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Fundamentals of Pricing Construction Contracts

Posted by Nicole Liotine | Nov 17, 2016 | 0 Comments

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A key component of survival and profitability in the construction industry is managing project risk. Risk management, broadly speaking, touches all areas of a business and includes activities from supervision on the job site to structuring and negotiating contracts. A well-drafted construction contract lays the foundation for a successful working relationship and a profitable job. A good contract will clarify key parts of the relationship along with the scope of work to be performed. In addition, a good contract is critical to addressing monetary matters, including the total price to be paid, the terms and conditions of payment, and the allocation of any payment-related risks.

In essence, there are two methods of pricing construction contracts: fixed price or cost reimbursable. Both pricing methods have upsides and downsides for the Owner and the General Contractor, and both methods have sub-types and variations that help balance and offset the corresponding risks. An Owner may prefer a fixed price contract because of the certainty it provides in terms of project cost. On the other hand, a Contractor may prefer cost reimbursable contract pricing to minimize the risk of reduced profit margins or projects that become unprofitable altogether. A Contractor can potentially profit equally from either pricing method, but fixed price contracts create a heightened need for accurate up-front cost predictions and careful management of change requests during the project to keep the budget on track.  For Contractors willing to take the risk of a potential loss, a fixed price contract can also provide a Contractor with a huge upside if they execute the project particularly well.

Fixed Price Contracts

As the name implies, fixed price contracts are agreements to pay a single price that is negotiated prior to the start of work. A fixed price contract might take the form of a lump sum or a unit price. A lump sum contract is an agreement to pay a fixed price that is set before the contract is officially awarded. A Contractor may arrive at an appropriate price by estimating units of required labor and materials, adding profit and overhead, and calculating the total, with a buffer amount added to deal with foreseeable changes.  Alternatively, the contract itself may use the unit price method with loaded rates built into each line item. Either type of fixed price agreement is generally not subject to any adjustment unless there are changes to the scope of work that are approved by both parties. If the Contractor's estimates prove incorrect or unforeseen costs lead to additional costs outside the budget, the Contractor absorbs the extra cost. This pricing method requires the Contractor to be extremely thorough and diligent when bidding for a job because of the risk exposure that results from an inaccurate bid.

On the other hand, if the Contractor completes the project for substantially less than the contract price, the Contractor receives the financial benefit that comes with the savings. To the Contractor, this risk-benefit scenario exists on a sliding scale; the proposition becomes less attractive as the complexity of the project increases. A Contractor experienced with complex jobs is far less likely to enter a fixed price agreement in such cases because the difficulty of making accurate predictions is extremely challenging and the agreed price is likely to interject tension into the relationship between the parties at some point when changes become necessary to complete the job.

Even when a Contractor effectively minimizes the risk of cost overruns or other unexpected costs, the fixed price arrangement carries further risks. Sometimes the Owner compounds the problem of unforeseen events. A hesitant Owner that is slow to make decisions can make it more difficult for the Contractor to manage the job. Numerous change orders can stunt progress and sometimes even require lender approval if the Owner has financed the project; if the Owner is required to borrow additional funds to cover the changes, the time spent securing the additional funding may cause the Contractor lost time, thwarting the Contractor's ability to timely complete the project.  When an Owner interferes with a project in this way, it is critical to have key provisions in the contract allowing the Contractor to recover costs related to such impacts.

Cost Reimbursable Contracts

A cost reimbursable contract, on the other hand, requires far less accuracy during the bidding process because any unforeseen expenses will be passed to the Owner instead of the Contractor. However, certain contractual features may limit this pass-through mechanism. The generic “cost plus fee” arrangement will generally be free of any limits, but an Owner may insist on a Guaranteed Maximum Price (“GMP”), in which the Owner will not pay anything above a fixed ceiling without prior mutual consent, or an estimated maximum price, in which the parties split all costs exceeding the ceiling price or share the savings if the project finishes under budget. From the Owner's perspective, a major advantage of cost plus fee arrangements is that the Contractor has little incentive to take shortcuts and the final cost may actually be lower than a fixed price contract because the Contractor does not need to inflate the cost to cover unforeseeable risks such as unanticipated additional labor hours, increases in the price of materials, or simple cost overruns due to inefficient performance by Subcontractors.

Ultimately, the type of project, along with other industry and market factors will inform which pricing form is most logical, but remember that no single method is necessarily the only correct approach for a particular project. Companies should consult with experienced counsel when drafting or negotiating construction contracts to determine which pricing style will best protect the company's interests. Careful planning in this regard can lead to a final pricing arrangement that is fair, balanced, and that paves the way for a successful project.

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