The delivery and contracting of an industrial facility project are complex processes involving many parties performing a wide array of services that support design, engineering, pre-construction, construction, and commissioning solutions.
This article discusses construction contract types, the importance of a properly aligned contract, how to choose, and a comparison of the most common types used for high-performance industrial facility projects.
Types of Construction Contracts For Industrial Projects
Construction contracts define the legally binding relationship with terms and conditions relevant to performance and accountability between two or more parties.
This article focuses on four primary contract types used for industrial facility CapEx projects:
- Lump Sum, Stipulated Sum, or Fixed Price
- Guaranteed Maximum Price (GMP)
- Cost-Plus
- Cost-Plus GMP
Also worth mentioning, but not covered in detail, are “Time and Materials (T&M) and “Unit Price” agreements. These are often used in specific applications, such as operational expenditures, maintenance, preliminary project development, cost estimating, etc. Since these are uncommon and not generally favorable to owners for facility CapEx projects, they will be addressed in a later publication.
Why it Matters
A well-aligned construction contract should first and foremost fulfill its primary function to:
- Support the owner’s business goals and project objectives.
- Mitigate risk.
- Prevent conflicts of interest between owners, engineers, and construction.
- Keep the parties out of litigation.
Too often, well-intended parties take a myopic, procurement-driven view of contract type selection, leading to unknown contractual risk embedded in the agreements.
Each contracting option discussed below carries distinct advantages and protections for the owner, the project, and the parties involved.
Choosing the right construction contract type will not guarantee success alone. It must be paired with the appropriate project delivery method. A fully aligned contract builds a strong foundation for protecting all parties involved. Done right, owners receive five primary benefits:
- Cost control by developing a comprehensive procurement strategy aligned with owner risk tolerances, ensuring price proposals aren’t artificially inflated to mitigate unnecessary contract stipulations.
- Increased efficiency and efficacy with work products being developed to the appropriate level of detail for assessing risk and funding criteria of commercial and technical analysis.
- Assurance and validation that selected solution providers can offer valuable consultative insights while being willing and able to execute based on what works best for the owner’s organization.
- Optimized outcomes through team collaboration, leveraging the combined knowledge and experience of available resources.
- Mitigated risk by aligning with capital funding requirements and risk tolerances governing the performance mandates to successfully deliver facility and equipment solutions.
Selection Considerations
The consequences of a misaligned contract can be severe. To mitigate risk and optimize results, use a prescriptive, proven process to identify, evaluate, and select the best-suited instrument unique to the owner’s needs and circumstances.
Seek the advice of project advisors who are familiar with the available options, have a clear process to guide decision making, and act as an owner advocate along the way. Among other things, the team should consider the following:
- The project delivery method that defines expectations around time to market, risk profiles, funding requirements, spending authority, level of design, time constraints, and more. It is essential that the contract type supports project delivery and vice versa.
- Procurement strategy, including the type and quantity of service and solution providers, how each is to be evaluated and procured in support of both commercial and technical funding criteria.
Key Features
Lump Sum, Stipulated Sum, or Fixed Price
Lump sum (and related) contract types establish a cap on the amount an owner will pay for the scope of work, inclusive of labor (direct and indirect), materials, equipment, and subcontracted items.
Lump sum provides an efficiency-based structure, offering early price certainty balanced with contractor responsibility for cost overruns and project savings (if any). Lump sum contracts are relatively simple to administer and manage.
Guaranteed Maximum Price (GMP) Contracts
As with a lump sum, GMP is a contract type that establishes a cap on the amount an owner will pay for labor (direct and indirect), materials, equipment, and subcontracted items.
GMP contracts also provide a structure offering price certainty. However, while the contractor is responsible for cost overruns, the client retains project savings (if any).
Guaranteed Maximum Price methods are complex to administer and manage.
Cost-Plus
Cost-Plus is a contract type in which the project price is derived by applying a negotiated fee (fixed dollar amount or percentage) to the cost of labor (direct and indirect), materials, equipment, and subcontracted items.
A Cost-Plus contract is a cost-reimbursable agreement where the contractor is paid for all actual project costs incurred (labor, materials, equipment, subcontractor costs), plus a negotiated fee for overhead and profit.
A common alternative is to align cost-plus with a guaranteed maximum price to arrive at a contract type that provides more assurances to an owner.
Conclusion
To select a contract type that supports a successful CAPEX project, owners should consider their goals and objectives, align with their project delivery method, and assess each contract type’s attributes against the selection criteria.
While every project and owner’s needs are unique, key considerations around scope, schedule, price, and risk can indicate a “best fit” for an Industrial-related CAPEX project.
Ask HRI’s experts about our processes and tools for selecting the right contract type for your next high-performance industrial facility project today…
