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Turnkey contracts

Turnkey contracts : what you need to know

May 15, 2022

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This article is written by Vihanka Narasimhan, currently studying law at Jindal Global Law School, O.P. Jindal University. This article attempts to explain the concept of turnkey contracts with an aim to throw some light on the components of such a contract, its types, advantages and disadvantages.

This article has been published by Sneha Mahawar.

Table of Contents

Introduction

The Oxford Dictionary defines the term ‘turnkey’ as a thing that is ‘complete and ready to use immediately’. Just as stated, when this term is applied in the context of project development, a turnkey contract can be perceived as a project which is designed, developed and equipped with all facilities by one company to another as specified under the contract. The term “turnkey” is based on the concept of only needing to turn the key to unlock the doors to begin operations. To be fully considered a turnkey solution, the business must function correctly and at full capacity from the moment when it is initially received. Basically, a turnkey contract is a contract in which a company is given full responsibility to plan and build something that the client must be able to use as soon as it is finished without needing to do any further work on it themselves. Further, the contents of such a contract contain clauses that deal with the cost, estimated time to complete, breach policy, etc. The seller in a turnkey contract is responsible for the design, fabrication, installation, aftermarket support and technical service for the project which they receive. This type of contract is most often confused with design and build contracts. In order to ensure proper execution of such a contract let us understand the concept in detail.

What is a turnkey contract

According to the free dictionary by Farlex, a turnkey contract has been defined as “A contract in which an independent agent undertakes to furnish for a fixed price, all materials and labour, and to do all the work needed to complete a project”. In a nutshell, one can say that a turnkey contract is simply an agreement that takes place between a builder and business wherein the builder agrees to complete a project which is in turn readily available to use for the company. It seems that the term ‘turnkey’ has originated from the oil and gas industries in the United States and gradually got imparted in international trade.

The idea behind getting into a turnkey contract is for the contractor to do jobs in relation to engineering, procurement and construction after which the required works once deemed ready for operations are handed over to the buyer so that business operations starts. To put it bluntly, a contract whereby the contractor provides whatever is necessary for a certain purpose can be construed as turnkey. These are sometimes also referred to as ‘Lump Sum Turnkey’ or ‘LSTK’ which gives out the apparent bargaining nature of the parties, with responsibilities delegated to the contractor to deliver the project on time and at an acceptable performance level in return for payment of a fixed price. A lump-sum turnkey price will include contingency allowances to hedge against the risk of things costing more or taking longer to deliver and the owners expect to pay a premium for a turnkey contract.

In such contracts, the responsibility of a contractor is limited to the point the project is in the process of being fully equipped and operational. Turnkey contracts are highly specialised in nature. In general, there are three types of businesses that partake in such projects. They deal in the manufacturing of engineering equipment, construction and consulting. A simple example of a turnkey contract can be undertaking activities such as building ventures such as the construction of airports, office buildings, malls, skyscrapers, etc. The parties involved in a turnkey contract work in accordance with the terms and conditions agreed upon between both the parties. There are three types of enterprises that take part in turnkey business activities. They are as listed below:-

Manufacturers of engineering equipment;
Construction companies; and
Consulting firms.

Basic elements of a turnkey contract

Turnkey contracts basically have three major elements. They are as follows: –

Design

The first and most important aspect of a turnkey contract is the design of the project. It is the duty of the project manager of such a contract to work on the detailed design. It is, however, crucial to note that such a contract can only be made with reverence to the design established or agreed upon by both the parties in the preliminary contract and does not exceed its scope.

Technology

This element of the contract is seen in action after the design of the contract has been laid out in the form of patents, know-how, etc. This element deals with the completed project. In some cases, provisions have already been laid down in the preliminary contracts as per the request of the buyer which allows the project manager to use the buyer’s own technology without any formalities or difficulties.

Supplies and construction

One of the major parts of the completion of a project is supplies, construction and erection are done in keeping to the project which will fulfil the buyer’s end goals. In order to do this, the buyer may have the project manager acquire materials required from a specified sub-contractor or limit the choice of materials. This is a common practice in such contracts as it ensures the employer that the quality is up to the mark and also allows the buyer to negotiate the prices directly of the material required.

Process of fulfilling a turnkey contract

Step 1: Defining the project

This is the preliminary stage of the formation of a turnkey contract. In this stage, the project manager usually focuses on the needs of the buyer and on its basis, creates a plan of action. This evaluation leads to the revelation of a few challenges and a project design in accordance with the requirements. This phase can also be called the conceptual design phase as the feasibility of all aspects of the project are considered to fulfil the needs of the buyer.

Step 2: Focusing on the design

The second phase is concerned with the actual design of the project. This is also known as the proposal stage. The design of the project is concerned with the details regarding the scope of work, development specifications, delivery, documentation, determination of vendors and suppliers etc. Basically, in this stage, the terms and conditions from both the buyer and the project manager marks the beginning of a turnkey contract.

Step 3: Construction and erection

After all the preparation has been made, the implementation process of the project takes place. The project manager finalises the manufacturing and application processes and also conducts the final testing for the smooth functioning of the project. This step is important as it revisits the problems encountered in the first place and ensures that a solution is delivered to it.

Step 4: Delivery of the project

The final phase of the project is making its delivery. Once the project manager is sure that all the production processes are satisfactory and fulfil the needs, the project is deemed to be completed. After this step, the liability of the project passes on from the project manager to the buyer.

Obligations of both the parties involved in a turnkey contract

In a turnkey contract, there are many obligations which have to be fulfilled by each party involved. There are mainly two parties: The buyer (the one who is seeking a project to be done) and the project manager (the one who is doing the project). They have been discussed below: –

Obligations of the buyer:

Granting access to the project manager to the site where the project is to be completed.
Assisting the project manager with obtaining licences and permits.
Ensuring proper payment has been made in accordance with the contract.

Obligations of the project manager

Obtaining the necessary permits and licences required to complete the project.
Making a plan with regard to the design of the project.
Providing the buyer with the required operation and maintenance manuals.
Providing the buyer remedy to the problems faced in accordance with the contract.

Important clauses in a turnkey contract

Project design

There should be a clause in the contract with regard to the product design. The key responsibility of the project manager is to ensure that the layout or the design of the project is taken into consideration so as to meet performance guarantees. The design should be complete, adequate and sufficient. It is important to take note that the main objective of the project design is to determine whether the construction has taken place in accordance with the initial plan irrespective of the quality and performance of the final product.

Place of construction

There should be a clause in the contract with regards to the construction site. It includes the location, access, availability of resources at the agreed site, etc. These aspects are often things which come under the purview of the buyer. However, it is essential that the project manager specifies his requirements regarding these things. The main point of discussing this aspect is that it prevents conflict between both parties.

Duration for completion

There should be a clause in the contract with regards to the time it will take to complete such a project. It includes the competition date, installation periods at various stages, etc. This ensures that the buyer gets his project on time and further, the buyer’s own production programme and the coordination of the contract by the project manager so it may require strict devotion towards completion of time.

Price and payments

There should be a clause in the contract with regards to the price and payments. In general, turnkey contracts are done in a lump sum which contains a list of unit prices that serve for the valuation purposes and also as a measure that determines the progress of the project. The basis of milestones of the project can be determined by payments made on dates of placing orders to suppliers, achievement of certain stages in the process of manufacturing, packing of equipment, shipment, arrival at the site, etc.

Performance guarantees

There should be a clause in the contract with regards to the project manager’s obligations to meet his promises made in the preliminary stages of the project. Failure in obligations which include defects in approved design and variations in the specifications ordered by the buyer can lead to consequences. Generally, the performance guarantees of a clause agreed upon by the project manager are on the basis of certain assumptions regarding the quality of raw materials or operating conditions such as climatic conditions, availability and regularity of supplies, etc.

Governing law

There should be a clause in the contract with regards to the law governing the contract. The law helps in determining elements of contract law such as contractual rights and obligations of the parties, the interpretation of the contract and subject to some reservations, its formation and validity. Apart from these basic laws, turnkey contracts can deal with intellectual property rights and monetary transactions which in case of disputes may need resolution usually possible through arbitration and mediation methods. The laws applicable to such dispute settlement procedures can take place in different countries often involving different countries with different laws. It is hence crucial to determine the rules regarding this aspect.

Advantages of a turnkey contract

Price evaluation

One of the major perks of getting into a turnkey contract is that there is a possibility to accurately calculate the value of the cost of the finished product. This further helps in analysing the Return on Interest (ROI) by the buyer. It diminishes the scope of uncertainty as observed in the case of traditional methods which determine the cost only after the bid of the design.

Fixed timeline

The seller assures the buyer a specified timeframe within which the project will be completed. This in turn guarantees the buyer of the time it will take to receive the project and make decisions on further business decisions relating to it.

Judicial use of resources

When a buyer enters into a turnkey contract, there is optimal use of the business resources. This can be said in the sense that the buyer is able to divert his costs efficiently in a space without disrupting the internal balance of the business.

Transfer of risk

Turnkey contracts are entered into to reduce the risk on the buyer’s part. Conveniently, the risk associated with construction and completion from scratch transfers from the buyer to the project manager till the period the project has been completed. This implies that the buyer does not have to worry about the contingencies may be caused during this period. The project manager is held responsible for the schedule, cost, and performance of the project.

Disadvantages of a turnkey contract

Even though there are a couple of advantages of turnkey contracts. They also have a few disadvantages which are along the following lines: –

Defining the scope of the project

In a turnkey contract, it is crucial that the scope of the project is strongly defined before making the designs for the project. This means that in cases where something has been missing in the initial stages, it is very hard to include it in the processes after the scope has been defined. In order to successfully complete the project, changes should not be made when construction, procurement, and planning activities have already commenced.

Based on trust

This contract is fiduciary in nature. This implies that there should be trust between the buyer and the project manager. In order to successfully complete the project, it is crucial that the goals of both parties align with each other with regard to budget, engineering and construction, etc.

Possibility of incurring higher costs

Even though turnkey contracts have a clause which specifies the cost prior to the design, construction and installation phase, the amount only serves as an estimate. This implies that there may be a change in price, usually higher than the estimated value due to unpredictable changes in budget requirements, inflation, government laws, labour, etc. This in turn can lower the ROI of the buyer which was calculated at the beginning of the project.

Difference between an engineering, procurement, construction contract and a turnkey Contract

Basis	Engineering, Procurement and Construction contract	Turnkey Contract
Meaning	An engineering, procurement and construction contract is a type of construction contract between parties where the contractor is responsible for all the engineering, procurement, and construction activities. It is a type of turnkey contract.	A turnkey contract is one under which the contractor is responsible for both the design and construction of a facility.
Scope	It has a limited scope as it only deals with engineering, procurement, and construction.	It has a wider scope as it deals with various things in a project from the beginning to the end.
Role of contractor	The responsibility of undertaking commissioning and start-up lies with a third party.	The contractor is responsible from start to finish that is from performing construction work, commissioning, start-up and taking over of the plant to the employer.
Risk	The onus does not lie on the contractor.	The onus lies on the contractor.
Guidelines	Specific guidelines are followed by the contractor.	General guidelines are followed by the contractor.

Conclusion

Turnkey contracts can be regarded as a useful tool for businesses looking forward to expanding their operation without using any additional resources. Turnkey contracts are generally suitable for such businesses which want to concentrate on their core operations or which cannot afford to invest in resources for development and construction saving time, money and effort. This type of contract should be made with the aim to have a clear understanding of the project which has been given by the buyer to the project manager. In conclusion, one can say that a turnkey contract is basically the equilibrium of the rights and obligations between the employer and the contractor which serves to buffer risks.

References

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