Posted by: Aliza Ganz
We are frequently approached by clients seeking our expertise in the drafting and negotiation of construction contracts. One of our first threshold issues essential to our preparation of the contract is resolving how the general contractor or construction manager (“CM”) will be compensated for its work. The following is a brief review of two of the most frequently utilized construction compensation structures known as: (1) lump sum (also known as fixed price or stipulated sum) and (2) cost-plus.
(1) Lump Sum
In this most basic type of construction contract, the contract sum is fixed from the start and includes all of the CM’s overhead and profit. It is the simplest payment structure, best suited for a project with a clear, specific scope from the start, sufficiently comprehensive and complete drawings, specifications and schedule at the time of contracting, and relative simplicity of construction. Here, the major benefit to an owner is a predictable cost which cannot be exceeded (unless resulting from approved change orders) even if unforeseen contingencies arise. In other words, if the actual cost to CM to perform the work is in fact higher than the lump sum stipulated in the contract, the CM by definition absorbs the loss. Conversely, if the actual cost to the CM to perform the work is in fact lower than the lump sum stipulated, the CM benefits from such saving. While an owner may appreciate the budgetary confidence inherent in knowing a pre-determined price, owners should be aware that lump sum contracts are often set at higher prices in order to provide the CM the assurance the project it will earn profit. In addition, if changes to the scope are required to be made (whether required by Owner or field conditions) during the course of the project, the “closed book” nature of a lump sum contract’s pricing may render the pricing of such change orders unpredictable.
(2) Cost Plus Contract
In this type of contract, a CM is paid a sum for the work plus an additional fee for its overhead and profit. Here, the CM will be less likely to overstate the contract price, as compared to in a lump sum contract, since there is a profit formula. While there are a variety of subcategories of the cost plus contract, our most popular cost plus arrangement is the Cost Plus with Guaranteed Maximum Price Contract, known as a “GMP”. A GMP contract contains a capped, not-to-exceed contract sum, in which the CM is compensated for its actual costs, plus a fee component (usually expressed as a fixed percentage of the other components of the contract sum, but may also be an agreed upon flat fee). Because the contract price is capped in a traditional GMP contract, a CM who exceeds the capped amount (assuming that all work performed is within the contract’s scope) is responsible to complete the work regardless of a shortfall. One of the major benefits to an owner in utilizing the GMP contract is that an owner can sign the construction contract before drawings, specifications and the schedule are construction-ready, and as such, the CM can be involved in the design and bidding phases of the project, which enables the CM to play a key role in assisting the Owner in preparing a cost effective and well-planned project. Once the project’s design intent is fully mapped out, the owner and CM may sign a GMP Amendment, finalizing the not-to-exceed contract price. Typically, savings realized at completion of a project and resulting from cost underruns or unspent contingency are returned to the owner either entirely or, as negotiated in the contract, are shared between owner and CM. If there is a shared savings structure, the CM is incentivized to keep project costs down, so as to be able to share in the savings. Any cost overruns in a GMP contract are a CM’s sole responsibility, unless the GMP has been increased via formal change order. There are a myriad of key issues on which a sophisticated owner, with the benefit of our expertise, should focus during negotiation of a GMP contract. By way of example, such issues include: (i) whether the GMP price may be reduced should the owner elect to reduce the scope of work; (ii) structuring the scope of work so that the GMP cannot easily be exceeded via a change order; and (iii) to what extent the CM’s fee may be earned on change orders.
For further information and/or our assistance in negotiating your construction contract, please contact us at Greenberg, Trager & Herbst, LLP.