Construction contracts generally cover four main areas: price, scope, time, and allocation of risk.
The final price of a project can be difficult to determine at the beginning of a project. Unfortunately, as a result, serious issues can arise because of the uncertainty of price, including owners running out of money or contractors substantially underbidding projects.
So, what is the best method to use in setting the price for construction contracts?
There are four methods to determine the cost of a construction project:
1) lump sum;
2) cost of work plus a fee;
3) guaranteed maximum price; or
4) working without any agreement on price and using equitable or legal remedies to set price after the fact.
The first three methods are all dependent on the scope of work and contract time, and so can increase or decrease based on change orders.1
Method 1: Lump Sum
A lump sum price means the price of the project is set before or during construction. The owner and contractor agree on a set price based on an agreed upon scope of work, and the time allocated for when the construction is to be completed.
Saul C. Glazer, U.W. 1990, is a partner at Axley Law Firm in Madison. He focuses his practice on construction law, and assists owners and contractors in preparing construction contracts and resolving construction disputes.
The lump sum may change if the scope of work changes (typically through a change order), so if the plans and specifications are not at 100 percent when construction begins, the lump sum may increase.
Alternatively, the owner may decide on scope changes during the project, which would also increase the price. If the construction schedule changes, for example, because of the need to finish early, adverse weather, or shortage of materials, the price may increase, depending on the contract language. If the contractor finishes late, and there are liquidated or actual damages for late completion, that may also affect the lump sum price.
Method 2: Cost of Work Plus a Fee
Another common method of setting compensation for a contractor is simply paying the contractor for its time and materials, and then paying the contractor a percentage of the cost of work.
This method requires identifying how the contractor may charge for its work. For example, the contract should specify which employees can bill against the project, and where they are working when they bill (whether they need to be on the project site).
The amount of burden to be charged for the contractor’s employees for such items as employment taxes, insurance, etc. must be determined, or, alternatively, whether burden may be included within a rate for employees.
The contractor may receive markup on subcontracts and materials, or that may be part of the contractor’s fee. Equipment rental costs should be addressed. Just as important is identifying what items are not chargeable to the cost of work, such as corrections for mistakes caused by the contractor.
Method 3: Guaranteed Maximum Price
A guaranteed maximum price (GMP) contract is similar to cost of work plus a fee, except the contractor agrees to limit the top of end of the price, even if the cost of work plus a fee exceeds the amount of the GMP.
If the cost of work plus a fee is less than the GMP, then either all or a percentage of the savings goes to the owner. If the GMP is set when the plans and specifications are not at 100 percent, then depending on what assumptions are made to set the GMP, the GMP may increase when the plans and specifications are at 100 percent.
When projects begin without complete plans and specifications, the contractor may provide a non-binding estimate until the GMP is set. Alternatively, a higher binding interim GMP (IGMP) may be used until there is enough information to set a final GMP which is either the same or lower than the IGMP. Additionally, an estimate followed by an IGMP and then a GMP may be used.
Method 4: Equitable and Legal Methods
Even in this day and age, some owners proceed without any oral or written agreement on price. In such instances, quantum meruit or unjust enrichment theories are used to set the price after the fact.
Because these methods are done after the fact, without any guidance on what costs can or cannot be charged to the project, they provide for much uncertainty, and also require use of the court system.
These theories are also often used when there are set methods for the construction prices, but the parties have not agreed on how to account for changes in price, scope, and time. Promissory or equitable estoppel may also be asserted in some instances, or an account stated, if the contractor has invoiced for its work during construction, and the owner has accepted the contractor’s invoices.
Choose Your Method Wisely
Depending on the size and complexity of the project and relationship of the owner and the contractor, the first three methods of setting price all have their place in construction projects.
Under no circumstances should an owner or contractor leave price to chance and not agree on a compensation methodology until after work is complete or substantially underway.
1 Written change orders should be used for methods 1-3 whenever the scope or time is changed – adjusting the time, scope, or price. For method 2 (cost of work plus a fee), the price will continue to be the total of cost of work plus a fee, but it is still important to be on the same page for scope and time.