In the previous post, we covered the contract classification based on Nature of Transaction and Mode of Project Delivery. Accordingly, we discussed the difference among Supply, Service Contracts & Works Contracts and among EPC, EPCM and Multiple Packages Contracts
In this post, we are going to discuss various kinds of contracts under the broad category called Compensation Method / Method of Payment .
One organization may prefer to pay Lump Sum Price for the entire scope of work. However, other one may choose to pay based on rates agreed for each work item multiplied by corresponding quantities. Yet a third one may like to pay the contractor based on the actual cost incurred plus reasonable profit. Each type has its own merits and demits and no one is absolutely wrong or right.
Based on the Compensation Method, contracts are classified as follows;
A) Lump Sum Contracts
B) Item Rate Contracts
C) Cost plus Contracts
We deal with such contracts very frequently in our work life. The purpose of this post is to understand the significance of each type and eventually know their distinguishing features. This will help to choose the right fit for a given situation.
Let us now discuss above contracts in more details
Classification based on Compensation Payment
A) Lump Sum Contract:
The word lump means to combine, aggregate, bunch or consolidate. The word Lump Sum means Aggregated Amount or Consolidated Amount.
As the name suggests, Lump Sum Contracts consists of Total Consolidated Amount against the given scope of work. In such contracts, Owner defines detailed Scope of Work and/or Materials to be Supplied and/or Services to be rendered by the Contractor and as required to execute and complete the work. And, Owner invites Total Aggregated Price from the bidders for the entire scope of work.
Consolidated Price which include all associated costs for all supplies and services is called Lump Sum Contract Price. Lump Sum Price is a consideration for all liabilities and obligations of Contractor. Also, this lump sum amount is a contractual price between the parties. Consequently, Owner is bound to pay such price as long as the scope of work remains unchanged. Any further break up of Total Price in the form of Price Schedule/Priced Bill of Quantities is to facilitate payment. Existence of item price, sub-component or component price in the Price Schedule does not dilute the essence of Lump Sum Contract
Significance and relevance of Lump-sum Contracts
Lump Sum Contracts are very common industry practice for procurement of engineered products, specialized services and for execution of design-build & EPC/Turnkey Contracts. Owner prefers to obtain lump-sum price so as to ascertain the Total Cost before starting the works. Also, it is easy to compare various offers when received on the basis of Lump-sum Price. By doing so, Owner transfer the risk of quantity variations to the Contractor
Lump Sum Contracts are best fit and most suitable when there is a full clarity on the Scope of Work. This means works items and quantities are known with greater certainty and the probability of scope/quantity change is comparatively less. This mainly happened for execution of works where industry practice is established and when bidders have full understanding of scope and enough prior experience to accurately calculate and quote the Lump Sum Price and successfully perform the awarded works
Item Rate and Cost Plus contracts shall be covered in the next post