Common mistakes in… lump sum contracts

Cost certainty is a critical issue on most major projects. Despite the passing fashion for adopting target price or guaranteed maximum price models, the majority of projects are still let on a lump sum basis.

A lump sum refers to the single aggregate price a contractor offers to undertake the work and cover all risks accepted by the contractor under the contract. However, don’t assume that a lump sum price is a fixed price or that it will be the final price.

Delay/disruption

A lump sum building contract usually provides that the contractor bears the consequences of its own actions, but not those of the employer.

There are good commercial reasons why the contract should provide for a contractor to be able to claim additional costs for delay and/or disruption caused by the employer, or example, a failure to give instructions on time where the instructions are necessary to progress the works. A provision of this nature reduces the risk of the contractor pursuing alternative legal remedies for breach of contract. Therefore do ensure that there is an adequate mechanism under the contract to pay the contractor these additional costs.

Force majeure

Building contracts usually make provision for events which are beyond the reasonable control of either party. Don’t assume that dumping the risk on the contractor will provide the best financial solution.

The premium price the contractor may be willing to offer to cover such risk has to be weighed against the likelihood of such events arising.

Where the contractor excludes the cost risk of a particular event, do ensure that the nature of that risk is clearly defined in the contract and not simply stated in generic terms.

The approach commonly adopted is for the contractor to bear its own costs resulting from the delay, but not to be penalised by the employer.

Inflationary risks

Some contracts provide for the contract price to be varied to cover fluctuation in the market prices of labour and/or materials. Do consider the prevalent market practice at the time you enter into the contract. In a boom market where work is plentiful and labour is in short supply, contractors are more likely to push this risk to the employer. In the current market, the prevalent practice is to strike out fluctuation clauses. The dynamics of inflationary risk will also be different for major projects taking years rather than months.

Provisional sums

This term is generally applied to a price for undefined work or work that the employer may choose not to undertake.

A provisional sum is usually included within the contract price as an estimate of the likely cost of the work. Where a provisional sum is to be included in the contract price it is essential that there is a contractual term that explains how a provisional sum is to be dealt with. Don’t assume that the provisional sum is to be omitted and substituted by an appropriate valuation of the work actually carried out.

Variations

A lump sum price is offered for a defined scope of work. Even where a scope of work is well defined, in a complex project some degree of change is inevitable. Do check that the original scope is defined adequately. If not, it increases the risk that changes will need to be ordered at a later date, either because the contractor requires further instructions from the employer or the employer realises that the contractor’s interpretation of the specification is not what he envisaged for the project.

It is also essential that the contract contains a robust change control and valuation procedure. A change during the course of the project will generally cost the employer much more than it would have done if priced as part of the original scope. The contract should seek to minimise uncertainty as to how changes are priced.

The way in which these issues are dealt with will vary from contract to contract to suit the requirements of the parties and the particular project in question. Most important is to understand how, and the extent to which, these issues will ultimately impact on the lump sum price.

Sean Austin is a senior associate at Berwin Leighton Paisner