Contracts in Project Implementation

Sir John William Salmond KC (3 December 1862 - 19 September 1924) was a legal scholar, public servant and judge in New Zealand.
Sir John William Salmond KC (3 December 1862 - 19 September 1924) was a legal scholar, public servant and judge in New Zealand. | Source

Rarely, a major project would be totally completed in-house. Quite a big chuck of work is given to contractors in particular (i) fabrication of machinery and (ii) construction of buildings. Even when the project is in operation, material supply is outsourced under Just-in-Time Inventory. In addition, many other services are obtained from security and maintenance companies, couriers and accounting firms.

There are a number of advantages. First, it enables a company to focus on its core activities and develop innovative techniques. It is economical since it reduces costs and does not require any capital investment. Moreover, it provide flexibility and contract can be adjusted as per business requirements.

At the same time, there is threat to security and confidentiality. There may be hidden costs not considered at the time of signing the contract. Also, quality may not be upto the mark and finally, the company may become hostage in the hands of contractor.

What is a Contract?

A contract is a legally binding agreement between two or more parties. It is an exchange of commitments with specific legal remedies for breach. According to a legal scholar, Sir John William Salmond, a contract is "an agreement creating and defining the obligations between two or more parties".

The definition of a contract that comes from the American Law Institute states that, "a contract is a promise or a set of promises for the breach of which the law gives a remedy, or the performance of which the law in some way recognizes as a duty. The basic stages of any contract includes - proposal, offer, acceptance, agreement and consideration.

Many other terms and impressions are used in place of “contract” like out-sourcing and partnering. Generally speaking, contract and outsourcing are one and same. The minor difference could be that outsourcing is “the transfer of a business function to an external service provider” whereas in contact there is no indication that the activity was previously being performed in house. However, partnering is one step above the contract since it the “process of transforming contractual agreement into a cohesive, collaborative team that deals with the issue and problem encountered in implementing project to meet a customer’s need (Gray and Larson).

TYPES OF CONTRACTS

There is a wide variety of contracts ranging from cost-plus percent fee to fixed-price Contract. A short list is given below:

  1. Cost plus percentage fee
  2. Cost plus fixed fee
  3. Cost plus guaranteed maximum
  4. Cost plus incentives (award fee)
  5. Cost and cost sharing
  6. Fixed price
  7. Fixed price with re-determination
  8. Fixed price incentive fee
  9. Fixed price with economic price adjustment
  10. Fixed price incentive with successive targets

Comparison of two extreme types of contacts is given below:

CONTRACT TYPE 
ADVANTAGES 
DISADVANTAGES 
Cost plus % Fee 
Provide maximum flexibility to owner 
No assurance of actual final cost 
 
Minimize negotiations 
Conflict of interest, minimizing cost and time would not benefit the contractor. 
 
Permit quick start 
Excessive changes may adversely affect the ultimate shape of the project
 
 
 
Fixed Price
Provide firm assurance of ultimate cost
Require exact knowledge of what is wanted before contract award
 
Require minimum owner follow-up
Require substantial in preparation document
 
Provides maximum incentives for quick completion at lowest cost
Cost may be increased to over high risk
The Hub River Power Comany Ltd (HUBCO), first Independent Power Producer established under BOT Contract.
The Hub River Power Comany Ltd (HUBCO), first Independent Power Producer established under BOT Contract. | Source
Laraib Energy Limited, a run of the river project of 84 MW
Laraib Energy Limited, a run of the river project of 84 MW | Source

Falling in any of the above categories were turn-key projects which were constructed by a developer and sold to buyers in a ready state. This concept has been extended to accommodate private sector in development of infrastructure projects like bridges, power houses, airports, industrial parks, water supply, land reclamation and roads. These projects fall into three distinct categories:

BOT: Build, Operate and Transfer

A company builds a project, operates it for some time and finally transfers it to owners. Pakistan’s first Independent Power Producer, The Hub Power Company Ltd, was built by National Power and handed over to the sponsors after satisfactory performance. Subsequently, motor-ways, cable-car and grain storage were completed and transferred to owners usually public sector companies.

BOO: Build, Own, Operate

Boo differs from BOT as it is never transferred but retained by the contractor who have already funded the project and have it in their own name. Theoretically, there is no government involvement whatsoever. The private sector builds the project, owns it, and operates it. Laraib Energy Ltd, first private hydro-power project, is being built on these terms.

BOOT: Build, Own, Operate and Transfer.

The constructor builds the project, own and operates for pretty long time from 20 to 25 years and finally hands it back to the government. A desalinization plant was completed under these terms and the  would earn revenues from sale of the water for 25 years. More, a number of toll bridges, flyovers are being built under this program.

Machinery Selection and Procurement
Machinery Selection and Procurement

MACHINE PROCUREMENT

When machinery is to be procured, it is first decided as to what would be its functional description and technical specification. Suppose, a delivery truck is required which is supposed to work for 10 hours daily, on bad roads, with lot of dust and frequent stoppages. Looking into these factors, the truck should be sturdy with big petrol storage capacity and good radiator. This would come under functional analysis. On the other hand, technical specification should match with this description such as 4 cylinders, noise level of 72 decibels, emission level low, good warranty and lesser petrol consumption.

Once these aspects have been looked into, the sponsors may ascertain whether the required plant and equipment are available off the shelf or would have to be tailor made. In case of latter, tenders are given in the newspaper invitation quotations. These are received, scrutinized and short listed on the basis of technical, financial and commercial as shown in the side-diagram.

A comparison of the three quotation is given below:

(click column header to sort results)
   
GEMINI ENTERPRISE   
WOLD DISTRIBUTORS   
AKHTAR & SONS  
TECHNICAL
 
 
 
BLOW ROOM 
One line 3 Sutchers 
One line 3 Sutchers 
One line 3 Sutchers
CARDS 
24 Machines 
24 machines 
24 macines
DRAW FRAMES 
8 machines 
 8 machines
8 machine
SIMPLEX
6 sets Chinese
6 sets SKF System
6 sets Chinese
RING FRAMES
30 sets
30 sets
30 sets
FINANCIAL 
 
 
 
 BLOW ROOM
200,000 
196,000 
205,000 
CARDS
347.000 
340,000 
338,000 
DRAW FRAMES
120,000 
117,600 
128,000 
SIMPLEX
190,000 
186,200 
192,000
RING FRAME
900,000 
882,000 
936,000
Spare Parts
155,000
151,000
NOT QUOTED
COMMERCIAL
 
 
 
BID BOND
Not provided 
Provided 
Provided 
DELIVERY PERIOD
8 months 
18 months 
12 months 
VALIDITY OF OFFER
3 months 
3 months 
3 months 
PAYMENT TERMS
Through L/C 
Through L/c 
Through L/c 
PERFORMANCE RECORD
Satisfactory 
Satisfactory 
Satisfactory 
SERVICES
Not quoted 
Not quoted 
Not quoted 
COUNTRY OF SHIPMENT
China
China 
China 
The study shows that cost and quality of all the three was equal. Therefore, on the basis of shorter delivery, offer by Gemani was selected.
Just-In-Invetory following a pull approach as in "Made to Order"
Just-In-Invetory following a pull approach as in "Made to Order"

Inventories

A company has to maintain a variety of inventories like (i) Raw Materials, (ii) Work-in-Process, (iii) Finished Goods, (iv) Packing Materials and (v) Stores and Spares. Quantity of each category depends upon the nature of business. Cotton and Woollen Textiles have seasonal raw materials but these unit operate the year round. Therefore, they have a large raw-material inventories. Sugar Mills and fruit processing plants operate seasonally but sell the year round. Such industries have a lot of finished goods inventories. Tobacco processing units and breweries have long production cycle, more than one year, so their work in process is very large. Bottling units like Coca Cola have substantial bottles in inventories all the time. Embroidery and knitting machinery keep substantial stores and spares.

There are carrying costs associated with stocks like (i) storage, (ii) safety, (iii) insurance, (iv) risk of obsolescence and (v) Cost of funds tied up. So companies try to reduce inventories to minimum possible levels. One such technique is "Just-in-Time Approach, whereby a purchase would only be made when needed. For this purpose, a company enters into supply contracts with its suppliers and give them a programme as to when the raw-materials are to be delivered at the factory premises. Since the raw materials are requisitioned against a confirmed orders, finished goods are shipped as soon as these are produced.

 The company and supplier stay in touch all the time through inter-facing of computers.  So a companies know exactly what is happening at the suppliers plant and may resort to buying from some where should a delay or problem is foreseen in the supplies.

JUST IN TIME INVENTORY

SUMMARY

The sponsors should negotiate good contracts with minimum of risk provisions.  They must manage it effectively to achieve good results. Wthe research and development, useful techniques have come up which facilitate good contract administration.

Main guidelines for management and control are:

  • Risk Evaluation
  • Use of template or checklist
  • Legal Review
  • Appropriating pricing
  • Improving contract administration at higher level, and
  • Period reviews.

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Comments 3 comments

Rufi Shahzada profile image

Rufi Shahzada 5 years ago from Karachi

Dear Sir Hafeez,

The BOT, BOO and BOOT are explained so well, the procurement part is really so simple to understand. This HUB really is a great for Project Management students as well as all Business Students.

Your HUBs are my all the time fav.

Multiple Thanks to you with Salutations...

Kind Regards,

Rufi Shahzada


Nathan Hunter 4 years ago

Dear Sir/ Ma’am,

This is in reference to a lucrative business opportunity in the North African Region.

Our company is the mandate for a client who wants to build an electric power plant. Our client is a government client from the MENA Region.

We are going through the process of identifying the right candidates so we can introduce the best contender. The client has several projects on its agenda. These projects range from construction; recycle, to energy, and many more. Some of these projects will be BOT contracts, some will require finance, and others will be in the form of partnership.

Our client’s primary assignment is a turnkey project for an electrical power plant based on BOT contract, and preferably, using renewable energy.

We would like to know if there are any companies who would be interested in such opportunity, please keep in mind that our firm will ensure a smooth process and guaranteed approvals throughout the entire development of the project and great potential to other business opportunities in the region.

Please reply to: nhunter@aljoudco.net.

We look forward to hearing from you.

Sincerely,

Nathan Hunter

Regional Manager/ Sr. Partner

nhunter@aljoudco.net


hafeezrm profile image

hafeezrm 4 years ago from Pakistan Author

Thank Mr. Nathan Hunter for your comments.

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