Cost Plus Contracts for Water Works Construction
Consideration of the Advantages and Disadvantages of this Form of Contract—Legal Right of Municipalities to Enter into Such Contracts—Summary and Conclusions
THE following paper, which was to have been presented at the Thursday evening session of the American Water Works Convention at Montreal, but owing to the unavoidable absence of Mr. Fuller was omitted, will be read with much interest by water works men. The excerpts which follow are the first publication of this important paper:
Prior to the Great War, the “cost plus” form of payment on contracts in the water works field was limited to a relatively few large projects built as a whole under this type of contract for private corporations and to numerous small unexpected features of enterprises executed under municipal contracts where “extra work” clauses were attached to either lump sum (bulk) or unit price contracts. During the war a large amount of emergency government work which had to be performed in the shortest possible time gave great impetus to the “cost plus” form of contract or what the British call “prime cost plus profit” type of contract. The unstable condition of the market for labor and materials now found in many places causes this form of handling construction work to come up repeatedly for discussion. Such discussion results from the necessity for finding expedients to meet present emergencies which, while not comparable with those of the war period, are neverthless present during this reconstruction period to an extent which perhaps is not generally recognized.
At this time when contractors are sorely puzzled to know how to bid or tender on construction materials on which quotations are made by dealers only on the basis of changes in price contingent on the actual date of future deliveries, and when labor is uncertain in quantity and of reduced and somewhat uncertain efficiency as to output of work per hour, it is obviously necessary to look conditions squarely in the face. Add to this the difficulties in transportation of construction materials and the loss incident to the contractor having a substantial payroll for labor when materials to work with are lacking and it is readily seen that this is a time for considering fundamental principles in handling construction work to an extent that would not be of interest under normal conditions.
The writer believes that water works construction which reasonably can be deferred should not be contracted for at present. In the case of many water works projects the existing works can with propriety be patched and overhauled in a manner similar to that adopted by the individual who under present stress makes use of old and patched clothes. There are some water works betterments which cannot be postponed owing to the fact that this expedient has been resorted to for so long that further postponing means positive disaster along various lines associated with a water famine.
Some water works construction must go forward. With conditions as they are at present the contractor, if he bids on a lump sum or unit price basis, is bound to name a price which in his opinion will protect him from loss and if possible assure a reasonable return on his capital investment and for the work of himself and his organization. Under these circumstances it is important to discuss briefly the cost plus form of contract with a view to seeing if the burden of uncertainty in some respects cannot be shifted from the contractor to the owner to the advantage of all concerned. In fact, if construction work is to go forward there are some projects where such steps seem imperative.
Legality of Cost Plus Contract
Before pointing out briefly the advantages and disadvantages of the cost plus form of contract, it is well to recall that there is serious doubt as to the legal right of municipalities in some localities at least, to enter into such contracts. State and provincial laws and municipal charters usually call for the letting of contracts for public works by open competitive bidding for all work in excess of certain specified amounts. Also such laws provide, almost without exception, that contracts shall not be made in sums in excess of appropriations duly authorized and in some cases above the estimates of the engineer of the governing body. As regards the first restriction the intent is obviously to take advantage of competition in making sure of proper market prices. The second restriction is a check on total estimated costs by actual bids for the work. In the absence of preliminary bidding, work might be started when appropriations are insufficient for completion, or opportunities might be lost for reducing costs by subsequent lettings through correction of misunderstandings as to construction procedures. Stabilization through such restrictions should not be abandoned unless there is a great emergency.
Cost Plus Contracts
There have been and always will be certain construction problems in which some means of payment in the form of actual cost plus a percentage or lump sum is legitimate and desirable, if not necessary. This is true even with lump sum contracts in which certain features may be indefinite or subject to changes regarding the character of the work. Cost plus provisions for extra work, or supplementary contracts based on such arrangements or estimates, are also pertinent where sufficient investigation previous to a letting is undesirable or too expensive in time or money for the advantage gained, such as extensive street openings to locate existing structures, and also in cases where the owner desires to retain complete control of the work regardless of the cost.
It is claimed that under the cost plus method a contractor has little incentive to keep down the cost of the work. This is frequently true of the cost plus percentage but need not be true of the cost plus lump sum type. In any case it must be remembered that a contractor who will deliberately be inefficient on a cost plus project is equally sure to attempt improper or inadequate construction on lump sum or unit price agreements. There have been a great many variations of the cost plus contract applied to construction work but the more important are:
- Actual proved cost with labor and material furnished without restriction by the contractor—plus a fixed percentage or lump sum to represent profit, supervision, financing, use of tools and plant, or any or all of these.
- Actual proved cost of labor furnished by the contractor and with materials furnished by the owner, with a fixed percentage or lump sum as above.
- Actual proved total cost for specified work plus a percentage for specified or unexpected extra or unforeseen work in connection with lump sum or sum or unit price contracts.
- Actual proved total cost to the contractor plus a sliding scale fee and upset maximum fee.
- Actual proved total cost to the contractor plus a fixed plant charge and fixed construction fee.
Advantages Claimed for Cost Plus Contracts
- The work may be started at any time and is not dependent on the prior completion of the plans.
- The owner may radically increase or decrease the quantities during construction, with lump sum fees subject to review.
- The owner may change the kind of construction during the progress of the work.
- The contractor will not try to skimp the job as is often done after finding himself losing under lump sum or unit price contracts.
- There is less need of having accurate preliminary estimates. In unit price contracts the preliminary estimate is often so approximate as to cause the contractor to gamble on some of the items, with resulting disappointment to the owner in the ultimate cost of the work. Such procedures sometimes cause an unfair result either to owner or contractor or both.
- Unit price or lump sum bids require a set of specification definitions which are not always clear and are sometimes deficient and sometimes overlapping. Such ambiguities may lead to arguments and variations in cost which result in claims and suits for extra work.
- Cost plus contracts may save the owner the money which the contractor usually adds to his lump sum or unit price bid to cover the complete but actually infrequent enforcement of material tests which cause him delay and expense, or necessitate the carrying of a large stock, entailing interest charges, storage space, rehandling, etc.
- Cost plus contracts do away with the substantial sums usually added in lump sum or unit price contracts to cover the following uncertainties: (a) Weather, (b) Foundations, (c) Changes and shortages in labor market, (d) Changes and shortages in material market. (e) Delayed deliveries of materials.
- For cost plus work it is the contract and not the specifications which is the crux of the matter from both the owner’s and contractor’s viewpoint. The writing of the contract is more simple than the writing of the specifications.
- Cost plus contracts tend to promote cooperation between the owner and the contractor.
Disadvantages Claimed for Cost Plus Contracts
- There is no way of determining the approximate cost in advance and this upsets budgets where definite appropriations have been made or are required.
- Competition—the key to efficiency—is killed.
- Greater opportunity is offered for favoritism on the part of the owner’s representative.
- Where the same contractor has several jobs, the lump sum and unit price contracts will get the good workmen and the cost plus contract will get the drones and misfits.
- A large general contractor often takes a job on the cost plus basis and sublets it to several smaller contractors on a lump sum or unit price basis. In making the sub-contractors complete the work on the latter basis the general contractor often treats them unfairly while he himself may be receiving a substantial profit for doing little or nothing.
- Should work be started before plans are completed, many errors may have to be straightened out in cases where competent engineers would avoid them if given an opportunity to get out a complete set of plans and accurate estimates of quantities.
- Engineers are tempted to be less thorough in their work when they know that there will be no comeback at them on account of extras resulting from their failure to have plans and specifications complete when needed. With cost plus contracts it may simply be a matter of correcting an error or supplying a deficiency when discovered, but the cost is there just the same although it may not appear as an “extra.”
- Engineers or other representatives of the owners must do an immense amount of accounting and clerical work in checking payrolls, material bills, etc., and expend much time and energy in expediting the delivery of materials.
- A premium may be put on extravagances and waste by giving unscrupulous contractors and engineers a chance to take advantage of the owner.
- The contractor may procrastinate in securing if not refuse to secure promptly adequate tools and equipment as to type and number.
- A combination of the above disadvantages, although no one by itself may be sufficiently pronounced to permit the owner successfully to obtain relief, may cause grief for the owner, unless protected by a maximum fee to the contractor, and by the assured adequacy of the latter’s organization and equipment.
Pre-War Status of Cost Plus Percentage Contracts
Much large construction work was and is done by railroads and other corporations in this way but this is done usually because these corporations unlike municipalities are legally able to select competent contractors with efficient organizations and equipment to work under the immediate direction of a skilled and alert staff of the owner who for the most part purchases supplies and material direct. The Grand Central Terminal in New York is a case in point. Much of the work was first awarded to a contractor on a unit price contract but it was completed under a cost plus agreement.
There can be no question that some work can be as economically and efficiently done under the cost plus basis as in other ways. But in the water works field such work appears to form the exception rather than the rule under peace time conditions.
General Considerations Regarding Contract Work
On contract work engineers should not be compelled to do the work of both the engineer and the contractor because contractors should be more capable than owners or their representatives to handle advantageously and economically the details of construction requirements. Contracts should therefore be drawn in such a manner as not to limit the work and responsibility of the contractor to the furnishing of labor and to the execution of details under the absolute direction of the owner and his engineer. Responsibility for good construction and final excellency of the work should rest with the contractor.
To insure satisfactory results from cost plus lump sum agreements the contracts should provide for the reimbursement of the contractor for all amounts actually spent by him, such expenditures being limited in the case of materials to their normal market value and for labor to price schedules of local labor unions. The lump sum fee allowance should include the services of the works superintendent and hand tools and such small equipment as would obviously be required for the work. For plant equipment such as machine tools, excavators, cable ways, etc., a per diem rental under stipulated conditions should be fixed or bids should be received. To prevent disputes the plank and specifications should be as carefully prepared as for other types of contract.
Profit sharing methods have considerable merit over the straight cost plus forms in that they give the contractor some incentive to keep the cost of the work down. A method which has been used with considerable success in Canada is described by R. O. L. French. By its terms the contractor receives 20 per cent, of the estimated cost and rebates to the owner 10 per cent, of the actual cost.
Contract Adjusted to Varying Labor Prices
Morris R. Sherrerd, Chief Engineer of the North Jersey District Water Supply Commission, in a recent contract for the construction of the Wanaque Dam provided for an adjustment of certain labor cost after the year 1920, provided such costs are 10 per cent, above or below normal 1920 prices. This places the burden of changes in material costs on the contractor, but causes the owners to share with the contractor unusual changes in labor costs. The advantage of this type of contract as to labor over cost plus agreements lies in the fact that the contractor is compelled to exercise the same careful supervision and that there is the same necessity for economical construction methods as is required on lump sum and unit price agreements, but he is not obliged to shoulder all responsibility for unexpected price changes.
In the Wanaque Dam contract, labor is a controlling item, but on ordinary construction work, particularly on comparatively small jobs, and where the value of labor and material are more nearly equal, there would be less advantage in it. To be more generally applicable the adjustment in prices should if possible include material as well as labor, and furthermore the length of time between successive adjustments should also be made to conform to the size of the contract and to the probable duration of construction.
The adjustment of prices is more difficult in the case of materials than for labor, because of the greater number of materials and also because of the variety of materials which might satisfy any particular specification. On this account the furnishing of the principal materials to the general contractor through separate contracts made by the owner may be advantageous in that the risk would be more widely distributed and the adjustment of prices made somewhat more simple and definite.
At a time when transportation facilities are abnormally inadequate the assumption by the owner of the responsibility of furnishing materials cannot eliminate wholly the troubles arising from the enforced intermittent use of the contractor’s laborers.
Summary and Conclusions
- Pre-war construction contracts were for the most part, and rightly so, agreements on a lump sum or a unit price basis. Cost plus contracts were used only on certain large work done for private corporations or as a part of other types of agreements.
- During the war the United States Government construction and much other work was done on a cost plus basis. Where proposals on a lump sum or unit price basis were obtained, the prices were intended to be sufficiently high to insure against loss due to constantly changing prices and the scarcity of labor and material.
- Since the war, the procedure has been somewhat unsettled, with an effort to do away with some of the
- disavantages of cost plus form and to combine so far as possible the good qualities of both types of contracts.
- The unit price contract under normal stable market and transportation conditions is the most satisfactory. The lump sum contract is principally advantageous in that the final cost is definitely known at the outset.
- Cost plus contracts, with proper provision for accounting and supervision, may be satisfactory where conditions are not definitely known and in the case of private corporations where well qualified contractors may be selected to work under adequate supervision. Under war conditions cost plus contracts were necessary and even now have many advantages.
- Construction work for private corporations may be successfully carried out with proper safeguards under any of the discussed forms of contract. For general construction work under municipal control the nearer a contract approaches the well-established lump sum or unit price contracts, if indeed any departure from such contracts is legal, the more satisfactory will be the results secured.
- Until such time, however, as the material and labor markets are better stabilized, contracts should in fairness place the burden of uncertainty on the owner and not on the contractor. This may be done as follows: (a) For much municipal work a form of contract may be adopted along the lines proposed by Mr. Sherrerd, and modified as suggested as to labor and material adjustments at proper intervals, (b) For municipal or other work contracts may provide for the furnishing by the Contractor of such labor and materials as are reasonably stable, with adjustment for changes in the labor market, and with materials of unstable price furnished by the owner through separate contracts.
- Construction work not absolutely necessary should be deferred, and materials and labor should be diverted so far as possible to work which is absolutely necessary.
- So far as possible necessary improvements should be made by repairing or enlarging present works, and new works should be confined for the present to immediate needs.