Lump-sum contract

From CEOpedia | Management online
Lump-sum contract
See also


A lump-sum contract is also known as a fixed-price contract. The contractor is paid a fixed amount for the scope of works which is specified in the contract. A Lump Sum contract is the most basic form of agreement between the parties (contractor and the owner).

The owner is obliged to pay the price upon completion of the work or according to negotiated schedule of payment. The main advantage of a Fixed-Price contract is that both parties know the scope of the work and the total cost associated to it before the work is started. This type of contract is used when the scope of work is defined accurately with no uncertainty.  [1]

Once the contract is signed the contractor is legally bound to complete the work within agreed fix total cost therefore the majority of the risk is held by a contractor, but if the contactor completes the work under the agreed total amount of costs, then the contractor makes an additional profit from the contract.

Application for lump-sum contract

This type of contract is normally used in the construction industry to reduce the contract administration costs. [2]

The conditions for using lump-sum contract:

  • project with well-defined work scope,
  • stables conditions – unlikely changes of scope and delays,
  • project with short duration.

The main advantages of lump-sum contract are:

  • good for controlling the costs,0
  • may reduce financial risk to the owner,
  • total costs are defined at outset,
  • may reduce time which is required to deliver project,
  • contractor selection is easy,
  • accounting related to lump sum contracts are low-intensive.

The main disadvantages of lump-sum contract are:

  • higher rist to the contractor,
  • additional changes of scope might  be difficult and costly,
  • higher financial risk to contractor may cause higher bids,
  • contractor may decide which methods and materials will be used what can cause lowest quality of materials, methods and equipment,
  • tendered price might include high risk contingency,
  • competent contractor might be not interested to bid to avoid the high risk.

The categories of lump-sum contract

Lump-sum contract types can have different variations and be built to meet the specific needs. It can be further divided into three categories[3]:

  1. Firm Fixed-Price contract (FFP) which is the simplest type of procurement contract. In this type of contract the price is fixed. The contractor has to complete the job within an agreed amount of money and time. Any additional costs due to bad performance of the contractor have to be covered by contractor. A Firm Fixed-Price contract is mostly used in government or semi-government contracts where the scope of work is specified with every possible detail outlined. Most of the buyers prefer a firm fixed-price contracts because the price is known upfront. The price remains the same unless there is a change in scope of work.
  2. Fixed Price Incentive Fee contract (FPIF) - In this type of contract, although the price is fixed the contractor can earn an additional amount if defined performance criteria will be met.
  3. Fixed Price with Economic Price Adjustment contracts (FP-EPA) - if the performance period is multi-year long, a Fixed-Price with Economic Price Adjustment contract is used. It is a fixed price contract with a provision clause which protects the contractor due to changing conditions, such as cost increases. The EPA clause has to relate to reliable finance index which is used for adjusting the total price.

Footnotes

  1. Berends T.C. (2006)
  2. Hyman W. (2009)
  3. Molenaar K. (2006)

References

Author: Sylwia Kotysz