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Managing Procurement: Part 3 – Contracting Models and Approaches

May 8, 2023

Contracting arrangements will often form the cornerstone of negotiations between parties, as they seek to ensure that it provides a mutually acceptable risk allocation. As part of this process, parties are required to evaluate the relevant project risks, the appropriate contracting model, and the payment mechanism. Each of these factors will be influenced by various considerations, arising in connection with the project or a party’s specific circumstances.

This article sets out key risk management considerations for parties, as well as the contracting models and payment mechanism which often arise in the Australian construction industry. Through this, the relevant strengths and limitations of each approach will be identified, as well as things for parties to keep in mind.

Downstream and Upstream Risk Management

When dealing with downstream contractors and suppliers, a party must also consider the upstream risks which need to be managed and the potential impact this has on any negotiations.

Importantly, parties should ensure when contracting downstream, any allowances that has been made reflects an associated entitlement to claim for such upstream. In doing so, a party can avoid the potential mismatch in risk positions which serves to significantly increase a party’s risk exposure.

By completing a comprehensive review of any upstream contract, and the associated project specific risks, a party can seek to mitigate the potential for these issues to arise. Similarly, where parties develop a contract suite specific to a given project or scope of works, it can ensure effective risk management without taking project personnels focus off completing the works.

Contracting Arrangements

The contracting arrangement adopted on any given project will considerably impact the parties’ respective commercial considerations, and associated risk tolerances.

Common contracting arrangements which are utilised within the Australian construction industry include:

1.       design and construct;

2.       design only;

3.       construct only; and

4.       collaborative and alliance models.

These contracting models each provide their own respective strengths and limitations, which should be considered prior to agreeing to the adopting of a particular model.

For instance, while a design and construct contract may allow for a project to be completed faster and transfers a greater level of risk to the downstream contractor, it attracts a cost premium. Conversely, where separate design only and construct only contracts are used, it can be effective in keeping costs down, but the managing entity will adopt the risk of design errors and omissions when entering the construct only contract.

The adoption of collaborative and alliance models has become increasingly popular, as people depart from traditional approaches. The attractive aspect of some of these contracts is that downstream contractors are encouraged to effectively performing works under the contract, creating an incentivised performance system. However, these approaches, while effective on paper, can lead to greater levels of uncertainty during the project lifecycle. Notably, agreed principles, such as “thou shall not litigate” can be illusory in nature and ineffective where disputes arise and the relationship between the parties, which underpins such contract, breaks down.

Payment Mechanisms

Another key consideration which will impact on the parties’ negotiations is the payment mechanisms that are adopted and the associated entitlements to claim.

Payment mechanisms which may be ordinarily adopted in Australia include:

1.      fixed price or lump sum;

2.      based on a schedule of rates;

3.      cost plus, which may include a guaranteed maximum price; and

4.      target cost.

Lump sum and schedule of rates payment mechanisms are those most likely to be found in the construction industry, commonly used on smaller scale projects. These provide all parties a level of certainty, though where the contract does not provide cost escalation mechanisms, may expose downstream contractors to significant risks given current market conditions. The practical effect of this is that it functions to insulate an upstream party from potential cost increases, which may be necessary in circumstances where there is no upstream relief for a party to claim against.

Another option which has found renewed popularity given the current market is the cost-plus contracting model, whereby a party is entitled to recover their actual costs involved in undertaking the works, plus a fixed margin or percentage for overheads and profit. The significant risk for upstream parties is that this provides for an unknown total cost of the works. This may be alleviated where a guaranteed maximum price is agreed, which allows the parties a level of certainty with respect to the total amount which the downstream party is entitled to recover. However, downstream parties must ensure the guaranteed maximum price is appropriate for the scope of works, given this functions as the upper limit for which they will be entitled to claim for, unless mutually agreed otherwise.

Collaborative Contracting and Target Cost

While conventional procurement contracts have long been preferred within the construction industry given their simplicity, certainty, and risk allocation, they have increasingly faced criticism. Importantly, these contracting models can be viewed as adversarial in nature, where the interests of the participants do not align, creating friction across the duration of the project.

Collaborative contracting approaches look to alleviate these issues and often adopt a form of target cost payment mechanism. These contracting models recognise the mutual benefits which participants can derive through the alignment of goals across the project documents. Typically these models include some form of commitment from the principal to share the benefits received from outstanding performance by a contractor, and a commitment from the contractor to share in the costs where poor performance increases a principal’s costs.

The target cost contracting model functions in these circumstances to incentivise the contractor’s performance. Importantly, they create a win-win scenario and therefore align the goals and interests both parties, an underpinning principle of the collaborative contracting approach.

Oddly, many alliancing and/or collaborative models are subject to the agreed ‘principles’ decided by the participants. However, these ordinarily function as just that, principles which are agreed but not always strictly adhered to. In these circumstances, clarity in drafting and clear risk allocation can alleviate concerns that may present themselves in the event of a dispute.

LPC Lawyers

LPC Lawyers have extensive experience in assisting parties during the preliminary stages of a project to establish procurement systems and contracting approaches which are designed for specific project requirements. LPC Lawyers leverages its experience across various industries and contracting models to ensure clients are provided with an approach tailored to addressing their specific requirements and concerns.

If you need assistance with your next project, LPC Lawyers is available to assist.

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 Ryan Bryett

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