A contract is an agreement between two or more persons (individuals, businesses, organizations or government agencies) to do, or to refrain from doing, a particular thing in exchange for something of value. Contracts generally can be written, using formal or informal terms, or entirely verbal. If one side fails to live up to his/her/its part of the bargain, there's a "breach" and certain remedies for solving the differences are available. The terms of the contract - the who, what, where, when, and how of the agreement - define the binding promises of each party to the contract. A contract requires an offer (example: tender, quotation or purchase order) to be made by one party and to be accepted by the other party. The acceptance must take place before the offer lapse or before it is withdrawn. If a period of validity is stated in the offer, it will lapse at the end of the validity period. The parties of a contract must have a capacity to contract, and the objects of the contract must be legal.
The tender submitted for a project represents the contractor’s offer to carry out the works and, therefore, on general principles, the tender must set out in very definitive and unambiguous terms the particulars of the contractor’s offer.
A contract is only brought into existence when the offer has been accepted unconditionally. If the offeree suggests any new terms and purports to accept the offer on those new terms, then, there is no acceptance, unless fully agreed and accepted by the offerer.
The Articles of Agreement forming the beginning of the contract document paves the way to the formal opening parts and recitals of the contract form and must be fully and properly completed. It comprises the date of the agreement, the names of the respective parties, the places of business or registered address, and a short description of the works to be completed with reference to the contract bills, drawings and specifications. It further introduces the employer, the contractor and the key personnel in the contract, specifies the scope of works, and the consideration payable and contains the operational definitions of the important terms and expressions used in the contract. The dates of commencement of work and completion will need to be filled.
The contracting parties are identified in the recitals of the contract form, which normally are the principle employer and the main contractor. The recitals are introductory to the operative clauses. The recitals include a brief description of the works to be constructed. They indicate the documents which are to be included as the contract documents. The recitals also state that the employer has caused drawings and bill of quantities “showing and describing the work to be done to be prepared by or under the direction of his named architect. They also state that a fully priced copy of the bills (contract bills) has been supplied by the contractor to the employer. The recital recognizes the standard procedure of examining the successful tenderer’s priced bills. This means that when the articles of agreement are executed, an employer (or his appointed agents) will have the priced bills in his possession
The law relating to construction contract stems from the general law of contract. All the elements of a simple contract must be present and the general rules of performance and discharge of contract apply to a construction contract.
Contracts generally can be written, using formal or informal terms, or entirely verbal. If one side fails to live up to his/her/its part of the bargain, there's a "breach" and certain remedies for solving the differences are available. The terms of the contract - who, what, where, when, and how of the agreement - define the binding promises of each party to the contract.
A contract requires an offer (example: tender, quotation or purchase order) to be made by one party and to be accepted by the other party. The acceptance must take place before the offer lapse or before it is withdrawn. If a period of validity is stated in the offer, it will lapse at the end of the validity period. The parties of a contract must have a capacity to contract, and the objects of the contract must be legal. For a contract to be valid, each side must have the capacity to enter into it. If the other side is to be held to the contract, you must give up something in exchange. This is called consideration. No side can have a free way out or the ability to obtain something of value without providing something in exchange. Money is the most common form of compensation, but it can also be property, giving up a right or valid claim, making a promise to do or not to do something, or anything of value.
When you ask someone to do something, or offer to see someone for a price, you are making an offer. An offer is the first step in forming a contract. The middle step is the other party's acceptance of the deal. The last step is performance -- where you each live up to your side of the bargain. Words, gestures, or actions can signal an offer to enter into a contract and an acceptance.
Key Elements of a binding contract
Competent Parties - For a contract to be valid, each side must have the capacity to enter into it. Most people and companies have sufficient legal competency. A drugged or mentally impaired person has impaired capacity and chances are a court may not hold that person to the contract. Minors (e.g., usually those under eighteen) cannot, generally, enter into a binding contract without parental consent, unless it is for the necessities of life, such as food, clothing, or for student loan contracts.
Consideration - If the other side is to be held to the contract, you must give up something in exchange. This is called consideration. No side can have a free way out or the ability to obtain something of value without providing something in exchange. Money is the most common form of compensation, but it can also be property, giving up a right or valid claim, making a promise to do or not to do something, or anything of value. Agreeing to perform an illegal or illicit act is not consideration and the contract is void.
Mutual Assent or Meeting of the Minds - This means that each side must be clear as to the essential details, rights, and obligations of the contract. Putting the deal down on paper prior to signing it goes A long way to avoid future misunderstandings and disputes. Meeting of the minds sometimes can be expressed by words spoken or gestures made or can be inferred from the surrounding circumstances. There is no meeting of the minds if:
o One side is obviously joking or bragging,
o There is no actual agreement (i.e., the farmer who is selling a gelding and the buyer thinks the horse is a brood mare), or
o Both sides have made a material mistake as to the terms or details of the contract.
The performance of a contract
Performance is actually completing the deal according to the terms given in the contract. For example, you want to buy that Proton Wira at your local dealer's sale. Your dealer, Mr. X, offers to sell you that car if you pay him $50,000. After a bit of bargaining, you agree to the terms and get the car at a reduced price of $49,500, signing on the dotted line. A contract has been accepted. Mr. X, your car dealer, will deliver the car and then you pay him the balance due. The dealer’s delivery of the car and your payment of $49,500 are the performance of the contract. Both parties must live up to their end of the bargain in the contract to have closure. In other words, until both parties have properly performed under the contract, the contract remains open.
Under Clause 1.1 of the PAM 1998 Form of contract, the contractor is obligated to provide materials, goods and standards of workmanship of the quality and standard in every respect to the reasonable satisfaction of the architect. The contractor is not responsible for the suitability of the materials and goods specified, but he is required to comply completely with the contract documents in providing those materials, goods and standards of workmanship.
Contracting process is normally divided into two phases: Contract Formation and Contract Administration. Contract formation consists of taking and analyzing the proposals and signing a contract. Contract administration consists of working with the contract until project completion and satisfying all the term and conditions.
At the tender stage, it is important to study the requirements to appreciate the basis of the tender and ascertain the manner in which the risks are to be priced or distributed. In essence, a tenderer is often required to quote an amount for carrying out the works upon the terms and conditions stated. When contracting, the parties are then obligated to abide by the terms and conditions thereof.
The contract itself sets out the scope of work and responsibility for the execution of the work. It also assigns and limits the risk sharing for the contracting parties. The project manager is responsible for the administration of the contract after it has been signed. Often, the project manager is the prime contact person between the contractor and the owner or his representative (consultants/ architect).
During the tendering process, the interested contractor will normally determine which portion of work it plans to build with it’s own workforce, and which portion they planned to sub-contract out. The contractor will then prepare a detailed estimate cost of the work with the assistance of the potential sub-contactors input. Quotations for materials and equipments are also solicited early in the bid period. Nearing the bid time, the contractor would have completed a detailed estimate of its own direct and indirect costs and anticipated profit. It would have also received preliminary prices from sub-contractors and major suppliers. The contractor would normally then add some markup on the cost quoted by the sub-contractors and suppliers, and the total prices would be summed up as the proposed contract sum.
Construction contract is part of a commercial plan, but it may also be defined as a legally binding document. All contracts should contain terms about prices and payment. Terms about price tell us the sum that the contractor is to receive. Terms about payment tell us about the timing of the payment or series of payments, the methods by which the money is to be transacted from the owner to the contractor.
The price in a contract usually includes everything that is required to achieve the performance of the works to be carried out. Estimators have to take into account all matters which may affect the price, and they should bear in mind that if an error in understanding what is required results in the under-pricing of a tender or offer, this will not invalidate the offer, unless any subsequent event had altered the terms of the original contract agreement which is only known to one party but unknown to the other.
The terms of payment in construction contracts are not standardized conditions and vary from one contract to another. Generally, the terms of payment are of the following:
Single payment or a series of payments
Stage payments with set milestones and proportion
Currency of payment
Method of payment (cheque, bank draft or letter of credit)
How each payment is to be secured in favor of the employer, if at all (security may be by way of bond or guarantee or by the passing of property in goods)
Payment terms are important to the buyer and the seller as they define how the money flows. Contractors normally do not want to finance projects for the owners, so their interest in regular payments is very keen. Normally, payments are invoice monthly or biweekly. Faster payment will help contractors avoid the high cost of financing the project.
Contract Type Selection
Contract type is an important consideration. Different types of contracts can be used in different situations. There are three broad categories of contracts:
1.Fixed Price or Lump Sum Contracts
2.Cost Reimbursable Contracts
3.Unit Price Contracts
1.Fixed Price or Lump Sum Contracts
This type of contract involves a fixed total price for a well-defined product or services. The buyer incurs little risk in this situation. If the product is not well defined, both the buyer and seller are at risk – that is the buyer may not receive the desired product or the seller may need to incur additional costs in order to provide it. Fixed Priced Contracts may also include incentives for meeting or exceeding selected project objectives such as schedule targets. For example, the contract could include an incentive fee paid for early product delivery. A Firm-Fixed Price (FFP) contract has the least amount of risk for the buyer, followed by a Fixed Price Incentive (FPI) contract.
2.Cost Reimbursable Contracts
Cost Reimbursable Contracts involve payment to the seller for direct and indirect actual costs. Direct costs are costs incurred for the exclusive benefit of the project (e.g. salaries of the full-time project staffs). Indirect costs, also called overhead costs, are costs allocated to the project by the performing organization as a cost of doing business (e.g. salaries of corporate office staffs, head office overheads). Indirect costs are usually calculated as a percentage of direct costs. This category of contract often includes fees such as profit percentage or incentives for meeting or exceeding selected project objectives such as schedule targets or total cost. Three types of Cost Reimbursable Contracts are:
i.Cost Plus Incentive Fee (CPIF)
ii.Cost Plus Fixed Fee (CPFF)
iii.Cost Plus Percentage of Cost (CPPC)
i.Cost Plus Incentive Fee (CPIF)
The buyer pays the seller for allowable performance costs along with a predetermined fee and an incentive bonus. If the final cost is less than the expected cost, both the buyer and the seller benefit from the cost savings based on a pre-negotiated share formula.
ii.Cost Plus Fixed Fee (CPFF)
The buyer pays the seller for allowable performance costs plus a fixed fee payment usually based on a percentage of estimated costs. This fee does not vary, however, unless the scope of the contract changes.
iii.Cost Plus Percentage of Cost (CPPC)
The buyer pays the seller for allowable performance costs along with a pre-determined percentage based on total costs. From the buyer’s perspective, this is the least desirable type of contract because the seller has no incentive to decrease costs. In fact, the seller may be motivated to increase costs, since doing so will automatically increase profits based on the percentage of costs. All of the risk is borne by the buyer.
3.Unit Price Contracts
This category of contract require the buyer to pay the seller a pre-determined amount per unit of service, and the total value of the contract is a function of the quantities needed to complete the work (e.g. $50 per hour for professional services; $180 per cubic meter of concrete). Unit Price Contracts can be viewed as high-or low-risk, depending on the nature of the project and other contract clauses.
Selecting the type of contract and the fee structure should occur during the formulation of the original contracting plan. Changes to the plan may occur as a result of additional ideas developed during the proposal and negotiation stages. It is important that there must be a clear statement as to the fee basis and payment terms in the final agreement.
Contractors who are doing lump sum contract; make a clear statement that all costs, overheads and profits for performing the scope of work are in the contract prices. A cost-plus contract should define in detail the allowable reimbursable costs such as overheads, labor rates, out-of-pocket costs, equipment rates, and the fee statement. These documents must form part of the contract documents rather then part of the text. Any incentives or penalty terms to the fee structure should be stated clearly and the formula for calculating them should be spelled out clearly.
Competitive bidding on construction projects involves decision making under uncertainty where one of the greatest sources of the uncertainty for each bidder is due to the unpredictable nature of his competitors. Each bid submitted for a particular job by a contractor will be determined by a large number of factors, including an estimate of the direct job cost, the general overhead, the confidence that the management has in this estimate, and the immediate and long-range objectives of management. So many factors are involved that it is impossible for a particular bidder to attempt to predict exactly what the bids submitted by its competitors will be.
All other things being equal, the probability of winning a contract diminishes as more bidders participate in the competition. Consequently, a contractor tries to find out as much information as possible about the number and identities of potential bidders on a specific project. For certain segments, potential competitors may be identified through private contacts, and bidders often confront the same competitor's project after project since they have similar capabilities and interests in undertaking the same type of work, including size, complexity and geographical location of the projects.
Negotiation is another important mechanism for arranging construction contracts. Project managers often find themselves as participants in negotiations, either as principal negotiators or as expert advisors. These negotiations can be complex and often present important opportunities and risks for the various parties involved. For example, negotiation on work contracts can involve issues such as completion date, arbitration procedures, special work item compensation, contingency allowances as well as the overall price. As a general rule, exogenous factors such as the history of a contractor and the general economic climate in the construction industry will determine the results of negotiations. However, the skill of a negotiator can affect the possibility of reaching an agreement, the profitability of the project, the scope of any eventual disputes, and the possibility for additional work among the participants. Thus, negotiations are an important task for many project managers. Even after a contract is awarded on the basis of competitive bidding, there are many occasions in which subsequent negotiations are required as conditions change over time.
In conducting negotiations between two parties, each side will have a series of objectives and constraints. The overall objective of each party is to obtain the most favorable, acceptable agreement. A two party, one issue negotiation illustrates this fundamental point.
Poor negotiating strategies adopted by one or the other party may also preclude an agreement even with the existence of a feasible agreement range. For example, one party may be so demanding that the other party simply breaks off negotiations. In effect, negotiations are not a well behaved solution methodology for the resolution of disputes.
The possibility of negotiating failures highlights the importance of negotiating style and strategy with respect to revealing information. Style includes the extent to which negotiators are willing to seem reasonable, the type of arguments chosen, the forcefulness of language used, etc. Clearly, different negotiating styles can be more or less effective. Cultural factors are also extremely important. Revealing information is also a negotiating decision. Some negotiators would readily reveal their reserve or constraint prices, whereas others would conceal as much information as possible (i.e. "play their cards close to the vest") or provide misleading information.
In light of these tactical problems, it is often beneficial to all parties to adopt objective standards in determining appropriate contract provisions. These standards would prescribe a particular agreement or a method to arrive at appropriate values in a negotiation. Objective standards can be derived from numerous sources, including market values, precedent, professional standards, what a court would decide, etc. By using objective criteria of this sort, personalities and disruptive negotiating tactics do not become impediments to reaching mutually beneficial agreements.
Some owners wish to delegate all responsibilities of design and construction to outside consultants in a turnkey project arrangement. A contractor agrees to provide the completed facility on the basis of performance specifications set forth by the owner. The contractor may even assume the responsibility of operating the project if the owner so desires. In order for a turnkey operation to succeed, the owner must be able to provide a set of unambiguous performance specifications to the contractor and must have complete confidence in the capability of the contractor to carry out the mission.
The basic structure of the bidding process consists of the formulation of detailed plans and specifications of a facility based on the objectives and requirements of the owner, and the invitation of qualified contractors to bid for the right to execute the project. The definition of a qualified contractor usually calls for a minimal evidence of previous experience and financial stability. In the private sector, the owner has considerable latitude in selecting the bidders, ranging from open competition to the restriction of bidders to a few favored contractors. In the public sector, the rules are carefully delineated to place all qualified contractors on an equal footing for competition, and strictly enforced to prevent collusion among contractors and unethical or illegal actions by public officials.
Detailed plans and specifications are usually prepared by an architectural/engineering firm, which oversees the bidding process on behalf of the owner. The final bids are normally submitted on either a lump sum or unit price basis, as stipulated by the owner. A lump sum bid represents the total price for which a contractor offers to complete a facility according to the detailed plans and specifications. Unit price bidding is used in projects for which the quantity of materials or the amount of labor involved in some key tasks is particularly uncertain. In such cases, the contractor is permitted to submit a list of unit prices for those tasks, and the final price used to determine the lowest bidder is based on the lump sum price computed by multiplying the quoted unit price for each specified task by the corresponding quantity in the owner's estimates for quantities. However, the total payment to the winning contractor will be based on the actual quantities multiplied by the respective quoted unit prices.
The contract price includes the direct project cost including field supervision expenses plus the markup imposed by contractors for general overhead expenses and profit. The factors influencing a facility price will vary by type of facility and location as well. Within each of the major categories of construction such as residential housing, commercial buildings, industrial complexes and infrastructure, there are smaller segments, which have very different environments with regard to price setting. However, all pricing arrangements have some common features in the form of the legal documents binding the owner and the supplier(s) of the facility. Without addressing special issues in various industry segments, the most common types of pricing arrangements can be described broadly to illustrate the basic principles.
All owners want quality construction with reasonable costs, but not all are willing to share risks and/or provide incentives to enhance the quality of construction. In recent years, more owners recognize that they do not get the best quality of construction by squeezing the last dollar of profit from the contractor, and they accept the concept of risk sharing/risk assignment in principle in letting construction contracts. However, the implementation of such a concept in the past decade has received mixed results.
In some projects, the contract provisions may allow the contractor to provide alternative design and/or construction technology. The owner may impose different mechanisms for pricing these changes. For example, a contractor may suggest a design or construction method change that fulfills the performance requirements. Savings due to such changes may accrue to the contractor or the owner, or may be divided in some fashion between the two. The contract provisions must reflect the owners risk-reward objectives in calling for alternate design and/or construction technology. While innovations are often sought to save money and time, unsuccessful innovations may require additional money and time to correct earlier misjudgment. At worse, a failure could have serious consequences.
A final important consideration in forming bid prices on the part of contractors are the possible special advantages enjoyed by a particular firm. As a result of lower costs, a particular contractor may be able to impose a higher profit markup yet still have a lower total bid than competitors. These lower costs may result from superior technology, greater experience, better management, better personnel or lower unit costs. A comparative cost advantage is the most desirable of all circumstances in entering a bid competition.