A look at different types of construction contracts
Vail, CO, Colorado
Construction agreements come in many flavors, most of which are variations on two major themes ” “fixed price” (or lump sum) contracts and “cost-reimbursable” contracts. Understanding the basic themes and their permutations is key to protecting yourself when embarking upon a construction project.
A fixed price contract sets a lump sum price for a specific scope of work.
Cost-reimbursable contracts reimburse the contractor for its direct “out-of-pocket” costs in completing the work, then add to those costs either a fixed sum or a percentage in order to determine the contractor’s overhead and profit. Fixed price contracts require the contractor to assume much of the economic risk associated with the project. Cost-reimbursable contracts allocate most of the economic risk to the owner.
Among the permutations of fixed price contracts are “lump sum-fixed price,” “lump sum,” and “unit price” agreements. Cost-plus contracts may include “cost-plus-fixed fee,” “cost-plus-percentage fee,” “cost-plus-incentive fee,” and “cost-plus-guaranteed maximum” agreements. Within the universe of cost-reimbursable and fee contracts may be found “cost-reimbursable-fixed fee” and “cost-reimbursable-incentive fee,” contracts. Whew! So how does each of these contract types potentially affect your pocketbook?
Lump sum-fixed price agreements contemplate a single price commitment by the contractor. All escalation in the price, whatever the cause, is included in the price. The way price escalation is treated is the distinction between fixed price lump sum agreements as compared to a simple lump sum contract.
A lump sum agreement is nearly the same, only different. In a lump sum contract, the price is fixed but any escalation in the cost of labor or materials during the course of construction is passed along to, and paid by, the owner. In other words, cost overruns are not absorbed by the contractor as they typically are in the lump sum-fixed price agreements.
A unit price contract specifies a dollar amount for a segment of the work that is described in detail, such that all the segments of the work, taken together, constitute the entire project. It’s sort of like buying sushi for dinner.
The “segments” or “pieces” can be units of labor or materials, or both. In this sort of agreement, the contractor’s compensation is determined by measurement of the quantity of “in place” work and application of the appropriate unit price to that work.
Employing such a mechanism, the final cost to the owner can (and often does) vary from the initial cost estimate, depending upon the final quantities of this or that which are ultimately employed in the project.
Also, the contractor’s cost of “units,” particularly units of materials, can vary considerably, the maxim of volume pricing (and volume discounts) being equally applicable to the construction industry as to any other. In other words, if the contractor purchases a greater volume of some material (say, bolts, for example), he will likely get them at a lower price from the materials supplier and, thus, the cost passed on to the owner will reflect the contractor’s lower price.
In cost-plus contracts, the owner reimburses the contractor for all direct costs, for overhead (usually as a percentage of direct costs), plus a fee either based upon a percentage of the work or a negotiated “fixed” amount. Understandably, the contractor must keep the owner apprised of the actual costs being incurred throughout the project, as compared to any estimates or budgets which may have been established.
Often, in cost-plus construction agreements, the initial plans and specifications may be painted in broad strokes and lack sufficient detail to accurately predict the ultimate costs. Accordingly, the grade and finish of certain elements are not specifically “called out” and the contractor must work diligently with the owner to establish these parameters and, thus, keep a reign on costs.
It is worth noting too that in cost-plus agreements, there is less incentive for the contractor to “build some fat” into the estimate. Whereas in fixed-price agreements the contractor may live or die by the price recited to the owner, in a cost-plus agreement the contractor is guaranteed that he will make a profit regardless of what overruns might ultimately be encountered. In order to project him or herself from a loss, it is understandable that a prudent and conscientious contractor will “pad” the bid in a lump sum-fixed price agreement, thus assuring him- or herself some flexibility against unpredictable variations in the price of materials or labor, or in encountering unforseen conditions in completing the work.
Accordingly, many owners feel more comfortable with the cost-plus arrangement, knowing that the construction will cost what it costs, that the contractor will be fairly compensated, and that the contractor is not incentivized to add a premium to protect himself from unforseen conditions.
In Part II of this series, we take a look at the “flavors” of cost-plus agreements as well as cost-reimbursable and fee agreements.
Rohn K. Robbins is an attorney licensed before the Bars of Colorado and California who practices in the Vail Valley. He is a member of the Colorado State Bar Association Legal Ethics Committee and is a former adjunct professor of law. He may be heard on Wednesday nights at 7:00 p.m. on KZYR radio (97.7 FM) as host of “Community Focus.” Robbins may be reached at 970-926-4461 or at his e-mail address: email@example.com.
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