Lump-sum contract

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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]:

  • 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.
  • 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.
  • 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.

Examples of Lump-sum contract

  • Construction projects: A lump sum contract is often used in construction projects where the scope of work is clearly defined, such as a house build, a road construction project or any other civil engineering project. The contractor is paid one set amount for the completion of the project.
  • Software development projects: A lump sum contract is also often used in software development projects. The contractor is paid a fixed amount for the development of the software, regardless of the amount of time it takes or any additional features that may need to be added.
  • Supply contracts: A lump sum contract may also be used in supply contracts, where the contractor is paid a fixed amount for the delivery of specific goods or services. This could include contracts for the supply of food, medical supplies, or other goods and services.

Advantages of Lump-sum contract

A Lump-sum contract is the most basic form of contract and is the simplest for both parties to administer. It offers a number of advantages, including:

  • Cost Certainty - The contractor is paid a fixed amount for the scope of works specified on the contract. This means the contractor is able to accurately budget and plan the project and the owner knows the total cost of the project in advance.
  • Easy to Administer - The contract is simple and straightforward, making it easy to administer. This reduces time and effort to manage the contract.
  • Faster Project Delivery - With the contract fixed, the contractor can focus on the project delivery, reducing risk and leading to faster completion.
  • Reduced Risk - The contractor is aware of the total project cost in advance, reducing the risk of cost overruns. The fixed-price also reduces the risk of performance related issues.

Limitations of Lump-sum contract

A lump-sum contract has some limitations that should be taken into consideration before entering into such an agreement. These include:

  • Lack of flexibility - A fixed amount is agreed upon and that amount cannot be increased even if the scope of work increases or the timeline is extended.
  • Risk of price overruns - If the contractor underestimates the cost of the project, the contractor can suffer financial losses and the customer might not receive the desired outcome.
  • Limited control - The customer has limited control over the project and the contractor may not take the customer's feedback into account.
  • Poor incentives - As the contractor is paid a fixed amount regardless of the quality of the work, there are no incentives for the contractor to do quality work or deliver the project on time.
  • Unpredictable outcomes - The customer may not be able to accurately predict the outcomes of the project under a lump-sum contract, as the contractor may take shortcuts to save costs.

Other approaches related to Lump-sum contract

A Lump-sum contract is the most basic form of a fixed-price contract. Other approaches related to Lump-sum contracts include:

  • Cost-plus contracts, where the contractor is paid for the actual costs of the works plus an additional fee.
  • Time-and-materials contracts, where the contractor is paid for their labor costs plus the cost of materials used.
  • Cost-reimbursable contracts, where the contractor is reimbursed for their actual costs plus an additional fee.

All of these approaches involve some form of fixed-price contract, but the exact terms and conditions vary depending on the type of contract. In all cases, the contractor is responsible for completing the work within the specified timeframe and budget. In summary, Lump-sum contracts are the most basic form of fixed-price contracts, with other approaches varying in terms of how the contractor is paid for their work.

Footnotes

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


Lump-sum contract — recommended articles
Firm fixed price contract — Unit price contract — Warranty bond — Cost reimbursement — Forms of contract — Task order — Provisional sum — Service lease — Progress billings

References

Author: Sylwia Kotysz

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