March 13, 2023
The costs to deliver a project in Australia have ballooned and continue to rise due to extraordinary escalation of material costs, rising interest rates, inflationary pressures, and a critical labour shortage. Budget papers from the state and territory governments reveal that the national pipeline of work is not slowing down either, with a combined $254.8 billion infrastructure expenditure expected over the next four years (Source: Infrastructure Partnerships Australia). In addition, the federal government has committed to circa $61 billion in infrastructure spending for projects across the country. In an overheated construction market, a number of industry participants have found themselves at, or near, breaking point.
Higher costs can cause financial distress for all project participants. As we have seen, when contractors cannot absorb these costs, the risk of collapse can crystallise. Where a contractor falls over, project owners are often left with unfinished projects which are delayed and inevitably cost more to complete than originally anticipated.
Compounding the problem is the operation of a commonly adopted project delivery model – fixed price contracts.
Fixed Price Contracts
Fixed price (or ‘lump sum’) construction contracts operate whereby parties agree upon a total price which a project owner will pay to a contractor to cover the contractor’s costs (including materials, equipment, labour, overheads, and profit) to perform a defined scope of works.
Popular fixed price contracting models include:
- Design and Construct (D&C);
- Engineering, Procurement and Construction (EPC); and
- Construct only.
Subject to the inclusion of contractual provisions addressing the occurrence of certain events (for example, latent conditions, variations, or delays), project owners are afforded certainty in price (perhaps debatable in the current conditions), much to the comfort of project lenders.
Under fixed price contractual models, contractors will usually be expected to wear any cost increases that occur during the life of the project, which can often stretch across a number of years. This may be sustainable in times of economic stability where project input costs are reasonably predictable. However, what we have seen is that when economic conditions are volatile, contractors who have committed to project-long price risks may quickly become unable to withstand the demands of said risks as they are realised. This may be especially so for contractors who are operating on razor-thin margins.
The collision between the prevailing economic headwinds and fixed price contracts has become a real issue. The recent high-profile collapses of Condev and administration of Clough Group are instructive examples of growing problems in the construction sector.
Operating on a margin of less than 1% in 2019 and 2020, followed by a $358,732 loss in 2021, Condev warned of the pressures it faced due to rising material costs. Prior to entering into liquidation in March 2022, five of its largest projects were being delivered under fixed price contracts. Although Condev sought funding from its clients to stay afloat, the majority declined to provide support, leaving Condev to suffer its fate.
Clough Group suffered through a similar situation where it ran into financial trouble due to extraordinary cost escalation, unsettled payment claims, and delays in project milestone payments on projects entered into under fixed price contracts.
Before signing up to a fixed-price construction contract in the current market conditions, contractors should be aware of the potential pitfalls and, where possible, take steps to:
- Identify all risks, including potential risks that are not quantifiable;
- Ensure that cost estimates are, as far as possible, precise;
- Include in cost estimates a contingency for unknown risks;
- Negotiate the inclusion of a price adjustment mechanism to protect against extraordinary cost escalation; and
- Avoid underpricing bids (and thus increasing exposure to financial risk) in an effort to “win” a project.
Cost Reimbursement Contracts
An alternative contracting model is a cost reimbursement (or ‘cost-plus’) contract. This contracting model operates differently to a fixed price contract. Rather than a project owner paying to a contractor an agreed total price for the contractor’s costs to perform works, a cost-plus contract operates whereby the project owner agrees to reimburse the contractor for the direct and indirect costs (Costs) actually incurred in properly performing the works, plus an amount for overheads and profit (usually a percentage of a project’s overall cost).
Popular cost-plus contracts include:
- Cost-Plus Incentive Fee (Costs plus an adjustable fee for meeting performance objectives);
- Cost-Plus Award Fee (Costs plus a fee for performance determined subjectively by the project owner); and
- Cost-Plus Fixed Fee (Costs plus a fixed fee).
Effectively, a cost-plus contract transfers the risk of cost escalation to the project owner which can make this an attractive project delivery model for contractors in the current market conditions. However, this view may not be shared by project owners who are often seeking a degree of price certainty, and to minimise their own risk profile.
Critically, though, a cost-plus model may very well be suitable where a project becomes distressed (i.e. where a project has failed to meet certain cost and schedule baseline targets, or where milestones and key deliverables have not been achieved).
Where a project has become distressed, largely for unforeseen reasons outside of a contractor’s control, an option that may be open to parties is to convert a fixed price contract to a cost-plus model. Parties may implement the following steps:
- Agree on a new scope of work which reflects the changes in the project and the reasons for the conversion to a cost-plus contract;
- Develop a detailed estimate of the costs associated with the new scope of work, including any additional costs that may be incurred due the project being in distress;
- Establish a cost accounting system that tracks all costs associated with the project, including materials, labour, and overhead expenses;
- Agree on a fee structure for the contractor’s services, which may include a fixed fee, a percentage of costs, or a combination of both;
- Establish a process for reviewing and approving all costs, including a procedure for obtaining the project owner’s approval for any additional costs;
- Implement a system for monitoring and controlling costs throughout the project, including regular reporting on the status of the project and any variances in costs; and
- Establish a process for resolving any disputes that may arise regarding the costs associated with the project.
With more construction business failures expected to come, the way in which projects are delivered has been brought into acute focus. Stay tuned for the next article in this series where we will discuss what the future of project delivery in Australia might look like and consider whether we should be moving away from fixed price contracts and towards cost reimbursement models?
Lamont Project & Construction Lawyers
We have the industry knowledge and experience to assist both project owners and contractors in all major construction projects. If you would like to discuss any of the matters raised in the above article or the forthcoming series as it relates to your specific circumstances, please contact Lamont Project & Construction Lawyers.
The content of this article is for information purposes only; it does not discuss every important topic or matter of law, and it is not to be relied upon as legal advice. Specialist advice should be sought regarding your specific circumstances.
Contact: Peter Lamont or Kristopher London
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