If you’re investing in real estate or are otherwise involved in real estate development, you will quickly find that construction contracts are often extremely complex. Who is liable for cost overruns? Who benefits if actual costs are lower than budgeted costs? The answers to many of these questions are resolved in the contract’s pricing. The three most common construction contracts are (1) fixed price, (2) cost-plus, and (3) maximum guaranteed price (“MGP”). Each method differently shifts cost overrun risk between owner and contractor.
In a fixed price contract, the contractor and owner agree to a single amount to be paid for construction prior to construction commencing. For example, a business owner may negotiate a construction contract with a contractor to build a storage facility for $200,000. In a fixed price contract, the contractor’s profit is the agreed price minus costs. The advantage to owners is that they have price certainty as the contractors take on the risk of cost overruns. However, this certainly comes at a price – fixed price contracts tend to be the most expensive method of pricing construction contracts. Additionally, there is concern for owners that contractors may cut corners to keep costs low to maximize profits. This issue is exacerbated when cost overruns become certain.
In a cost-plus contract, the owner agrees to pay the contractor a fee in addition to the costs. The fee can be fixed or flexible, such as costs plus an agreed sum, or it could be costs plus a percentage of the project’s total costs. Here, the risk of cost overruns is placed on the owner – opposite that in a fixed price contract. Because contractors are not responsible for costs, there is often concern that contractors will take a relaxed approach to control costs. Similarly, setting the fee to a percentage of project costs could incentive contractors to drive up construction costs to increase their fee (and therefore profit).
Maximum Guaranteed Price
The MGP contract is a hybrid of the fixed fee and cost-plus contract. Here, the cost-plus structure is used with a maximum cap set on price. This structure shares cost overrun risks between the owner and contractor, whereas fixed price and cost-plus contracts generally allocate cost overrun risk to a single party. As a result, an MGP contract more evenly balances incentives and liabilities between the owner and contractor. Construction contracts are complex documents with significant consequences for the parties involved. A proper construction contract should be drafted in light of a project’s specific needs, such as those for price certainty or minimizing overall costs. The experienced real estate and construction attorneys as the Law Offices of Richard Palumbo have successfully advised individuals and business owners in Rhode Island on construction contracts for decades. If you have questions relating to construction contracts or need legal advice, please contact our office to set up a consultation or complete the contact form.