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This article explains the basics of “Guaranteed Maximum Price” construction contracts, including an explanation of contingencies and allowances, two common components of these types of contracts. For a broader discussion on general contractor agreements, check out our article: General Contractor Agreements Explained.
In that article, we describe different types of pricing structures that can be used in general contractor agreements. One of the most common price structures is for the owner to pay the contractor the cost of work plus the contractor’s fee.
One of the most common price structures is for the owner to pay the contractor the cost of work plus the contractor’s fee. Often, in a “cost-plus-fee” contract, the contractor’s fee is calculated as a certain percentage of the actual costs associated with the work, including labor, materials, storage, and transportation. A common way to mitigate the owner’s risk and provide a level of certainty as to the cost of the project is for the contractor to set a guaranteed maximum price.
A guaranteed maximum price is a limit on the amount that the owner will have to pay the contractor on the project, regardless of the actual cost of the project to the contractor. Unlike a standard “cost-plus-fee” contract, a guaranteed maximum price contract shifts the much of the risk that the project will be more expensive than estimates from the owner to the contractor. Unlike a lump sum contract wherein a contractor is paid a flat fee for the work, the guaranteed maximum price contract allows the owner to potentially save money if the project ends up costing less than estimated. Sometimes the owner and contractor will agree in advance that these savings be shared between the two parties, as an incentive to the contractor to come in below estimates. So, to recap, in a guaranteed maximum price contract the contractor will charge the owner the cost of the labor and materials plus a percentage of that cost for profit. The total cost to the owner may be less than the guaranteed maximum price, but it will not exceed it.
Typically, the contractor will prepare a Guaranteed Maximum Price Proposal that will break down the project’s estimated costs and contractor’s profit into line items for specific elements of the work. This is called a “Schedule of Values.” The total of these line items results in the guaranteed maximum price.
A point of negotiation between the owner and contractor is whether the contractor will be bound to the guaranteed maximum price for each individual line item, or whether the contractor will only bound to the total guaranteed maximum price. The issue is what happens if the contractor exceeds the line item amount in one area of the project, but is able to come in under that amount in another area. Will the contractor have the right to take advantage of the savings in one area to cover the additional costs in another area, or will the savings in one area be passed on to the owner while the contractor eats the additional costs in another area? It is advantageous for the owner if the contractor is bound to a maximum price for each line item. However, this may cause the overall guaranteed maximum price to increase, as the contractor may increase each line item to account for this risk.
One of the items on the schedule of values is a “contingency” amount. The purpose of the contingency is to provide the contractor with a safety valve if the estimated costs of one or more of the line items are exceeded. This is essentially a buffer between the amount that the contractor estimates as the actual cost of the work and the amount quoted to the owner as the guaranteed maximum price. The contingency is meant to be used for unforeseen costs that are not due to the contractor’s or subcontractors’ negligence or wrongdoing and that are not subject to a change in the guaranteed maximum price by way of a change order. We will discuss change orders in more detail below.
The estimated cost of the work for each line item, the owner’s estimated profit, and the contingency are the elements that are added together to make up the guaranteed maximum price. Often the dollar value of the contingency will be calculated as a percentage of the other cost plus profit that be applied to the overages above estimates in any of the different line items in the schedule of values. In situations where the contractor is to be bound by a guaranteed maximum price for each line item, each line item may have its own specific contingency and the contractor may be prohibited from using the contingency for one item to cover excess costs from another line item. This is obviously favorable to the owner and unfavorable to the contractor.
Owners will typically seek written notice prior to the use of a contingency, and may require that the purpose of the contingency use be detailed with specificity in order to prevent the contingency amount from being used by the contractor as a blank check.
Allowances are amounts that are set aside in the contract sum for decisions that the owner has yet to make regarding specific parts of the work. For example, $1,000.00 may be set as an allowance for tile. The owner does not have to decide what type of tile he or she wants to use until later in the project. The tile may be more or less expensive than the $1,000.00 allowance. If the tile is less expensive than the allowance, then any savings will reduce the price of the contract. If the tile is more expensive than the allowance, then the guaranteed maximum price will be increased. Allowances are typically strictly used for actual material costs, as opposed to profit and overhead.
“Change orders” are a process used by the contractor and owner to increase the guaranteed maximum price or time for completion of the contract based on unforeseen conditions, unfinished plans, or changing wishes of the owner that materially affect the scope of the project. The contract will lay out a process for the owner or the contractor requesting a change order, and the other party agreeing to it. The contract should also detail a dispute resolution process if the parties cannot agree on the price increase.