Dr. SangHyun Lee

Dr. SangHyun [email protected]@mit.edu

Department of Civil and Environmental Department of Civil and Environmental EngineeringEngineering

Massachusetts Institute of Technology Massachusetts Institute of Technology

1.040/1.4011.040/1.401

Project ManagementProject ManagementSpring 2007Spring 2007

Project Organization Part 2 & 3Project Organization Part 2 & 3Payment & Award MethodPayment & Award Method

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Payment SchemesPayment Schemes FundamentalsFundamentals Lump sumLump sum Unit pricesUnit prices Cost plus percentage feeCost plus percentage fee Cost plus fixed feeCost plus fixed fee Guaranteed maximum priceGuaranteed maximum price IncentiveIncentive

Award MethodsAward Methods BiddingBidding NegotiationNegotiation Best ValueBest Value

Fundamental IdeasFundamental Ideas

Contractors are often highly risk averseContractors are often highly risk averse For risks that contractor For risks that contractor can’t can’t control, may be control, may be

willing to pay a risk premium (charge less for willing to pay a risk premium (charge less for contract) to owner to take overcontract) to owner to take over

For risks that contractors For risks that contractors cancan control, may be control, may be willing to willing to managemanage risk than to pay a risk premium risk than to pay a risk premium (charge less for contract)(charge less for contract)

Fundamental IdeasFundamental Ideas

Structure contract so thatStructure contract so that Risks contractor can better handle are imposed Risks contractor can better handle are imposed

on contractor (i.e. contractor will lose $ if don’t on contractor (i.e. contractor will lose $ if don’t

control)control) To be competitive, will have to To be competitive, will have to managemanage these these

Risks owner can better handle are kept by ownerRisks owner can better handle are kept by owner

Fundamental BalanceFundamental Balance

Impose Impose highhigh enough risk incentive to get contractor do job enough risk incentive to get contractor do job

efficiently – within the specifications of the contractefficiently – within the specifications of the contract E.g. Incentive to finish on time, incentive to stay within budgetE.g. Incentive to finish on time, incentive to stay within budget

Impose Impose lowlow enough risk to have reasonably low bid enough risk to have reasonably low bid

Impose according to contractor ability to tolerateImpose according to contractor ability to tolerate

Derivative Results of Risks: Derivative Results of Risks: Impact on Construction Impact on Construction

TimingTiming

More risk on contractor, the longer will delay More risk on contractor, the longer will delay

construct.construct. Also, in terms of costAlso, in terms of cost

Given uncertainty, contractor will charge more up frontGiven uncertainty, contractor will charge more up front Owner doesn’t want to pay a huge amount up frontOwner doesn’t want to pay a huge amount up front

Owner can expedite – by paying higher price (risk Owner can expedite – by paying higher price (risk

premium) to contractor or by shouldering riskpremium) to contractor or by shouldering risk

Remember; delay can have major costs – but so can Remember; delay can have major costs – but so can

wrangling over change orders!wrangling over change orders!

Addenda and Change Addenda and Change OrdersOrders

Addenda Addenda Any changes that arise before bid opening and Any changes that arise before bid opening and

during the bidding period become part of the bid during the bidding period become part of the bid

packagepackage

Change OrdersChange Orders Any changes that arise after the contract is signed Any changes that arise after the contract is signed

due to:due to: Different Site ConditionsDifferent Site Conditions Errors/ Omissions in the Contract DocumentsErrors/ Omissions in the Contract Documents Owner’s RequirementOwner’s Requirement OthersOthers

Requires adjustments in scope, time, and cost.Requires adjustments in scope, time, and cost.

Note on Change OrdersNote on Change Orders

Changes contract (cost/schedule/scope/etc.)Changes contract (cost/schedule/scope/etc.)

Can lead to costs beyond contract specificationCan lead to costs beyond contract specification

Anticipated costs incorporated in “contingency”Anticipated costs incorporated in “contingency” Often 1-10% on top of agreed upon priceOften 1-10% on top of agreed upon price

Often only paid for additional direct costsOften only paid for additional direct costs Big problem if disruption in workBig problem if disruption in work

Source of very large riskSource of very large risk

Addenda - ExampleAddenda - Example

Source: Fisk, 2003

CITY OF PALM SPRINGSENGINEERING DIVISION

ADDENDUM NO.1

To all prospective bidders under Specifications for Re-roofing the Police Department Building, City Project No. 93-52, for which bids are to be received by the City of Palm Springs at the office of the purchasing manager at 3200 East Tahquitz Canyon Way, Palm Springs, California 92262 until 4:00 pm on Tuesday 21 March 1995.

I. The existing three bid schedules in the Specifications and Drawings for this contract have been revised. Bid schedules “A”, “B”, and “C” have been changed and revised bid Schedules have been included as a part of this Addendum No.1.

II. The Specifications as originally issued, along with revised Schedules “A”, “B”, and “C” shall be used in submitting bids, and acknowledgement of receipt of this Addendum No.1 shall be entered on Page 1 of the Bid. Failure to provide such acknowledgement shall render the bid as non-responsive and subject to rejection.

BY ORDER OF THE CITY OF PALM SPRINGS

13 March 1995 By Robert J. Rocket, PECity EngineerCivil Engineer C 28209

Change Order - Change Order - ExampleExample

Source: Fisk, 2003

E.R. FISK & ASSOCIATES

P.O. Box 6448 Orange CA 92613.6448 CHANGE ORDER

PROJECT TITLE: Dalles Hydroelectric Project PROJECT No.: F-409 CONTRACT NAME: w34-6759 CONTRACT DATE: 29 OCT 1990

CONTRACTOR: International Constructors, Inc.

The following changes are hereby made to the contract Documents: Construction of access bridge abutment No.1 drainage system; and Reset two penstock bearing plates. All in accordance with revised DWG S-17209 Revision 3, dated 28 August 1991.

JUSTIFICATION: Unforseen soil conditions

CHANGE TO CONTRACT PRICEOriginal Contract Price: $ 13,231,053.00Current Contract Price as adjusted by previous change orders: $ 13,257,760.00The Contract Price due to this change order will be increased by $ 14,342.00The new Contract Price due to this change order will be: $ 13,272,102.00

CHANGE TO CONTRACT TIMEThe Contract time will be increased by 21 calendar daysThe date for completion of all work under the contract will be 24 June 1992.

APPROVALS REQUIREDTo be effective, this order must be approved by the Owner if it changes the scope or objective of the project., or may otherwise be required under the term of the Supplementary General Conditions of the Contract.

Requested by: Proj Mgr – E.R. Fisk & Associates (date 28 Aug 1991)Recommended by: E.R. Fisk & Associates (date 28 Aug 1991)Ordered by: Dalles Power Company (date 02 Sep 1991)Accepted by: International Constructors, Inc. (date 09 Sep 1991)

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Lump Sum or Fixed PriceLump Sum or Fixed Price

The Owner knows the actual cost of the project The Owner knows the actual cost of the project before it begins before it begins

Contractor required to achieve the project at the Contractor required to achieve the project at the Bid/Negotiated Contract ValueBid/Negotiated Contract Value

Minimize the risk for the Owner if the project is Minimize the risk for the Owner if the project is well estimated, contractual documents accurate, well estimated, contractual documents accurate, and project clearly definedand project clearly defined

Lump Sum or Fixed PriceLump Sum or Fixed Price

High risk for the Contractor in case of many High risk for the Contractor in case of many unforeseen problemsunforeseen problems

Generally utilized with the Traditional Method & Generally utilized with the Traditional Method & usually not possible with Fast Trackusually not possible with Fast Track

Usually a high incentive to finish early at low costUsually a high incentive to finish early at low cost

Cost Versus Price for Cost Versus Price for Lump SumLump Sum

Source: Macomber, 1989

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Unit Price ContractUnit Price Contract

Agreement on the price charged per unit by the Agreement on the price charged per unit by the Contractor to the OwnerContractor to the Owner

Contractor overhead must be integrated in the Contractor overhead must be integrated in the Unit’s PricesUnit’s Prices

The lowest bidder is normally selectedThe lowest bidder is normally selected

Necessity of an Owner presence on site to Necessity of an Owner presence on site to measure the actual quantitiesmeasure the actual quantities

Unit Price ContractUnit Price Contract

Highly dependant on the accuracy of the Highly dependant on the accuracy of the estimation of the quantities given by the estimation of the quantities given by the Owner/DesignerOwner/Designer

Difficult to accurately quantify the work necessary Difficult to accurately quantify the work necessary

Contractor can make a more profit because payment is Contractor can make a more profit because payment is based on actual quantities but he can also lose money in based on actual quantities but he can also lose money in the same waythe same way

The total cost for the Owner can be greater than plannedThe total cost for the Owner can be greater than planned

Unit Price: ExampleUnit Price: Example

Activities:Activities: FootingsFootings 80 $/sq ft 80 $/sq ft ColumnsColumns 1,550 $/unit1,550 $/unit

Scheduled quantities:Scheduled quantities: FootingsFootings 100 sq ft100 sq ft ColumnsColumns 9 units 9 units

Contract initial value:Contract initial value:

80 * 100 + 1,550 * 9 = 14,750 $80 * 100 + 1,550 * 9 = 14,750 $

Example: Pile DrivingExample: Pile Driving

Too risky to just charge fixed priceToo risky to just charge fixed price Geotechnical uncertainties make length of piles Geotechnical uncertainties make length of piles

uncertainuncertain

Risk allocationRisk allocation Price risk more under contractor control (efficiency, Price risk more under contractor control (efficiency,

crew and equipment selection): to contractorcrew and equipment selection): to contractor

Length out of contractor control: to ownerLength out of contractor control: to owner

Owner must precisely monitor length usedOwner must precisely monitor length used

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Cost Plus Percentage FeeCost Plus Percentage Fee The Owner is paying The Owner is paying the actual costthe actual cost plus a fixed plus a fixed

percentage feepercentage fee

High risk for the OwnerHigh risk for the Owner

Maximum flexibility for the OwnerMaximum flexibility for the Owner

Used only if the pricing could not be calculated in Used only if the pricing could not be calculated in any other way and if it is urgentany other way and if it is urgent

No financial insurance of ultimate costNo financial insurance of ultimate cost

Cost Plus Percentage FeeCost Plus Percentage Fee

Little incentive to reduce costs Little incentive to reduce costs

The Contractor agrees to do his/her best efforts to The Contractor agrees to do his/her best efforts to achieve the goalsachieve the goals

Whatever the quality of the work, the reward is the Whatever the quality of the work, the reward is the same but the owner gets the quality he/she pays forsame but the owner gets the quality he/she pays for

Permits collaboration at the early stages of the Permits collaboration at the early stages of the ProjectProject

Cost Versus Price for Cost Versus Price for Cost Plus %Cost Plus %


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Cost Plus Fixed FeeCost Plus Fixed Fee

Cost may vary but the fee remains firmCost may vary but the fee remains firm

The fee is independent of the duration of the projectThe fee is independent of the duration of the project

Used only if the pricing could not be determined in Used only if the pricing could not be determined in an alternative manneran alternative manner

No financial insurance of ultimate costNo financial insurance of ultimate cost

Cost Plus Fixed FeeCost Plus Fixed Fee

Little incentive to reduce costs but high incentive Little incentive to reduce costs but high incentive to finish earlyto finish early

The Contractor agrees to make best efforts to The Contractor agrees to make best efforts to complete the workcomplete the work

Promotes collaboration at the early stages of the Promotes collaboration at the early stages of the projectproject

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Guaranteed Maximum Price Guaranteed Maximum Price (GMP)(GMP)

Variation of the Cost Plus a Fee by having a cap, Variation of the Cost Plus a Fee by having a cap, or GMPor GMP

The Contractor assumes any additional costs after The Contractor assumes any additional costs after the “Ceiling” Point is reachedthe “Ceiling” Point is reached

Similar to CPFF but quality may be sacrificed to Similar to CPFF but quality may be sacrificed to avoid increases in cost beyond GMPavoid increases in cost beyond GMP

Variation: Usually, GM Shared Savings - Below Variation: Usually, GM Shared Savings - Below the guaranteed maximum, savings are shared the guaranteed maximum, savings are shared between Owner and Contractorbetween Owner and Contractor

Cost Versus Price for Cost Versus Price for GMPGMP


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Principles of Incentive Principles of Incentive ContractsContracts

TARGET COST: $20,000TARGET FEE: $1500SHARING RATIO: 80/20 %

•CUSTOMER PAYS 80 % OF OVERRUN

•CONTRACTOR PAY 20 % OF OVERRUN

•PROFIT IS $1500 LESSCONTRACTOR’S 20 %

•CUSTOMER KEEPS 80% OF UNDERRUN

•CONTRACTOR KEEPS 20% OF UNDERRUN

•PROFIT IS $1500 PLUSCONTRACTOR’S 20 %

Note: Limitations may be Imposed on Price or Profit

EXAMPLE

Additional Profits are Possible by Lowering Cost Customer and Contractor Share Cost

Savings

Source: Kerzner, 2000

$20,000

Incentive Contracts: Incentive Contracts: ExampleExample

Fixed Price Fixed Price Incentive FeeIncentive Fee

•Sharing: 70/30 (O/C)

•Target Cost: 10,000

•Target Fee: 850

•Target Price: 10,850

•Price Ceiling: 11,500

Fixed Price Incentive Fee

-4000

-2000

0

2000

4000

6000

8000

10000

12000

14000

9000 10000 10928 11300 11500 12000 13000

Profit

Final Price

Incentive Contracts: Incentive Contracts: ExampleExample

Cost Plus Incentive Cost Plus Incentive FeeFee

•Sharing: 85/15 (O/C)

•Target Cost: 10,000

•Target Fee: 750

•Maximum Fee: 1350

•Minimum Fee: 300

More financial risk for the owner in a CPIF, the target fee is usually less than in an FPIF contract and the contractor’s portion of the sharing ratio is small

Cost Plus Incentive Fee

0

2000

4000

6000

8000

10000

12000

14000

16000

4000 6000 9000 10000 13000 14000

Profit

Final Price

Contractor’s RisksContractor’s Risks

FFPCPPF Risk For Contractor

HIGHLOW

LEGEND

FFP FIRM FIXED PRICE-LUMPSUMCPPF COST PLUS PERCENTAGE FEE

Source: Kerzner, 2000

Contractual Risk Contractual Risk AllocationAllocation

100 %RISK Allocation

Lump-Sum (Fixed Price)

0 %

100 %

CO

NT

RA

CT

OR

’S R

ISK

0 %

OW

NE

R’S

RIS

K

RISK SHARING METERModified from Kerzner, 2000

Fixed-Price w/ Economic Price Adjustments

Fixed-Price Incentive

Cost-Plus Incentive

Cost-Plus Fixed Fee

Cost-Sharing

Cost-Plus Percentage

ConclusionConclusion When the market is not very good, clients insist on When the market is not very good, clients insist on

fixed price bids whereas when the project offers are fixed price bids whereas when the project offers are numerous, it is more difficult to obtain those numerous, it is more difficult to obtain those conditionsconditions

The Choice of payment scheme (i.e., contract type) The Choice of payment scheme (i.e., contract type) must depend on:must depend on:

The accuracy of the estimationThe accuracy of the estimation

The ultimate cost known since the beginning or at least the The ultimate cost known since the beginning or at least the maximummaximum

The desired riskThe desired risk

The priority of the goal of quick completion of workThe priority of the goal of quick completion of work

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Competitive Bidding – Competitive Bidding – Lowest PriceLowest Price

Traditional & Widely UsedTraditional & Widely Used

Time consuming process involving a bidding period as well as a bid Time consuming process involving a bidding period as well as a bid evaluation & review period prior to issuing notice to proceed with evaluation & review period prior to issuing notice to proceed with constructionconstruction

Work awarded to lowest bidderWork awarded to lowest bidder

Project constructed with specified quality at lowest priceProject constructed with specified quality at lowest price

Formal procedure for public agenciesFormal procedure for public agencies

Two main typesTwo main types Open Form: Bid open & read publiclyOpen Form: Bid open & read publicly Closed Form: No public openingClosed Form: No public opening

Contractor estimates cost of building project along with profitContractor estimates cost of building project along with profit Unit-PriceUnit-Price Lump-SumLump-Sum

Loss is absorbed by the Contractor, if actual cost exceeds contracted Loss is absorbed by the Contractor, if actual cost exceeds contracted amountamount

Issues with BidsIssues with Bids

Low bidders can be unreliableLow bidders can be unreliable Prequalify aggressively!Prequalify aggressively!

Pressure for lowest bid can createPressure for lowest bid can create Cutting cornersCutting corners

Low-quality personnelLow-quality personnel

Bad feelingsBad feelings

Growing Frequency: innovative bidding methodGrowing Frequency: innovative bidding method Multi-parameter bidding (e.g., low bid + other factors)Multi-parameter bidding (e.g., low bid + other factors)

To Bid or Not to BidTo Bid or Not to Bid

Strategic Goals of the CompanyStrategic Goals of the Company

Capabilities of the CompanyCapabilities of the Company

Location of the WorkLocation of the Work

Bid LogisticsBid Logistics

LicensingLicensing

Pre-QualificationPre-Qualification

BondingBonding

Scope of WorkScope of Work

Resource RequirementsResource Requirements

BondingBonding

Protection for Owner against Contractor’s DefaultProtection for Owner against Contractor’s Default The Miller Act (1935) – the level of bonding required for The Miller Act (1935) – the level of bonding required for

federally funded projects. federally funded projects. Source: Halpin and Woodhead, 1998

Owner Contractor

Surety(BondingCompany)

BondingBonding Bid Bond: will the selected bidder start the project? Bid Bond: will the selected bidder start the project?

PublicPublic ~20% or as low as 5% of Bid~20% or as low as 5% of Bid

PrivatePrivate 5% to 10% of Bid5% to 10% of Bid

Performance Bond: will the contract work be completed and Performance Bond: will the contract work be completed and comply with project specification?comply with project specification? 100% Complete Job at Bid Price100% Complete Job at Bid Price

Payment Bond: will a contractor pay any associated charges (e.g., Payment Bond: will a contractor pay any associated charges (e.g., subcontractor fee)? subcontractor fee)? Cover Unpaid Bills by ContractorCover Unpaid Bills by Contractor

50% for < $1M50% for < $1M 40% for $1M < X < $5M40% for $1M < X < $5M 2.5M for > $5M2.5M for > $5M

Most Institutions Now Require 100%Most Institutions Now Require 100%

Bonding Capacity CalculationBonding Capacity Calculation No Track Record: (5 or 6) × Net Quick Assets No Track Record: (5 or 6) × Net Quick Assets Old Reliable Record: (40+) × Net Quick AssetsOld Reliable Record: (40+) × Net Quick Assets

Net Quick Assets = Quick Assets – Current LiabilitiesNet Quick Assets = Quick Assets – Current LiabilitiesSource: Halpin and Woodhead, 1998

MIT Wood Inc.MIT Wood Inc.

Bonding Capacity Bonding Capacity $2,500,000$2,500,000

Potential New JobsPotential New Jobs PP1: $750,000PP1: $750,000 PP2: $1,000,000PP2: $1,000,000

Current Jobs as SubCurrent Jobs as Sub P1: $1,000,000; 25% CompleteP1: $1,000,000; 25% Complete P2: $1,000,000; 50% CompleteP2: $1,000,000; 50% Complete

Current Job as GCCurrent Job as GC P3: $500,000; 50% CompleteP3: $500,000; 50% Complete

BondingBonding Potential New JobsPotential New Jobs

PP1: $750,000PP1: $750,000 PP2: $1,000,000PP2: $1,000,000

Current Jobs as Sub Current Jobs as Sub PerformancePerformance

P1: $1,000,000*0.75 = $750,000P1: $1,000,000*0.75 = $750,000 P2: $1,000,000*0.50 = $500,000P2: $1,000,000*0.50 = $500,000

Current Job as GC Current Job as GC PerformancePerformance

P3: $500,000*0.50 = $250,000P3: $500,000*0.50 = $250,000 PaymentPayment

P3: $500,000*0.50*.0.50 = $125,000P3: $500,000*0.50*.0.50 = $125,000

Used Up BondingUsed Up Bonding $1,625,000$1,625,000

Available BondingAvailable Bonding $875,000$875,000

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NegotiationNegotiation

Pre-selected ContractorPre-selected Contractor

Common practice for private ownersCommon practice for private owners

Owner picks Contractor on basis of:Owner picks Contractor on basis of: ReputationReputation Overall qualifications to do the jobOverall qualifications to do the job

Typical financial contract types are:Typical financial contract types are: Cost Plus FeeCost Plus Fee Guarantee Maximum Price (GMP)Guarantee Maximum Price (GMP)

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Best ValueBest Value

Used by the Federal GovernmentUsed by the Federal Government Provides a uniform set of procurement regulationsProvides a uniform set of procurement regulations Request for Proposal (RFP) states:Request for Proposal (RFP) states:

Relative importance of priceRelative importance of price Technical meritTechnical merit Technical evaluation criteria and their weightsTechnical evaluation criteria and their weights

Selection of Contractor is based on the best value Selection of Contractor is based on the best value of the proposed workof the proposed work PricePrice Technical FactorsTechnical Factors