The UAE construction industry is experiencing a growing yet significant debate, driven by the desire of Employers to successfully procure and deliver projects through alternative contractual pricing mechanisms.
The debate centers on whether to continue using the preferred “fixed price” lump sum or alternatively whether to use the cost reimbursement (plus profit) model.
The cost-reimbursable (plus profit) basis is gaining popularity in the UAE, given the recent surge in the costs of materials, shortage of consulting and capacity contracting to service projects and the gradual adoption of non FIDIC international standard form construction contracts such as the NEC Contracts (commonly known as the ECC).
There is increasing evidence in the local construction press and from client feedback to suggest the effect of the debate in the short term is likely to encourage industry participants to seriously re-evaluate whether the preferred contractual pricing methods are delivering transparent value for money for their organisations. In the medium to long term, the cost-reimbursable (plus profit) model is likely to seriously rival the fixed price model given its pricing characteristics and mechanisms designed to lower the risk of disputes by fostering a tiered multilateral approach in successfully delivering projects.
What is a “Fixed Price” Contract?
A fixed price contract obliges a Contractor to provide all that is necessary to ensure that the works complies with the contract, ie the specification and drawings to achieve the required levels of per formance.
It is common practice in the UAE, for a contract price and programme for the delivery of the completed works to be agreed by the parties often before a contract is formalised. This is usually on the basis of an outline design usually followed by a letter of intent or a more formal contract based on a hybrid of the FIDIC standard forms.
Does “Fixed Price” mean the price is not adjustable?
The short and simple answer is no.
A “fixed price” contract does not necessarily mean the employer has the comfort of committing the contractor to a guaranteed maximum fixed price agreement. Any changes to the scope of the works, the design or the occurrence of risks for which the Employer may be typically responsible e.g. late or non issue of instructions, may entitle the Contractor to claim more than the fixed price.
An Employer should proceed with extreme caution when modifying conditions of contract with a view to ensuring that the pricing mechanism actually reflects a guaranteed maximum price.
Why do Employers typically choose “Fixed Price Contracts”?
One of the main reasons an Employer prefers this form of pricing is based on its desire to reduce its exposure with regard to increase in prices of quantities as a result of discrepancies in the amount or scope of quantities to be used by a Contractor on a project.
Employers are also often under time pressures for works to commence as soon as practicable, on the basis of a contract price based on a bare/ simple outline design, financial pressures i.e. rates on funding costs, rapid rises in land values and its desire to maximise and utilise revenues from pre-lets and sales to help fund prospective developments.
Benefit/Disadvantage to Employer under “Fixed Price” Contracts
Subject to the wording of the contract, the Employer may not carry the risk of cost overruns as the Contractor is deemed to satisfy itself as to the risks involved in carrying out and completing the works before they are undertaken.
Current contractor profit margins in the UAE construction industry
Whilst the Employer is advised by professionals such as quantity surveyors to scrutinise the costs and pricing methods of the Contractor in respect of the breakdown of a contract price, an allowance is usually made for the Contractor’s profit margin. A Contractor’s profit margin typically reflects the size, experience and reputation of the Contactor together with the scale and costs of a project. Contractors in the current market can expect to make on average 8-13 % net profit (according to current statistics provided by MEED).
Why might a Contractor choose “Fixed Price Contracts”?
This type of pricing arguably gives a Contractor greater flexibility to include contingencies in his tender (price) for estimating errors, price material escalation and currency fluctuations, costs which, on the basis of his experience will inevitably be incurred from time to time.
Such costs may arise from design or procurement errors, and any other unforeseen costs that the Contractor might incur.
Benefit/Disadvantage to Contractor under “Fixed Price Contracts”
On this basis an experienced Contractor includes in his contingencies the eventual costs of the works which approximately corresponds to his initial estimates or his tender together with any agreed variations that may arise during the contract period, it may make a healthy profit.
The opposite could be said to be true if the Contractor’s initial estimates prove to be incorrect, reducing the original estimated profit margin such that the Contractor may possibly incur a loss.
“Fixed” becomes “Fluid”
The “fixed” element of the contract price begins to unravel after works commence in circumstances including where the outline design is developed to a greater level of detail, enabling a Contractor to ascertain the full extent of its obligations, increasing the possibility of Contractor instigated variations i.e. increase to the “fixed price”. Other circumstances would include where the project brief (which sets out the parameters and general characteristics of the project) is non existent or is limited in scope or inaccurate e.g. estimated total sq feet of development which renders an Employer vulnerable to contract led variations.
FIDIC 4th Edition and Fixed Price Contracts
Construction contracts based on the FIDIC (4th Edition) Red Book and the 1999 edition presuppose a remeasurement basis of pricing works. Re-measurement is simply where a bill of quantities is used for both the final re-measurement of all components used in the works, together with a final valuation of the contract price once the works are complete.
The conditions of those contracts are often modified in the Middle East in favour of the Employer. The modifications include the purported conversion of the standard form contract into a fixed price contract with all the inherent problems this entails if those making the modifications are not familiar with the complex interaction of the standard conditions of contract, particularly with regard to pricing.
What is a Cost Reimbursable (plus profit) Contract?
The Contractor is reimbursed by the Employer for pre agreed costs under the contract which the Contractor may incur in carrying out the works e.g. labour, materials. The Contractor is also paid an additional fee in the form of a fixed amount or percentage of the paid reimbursed costs as compensation for items including overheads, profit and preliminaries.
Interim payment valuations are made on an actual cost, open-book or current market basis.
Why might an Employer choose a Cost-Reimbursable Contract?
In an economy such as the UAE where the construction industry is currently facing sharp fluctuations in the cost of materials such as steel, the risk of those fluctuations can be largely mitigated thereby affording the Employer more certainty as to its eventual financial exposure under the contract.
In other words an Employer is likely to adopt a cost-reimbursable contract if it considers contingencies for pricing risk in a fixed price contract are likely to be considerable.
Benefit/Disadvantage to Employers under “Cost Reimbursable Contracts”
The Employer gains the benefits of any engineering, material or construction cost savings on the basis there is a presumption of more transparency in the procurement of materials. In this respect the Employer is also able to derive greater benefit from the Contractor’s discounted rates with its suppliers and subcontractors for the cost of materials.
It is possible for the parties to agree for the cost reimbursable pricing element to be converted into a fixed price contract when the scope of the works have been defined.
The Employer is at a disadvantage in that it bears the risk of any cost overruns in the event the contractor has underestimated the type and amount of materials to be used. As opposed to a “Fixed Price Contract” which presumes the Employer is paying for the works at a “fair market” value, there is arguably no such presumption under cost reimbursable contracts.
This type of pricing ultimately requires both parties to hire competent project management and effectively obliges the contractor to adhere to strict subcontract or supply chain procurement and management. In other words, they require extensive and detailed professional management services in administering the contract and an effective inter face in this, respect between the contracting parties professional teams.
Cost Reimbursable Contracts require a more subjective determination on the part of the Employer in respect of the “reasonableness” of the costs incurred by the Contractor which could potentially cause disputes over payment.
Why might a Contractor choose Cost Reimbursable Contracts?
A Contractor is likely to prefer a Cost Reimbursable commit to Contract if it is not prepared to a project which is substantial in scope, size, cost and complexity, given periods of high and rapid fluctuations in materials and where associated contingencies are numerous.
Benefit/Disadvantage to Contractors under Cost Reimbursable Contracts
The project brief may not be sufficiently defined but given time pressures the Contractor is able to start earlier on site leaving contract issues such as design to be developed at a later stage. This arguably allows the Contractor to claim additional costs, time and profit.
Increased Employer inter ference in the manner in which the works are carried out and the element of subjectiveness on the part of the Employer in respect of costs can potentially lower the actual profit a Contractor can make or lead to costly and time consuming disputes.
Is there an established form of contract for cost reimbursable contracts?
Whilst it is important to note the structure and content of the widely used 4th edition FIDIC Red Book form of contract cannot be easily adapted to suit a cost reimbursable type contract, the simple answer is yes!
The Construction and Engineering Department are increasingly being asked by clients to advise and negotiate forms of construction contracts including hybrid forms based on the NEC Contracts which include the option to use cost reimbursable pricing mechanisms.
The NEC forms of contract are drafted on a “partnering” ethos of contracting based on a pre-agreed charter of good faith between the parties to effectively cooperate to achieve the project’s goals.
The charter is based on trust, respect, open and regular communication and procedures to deal with implementing contract mechanisms including dispute resolution.
Are NEC Contracts being used in the UAE?
The construction industry in the UAE is experiencing a growing interest in the NEC form of contract. Developers such as Aldar Properties publicly stated they have adopted this form on a mixed use project in Abu Dhabi with an estimated procurement value of UAE 54 billion Dirhams.
Are NEC type contracts compatible with the legal system or laws of the UAE?
Given their adoption by developers such as Aldar, the short answer is yes.
It is also worth considering the legal principle of good faith (based on Shariah law) is an important contractual obligation under the UAE Civil Code. The importance of this principle and the partnering ethos of contracts such as the NEC, it is submitted, are not mutually exclusive.
Conclusion
The current preferred method of pricing construction contracts amongst Employers in the UAE remains on a fixed price basis given the prevailing attitude of “better the devil you know”.
This may be partly as a result of the peculiar cultural notion of competitive tendering. It may also perhaps be due to a misconception that a fixed price contract means a guaranteed maximum fixed price no matter what risks may materialise during the construction of a project, save perhaps Force Majeure, Employer Risks, Neutral Risks (neither party at fault) and Employer driven suspension.
Given the rapidly increasing sophistication of the construction market of the UAE, the debate is now gradually shifting from fixed price to cost reimbursable contracts (plus profit).
It is worth noting contracts such as the NEC Contracts are becoming the contract of choice for public sector projects. NEC’s popularity is evidenced by its adoption for the 2012 Olympics in London and are also becoming increasingly popular in countries such as Australia and New Zealand.
The Construction and Engineering Department will be pleased to discuss the suitability and applicability of the NEC form and similar forms of contract which cater for Cost Reimbursable Pricing to suit your project and requirements.
A table highlighting the advantages and disadvantages of fixed price vs cost reimbursement (plus profit) pricing models is set out below for the benefit of the reader.
By Omar Al-Saadoon Construction and Engineering Department
© Al Tamimi & Company 2007