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Building a Home? Choose the Right Pricing Model for Your Construction Agreement

Christa L. Folkers

Williams Parker regularly advises clients who want to engage a general contractor to build or remodel their home. If you are contemplating a major home-related project, you should carefully consider the pricing model before entering into any formal agreement. There are several traditional methods to price construction work. Factors that impact the selection include the type of construction, relationship between the parties, certainty of cost, quality of work, and time and schedule constraints. This article discusses the primary advantages and disadvantages of three common pricing models:  fixed-price, cost-plus, and guaranteed maximum price (“GMP”). If you understand these pricing models, then you are more likely to achieve a satisfactory result with your construction project.

A fixed-price contract sets a guaranteed price to complete the construction work. This arrangement is generally used when the contractor has constructed other homes with a similar set of plans and specifications and can provide a reasonably accurate cost estimate. To predict the total construction cost with reasonable certainty, the contractor needs a sufficiently complete set of plans and specifications. As a result, you will probably spend a significant amount of time early in the process working out the project’s details, incorporating design changes, and determining the component specifications. The time spent in the early stages may lead to a longer time frame for the project.

From your perspective, the main advantage of the fixed-price contract is budget certainty. The certainty of the construction cost may be important if you plan to obtain a construction loan for the project or if you simply need or want to limit the amount spent on the project. This is the most basic method for pricing construction work. Under a fixed-price arrangement, the contractor is obligated to complete the work for the agreed-upon amount and must absorb the impact of any cost overruns. As a result, the contractor’s price will typically include a premium to compensate for the risk of a cost overrun. If it turns out that the contractor’s cost to complete the project is less than the fixed fee, then the contractor keeps the difference between the actual cost and the contract price. As a result, this fee structure may lead to a lower-quality project either through the use of inferior subcontractors or poor quality materials. Both of these actions would reduce the project’s cost and increase the contractor’s profit.

In a cost-plus contract, you agree to pay the contractor the actual construction costs plus a pre-determined fee. The pre-determined fee may be a stipulated amount or a percentage of the construction costs. This may be a desirable arrangement if you have experience in the construction industry or if you cannot initially define the project’s scope. The cost-plus contract is often used when the quality of work is a higher concern than the total cost. This arrangement allows you to commence preliminary phases of construction without having a completed set of plans and specifications and gives you flexibility to change designs and materials during the construction process.

Under the cost-plus contract, the final cost may be less than it would be in the fixed-price contract because the contractor does not need to increase the price to cover the risk of cost overruns. However, when you enter into a construction agreement with a cost-plus arrangement, the project’s final cost is uncertain. This is the biggest disadvantage of the cost-plus contract. You are responsible for all costs—even if they exceed your estimates of what is fair. Further, since you are required to pay the contractor for all of the construction costs, the contractor has little incentive to keep costs under control. In fact, if the contractor’s fee is a percentage of construction costs, then the contractor has an economic incentive to let the costs rise. Basing the contractor’s fee on a fixed fee instead of a percentage of the actual costs is one way to minimize this concern.

Guaranteed Maximum Price (“GMP”)
A GMP contract is a variation of the cost-plus contract. Under the GMP arrangement, you are obligated to pay the contractor the actual construction costs up to an agreed upon amount plus a pre-determined fee. If the construction costs exceed the agreed upon amount, the contractor is responsible for the difference. If the construction costs are below that amount, the savings are returned to you. Alternatively, you and the contractor may agree to split the savings. The GMP arrangement addresses several disadvantages of the fixed-price and cost-plus models by limiting your economic risk and allowing flexibility during the construction process.

Although the GMP contract has several advantages, there are risks to you. Similar to the guaranteed price in a fixed-price contract, the contractor is likely to inflate the GMP to minimize the contractor’s risk of a cost overrun. If you agree to a shared savings clause, an inflated GMP will result in an increased profit to the contractor. The construction agreement should clearly define what is included in the GMP. GMP contracts require significant sophistication and often result in more work on your part to administer.

Protect Your Interests
It is important that you understand the different pricing models that are available before executing a construction agreement. Once you determine an appropriate pricing model, the terms of the arrangement need to be incorporated into the construction agreement. Careful drafting of the construction agreement will help to ensure that you end up with a new home or home improvement that meets your expectations in terms of price and quality.

For more information regarding this article, please contact Christa Folkers at (941) 552-5554 or cfolkers@williamsparker.com.

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