3 Payment Methods-Lecture

Payment Schemes
Payment Schemes
Lump-sum
Cost plus fixed fee/% price
Unit price
Guaranteed maximum price
Award Methods
General points
Negotiation
Bidding
Risk Sharing
Divide risks within an agreement to

Save money on contract price
Provide incentive to contractors to finish early, in budget, good

quality
Fundamental Ideas
Contractors are often highly risk averse

Contractor willing to pay the Owner (charge less for contract) if the
owner takes on risk
For risks that contractor cant control, may be willing to pay a risk
premium to owner to take over
For risks that contractors can control, cheaper for a contractor to manage
risk than to pay a risk premium
Structure contract so that
Risks that the contractor can handle better are imposed on contractor (i.e.
contractor will lose $ if dont control - to be competitive, will have to
manage these)
Risks that the owner can handle better are kept by owner
Risk can be better handled by A vs. B means that the risk premium that
would be charged by A for taking on this risk is smaller than would be
charged by B
Fundamental Balance
Impose high enough risk incentive to get contractor to do job efficiently

within the specifications of the contract
E.g. Incentive to finish on time, incentive to stay within

budget
E.g. better team assignment, equipment provision, mgmt
Impose low enough risk to have reasonably low bid
Impact of Risk
Accountability/Monitoring
Consider parties A and B in an agreement, the greater the risk on party A
The more incentive on party A to manage this risk and less on party B
More incentive on A to monitor the relevant factors

More incentive on B to make sure that As means of risk management falls within
the agreement (i.e. not cutting corners or cheating)
Impact on Construction Timing

Both parties must agree on cost to move forward
More risk on one party, less that party is willing to move forward
More risk on contractor, the longer will delay construction.
Given uncertainty, contractor will charge more up front
Owner doesnt want to pay a huge amount up front
As uncertainty is lessened in design, prices converge
Owner can expedite by paying higher price (risk premium) to contractor

or by shouldering risk
Risk & Change Orders

Changes contract (cost/schedule/scope/etc.)
Can lead to costs beyond contract specification
Anticipated costs incorporated in contingency

Often only paid for additional direct costs

Often 1-3% on top of agreed upon price
Big problem if disruption in work
Source of very large risk
Contractual Risk Allocation
Lump Sum Fixed Price

Contractor required to achieve the project at the negotiated contract value
All risk of cost, schedule fall on contractor
The owner knows the actual cost of the project before it begins
Minimizes risk for the owner if the project is well estimated, contractual
documents accurate and project clearly defined
High incentive for contractor to finish

Early (so can move on to other jobs)
Low cost (so can make a profit)
Required for many public projects
Good for some well-defined projects
Bad for ill-defined projects (Adversarial relationship over responsibility and

payment for of changes)
High contractor risk means typically start late
Cost Plus Fixed %

Owner is paying the actual cost plus a fixed percentage
Contractor agrees to do his best efforts to achieve the work
Contractor assumes very little risk
Typically select contractors based on reputation and comfort
Applicability
Requires sophisticated owner to manage
Used if the pricing could not be performed in any other way and if it is
urgent
Ill-defined, risky scope
Either scope or construction method unknown
Confidential projects (limit public knowledge)
Cost Plus Fixed %

Advantages
Maximum flexibility to the Owner (No fighting over change orders

contractor gets paid for any extra work required)
Permits collaboration at the early stages of the project (Minimal

negotiation time and minimal fear of commitment by contractor)
Only have to pay for actual costs (If managed closely, can save
money vs. fixed-price)
Disadvantages
Owner assumes all risks

Little incentive to reduce costs
Cost unknown until contract completes
Owner needs to oversee construction closely (Speed up slow crews

and identify management problems)
Contractors have incentive to grow scope, price
Terrible with turnkey delivery type!
Cost Plus Fixed Fee - Fixed Fee
Cost may vary but the fee remains firm
The fee is independent of the duration of the project
Like Cost + fixed % except some shared risk

Less time risk: High incentive to finish early
Less risk of contractor growing size of project
Unit Price Contract

Agreement on price charged per unit

Owner risk for uncertainty in quantity and Contractor risk for unit price
(efficiency, procure)
Contractor overhead must be integrated in the unit price
Necessity of an owner presence on site to measure actual quantities
Typically, renegotiation if quantity 20% off
Highly dependent on the accuracy of the estimation of the quantities

given by the Owner/Designer
Risk of unbalanced bidding

If contractor believes actual quantity will differ, case increase

and/or decrease the unit price
Contractor can make profit because payment is based on

actual quantities but he can also lose money in the same way
A contractor can be excluded if its bid is very Unbalanced
The total cost for the owner can be greater than planned
Guaranteed Maximum Price or GMP
Variation of the Cost Plus a Fee but GMP can be a cap on direct
costs
After a certain point, the floor or ceiling, the contractor

assumes any additional costs
Often start in cost plus fixed fee and then impose GMP at e.g.
90% design
Best: GM Shared Savings: Below Guaranteed Maximum, savings

shared (60-40% or sliding)
Very good for turnkey, well-defined scope
Guaranteed Maximum Price or GMP

Advantages
Permits easier financing
Owner keeps savings below GMP
Can fast-track and Often can get started quickly on construction

Particularly if contractor already involved in design
Contract may be higher than for fixed price because design often not
complete when contract is set
Disadvantages
Owner must monitor contractor spending
Can be fights over what falls below GMP
Bad if unclear scope after GMP agreed to (must renegotiate)
Just as for CPFF, quality may be sacrificed whereas without GMP, cost
and/or schedule would have increased
Principle of Contract Incentives
Contract Type Selection

When market is not very good, clients insist on fixed price bids whereas
when the project offers are numerous, it is more difficult to obtain those
conditions
The contract type choice must depend on:

The accuracy of the estimation
The ultimate cost know since the beginning or at least the

maximum
The desired risk
If quick completion of work is wanted

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Payment Schemes

Divide risks within an agreement to

Save money on contract price

Provide incentive to contractors to finish early, in budget, good

Contractors are often highly risk averse

Structure contract so that

Impose high enough risk incentive to get contractor to do job efficiently

E.g. Incentive to finish on time, incentive to stay within

E.g. better team assignment, equipment provision, mgmt

Impose low enough risk to have reasonably low bid

More incentive on A to monitor the relevant factors

Impact on Construction Timing

Both parties must agree on cost to move forward

More risk on contractor, the longer will delay construction.

Given uncertainty, contractor will charge more up front

Owner doesnt want to pay a huge amount up front

As uncertainty is lessened in design, prices converge

Owner can expedite by paying higher price (risk premium) to contractor

Risk & Change Orders

Changes contract (cost/schedule/scope/etc.)

Can lead to costs beyond contract specification

Anticipated costs incorporated in contingency

Often only paid for additional direct costs

Often 1-3% on top of agreed upon price

Big problem if disruption in work

Source of very large risk

Contractual Risk Allocation

Lump Sum Fixed Price

Contractor required to achieve the project at the negotiated contract value

All risk of cost, schedule fall on contractor

High incentive for contractor to finish

Early (so can move on to other jobs)

Low cost (so can make a profit)

Required for many public projects

Good for some well-defined projects

Bad for ill-defined projects (Adversarial relationship over responsibility and

High contractor risk means typically start late

Cost Plus Fixed %

Owner is paying the actual cost plus a fixed percentage

Contractor agrees to do his best efforts to achieve the work

Contractor assumes very little risk

Typically select contractors based on reputation and comfort

Requires sophisticated owner to manage

Ill-defined, risky scope

Either scope or construction method unknown

Confidential projects (limit public knowledge)

Cost Plus Fixed %

Maximum flexibility to the Owner (No fighting over change orders

Permits collaboration at the early stages of the project (Minimal

Owner assumes all risks

Little incentive to reduce costs

Cost unknown until contract completes

Owner needs to oversee construction closely (Speed up slow crews

Contractors have incentive to grow scope, price

Terrible with turnkey delivery type!

Cost Plus Fixed Fee - Fixed Fee

Cost may vary but the fee remains firm

The fee is independent of the duration of the project

Like Cost + fixed % except some shared risk