Fixed prices, fluid risks: Managing costs in EPC contracts

Fixed prices, fluid risks:

Managing costs in EPC contracts

In engineering, procurement and construction (EPC) contracts, effective cost management is essential for delivering large-scale infrastructure and industrial projects on time and within budget. Cost risks are inherent and managing them requires a well-structured approach to contract drafting, risk allocation and project delivery mechanisms. Here are several key areas where stakeholders can better manage costs in EPC contracts:

1. Fixed price contracts

Fixed price contracts are widely used in EPC arrangements to provide principals with budget certainty. However, this shifts the risk of cost overruns to contractors. To mitigate their exposure, contractors typically include contingencies in their pricing – which may lead to inflated bids if risk is not carefully or clearly allocated – and negotiate exceptions that afford limited cost relief.

Well-defined scopes, risk registers and pre-tender site investigations can help manage this balance and avoid adversarial cost claims down the line.

2. Fully wrapped vs balance of plant

The contractor’s scope under an EPC contract significantly influences cost outcomes. In ‘fully wrapped’ contracts, the contractor assumes responsibility for all aspects of design, procurement, construction and commissioning. Conversely, under a ‘balance of plant’ model, the principal may retain responsibility for key equipment procurement.

Principals often prefer to procure key equipment themselves and free-issue such to contractors – especially where they have supply chain advantages, which are often driven by volume or relationships – to avoid margin that would otherwise be charged by contractors on these items. This can be a practical way to reduce total contract cost.

Naturally, contractors will often look to exclude (or at least limit) responsibility for defects and system underperformance to the extent these shortcomings are caused or contributed to by such free-issued equipment.

3. Variation regimes

A fair variation regime should provide the principal with visibility of cost changes while preserving the contractor’s ability to recover additional costs arising from genuine scope changes during delivery.

Principals often insist that contractors should only be paid for variations that are instructed by the principal pursuant to a written document titled a ‘variation order’, which may include a fixed price or variation-specific pricing mechanism for the variation that has been agreed by the parties. This is designed to give principals greater certainty as to what costs they’re up for and how their project budget and financial forecasts need to be revised. That’s all fine, provided principals understand that, in practice, if contractors believe they are being asked to undertake work outside their priced scope they may decide down tools and claim an extension of time until they receive such a document.

Sometimes variation orders may not include a fixed price or variation-specific pricing mechanism, in which case the cost of the variation will often be determined by reference to agreed rates (if any) specified in the contract and, in the absence of such relevant agreed rates, as actual cost incurred by the contractor plus an agreed margin for profits and overheads (if any) specified in the contract. Principals are more likely to go down this path when they believe the additional work and associated costs will not be material (or at least not be material when weighed against the profits that will be lost as a result of delays attributable to the contractor preparing a quote for, and the parties pre-agreeing, a fixed price or variation-specific pricing mechanism).

4. Site conditions risk

Unforeseen site conditions, often referred to as ‘latent conditions’ – such as rock, groundwater and contamination – are a common source of dispute and cost escalation. In our view, it is critical that the contract clearly allocate risk in this regard as this allows the parties to more clearly understand and price their exposure.

Principals often try to shift all site risks onto contractors, but this can lead to highly qualified and inflated bids, more extensive contract negotiation and delays to signing  and more (and bigger) claims down the track.

Contractors should only accept such risks if they are clearly priced (or adequately covered by contingency) and defined in the tender documents (such as geotechnical and soil reports and risk registers) or could reasonably be foreseen through reasonable site enquiries.

5. Time bars

Contracts often include strict time bars for claims, requiring contractors to notify principals about variations, site conditions and delays within very short timeframes. While these provisions may help principals to more regularly revise their project budget and financial forecasts and avoid an avalanche of claims towards the end of project delivery, they may conversely become a trap for contractors, particularly on jobs where communication lines are blurry or have not been formalised.

We recommend qualifying such provisions so that the contractor is not barred from legitimate claims except to the extent their failure to notify actually prejudices the principal – for example, by limiting their opportunity to mitigate the cost or delay.

6. Payment structures

This is one of the most overlooked areas of cost control. Even well-priced contracts can experience difficulties if payment structures are unrealistic or poorly aligned with actual progress and cost outflows.

Payment structures should reflect the sequencing of work and the cash needs of the contractor. For example, front-loaded procurement or early mobilisation will often need to be matched with milestone or advance payments. If the contractor is required to self-fund large portions of the project for extended periods, they may seek to pass on their financing costs, and contractor cash flow constraints may affect their productivity and the quality of their work.

Typical mechanisms include the following:

• Milestone payments – linked to completion of a milestone e.g. foundation works.

• Monthly progress payments – supported by verified progress reports or third-party certifications.

• Advance payments – to support early mobilisation or (often conditional on provision of suitable security) procurement.

• Retention money – as an alternative to bank guarantees, held to secure performance and often released in part on completion with the balance released upon expiry of the defect liability period (provided all notified defects have been rectified).

Clear and efficient payment processes in the contract should help to minimise payment delays. Ensuring healthy cash flow for the contractor benefits all parties – reducing the likelihood of claims, improving workforce morale and supporting timely project delivery.

Conclusion

Managing costs in EPC contracts is about far more than setting a fixed price. It requires thoughtful structuring of commercial arrangements, fair allocation of risk and attention to the realities of project delivery. From contractor scope and payment structures and to variation regimes and allocation of site risk, every aspect of the contract should be tailored to promote transparency, efficiency and cooperation. Principals and contractors will then be better placed to deliver projects on budget, avoid disputes and achieve long-term success.

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For tailored advice on managing costs in EPC contracts, reach out to our team.