Basics of project contracts

Several potential pitfalls confront any company trying to outsource project services. - First, the firm doing the contracting may not have the expertise to manage the contract and to prevent mistakes or omissions in the contract specifications.

By Darren A. Traub March 1, 1999

Several potential pitfalls confront any company trying to outsource project services.

– First, the firm doing the contracting may not have the expertise to manage the contract and to prevent mistakes or omissions in the contract specifications.

– Second, contractors often represent themselves as having a higher level of technical competence than they actually have.

– Third, some contractors bid on almost any contract, relying solely on low price as the way to win the business.

– Fourth, you may be sold on the premise that the company you are dealing with has vast experience, but if the project team you are assigned has none, you are effectively dealing with a “grass roots” company.

– Fifth, the company you are outsourcing to may, in turn, be outsourcing to a subcontractor. This situation is not necessarily a problem, depending on the capabilities of the primary, secondary — even tertiary — contractors. But the contracting organization needs to know the capabilities of each potential contractor and subcontractor.

Project contracts fall into two basic categories, each with its own set of benefits and limitations.The first contract bases cost on a fixed bid or lump sum and predefined scope of work. The other approach is based on compensation for time and materials (or cost plus). In the following lists, “client” is the organization providing the contract, the end user; “contractor” is the organization providing the services used by the client.

Fixed-bid contracts

In fixed-bid contracts (also known as “lump sum”), the complete scope of work is defined in terms of supply (services, equipment, construction, etc.) and schedule (milestones and completion). Acceptable (quantity and quality) goods or services will be provided by a scheduled date at an agreed cost. Changes in the cost of labor or materials is normally absorbed by the contractor. If the contractor miscalculated in his estimate, he will be responsible for covering the deviation.


There are several benefits associated with a fixed-bid contract.

– There is a defined scope of work.

– An accurate estimate of the final cost is established before the contract is awarded.

– Payments are based on progress, usually according to performance or milestones.

– There is a clear statement of responsibilities and, therefore, accountabilities.

– The client’s risk on system performance and operation is minimized.

– Work is schedule driven (contractor not compensated for its delays).

– There is an expectation of a high level of productivity and cost effectiveness.


There are also several drawbacks to the fixed bid.

– Poorly defined scope of work can cause significant cost overruns.

– Lack of client knowledge and involvement can cause inconsistencies with expectations.

– Scope of project may be unclear. (Did client specify a list of components,an operational requirement, or a performance-based system?)

– Limited flexibility fosters adversarial management tactics.

– Client preferences may cause conflicts in design, schedule, or procurement.

– Contractor may seek to cut corners in an effort to lower costs, conserve resources,and maximize profit.

Time-and-materials contracts

In time-and-materials or cost-plus contracts, the total value is an estimate or forecast. As the project progresses, the client is billed for labor and materials at a negotiated rate. If costs of labor and materials are less than estimated, the client benefits; if more, the client pays the additional expense.


This contract offers several benefits.

– Client gets exactly what he wants (whether specified or not).

– Client is typically more involved and better able to direct work.

– Client can control costs.

– Changes, variations, and modifications are more easily accommodated without conflict.

– Client can end contract or change contract personnel.


There are several negatives connected with this type of contract.

– Urgency to meet schedule dates is reduced because a prolonged project can be to the contractor’s advantage.

– Productivity may suffer from contractor adding personnel to inflate billing.

– Payments are required regularly regardless of performance.

– Accountability for project functionality under the client’s direction may be lacking.

– Client is responsible for all material costs. Remedial actions caused by contractor weaknesses, missing components, replacement parts, and excesses are at the client’s cost.

– Client pays for all engineering and labor, productive or not.

– Client is susceptible to exploitation by devious contractors.


Clearly, the type of project, specifically with respect to defining the scope, needs to be evaluated in selecting the best form of contract. If the project represents a new, undefined, or risky technology, a contractor would be loathe to take a fixed-bid approach. If the project is simple, well defined, or “cookie cutter,” fixed-bid would probably be advantageous.

In selecting the form of contract one also has the option of splitting the project and executing each segment using a different type of contract. For example, one could contract a building or facility on a time-and-materials basis, and contract the process, equipment, and/or installation of the equipment for that facility on a lump-sum basis.