fixed unit price and the estimated quantity of units of work. For instance, a bid item might read
BI 21—Powerhouse Structural Excavation
10,200 cy @ $12.25 per cy = $124,950.
As the actual work progresses, the quantity of units of work performed are physically measured or counted in the field, which, when multiplied by the fixed unit price stated in the contract, determine what the contractor will be paid that month for the work of that particular bid item. Some bid items are specified by the bid form to be fixed lump sum prices. The total contract price paid to the contractor is the monetary sum of all unit price extensions and lump sum amounts for the quantities of work actually performed. Payment is usually made monthly for measured quantities of work units actually performed that month. If no changes are made in the nature of the work described in the various bid items, the fixed unit prices and fixed-bid-item lump sum prices will not change even though the quantity of work units actually performed for the unit-price-bid items may turn out to be more or less than stated in the contract.
Contracts of this type contain language to the effect that the bid item quantities are provided for bidding purposes only and are not warranted or guaranteed by the owner. Thus, the total contract price (the sum of the bid items) paid by the owner for actual contract performance may turn out to be more or less than the apparent contract price at the time the contract is signed. This can occur even when there are no changes, depending on the accuracy of the contractually stated quantities of units of work to be performed under the various bid items. Since the fixed unit and lump sum prices are determined by competitive bidding or negotiation prior to contract formation, the potential for differences between the contractually stated and the eventual measured quantities when the actual work is performed creates some interesting problems for both owner and contractor that are beyond the scope of this book.
Figure 3-3 illustrates some of the comparative consequences of previously discussed forms of commercial terms. The table is constructed around the performance of a hypothetical project with an assumed estimated cost of $15,000,000, representing the best estimate possible at the time the contract was signed. The table indicates the consequences to the contractor and to the owner for both cost underrun ($13,500,000) and cost overrun ($16,500,000) outcomes under the various forms of commercial terms illustrated.
| Commercial Terms | Cost Outcome At Completion | Contractor's Profit | Total Cost to Owner |
|---|---|---|---|
| CPPF @ 5% Agreed Profit | (1) Costs = $13,500,000
(2) Costs = $16,500,000 |
($13,500,000)x(0.05) = $675,000
($16,500,000)x(0.05) = $825,000 |
$13,500,000 + $675,000 = $14,175,000
$16,500,000 + $825,000 = $17,325,000 |
| CPFF @ 5% Profit on Estimated Cost | (1) Costs = $13,500,000
(2) Costs = $16,500,000 |
($15,000,000)x(0.05) = $750,000
($15,000,000)x(0.05) = $750,000 |
$13,500,000 + $750,000 = $14,250,000
$16,500,000 + $750,000 = $17,250,000 |
| CPIF @ 5% Profit. 50-50 Split on Underruns and Overruns |
(1) Costs = $13,500,000
(2) Costs = $16,500,000 |
($15,000,000)x(0.05) + (0.5)x($15,000,000 - $13,500,000) = $750,000 + $750,000 = $1,500,000
($15,000,000)x(0.05) - (0.5)x($16,500,000 - $15,000,000) = $750,000 - $750,000 = $0 |
$13,500,000 + $1,500,000 = $15,000,000
$16,500,000 + $0 = $16,500,000 |
| GMP 5% Profit on Estimated Cost GMP = ($15,000,000)(1.05) = $15,750,000 |
(1) Costs = $13,500,000
(2) Costs = $16,500,000 |
($15,000,000)x(0.05) = $750,000
$15,750,000-$16,500,000= ($750,000) |
$13,500,000 + $750,000 = $14,250,000
$15,750,000 |
| Fixed Price Competitively Bid at 5% Profit on Estimate Bid =($15,000,000) (1.05) = $15,750,000 | (1) Costs = $13,500,000
(2) Costs = $16,500,000 |
$15,750,000 - $13,500,000 = $2,250,000
$15,750,000-$16,500,000= ($750,000) |
$15,750,000
$15,750,000 |
Figure 3-3: The comparative effect of contract commercial terms.*
*Financial outcomes for a common construction project, with an estimated cost of $15,000,000, contracted for with the Owner on the basis of the five different forms of commercial terms shown.
Conclusion
This chapter presented a general overview of prime construction-related contracts from the standpoint of the typical parties involved, the nature of the services contracted for, and the commercial terms.
Chapter 4 will augment this general discussion by examining the format and general components of the prime construction contract between owner and general contractor for the performance of construction work. Chapter 5 will then concentrate on the content of the key clauses of such contracts.
Questions and Problems
- Who are the four typical parties involved in most construction-related prime contracts? What is the nature of the contract services performed for each of the three prime contract types discussed in this chapter?
- What do the terms turnkey and fast-track mean? Discuss the relationship of each to design-construct contracts.
- How do the services provided by a construction manager in an owner–CM contract and by a general contractor in an owner-contractor contract differ? Is it ever possible for a single construction contractor to function partly as a CM and partly as a general contractor on the same project?
- In a typical project where the owner contracts with a CM and the work is performed by a number of individual trade construction contractors, with whom do the trade contractors contract? Who bears the financial risk of performance for any overruns in the estimated value of the payments to the trade contractors—the CM or the owner?
- Define each and explain the differences between CPPF, CPFF, CPIF, GMP, and fixed-price commercial terms. Discuss the allocation of the risk of performance between owner and the provider of the services for each of these commercial terms arrangements. Does the amount of profit or fee that the provider of the services can reasonably expect to receive relate to the allocation of risk of performance? How?
- Consolidated Energy Corporation (CE) entered into a contract with the Slippery Hills Utility District (SHUD) to perform a feasibility study for a hydroelectric project on the basis that payment to CE would include actual costs of all direct salaries and expenses required for the study multiplied by a billing rate factor of 1.85. Following receipt of a favorable report (which SHUD and CE considered to complete the first contract), SHUD and CE entered into a second contract under which CE was to design completely a dam and powerhouse and, concurrently with the design work, was to start construction of the project and pursue construction to final completion. SHUD reserved to itself the task of procuring the hydraulic turbines and generators according to CE’s design. CE was to be paid all costs for its work plus a fee of $5,000,000, with the provision that CE would absorb any costs in excess of a total project cost of $35,000,000 (including the $5,000,000 fee, but excluding the cost of the hydraulic turbines and generators).
- What kind of a contract was the first contract with respect to commercial terms?
- Briefly discuss the second contract, identifying the type of contract service provided, whether it was a turnkey or nonturnkey contract, and the commercial terms.
- Had CE agreed to perform the same contract work for the unqualified sum of $35,000,000, what kind of contract would result from the standpoint of commercial terms?
- Had SHUD and CE agreed to share equally any cost savings under $30,000,000 and to each pay one-half of any overruns, what kind of contract would result from the standpoint of commercial terms?
- A contract was entered into for which an estimate of project costs (exclusive of the contractor’s fee) equal to $12,250,000 was agreed to by the parties. The contractor’s fee was agreed to be 4% of the estimated cost. The contract further provided that the owner would reimburse all project costs to the contractor as they were expended and pay the contractor’s fee periodically as the work progressed with the proviso that the owner’s obligation to pay costs and fee was limited to a total sum of $12,962,500. Any expenditure in excess of this total necessary to complete the work were to be for the account of the contractor.
- With respect to commercial terms, what type of contract was this?
- When the project was completed, the total costs, exclusive of fee, amounted to $11,275,000. How much did the owner pay for the job?
- Under the circumstances in (b), how much money did the contractor gain or lose from the entire transaction?
- If the total project costs had been $13,625,000, how much would the owner have paid for the job?
- Under the circumstances in (d), how much money did the contractor gain or lose?
- A contract was entered into for which an estimate of the project costs (exclusive of the contractor’s fee) equal to $22,425,000 was agreed to by the parties. The contractor’s fee was agreed to be 6% of the estimated cost. The contract further provided that the owner would reimburse all project costs to the contractor as they were expended and would pay the contractor’s fee periodically as the work progressed. The contract further provided that the owner and contractor would share in any cost overruns or underruns, 60% to the owner and 40% to the contractor.
- With respect to commercial terms, what kind of contract was this?
- When the project was completed, the total costs, exclusive of contractor’s fee, amounted to $20,125,000. How much money did the owner pay for the job?
- Under the circumstances in (b), how much money did the contractor gain or lose from the entire transaction?
- If the total costs on project completion, exclusive of contractor’s fee, had been $24,975,000, how much would the owner have paid for the job?
- Under the circumstances in (d), how much money would the contractor gain or lose from the entire transaction?
- Because of a change in political sentiment driven by a competition for funds and a recession economy, this project was terminated at the end of the first phase and remains uncompleted at this writing. ↵
