RISK MANAGEMENT IN PROJECT

PROCUREMENT AND CONTRACTS

Prof. Vijaya Dixit

Price Regime

Governing Principle
Firm Price A price which is not variable for any reason(other than change
in specification, quantity or time for performance)

Fixed Price A price the final value of which is fixed by reverence to some
variable parameter such as an inflation index or currency
exchange rate

Cost Incentive A price based on contractors actual cost but with prime
contractor and subcontractor sharing overspends or
underspends against a pre-agreed target cost

Cost Re- A price based on the subcontractor actual cost plus a pre-
determined amount or percentage by way of profit.
imbursement
In effect they represent a spectrum of cost-risk allocation between
client and prime contractor as shown in figure
The Cost
In a incentive
conventional contract
arms-length The fixed provides the
relationship
the prime price compromise
contractor will approach solution for
prefer a firm deals with high risk
price where he one or two work where
perceives the risks only neither side
risk to be such as is willing or
small and the
opportunity inflation and able to carry
for profit foreign the entire
great currencies cost risk

The greater The primary

the risk the choice is
more he will between
want a firm firm price
price and cost-
arrangement reimbursem
ent
 Outsourcing Strategy

Procurement Type Contract strategy

Pricing Regime

Non-Competitive(sole Cost reimbursement Service only

source)

Non-competitive(non- Cost incentive

monopoly) Design only

Fixed price Make only

Partnership sourcing

Competitive arm-length Firm price Turnkey

PROCUREMENT TYPES
PARTENERSHIP
SOURCING
NON-
COMPETITIVE
Buyer Control

NON COMPETITIVE
COMPETITIVE (SOLE SOURCE)
ARMS-LENGTH

Buyer Risk
CONTRACT STRATEGY
MAKE SERVICE ONLY
BUYER CONTROL

TURNKEY

BUYER RISK
 PRICING REGIME
COST RE-
COST INCENTIVE IMBURSHMENT
BUYER CONTROL

FIRM PRICE FIXED PRICE

BUYER RISK
Contract types based on
scope of the project
 Design-Build : A single business entity that performs
both the design and construction of a project. The team
can be one company or a partnership of firms.
 Turnkey: One business entity that performs the design,
construction, and construction financing of the project.
Payment is made at the completion (when the
contractor turns over the "key").
 Build-Operate-Transfer: One business entity that
performs the design, construction, construction and
long-term financing, and temporary operation of the
project. At the end of the operation period, which can
be many years, operation of the project is transferred
to the owner.
Poor Contract Management
 Poor Contract Management Costs Companies 9% — Bottom Line

 By International Association for Contract & Commercial

Management (IACCM)

 IACCM identifies the major areas of contract and management

weaknesses leading to leakage as:
1. Disagreement over contract scope
2. Weaknesses in contract change management
3. Performance failures due to over-commitment
4. Performance issues due to disagreement over what was
committed
5. Inappropriate contract structures
6. Disputes over pricing
7. Issues with subcontractors
 Contract Types & Risk
In effect they represent a spectrum of cost-risk allocation between client and prime contractor as
shown in figure

• In a conventional arms-length relationship the prime

contractor will prefer a firm price where he perceives
the risk to be small and the opportunity for profit
great
• The greater the risk the more he will want a firm price
arrangement
• The fixed price approach deals with one or two risks only
such as inflation and foreign currencies
• The primary choice is between firm price and cost-
reimbursement
• The Cost incentive contract provides the compromise
solution for high risk work where neither side is willing
or able to carry the entire cost risk
Cost Plus Incentive Fee

Advantages of scheme
 The first main advantage of such schemes is that they are
flexible and can be tailor-made to individual circumstances.
 The second advantage of cost incentive schemes is that they
promote co-operation, openness and sensible decision-making
between client and prime contractor.
 Much the better than in a firm price arrangement where the
client is motivated to squeeze the last ounce of performance
from the prime contractor (regardless of cost to the prime
contractor) & the prime contractor is motivated to deliver
the bare minimum performance (regardless of client's
situation).
Payment Types
Arrangement Objective Principle
Advance payment A proportion of prime
contract price placed with
order
Stage payments Discrete sums of money paid
as and when proportions of
the work are completed
Milestone payments Discrete sums of money paid
as and when specific, key
tasks are completed
Progress payment Regular re-imbursement of
costs incurred by the prime
contractor
Project Contract and Procurement
Management
Project Procurement Management
Processes and Key Outputs
Engineering , Procurement
and Construction
Engineering , Procurement and
Construction with long lead time
items
EPC Contract structure
PMC contract structure
EPCM contract structure
Progressive Lump Sum
 The timeframe obligation
 If the contract does not specify a completion date then the Sale of
Goods Act comes into operation and obliges the prime contractor to
complete within a reasonable period.
 Client wants that he has not accepted any part of work until whole is
completed before specified date, on the other hand milestone for
which contractor mention the date are critical to him in deciding to
release interim payments.
 Failure to completion on time normally allows the client the remedy of
termination, in that case prime contractor must try to avoid milestone
dates carrying the penalty and careful drafting the contract.
Time is the essence
 Essence meaning the intrinsic nature or indispensable quality of something, especially
something abstract, which determines its character.
 ‘Time is of the essence of the contract’- clients recommended to include it in contract
but prime contractor urged to avoid…!!!
 In business contracts time is usually to be considered to be of the essence, provided
dates are specified, whether or not this expression is included.
 The meaning of time is essence is that the parties have agreed to perform at a given
time agreed in a contract and shall not extend the specified time in a contract. In case
a contract does not expressly provide this phrase then in that case time is not the
essence of a contract.
 Time is the essence is specified in Section 55 of The Indian Contract Act, 1872, “When
a party to a contract promises to do a certain thing at or before a specified time, or
certain things at or before specified times, and fails to do any such thing at or before
the specified time, the contract, or so much of it as has not been performed, becomes
voidable at the option of the promisee, if the intention of the parties was that time
should be of the essence of the contract.”
 When time is the essence in construction contracts the standard rule is that the parties
have agreed to perform their obligation as per the time specified in a contract and
there shall not be any extension of time. Whereas, if time is not the essence of the
contract, the court allows the parties to a contract perform at some other time than
agreed upon.
Consequences of delay
 Unplanned delay is bad news for the contractor in terms of additional
costs, delayed payments, negative cash flows and other such effects.
 In the event of default the client is entitled to recover damages from
the prime contractor to the extent necessary to compensate him for
any financial loss suffered.
 There is no good definition of direct and consequential damages since
the distinction is not absolute, it depends upon the particular
circumstances.
Liquidated damages
 The ‘liquidated damages’ is a reasonable
pre-estimate of the likely level of damage potentially
to be suffered by client in the event of delay and
having agreed the sum, fixed it within the contract
the damages then payable in the event of delay.
 Liquidate damages clauses generally provide for
certain amount to be paid per week to a max. period/
max. amount/ max. percentage.
 Client takes the risk that amount so fixed would indeed cover his actual
loss but gains in return a much more ready means of securing payment
for damage.
Force majeure

 If prime contractor is late he is liable for damages and termination, so

to avoid these risks contract should be extended by some automatic
mechanism this is called ‘Force Majeure’ or ‘excusable delays’.
 there are two approaches-
1. prime contractor entitled to more time if delayed by any event
beyond his reasonable control
2. To list the particular events.

‘Effect of force majeure clause is usually only more time, not

more money.’
Inflationary Cost Increases
 Effect on cost brought by changes in economic condition
 Specific to prime contractor. Example
 Passing some of these risk to client can be worthwhile
 Contract Clauses:
 VOP: Variation of Price
 CPA: Contract Price Adjustment
Formula
𝐿𝑓 𝑀𝑓
𝑃𝑎 = 𝑃𝑜 × 𝐴+𝐵 +𝐶
𝐿𝑜 𝑀𝑜
 𝑃𝑎 =Prime contract price as adjusted
 𝑃𝑜 =Original prime contract price 𝐿𝑓 = Labor index final
 𝐴 = Non-variable element of price 𝐿𝑜 = Labor index original
 𝐵 = Labor proportion of variable element 𝑀𝑓 = Material index final
 𝐶 = Material proportion of variable element 𝑀𝑜 = Material index original
Inflationary Cost
Fixed price contract:
 Prime contractor would prefer A to be 0
 For B & C: client responsible
 Risk transfer

 Vop/cpa:
 Given some control
 How to control cost:
 Material: seek long term prices
 Wages: make agreement
 Foreign Currency Fluctuations

Foreign currency fluctuations

 Problem with overseas projects
 If suppliers are chosen from a wide range of overseas territories.
 Considerations to bear in mind are:
 The currency in which the end client will pay.
 The stability of various currencies - the greater the instability the greater the risk.
 The availability of currency.
 The commercial advantage in paying overseas suppliers in currencies other than their
own.
 The cost of dealings in foreign currencies.

Fluctuations in Currency also affect a firm's balance sheet by changing the value of the firm's assets and liabilities,
payable account’s, receivable account’s, inventory, loans in foreign currency, investments (CDs) in foreign banks
Foreign Currency
Fluctuations
 If a UK prime contractor is selling abroad to a client who will pay in his
own currency, the currency should be sold forward or the prime contract
should include a formula for adjusting the price for variations in exchange
rate:
 Pa = Po x (A * Er0 + B) Er1
Where Pa = Price as adjusted for exchange rate variation
Po = Price at date of prime contract
A = Variable element
B = Fixed element
Er0 = Exchange rate at base date
Er1 = Exchange rate at date of variation
Foreign Currency Fluctuations

 Two Elements: Fixed & Variable

 Greater the fixed element greater the currency risk with
contractor
 Rate may be decided at the base date of tender or contract

 ERV Formula:
 Adjust prime contract price currency fluctuations
 client pays in the prime contractor's national currency but
where the prime contractor has significant expenditure in a
different currency. Change in formula: A<1, i.e. proportion
of the prime contract price which is attributable to the
overseas expenditure
THANK YOU