In a perfect world, projects are completed on time and exactly according to specification. However, we don't live in a perfect world and not everything works out according to plan. To effectively manage this risk, sometimes within the contract a set amount (called "Liquidated Damages") is agreed upon to be paid for each day that the project is late or under-performing.
What are Liquidated Damages?
Liquidated Damages (LD) contractual clauses are beneficial in mitigating the uncertainty of damages incurred due to supplier's breach of the contract, such as the failure to meet the completion date or failure to reach a certain performance threshold. To demonstrate how LDs are calculated, let's outline this construction example:
ABC Rentals decides to build a 7-storey building containing 40 apartments for rental. ABC Rentals estimates that after completion this project could generate revenue of $42,000 per month (which works out to $10,500 per week or $1,500 per day).
ABC Rentals signs a contract with XYZ Construction to build the complex and deliver it on June 30, 2014. As the owner, ABC Rentals ideally wants the project completed on time and according to specification, however, in case it isn't ABC has calculated and set in the contract an amount of $1,500 per day as "Liquidated Damages" as a genuine pre-estimate of likely loss of revenue. In other words, if XYZ Construction delivers the building 10 days late, they will have to pay 10 X $1500 = $15,000 of LDs to ABC Rentals.
Further, XYZ Construction in turn can decide to place a Purchase Order to PQR Electrics for completing the electrical wiring of the building. XYZ might decide to include LDs of $300 per day in the PO to PQR to reduce any risk of delays from PQR. The LD amounts in that PO can be proportional to the ratio of the main contract (between ABC and XYZ) and the value of the PO (between XYZ and PQR).
The LD amount in the contract is to be a genuine pre-estimate of the actual damage or loss likely to be caused or incurred to the owner. It is intended to be a fair and reasonable compensation. It is not to act as a penalty fee or a fine charged to the contractor, nor a disproportionately excessive compensation.
Liquidated Damages are not just for delivery delays. They could also be assigned to specific "performance" related issues. For example ABC Rentals could include another clause in the contract imposing that the Solar Heating System for the outdoor swimming pool should be able to increase the average temperature of the pool by 5 degrees within 60 minutes. If during the final tests the 10-degree increase in temperature is achieved in more than 60 minutes, then XYZ Construction should pay to ABC Rentals one-time liquidated damages of $1000 for every additional 15 minutes. This will ensure that the XYZ Construction will not install a low efficiency heating system just to save money.
Quick Tips for Project Managers:
- Understand how the LD values have been calculated by your client (they don't usually come out of a hat). When placing LD figures into a contract, it is prudent on the client side to prepare a brief summary supporting the estimated values. This must be based on the estimated losses that will be triggered from contractor's breach of contract, and cannot be extravagant or unfounded.
- Review the LD clauses in detail. Some LD clauses are very complex especially if your project delivers several components to the client and each component has a different amount of LD attached to it. In some cases LD could even exclude each other so it's important that you (and your team) have a good understanding of the contract clauses. Breakdown the timeframes and expectations for each and every component clearly in Excel tables and worksheets, and calculate estimates for the LDs risks as your project progresses (based on delivery dates or any other criteria that is used for imposing the LDs). This will allow you to keep up-to-date assessments of where you stand and the risks involved as each component of the project becomes completed.
- Include LD Clauses in your contract to your suppliers to protect yourself against their delays. That's called "Risk Transfer" (refer to the PMBOK Guide in Chapter 11). This will assist you in mitigating any unforeseen setbacks and delays that are forced on you by your suppliers, thus making it difficult for you to deliver and meet your contractual obligations to your clients.
- Document and communicate. Make sure you have clear, concise and regular communication with your client about the estimated LDs. You should also closely document and maintain careful records of the events and situations that caused your organization to be in breach of the contract specially if some events were not under your control (such as Force Majeure events, delays due to your client or your client's other sub-contractors). Good communication during the project is essential for minimizing Liquidated Damages at the end.
- Negotiate and settle your LDs as part of a global negotiation with your client towards the end of the project. This is the best way to minimize the due amounts. In calculating a reasonable sum for the damages associated with the delays, all the facets of the project affected should be carefully assessed and determined by differentiating the apportioned stages of work completed.
Finally, a couple of suggestions that you can convey to your sales teams:
-- Before signing the contract do try to include Bonus clauses in there, specially if you realize that early delivery or higher than expected performance means savings or additional revenue for your client. Many large energy projects include such Bonus clauses (mirroring the LDs) because if the unit is delivered earlier than expected or if the generating unit is more efficient than model test predictions, well.. it would mean more revenue for the owner in the long run!
-- LDs should be capped within the contract, for example to maximum 10% of the contract value.
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