Construction contracts commonly feature a guaranteed maximum price. Essentially, that puts a cap on project costs (i.e. The job cannot exceed $____…). With all construction topics, there’s more than meets the eye with a contract featuring a guaranteed maximum price (GMP) contract. Let’s look at some of the in’s and out’s.
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What is a Guaranteed Maximum Price (GMP) Contract?
A guaranteed maximum price contract sets a limit, or maximum price, that the customer will have to pay their contractor or subcontractor, regardless of the actual costs incurred. In its simplest form, a guaranteed maximum price contract simply puts a cap on the contract price that can’t be exceeded. Costs beyond that guaranteed maximum price may need to be covered by the contractor or sub.
GMP contracts are attractive to customers because they shift a significant amount of risk to the party performing work. Plus, it gives a clean, easily understandable price. Any costs that exceed the number given to the customer will be absorbed by the party performing work. If there are overruns, or if issues pop up – the customer can point to that guaranteed maximum price to argue that no extra pay is warranted. At the same time, if a project comes in under budget, the customer still reaps the benefits, unlike a fixed price contract (after all, it’s just a maximum price – not the actual price). Though, depending on the terms of the agreement, these savings might be shared. After all, it’s usually a good idea to incentivize contractors and subcontractors to finish the job on time and under budget.
To recap: The total GMP generally includes the cost of labor/materials and overhead, plus a percentage of that cost as profit. The total cost to the customer can be less than the guaranteed maximum price, but will never go over.
How a Schedule of Values Works With a GMP Contract
A proposal for a guaranteed maximum price contract will include a schedule of values. To determine the GMP for the project, the schedule of values will be used to break down each job or task into line items. (Think foundation work, then roofing, then siding, etc.) The customer and management team will then set an estimated price for each of these line items, often with input from their contractor or subcontractor.
So is the guaranteed maximum price the added total of all these line items? Maybe, maybe not. This is when negotiations will start!
From the customer’s perspective, they’ll want the GMP to apply to each line item. Knowing the exact limit for each line item helps make accounting easier, and the savings on any line item might go directly to the customer. From the perspective of the contractor or sub, they’ll prefer one overall guaranteed maximum price for the entire project. This way, if one line item goes under price and others go over, they can easily shift costs across multiple line items. It’s more common for a job to have one overall GMP.
Regardless of which price structure is chosen, it’s important to know which one will apply to the project!
Construction Accounting: Understanding the Schedule of Values
Planning for Uncertainty With a GMP Contract
The problem, not only with guaranteed maximum price contracts – but for every project, is planning for uncertainty. Since GMP contracts attempt to cap the total contract price, there needs to be some mechanisms in place to add flexibility to the project.
Contingency amounts are how to plan for the unknowns! These act as a contractor or sub’s safety valve if one or more line item exceeds their estimated costs. These can be structured in two general ways. A contingency can be a customer’s reserve (an amount set aside to address any additions or alterations to the project). Another way to structure contingencies is to have it built into the anticipated price for the work.
If the contingency is built into the contract, there is still an opportunity for negotiation here as well. If the GMP is assigned per line item, the contingency amounts will likely be a percentage assigned to each task. Again, contractors and subs prefer lump sum contingencies. That allows them to spread costs among various line items.
Customers will prefer to assign contingency percentages to each individual line item. The reasoning being, contingencies are typically where the customer can make some savings on a project. Unless, of course, the customer decides that any unused contingencies go to their contractor or subcontractor as an incentive to keep the project under budget. The power of negotiation!
Although many times confused with contingencies, allowances are a way to plan for the known unknowns. Allowances are amounts that are set aside for decisions that the owner has yet to make regarding specific parts of the work. However, these costs are only to be used for material costs, not for labor, profits or overheads.
For instance, imagine that the construction plans include bathroom tiling, but the owner hasn’t decided what type of tiling they want. The contractor will set a middle range for the materials and wait for a decision from the owner. If the materials the owner chooses is less than the estimate, the savings will revert back to the owner. If the owner ends up choosing a more expensive type of tiling, this increases the total price of the contract.
A well-drafted allowances clause should detail whether the allowance covers materials only or if it also includes labor. It should detail the notice and authorization procedures, and explain how the overages and underages are handled.
Change orders are another way to prepare for uncertainty in a guaranteed maximum price contract. These are mutual agreements to increase the contract price or extend the time of completion due to unforeseen conditions, unfinished plans, or owner changes that materially affect the scope of the project.
The GMP contract should establish the procedure for the owner and/or contractors to request and approve these change orders. Also, in case a dispute arises concerning price or work, the contract should include a dispute resolution clause to detail how to handle disagreements. Without the flexibility to incorporate change orders into the GMP, a project could get stuck in limbo.
Benefits & Drawbacks of Utilizing a Guaranteed Maximum Price
Accelerated Schedule. Since a guaranteed maximum price contract solidifies the final contract price early on it, and that will expedite the bidding process. It also makes obtaining financing on your project easier – construction lenders don’t like uncertainty. Consequently, this can also help accelerate the project schedule itself.
Savings Incentives. As mentioned earlier, most of the risk under a GMP contract shifts to the party performing work. This gives an initial incentive to contractors and subs to keep costs down and complete their work before schedule. As stated earlier, cost savings can be structured in a number of different ways. But, customers will typically agree to share in the cost savings. By sharing in the potential rewards of low cost, efficient work, this incentivizes everyone to collaborate and build a team mentality.
Inaccurate cost reporting. If the customer wants to reap the benefits of cost reductions, the accounting needs to be visible and transparent. The larger the construction project, the more cost and time it takes to review the accuracy of each payment application. One way to combat this is to use a cloud-based construction management software. This will allow the customer to have direct and up-to-date cost details for each phase of the process.
Increased contractor risk. Operating under a GMP contract will transfer a majority of the risk to the parties performing work since they will have to eat any cost overages. What can be done to mitigate that risk? First of all, a contractor or sub can charge more. Greater risk should lead to greater rewards. Obviously, that’s a dangerous proposition – especially when the contract awarding process is done by competitive bidding. Another option is to pass that risk on to your subs by making their contracts GMP as well. Lastly, a contractor or subcontractor can minimize their exposure to risk by using solid estimating software. Having the ability to accurately cost out a job can help eliminate the need to overcharge the customer.