There is the popular conception that under lump-sum or fixed-price contract formula, the risk for the contracted scope of works is mostly or entirely transferred to contractor, giving certainty of cost on the contracted scope.
But what if it is only a partly true, misleading clients’ perspective and risk assessment?
If we check the definition on several sources, we will find the general definition that lump-sum or fixed-price contracts intend to move to contractor´s back all or most of the risk associated to an associated scope of work in exchange of an agreed fixed price and giving authority to contractor on the execution on the scope of work; following requirements stated in the contract. Even when we check within PMI, we can find the following statements:
“If completing the scope of work and producing the deliverables takes more effort or otherwise costs more than you, …… budgeted, the client will not pay any more. The risk of incurring additional costs to complete performance of the project falls entirely on the supplier. You must continue working until the project scope and deliverables are accomplished and accepted; otherwise, you may be in breach of the contract.” (1)
This approach is deeply enrooted in some organization, being the common approach used by many project managers, at client side; considering that company has no real risk on scope of work execution, while client does not interfere with contractor’s work, and the entire risk relies on contractor’s side.
But, let me illustrate with a story, what is the perspective from contractor’s side.
Some time ago I was in risk workshop, a relevant point was the distorted risk assessment matrix where “very high financial impact” was between 20% and 80% of contract price per event. During the workshop and conversing with the project sponsor at contractor’s side, I asked if they expected any risk within this range. The reply was simple and clarifying:
“No, we don’t expect any risk with this impact and if we find any, you will know through our notice of termination of contract”.
Then, how to harmonize both perspectives within a lump-sum or fixed-price contract? Or how is it possible such different positions?
The answer is simple: when executing projects, we are running two different games in the same operation field.
In one hand we have the execution of the project itself, with a clear objective (complete the project) and rules (the contract).
On the other hand, project execution is within a bigger game and with different rules, being the main contractor´s objective to perpetuate their organization in business.
You will easily find the reflection of business objectives in any execution contract; we just need to look at the clause relative to the maximum liability of contractor versus the client. This clause reflects the maximum financial exposure and risk accepted by your contractor and it is quite common to fix this exposure to around 10% of the contract price, including any liquidated damages.
The maximum liability of contractor versus client can be taken not only as maximum exposure but the maximum bill to be paid by the contractor to abandon the game and the maximum punishment enforceable on the contractor.
Therefore, there is no infinite punishment and obligation in business.
This situation is more relevant in current times, where several crises impacted the sector and COVID-19 doesn´t help either, promoting contractors a more aggressive approach to get awarded with contracts for their companies’ continuity, with lower margins and lower prices, which make even worse scenario than the previous one.
Once we find that risk transferred to the contracted scope has a limitation, we should consider that even in lump-sum or fixed-price contracts, contractors’ risks beyond a certain threshold are also client risks and client has a labour of ensuring risk is handled adequately That should be standing on:
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- Having a robust estimate, giving information to the client on the real cost of the project.
- Have a robust process of bid evaluation and contract award, not only based on the lowest cost. The lowest cost is double poisoned as contractor margins are assumed lower and the lower price represents even lower liability; making it easier to reach the edge of abandoning the game.
- Taking on board, in client’s risk management, part of contractor´s risks to have them monitored and support contractor on managing risks, helping to keep contractor so far away from the edge of maximum exposure.
As summary of this article, in lump-sum or fixed-price contracts doesn´t exist endless transfer of risk associated to the contracted scope of work and therefore client still has to keep a surveillance position to ensure risks are handled adequately and projects are completed successfully.
(1) Lowden, G. & Thornton, J. (2015). The special challenges of project management under fixed-price contracts. Paper presented at PMI® Global Congress 2015—EMEA, London, England. Newtown Square, PA: Project Management Institute.
Well explained Miguel. What appears to be the lowest bid price is not automatically the best solution for the client, neither the cheapest at the end.
However contractors normally feel obliged to give an initial low price, as they know that price is the key evaluation criteria in most cases. In order to survive, the contractors do have very competent contract people that knows how to use the contract to their advantage. And then the cost increases through variation orders.
Hi Reidar,
Exactly, this is the point and especially during crisis. Whatever is not shown by contractor in the first place, should be taken into consideration by client, as something else will come and the main target is successfully complete the project.
Regards