Cost-Plus Gains Traction in the Face of Price Uncertainty
Posted: June 26, 2023 | Legal
Cost-of-the-work agreements (aka “cost plus” contracts) are commonly used in commercial construction contracting to establish the terms and conditions for a project based on the cost of the work performed.i The majorfamilies of standard construction contracts include a cost-ofthe-work plus overhead and profit in their product offerings. In light of price escalation, supply chain disruptions, and rampant inflation, cost-plus contracts have been identified as a contracting tactic to address price uncertainty that still runs rampant in today’s design and construction industry. ConsensusDocs is offering a webinar that will take a deep dive into cost-of-the-work agreements and factors in evaluating if, how, and when to set a guaranteed maximum price (GMP) on such agreements.
A cost-of-the-work agreement provides for the owner to pay for the costs of the project (including labor, equipment, and materials — as further explained below) plus a fee to the builder. Hence, some call these agreements cost-plus in shorthand. The fee can be fixed/predetermined, based upon the estimated cost of the work or a percentage of the total project cost actually incurred during construction. The fee typically includes the builder’s profit, and sometimes the fee delineates how much is for overhead and how much is for profit. Other times, the fee is presented as one amount. The advantage of a fixed/predetermined fee in cost-plus contracts is that there is no incentive (or appearance of incentive) to increase the overall project costs during the course of construction to correspondingly increase a builder’s fee and profit.
ConsensusDocs offers cost-of-the-work agreements without a GMP: ConsensusDocs 235 and 510, and cost-of-the-work agreements with a GMP: ConsensusDocs 230 and 500.
Determining the Cost-of-the-Work
Determining what is included as a cost-of-the-work might seem straightforward, but it isn’t always. It causes additional record-keeping and administrative burdens on the builder that can be rather burdensome for smaller construction projects.ii The owner is more likely to have auditing rights to protect themselves. It is important to contractually define what is and what is not included in cost-of-the-work items. A contract should define direct and indirect costs for a project. Generally, specific project costs, including home office personnel assigned directly to the project, are considered direct costs. Within direct costs, some costs are fixed and not time-sensitive, and other direct costs are variable and time-sensitive. For instance, rental items are variable costs because the longer a project uses them, the more cost a project will incur. Of course, an owner will want to ensure that the duration of the rental doesn’t exceed the fair market price of the equipment being rented. Subsection 8.2.8 of the ConsensusDocs 500 caps rental charges up to 85% of the fair market value of the equipment, and the Bluebook is the source to determine fair market value.
A cost-of-the-work approach addresses unpredictable price fluctuations better than lump sum projects. If material prices increase or decrease, costs and payments adjust accordingly using a cost-of-the-work approach. In light of price escalation, inflation, and supply chain shortages, owners and builders and owners are more likely to seek early buy-out of subcontracting packages and supplies as soon as feasible so that prices and the availability of materials are locked in place.
Setting the GMP (To GMP or Not to GMP?)
Many cost-of-the-work agreements set a guaranteed maximum price (GMP) on a project. Without a GMP, the risk for cost of overruns generally falls on the owner. Conversely, once actual costs exceed the GMP, the builder absorbs those additional costs. Many believe the risk in CM at-risk contracts is the risk of meeting the GMP. When and how aggressively to set the GMP is something that is hotly debated. The risk profile of a project with a GMP is higher than a project without a GMP. To this end, the amount of fees and contingency a builder seeks under a GMP contract should account for that risk. In some markets and considering the unprecedented price uncertainty, there has been greater acceptance of considering cost-of-the-work agreements without a GMP.
Cost-of-the-work agreements offer an effective contracting tactic to address uncertainty in construction. When and whether a GMP is set will depend on project-specific facts and the parties’ preferences. Carefully defining and determining cost-of-the-work items in your contacts is critical, and there are standard construction contracts that can help you do so. The more uncertainty and earlier a GMP is set, will increase builders’ pricing.
If you have questions or comments about this article, contact Brian Perlberg, ConsensusDocs Executive Director & Senior Counsel at [email protected].
About ConsensusDocs: ConsensusDocs publishes a comprehensive catalog of 100+ documents that cover all contract document needs. ConsensusDocs are the only standard contracts developed by a diverse coalition of 40+ leading associations with members from all stakeholders in the design and construction industry. ConsensusDocs contracts incorporate best practices and fairly allocate risk to help reduce costly contingencies and adversarial negotiations. For more information, visit www.consensusdocs.org.
Reprinted with permission from ConsensusDocs www.consensusdocs.org