This is the fifth post in our “Top 10 Construction Contract Provisions” series, which covers the topic is price and payment provisions. Although these are typically separate terms they are so closely related that we are counting them together in our “Top 10.” Together, they answer some of the most fundamental questions about the contract: What will be paid for the work, when, and how? Part I of this post will cover the different type of pricing arrangements. Part II of this post will cover the related topic of payment, including how and when payments are made toward the overall contract price.
Price Terms
In theory, a project owner and contractor are limited only by their own creativity in determining how and when the contractor will be compensated for its work. However, nearly all projects are priced under some variation or combination of a small number of models: lump sum, cost or cost-plus, and unit pricing. The discussion below is by no means exhaustive, but offers an overview of the function, benefits, and some key issues associated with each pricing method.
Lump Sum
Although it has yielded some ground to other pricing arrangements as alternative project delivery methods have gained traction in the market, the traditional “fixed price” or “lump sum” contract remains the go-to price arrangement for construction projects. In the ideal scenario, the parties agree on a lump sum price based on the contractor’s estimate to build the project based on a complete and detailed design that clearly defines the contractor’s scope of work. In this situation, a single dollar amount includes the contractor’s estimated cost of all labor, materials, subcontracts, general conditions, indirect costs/overhead, and profit.
Fixed pricing can also be used where the design is less than 100% complete, but the price is generally higher to reflect the uncertainty and increased risk to the contractor. While a fixed price can be used for a design-build or other alternative delivery project, it is less common for such projects because the high degree of uncertainty would entail premium pricing, and fixed pricing would undermine (or at least complicate) opportunities to promote and distribute cost savings, a primary purpose of these project delivery methods.
Fixed pricing shifts the majority of the financial risks and rewards in the construction process to the contractor. Efficient labor and management, low material and subcontract costs, reduced waste, and the like can increase the contractor’s profit margin, while the opposite reduces profit and can entail a financial loss to the contractor. The owner’s primary risk in this scenario lies in the quality, completeness, and finality of the project design. For more information on this risk, click here.
With fixed pricing, changes to the design after the contract is formed generally trigger adjustments to the price through change orders. Changes are the primary source of disputes on a fixed price project because the parties may not agree on the price to implement a change, whether a change has actually occurred, or who bore the risk of the change. While other pricing approaches do not eliminate these disputes, lump sum pricing can highlight the cost impact of each change in ways that can invite conflict earlier and more often.
Cost / Cost-Plus and Unit Price
In its pure form, a “cost” or “cost-plus” contract is one for which the owner reimburses the contractor for all costs incurred in connection with a project, plus an agreed markup – usually a percentage of the cost or a flat fee in addition to the cost. Under a “unit price” contract, the parties agree on pricing rates for relevant measures of work, e.g. per hour, per cubic yard, per linear foot, per item, etc. Under either arrangement, the contractor’s general conditions and overhead costs may be accounted for and paid as a distinct line item, or they may be built into the agreed markup or unit prices.
Cost-plus and unit price contracts are often used where there is insufficient time to agree on a fixed price, the project is subject to variability in the amount of time or materials required, the project is relatively small, or the owner is willing to take the risk of budget overruns in order to reap the reward of potential cost underruns. Cost-plus pricing can provide advantages where cost items are relatively simple to monitor and verify, or where the owner can help the contractor negotiate lower prices from subcontractors and vendors. Unit pricing may provide a better option if actual costs are difficult to document, but the relevant units of work are easily tracked. It is common for contracts to use unit pricing for some items and cost or cost-plus for others-for example, a Time and Materials (“T&M”) contract uses unit pricing for the time component and cost for the materials component.
Because the price paid by the owner depends on the work performed and costs actually incurred, cost-plus and unit price contracts often give the owner the right to audit the contractor’s records to verify the hours worked, wages paid, materials purchased, subcontract costs, and other relevant costs and quantities. When unit prices are involved, it can be beneficial to specify in the contract that the audit extends to information necessary to verify the quantities charged, but not the composition of the rate. Our general view is that the time to scrutinize what might be included in the rate is during contract negotiations (not the audit), and disputes can be avoided by clarifying and understanding this up front.
With a higher degree of risk and reward to the owner, cost-plus and unit price arrangements typically involve (and, in many cases, require) a heightened degree of owner involvement and management during construction. Increased owner participation helps verify the work is proceeding efficiently and costs remain in line with budgets and expectations. If not carefully managed by both the owner and contractor, however, cost-plus and unit price projects can allow overruns to accumulate more subtly until later in the project when value engineering, scope reduction, and other remedies are more difficult and costly to implement, and potential disputes are even larger and more intractable.
Guaranteed Maximum
A guaranteed maximum price contract (synonymous with “GMAX,” “GMP,” or “not-to-exceed”) uses cost-plus, unit price, or hybrid pricing, and places a cap on the aggregate amount the owner will pay. If the final price of the project is less than the guaranteed maximum price, the “savings” may be allocated to the contractor, the owner, or between them both.
GMAX pricing can provide either the best or worst of all worlds when compared to pure lump sum, cost-plus, or unit pricing. If the contract is clear and the project is carefully managed, a GMAX can provide motivation to save costs, maintain incentives to track and timely resolve significant changes to the scope of the project, and protect the owner from unexpected overruns. However, if both parties do not actively monitor and manage the contract, a GMAX can reduce the perceived urgency of the change order process, give the owner a false sense that scope changes will not impact the price, and create confusion in reconciling budgets to actual costs.
Issues can also arise with guaranteed maximum pricing if the contract does not specify clearly when and how the actual price will be reconciled against the GMAX, or how the contractor will bill for progress (e.g., will progress billings be based on estimated percentages of completion of a schedule of values, with cost substantiation and final price reconciliation at the end of the project, or will each invoice be based on costs to date with supporting cost substantiation?) Parties to a GMAX contract must also be clear about any special agreements, such as an agreement to use a “line item GMAX” approach in which a separate price cap is applicable to each line item in the schedule of values rather than the typical approach in which the GMAX caps only the total price, and the contractor may use savings on some work items to cover overages in others.
Contingencies
Construction contingencies warrant separate note here because they can significantly impact how a project is priced and paid. A “contingency” is an amount of money designated to cover uncertainties in the construction process. Contingency provisions are widely varied, depending on the particular features of a project, financing needs, and the desired allocation of risk. For example, a contingency fund may be part of the contract price or may be established outside the price. It may be controlled exclusively by the owner or contractor, or may require agreement before funds can be applied. It can be structured to encompass a broad range of potential risks and changes, or may be tailored to address one or more specific events.
A contingency provision can be a valuable tool to avoid conflict during a project because the parties have already negotiated and earmarked money to cover events that might otherwise require negotiation and resolution while work is underway. However, a contingency provision may also create or complicate disputes if the contract language is not clear and the parties cannot agree on whether an event falls within the contingency. Because contingencies can come in such varied forms and cover such a wide variety of project objectives, a contingency provision warrants particular attention during the contracting process and demands clear communication during the project.