chen y, peng f&sun l

8/13/2019 Chen Y, Peng F&Sun L

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Analysis of cost issues for Project Management Contracts:

a new management mode for engineering projects

Chen Yongqiangi Associated Professor, School of Management, Tianjin University

Peng Fei

ii

Senior Engineer, SINOPEC Engineering IncorporationSun Libo

iii Graduate, School of Management, Tianjin University

Abstract

This paper begins with the introduction of background and basic concepts of Project

Management Contract (PMC), a new management mode for engineering projects in the

industry of international engineering project. It analyzes the contract form and the cost

composition of the PMC under the typical mode; and then analyzes respective components of

the cost of PMC and the issue of fee setting and categorising. The paper also focuses on the

key issue of how the owner should establish an incentive program and then proposes a typical

mode of incentive program. With the analysis of the composition of the PMC cost, it finally

addresses the advantage of PMC over other project management codes, namely the win-win

between the owner and the Project Management Contractor.

Keywords: Project management; Project Management Contract (PMC); Project Management

Contractor; Cost; Incentive.

Nowadays, engineering projects are increasingly becoming large and complicated.

Generally, owners project management organizations of large projects provide at a time many

high-quality management personnel with various disciplines. While most contractors have no

management measure and system capacity for life cycle management of large projects. Project

Management Contracts, a new management mode for engineering projects, have gradually

gained popularity in owners of super-large project. It has been proved by practice that the larger

the investment on a project, the more complicated the project, and the weaker the owners

ability for asset guarantee, it is more necessary to use PMC for management. To maximize the

benefit from this mode, there exists an issue worthy of further study: the composition of the

PMC contract cost, especially the PMC incentive mechanism.

1. Definition of PMC and project stages

Project Management Contract (PMC): After the feasibility study of the project, the owner

will not select design company and construction company or a general contractor as traditional

modes require. Instead, the owner will first select (via tendering) a experienced engineering

company or consultant company for the all-round life cycle project management. Under thismode, the owner just needs a few management personnel for decision making of key issues

during the execution. Almost all the project management is left to the Project Management

Contractor. The organization undertaking the project management for the owner is called the

Project Management Contractor.

The Project Management Contractor can be defined as an organization that is responsible

for the project management of the engineering, procurement, construction and commissioning


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of the project. The organization, responsible for both the management of other contractors and

itself, must have the various comprehensive capabilities for the completion of the project. On

behalf of the owner, Project Management Contractor assists the owner in the whole execution

(including early stage conception, project definition, project planning, and determination of

financing plan, engineering, procurement, construction and commissioning) for effective control

of quality, schedule and cost, successful execution, and optimization of technical &economicindicators in the life cycle of the project. Generally, the Project Management Contractor does

not participate in detailed work such as engineering, procurement, construction, or

commissioning. However, the owner may sometimes delegate some specific design work to the

Project Management Contractor, dependent on the work scope of the contract between the

owner and the Project Management Contractor.

Under the mode of PMC, a project is divided into two stages, namely the early stage (also

called definition stage, FEL or FEED) and the execution stage (including EP (Engineering

&Procurement) stage, C (Construction) stage, commissioning and project close-out stage).

Cost and incentive issues of PMC discussed in this paper cover both stages.

2. PMC contract form and cost composition of PMC

Project Management Contracts signed by the owner and Project Management Contractor

vary a lot in form. This paper discusses the form of cost+fee+incentive or penalty. The

following part will discuss and analyze the three components of PMC contract: cost, fee,

incentive or penalty.

The PMC cost is primarily manhour cost, which is the hours multiplied by a manhour rate.

Different rates apply to different level of personnel. The rate consists of many items, which

could be categorised as fixed rate and variable rate.

Fixed rates consist of the following:

1 Salary.

2 Payroll burden: includes (1) payroll taxes and payroll related insurance; (2)

non-productive time, including vacation, sick leave, military leave, bonus and the

like.

3 Overhead: includes management personnel salary, payroll burden and travel cost

apportion, retirement allowance, training cost for new recruit and staff, project team

development &entertainment cost, depreciation and maintenance of some fixed

assets, market development cost, standard specification &technologydevelopment cost, social tax, Labor Union operation cost, advertising cost,

consulting cost, and auditing costs.

4Office cost: includes office space and furniture, local communications, LAN and

WAN activities, personal computers and normal office software, provision of

telephones, office maintenance, security and janitorial services.

The above four items make up the fixed manhour rate. The former two items vary


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according to the category of staff; while the latter two items are the same for all personnel.

Variable rates consist of the following:

1 CAD cost: the level of usage of CAD varies in different design phases. CAD costs

are based on manhour to calculate and control CAD rate.

2 Reproduction and printing cost: includes printing and reproduction cost of

documents, drawings and project materials.

3 Communication cost: includes cost of international and long distance

communication, fax, mail and express service and other forms of communication.

4 Travel cost: includes domestic and international business travel cost.

5 Assignment allowance: assignment allowance applies to personnel assigned to a

foreign country, to domestic contractors office and site. Assignment allowance

plus travel cost make the total cost of air, bus, sea travel cost, accommodation,

local transport cost and other cost.

6 Personal income tax.

The above fixed rates and variable rates make up the manhour rates. Both the manhour

rate and the hours are the owners concern. Therefore, manhour rates should be one of the key

issues discussed in the commercial negotiation between the owner and Project Management

Contractor.

3. Contract fee of PMC

Contract fee of PMC generally includes two parts: the fixed fee and fee at risk. The total

amount of the two parts is fixed.

Fixed fee relates to the milestones formulated in the PMC. Project Management

Contractor will be paid the corresponding fee after successfully completing these milestones.

Fee at risk relates to the project milestones formulated in the PMC. Each target is set as a

percentage with specific testing criteria. Such as HSE 20%, project execution 20%, quality and

human resource input 20%, sustainable development 10%, equipment performance test 5%,

ECA 5%. Evaluation of this criteria will be carried out in accordance with these milestons as the

project closes out. The Project Management Contractor can only be paid fee of this kind after

the criteria has been achieved. The Project Management Contractor must achieve all his

milestones in accordance with the contract requirements before the fee will be paid.

4. Incentive program in PMC contract

To encourage creativity of Project Management Contractors work and reduction of

investment on project, items of incentive or penalty, namely the incentive program, will usually

be embodied in the Project Management Contract.


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Before the end of the definition stage of the project, the owner, together with the Project

Management Contractor, will agree on a target budget or agreed budget. If the Project

Management Contractor, while ensuring the quality, safety and schedule, managed to keep the

investment within the approved target budget, he will get an incentive of an agreed percentage,

if this is not achieved penalties will be incurred.

Assume the target budget determined by the owner and the Project Management

Contractor is A, and the actual investment at the end of the project is B;

If B=A, then the Project Management Contractor can get basic incentive T;

If BA, then the Project Management Contractor will take on the penalty of (B-A) xP2(P2 is

the penalty percentage for exceeding as stipulated in the contract). In view of the fact that the

PMC is a service contract, the total amount of the penalty will also be limited.

Half of the incentive will be paid by the owner unconditionally, while the other half will be

linked to related risks. For instance, progress completed represents 20%, plant performance

test passed represents 25%, and plant final acceptance 5%.

The incentive program covers both the definition stage and the execution stage of the

project. The owner has provided an incentive program for the definition stage and for the

execution stage at the tendering of the Project Management Contractor. Details of the incentive

program for the execution stage will be completed at definition stage. Before the execution

stage, the amount of fixed incentive will be determined. The amount of incentive that is related

to investment will be determined after the final project cost budget has been fixed.

The cost at definition stage and at execution stage, namely the manhour cost and other

related cost input by the Project Management Contractor, will be reimbursed by the owner.

Generally, the final investment decision will be carried out between the two stages to decide

whether to continue the project or not. If the owner decides to cancel the project at the end of

the definition stage, the Project Management Contractor will be paid the total cost of the

definition stage and all associated fees. If the project progresses to the execution stage, the

owner will only pay the total cost of the definition stage and the fee that corresponds to achieved

milestones, the part of fee related to risk will be paid at the end of the project in accordance with

contractual requirements.

5. Conclusion

PMC varies in type. Different forms apply different risks on Project Management

Contractor. The type discussed in this paper is a risk type, which will realize the true meaning of

PMC. However, PMC can be individualized according to the requirements of various owners

and projects. That is to say, the cost composition and incentive program can be adjusted as

applicable. Under the mode discussed in this paper, there still exists a key issue: how the owner

and the Project Management Contractor will agree on the target budget before the end of the

definition stage. It is really a issue that this paper does not address.


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It is critical to formulate an incentive structure that is acceptable to both parties after

identifying all the costs associated with a PMC. The objective of the incentive structure is to be

beneficial to both parties. With the incentive program, the Project Management Contractor will

get fee and incentive through its excellent performance relating to cost and schedule of the

project, plant performance and operability. The objectives of both the owner and the Project

Management Contractor will be satisfied via the incentive program. Under this program, boththe owner and the Project Management Contractor will share both the risks and the benefits. It

is a structure that benefits both the owner and the Project Management Contractor, that base

the profit of the Project Management Contractor on the success of the owner, and that realizes

a win-win situation between the owner and the Project Management Contractor.

Reference

1. Wang Zizong. Project management mode of PMC [J]. Petroleum & Petrochemical Today.

2002,(10): 31-33.

2. T. C. Berends. Cost plus incentive fee contracting experiences and structuring [J].

International Journal of Project Management. 2000. (18): 165-171.

3. Rosenfeld Y, Geltner D. Cost-plus and incentive contracting: some false benefits and

inherent drawbacks[J]. Construction Management and Economics. 1991,(9): 481-492.

Author:

Mr. Chen Yongqiang, MCIOB, is associate professor in School of Management, Tianjin

University, P. R. China. He specializes in construction management and has been involved in

construction projects as construction management consultant both in China and abroad. He is

currently involved in a IT project for the Olympic Games Beijing 2008. He has published many

papers in academic journals and presented papers at international conferences. His research

interests cover construction procurement, IT in construction and construction contract

management.

Cell phone: 13602106508. E-Mail:[email protected]

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