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Is lump-sum contract suitable in real estate ?

HIGHLIGHTS

Lump-sum Turnkey (LSTK) contracts are less prevalent in the real estate sector while it is more common in other sectors like infrastructure, industrial and oil & gas. In the Infrastructure sector in India also, there are many instances of EPC/Lump sum contracts. In the real estate sector, as per our experience, item rate contracts are used more often, but Lump Sum contracts are not unheard of.
In a lump sum contract, the contractor bids a single fixed price for all items of work covered in the project scope. The owner expects the contractor to do all that it takes to deliver the ‘project’ to the owner to the required scope and specifications. The contractor bears most of the technical and commercial risks associated with this contract and is responsible for estimating project costs from the drawings or specifications including his overheads and profit to determine the price of the project.

Let us see what the advantages and disadvantages of the Lump Sum contract from the perspective of the owner are.

Advantages:

  • There are limited reasons for any cost overrun and the same may be primarily due to changes called for by the Owner.
  • Since the contractor has accepted a fixed price for the construction, the Owner is assured of project completion within budget.
  • Bid analysis and selection of a contractor is relatively easy.
  • It is much easier to administer measurement and payments in a Lump sum contract.
  • The payments are made stage-wise based on the progress achieved.

Disadvantages:

  • Since the contractors have to share greater risks the bid prices may be higher as the contractors may factor all the foreseeable risks in the bid price.
  • The Lump Sum contracts are not amenable to changes. Such contracts demand documentation and record-keeping of change orders at all stages that further requires more paperwork.
    The entire scope related to detailed engineering needs to be completed well before the beginning of the bidding process. This is rarely the case in the real estate business as of now!
  • Since the contract is based on a fixed price, the contractor may use sub-standard means, methods, and products. In such a case, the Owner should provide detailed specifications of all works and materials involved, at the bidding stage only.
  • To facilitate progress payments, the lump sum price is generally divided under various stages or items of work. The contractor may submit an unbalanced bid by allocating higher prices on such items required early in the construction and reducing the price of items of works that are to be executed at later stages. In case of contract termination owing to poor performance, such an unbalanced bid may lead to disputes.
  • It is very difficult to change scope, specifications, or quantities as there can be disagreement between the Owner and contractor on adjustment of price on account of any change.

In the real estate business, change is one of the rare constants! Changes may be caused by changes in Development Control rules, value engineering, request from end-user or an improvement considered necessary by the owner. This coupled with the fact that complete design engineering is rarely completed at the time of awarding the contracts, the Lump Sum type of contract is not considered suitable. This is perhaps the reason why the Lump Sum contracts are not much in vogue in real estate. 

We will be surprised if this type of contract becomes the norm in the near future!

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