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This article has been written by Khushboo Naik, pursuing a Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from LawSikho. This article has been edited by Ruchika Mohapatra (Associate, Lawsikho). 

Introduction

An incentive contract is a contract between two parties in which one party promises to accord a supplementary remuneration to another party on excellent accomplishments. The owner is obligated to make an additional compensation to a contractor based on the contractor’s execution, performance, delivery on or before schedule, maintenance of quality, and safety according to the contract terms and conditions. And these incentives are supplementary to the settled amount offered by the executing party. Generally, such contracts are in favour of the contractor and are primarily used in construction projects where there are two parties, the contractor (performing party) and the client or buyer. Besides this, incentives have their pros and cons, depending on contractual terms and the contractor’s performance. Additionally, these contracts have positive incentives for excellent outcomes and negative incentives for undesirable outcomes. 

Elucidation of incentive contract

Each incentive contract varies from other incentive contracts. Thus, these contracts are not merit-based rather they are customised. And each contract varies in its incentive assembly, occasion, and measures. Besides, the disparity depends upon the kind of contract made and the work included. Here, the contractors and the clients negotiate and decide on the terms as per the necessities of the contract. The contractor generally stays persuasive and assertive in meeting those constituent necessities. Every so often, the duo determines to aim for profit and costs in advance as part of this contract. 

Three basic directives of incentive contract

  • The first directive is to administer incentives to the outcomes, productions, or cost of projects. And the incentives should be uncomplicated to carry on and compute and should circumvent subjectiveness to the level viable and possible.
  • The second directive is that the costs and advantages of the project should be at the stage where incentives are dispensed, and the incentives should elucidate the costs and advantages of the project for both parties.
  • The third directive is that it is obligatory to generate a legitimate contract comprising all the contractual elements. Therefore, documentation on incentives should be required.

Types of incentive contracts

There are two essential types of incentive contracts. They are as follows:

Fixed-price incentive contract

Within the fixed price incentive contract, the contractor predicts the complete costs of the project and sets forth the estimation. Then the client will choose the inexpensive estimation from all bids. Lastly, the contractor and the client discuss the price cap of the contract and estimate the ultimate costs. Such lastly discussed costs should involve all sorts of costs linked to the project, that is labour costs, material costs, and fix costs. Consequently, if the original project costs are lower than the final costs, the contractor gets a profit. On the same point, the contractor makes a loss if the original cost of the project is more than the final cost.

Cost reimbursement contract

Contrary to the fixed-price incentive contract, the type and extent of the project under the compensation agreement are not certain. Therefore, it is not feasible to correctly anticipate the total cost of the project under the cost-reimbursement contract. Hence, it is a contract in which the customer promises to pay the whole cost of the project and to offer the contractor an extra incentive when the project is done.

 

Advantages of incentive contracts

It gives additional ownership above the work being finalised

When there is an incentive to receive additional work that meets certain specifications, there is additional ownership by the contractor over the end result. They get to be in control of the final outcome, deciding if the incentive is worth the effort to meet a certain time limit.

It incentivises reorganisation

Incentives uplift contractors to be reorganized in their perspective towards projects at a discrete level. Rather than producing  similar kinds of outcomes in a project after project, incentives uplift originality in the perspective by awarding those who are proficient to exceed presumption. 

It boosts finer lines of communication in the course of the project

When incentives are in progress, contractors and owners tend to communicate with one another. Both parties have benefits to be accrued here. Owners often get updates about their project, which initiates overall responsibility for the work being done. 

It uplifts skill-based workforce assignments

When duration or standards are not part of the contract negotiation procedure, it is more probable that untrained workers will be given certain tasks for the project. When you incentivize essential elements of a project, there is an incentive for contractors to put their best people into the vital skill-based assignments. 

It permits better administration and supervision of projects

Many contracts are uncomplicated propositions. Do a certain job, then obtain a certain payment in the end. As incentives need confirmation to be paid, there is a need for an excuse for management or owners to have more supervision on the work being done. This generates responsibility within the relationship for both parties, giving a collective guarantee of advantage. 

Advancement of greater levels of personal discipline

Incentive contracts also advances an approach that tends to be stricter. Contractors utilise the details accessible to them to work related to the incentives they desire. Owners use the control structure in place to direct the relationship in a way that contractors consider it as support rather than as being administered through all the procedures. 

Affirmative or pessimistic incentives to be incorporated

When negotiating an incentive contract, the pivoting point is frequently placed on the affirmative incentives which are recommended to the contractor. Owners or managers have the chance to have affirmative incentives incorporated for them as well to secure themselves against pessimistic results produced by the contractor. 

Permitting non-economic awards to be rendered as an incentive

Though cash is of prime priority when negotiating an incentive contract, there are non-monetary items that can be given out as awards for a job done excellently as well. One of the most distinctive choices in this class is the award of a U.S. savings bond. 

Disadvantages of incentive contracts

Generating extra managerial money for owners 

As there is extra supervising accountability included on grounds of incentive contract, there are higher administrative costs that must be predicted by the one who owns or manages. 

Requirement of additional negotiation time

As the incentives are an additional part of the contract, owners and contractors must be involved in additional negotiations to discuss what the final incentives will be. There are many types of incentive contracts that may be recommended, from mechanical incentive methods to sliding scale percentages to fixed-cost bonuses.

It can change the preference of the contract

If incentives are added within a contract, then it may change the preference of the project being contracted out. Rather than concentrating on the important component of the project and the price included, the observation is put on the bonuses that are recommended when certain  conditions are met. 

Enhancement of the possibility of a clash occurring 

If you have a fundamental contract that administers the work being finalised, then you have one fundamental place where a clash may happen. For that purpose, the terms and conditions of the contract must be defined absolutely, to the reciprocal contentment of both parties, to make certain a standard delivery. 

It can be strenuous to examine what an honest incentive plan takes place

If managers or an owner  group is not familiar with the work that is necessary to be finalized, then a contractor can take advantage of their dearth of experience to set up very high incentives which  would result in the cost of the project being unnecessarily high. The contrary is also true. 

It does not furnish a one-size-fits-all solution

Each project is different which means every incentive alternative must also be different. There are no incentive contracts that will be globally suitable. Despite similar managers and contractors being incorporated in numerous projects, each project must have its own set of incentives negotiated for it. 

It may not be needed every time

Incentive contracts are excellent when there are certain results which owners or managers desire to put forward in a specific amount of time. If these components are not there within a project, then the costs of the incentives may add to the merit that they in effect offer to the project.

Conclusion

In spite of the many disadvantages of the incentive contract, it is one of the most favoured construction contracts. It uplifts the optimisation of the contractor by dispensing affirmative incentives for production. It grants the contractor the possibility to make  more profit on this kind of contract. Incentive contracts give rise to modernisation in the industry and that results in development. This contract takes complete benefit of assets by evading squander. As a consequence of all these elements, incentive contracts mainly get priority from clients and contractors. The client is also certain that the scope of surplus is at a rational level and he can corroborate all costs and relinquish what is not rational.

References

  1. https://www.theprojectdefinition.com/incentivecontract/#:~:text=An%20Incentive%20Contract%20is%20one,the%20contract%20terms%20and%20conditions.
  2. https://scholar.harvard.edu/files/weitzman/files/efficientincentivecontracts.pdf 

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