IDENTIFYING THE RISK IN COST REIMBURSABLE CONTRACTS

ABSTRACT

The primary goal of the research is to assess risk elements in cost reimbursable contracts. There is a notion that these contract types serve little risk to a contractor. Nine total contracts were read and, using a standard definition for risk; risky clauses were selected and evaluated. The contracts were all from large industrial projects with large owners. The clauses analyzed were broken down into smaller categories such as entitlement and rights and responsibility. The clauses were then ranked as low risk, intermediate risk and a high risk. Stripping all superfluous language from the clause, specific risk factors were identified for each category. This provided a table where risk factors and level of risk were shown, which allows for comparison to any contract when assessing contractual risk. Furthermore, other risk aspects were discovered when reading the contracts. Contract coordination, overall contract tone and excessive referencing were some of the other non-clause related risk factors identified in the contracts. The result of the research identified that even in cost reimbursable contracts there will be risk for the contractor. The owner includes specific clauses to shed risk to the contractor, the more clauses are included the more risk can be identified. The term cost reimbursable does not always include all the aspects of a job and will have disallowed costs, which must be carefully managed.

 

 

 

 

 

 

 

 

 

 

 

 

Table
of
Contents


List of Tables…………………………………………………………………………………………………………….. vii


List of Figures………………………………………………………………………………………………………….. viii


1. INTRODUCTION……………………………………………………………………………………………………. 1


Objective………………………………………………………………………………………………………………… 2


Scope…………………………………………………………………………………………………………………….. 2


2. METHODOLOGY…………………………………………………………………………………………………… 3


Literature Review…………………………………………………………………………………………………….. 3


Review of Contracts………………………………………………………………………………………………….. 3


Preliminary Analysis…………………………………………………………………………………………………. 3


Identify Other Risk Aspects of Contracts……………………………………………………………………….. 7


3. LITERATURE REVIEW…………………………………………………………………………………………… 8


Important topics within literature…………………………………………………………………………………. 8


4. BASIC CONCEPTS ABOUT RISK IN COST REIMBURSABLE CONTRACTS………………… 15


Risk Shedding Strategies………………………………………………………………………………………….. 15


Cost Definitions……………………………………………………………………………………………………… 15


Ceiling Price………………………………………………………………………………………………………….. 16


Disallowed Cost……………………………………………………………………………………………………… 17


Saving-Sharing and Sharing of Cost……………………………………………………………………………. 17


Fee Structure…………………………………………………………………………………………………………. 17


Role of General Conditions………………………………………………………………………………………. 18


5. CONTRACT STRUCTURE……………………………………………………………………………………… 19


Issues in Risk Allocation………………………………………………………………………………………….. 20


Ceiling Price in Risk Allocation…………………………………………………………………………………. 20


Disallowed Cost in Risk Allocation…………………………………………………………………………….. 22


Fees and Risk………………………………………………………………………………………………………… 23


Incentives and Risk…………………………………………………………………………………………………. 23


Discussion…………………………………………………………………………………………………………….. 24


6. ANALYSIS TO IDENTIFY CLAUSE RISK………………………………………………………………… 26


ENTITLEMENT CLAUSES…………………………………………………………………………………….. 27


RIGHTS AND RESPONSIBILITIES………………………………………………………………………….. 40


PROCEDURES……………………………………………………………………………………………………… 50


OTHER CONTRACT ISSUES………………………………………………………………………………….. 55


8. CONCLUSIONS AND SUMMARY…………………………………………………………………………… 57


Core Contribution…………………………………………………………………………………………………… 57


Summary………………………………………………………………………………………………………………. 57


Future Research……………………………………………………………………………………………………… 58


REFERENCES…………………………………………………………………………………………………………………………..

1. INTRODUCTION

Design and construction contracts are an integral aspect of the delivery process. Contracts assign responsibility, describe procedures, and define specific rights to all parties. That said, before committing to a contract, one must thoroughly read and understand all areas of a contract.

The contract’s language is of utmost importance as it is strictly interpreted in a court of law.

There are many types of contracts, with different elements meant to serve different components. A modern-day cost reimbursable contract is no different than any other contract in the sense of the risk associated with it. This contract structure defines the agreed upon allowable costs, with a typically enforced Ceiling Price clause also. A contract may define a Target Price, also called an Estimated Price, which is the predetermined cost estimate for construction services. In theory cost reimbursable contracts were thought to be more risky for owners. This stems from the fact that the owner covers costs. This was not the case in industrial contracts.

Quasi cost reimbursable contracts have the same structure as a cost reimbursable contract with some added components to serve a specific purpose. Both quasi and cost reimbursable contracts have defined allowable costs, a target price and a Ceiling Price (cost reimbursable contracts omit this ceiling agreement). The difference between the two is the added agreement as a form of an incentive. Some contracts deviate from the standard cost reimbursable contract style to the “quasi” form by adding a Savings-Sharing agreement to the contract structure or by adding a Cost-Sharing agreement and the GMP. To be clear, for the purpose of the research a cost sharing agreement is a sharing mechanism that describes the sharing of the cost of the work over a predetermined price and at a predetermined split with the owner. The contracts are essentially meant to serve the same purpose but the variability comes from the added comfort of the extra agreements for the owner.

Typically in industrial projects the contract format used is an EPC (Engineering, Procurement and Construction) contract. The Construction contracts tend to be cost reimbursable contract structure. The contracts analyzed all stem from large industrial projects and are unique  to typical commercial contracts.

 

 

Objective

The purpose of the research is to provide a framework to evaluate levels of contract risk for contractors in industrial cost reimbursable contracts. In this respect, the various risk bearing clauses in the general conditions are described illustrating that the risk allocated is a function of how the clause is written. Examples of low, intermediate, and high risk clauses will be given from the industrial cost reimbursable contracts reviewed. This process identifies clauses, which are more opportunistic for negotiation. Other contract risks are also discussed, for example,  contract integration and excessive referencing.

Scope

The risk elements identified are limited to construction contracts for industrial facilities and examine risk in clauses, fee structures and other risk factors. Not all risk bearing clauses are mentioned in the thesis; rather, the main clauses, which are more common, are analyzed. An important aspect to understand is that risk is relative and, because this thesis is geared to the contractor’s perspective, it depends on what a specific contractor may determine as risky and is not a complete guide to analyze risk. In that respect, risk bearing clauses will be described. Examples of low, intermediate and high risk clauses are given, with the risk factors of the specific examples identified and explained. No recommendations are made relative to which clause to choose; instead it is only a means to identify theoretical contract risk.

IDENTIFYING THE RISK IN COST REIMBURSABLE CONTRACTS

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