Choosing the right contract

A contract can be a stone in your shoe. Knowing which type of contract to choose can make your job easier. Chemical Processing's Senior Editor Dirk Willard provides tips on various types of contracts.

By Dirk Willard, senior editor

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It was easy to see he was upset. My Turkish client was choosing his words carefully but he clearly was angry and frustrated. We were standing under the spray roaster, our conversation periodically interrupted by welders grinding on some structural steel. I turned to him and said, “Look, this is a low-bid contract — right?” He nodded his head. I went on, “A low-bid contract means that you assume responsibility for the knowledge of the technology in the scope.”

Now, I made my point, “I am sorry to say, heat-tracing wasn’t part of the deal.” He accepted my words graciously — I only wish that he had done something sooner. Although construction contracts may be out of your control, you should know what you are getting into once a contract becomes your problem.

In degrees of risk to the company engineer, there are four basic types of contracts: 1) lump-sum, i.e., “low-bid”; 2) cost-plus-fixed-fee (CPFF); 3) incentive; and 4) open-ended.

A contract is probably not risky for your company — only to you, if your career is pinned to completing the project. Especially for a lump-sum contract, your success depends on quickly defining the following: the scope — and any new technology, the schedule, and the capabilities of the contractor. Define cost-adders quickly and win approval for additional funds; if you wait, the contractor will use the adders to cover the cost of his mistakes — I  know: I’ve worked on both sides. Once you’ve identified the adders, your greatest dangers will be delays for equipment I have heard of a half-a-dozen cranes sitting idle for more than a year — I wonder how much that cost! Managing a contractor isn’t an adversarial relationship. When you assumed responsibility for a contract, the contractor became your partner. He risks losing money but you risk your career if he fails.

Risk in a lump-sum contract is sometimes reduced by breaking down the contract into several tasks, typically by trade, or by deliverables — this is called a unit price contract. A contract of this sort is very useful with engineering firms because their cash flow depends on winning the next contract — they can go out of business and leave you hanging.

Sometimes a project is broken up into a lump-sum contract and a unit-price contract; materials are purchased on a lump-sum basis; labor is a unit-price contract.

Fixed-fee contracts are less risky to both the contractor and the company because the company is guaranteed a profit based on a percentage of the work completed. Sometimes, the contract has a ceiling, requiring approval before the contractor can receive additional payment. When I worked with Chevron, the limit was 10%; this is typical. Above 10%, meant an unpleasant meeting with purchasing — a party to be avoided.

An incentive contract is a CPFF contract with a bonus or a penalty for extras, or for completing the work ahead of schedule. This type of contract is ideal where missing a specific deadline will hurt your company. I once faced such a situation. A rebate program was ending; the work had to be completed by December. With some convincing, I won approval to award a 10% bonus, based on the original contract price, or to assign a 10% penalty, if the rebate deadline was missed. This led an instrument contractor, who fell behind, to bring in its two best technicians to complete the PLC work on time. The open-ended contract can pose the least risk to you. This type of contract is often awarded to contract engineers and consultants. Payment is dolled out based on hours of work completed. One danger is that the contractor may try to aggrandize its work. Avoid problems by developing a clear scope of work and establishing good communication.

One way to control the tendency to explore engineering problems is by carefully defining the deliverables. Deliverables should focus on a specific problem. If, for example, an engineering firm was hired to evaluate pressure relief systems, the methodology should be established before beginning work. It shouldn’t be spending your money training its people to size a vent system.

Another danger with the open-ended contract is a delay. For example, what will the contract engineers work on while they wait for pumps to be delivered? It is best to have a blend of projects at various stages from the qualitative estimate through construction and start-up.

Managing contracts is a big part of engineering. Know what you are getting into before you sign on the dotted line.

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