Financial Contract Types

Question 1

Cost VS Price

Answer 1

COST
- what it takes (dollars/resources) to produce particular product/service

PRICE
- what someone is willing to pay for product/service

• usually PRICE > COST to give business profit

Question 2

Types of Financial Contracts

Answer 2

• Lump Sum Contract
• Unit Price Contract
• Cost Plus Fee Contracts
• Guaranteed Maximum Price (GMP) Contract

Question 3

Fundamental Ideas: avoiding risk <–> being competitive

Answer 3

• risks that contractor can’t control –> pay risk premium to owner
• risks that contractors can control –> manage risk

Question 4

Financial Contracts Risk Balance

Answer 4

Impose:
- high enough risk incentive so contractors does job efficiently
- low enough risk to have reasonably low bid
- according to contractor ability to tolerate

Question 5

Derivative Results of Risks: Impact on Construction Timing

Answer 5

• more risk on contractor = longer construction delay
• owner can expedite –> pay higher price (risk premium) to contractor or shoulder risk
• delay can have major costs

Question 6

Lump Sum

Answer 6

Firmly FIXED final PRICE:

HIGH RISK CONTRACTOR

• owner knows actual cost of project before it begins
• contractor required to achieve project at negotiated contract value
• usually no fast track
• usually high incentive to finish early at low cost

Question 7

Unit Price

Answer 7

QUANTITY X UNIT PRICE

HIGH RICK CONTRACTOR

• prices for defined units
• approx quantities provided by OWNER
• payment based on installed quantities
• used bc uncertainty in field quantities
• used on heavy & highway contracts
• contractor overhead must be in unit’s prices
• lowest bidder selected
• owner on site to measure quantitites
• dependent on accuracy of estimation of quantities given by owner/designer

RISK ALLOCATION:
- price risk (unit price) –> CONTRACTOR
- length (quantity) –> OWNER

Question 8

Cost + Percentage Fee

Answer 8

HIGH RISK OWNER

• owner pays
• only used if pricing cant be calculated in any other way + urgency
• no financial insurance of ultimate cost
• little incentive to reduce costs
• reward is same despite quality of work
• allows collab at early stages of project

Question 9

Cost + Fixed Fee

Answer 9

HIGH RISK OWNER

• fee independent of the duration of project
• only used if pricing cant be determined in alternative manner
• no financial insurance of ultimate cost
• little incentive to reduce costs, high incentive to finish early
• promotes collab at early stages of project

Question 10

GMP - Variation of Cost + Fixed Fee

Answer 10

• GMP is defined price for undefined product
• contractor assumes any additional costs after ceiling point is reached
• quality may be sacrificed to avoid increases in cost beyond GMP
• GM shared savings –> below guaranteed max , savings are shared btwn owner & contractor

Question 11

What does the choice of contract type depend on?

Answer 11

• accuracy of estimation
• ultimate cost known since beginning
• desired risk
• priority of the goal (eg quick completion of work)