Spend Matters welcomes this guest article by Diarmuid O’Donoghue of GEP.
Before any project is kicked off, an owner is faced with many difficult decisions. Most importantly, they must decide what kind of contract to enter into with the contractor.
Fixed-price and time and material (T&M) agreements have both their strengths and weaknesses, but it’s hard to outline the best fit until you dig a little deeper. Understanding some of these strengths and weaknesses will help you choose the correct solution and deliver a successful project.
In fixed-price agreements, as the name suggests, the contractor is responsible for completing the project within the agreed-upon fixed cost set forth in the contract. If the contractor completes the project under the fixed total cost, then the contractor keeps the difference and makes a profit from the work.
- Ease of management: Fixed-price arrangements are fairly easy to manage, as payments to the contractor can be based on a percentage of completed work.
- Predictability: Because the owner has agreed upon a fixed price, this limits the owner’s exposure and liability during the project.
- Collaboration: This arrangement generally fosters a higher degree of collaboration, as the contractor protects his or her margins through tight project management communication with the owner to ensure scope compliance.
- Defined scope of work: Under fixed price contracting, it is very important to have a clearly defined scope of work. In order for an owner to protect themselves, he or she must work closely with the project team to ensure all scope and deliverables are documented in the final agreement.
- Closed book: A fixed price contract is generally a closed-book arrangement, so the contractor does not have to report a detailed cost breakup of labor and materials to the owner.
- Lack of flexibility: Owners must understand that the lump-sum nature is fairly inflexible; they are responsible for any unforeseen changes that are beyond the contractor’s control or that the owner initiates.
- Quality of materials: As the contractor is working to a fixed price, they might be tempted to skimp on subcontractors or use lower-grade materials. Therefore it is imperative the owner must specify materials he requires to be used at the outset.
Time and Materials Agreements
For a T&M job, the contractor provides you an hourly rate of labor and your cost will be determined by the retail price of materials plus the hours of labor. It is worth noting that a cost-plus agreement is similar to T&M, except the materials cost – which may include subcontractors, permits and rentals – is negotiated as a percentage markup over invoice.
- Lack of scope clarity: For whatever reason, if an owner cannot initially define or detail the scope of work, a T&M agreement is best suited.
- Flexibility: For fast-tracked projects, the cost-plus contract allows an owner to have more flexibility to change scope, designs and materials as the project proceeds.
- Urgency: If you have an emergency situation, you probably won't have time to go through a lump-sum bidding process, as you need someone in there today. T&M agreement allows for scenario.
- Budgeting risk: The biggest disadvantage of a T&M agreement is the final costs can rise above the budgeted amount. For example, using a T&M method where a project budget is $500,000, it could end up costing $400,000 or even $700,000! With a T&M approach, you own the risk of that variability.
- Increased Management: Extra “hands-on” management will be required from the owner to ensure the contractor is delivering toward (new) scope agreed to the tedious task of ensuring the correct amount of hours are being invoiced relative to work completed.
Picking the right contract type is a central aspect in the overall success of your project. Choose wisely knowing the strengths and weaknesses of each type and how they relate to your project.
For more interesting thinking on procurement, visit the GEP Knowledge Portal.