Contract Risk

Introduction
Most construction work is administered through the use of contracts. The process usually
involves the principal inviting tenders, either generally or from a prequalified group, from
which one is selected and a contract entered into. The principal writes or selects the
contract documents to be used. The selected builder is called the contractor.

Commonly the contractor will assign work to other companies through subcontracts. The
parties in this case are called the head contractor and the subcontractor.

Industry accepted standard forms of contracts are generally used between the principal
and the contractor. These will be modified to suit the particular project. This gives the
advantage that the clauses of the contracts are generally recognisable and legal precedents
exist as to their interpretation.

Head contractors on the other hand often have their own set of standard contracts that
they issue to subcontractors.

Contract Formulation
Ideally a party to a contract should bear a risk where:
 The risk is within the party’s control
 The party can transfer the risk (eg insurance) and this is the most economical way to
deal with the risk
 The preponderant economic benefit of controlling the risk is with the party in
question
 To place the risk upon the party in question is in the interests of efficiency, including
planning, incentive, and innovation
 If the risk eventuates, the loss falls on that party in the first instance and it is not
practicable, or there is no reason under the above principles to cause expense and
uncertainty by attempting to transfer the risk to another. (NPWC/NBCC Joint
Working Party, 1990)

There is obviously scope to argue these guidelines in either party’s favour. Negotiation
may be used for “neutral” risks.

Technically contracts do not allocate risks they allocate obligations. These obligations
bring risks with them. Therefore when comparing contracts, what should be compared
are the obligations.

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A major risk and the major cause of disputes is ambiguity in the contract documents.
Therefore it is recommended that standard forms of contracts be used whenever possible.
 These are recognisable
 Precedents exist for their interpretation
 They appeal to the widest range of contractors and principals
 They have equitable share of obligations (risks)

These can then be amended to suit the specific situation. Amendments should be clearly
identified, either in a suitable annexure, or as Special Conditions of Contract.

Payment Methods
Contractual arrangements are the arrangements in the contract documents that show the
obligations, rights and liabilities of the parties to the contract. Contractual arrangements
that can be used for implementing projects can be classified into the following three
broad categories (according to the method of payment to the contracting organization):
Fixed-price or lump-sum contracts - involve the payment of a predetermined fixed total
price for a defined product. Fixed price contracts can be based on:
i. Performance specifications
ii. Drawings and Specifications
iii. Schedule of Rates
iv. Bills of Quantities
Lump sum contracts place most of the pricing risk on the contractor

A variation of the lump sum contract is the target cost contract - in which the
contracting organization is given a bonus for achieving a predetermined cost and/or time
target and penalized in some way for failing to achieve the target
Target cost contracts share the risk between the contractor and the owner
Cost-reimbursable contracts - which involve paying the provider of a product or
service the actual costs incurred in providing the product or service. Cost Reimbursable
contract can be based on:
i. Prime Cost + Percentage
ii. Prime Cost + Fixed Fee
Cost reimbursable contracts place all of the risk on the owner

Unit-price contracts – also referred to as schedule of rates contracts, involve paying the
provider of a product or service a predetermined amount of money per unit of product or
service (e.g. $70 per hour for professional services; or $1.08 per cubic meter of soil
removed).

Unit price contracts divide the risk between the owner and contractor

Management of Risk Contracts Page 2

Tender Analysis
Tender documents should be studied carefully for any traps (which may be
unintentional), perhaps related to payment or work quality and quantity.

Details that the tenderer may wish to know about are:

 How fair are the client’s tender requirements
 What information will be available on the tender prices
 What is the client’s integrity in evaluating tenders
 Will the client undertake equitable treatment of the tenderer’s qualifications
 Will the client accept alternatives
 What is the client’s financial situation

When contemplating whether or not to tender there are a number of issues to be

considered:

The Cost of Tendering

Contractors are expected to cover the cost of tenders, which becomes part of the overhead
included in the tender price.

Owners argue:
 Preparation of tenders is an inherent part of the contractor’s work and should be
treated the same as other overheads
 The debate is only relevant for large projects

Contractors argue:
 Some projects have exceptional tender costs
 Owner paying tender costs will allow small contractors to tender more often and grow
 A lack of a bill of quantities implies duplication of effort that should be paid for
 Recalling tenders using borrowed ideas means tenderers must tender twice and the
owner gets free expertise
 Design, develop and construct, or build, own, operate, transfer work requires designs
as part of the tender
 High tech projects require “development grants”

Financial Status

Some projects fail because the contractor cannot finance the work. Others because the
principal is slow in making progress payments.

Current and Future Workload

Contractors must balance overcommitting plant and labour resources and having
insufficient work. A steady stream of work makes good relations with subcontractors and
suppliers. Large contractors are more able to cope with fluctuations than small ones.

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Type of Work

Large contractors have a larger database of costs to work from.

Rise and Fall

For contracts over an extended period there should be some price adjustment mechanism.
The contractor should consider
 Can equipment etc be ordered early and stored?
 Are rise and fall conditions demanded by subcontractors and suppliers recoverable
under the specified conditions?
 What is the true labour/material ratio of the project?
 Must orders for some equipment be deferred and if so will the price stand?

Confidentiality

One problem is how to protect the confidentiality of information supplied with the tender.
The best legal method for doing this is inclusion of a clause insisting on this in the tender.

Disclaimers

Often tender documents disclaim any responsibility for the correctness of information
supplied.

Conflict between Documents

Tender documents are not always clear, unequivocal and complete.

There should be a precedence of documents stated in the contract in case different
documents treat the same matters differently.

Nomination

Subcontractors prefer to be nominated as this gives them some security to their payments.

Contract Type and Strategy

Design and construct work tenders are much more expensive than design only contracts.

Payment Provisions

Possibility of principal becoming insolvent.

Subcontractors may not be paid until after the head contractor is paid.

Time Provisions

Time provisions should reflect the availability of labour and materials. Specifications
may be for components that are in difficult supply.

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Bills of Quantities

Contractors (and quantity surveyors) argue that there should be a complete detailed and
measured bill fully guaranteed by the principal. Some owners argue having no bill at all.

Arguments against bills include:

 For some projects bills are unnecessary and in others they are unsuitable
 Contractors use bills as a basis for disputes
 They are not suitable for non-traditional procurement systems where the work is not
fully designed or documented before calling tenders.

Arguments for bills include:

 Lack of a bill creates additional tendering costs
 Cost control is on a sounder footing
 Bills provide a sound basis for assessing tenders and variations
 Lack of a bill transfers risks to the contractor and raises tender prices

Weather

Abnormal weather patterns can seriously disrupt the progress of a project.

Industrial Disruption

In order to minimise any industrial disruption, both the owner and contractor have to
focus on industrial matters.

Tender conditions may require that the tenderer pay attention to special requirements in
the areas of:
 Industrial practices
 Site agreements
 Occupational health and safety agreements
 Site amenities

Local site disputes may be controllable, national ones may not be.

Market Conditions

The number and size of contractual claims is correlated to the level of activity in the
overall construction market (McKenzie, 1989).

References
McKenzie, A., 1989, “Tender Preparation and Risk Evaluation”, Tendering Conference,
CPLI, July, Sydney.

NPWC/NBCC Joint Working Party, 1990, “Risk Allocation” No Dispute, Canberra

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