Three Types of Contracts Offer Different Benefits and Risks

For the first time in years, construction material costs are rising. In March, the Bureau of Labor Statistics reported numbers showing a 4.8 percent rise in material prices between February 2016 and February 2017.

For contractors who have been working on long-term projects, the price increases could mean lower profit margins, or even losses, as they complete their work. Contractors who are in the estimating, bidding, and contract negotiation stages for new projects will want to ensure profitability and manage risk where possible. In particular, selecting the best pricing system for a project and properly drafting the contract to reflect it is essential, especially during periods of material cost increases.

Three prevalent pricing mechanisms are fixed-price contracts, cost-plus contracts, and guaranteed maximum price contracts. Here’s the lowdown on each type and the benefits and risks with respect to cost changes.

FIXED-PRICE CONTRACTS

Fixed-price or lump-sum contracts are contracts where the parties, sometimes through extensive negotiation, agree upon a fixed sum for the labor and materials to be furnished. Typically, the contractor will prepare a schedule of values where portions of the work correspond with a certain percentage of completion, and pay applications are submitted for the appropriate percentages (often, minus an agreed-upon amount of retention). If the parties want to change the scope of work, a signed change order will be required, and the parties must negotiate and agree upon the change order pricing before signed.

Fixed-price contracts offer contractors limited protection—and in some cases, no protection—in the event of material price increases. Indeed, “the normal risk of a fixed-price contract is that the market price for subject goods or services will change.” (See Seaboard Lumber Co. v. U.S., a 2002 Federal Circuit Court opinion.) Many contracts contain force majeure provisions that excuse or absolve parties from performing their contractual duties in the event of unforeseeable circumstances that are beyond their control and that make performance impossible or commercially impracticable. Examples of such events include “acts of God” like floods, tornadoes, and earthquakes, as well as events such as riots, terrorist attacks, and labor strikes. However, force majeure clauses can be difficult to enforce, and most courts, like the Federal Circuit in Seaboard, view cost changes as a normal, foreseeable risk and not an event that will excuse contractors from further performance. Therefore, when negotiating a fixed price, contractors generally should plan to be held to that price.

However, properly drafted fixed-price contracts can give contractors options to mitigate potential losses arising from cost increases. One strategy is drafting the contract to read that the fixed price is based upon material prices as of the date of signing and that significant increases in material prices will or shall (not “may”) entitle the contractor to an equitable adjustment of the contract price through a signed change order.

Contractors should also be entitled to adjust the contract price or time of completion to account for other problems—like delays, material shortages, or other difficulties acquiring materials—that can occur when costs increase. Such provisions will have better chances of being enforced if the contract specifically defines what constitutes a “significant” percentage increase in price. Additionally, contracts should include provisions protecting contractors from liability associated with delays and shortages. Some fixed-price contracts also provide that in the event the parties cannot agree on a price for change orders, the change order work shall be paid for on a time-and-materials basis including overhead and profit. If contractors are unable to negotiate an equitable adjustment provision, a time-and-material measure for change orders can provide some protection.

COST-PLUS CONTRACTS

For contractors, while the above revisions to fixed-price contracts may be helpful, cost-plus contracts will provide the maximum protection against material cost increases. Cost-plus contracts—also known as time-and-material agreements—are agreements whereby contractors bill for the cost of the labor and materials, plus a fee that is either a percentage of the project costs or an agreed-upon flat fee. When invoicing, contractors include documentation of their payment to subcontractors, vendors, and material suppliers to provide proof of the cost. They then invoice for the cost plus the agreed-upon percentage of the cost.

Unlike fixed-price agreements, cost-plus agreements place the risk of cost overages and increases on the owner. If the contractor’s fee is a percentage of the labor and material costs, these arrangements also create potential for contractors to benefit from cost increases. However, they eliminate the need to negotiate a fixed price, they make change orders much simpler to implement, and in periods of cost decreases, they can benefit owners.

GUARANTEED MAXIMUM PRICE CONTRACTS

While some owners will be wary of cost-plus agreements—especially when material prices are on the rise—guaranteed maximum price (GMP) contracts may serve as a compromise that could help both contractors and owners mitigate risk. GMP contracts are a modified cost-plus option in that they function like cost-plus agreements—contractors invoice for the labor and material costs, plus their fee—but the contracts establish a maximum price for the entire project. Contractors invoice in the same manner they would for a cost-plus agreement, but once the owner has paid the maximum agreed-upon amount, the remaining costs are the contractor’s to bear.

Often, parties to GMP contracts also agree that if the sum of the cost of work and the contractor’s fee total less than the guaranteed maximum price, the difference in the cost and the agreed-upon maximum fee reverts to the owner or is split between the two parties. This makes some owners more amenable to these agreements than they would be to traditional cost-plus agreements, which can make project costs very unpredictable.

Whether parties decide that a fixed-price or cost-plus agreement is best for their needs, they should take care to draft the price terms clearly in order to avoid ambiguity and confusion. Generally, courts enforce contracts as written if they are clear and unambiguous, but if an ambiguity exists, courts will must look to extrinsic evidence to determine what the parties intended, leaving the fate of the dispute to a jury or fact finder. For example, in Rosa v. Long (a 2004 N.C. Court of Appeals opinion), a homeowner and contractor entered into a contract stating that the contractor would build a turnkey dwelling for the “sum of $193,662.60” but later stating that contractor would receive a commission in the amount of 10 percent of all materials, subcontracts, and labor obtained and expended by the contractor. Because these terms suggested that the contract was both fixed-price and cost-plus, a jury decided what the parties intended instead of a judge enforcing the terms as drafted. Clear, proper drafting is essential to increasing the parties’ chances of a predictable outcome in the event of a dispute.

About Caroline Trautman

Caroline Trautman is an attorney with Anderson Jones PLLC, Raleigh, N.C. She assists clients with construction litigation, contractual drafting and disputes, collections, lien and bond claims, licensing issues and other matters affecting businesses.

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