Which contract type is best for this job?

Contract law is a complicated topic that can present unique challenges to an estimator and their company.  You should always seek qualified legal counsel to answer questions or concerns before making any contractual commitments.  The purpose and intent of this article is to identify the most common construction contract types to illustrate their definitive characteristics.  None of what follows is legal advice, it is your responsibility to seek appropriate and qualified legal counsel before making any contractual commitments.

A construction contract is a legally enforceable agreement between at least two parties, generally the client and the General Contractor (GC).  Construction contract types are generally categorized according to how the final project cost is determined.  Each contract type will present pros and cons for all parties.  Generally speaking, a party with greater control over their risk will see a corresponding reduction in reward.  For example, Clients who can control every aspect of the work, will typically pay dearly for the privilege.  Conversely, GC’s who can control every aspect of their work, will typically have no means to increase their contract amount after its ratified.

Think beyond your own hand to see who else is playing at the table

It’s very important to understand that the design team’s contract adds a third dimension to the risk versus reward relationships in any given construction contract.  If construction documents were perfect, there wouldn’t be much need for estimators. Taking this thought a step further, if everyone always delivered on their promises, contracts wouldn’t exist. Well-written contracts reward human nature’s response to incentives.

Mark didn’t read his contracts, now he’s begging on the streets.

The more impact a contract can have on the performance of others, the more structural that relationship is to the overall project’s success.  Contractual incentives should be aligned accordingly.

Pareto Principle

Vilfredo Pareto was an economist who identified an unequal relationship between inputs and outputs.  The Pareto principle states that 20% of invested input into of a phenomenon is responsible for 80% of the results obtained.  Applying the Pareto principle to construction estimating means that pre-construction effort is responsible for 80% of the projects final value. Since pre-construction ends with a signed contract, it behooves the estimator to take a sober look at the state of that 20% to get a sense of where 80% of the job is headed.  The terms of your contract will define the limits of what can be done to steer your course, so you must consider them carefully.

Fixed price, Lump sum, Hard Bid

The most popular construction contract type is known as the “fixed price”, or “lump sum”.  The client agrees to pay the bid price upon competition for the defined scope at the time of contract.  They are generally not entitled to demand any cost breakdowns that would allow them to re-calculate their total contract amount.  It is however common practice to require a schedule of values which is used to determine the validity of progress payments.  This contract type is often solicited via a Request For Proposal (RFP) stipulating that the contract will be awarded to the lowest complete bidder.  Trade parlance refers to this as a hard bid because the bidders are not allowed to modify their price after the deadline.  The objective of a hard bid is to dispense with all opportunities to negotiate, barter, or collude in order to ethically award a contract.  Hard bidding is often a legal requirement for publicly funded work for this reason.

Since fixed price contracts are hard bid, the client can reasonably expect to achieve market-leading pricing proportional to their projects desirability, and publicity.  I’ve written at length about how to lower prices, and how relationships factor into how a given project may attract better pricing.

Fixed price contracts are notorious for change orders because incomplete, misleading, or erroneous information be exploited by bidders to deliver a lower bid-day price than the designers intent would have required.  This issue cuts both ways when unprofessional design teams require extraordinarily expensive items via a single note that’s buried where it will be easily overlooked.  In this case, the design team is trying to make the contractor pay for budget-blowing aesthetic features their client would otherwise strip out.

Since the contract price is fixed, so too, is the agreed-upon design.  This means that the bid-day Plans, Specifications, Requests For Information (RFIs), and Addenda, are all collectively defined in the contract as construction documents.  Any changes to the design or project scope after the bid date are subject to change order. Conversely, the design team will insist that anything that can be intuited from their bid-day documents is the General Contractor (GC’s) responsibility to include in their bid.

This adversarial relationship is made exponentially worse on projects where the design team wasn’t given sufficient time or budget to generate complete CD’s.  These projects are often put out to “cattle call” bids where any interested firm is welcome to submit a proposal regardless of their actual abilities. Clients with dodgy morals and small pocketbooks tend to short-change their design teams up front, and their build teams later on.  There is little to recommend pursuing the lowest common denominator in a given market.

On the other hand, fixed price contracts can be among the best arrangements for a client with a strong design, and an attractive project.  If the design team did their job properly, there should be very little that needs to change from the original design.  Clients that pre-qualify GC’s to ensure they’re soliciting only a select few market-leading firms will reduce their risk of hiring a contractor that falters on the project.

The fixed price contract presents opportunities for the GC to potentially improve their profitability by making better production, or finding more efficient means of construction.  Conversely, the GC cannot expect additional compensation if they underestimate the project’s cost.

Clients will reject cost increases even when they’re presented in the cutest possible terms.  

Lump sum contracts do not require the bidders to provide detailed breakouts of their costs.  Most lump-sum contracts require a schedule of values which identifies major assemblies or systems and their contribution to the total.  When payment draws (invoices) are submitted, the line items of the draw refer to items listed on the schedule of values along with the percentage of their completion.  This gives the client a way to identify and confirm the contractors production claims on every payment draw.

Cost plus fee

There are some projects that require scope flexibility to such an extent that a fixed-price contract would generate excessive change orders.  Rather than obliging the GC to commit to a fixed price based on a fixed design, the GC agrees to invoice the client for their actual costs plus their fee.  Sometimes this relationship is called “time and material” because the invoices provide a detailed breakdown of the labor costs attributed to the actual time spent working, in addition to the receipts for the material that was installed.  Cost plus contracts are generally “open book” which means that the client is entitled to a copy of every invoice or receipt attributed to the work completed.  These contracts also generally require some form of work verification.  Cost plus fee contracts allow either a fixed fee for the entire project, or a fixed percentage applied to every invoice.

GC’s facing a project that’s likely to grow in scope would likely earn more from a fixed percentage, whereas projects likely to shrink in scope would probably pay better with a fixed fee.  GC’s need to understand their obligation to job billing to ensure that the Project Manager and their staffs time is properly accounted for.

Cost plus contracts generate  an incredible amount of paperwork that both the GC and the client must go through.  The administrative time requirements should not be underestimated because the required transparency means the client can use the information provided to dispute or delay payment.  This is a stark contrast to the lump-sum contract where payment draws are based on percentages of completion against the schedule of values.

Estimators reading this may have already noticed that the cost plus fee contract doesn’t give them much to actually bid.  The considerations here are more systemic to your workflow  in that the obligation to the work is variable.  Committing to a project that could grow exponentially may prevent the company from pursuing other work.  Conversely, a little project that just never ends can interfere with other commitments.  These projects can have severe time constraints, and difficult site logistics just like any other.  Naturally the more limited the scope, the less risk these contracts will involve.

It may sound surprising to hear that cost-plus contracts can be solicited for competitive bid.  RFPs for Service contracts may require bidders to submit hourly rates for specific conditions, crafts, and terms with a corresponding fee requirement.

Cost Plus GMP

The cost plus contract allows greater scope flexibility to the client however the total budget is undefined.  A Guaranteed Maximum Price (GMP) is the maximum amount the client is obliged to pay for the scope of work.  A cost plus GMP contract provides a client with cost transparency and the ability  to retain any construction savings while defining their maximum price.  Clients are well advised to consider incentives here because they rely on the GC’s expertise to find less expensive means and methods.  If the GC’s fee was based on a percentage of the total, the cheaper solutions would reduce their profitability.  For this reason, many clients commit to shared a percentage of any savings with the GC.

A cost plus GMP contract combines the GC’s risks of a fixed-price with a cost-plus contract.  Since the client is capturing all or most of any construction savings, the estimator cannot rely on savvy PM’s to improve on the bid-day profitability.  The GMP constitutes the estimated construction costs plus any merited contingency funds.

Estimators should consider the client’s incentives depending on their position in the project’s budget.  A client whose project total is headed towards the maximum price, has little incentive to make the job cheaper.  Any additional work beyond the GMP is full price work for free from the client’s perspective.  Clients with shared savings agreements in this situation would only recoup a portion of any budget savings.

All of the administrative workload of the Cost-plus contract applies to the cost plus GMP contract as well.  Clients choosing this contract type must be prepared to analyze and administer the payment process as well as the work reporting.

Unit Price

Unit pricing is a greatly simplified contractual model.  Unit pricing is often referred to as “menu pricing” because the client is free to select as many or as little of any particular unit as they may need.  Unit pricing is  typical in situations with repetitive scopes of work that come in varying quantities.  For example, a property owner might want to remove and replace out-dated finishes in all their public hallways.  Rather than paying a design firm for plans of every hallway, the project RFP solicits unit pricing for all applicable finishes from GCs.

Estimators should consider how the clients contractual flexibility could present an unprofitable arrangement to the GC.  Mobilization is a costly endeavor, and unit pricing encourages phasing inefficiency.  This is because it costs the client the same amount to have you do one task on five different occasions, as it does to have you do five tasks at one time.

Opportunity cost is the lost profitability of working somewhere else.  All of which means that if the client is likely to require a small amount of work at a particularly inopportune time, the unit price must be high enough to make that obligation worthwhile.

Reminding ourselves of the Pareto principle, we must consider the diminished value of a project that’s so poorly defined in pre-construction.  Any unit price should include its commensurate management,  overhead and profit so that the little unit priced job pay’s it’s fair share of the management, rent, office supplies, etc.

Turnkey

By now it’s pretty clear that most construction contracts are arranged to balance the risk and rewards between the client and the GC.  Much of the GC’s risk could be mitigated by controlling the projects scope.  Obviously clients are concerned about relinquishing their control over the scope when they’re obliged to pay for the final outcome.  One way of approaching this impasse is the turnkey contract.  A turnkey construction project is completely designed and built according to client criteria for an agreed upon sum.  The client generally has little to no project input after the agreed upon contract criteria.  Once the project is completed, the client pays and takes ownership.  The GC is liable for any cost over-runs, however they are also able to retain any savings they can generate.   Turnkey projects present the least administrative burden because there is no payment (hence no payment draws, owner meetings, or change orders) until the building is accepted.  These projects obviously require extensive GC capital to fund the design and construction of the clients building.   Turnkey projects generate very little cash flow because you’re only paid when the job is done.  This means that only the most financially robust GC’s are equipped to profitably pursue this contract type.

Design build

With the exception of turnkey, all of the previous contract types require the client to hire their own design team.  For clients seeking greater input than a list of specified criteria, but no obligation to hire their own architect, design-build may be a better arrangement.  GC’s in a design-build contract will hire their own design team to prepare the construction documents for the project.  This arrangement allows the GC to direct the design team towards the most cost-effective and timely solutions for the client.

Artistic rendering of a GC providing direction and motivation to the design team.

Design-Build contracts typically lay out design milestones with accompanying budget checks so the client can verify plan progress, and budgetary conformance.

Since the design-build contract is signed before there are completed CD’s, the client has less assurance that they’re getting a competitive price.  Most design-build RFP’s provide a narrative of project requirements which are used to generate a proposal presentation.  Sometimes schematic drawings are provided to illustrate the project intent.  Competing GC’s prepare an estimated budget and schedule for the project which are presented in an interview with the client.

Clients are well advised to look for competent and resourceful companies who can quickly resolve problems as they come up.  A strong history of on-time, and on-budget projects with happy clients is perhaps the best indicator of future success.

Estimators must understand that clients interpret design-build to mean that change orders for unexpected items are “impossible” because the design is the GC’s responsibility.  Clients also expect to see refunds from any bid allowances or contingencies that were not fully allocated.  As with all things in estimating, any number provided to the client may be used against the GC.  It’s remarkable how immediately an inconvenient number will be recalled, while its attendant context will be forgotten.

Many estimators approach design-build projects with less focus on low prices than controlling risk.  Including funds to accommodate unknowns allows the project to progress without budgetary blowout later  on.  Some design-build contracts require “open book” estimating which means that the client will receive a copy of all the bids, and the GC’s completed estimate.  Subs should be directed to provide conceptual pricing based on past experience, rather than the schematic plans and narrative.

Negotiated Agreement

The most preferred contract type among GC’s is the negotiated agreement.  The client hires the GC early in their project so that the GC may provide meaningful insight and guidance to the clients design team.  Negotiated agreements trade the competitive bidding of a fixed-price contract for an open-book bid.  I’m not sure if we have baseball to thank for this, but a common client requirement is that the GC must provide “at least three” bidders for every subcontracted scope of work.  The client expects budgetary checks at the Schematic Design (SD), and Design Development (DD) phases.  The final construction budget is established at the Construction Document (CD) design phases.

GC estimators must understand the underlying contractual relationships as they pertain to incentives.  The design team’s contract may allow for hourly billing up to the final construction budget, followed by a fixed percentage of that budget for owners-rep services thereafter.

Architects in this position stand to make more money by delaying the final design, and driving the project costs to the clients maximum budget.  GC’s hired to provide insight and guidance to such a design team may find their comments ignored.  Since the Architect will be the owners representative during construction, the GC has little incentive to risk the Architects wrath during design review.

Just as with the design-build contract, the client expects that change orders for the unknown are “impossible” since the GC is embedded in the design process.  This means that the GC has every incentive to pave the way for a smooth project delivery by packing the bid with contingency funds and low-risk subcontractor bids.

GC’s with a negotiated agreement project have an advantage on the bid market because their opportunity is more attractive to subcontractors.  When there are multiple GC’s bidding a project, the subs odds of winning are much lower than when there’s only one.  Since the GC with a negotiated agreement is more focused on low-risk than low price, they can afford to solicit only the best performing subcontractors on the market.   Clients can benefit from a build-team whose primary focus is successful project delivery.

Since the negotiate agreement discourages GC change orders, the client may find that their total costs for the project are comparable to a hard-bid job once all the change orders are included.  The negotiated agreement tends to be a more pleasant experience for the client because they’re not obliged to argue over change orders the whole project long.  Also, the negotiated agreement tends to attract market-leading subcontractors who have the experience, staff, resources, and buying power to make their projects successful.

Clients interested in the negotiated agreement should give careful consideration to their design team’s contract.  A fixed fee for the entire design is a sensible option that removes incentives to act against the client’s interests.

Summing up

Estimators must carefully consider the construction contract and alter their bidding strategies accordingly.  The contract types listed above represent popular solutions to common construction situations.  While it’s theoretically possible to build a project with any of these contracts, the most successful outcomes come from pairing the contract type to the project situation.

It’s vital to understand the terms of exchange that define an equitable arrangement.  Contracts that are one-sided tend to increase the risk for one party which they mitigate by lowering the projects value to the other party.   When the contract favors the client, the GC’s mitigate their risk by increasing their prices for the work. Conversely, when the contract favors the GC, the client’s mitigate their risk by reducing the amount they will pay for the work.  Estimators who are familiar with rates for  hard-bid work should therefore expect different prices for design-build, or cost-plus GMP projects because the risk is different.

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© Anton Takken 2016 all rights reserved