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Construction Law Today

Construction Contracts: The 10 Most Important Terms – Price

Posted in Top 10 Construction Contract Terms

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No. 2: Price

Price is No. 2 on the list of ten most important construction contract terms. Sometimes you’ll see the price called the "contract price" or the "contract sum." To keep it simple today, we’ll just keep it as the "price." The price makes it to No. 2 because it’s another of those few things you must have in a construction contract: one side (a prime contractor, subcontractor, sub-subcontractor, etc.) provides the Work (the "working side") in exchange for the other side paying the price (the "paying side"). There’s three common ways to price construction work and many issues that affect each. Today we’ll talk about each of the three types of pricing and introduce some of the important issues affecting each. At the end we’ll also talk about Schedules of Value, an important price breakdown device that helps you keep track of how, when, and where the price is spent as the Work progresses.

Lump Sum Price

The lump sum is the simplest and easiest price. The working side estimates their cost to provide the Work, adds a profit margin, then proposes the sum as a price to the paying side. When the paying side accepts that amount, it’s included in their contract and becomes a lump sum price for the Work. Keep these issues in mind when considering a lump sum price: 

  • Working Side Benefits. The working side benefits from a lump sum price because, if they manage to keep costs below their estimate, they keep the money they would otherwise have spent on costs. The result is a higher profit margin on the contract. A lump sum price also requires less intense accounting, reporting, and back office work. So it imposes fewer overhead costs on the working side too
     
  • Working Side Drawbacks. The lump sum price has risks for the working side too. Among them, if they underestimate their costs, their profit margin shrinks. It may even disappear. Depending on their contract terms, the working side might even have to come out of their own operating profit on other projects, use cash reserves, or even borrow, to pay the extra costs and complete the Work in exchange for the lump sum price
     
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  • Paying Side Benefits. The paying side benefits from a lump sum price too. Depending on their contract terms and the working side’s creditworthiness, they get a level of certainty on how much the Work will cost. If it’s a prime contract, the paying side’s lender usually likes this too
     
  • Paying Side Drawbacks. Among the drawbacks, there there’s no "transparency." The paying side doesn’t know how large or small a profit margin the working side has. If the paying side suspects it’s too big, they’re inclined to think they’re overpaying. If they suspect it’s too little, they could think there’s a risk of too little quality control with the working side tempted to cut corners to maintain their margin. Though it doesn’t fix everything, competitive bidding for a lump sum price can allay at least some of the paying side’s overpayment concerns
     
  • Payment Timing and Sequence. One of the most important issues with lump sum pricing is identifying when the paying side pays. Although the price is a lump sum, the paying side doesn’t usually pay it all at once. Instead, they usually pay once a month in proportion to the amount of Work completed during the immediately preceding month (i.e., pay in August for Work provided in July). For example: if, during July, the Work goes from 45% complete to 53% complete, in August the paying side will pay 8% of the lump sum price, less a certain amount for retainage depending on other terms of the contract

A lump sum price is simple to structure and easy to manage. It usually has more appeal when:

  • One or both sides, especially the paying side, has no, or only little, construction management resources and experience, and
     
  • The price is modest

Cost Plus A Fee Price

Cost plus a fee pricing, usually referred to as just "cost plus," is set by adding two components together: (a) costs the working side incurs to provide the Work (usually just referred to as the "cost of the Work") and (b) the working side’s fee for providing the Work. Cost plus pricing provides the transparency missing from a lump sum price. It allows the paying side to share in benefits that come from more efficient Work and costs that are lower than originally estimated. But cost plus pricing is not simple and not easy. It raises many issues and complications. Some examples:

  • Cost Identification. Identifying what does, and what does not, qualify as a cost of the Work. For instance:
     

    • Should the working side’s cost to re-perform rejected Work qualify as a cost of the Work?
       
    • If the working side rents equipment needed to provide the Work (e.g., a crane, a hoist) from an affiliated rental company, how much of the rental fee should qualify as a cost of the Work?
       
  • Amount of the Fee. How much should the working side’s fee be? How should it be structured?
     

    • As a percentage of the cost of the Work? This is simple, but it rewards the working party for increasing the cost of the Work
       
    • A fixed fee regardless of the the cost of the Work? This is simple too, but if the scope of the Work changes, when amending the contract to change the Work, both sides need to remember to adjust the amount of the fee to preserve its proportion to the cost of the Work
       
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  • High Maintenance. Cost plus pricing is more burdensome for both sides. The working side must devote extra time to tracking and reporting on costs and getting cost data from those providing Work on their behalf downstream. The paying side must scrutinize the working side’s reporting to ensure it’s accurate. Cost plus a fee contracts require a lot of professional expertise, familiarity with construction costs, and back office work. That makes them more labor intensive and more expensive
     
  • Audit. If the money at stake is big enough and the paying side wants to ensure that the cost of the Work and amount of the fee is accurate, they’ll need to perform at least one audit. Audits take time and cost someone money. They also require the working side to maintain records for some minimum amount of time and impose disruption on the working side’s operation while auditors scrutinize records and analyze data. That adds costs for both sides
     
  • Challenging Contracts. Because there’s more issues, negotiating a cost plus contract often takes longer and requires more involvement from lawyers and consultants. That also means higher costs for both sides. And those are "soft costs" that aren’t popular with investors and lenders

Guaranteed Maximum Price

GMP 2.JPGWith few exceptions, cost plus contracts include a guaranteed maximum price (the "GMP", sometimes called a "GMAX"). Under a GMP contract, the working side guarantees that the paying side will pay no more than the GMP for completion of the Work. Ideally, regardless of how high the actual cost of the Work, plus the working side’s fee actually gets, the paying side won’t pay more than the GMP in exchange for the Work. Keep these issues in mind when considering a cost plus with a GMP contract:

  • Who Gets the Savings? "Savings" is the difference between (a) the GMP and (b) the final cost of the Work, plus the working side’s fee:
    Savings = (GMP) – ((Total Cost of the Work) + (Total Working Side Fee))
     

    By default, the paying party benefits from savings. They’re obliged to pay no more than the cost of the Work plus the fee. So if that amount is lower than the GMP, the paying side owes no more and they enjoy all of the savings
     

  • Sharing the Savings. To offer the working side extra incentive to minimize the cost of the Work – thereby maximizing savings – some GMP contracts set up a sharing of any savings. Usually the contract will identify a percentage of savings that goes to the working party. Sometimes it’s a single percentage of all savings. Other contracts increase or decrease the percentage at various levels of savings. For example, the working party may get 25% percent of the first $50,000 of savings, 40% of the savings between $50,001 and $100,000, and 50% of all savings above $100,001
     
  • Sub-GMPs. Some contracts set a sub-GMP for select cost categories. A frequent example in prime contracts is a sub-GMP on the prime contractor’s general conditions costs (sometimes called "jobsite overhead" costs). Some cost plus contracts take a hybrid approach, they set:(a) a sub-GMP for some cost categories, (b) a lump sum for some cost categories, and (c) no limit on other categories (as long costs in those categories don’t make total of the cost of the Work, plus the working side’s fee, exceed the overall GMP)

    But be cautious if you’re on the paying side! Proposing spending limits in specific cost categories ordinarily arouses controversy with the working side. They may be inclined to accept a sub-GMP, or a lump sum, for general conditions costs, but you’ll usually find them very reluctant, often with good reason, to impose limits on other cost categories. So before you ask for these kinds of limits, make sure you really need them and carefully analyze whether they’re really going to be worth your while
     

  • Cost vs. Benefit. The allure of keeping savings often attracts the paying side to a GMP contract, especially when the paying side is an owner. But it’s easy to overlook the extra costs that come with the GMP contract. It may be worth it for owners (a) with the in-house construction expertise to analyze and manage the payment process and scrutinize cost of the Work reporting or (b) have the budget to hire qualified consultants. But owners who don’t have either should really stop and think twice before opting for a GMP contract. They may just be better off with a lump sum contract, especially if the project isn’t really big enough to justify the extra professional costs needed to negotiate a GMP contract and review cost of the Work in each application for payment

Unit Prices

Unit pricing is another simple way to price the Work. The working side simply sets a price for each unit of Work, or category of cost. Road building contracts are a good example. The paying side pays the working side a set unit price for each kilometer or mile of road they build over a specified area or type of terrain. Because units of Work usually must be very similar for accurate unit pricing, you’ll see unit pricing most often used on public infrastructure projects (e.g., roads, runways). You’ll see it only infrequently on private building projects, and then usually only on select cost categories (e.g., door handles, faucets).

Schedule of Values

Schedule of Values.jpgA Schedule of Values breaks the price down and allocates it among various components of the Work: excavation, foundation, superstructure steel, curtain wall, electrical, plumbing, HVAC, vertical transportation, drywall, paint, general conditions costs. This sample contract has a scaled-down example of what a Schedule of Values ordinarily looks like. This breakdown helps you compare progress of the Work to how much of the price has been paid to date. It’s critical to architects, engineers, other consultants, and lenders who review the Work each month, compare its progress to how much money has already been paid, and how much the working side is requesting in their latest monthly application for payment. The Schedule of Values allows everyone to see whether progress of the Work is "in balance" with payment of the price. And, if it’s not, identify how far it’s out of balance. A Schedule of Values is especially critical to a prime contract. Construction lenders often insist on them before they’ll fund any loan proceeds. If you’re the paying side on a prime contract, be you need to use extreme caution approaching a contract that doesn’t have a Schedule of Values, or that says the Schedule of Values will come later, after you sign.

Coming Up Next

Coming up next at No. 3 is the contract time: deadlines and delays.