CHAPTER 4

Contracting Methods

When the appropriate project delivery strategy for a given project is being devised, it must be acknowledged that the conduct and behavior of the contracting parties can be heavily influenced by what they perceive to be their best interests. Project delivery goals and practices aimed at promoting collaboration and modifying traditional roles and responsibilities are thus most effective if complemented by a commercial structure that rewards, or at least aligns with, the desired behavior. After the optimum delivery method and procurement approach for a given project have been selected, the next step is to determine the appropriate payment terms to include in the associated contract.

To help owners align payment terms with project goals and objectives, this chapter discusses the potential benefits and limitations of common payment mechanisms and performance incentive strategies used in airport construction.

4.1 Payment Provisions

Designers and builders are typically compensated for their services on the basis of cost reimbursement (with or without a guaranteed maximum or not-to-exceed price), unit rates, or firm fixed or lump-sum pricing. Each of these contracting methods takes a different approach to the allocation of cost risk. As illustrated in Figure 4-1, these contract types can be placed along a continuum of increasing industry responsibility for construction cost performance. At one end of the continuum are cost-reimbursable contracts, under which the owner assumes most cost (and schedule) risk. At the other end of the spectrum are fixed-price or lump-sum contracts, under which the contractor bears such risk. Each of these contract types is discussed in this section, including its perceived advantages and disadvantages and the conditions under which its use can be most effective.

4.1.1 Cost-Reimbursable Contracts

Overview

Cost-reimbursable contracting models generally require owners to provide payment for all the contractor’s allowable, allocable, and reasonably incurred costs on the project plus a fee. Final construction costs remain unknown until the project is completed.

To effectively implement a reimbursable payment model requires clear contractual provisions that define

• The method by which the contractor’s fee will be determined;
• The accounting system that will be used to ensure the contractor’s accounts are transparent and auditable;

• Allowable versus unallowable costs (costs that are often excluded include the cost of correcting defects, work outside the scope or intent of the contract, overpaying a subcontractor, extra costs incurred due to not following a procedure stated in the contract, and costs that cannot be properly accounted for); and
• The contractor’s regular cost-reporting requirements, which will typically include information regarding
  • Incurred costs to date (i.e., the sum of accruals for actual work completed and actual expenditures),
  • Actual expenditures (i.e., the total invoices processed to date),
  • Remaining forecast,
  • Approved change orders, and
  • Pending change orders.

Regarding establishing the contractor’s fee, there are two general approaches, of which the cost-plus-fixed-fee arrangement is the more common (and typically the only method allowed under most procurement rules):

• Cost plus percentage fee: The contractor’s fee is determined as a percentage of construction costs (with the percentage either set at a fixed amount or allowed to vary in accordance with a prescribed sliding scale); the amount of the contractor’s fee thus grows as the cost of the work increases.
• Cost plus fixed fee: The fee is established, prior to contract performance, as a fixed sum of money that does not fluctuate with the actual cost of the project (unless there are approved changes).

To help align the owner’s and contractor’s commercial interests toward minimizing construction costs, the fixed-fee approach, in which the contractor’s profit or fee is set on the basis of the estimated cost of the work prior to contract performance, is preferable. Under a fixed-fee arrangement, the actual profit percentage that the contractor may earn will fall or erode as actual construction costs increase. The contractor is thus incentivized to deliver the project as diligently as possible to avoid erosion of its fee.

Advantages and Disadvantages

Reimbursable contracts present two primary disadvantages:

• The contractor is not responsible for cost overruns and, therefore, has no inherent motivation to minimize or control the cost of the work.
• The owner must review and approve all contractor expenditures, increasing its administrative burden.

These disadvantages, however, can also work in the owner’s favor. For example, compensating the contractor for all its reasonably incurred actual costs should help

• Alleviate the contractor’s commercial concerns, allowing it to focus on project execution and quality of construction;
• Avoid disputes over cost recovery; and
• Promote a more a collaborative, integrated team approach to project delivery.

The higher level of administration associated with reimbursable contracts largely stems from the open-book nature of the project, which typically requires project cost and progress records to be maintained and shared at a far more granular level than would be expected under a lump sum or fixed-price arrangement. Owner preapproval of certain expenditures and costs (e.g., overtime, material requisitions and subcontracts over a certain dollar threshold, travel, miscellaneous costs) is also generally required.

In Procurement Routes for Partnering: A Practical Guide, author Jon Broome compares attributes of cost-reimbursable payment mechanisms with those of fixed-price methods (Broome 2002). As

Table 4-1. Advantages of reimbursable versus fixed-price payment mechanisms.

Source: Broome (2002, Chapter 7).

shown in Table 4-1, many of the advantages of cost-reimbursable methods stem from the transparency associated with open-book cost accounting. As Broome notes, a key advantage of such transparency and the more up-to-date monitoring and forecasting that it allows is that “as soon as a deviation is detected, the cause can be investigated, and steps instigated to bring forecast and actual costs back in line.” This proactive management approach is in stark contrast to the more reactive and confrontational “wait for claim” tactics associated with fixed-price contracts.

These observations are consistent with those included in the Construction Industry Institute’s Guide to Reimbursable Contracting (CII 2011), which recognizes that a reimbursable contracting strategy typically allows owners

• Much more extensive involvement in decision-making;
• Access to and involvement in project control aspects of the work that, on a lump-sum contract, are the sole domain of the contractor; and
• A level of project monitoring that is significantly greater than would be possible on a lump-sum contract.

Table 4-2 summarizes the advantages and disadvantages of cost-reimbursable contracts.

Table 4-2. Advantages and disadvantages of cost-reimbursable contracts.

Application

Reimbursable contracts provide a good option for addressing projects that face a high degree of uncertainty, for which the owner would otherwise pay a high-risk premium to engage a contractor under a lump-sum or fixed-price arrangement. This would include situations in which

• The owner wishes to execute the project before the scope has been sufficiently defined for a contractor to price it with any reasonable degree of accuracy;
• The project presents a high potential for unknown or poorly defined risks, leading to highly uncertain or speculative labor hours, labor mix, or technical and material requirements;
• Designs are otherwise complex, difficult to define, or subject to change (as could be the case if the design must satisfy the possibly competing interests of multiple stakeholder groups); and
• Information on existing conditions needed to complete the design can be obtained more effectively or economically by making it part of the contracted work rather than by the owner conducting a preliminary study.

Reimbursable contracts are also appropriate when

• Project objectives can best be achieved through a collaborative team environment supportive of joint resolution of project risks and issues to minimize cost and schedule impacts and
• The owner wishes (and has the ability) to retain a more active role in project decision-making, risk management, and the control of contingency spending.

Finally, projects in which time or quality objectives outweigh the relative cost tend to favor a reimbursable contracting approach. As the owner will be responsible for paying all the contractor’s reasonably incurred costs, the contractor will be more inclined to provide the necessary resources and workmanship to meet the owner’s performance objectives. If the contractor were instead working under a fixed price, it could be motivated to limit resources or compromise quality to protect its profit margin.

4.1.2 Guaranteed Maximum Price

Overview

A guaranteed maximum price (GMP) contract is a type of reimbursable contracting method in which the contractor commits to constructing a project in full accordance with the approved plans and specifications for a price that will not exceed a certain guaranteed maximum (i.e., the contractor assumes responsibility for cost overruns).

The contractor’s GMP generally comprises the following elements:

• Contractor fee, which is typically a fixed fee negotiated on the basis of the type and complexity of the work and the degree of risks and unknowns;
• General conditions costs consisting of the indirect costs incurred in performing the work, including overhead (home office and field), supervision, and administration;
• Direct costs of performing the work, including materials, equipment, labor, support services, and subcontractor and supplier billings; and
• Contractor’s contingency, which typically covers buyout gaps, overruns due to items that are not fully detailed but are otherwise reasonably inferable as being part of the work, escalation, and so forth.

Under a GMP contract, the contractor is entitled to receive the maximum price amount only if its actual project costs, including direct costs, indirect costs, and fees, equal or exceed the negotiated GMP amount (as amended by any subsequent change orders to cover scope adjustments or quantity changes that were not reasonably inferable at the time the GMP was established).

If the actual cost is less than the maximum amount, the contractor only receives its actual costs. An incentive for the contractor to keep costs below the GMP is sometimes provided by incorporating a shared savings clause that allocates the savings between the contractor and the owner.

Advantages and Disadvantages

In comparison to the cost-reimbursable contracts discussed in Section 4.1.1, the GMP method provides owners with more certainty regarding their maximum cost exposure. When coupled with a shared savings clause, the method can incentivize both the owner and the contractor to work together as efficiently as possible. However, as a trade-off for assuming the risk of potential cost overruns, the contractor may overstate the GMP or insist upon a large contingency to cover any uncertainties or incomplete design elements still present at the time the GMP is negotiated and set.

Holding a contractor to its GMP may also lead to a more adversarial project culture and disputes over the completeness of the design, what is included in the GMP, and what constitutes a change to the contract. Table 4-3 summarizes the advantages and disadvantages of using GMPs.

Application

GMP arrangements, while commonly referenced in the literature in association with the use of construction manager at risk (CMAR) and progressive design–build (PDB) project delivery, do not appear to be as prevalent in airport construction. Most airports interviewed as part of the development of this guide indicated they were subject to legislative constraints or policy preferences that required competitive bidding of construction trade work. A GMP would, therefore, have to be set very late (typically at 100 percent design and following complete buyout of the construction work packages), which would minimize the ability to transfer much cost risk to industry and, hence, most of the benefits of GMP contracting.

Another option is for the GMP to be developed incrementally, for discrete portions of the work, on a package-by-package basis (which can be developed to the level of design detail needed to support a bidding process). Box 4-1 presents sample contract language from the Nashville International Airport addressing the progressive establishment of a GMP.

4.1.3 Unit Price

Overview

In a unit price contract, the contractor agrees to perform each item of work stipulated in the contract at a fixed price per unit of work, and payment to the contractor is made on the basis of actual quantities of work accomplished.

Table 4-3. Advantages and disadvantages of GMP contracts.

Advantages and Disadvantages

The key advantage to unit price contracts is that the owner must only pay for actual quantities installed or supplied for the project. The owner thus retains the quantity risk, but, otherwise, prices are fixed, with the contractor bearing the risk of escalation of material or labor costs. Table 4-4 summarizes the advantages and disadvantages of unit pricing.

Application

Although not widely used for airport capital construction projects, unit price contracts have some application for

• Work orders issued under indefinite delivery, indefinite quantity (IDIQ) agreements and
• Certain project types (e.g., airfield paving) that do not entail a large variety of items but, rather, high quantities of a small number of well-defined items.

It is more common to see unit prices as part of an overall lump-sum or cost-reimbursable contracting strategy applied to select elements of the work that are well-defined but for which the total required quantities cannot be accurately forecast at the time of contracting. Locking in

Table 4-4. Advantages and disadvantages of unit pricing.

a contractor’s unit prices in such circumstances can minimize the owner’s risk related to rising material or labor costs.

4.1.4 Fixed Price

Overview

Fixed-price contracts are those in which the contractor provides a fixed price (or lump sum) for the whole of the work (or, alternatively, a series of lump sums for discrete portions of the work). The contractor bears the risk of cost overruns, rather than the owner.

The amount of the fixed price is typically quoted by the contractor, who will estimate its direct and indirect costs to perform the required scope and then add a fee commensurate with its perceived financial risk for entering a lump-sum contract for the work. (Alternatively, some owners may implement DB by stipulating a fixed price that the contractor must design and build to.)

Advantages and Disadvantages

When a contractor works under a lump-sum arrangement, it assumes the risk and responsibility for cost overruns. Although this risk transfer can be advantageous on certain projects, it can also lead to some downsides. For example, to cover its exposure, the contractor may include hidden contingencies in its lump-sum price to account for potential risks and uncertainties. The owner must pay this premium regardless of whether any risks materialize. Likewise, the owner must pay the total lump sum, even if quantities underrun the estimated amounts.

Working under a fixed price can also motivate the contractor to maximize profit by minimizing the cost of performing the work. Actions taken in pursuit of such financial motivations (e.g., compromising on quality or safety) may conflict with the objectives of other project participants or of the project as a whole. Such misalignment of commercial interests can act as a source of discord and disputes that discourage the collaboration needed to efficiently advance a project’s goals.

A commonly cited advantage of fixed-price contracts, particularly when viewed in contrast to reimbursable payment mechanisms, is that they provide the owner with early cost and schedule certainty. However, if the contractor begins to adopt a more commercially aggressive stance to protect its profit margin, the benefit of any perceived cost and schedule certainty may largely be negated by an uptick in change orders or claims.

Lastly, because costs are not open book, fixed-price contracts generally require less owner administration. The contractor will typically receive regular monthly progress payments based on validated estimates of the percentage of work performed or in place. Because prices are fixed at contract award, the contractor does not need to provide evidence of the actual costs incurred in performing this work. This lack of cost transparency can make pricing changes to the work

Table 4-5. Advantages and disadvantages of fixed-price contracts.

challenging. For this reason, fixed-price contracting is generally undesirable if the owner is either unsure of what it wants or is likely to change its preferences over the course of the project. Table 4-5 summarizes the advantages and disadvantages of fixed-price contracts.

Application

Lump-sum contracts are generally well suited to design–bid–build (DBB) or DB projects that have a well-defined scope of services, a stable design, and mature specifications that contractors can use to develop estimates and pricing with a high degree of confidence. Any conditions or characteristics that could lead to uncertainty in cost estimates, such as market volatility, industry inexperience in meeting the project requirements, or potential delays (e.g., due to utility or other third-party coordination issues), could lead to unacceptable risk premiums that would suggest a reimbursable strategy could be more appropriate.

4.2 Performance Incentive Strategies

When there is some uncertainty or urgency to meet a particular project objective, incentive mechanisms can be used to more closely align the motivations of the contractor with those of the owner. Some approaches used by airports to commercially incentivize contractors to complete the work as quickly as possible or to meet other performance objectives are discussed in this section.

4.2.1 Early Completion Bonuses

Incentives or bonuses for early completion provide payments to contractors for completing work on or ahead of schedule. Projects that would benefit from such an incentive strategy include

• Those that require complex phasing or closures that would result in high operational impacts and
• Those that are relatively free of third-party coordination or stakeholder issues (e.g., utility, environmental issues, public opposition) that could affect the project schedule.

For early completion bonuses to be effective, an appropriate target completion date must be established and the owner must have the ability to estimate an appropriate bonus based on expedited production rates for similar work, historical records, or critical path method (CPM) scheduling. The bonus amount should result in a favorable cost–benefit ratio (i.e., the benefit to the owner exceeds the bonus amount, and this amount is high enough to motivate a contractor to accelerate).

In highway construction (in which the use of time incentives is more prevalent) some agencies have expressed concerns that the frequent payment of incentives is the result of agency time

estimates that are based on the performance of the average contractor. In such cases, a more time-efficient contractor may complete the work and earn an incentive without expending any extra effort.

It should also be noted that if reducing the duration of a project is a particularly important objective, the selection of project delivery methods (PDMs) that allow fast-tracking of design and construction (e.g., DB) would likely be more effective than simply applying a time incentive to a DBB project. The advantages and disadvantages of early completion bonuses are listed in Table 4-6.

Hartsfield–Jackson Atlanta International Airport (ATL) provides an example of using an early completion bonus. ATL implemented a completion incentive strategy on a project involving a 500-foot extension of its longest runway. The contractor received notice to proceed in June for substantial completion the following year on the Thursday before Memorial Day.

The project scope included the electrical and pavement section, blast pad, final dressing of approach, and markings. The work required shortening the runway 1,000 feet to provide a safe area to work. The runway shortening was implemented in March, so the duration for most of the construction was about 85 days.

The contract set forth the following incentive strategy:

• Last 10 days of the schedule were valued at $15,000/day.
• An allowance of $150,000 was included in the contract to cover the incentive.
• Runway extension had to be open at 6:00 a.m. for full operations, or the entire day would be lost.
• For each day the runway extension was not opened during those last 10 days, the allowance total would be reduced by $15,000.
• After the deadline of the Thursday prior to Memorial Day, liquidated damages would be assessed on an hourly basis.

The results were as follows:

• The contractor went 1 day into the incentive period and earned an incentive of $135,000.
• Good weather throughout the spring aided the contractor.
• The contractor did not bid the project trying to earn the incentive; instead, the incentive was offered as a project bonus to the contractor’s project management team. As the deadline neared and the project team realized they could earn the bonus, the entire team became very motivated and energized to meet the airport’s completion goals.

Table 4-6. Advantages and disadvantages of early completion bonuses.

4.2.2 Construction Area Rental Provisions

Construction area rental provisions assess contractors a rental fee for occupying an area (e.g., aprons or shoulders) to perform contract work. The fee is based on the estimated cost of delay or inconvenience to users during the rental period. The fees for each rented area can vary according to the time of day and the amount of traffic.

Rental provisions encourage contractors to devise innovative project execution and phasing plans to minimize user impacts during construction. They also allow the costs associated with closures, detours, and accidents to be considered in the contract price.

Rental fees are typically established per unit of time that reflects the cost of the impact to the airport and users. The owner estimates a reasonable duration to execute the work at no rental cost, after which an hourly or daily rate of rental is charged to keep the area closed. An allowance is included in the project to cover the rental duration. If the contractor opens the phase for airport operations in less time than the rental duration, the remainder of the allowance is its to keep. Table 4-7 summarizes the advantages and disadvantages of rental provisions.

Although rental provisions have been more commonly applied by highway agencies (as “lane rentals”), the experience of two airports—ATL and Phoenix Sky Harbor International Airport (PHX)—suggests that such provisions can also be of benefit to airports, particularly for areas where closures would represent a severe impact to airport operations and schedule is critical.

ATL’s Use of Construction Area Rental Provisions

ATL applied the concept of rental provisions to the replacement of the pavement of a critical taxiway used to stage aircraft for runway access:

• The tower and airlines were told the phase would take a total of 14 days:
  • Estimated reasonable duration for pavement replacement (working two 10-hour shifts in 24 hours until completion) with 12 hours of contractor float: 12 days.
  • Estimated weather delays: 2 days.
• The contract included the following provisions:
  • 10 neutral days of no fee.
  • Then 4 days of rental at $12,000/day (taxiway must open at 6:00 a.m. or the entire day would be charged because the location was critical to planning airfield operations for the day, and using the taxiway quickly after 6:00 a.m. was not feasible).
  • Rental fees were billed against an allowance of $48,000 to cover all 4 days.
  • After 14 days, liquidated damages would be assessed at $500 per hour until the taxiway opened.

The contractor completed the work within the allotted rental time and liquidated damages were not assessed.

Table 4-7. Advantages and disadvantages of construction area rental provisions.

PHX’s Use of Construction Area Rental Provisions

ATL was motivated to apply the rental concept after learning of its use on a project at PHX that entailed closing half of the apron throat, which severely restricted the size and number of aircraft.

• PHX allocated 3 days (72 hours) to execute the work.
• The rental amount included the entire 72 hours (on a per hour basis), with an allowance to cover this amount.
• After 72 hours, liquidated damages would be assessed until the area opened for operations.

4.3 Considerations in Selecting Payment Provisions

As with PDMs and procurement methods, there is no one-size-fits-all approach when it comes to developing a contract payment strategy. The approach that best suits a particular project will depend on the owner’s project delivery goals, project characteristics, the PDM selected for the project, and market considerations.

Tables 4-8 and 4-9 assist owners with aligning project goals, project characteristics, and PDMs with an appropriate payment strategy. Table 4-8 summarizes the attributes of and challenges to implementation associated with the most common payment methods used in airport construction (i.e., cost reimbursable, GMP, unit price, and fixed price) and the PDMs with which they are commonly used. Table 4-9 presents typical factors that may drive the payment method selection decision, along with the perceived applicability of different methods in the context of these considerations.

When an approach is being considered, it is important to note that, in practice, many projects ultimately adopt a hybrid contracting method in which multiple payment methods and incentive strategies may be used in combination. For example, large projects may be broken into several phases, with reimbursable contracts being used to execute earlier work packages, while later phases, which can benefit from a more defined scope of work and mature design, may see increased use of fixed pricing or the conversion of the entire project scope to a lump sum.

Table 4-8. Comparison of payment methods.

Table 4-9. Considerations in selecting payment methods.

Consideration	Payment Method
	Reimbursable	GMP	Unit Price	Fixed Price
Level of Project Uncertainty and Risk
Scope is evolving and/or lacks definition Reimbursable contracts provide a good option for addressing projects with an incomplete or evolving design, for which the owner would otherwise pay a high-risk premium to engage a contractor under a fixed-price arrangement. If required performance is generally well understood and it is only quantities that remain uncertain, unit pricing could also provide a reasonable approach.
Changes are likely to occur The more transparent, open-book nature of reimbursable contracts facilitates the negotiation of changes and thus can provide an attractive mitigation strategy for managing the risk of anticipated scope changes and owner delays. In contrast, fixed-price contracts, in which the owner may have little insight into the contractor’s original basis of estimate and actual cost of the work, are generally less accommodating of changes.
Market volatility When prices are volatile, contractors will be unable to price the work with any accuracy, which leads to high-risk premiums if a fixed-price contract is used. In such situations, owners may be best positioned to assume the risk through the reimbursable approach.
Timing of Contract Award and Level of Design
Award made early in the project cycle Because a reimbursable contract does not require a complete design, it can be entered into much earlier than would otherwise be possible under a fixed-price contract. In contrast, fixed-price contracts require relatively well-developed scopes or specifications, or both, meaning that the procurement and award process are better left until later in the project cycle. The same holds true for GMP contracts, though to a lesser degree, due to the increased use of allowances and contingencies for uncertain items.
Owner Involvement
Owner desires a collaborative, team approach to project decisions If the owner desires a high level of involvement in project decisions regarding materials, work sequencing, productivity, and similar matters that would otherwise be the sole domain of the contractor, a reimbursable approach is generally preferable, given the increased transparency and project insight provided through open-book accounting. In addition, a reimbursable approach largely avoids disputes over cost recovery, thus allowing the project participants to work toward joint resolution of issues.
Owner desires minimal involvement or has limited staff oversight capabilities If the owner would have difficulty committing the resources needed to actively oversee the project and would like to transfer more execution risk to the contractor, a fixed-price approach would be more appropriate. Effective oversight of a reimbursable contract (with or without a GMP) requires having staff with experience in administering such contracts, including verifying and authorizing payment requests and change order requests and monitoring productivity and progress to minimize overpayments.
Project Goals
Time or quality objectives outweigh cost concerns Projects in which time or quality objectives outweigh cost concerns tend to favor a reimbursable contracting approach. As the owner will be responsible for paying all reasonably incurred costs, the contractor will be more inclined to provide the necessary resources and workmanship to meet the owner’s performance objectives. A contractor working instead under a fixed-price arrangement could be motivated to economize on resources or quality to protect its profit margin.