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This article explains the basics of “Guaranteed Maximum Price” construction contracts, including an explanation of contingencies and allowances, two standard 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 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.
Understanding the Basics of a Guaranteed Maximum Price Contract
A guaranteed maximum price contract is a legally binding agreement between a contractor and project owner, where the contractor agrees to complete services for an agreed-upon maximum price. Unlike stipulated sum contracts, which hold contractors responsible for completing projects at fixed prices regardless of actual costs incurred, GMP contracts transfer this risk to the contractor by setting a limit on how much the customer will be charged. These types of contracts have become increasingly popular in construction due to their ability to provide cost certainty and potential savings for clients.
For owners, GMP contracts offer financial predictability as they establish a predetermined spending cap on services provided by the contractor. This could result in cost savings if managed efficiently and if the final project comes under budgeted expenses - unlike fixed-price agreements where owners are required to pay irrespective of total project costs incurred. In summary,GMPs shift risks from customers onto contractors while providing more control over expenditure through set limits. Making it clear that both parties benefit mutually depending on one contingency plan worked out beforehand.
What is 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 project’s actual cost to the contractor. Unlike a standard “cost-plus-fee” contract, a guaranteed maximum price contract shifts 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.
What is a Schedule of Values in a GMP Construction Contract?
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 line item or whether the contractor will only be bound to the total guaranteed maximum price. The issue is what happens if the contractor exceeds the line item amount in one project area but can 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.
What is a Contingency in a GMP Construction Contract?
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 the contractor estimates as the actual cost of the work and the amount quoted to the owner as of 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 before the use of a contingency. They 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.
What are Allowances in a Construction Contract?
Allowances are amounts set aside in the contract sum for decisions 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 they want 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 contract’s price. If the tile is more expensive than the allowance, then the guaranteed maximum price will be increased. Allowances are typically used for actual material costs instead of profit and overhead.
What are Change Orders in a Construction Contract?
“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 project’s scope. 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.
If you still have questions regarding the broader topic of contractor agreements read our article, Employment agreements and independent contractors explained.
Frequently Asked Questions
What is GMP in a contract?
The acronym GMP refers to Guaranteed Maximum Price, which is a contractual term specifying the highest amount that can be charged by the contractor for their services. This sets an upper limit on the compensation they receive based on their actual costs incurred plus a fixed fee. The contract ensures that both parties are aware of and agree upon this maximum price for the project’s completion without exceeding it. It considers all related expenses and includes them in determining this cost ceiling.
What are the benefits of a GMP contract?
The main advantage of entering into a GMP contract for owners is the reduction in risks and costs. Due to increased efficiency, contractors are able to achieve significant cost reductions, which ultimately leads to savings for the owner.
What is the difference between a GMP contract and a lump sum contract?
A GMP contract offers the owner the possibility of saving costs if the project is completed under budget, while a lump sum contract requires that the contractor be paid a predetermined fee for their work. The main difference between these two contracts lies in how payment is determined, one based on potential cost savings and another with a fixed fee. Ultimately, both types of contracts involve an agreement between the owner and contractor.
What is an example of a GMP contract?
A GMP contract is formed when a contractor commits to finishing a project at an agreed-upon price, which covers the direct construction expenses as well as overhead costs and the contractor’s deposit fee. This agreement specifies all necessary details about the project such as cost estimates, payment schedules, and deadlines. Both parties involved must adhere to these terms in order for successful completion.
How does a guaranteed maximum price contract work?
A contract with a guaranteed maximum price is agreed upon for a construction project, ensuring that the contractor takes on any extra costs. This kind of agreement reduces financial risk for the owner by setting an upper limit to all expenses related to the project’s completion. The contractor will cover additional costs if they go beyond this predetermined maximum amount in order to complete the project.