Paul M Lurie Heidi Hennig Rowe October 30 2006 Lump-Sum v Cost-Plus Contracting: US Practice Schiff Hardin LLP | Projects, Construction & Infrastructure - USA Paul M Lurie, Heidi Hennig Rowe Projects, Construction & Infrastructure In the United States, the two most common 'contractor-at-risk' economic models for large commercial design and build construction contracting are payment by an owner to a general contractor on either a 'lump-sum' basis or a 'cost-plus' basis. Under the lump-sum model, the owner pays the contractor a stipulated lump sum, regardless of the contractor's actual costs and expenses. Under the 'cost-plus' model, by contrast, the owner pays the contractor its actual costs, including subcontracts and self-performed work, plus a negotiated fee for overhead and profit. All or a part of the costs may or may not be limited by a guaranteed maximum price (GMAX). In cost-plus contracting the contractor procures all the trade contracts by lump-sum competitive bid. Under either lump sum or cost plus, and unlike in other countries, it is unusual for the contractor in the United States to take assignments of subcontracts or trade contracts procured by the owner. The American Institute of Architects (AIA) Form A101 is commonly used for lump-sum contracts. AIA Form A-121cMc or AIA Form A111 is used for cost-plus contracts with a GMAX, and AIA Form A114 is used for cost-plus contracting without a GMAX.An owner often prefers cost-plus contracting over a lump-sum method when the plans and specifications for the project have not been fully developed, but the owner wishes for the contractor to proceed with mobilization and procurement of long lead time items while the plans are being completed. The owner is likely to have concerns that a contractor's pricing for a lump-sum contract based on incomplete plans may result in excessive prices as the contractor hedges as to what may or may not be finally included in the scope of work. This lack of full plan development may result from, for example: a tight design schedule; a desire to proceed on a fast-track basis with construction preceding design finalization; a lack of regulatory approval of the design; uncertain user market conditions; or a lack of financing. It is common for an early version of a cost-plus contract to be amended to include a GMAX when the plans are between 50% and 80% complete. However, if the final plans differ materially from the plans upon which the GMAX was estimated, the owner bears the risk of additional cost obligations above the GMAX. Under the AIA forms, failure to reach agreement on such a GMAX limit gives the owner the right to terminate for its convenience (ie, without penalty) any further obligations to the contractor other than reimbursement of the approved costs that the contractor has incurred to date. The GMAX amendments will contain the contractor's assumptions upon which it is committing to the GMAX and a project completion schedule. These amendatory documents, often drafted by businesspeople rather than construction counsel, should be carefully examined for their effect on other changes to the contractual rights and obligations. Based on their perception of market conditions, owners may believe that final construction costs can be procured at less expense later in the process and even after construction has commenced. In such situations it is common for owners, using cost-plus methodology, to pay a bonus to the contractor based on a percentage of the cost savings if the final project costs are less than the GMAX. Contractors justify such bonus based on the theory that they are being incentivized to lower the project costs. Whether such a bonus is necessary or desirable should be closely examined by the owner, especially as it relates to the size of the GMAX. Although a contractor may have entered into a cost-plus contract with the owner, the contractor usually enters into lump-sum contracts with its subcontractors. As such, a contractor may earn a bonus based on the percentage savings below the GMAX actually incurred in the process by which suppliers' and subcontractors' costs are fixed based on lump-sum subcontracts. However, when subcontractors observe uncertainty about final design quality or quantity, they will often qualify their lump-sum price by stating certain assumptions reflected in cost allowances which, if exceeded, would result in additional cost to the owner beyond the lump sum. These are referred to 'allowances' that can increase the total cost to an owner under a cost-plus contract. In determining the economics of a cost-plus contract, therefore, an owner must examine the GMAX in relation to allowances, cost-savings sharing and contingencies. Owners believe they can save money, either with or without a GMAX, by auditing the contractor's indirect costs on a cost-plus contract. These indirect costs include insurance, which is normally a variable cost depending on the contractor's insurance and the payroll taxes. However, many owners have no intention of doing a formal audit of actual expense and basically trust the contractor's representation as to indirect costs. Unless the owner believes that the contractor will try and save indirect costs, the actual indirect costs of the project may be no different from those resulting from the use of a lump-sum approach. When owners rely on the GMAX to fix costs, the negotiation of the amount of the GMAX is critical. However, if the owner has no independent method of verifying costs, the owner may be at the mercy of the contractor's determination of the GMAX. If there is also a cost-savings arrangement based on costs coming in below the GMAX, there is also a potential for the contractor to propose a GMAX that is high to guarantee a contractor's cost-sharing bonus. In cost-plus contracting there is often misunderstanding by owners and contractors about the use of change orders. In cost-plus contracting the owner is responsible for all 'costs', as that term is contractually defined. Therefore, a change order is required only if the effect of the change is or could cause a GMAX, if any, to be exceeded, and then only to increase the GMAX. Unless a change order is going to reduce a GMAX, a deductive change order need not address price, but only reduced scope of the work. A common accounting scheme requested by contractors is to include in a cost-plus contract, with a GMAX, a contingency account which the contractor can use for costs which fall outside the contractual definition of 'costs'. Typically, these are costs that result from construction or procurement error of from the financial failure of a subcontractor. The size of this contingency and the controls over its use can greatly affect the efficacy of the GMAX and can allow the contractor to recover for costs for which the owner believed the contractor was at risk. For further information on this topic please contact Paul M Lurie or Heidi Rowe at Schiff Hardin LLP by telephone (+1 312 258 5500) or by fax (+1 312 258 5600) or by email ([email protected] or [email protected]).