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 Project managers know that cost control is a vital
aspect of project success, even for one driven
principally by schedule or quality. Nevertheless, most
project managers rarely give close attention to the
contracting strategy, whether due to other seemingly
more pressing issues at the contracting stage or the
lack of opportunity afforded by the project manager’s
company for him or her to be involved in contract
negotiations.
Experience suggests that project success is highly
influenced by contracting strategy and that failure of
focus on proper contracting strategy can lead to project
failure in the area of cost control.
This article focuses on three aspects
of pricing strategy:
The importance of strict
oversight of percentage completion
claims on lump sum billing;
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The importance of understanding how costs will be
billed in a contract where the price is based on cost;
and
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The importance of
synchronising the contract pricing provisions for work
within the original scope with the pricing provisions
for change orders.
The article does not focus on
whether a company contemplating a project should adopt a
lump sum or cost plus approach for a particular project
or portion of a project, except for general comments on
that subject.
Background
Recently, the owner of an offshore
vessel under construction (called
the “Owner” for the remainder of this
article) required our assistance in
connection with termination of a
subcontract for the fabrication and
integration work. The Owner had decided
to move the work elsewhere and a dispute
arose over the final amount to be paid.
When initially planned, the parties
had expected the contract price for the
entire scope of work for the subcontract
in question to total £23
million. The pricing for the initial
work scope was based on actual cost of
labour and materials for work within the
initial scope, plus a lump sum for
overhead and profit elements. Pricing
for change orders was based on rates for
labour that included substantial profit
and overhead elements and on actual cost
for materials plus a 10% mark-up.
Billing and payment were based on
forecasts for the work to be performed
the following month. The lump sum
elements for overhead and profit for
work within the initial scope were also
billed and paid on the basis of
forecasts of the percentage of
completion of work within the initial
scope.
The Owner had paid all amounts
previously billed by the contractor
until the final billing. By the time of
termination, however, a substantial
question existed as to the amounts owed
for the work actually performed. In
addition, the contractor claimed an
extraordinary sum for impacts as a
result of contract termination. The
Owner required our assistance in
determining what should have been
charged for that work and eventually a
financial audit was required for part of
that determination.
Our review proceeded along two
paths. One was an assessment of the
work actually performed and an estimate
of the costs necessary to achieve that
progress. The other was a examination
of the contractor’s billing statements,
which included deficiencies on the face
of the documents and on comparison to
the actual work performed. Part of this
examination required exercise of the
contract audit rights and an accounting
firm’s review of the contractor’s
financial records.
Our review disclosed several serious
issues in both the pricing concept and
its administration. These included:
Inflated progress reports
of completion on the initial scope
of work and inadequate supervisions
led to an overstatement of the
amounts due for the lump sum items
of profit and overhead on initial
scope work. Unsuitable record-keeping
in light of the pricing provisions
led to difficulty and expense in
reviewing the contractor’s records
and a a probable overstatement of
costs to be paid by Owner. The difference in pricing for
initial scope work and change order
work led to Incentives to classify
work as change order instead of
initial scope.
Each of these is discussed further
below.
Inflated
Progress Reports on the Initial Scope of
Work
The only lump sum portion of the
contract was for profit, overhead, and
insurance premium on the initial scope
of work, which totalled almost £3
million. The sums were to be paid
monthly based on forecasts of progress
toward completion of the initial scope
work for the following month. By the
time the Owner terminated the contract,
the contractor had billed Owner on the
basis of progress on initial scope work
at over 66%, even though not all the
topsides had been fabricated and no
integration work had begun.
Other statements regarding progress,
including one by the contractor,
estimated progress between 24% and 33%.
Our assessment ultimately indicated that
the percentage completion on the initial
scope was approximately 39%. That
difference alone meant that the Owner
had been overbilled for the lump sums on
the order of £800,000 and had actually
overpaid by £675,000.
This real world scenario is just
another lesson in human nature and that
the project manager (or the cost
controller) must carefully review a
contractor’s billing claims on
percentage completion for lump sum
billing. Otherwise, an owner runs a
very real risk of overpayment early in a
project and the inherent problems when a
contractor runs short on cash toward the
end of the project.
Inadequacy of
Contractor Recordkeeping for Contract
Terms
Two real world issues confront any
contract in which costs determine the
price. First is the recognition that
the only practical way to capture labour
costs on an ongoing project is through
rates that include at a minimum all
elements of an employee’s compensation
spread over the expected number of
working hours for that employee. Second
is the question of how the contractor’s
accounting system is set up to capture
and report costs.
On the project in question, the
contractor charged rates for labour on
work within the initial scope, and
claimed that they only covered actual
cost. The parties, however, had never
defined what would be included in these
labour cost rates, and they actually
included not only labour costs but also
recovery elements for plant and
machinery used in the project.
Despite the contractor’s claim that
the rates were costs only, the financial
review revealed that the labour rates
charged for initial scope work were
nearly identical to the labour rates set
out in the contract for change orders,
which did specifically include overhead
and profit. Determination of whether
the labour rates used on the initial
scope work indeed fairly reflected only
costs would have required further
financial review and extensive testing
of the contractor’s plant and machinery
registers, depreciation, and usage for
such equipment, in addition to the costs
normally associated with labour.
The Owner and the contractor came to
an agreement as to a final amount owed
before it was necessary to proceed with
that scope of review, so the final
amount of overcharges, if any, caused by
this recordkeeping inadequacy is not
known. Nevertheless, we estimated the
overcharges on the order of magnitude of
£300,000. Moreover, several undesirable
consequences clearly resulted from the
mismatch between the contract terms and
the manner in which the contractor
actually maintained its records:
The inability to distinguish
readily between recoverable cost and
overhead because of using rates that
included overhead elements led to a
greater cost for the Owner’s
financial review of the contractor’s
costs because of the substantial
additional time that would have been
required to test elements of the
labour rates. The Owner in all likelihood
actually paid substantially more
than the contract provided for the
work actually performed, because of
a double recovery of profit and
overhead on labour for work within
the initial scope.
These ill effects could have been
substantially reduced if the parties had
addressed how “actual cost” would be
determined at the contracting stage.
That is, the only remedy for this
situation is for the parties to set out
an agreement as to what will be included
in labour rates and what will not be.
Different Pricing Provisions for
Initial Scope Work and Change Orders
Another defect in contracting strategy on the project
in question concerned the differences between pricing
for initial scope work and for change orders. Although
materials were to be priced at actual cost for both,
labour for change order work was to be billed at rates
set out in the contract, not actual cost as for initial
scope work, and the contract specified that the rates
included profit and overhead.
As a practical matter, initial scope work and change
order work will normally proceed side-by-side. In
addition, the nature of the change order process made it
difficult to distinguish between initial scope work and
change order work on several aspects of the project in
question.
The contract therefore gave the contractor an
incentive to class as much work as possible as change
order work, rather than initial scope work. Although we
found no specific evidence that the contractor had taken
advantage of this incentive, we also had no effective
way to review the contractor’s records to make such a
determination. The contractor’s records on whether
labour had been performed on the initial scope work or
on change orders were the only records on which the
Owner could rely on this issue.
As with the issue regarding mismatch on the
contractor’s records to the pricing provisions, this
issue could have been resolved at the contracting
stage. The lesson here is that pricing provisions for
change orders should closely follow the pricing method
for initial scope work.
Conclusion
The examples discussed above illustrate just a few of
the issues that should be addressed at the contracting
stage on price and administration. Paying attention to
pricing issues at that stage can lead to payoffs on the
cost front during the entire project. At the least, all
the parties will be more acutely aware of what is
expected and the Owner can minimise unexpected surprises
on the expense front.
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