Owners Guide to the Design and Construction Process – part 9
Tuesday, August 19th, 2014
III. Common Contract Forms and Bases for Payment
A. Stipulated Sum
A stipulated sum contract, sometimes called a lump sum contract, sets forth a specific amount as total payment for performance. Contracts resulting from competitive bidding take this form.
A cost-plus-a-fee contract is an agreement in which the contractor (in an owner-contractor agreement) or an architect (in an owner-architect agreement) is reimbursed for his direct and indirect costs, and in addition is paid a fee for his services. The fee is usually a stipulated sum or a percentage of costs.
C. Cost-Plus-a-Fee with a Guaranteed Maximum
This contract form is the same as cost-plus-a-fee except there is a guaranteed maximum (GMAX), or “upset” amount.
It is common that savings below the GMAX be shared between the contractor and the Owner as an incentive to the contractor to minimize costs. The percentage shares are negotiable. The contractor’s share (incentive fee) sometimes has a maximum defined as a percentage of the costs. For instance, it might be stipulated that the contractor receives 50% of the savings below the guaranteed maximum, but such amount received will not exceed 10% of the cost. The purpose here is to prevent the contractor from earning an unreasonable incentive fee by establishing an unrealistically high GMAX.
D. Design-Build Agreement
This procedure is applicable to the Design-Build or Partnering approaches. Normally a letter of agreement is executed between Owner and contractor describing the phases of the project. This serves as a letter of intent to enter into a construction contract, providing a satisfactory program is developed after preliminary drawings and definitions have been completed, and after agreement upon a guaranteed maximum cost. This agreement stipulates the basis for the contractor’s fee, and sets forth the compensation to the contractor in the event the project is abandoned prior to construction. The agreement also establishes the ultimate form of the contract between Owner and contractor.
In the traditional approach, where award of construction is based on competitive bidding, the most common form of contract is the stipulated sum. If the contract is negotiated rather than bid, however, it may take the form of stipulated sum or cost-plus-a-fee, usually with a guaranteed maximum cost.
With Design-Build or the Partnering method, the construction agreement may take any of the forms described, depending upon the individual project circumstance. With these methods, however, the Owner is in a position to learn all the facts and details which make up the total costs.
The traditional payment terms for any of the forms of agreement call for partial payments made for progress of the work, usually each thirty days, for work completed and materials suitably stored.
The complexity of the construction process entails certain liabilities. The contract documents will include “general conditions” which set forth many of the rights, responsibilities, and relationships of the parties involved.
Standard time-tested documents, which represent fair consideration for all parties, have been developed for this purpose. Examples are those prepared by the American Institute of Architects, and the Associated General Contractors. Review by attorneys for specific application is recommended
E. Verifying Construction Costs
In the traditional approach, with selection of the contractor through the bidding process, costs are not verified. The Owner is only interested inthe low-bid amount and stipulated sum of the contract. The makeup and total of the costs are the prerogative of the contractor. The contractor’s final costs may be less, or more, than his anticipated costs at bid time. His objective, obviously, is for final costs to be less than anticipated to increase his profitability, or to increase his profit with changes and extras.
If the construction management without risk method is used, the Owner makes all of the purchases, executes all of the subcontracts, and pays all of the bills. Costs are on a cumulative (as they occur) basis. Costs are monitored via the accounting system established for the project under advisement of the construction manager. Final costs are known only after completion of the project, when all the bills have been received and paid. Because the Owner is paying all bills, the risk of construction is on him, not on the construction manager.
Agreements which take the form of cost-plus-a-fee, with or without a guaranteed maximum, have the basic and contractual legal premise that all costs are verifiable in order to qualify for reimbursement to the contractor by the Owner. The Owner should verify that the contractor has the capability, systems, and procedures to develop detailed cost accounting records. The contractor’s accounting system should provide for the periodic submission of detailed cost reports with classification and summarization of costs into appropriate categories which are meaningful to the Owner. All reported costs should be reconciled by the subcontractor agreements and billings, material invoices, labor payroll records, equipment rental and/or use records, and all other miscellaneous cost documents.
In short, in a cost-plus arrangement the contractor’s books are open at all times.
There should be accounting records maintained by the contractor that will permit the Owner’s designated representative to conduct examination of project costs by applying generally accepted auditing standards. The agreement between Owner and contractor should provide for full disclosure of all project costs and auditing privileges. The accumulation of materials for the audit is expensive to the contractor and he is entitled to reimbursement for these costs, which are paid by the Owner.
Some owners may be concerned about co-mingling of costs between projects, or sub-rosa agreements with subcontractors resulting in payments “under the table.” These practices are best avoided by original selection of a reputable contractor with the integrity and good sense to recognize the laws and the serious consequences that could result from such practices.
In a negotiated cost-plus agreement, the contractor accepts the relationship of trust and confidence established between him and the Owner, and the corresponding fiduciary responsibility. Improper behavior (by taking money under false pretenses) could be construed as commission of a felony or even embezzlement.
F. Establishing Contractor’s Fees
The term “fee” here is to mean the general overhead and/or profit amount anticipated or actually earned by the contractor for performance of a contract. It may be expressed, in dollars or percentage, as the markup on all direct job costs.
As with any business, the contractor has certain general overhead operating expenses which are not chargeable as individual job costs, but which must be recovered in his operations. Also, as in any business, the purpose of the job is to generate a profit. Application of these factors depends upon the nature of each specific project. The variables that determine overhead application are job complexity, staff and resources, time requirements, job magnitude and duration, costs of capital employed, and the relationship of the project under consideration to the contractor’s total volume.
It is not necessary to explain that a low overhead operation may not produce quality performance. At the same time, efficiency of overhead is necessary to produce economical results, and there needs to be proper balance. There are a lot of risks and uncertainties in construction. It takes a contractor well experienced in your type of project to develop a reasonable profit by anticipating the inherent problems.
If the agreement is a stipulated sum contract resulting from a competitive bid process, the Owner is not aware of the contractor’s anticipated profit, and normally does not learn his final profit, since there is no requirement for disclosure. The bidding contractor normally considers the minimum he is willing to accept, but is strongly influenced by what he feels the bidding market will bear in applying markup on costs.
In Design-Build or the Team Partnering method, where the construction contract is a stipulated-sum or costs-plus, the overhead and profit fee are revealed since the contract is a negotiated percentage or amount considered reasonable by both Owner and contractor.
If the eventual contract under one of these methods is a stipulated-sum, the negotiated fee is applied to the total of all selected subcontractors bid amounts, estimated costs for work to be performed by the contractor, and other estimated direct costs. All subcontractors bids and estimates are reviewed by both parties.
With the stipulated-sum contract, the risks of actually realizing his anticipated fee all belong to the contractor. Since subcontractor amounts, constituting the majority of costs, are fixed with the Owner, it is improbable the contractor will realize a fee amount higher than agreed upon and highly possible he will realize a lesser amount because of the normal risks in execution.
If the eventual negotiated contract is cost-plus with a guaranteed maximum, the contractor’s fee remains the original negotiated amount unless the GMAX is exceeded, in which case the fee is automatically reduced by the amount over the GMAX.