Construction Contract Primer

Posted on Tuesday, February 19, 2019 in eNewsletters, Hemmer Way.

All construction projects incur risk and require leaps of faith between both the owner and the contractor.  One of the primary purposes of the construction contract is to balance the risk associated with what can be a complicated and risk-laden endeavor. 

In the design-build process, there are primarily three contract types.

1.       Lump Sum (fixed price)

2.       Cost Plus

3.       Guaranteed Maximum Price (GMP)

The primary difference with each of these contract types is the allocation of the financial risk between the owner and the contractor.

Lump Sum Contracts

Lump sum contracts are sometimes also referred to as fixed price contracts.  They are generally used when the scope and work is well defined.  As the name implies, the owner and the contractor agree to a fixed price for an agreed upon scope of work.  The contractor is responsible for cost overruns. 

Cost Plus Contracts

With a cost plus contract, the risk shifts from the contractor to the owner.  This contract type is generally used when the project is less defined and the owner and contractor are working to jointly develop the scope.  The owner agrees to reimburse the contractor for agreed upon expenses plus an additional payment to compensate the contractor as its fee for managing the work.  This fee can be fixed or based on a percentage of the work.  However, the owner is responsible for all costs, so these contracts are used when there is an established trust and confidence between the owner and the contractor.

Guaranteed Maximum Price Contracts

With a Guaranteed Maximum (GMP) Price contract, the owner and contractor also agree to a maximum price for the work.  Like a cost plus contract, the owner agrees to reimburse the contractor for agreed upon expenses plus a fee.  It is generally used when the contractor is managing design to achieve a specific budget.  A GMP contract also helps to balance the financial risk between the owner and the contractor.  Often, the difference between the actual cost of the work and the GMP is shared between the owner and the contractor, which helps to encourage a team approach to the project. 

Contract Comparison

 

Lump Sum

Cost Plus

Guaranteed Maximum Price

Contract Amount

Fixed amount subject only to changes in scope.

Contract amount is uncertain until project is defined. No maximum price.

Contract amount is uncertain until project is defined and GMP is established.

Cost overruns

Contractor responsible for cost overruns.

Owner responsible for cost overruns.

Contractor responsible for cost overruns if greater than GMP.

Fee

No obligation to reveal

Fixed or set as a percentage of the work

Fixed or set as a percentage of the work

Schedule

Contractor incentivized to finish early

No incentive for early finish

Shared incentives for early finish

Financial Transparency

No obligation to share financial information

Open book accounting

Open book accounting

Change Orders

Subject to negotiation between Owner and Contractor.

Fixed fee. Contractors are generally more flexible to changes.

Fixed fee. Contractors are generally more flexible to changes.

Buyout/Savings

Contractor

Owner

Generally shared between contractor and owner.

Owner Oversight

Limited involvement

Requires additional oversight and administration to ensure that only permissible costs are paid and that contractor is exercising adequate cost controls.

Requires additional oversight and administration to ensure that only permissible costs are paid and that contractor is exercising adequate cost controls.

 

Determining which contract type is best for a particular project depends on the goals of the owner, as well as the nuances of the particular project.  Ultimately, however, the owner must have the trust and confidence that the contractor will deliver as expected.

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