Hong Kong Institute of Vocational Education CON4126 - Building Procurement and Contract Administration

Department of Construction

Chapter 2 – Contractual Arrangements

2.1 Introduction
Procurement describes the merging of activities undertaken by the client to obtain a
building. There is a wide matrix of routes to the procurement of a construction project.
The criteria of selection depend, to an important extent, on the characteristics of the
project (such as size and complexity). In addition, the contractual arrangement so
selected must meet the project’s and the client’s requirements, satisfy a variety of
constraints (such as time, cost and quality as given in Figure 2.2) and withstand the
uncertainty associated with the project (different possibilities of risk as given in Figure
2.3).

2.2 Lump Sum Contracts

For this type of contract, the contractor will carry out a defined work for a price that has
been agreed upon with the client. However, that price will be subject to possible
increases or decreases according to some strict conditions prescribed in the contract.

 If the project is small, the building owner employs a building contractor to design
and construct the building for him at a lump sum basis.

 In case of larger projects, the employer appoints an architect who then produces
the drawings and specifications. If the architect considers it necessary, he
requests a quantity surveyor (QS) to prepare a bill of quantities (BQ). Then on
the basis of either a) the drawings and specifications or b) the bill, contractors are
invited to tender in competition to carry out the work.

Characteristics:
 The contract sum is agreed upon in advance, subject to possible increases or
decreases as a result of variations.

 The sum agreed upon may be fixed, or adjustments may be made to allow for
fluctuation in material or labour prices.

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It is important that the scope or detail of the work should not be changed to a great
extent by either the client or the designer. Otherwise, the lump sum contract which
intends to produce a fully pre-defined work package, and to inform the client of his
financial commitment before the construction commences is ineffective.

There are two types of lump-sum contracts.

2.2.1 Lump Sum based on Drawings and Specification

 This is appropriate for smaller projects. Tenderers are supplied with complete
drawings and full specification. Tenderers have to prepare their own quantities
from the drawings provided.

 The contractor undertakes the work described to completion, for an agreed upon
lump sum.

 As the time allowed for tendering is usually rather limited, it is difficult for
contractors to establish accurate quantities for all items needed in the project.
They have to estimate the quantities and also to price the contract at the same
time.

 The tenderers may be required to provide some means of valuing variations, such
as day and work schedules, schedule of rates or a price breakdown which may be
incorporated into the contract.

Advantages
 The time required for the preparation of tender documents by the QS consultant
is reduced, as is the time-consuming process of preparing bills of quantities.

 The client’s risk in respect of errors in BQ is avoided because the contractor

prepares his own measurements and quantities.

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 Both parties can have a clear picture of their respective commitments when
signing the contract.

Disadvantages
 Tenders are not as easily comparable to each other as are Bills of Quantities.

 There are substantial risks imposed on the tenderers. Since the contract sum will
not be adjusted for any errors made in the quantities, the contractors have to
make their calculation very carefully, being responsible for any errors they make
in the measurement.

 For the design team, the time-consuming process of BQ preparation is eliminated.

However, this means that tenderers need to spend a lot of time and resources to
estimate or calculate their own quantities from the drawings.

2.2.2 Lump Sum Based on Bills of Quantities

 A lump-sum contract with bills of quantities is by far the most commonly
adopted type of building contract in Hong Kong.

 The contractor undertakes the work in accordance with the drawings and
specifications, as described in the bills for a lump sum.

 It is appropriate for projects when design work is completed so that detailed

measurements can be made before the tenders are sought.

Advantages
 Cost certainty is generally high but depends on the degree of completeness of
design at the time when the Bills of Quantity are prepared and on the accuracy of
the Bills of Quantities. It enables the contracting parties to have a clear picture of
the extent of their respective commitments.

 It gives a good basis for measurement and valuation of variations and for the
calculation of interim valuations and the eventual final account.

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 A detailed breakdown of the tender sum is readily available. It provides an

excellent comparison of tender bids because all tenders are based on the same
measured information.

 This improves the quality of tender submission as it creates a low-risk and low-
cost tendering environment, allowing tenderers to give their most competitive
price because the risk for the contractor is well understood and defined.

Disadvantages
 The cost in preparation of tender documentation

 The design team must prepare and deliver the building design before the Bills of
Quantities can be prepared. The reduction of design risk often leads to much
greater cost. The pre-contract phase of procurement is lengthy compared to other
procurement methods and often leads to a later start on construction.

 Errors in the tender documents are normally required to be corrected at the

client’s cost.

2.3 Measurement Contracts

In measurement contracts, the contract sum is ascertained by measurement and
valuations related to bills of approximate quantities or to a schedule of rates included in
the contract.

There are two types of measurement contracts, which are:

2.3.1 Measurement Contract Based on Bills of Approximate Quantities

 Bills of approximate quantities are an alternative form of Bills of Quantities and
are prepared early in the designing process before a firm design is available.

 This is essentially a traditional Bill of Quantities but with the quantities assessed
from professional experience by the quantity surveyor rather than firmly
measured, as would be the case with Bills of Quantities.
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 The contractor carries out the work required, which is then measured and priced
based on approximate quantities.

 It is appropriate for projects that require an early start, or where the design is
reasonably well-defined, or where the work is of a repetitive nature based on
similar projects, or where time is not available for the traditional Bills of
Quantities to be prepared.

 It is suitable where the urgent nature of the project does not allow adequate time
for design and accurate quantities to be established previous to the tendering
procedures.

 The approximate quantities included in the contract are subject to final

measurement.

 The bills serve to provide a competitive base for the submission of tenders, to
give a fair indication of the ultimate cost, and to provide a basis for the valuation
of variations.

Advantages
 Work on site can commence well before the completion of design.

 The extra expense of preparing firm quantities is avoided (although this is offset
by the cost of fully measuring the work as actually carried out).

Disadvantages
 It does not establish a firm cost for the work at the time the contractor is
appointed, thus there is less price certainty. Also, the client proceeds to the
construction stage at greater risk.

 The construction works have to be measured completely as they are actually

carried out, which may prove more costly than to have prepared bills of firm
quantities.

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2.3.2 Measurement Contract Based on Schedule of Rates

 The contractor carries out the required work, which is measured and priced at the
rates in a schedule of rates.

 The schedule consists of a list of items with “units of measurement” but no

quantities given.

 A set of preliminaries will be needed.

 The contractor executes the work solely on the instructions of the employer,
without knowing what the eventual outcome of the project will be.

 This type of contract is useful where the employer cannot determine his
requirements in advance, not even sufficiently for approximate quantities to be
prepared. It is suitable for use of “term contracts” or where there is a limited
range of repetitive work to be carried out, such as external redecoration of
housing estates. The contractor tenders on the basis of unit rates which are to
remain for the stated term. The ArchSD (Architectural Services Department) term
contracts are usually from 18 months to three years. During this time, the detailed
work orders are to be issued to the contractor.

 For private works, tenderers are normally required to calculate their costs and
insert rates for work items in the tender. For public works, the ArchSD publishes
a “Schedule of Rates for Term Contracts for Building Works” which forms a part
of a term contract. For each work item in the Schedule, a unit rate is estimated by
the ArchSD. Tenderers are requested to indicate in the tender documents “plus”
or “minus” percentages for the individual sections of the Schedule of Rates.

Advantages
Tenderers using a particular schedule (Standard Schedule of Rates) soon become
familiar with both the item descriptions and the rates and are able to assess percentage
adjustments relatively easy.
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Disadvantages
 In comparing and assessing a range of tenders, the QS has the task of gauging
the effect of a series of variables, making the choice difficult.

 The parties are unable to have precise information about their respective
commitments.

 Because of the above, the contractor finds it difficult to quote realistic tender
prices. In the pricing process of the contractor, the preliminaries cost is, to a
certain extent, directly related to the amount of the contract sum. The unit rates,
as well, are greatly influenced by the quantities required for each item of work.

In practice, different contract types are used according to the task at hand. For example,
in a residential project in which all the details of the designs - except the podium - are
complete, a lump sum contract can be used for the residential blocks, whilst a re-
measurement contract would be used for the podium in order to establish the contract
sum.

2.4 Cost Reimbursement Contracts

In cost reimbursement contracts, the price to be paid is determined on the basis of the
actual cost incurred by the contractor in carrying out the work, plus an agreed upon
amount to cover overheads and profit. In a cost reimbursement contract, no tender sum is
contained in the tender and it may be very difficult for both the client and the contractor
to form any reliable estimate of the final cost.

Prime cost and cost reimbursement contract arrangements are seen by many as a last
resort due to the high level of uncertainty of the final costs. It is generally only suitable
where time is the most critical factor and an immediate start is necessary. Emergency
projects are another example where this method is desirable, for instance, to remove a
risk to the public or to repair a facility which is of critical importance. The contract may
contain various provisions to assist in keeping the expenditure of prime cost to a
minimum and yet provide a completed work on schedule.
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Advantages
 The time required for preparation of tender documents and for obtaining tenders is
minimized, thus enabling an early start on site. The contractor does not have to
source competitive prices for good, materials, labour or specialist items at the time
of submitting his proposal.

 Work on site may proceed before the detailed design is complete. It can begin as
soon as the contract has been signed.

Disadvantages
 Apart from the absence of quantities, the cost of labour involves the estimation of
productivity which is very difficult to establish. Hence, the contracting parties
have little understanding of their respective commitments before the project
commences.

 The risk of unforeseen circumstances generally lies with the client.

 The computation and verification of the total prime cost is a long and tedious
process.

There are three variants of this type of contract, distinguished by the way the payment to
contractor is calculated.

2.4.1 Cost Plus Percentage Fee

 The contractor carries out the work and is paid all costs plus a fee, calculated as
a percentage of whatever the total cost may be, for overheads and profit. This is
used for building work of an unusual nature, such as experimental work, where
requirements cannot be ascertained before the contract is let, and where it is not
possible to make any estimate of the total cost.

 There is no financial incentive to encourage the contractor to carry out the work
economically. The contractor may even make the cost as great as possible. This

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type of contract is therefore not recommended. Tight control must be

implemented if it is used.

2.4.2 Cost Plus Fixed Fee

This may be used where an accurate estimate of the maximum total cost can be made.
Since the fee is fixed and will not be affected by the costs, the contractor may try to
reduce the time, and thus the cost of the construction. This method keeps the employer’s
costs to a minimum.

2.4.3 Target Cost

 Similar to “cost plus fluctuating fee,” the employer’s requirements must be
known in some detail, and it must be possible to prepare a reliable estimate of
the probable cost. Under this arrangement, a target price is agreed for the work.

 Then payment will be made according to the comparison of the actual cost and
the target price.

 Any savings, compared with the target price, will accrue to the contractor either
by way of a share of the savings or an increased fee.

 Conversely, should the cost exceed the target, the contractor would be paid a
substantially reduced fee.

Supposing that a client has been requested by his landlord to move out from his existing
premise the next month. He then rented another premise to continue his business. The
total cost of renovation work was estimated to be around HK$5,000,000. As a matter of
urgency, a cost reimbursement contract (target cost) was adopted. Four contractors were
invited to tender for this innovation project and the work was scheduled to commence
two weeks later. Based on the client’s requirements and a set of conceptual drawings,
one of the tenderers calculated his overheads to be 15% and expected to realize a profit
of 5% on the total estimated cost. He therefore tendered an overall of 20% on top of the
prime cost as his management fee and his tender was accepted. The contract contained a

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sharing formula (50%:50%) for the difference between the agreed amount and the actual
cost, in order to encourage the contractor to economize.

The agreed-upon sum was based on the likely construction cost of HK$6,000,000. At the
end of the job, the prime cost was verified to be HK$5,500,000. The final cost to the
client would be as follows:

Total prime cost $5,500,000

Fee to the contractor $1,000,000

Total cost to the client under cost plus fixed fee $6,500,000

Deduct penalty, being 50% of total cost over

$6,000,000 (target cost) ($250,000)

Total cost to the client under target cost

arrangement $6,250,000

2.5 Design & Build and Turnkey Contracts

 The contractor is responsible for the design and construction as well as the
management of the project.

 The contractor can offer a better deal when he is in control of all aspects of the
project, and that the client does not have to employ a design team.

 Clients will usually employ consultants to monitor the various aspects of the
work and to ensure that the work of the contractor is of an acceptable standard.

 Depending on the requirements of the client, design and build contracts can also
exist in the form of Enhanced Design and Build (or Develop and Construct).
Upon tendering, consultants design the building to a partial stage, which is often
referred to as “scope design.” They then obtain competitive tenders from
contractors on the basis of the scope design, and possibly include performance
specifications for developing and completing the design as well as constructing
the building.

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The extent of consultant design varies from project to project, some of which are very
extreme according to the requirements of the client. The consultants may simply
stipulate the area of spaces to be required for the whole building, and the size and
function of each room. Furthermore, broad indications of floor layouts and types of
finishing materials may also be given. In extreme cases, the consultants prepare a
scheme design similar to that provided to the contractors who bid for projects delivered
by the traditional procurement method. It may specify all the major components,
materials, elevations and sections of the building. The design responsibility to prepare
working details for the erection of building is left to the contractor.

 Apart from using the “Design and Build” procurement method for entire
building projects, it has also been used extensively in other areas of construction
projects such as the design, supply and installation of curtains, walling, and
other building service systems which represent a significant portion of the
contract sum, or those less costly - yet significant - items such as vanity counter
tops. The Architectural Services Department sometimes adopts traditional
Design and Build for the procurement of office and governmental quarters so as
to gain the benefit of a shorter design and construction period. The form of the
Design and Build contract usually adopted by the Hospital Authority is enhanced
Design and Build. In addition, enhanced Design and Build was used for the
procurement of new buildings at the City University of Hong Kong and the
Hong Kong University of Science and Technology.

 Turnkey contracts require the contractor not only “design and build” but also
“furnish and fit out.” The construction of speculative and private housing is a
prime example of using turnkey contracts in Hong Kong.

 All the client has to do when he receives the keys to the completed building is to
put the key in the lock and turn (hence the word, “turnkey”), step in and start
using the building for its intended purpose.

Advantages
 A single point of responsibility is provided. The contractor is solely responsible
for failure in design or in construction. In principle, all the risk is transferred to
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the contractor and thus it is not necessary to distinguish whether it is a design

fault or a workmanship fault should any defective work is found.

 The contractor’s knowledge of “buildability” can be beneficial in regards to both

the cost, and the programming of the project. Since the contractor retains full
control of design, features which are impractical or awkward to carry out can be
rejected.

 Since the contractor undertakes the design work, there are opportunities to
overlap the design and construction processes and thus to get an early start on
site. Moreover, internal bureaucratic procedures are reduced because the design
team and the construction team belong to the same organization.

 A firm price can be established in advance of construction on the condition that

the client’s brief is concise and unambiguous at an early stage and is unlikely to
change.

 Close intercommunication between the contractor’s design and construction

teams promotes co-operation in achieving smoother running of the contract and
prompt resolution of site problems.

Disadvantages
 The nature of Design and Build contracts tends to restrict changes during
construction because of the relatively high cost to the contractor and client of
assessing variations. Hence in most cases, tender sum breakdowns are required
in contractors’ proposals. They should contain sufficient pricing information to
enable the evaluation of variations should they arise.

 If the contractor’s organization is relatively small, he is unlikely to be as skilled

in design as he is in construction, and the resulting building may be aesthetically
less acceptable.

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 Professional advice given on assessing contractor’s proposals may be significant.

Considerable time may be involved in this as there must be extensive evaluation
of design, quality and construction costs. There must also be negotiation, and
presentation from the contractors in order to select the right tender.

 If the brief is vague, the client may pay an inflated price or take possession of an
inferior building. It can be difficult in certain instances to precisely define the
standards and quality of design required.

 For most contractors, it is very costly for them to bid for Design and Build
contracts as they have to employ a whole team of design consultants to prepare
the tender. Design costs of unsuccessful tenderers may be very significant and
usually become a cost that needs to be recovered from their successful projects.

2.6 Management Contracting

In this arrangement, the contractor joins the employer’s team at the design stage of a
contract to assist in the planning and design by providing the team with the benefit of his
practical experience and construction expertise. Once the project gets underway, the
contractor himself does not carry out any of the construction work. Each trade’s work
commences as their plans and specifications are substantially completed. Subcontractors
will construct all the works, whilst the contractor takes all of the management
responsibilities.

The management contractor’s role therefore is that of providing a construction

management service on a fee basis as part of the client’s management team – organizing,
co-ordinating, supervising and managing the construction works in co-operation with the
client’s other professional consultants. Due to his early appointment, he can also advise
on quality, buildability, suitability and availability of labour, plant and materials and
construction methods during the design phase and have more flexibility of the
programming of the work.

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As part of his service, he provides and maintains all the necessary site facilities, such as
offices, storage and mess huts, power supplies and other site services. He also oversees
the common construction plant, the welfare of the workers, the work of subcontractors
(in, for instance, unloading and storing materials, providing temporary roads and hard
standings and removing rubbish and debris) and even deals with labour relations matters.

Management Contracting is appropriate for large, complex projects where an early start
is required. Examples in Hong Kong include the Hong Kong Bank Headquarters and the
KCRC Kowloon station.

Advantages
 Work can begin on site as soon as the first one or two works packages have been
designed. Overlapping of design and construction can significantly reduce the
time requirement, resulting in an earlier return of the client’s investment.

 The contractor’s practical knowledge and management expertise are available to

assist the design team.

 The system allows a great flexibility for design change or late decisions where
work packages have not been tendered. Thus, there is a reduced risk of claims
affecting other packages in the event that major changes are made.

 The “them and us” confrontational attitudes and communication between the
design and construction team can be improved because of the impartial position
of the contractor who is working for a fee.

Disadvantages
 The final cost of the project is uncertain until the last works contract has been
signed.
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 The number of variations and the amount of remeasurement required may be

greater than those of traditional contracts because of the greater opportunity to
make changes in design during the construction period, because of problems
connected with the interface between packages, and because packages are
sometimes sublet under incomplete design information.

Client

Engineering Quantity
Consultants Surveyor

Management
Architect
contracting

Indicates lines of
communication WC1 WC2 WC3 etc
WC = Works contractor

Figure 2.1: Management Contracts: Relationships of the Parties

2.7 Build-Operate-Transfer (BOT)

The government owns major infrastructure projects. For example, they are the sole
shareholder in the Airport Authority. The government also owns the major toll tunnels in

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Hong Kong which were built on a BOT (build, operate, transfer) system operated by
private enterprises. The backbone of a BOT project is the Concession Agreement.

 BOT is one of the most popular contractual arrangements of privatizing

government infrastructure (civil) work such as highways, bridges and tunnels.

 Under this scheme, a private sector organization, usually in the form of a

contractor-led consortium, undertakes the finance, design, construction and
operation of an infrastructure facility.

Mechanism
The contractor usually carries out the construction under a Turnkey contract, with
independent monitoring by a consultant hired by the government. When a facility is
complete, the consortium establishes a company. It then operates the facility for a period
of time (anywhere from 10 to 30 years) as defined by a concession granted by the
government. Such a concession will allow the company to charge the public for use of
the facility in order to repay loans and provide returns for investors. At the end of the
concession period, the facility is handed back to the government free of charge.

In Hong Kong, there are many examples of government infrastructure facilities which
have been successfully completed under the BOT Scheme. The Cross Harbour Tunnel
was an example of a BOT. It generated a good profit for its franchisee and then was
successfully transferred back to the Government. Other examples include the Tate’s
Cairn Tunnel, the Western Harbour Crossing and Expressway Route No. 3.

Specifically, the Tate’s Cairn vehicular tunnel linking Shatin to North Kowloon, was
undertaken by Nishimatsu Construction Ltd. and Gammon Construction Ltd. With the
granting of a 30-year franchise, the joint venture established the Tate’s Cairn Tunnel
Company to operate the facility. A return on the company’s investment is achieved by
levying a toll on the public’s use of the tunnel. The tunnel will be handed back to Hong
Kong government in the year 2021.
2.8 Criteria for Procurement Assessment
The criteria for selecting a procurement system for a project are drawn from the client’s
brief. Figure 2.2 illustrates the three major interrelated objectives of the project which

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are time, cost and quality. None of the procurement options are absolute - there is no
‘best’ procurement route. The client’s priorities in terms of time, cost, quality and other
measurable or non-measurable dimensions for a particular project generally lead to some
routes being better than the others. Any emphasis placed on these objectives must be
clearly sought from clients at the outset for a project to be fully successful. Change of
emphasis during the project could jeopardize the outcome.

Quality
(performance/function)

Project

Cost Time
(price) (programme)

Figure 2.2: The Client’s Project Objectives

Note: Quality (product function and performance), time (programme) and cost (price)
are the key elements of the client’s brief. The position of the project in the objectives
triangle will indicate the emphasis in the client’s brief. The project above is shown
central indicating an equal balance of priorities, but clients will often have a bias
towards one or two of the objectives.

The choice of the procurement route not only depends on the client’s required balance
of time, cost and quality but also on the client’s other requirements, e.g. his required
level of involvement in the design and construction process and the extent to which he
may change his mind or wish to alter the specification during construction. Below is a
useful set of criteria for selecting an appropriate form of contractual arrangement.

 Speed - design and construction

 Cost certainty
 Dealing with complexity
 Client’s involvement
 Capacity for variations

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 Clarity of remedies
 Separation of design and management

In addition, “transfer of risk” and “allocation of risk” are major considerations in any
form of contract. For example, “price certainty” is bought by paying the contractor to
accept the risk of fixing a price in a commercial, changing market. Other key risk areas
identified for consideration could be delay and quality. For instance in the Design and
Build system, cost certainty will be negated if the client still makes changes after the
award of the contract. Figure 2.3 provides an indication of the different levels of risk
inherent in different procurement methods.

Figure 2.3: Allocation of risk

End of Chapter 2

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