Cost versus market: how are price variations measured in construction contracts?

Construction contracts will often say that variations should be valued at a “fair and reasonable” price. In practice, there are two ways of making such an assessment. A price can be built up using the costs the contractor incurs doing the work. Or, alternatively, it can be done by determining the price of getting the work undertaken in the open market. The two methodologies will often provide similar answers, but not always. And when the difference is significant, the parties will understandably ask what guidance the courts have given on this point. 

Evidence of cost is easier to test […] the market-based approach will often be less transparent 

English case law on the subject has been helpfully reviewed in the recent Hong Kong High Court case Maeda & China State vs Bauer [2019] HKCFI 916, which concerns a dispute on the packages for the construction of the Hong Kong to Guangzhou Express Rail Link. As with many large transport projects, it has had its fair share of problems and controversies. The cost of the 26km Hong Kong stretch of the project has increased from the initial budget of £6.7bn to £8.6bn, making it (currently) the most expensive per-kilometre rail line in the world. 

One small element of this increase came under scrutiny in the Maeda case. 

The main contractor was a joint venture comprising Maeda and China State, which had subcontracted diaphragm wall works to Bauer. Problems arose because of unforeseen ground conditions and this led to delay and variations. When the parties’ differences could not be resolved, Bauer referred them to arbitration. The High Court case came about because the JV did not accept certain decisions forming the arbitrator’s award and appealed those points of law. 

One of those points concerned the assessment of a fair and reasonable price for variations. 

The variation under scrutiny related to the deferment of certain works and Bauer claimed money for the standby of plant and equipment. The resources in question were in storage and not in use, but the arbitrator awarded Bauer a sum for the plant and equipment anyway. The JV argued that it was unfair for Bauer to be paid money for resources that had cost it nothing. It said that a fair and reasonable sum must be determined by reference to what those items actually cost the subcontractor and not what they would have cost the contractor to hire on the open market. 

The Hong Kong judgment referred to a number of English court cases cited by the parties. In Henry Boot vs Alstom [1999], the judge indicated that a costs-based approach should be followed, saying, “A fair valuation […] generally means a valuation which will not give the contractor more than his actual costs reasonably and necessarily incurred plus similar allowance for overheads and profit …”

As with some of the other regularly cited cases on this subject, the court suggested that a costs-based approach was fair, without fully analysing why it should be preferred over other forms of assessment. The judge seemed to simplistically conclude that a reimbursement of cost was fair without analysing how this may differ from a market-based approach. 

The one authority that really tries to get to the nub of the issue is Laserbore vs Morrison Biggs [1993]. In that case, the judge gives examples of situations where cost and market value would give different results, to test the point. He asks: “If a company’s directors are sufficiently canny to buy materials for stock at knockdown prices from a liquidator, must they pass on the benefit of their canniness to their customers?” 

The judge goes on to answer his own question by saying that the company should be entitled to charge at the market rate and take the benefit of the savings and efficiencies it generates. 

One factor for a court (or arbitrator or adjudicator) in trying to make a “fair and reasonable” assessment is that evidence of cost is easier to test. After all, costs can be audited. The market-based approach will often be less transparent. It will be reliant on open-market quotes, expert evidence or price books such as Spons. Each of these forms of evidence can present difficulties. 

The Maeda case involved an appeal of the arbitrator’s award on a point of law. This meant that for the JV to overturn it, they had to show that the arbitrator had misdirected himself in law, such that the decision was one that no reasonable arbitrator could reach. The court found this was something they had failed to establish. On the basis of the English law authorities, the arbitrator’s assessment, based on the subcontractor’s actual cost, was a permissible approach. 

The Maeda case provides a good reference point for anyone involved in a disagreement on the approach to valuation. While it illustrates that there are some cases that refer to a costs-based approach and others to a market-based one, the one authority that makes a sophisticated comparison between the two is Laserbore, and that concludes in favour of market-based. 

Michael Sergeant is a partner in the HFW construction team and co-wrote the book, Construction Contract Variations