CONTRACT RISK ASSESSMENT TO THE PERSPECTIVE OF A CONTRACTOR
CHAPTER 1
INTRODUCTION
People say risk is unavoidable in life, and that’s probably true.
However, risk is not necessarily unavoidable when it comes to the contracts
you enter to.
Risk analysis and Risk allocation in the construction industry is established
through the construction contract. Accordingly, when drafting their standard
agreements with subcontractors, general contractors frequently incorporate
multiple provisions that have the effect of transferring liability to the
subcontractors.
The logic expressed by the general contractors is that risk should be
allocated to the party that is in the best position to manage it. In reality, it
frequently happens that the party with the strongest bargaining position gets
to allocate the risk in a contract.
As the risk-sharing provisions in domestic public construction contracts are
not completely fair and reasonable, contract disputes often arise as a
result which in turn cause delays, quality impacts, and other problems
that urgently need improvement. Introduced in this article is the
development of a decision system for risk-sharing in public construction
contracts. Said system was developed through literature review, fuzzy
synthetic evaluation in conjunction of analytic hierarchy process, definition
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of risks in public construction contracts, and establishment of decision
models for risk-sharing. Subsequently, the "escalation" risk was employed
as an example to select suitable decision models for analysing risk-sharing
decisions. The evaluation model of contract risk-sharing performance
established in this article can be the basis for authority in its optimal risk-
sharing decision-making.
The fair and reasonable risk-sharing is helpful for smooth completion of
construction, cost saving and prevention of contractual dispute. However,
research and investigation have shown that in order to protect its own
interests, construction authority in the past often made use of exceptions to
exert most of the risks onto the contractors. Although the authority can
avoid the risk with such contract agreement that is lack of fairness, adverse
effect can possibly arise due to the over provision and cause difficulty to
undertaking personnel; moreover, it is found from many cases of arbitration
and mediation that the authority may still need to compensate the
contractor's loss due to breach for violating principle of fair and sincere
contract. In addition, the increase of contract risk is not only incapable of
stopping unworthy companies on vicious acquisition of tender, but also
strangles willingness of tendering from honest companies, which forms
the vicious circle of "bad elements driving good elements away" and
hence no protection is provided on construction quality.
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Nevertheless, contractual amount and hidden risk involved in public
construction are often vast and complicated, the selection on suitable
decision making of risk-sharing is truly an important subject that is
worth for discussion at present under principle of reasonable fairness; so
that both contractual parties can bear affordable risks and thoroughly
bring out their professional skills to pursue maximum profit for the overall
construction. In view of this, the article starts with brief description on
connotation of risk-sharing decision for public construction contract. This
follows logic of decision on risk-sharing to define risk of public
construction contract and establish risk-sharing decision model, develop the
"Risk-sharing decision system for public construction contract"; moreover,
the recent risk of "escalation" that seriously affect execution of domestic
public construction is taken as example for escalation of suitable decision
model and execution on decision analysis relating to risk-sharing, which
provides reference for the authority upon selection on risk-sharing decision
and setting of contractual clauses.
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CHAPTER 2
ALLOCATION OF RISK INTO CONTRACTS
There are numerous risks that are apparent in any business deal,
however, outsourcing by its nature creates additional risks that need to
be assessed and apportioned in the contract. This chapter scusses the
terms of the contract, disclaimers, subcontract provisions, privity of
contract and general issues of insurance and force majeure.
2.1 Types of risks and terms within a contract
As in any contract agreement , specification of the scope of services and
the allocation of responsibilities between the client and service provider is
essential .
An important function of the outsourcing agreement is the allocation
between the parties of the various risks associated with the
contemplated transaction. The risk allocation schema poises one of the
most difficult of issues between the customer and service provider.
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There are numerous risks that are apparent in any business deal,
however, outsourcing by its nature creates additional risks that need to
be assessed and apportioned in the contract.
There are several risk categories that need to be considered as part of
the agreement and relationship. These include (but are not limited to) :
Budget Risk – Such as Funding constraints, Prioritization
uncertainty, Under funding potential
Cost Risk - including Contract price fluctuation ,excessive
consumption of resources , project overruns, unexpected
changes in rates of material and labor wages.
Technical Risk - such as failure of structure, or incomplete
transactions that disrupt operations and involve substantial
direct and indirect losses.
Schedule Risk – like productivity uncertainty, Area / Facility
availability, and adverse environmental availability
Scope - typically the most frequent source of friction after
signing the contract.
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Legal and Regulatory Risks - affect not only such
regulated industries as health care and banking, but
increasingly most other businesses.
Extraordinary Risks - including the familiar circumstances
that constitute force majeure. Parties must also consider
other extraordinary risks and events, including
acquisitions and divestitures, changes in control etc.
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CHAPTER 3
CONTRACT RISK MANAGEMENT
Contract Risk Management (CRM) is an enterprise-wide issue, which
directly or indirectly affects everyone in the organisation. In the final
analysis, all transactions in every organisation are based on contracts of one
type or another. Historically, despite ‘policies and procedures’, contracts are
seen as the responsibility of the legal department, and normal practice is to
abdicate contractual issue, processes and procedures to the legal department.
The consequences of this are all too evident:
Unwritten contracts (handshakes and verbal commitments)
Unsigned contracts
Missing and lost contracts
Operational activity in breach of contractual obligations
Missed events and deadlines, such as renewals and
terminations
Multiple, often contradictory, contracts with third parties
Inability of management to monitor or respond to contractual
exposures and liabilities
Over-expenditure, for example through not exploiting bulk
supply agreements, rebates & discounts
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Companies with good Governance need to be sure of their contract
management and need to understand the risks inherent in their contractual
obligations. Unless the organisation has a sophisticated and dedicated
approach to contract management it can have no way of measuring this risk.
3.1 Myths and Misconceptions
In their search for solutions, organisations usually start with the idea that
they need a system that captures images of the actual hardcopy of the
document, and which then maintains a central repository from where the
images can be readily retrieved -in other words, a ‘document imaging’
system. A dilemma then arises because there is a need to identify how the
document flows through the process from creation to termination, so
(logically) the document imaging system must have workflow on top. At
this point, confusion reigns because these are two separate applications of
technology, and the search for products that will integrate these two ideas
leads the customer down many dead ends.The outcome is that the
functionality of workflow is well presented by workflow vendors, while the
‘superiority’ of a specific document imaging solution is sold in terms of
efficient storage, retrieval, indexing and scanning.
Nowhere does this line of thinking address the real functional requirements
of a system to facilitate the management of contract lifecycles and risk. All
this is seen as add-on development either by the user or by an external
development team.
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3.2 The Practical Solution
Naturally, a widely accessible repository of contract information in
electronic format is desired, but it goes far beyond that. Managing contracts
responsibly means
Knowing what contracts are in place, and knowing where
they are
Knowing what contracts you have with all the business
entities within your business domain
Knowing in advance when the events on every single
contract will occur (reviews, renewals, terminations)
Knowing continuously the financial implications of all the
contracts, individually and overall
Knowing the consequences and obligations inherent in each
and all the contracts
Knowing all the business constraints which the contracts
impose on your business
Knowing when contracts become unsustainable because of
new socioeconomic and regulatory circumstances
Ensuring that every individual within the company is aware
of and
complies with all the terms and obligations of the contracts
which affect them
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Knowing why the contract exists and what risks are
addressed by every contract
Knowing the risk profile of every contract and being
accountable for the overall exposure of the company to the
risks in all the contracts.
Having a clear and accurate view of the significance of each
contract and being able to categorise them in terms of ‘urgent
and important’ in the daily activities.
3.3 The Challenges of Contract Management
It becomes evident that a document imaging system with workflow doesn’t
begin to address these issues. Success still depends on the ability of the
individual managers to read through the contracts every day to extract what
has to be done. This is clearly impractical, and therefore a good deal more
automation must be introduced so that contracts ‘can speak for themselves’.
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3.4 Contract Knowledge Bases
To achieve these objectives, each contract must be reviewed and the salient
points, events, dates, clauses and tasks must be recorded in an active data
store. This data store must not only deliver meaningful information in
response to enquiries, but should also ‘push’ information to the relevant
individuals whenever necessary. Scanning the contract documents is easy –
interpreting them is not. It is a manual exercise, and is very subjective.
Legal will extract legal risk; Finance will see the risks in ROI, payment
terms, cash flow and capex. The Business Continuity Manager will have
another view, as will Operations. The challenge is to make the interpretation
and management of contracts as consistent as possible, so that risks can be
compared and policies and procedures can be standardised. This doesn’t
necessarily mean introducing an automated ‘contract authoring’ system.
That in itself is a separate subject for heated debate, as it introduces many
dilemmas and control requirements.
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3.5 Risk and Contracts
A framework for managing contractual risk must be defined and
implemented in policies and procedures. This must be applied to every
contract in place and new contracts must be reviewed against this
framework. A risk framework must at very least, categorise risk types,
identify and classify possible risk events, impact types, vulnerabilities and
probabilities. From this, a simple ‘exposure’ can be deduced, which, even
though it is unlikely to be accurate, does give management a vehicle for
measuring and controlling the company’s exposure. It must touch and guide
all role players, contract owners and administrators in their daily activities.
It is not a direct part of the ERP system. Instead, the ERP system must be
configured to guide operations in conforming to contractual obligations and
processes.
3.6 Interdependencies
Contracts are not discrete, freestanding documents. There is always a
structure within a company’s contractual landscape wherein contracts are
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interrelated or interdependent. A particularly visible instance of this is seen
in the area of Property Leases. The lease must
govern the services contracts for the premises, because they should all have
synchronised ‘termination’ clauses. Furthermore, contracts that depend on
other contracts ‘inherit’ the risk profiles of the associated contract, and this
makes management even more complex.
3.7 Positioning Contract Management solutions
The true context of contracts is based on the premise that a business
interacts with others to exchange goods and cash. This exchange process
creates a contractual relationship, regardless of the depth or clarity to which
that relationship is negotiated. The idea of ‘never signing contracts’ is a
fallacy –obligations and liabilities arise anyway.
The reality is that contractual relationships are ingrained in the very fabric
of the enterprise. Therefore, Contract Management must be deployed ‘from
the top, down’ as an instrument to ensure good Governance, Compliance
and Risk Management throughout the organisation.
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CHAPTER 4
Managing RISK in Contracts
The logic expressed by the general contractors is that risk should be
allocated to the party that is in the best position to manage it. In reality, it
frequently happens that the party with the strongest bargaining position gets
to allocate the risk in a contract.
Let’s take a look at some of the most common mechanisms general
contractors will employ in this risk allocation process:
Indemnification clauses
Additional insured requirements
No damage for delay clauses
Pay-if/when-paid clauses
4.1 Indemnification Clauses
One of the most common risk allocation devices utilized by “upstream”
parties in the construction contract is the indemnification/hold harmless
agreement. Indemnification may be simply described as the obligation of
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one party (the indemnitor) to reimburse a second party (the indemnitee) for
the losses that second party incurs, or the damages for which it may be held
liable.
In the construction context, indemnification clauses are used to shift risk
from upstream parties to subcontractors. Through contractual provisions the
subcontractor is often required to indemnify not only the general contractor
and the owner, but also the architect and the engineers.
Indemnification clauses are used to transfer liability for damages and/or
judgments, transfer the duty to defend, and transfer or allocate the duty to
insure. The indemnification clause is usually found in its own section of the
contract.
Today, most states designate, by statute or judicial ruling, the types of
liability that can be transferred contractually and the type of language
required for such transfers to be enforceable.
The modern indemnification provisions can be grouped into three different
categories: broad form, intermediate form, and limited form.
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4.1.1 Broad form indemnification clauses
The broad form (also called no fault) indemnification clause requires the
subcontractor to assume any and all liability for the project regardless of
fault, even if the liability arises from the sole negligence of another. Since
this type of clause shifts the entire risk of loss, the subcontractor who agrees
to this provision absorbs massive amounts of liability for the project. Today,
most states either prohibit broad form indemnification clauses by statute, or
simply refuse to judicially enforce these agreements.
4.1.2 Intermediate form indemnification clauses
With this type of clause, the subcontractor is required to assume all liability
for the project except that which is due to the sole negligence/fault of the
indemnitee. Under the intermediate form, the subcontractor will have to
indemnify from all liability and damages, so long as it does not arise from
the sole fault of the general contractor, the owner, or anyone else the
subcontractor has agreed to indemnify.
This type of indemnity imposes on the subcontractor liability for its sole
negligence, as well as for the joint negligence of itself and the indemnitee,
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without regard to the indemnitee’s proportion of fault. Therefore, a
subcontractor can find itself responsible for all liability resulting from an
accident in which the general contractor was 99% at fault. This type of
indemnification poses the same problem that broad form indemnification
creates; having a subcontractor with a relatively low financial net worth
taking on the financial risks of the large general contractor and owner.
Even though this intermediate form does not allow for zero fault
indemnification, it offers only a modicum of protection more than the broad
form and should be avoided if possible by a subcontractor.
Today, several states ban these types of clauses in at least some contexts.
However, 18 states ban only broad form clauses.
4.1.3 Limited form indemnification clauses
Limited form indemnification clauses are the least stringent on the
subcontractor. Limited form indemnification is the basic concept of
comparative fault. Under this form, the subcontractor assumes liability only
to the extent of its own negligence or fault.
This form of indemnity is simply a restatement of the common law principle
that an entity should be held liable for only those circumstances over which
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it exercises control. In order to control risk and limit potential liability, all
subcontractors should try to ensure that any contract entered into contains
only a limited form indemnification agreement.
4.2 Additional Insured Requirements
Additional insured requirements are often used to reinforce indemnification
agreements, and in some cases to circumvent anti-indemnity statutes.
Construction contracts typically require all general contractors and
subcontractors to carry a certain amount of liability insurance to pay any
defense costs, settlements, or judgments arising out of claims related to that
contractor’s work. The named insured is the person or business to which the
commercial general liability policy is issued, and also is the one who pays
the premiums and deductibles, has the power to cancel the policy, and
receives any notice of cancellation.
With the rise of anti-indemnity statutes, it has become a common risk
management technique in the construction industry for the general
contractor to require the subcontractor to grant both the general contractor
and the owner additional insured status on the subcontractor’s commercial
general liability (CGL) policy.
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The effect of the additional insured status is similar to the effect achieved by
an indemnification agreement. Essentially, the general contractor obtains a
direct contractual relationship with the subcontractor’s insurance carrier, but
is under no obligation to pay either the policy premium or deductibles.
There are several reasons general contractors require subcontractors to grant
them additional insured status.
General contractors require subcontractors to name the GC as additional
insured in order to protect the GC’s own insurance policies. A general
contractor would generally prefer not to use its own insurance to defend a
claim, when another option is available.
Many jurisdictions have held that by tendering its defence to the
subcontractor’s insurer, the general contractor keeps its own insurance
company out of the suit. If the general contractor uses the subcontractor’s
carrier for defense and does not seek indemnification from its own insurer,
the subcontractor’s carrier cannot sue the general contractor’s insurer for
reimbursement of any money paid out on the general contractor’s behalf.
Therefore, the general contractor’s premiums will not increase and no
deductibles will need to be paid.
Furthermore, a carrier has no right of subrogation against an insured. Thus,
additional insured status prevents the subcontractor’s insurer from bringing
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suit against the general contractor for damages, even if the general
contractor caused the loss.
Additional insured status can also be used to circumvent anti-indemnity
statutes, since many ant indemnity statues make exceptions for insurance
contracts. Using additional insured status, a general contractor can shift the
burden of liability to the subcontractor just as in broad form or intermediate
form indemnification; yet not have the provision be declared void as against
public policy. In addition to the requirement that the subcontractor include
the owner and contractor as additional insured on its CGL policy, there will
likely also be a provision containing a waiver of subrogation. This is a
contractual term that waives a subcontractor’s rights of subrogation for loss
payments and expenses made by the subcontractor or covered by the
subcontractor’s general liability insurance.
4.3 No Damage for Delay Clauses
Construction owners are increasingly placing “no damage for delay” clauses
in their contracts, and general contractors are in turn including similar terms
in their subcontracts. These clauses provide that the contractor will be
entitled to an extension of time for delays, but no additional compensation
to the subcontractor is required.
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The no damage for delay clause is utilized to protect the owner and general
contractor from liability for unanticipated additional costs associated with
delay to, disruption of, or interference with the subcontractor’s work. Many
construction delays result from the acts and omissions of the owners, its
design professionals, or the general contractor. These delays result in higher
overhead and construction costs which impose a significant financial burden
upon subcontractors.
The treatment of no damage for delay clauses is varied among the states.
Some states have declared that for both private and public contracts clauses
which disallow remedy for delay caused by the owner or contractor are void
as being against public policy. Other states have declared that no damage for
delay clauses are only void when incorporated into a public contract. Some
jurisdictions have allowed these clauses to be enforced in both public and
private contracts, but there are numerous exceptions to that enforcement.
And yet other states enforce no damage for delay clauses as written, but
strictly construe them against those seeking their benefit.
Be aware of the local law, and review the construction contract to make sure
that it does not require you to waive your rights to remedies for costs
associated with delays in construction caused by the general contractor or
owner.
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4.4 Pay If/When Paid Clauses
Time of payment clauses are generally considered either pay-if-paid or pay-
when-paid. In the majority of jurisdictions, these clauses will generally be
construed as pay-when-paid clauses and therefore serve only to determine
the time of payment. A pay-when-paid clause is the standard provision and
will be found in most construction contracts. However, pay-if-paid or
contingent payment provisions have become increasingly popular with
general contractors, so you should carefully scrutinize all payment
provisions.
A pay-if-paid clause actually shifts the risk of owner insolvency from the
general contractor onto the subcontractor. A true pay-if-paid clause places a
subcontractor in the position of working on a contingency basis, where the
subcontractor only gets paid for the work performed if the owner makes
payment.
These types of clauses place a subcontractor at risk for non-payment by the
owner for reasons created by the general contractor and/or other
subcontractors.
Therefore, you should be ever vigilant as to the specific wording of the
payment provisions of contracts, so as to ensure that they have not without
knowing absorbed the risk of owner insolvency.
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Risks may indeed be an unavoidable part of life, but when it comes to the
contracts your company signs, there are ways to minimize them. Read
contracts carefully, and know your state’s laws. If in doubt, get matters
clarified in writing. Be on your toes, and do your homework upfront,
because after a contract is signed isn’t the time to realize it has unfavourable
provisions.
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CHAPTER 5
Escalation – Meaning and Scope
The term Escalation means an increase that counteracts an unjust
discrepancy between the price of a product and the cost of material. It is the
provision of "the adjustment of prices proportionally and usually
periodically and automatically to an alteration (as a rise) in the cost of
materials, or a similar adjustment of wages to an alteration in the cost of
living"1.\ In a works contract, it would mean an increase in the price of an
item of work over and above rate stipulated in the tender, during the period
of the contract and according to the escalation clauses as well as the
formulae therein.
The basic rationale for the price escalation clause is to compensate a
contractor for increase in construction cost during the contract period. It is
difficult, however, to determine precisely the quantum of actual increase in
cost as construction activities are multifarious in nature and involve many
parties, materials and equipments. This difficulty is sought to be overcome
by resort to a “Formula” approach which has the additional advantage of
simplicity and obviation of the necessity to audit actual costs/Separate
formulae can be derived to represent the elements of increase in cost of
labour, materials and other commodities used in construction .The
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fluctuation in their costs can be related to appropriate indices compiled by
various “approved” agencies.
Wage structure of labour has been moving upward continuously.
The Minimum Wages Act, 1948 was made applicable to employments in
“Building and Construction and Maintenance of Roads”. Though not
specifically applicable to the river valley projects, it is nevertheless deemed
as extended to them as well. Fair wages have been prescribed by the
competent authority for various areai under its jurisdiction in the State of
Andhra Pradesh. In the States of Bihar, Gujarat, Kerala, Tamil Nadu and
West Bengal, the minimum wages have been linked to the consumer price
indices and, therefore, vary from month to month. In other states, however,
the wages remain static till revised through a gazette notification by the
State Governments concerned. Normally this is done biannually. Apart from
the minimum wages, labour wages are subject to supply and demand
syndrome. Many large project sites become supplier's markets particularly
in respect of skilled and semiskilled workers. Wages get pushed up far
above the minimum prescribed.
The principle that the contractor needs to be compensated for
"Increase in costs over the tendered prices due to increase in labour wages,
cost of POL and other materials are now fully accepted. Different
government organisations, however, adopted varying formulae and linked
them with the whole sale price.
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Index, Consumer Price Index, Cost of Petrol/Diesel etc. compiled
and published by the Government periodically. As the number of projects
financed by the World Bank increased, model tender documents based on
International Competitive Bidding (ICB) or Local Competitive Bidding
(LCB) procedures were compiled by the Government and suggested for
adoption in the various World Bank assisted projects in the country. The
World Bank lender documents provide for compensating contractors for
increases in the prices of materials, labour and POL over and above those
stipulated in base period. Separate provisions arc made for escalation in
foreign exchange and local components of costs. Freezing the rate of
exchange of foreign currency is also provided these days.
The operating overheads and profit margin of contractors as well as
the basic construction materials supplied by the client are excluded in
calculating escalation by applying a suitable factor in the escalation
formulae. Some contract documents exclude works of small value or of
shorter durations or a specified initial period from the application of
escalation clauses contained herein.
The international practice is mainly based on the conditions of
contract for works of civil engineering construction stipulated by the
Federation Internationale Des Ingenicurs Conseils (FIDIC). The fourth
edition of the FIDIC Conditions of Contract (1987) contains three
alternative provisions for dealing with escalation (price adjustment). In the
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first alternative, the contract being of short duration no price adjustment is
suggested. In the second alternative, price adjustment is suggested
establishing the difference in costs between the basic price and the current
prices of local labour and "specified In the third alternative, price
adjustments are the application of indices in a formula.
The issue that may be raised here is that though the principle of full
compensation for additional costs (compared to the base period) incurred
because of the increase in rates and prices of various inputs is accepted by
the client and the World Bank, incurred because of the intent of the
principle, and therefore, it needs to be reviewed. The following
specific instances may be noted in this regards
i. Only 75 percent of the work done is considered eligible for
escalation under the formula. The cost of “Overheads” at 15
per cent and “Profits” at 10 per cent is presumably taken as
ineligible. If overheads arc a cash cost in this industry, and
inflation erodes profits, could these be excluded from the
scope of escalation.
ii. The works contract grants various types of advances to
contractors. But the percentage component of the advances
(PA) taken is excluded for purpose of escalation in the
formula. As it is contrary to the intent of the provision of
granting advances; could this also be considered.
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iii. The cost of departmentally issued materials – cement steel
etc. is deducted from the value of work done. It is argued that
these material process and therefore may not be excluded for
calculating escalation on labour and fuel.
iv. The rate of escalation is calculated by linking it with the
Wholesale Price Index (WPI), the Consumer Price Index
(CPI) and the price of diesel only for POL. There is a
standing debate in the country that WPI and CPI do not truly
reflect the price variations in any specific industry including
the construction, its materials and wages of construction
labour.
Further, diesel price is no index of the variations in the price of
lubricants. Consequently, different and specially constructed indices
should be considered in order to reflect the situation more accurately in civil
works projects.
All these and related issues need detailed examination. Timely
completion of projects is the common goal of all those involved in the
construction process. Therefore, the relations between the parties should be
based on mutual confidence, trust, equals and equity. The problems arising in
the course of project execution could be settled through mutual discussions
and consensus. In any event, the costs of payment of escalation
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are much less than those suffered due to project delays and cost
overruns.
5.1 ESCALATION FORMULAE
The total cost of a civil works project, based on the rates quoted in the
accepted tender, comprises the following five components:
Materials and POL delivered at site.
Manpower employed for carrying out operations
necessary to comple te the con t rac t .
Operation of machinery, plant and tools
Contractor's overheads and supervision
Contractor's profits
Each component includes numerous items whose costs
may fluctuate over time. For computing escalation on a component, the
cos t var ia t ion of a l l o f i t s cons t i tuen t i t ems i s s tud ied ,
customari ly every quar ter . Whereas a few smal l volume or
old time contracts may still resort to a study of rate variations for
escalation, the trend everywhere is to follow the “Formula” approach
adopted by the World Bank assisted projects.
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The Formulae fo r ESCALATION
a. Materials VM = 0.75 x PM x R l (Mi - Mo)
100 Mo
b. Labour VL = 0.75 x PL x R1 (Li - Lo)
100 L0
c. POL VF = 0.75 x PF x R1 (Fi - Fo)
100 Fo
The main features of the above formulae are the following:
i. Only 75 percent of the total value of work done is eligible for
calculating escalation.
ii. The value of work done eligible for escalation is considered as
value of work done in the quarter minus the cost of materials
supplied by the client and consumed in the quarter , minus
proportionate advances from the value of work done during the
quarter (PA).
iii. The respective percentage for material (PM), Labour (PL) and
fuel and lubricants (PF) might vary depending upon the nature of
the work.
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iv. The stipulated index for materials (Mi, Mo) is the whole sale
price index for all commodities published by the reserve bank of
India.
v. The stipulated index for labour (Li, Lo) is the average consumer
price index for industrial workers in different industrial centres
as published by the labour bureau , Ministry of labour.
vi. The stipulated index for fuel and lubricants (Fi, Fo) is the retail
price of diesel at a specified retail outlet in the vicinity of the
project.
5.2 How to Use the Consumer Price Index for Escalation
The Consumer Price Index (CPI) measures the average change in the prices
paid for a market basket of goods and services. These items are purchased
for consumption by the two groups covered by the index: All Urban
Consumers (CPI-U) and Urban Wage Earners and Clerical Workers, (CPI-
W).
Escalation agreements often use the CPI—the most widely used measure of
price change—to adjust payments for changes in prices. The most
frequently used escalation applications are in private sector collective
bargaining agreements, rental contracts, insurance policies with automatic
inflation protection, and alimony and child support payments.
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The following are general guidelines to consider when developing an
escalation agreement using the CPI:
DEFINE clearly the base payment (rent, wage rate, alimony, child support,
or other value) that is subject to escalation.
IDENTIFY precisely which CPI index series will be used to escalate the
base payment. This should include: The population coverage (CPI-U or
CPI-W), area coverage (India City Average, West Region etc.), series title
(all items, rent of primary residence, etc.), and index base period (1982-
84=100).
SPECIFY a reference period from which changes in the CPI will be
measured. This is usually a single month (the CPI does not correspond to a
specific day or week of the month) or an annual average. There is about a 2-
week lag from the reference month to the date on which the index is
released (e.g., the CPI for May is released in mid-June).
STATE the frequency of adjustment. Adjustments are usually made at fixed
time intervals, such as quarterly, semiannually, or, most often, annually.
DETERMINE the formula for the adjustment calculation. Usually the
change in payments is directly proportional to the percent change in the CPI
index between two specified time periods. Consider whether to make an
allowance for a "cap" that places an upper limit to the increase in wages,
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rents, etc., or a "floor" that promises a minimum increase regardless of the
percent change (up or down) in the CPI.
PROVIDE a built-in method for handling situations that may arise because
of major CPI revisions or changes in the CPI index base period. The Bureau
always provides timely notification of upcoming revisions or changes in the
index base.
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6. CONCLUSION
This literature will help in understanding the Risk inherent in Contracts and
implementing robust contractual risk management process. By referring to
this literature and following logic of risk-analysis and Escalation
calculation, the Allocation of Risk in Construction contract has been
evaluated and implied. Any kind of risk arises from the contractual clauses
and claims has been enumerated. The escalation clause has been discussed
in detailed and the calculation of escalation on construction material has
been calculated with the help of Consumer Price Index. This is an overall
work related to Risk Analysis and Management in Contracts and Escalation
related with it.
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REFERENCES :
1. http://www.bls.gov/cpi/cpi1998d.htm
2.
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Contractor not entitled for any claim on account of variations in many a
case:
Eg: Clause 11.(a)-Probable distribution of various items of
internal/external services are indicated on drawings. These are tentative and
may be varied wherever necessary at the discretion of the Engineer-in-
Charge. The Contractor shall not be entitled for any claim on account of any
such variation.
(b)-Layout of the building indicated in the site plan is tentative. No
adjustment in price shall be done on account of final approved layout within
the site plan area.
Security Deposit- Government shall not be responsible for any loss of
securities or for any depreciation in the value of securities while in their
charge nor for loss of interest thereon.
Re-imbursement/refund on variation in price-Provided, however, no re-
imbursement shall be made if the increase is not more than 10% of the said
prices/wages and if so, the re-imbursements shall be made only on the
excess over 10% and provided further that any such increase shall not be
payable if such increase has become operative after the contract or extended
date of completion of the work in question.
Minimum Wages payable-The Contractor shall have no claim whatsoever,
if on account of local factors and/or regulations, he is required to pay the
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wages in excess of minimum wages as described above during the execution
of work.
According to the General Conditions speaking about the schedule of
payments, 1,50,000 or 1% of the remaining amount after the payment of
Advances on Account whichever is greater shall be held by the client as the
retention money.
The above are few clauses observed from the contract which provide no
claim for the Contractor on account of any variation in price.
No reimbursement on the variation pertaining to plant and machinery is
provided.
Reimbursement/Refund on variation in Prices of fuel:
EP= (KP X VG1) (F1-F0)
100 F0
Where,F1 = Wholesale Price Index for the sub group for fuel, power, light
and lubricants published by Economic Adviser to Government of India as
on the date of commencement of the period of reckoning.
This provision does not suffice the Contractor’s expenses on fuel since it is
based on WPI and does not take into consideration the local prices. This
may lead to client’s advantage during calculation of escalation.
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The Contractor keeping in view such factors as mentioned above tends to
quote a higher price to cover the contingencies and overheads and the
additional expenses for which he is not entitled for any compensation.
On the observing the General Summary of the Tender we find a vast
variation in the quoted prices of the client and the contractor wherein the
price quoted by the Contractor is on a very high side which may be due to
the effect of the one-sided nature of the Contractual clauses.
The Contract as a whole provides no provision of claim for the Contractor in
the event of any variation. Consequently the Contractor tends to quote a
very high price for the work keeping in view all the potential risks arising
due to variations hence leading the Client into heavy expenses.
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