The Pros and Cons of Pricing Options in Construction Contracts

Second in a series of articles addressing ten key provisions in construction contracts.

One of the most fundamental provisions of any construction contract is the price to be paid for work performed.  Different pricing methods may be utilized.  Factors such as budget constraints, status of design completion, anticipated risks and project difficulties, construction schedule, and certainty of costs and time impact how the parties select and negotiate contract provisions regarding pricing.

In general, there are three industry standards for pricing options: fixed price or lump sum pricing, cost-plus pricing (with or without a guaranteed maximum price) and unit price.

Fixed Price / Lump Sum Pricing

Fixed price or lump sum pricing, as the name indicates, provides for payment of a set amount.  The amount of the fixed price or lump sum is determined by a contractor by estimating their cost to provide the work, and then adding overhead and a profit margin.  Provided an owner finds the lump sum calculation acceptable, either through a bidding process or negotiation, then the lump sum price becomes part of the contract. The lump sum amount is typically paid out monthly during the project depending upon the percentage of work completed.  To aid in payment on this percentage basis, often a contractor will prepare a schedule of values to assign value to each component of the work that makes up the overall contract.  Payment occurs over time commensurate with completion of the work (often through estimated percentages).

Advantages:

  • A contractor providing work stands to benefit from increased profit if actual costs turn out to be below the estimated costs.
  • An owner required to pay for work contracts for certainty on how much the work will cost (absent changes) – often an important factor, and potential requirement, in securing financing.

Disadvantages:

  • The other side of the coin for contractors providing work is that, if they underestimate costs, their profit margin decreases and may disappear altogether.
  • Depending upon their construction knowledge and experience, owners obligated to pay for work may lack of a full understanding of how large or small the profit margin is for the other party, though utilizing competitive bidding in conjunction with lump sum contracting can address this concern.

Cost-Plus – With or Without a Guaranteed Maximum Price           

“Cost-Plus” is a pricing option in which a party providing the work calculates the cost to complete the work, and then adds a fee.  Costs to complete the work typically include all amounts paid to subcontractors for labor and materials, plus general conditions – or those items that are outside direct labor and materials such as project management, site office, tools and equipment.  The fee, which is the profit estimated by the contractor, and with some contracts all or part of overhead, may be one defined amount or it may be based on a percentage of the defined costs.

It is not hard to imagine a pricing method based on costs, which are often a moving target, escalating out of control.  That is why cost-plus pricing is often combined with a guaranteed maximum price (GMP).  Cost-plus with GMP provides an upper limit on total construction costs and fees for which an owner is responsible.  If the party providing the work under this pricing method runs over GMP, it is responsible for such overruns.  Recognize, however, that changes to the scope of work may increase the GMP.  The parties to a cost-plus with GMP contract negotiate at the outset how any costs savings (i.e., work performed for less than GMP) will be allocated, often agreeing to share in these savings.

Advantages:

  • For projects that need to be fast-tracked, cost-plus pricing enables a contractor to begin work earlier with preliminary phases of construction while design of the project is completed.
  • Cost-plus with GMP and an agreement for sharing cost savings can incentivize both parties to a construction contract to work together as efficiently as possible.

Disadvantages:

  • Cost-plus without GMP leaves an owner responsible for paying for work exposed to unrestrained liability for costs.
  • Cost-plus pricing requires more work from both parties to the contract; the contractor providing the work must track and report costs, and the owner obligated to pay for the work must analyze this data for accuracy.

Unit Price

Yet another pricing option is unit pricing, where the party providing the work sets a price for each unit of work.  This type of pricing is more common on certain public works projects, such as road building projects.  The contractor quotes an owner a price for a particular task or scope of work, though at the time of contracting the parties may not know the actual number of the units of work to be completed.

Advantages:

  • Well-suited for repetitive and well-defined tasks.

Disadvantages:

  • Not particularly useful for most private building projects, except as part of a lump sum or cost plus contract, applied to select components of work items such as dirt removal or fill, finish hardware, etc.

Additional Construction Contract Pricing Considerations

Parties should also take note of the considerations below when negotiating the price to be included in a construction contract:

  • How do parties define costs in a cost-plus pricing method, and what is included in the definition of costs?  For example, do costs include the contractor providing work having to re-do rejected work?  Do costs include rental fees for equipment rented to perform the work?  What about equipment owned by the contractor, and at what rate?
  • How do parties define the fee in a cost-plus pricing method?  Is the fee calculated as a set amount, or is it a percentage added to the sum of costs? 
  • In a cost-plus method, how are savings to be allocated?  Do all savings go to the party obligated to pay for the work, or do the parties agree to share the savings?
  • How will the project be designed and built?  If plans, specifications and other documents are complete prior to construction (a project delivery method commonly referred to as “Design-Bid-Build”), it may be that a fixed price construction contract makes more sense.  On the other hand, if either design is not complete, or if the contractor is procuring design, (known as “Design-Build”), then perhaps parties should utilize cost-plus with or without GMP in their construction contracts.  In some circumstances, separate GMPs for different components of the work are set at different times, as design progresses.
  • What allowances are utilized?  Allowances allocate a portion of the price to certain parts of work with costs that cannot be specified with particularity at the time the parties enter into the contract.  Allowances may also be used because of the volatility in pricing of materials.  The price paid will be adjusted to the extent the actual cost of an allowance item is more or less than the allowance stated in the contract.
  • Finally, parties should ensure that any assumptions on which the price is based (e.g., services provided by owner, atypical site access, etc.) are appropriately identified in the contract or contract documents.

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About the Authors

Adam T. Duke

Adam Duke's practice covers a broad spectrum of creditors' rights matters including loan modifications, repossession and sale of collateral, litigation and bankruptcy.
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D. Anderson Carmen

Andy Carmen focuses his practice on construction law matters, creditor representation and serves as a mediator and arbitrator.
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