Owners and contractors should be knowledgeable in the various contract forms and their associated risks. Among the most common construction forms are 1) lump sum, 2) cost plus a fee and the hybrid, 3) cost plus a fee with a guaranteed maximum price. Each allocates risk differently and has different benefits for the parties.
A lump sum or stipulated sum contract is common. In this contract form, an owner has a set price for all work contained in the contract. In its simplest form, the owner knows the price of the contract work, and that the owner will receive the building described in the contract in the time stated in the contract. Assuming no owner changes or other basis for the contractor to claim extra or additional costs or time, the contractor has to complete its work for the contract price and within the contract time. The owner obtains the best price by competitively bidding the work, so contractors compete to provide the best lump sum price. That mitigates the risk of excess profit or too large a contractor contingency as part of the lump sum price. If an owner is concerned about the contractor’s ability to perform for the contract price, then the owner can require the contractor to obtain and provide performance and payment bonds. In a lump sum contract, unless there is a dispute, there is rarely the ability for the owner to audit the contractor’s books or know the contractor’s profit margin.
When the owner wants more information, cost plus contracts may be proper. These are especially useful where a project starts before design is complete, making it difficult to provide a lump sum price. Open book cost plus is also useful when the owner wants a say in selection of subcontractors and materials and wants to know the cost of each. In these situations, the contractor receives a fee on top of the amount expended, sometimes based on the original budget amount. To incentivize thrift, there may be a shared savings provision where the owner and contractor split any savings. The risk of this method is that once the shared savings are over budget, there is little incentive for the contractor to control cost. The owner then bears all of the additional cost.
One benefit of cost plus over stipulated sum is in change order work. With a stipulated sum contract, change orders are also in stipulated sum, with the owner lacking access to all information on how the change order is calculated. In an open book format, the owner participates in the price selection process.
Audit rights are common in a cost-plus contract. The owner needs the ability to review everything to confirm costs being passed from the contractor.
The hybrid form of this is a cost-plus fee with a guaranteed maximum price (GMP). In this instance the contractor assures the owner, subject to the contractor’s assumptions, qualifications, and conditions (the devil is always in those details), that the project will be completed for a price under the GMP. The owner still sees all costs and records, but the risk of price increases beyond the GMP is generally on the contractor, subject to adjustment as otherwise permitted in the contract. These contracts may lead to disputes, however. For example, disagreements often arise over issues such as what is or is not properly included in the GMP.
While these are most common, other types of construction contracts and variations exist, such as time and material contracts (typically used for projects without a well-defined scope of work), and unit price contracts (sometimes used for repetitive construction tasks where the work to be completed is divided up into separate units). Indeed, as owners and contractors continue to struggle with severe supply chain issues, labor shortages, and other unusual levels of market risk in the wake of the COVID-19 pandemic and shutdowns, a variety of modifications, revisions, and strategies for shifting or avoiding risk have been creeping into construction contracts. Contract provisions reflecting allocation of these risks are prudent.
Each form has different risk/reward profiles. Carefully thought through, and negotiated contracts, can help mitigate risk of surprise costs for either side. Now more than ever, owners and contractors need to carefully review their options – and their contracts – to make sure they are selecting the arrangement that best suits their tolerance for risk, and that there are no hidden surprises in the final agreement.