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Friday, October 31, 2014
April 13, 2011

Effectively Managing the Challenges of GMP Contracts

Written by  Rick Burnham

Owners and contractors sometimes find themselves in stormy seas when trying to successfully administer Guaranteed Maximum Price (GMP) contracts. As “surprises” pop up, additional costs and problems arise, and disputes over these issues start to turn the project sour. The underlying cause can often be traced to the parties using an unfamiliar contract format and failing to adjust their standard practices to accommodate the nuances of this project delivery system.

Examples of practices that can lead to disputes on GMP contracts include:

  • Poor administration of allowance items
  • Misunderstandings with respect to the effects of “qualifications” and “clarifications” that are listed in the contractor’s proposal
  • Waiting to resolve value engineering proposals until after the GMP is agreed to and the contract is signed
  • Lack of a good working definition of what is a “change to the GMP”
  • Misconceptions regarding contingencies and how to deal with “buyout savings” and “buyout overruns”
  • Misunderstanding of shared savings and the timing of contract adjustments relating to them
  • Administrative practices relative to those parts of the monthly progress payments that cover:
    • Contractor’s fee
    • Contractor’s general conditions
    • Work that has been self-performed by the contractor
    • Costs associated with the contractor’s contingency

When one or both parties ignore the potential problems that can be created by these issues, the likelihood of a shipwreck grows. When both parties understand the subtleties of these issues at the outset, they enhance their chances for smooth sailing. The purpose of this article is to make the ships and crews of both parties more seaworthy.

Allowances

An allowance is basically a device that is used with regard to materials and equipment that have not been selected and specified with sufficient detail to permit the contractor to reasonably ascertain its cost as of the time that the GMP proposal is submitted. This lack of selection may occur where the level of quality has not been established or where details related to interior design have not been resolved prior to the establishment of the GMP.

In effect, an allowance prescribes a “plug number” for that work. That is, a specific dollar amount is included in the GMP as an allowance, but with the understanding that as the design evolves and the Owner makes the choices necessary to define that work, the GMP will be adjusted up or down to the same extent that the actual cost of the allowance item exceeds or is less than the “plug number.”

Allowances should be used only when the parties are in agreement that some aspects of the plans and specifications are so devoid of definition that there is simply not enough information to realistically price that item of work. An example is carpeting—the price of carpeting can vary widely, and if a specific carpet has not been designated at the time of the proposal, the establishment of a carpeting allowance is common.

Th is seems fai r ly simp le. Administratively, however, this straightforward pricing technique can become problematic. Two common issues and practical measures for mitigating problems are:

Issue: What is the scope of the allowance? Was the “plug number” intended to cover the cost of the materials only, or was it intended to cover both materials and installation labor? What about freight charges, taxes, insurance, and mark-ups? What if the Owner’s choices with respect to the allowance have an impact on other work (for instance, the choice of a chandelier that weighs so much that a structural change is needed)?

Mitigation Strategy: Not all allowance items are the same, but many contracts treat them that way. Think through each allowance item carefully. Drafting contract provisions that address each of the allowances provided for in the contract is the best way to minimize or even eliminate this problem.

Issue: Should the actual cost overrun or under-run for an allowance item result in an alteration of the Guaranteed Maximum Price only after taking the remaining balance of the contingency into account? In the absence of specific contract language stating otherwise, I believe the answer to this question is an unequivocal “no.” Allowances and contingencies are two entirely separate and discrete concepts—there is no connection between the two. Nevertheless, my experience includes numerous instances in which Owners have insisted that allowance overruns be charged to contingency without specific contract language to back them up. If the contingency amount is not used up and there is no provision for shared savings, then this practice can be benign. However, when the contingency is consumed during the course of performance, or when there is a provision for shared savings, this practice will likely lead to a dispute.

Mitigation Strategy: Add a clarifying statement to the allowance section of the contract that states something like:

“All adjustments to allowance amounts shall result in an identical adjustment to the GMP. No adjustment to an allowance amount shall offset or add to the amount of the contingency.”

Qualifications and Clarifications

Issue: Most GMP proposals contain a list of qualifications and clarifications that has been prepared by the contractor to accompany its bid. This list should be viewed by the parties as a useful and necessary part of the full and open communication that should accompany the negotiation of all GMPs. The need for qualifications and clarifications is often driven by: (a) the extent to which the plans and specifications are not complete, and (b) the potential cost-significance of those details that are not shown on the GMP drawings. A qualification or clarification is typically somewhat different in nature than an allowance, in that it usually applies to aspects of the work where the design team and owner have made some choices, but where all of the details related to those choices are unclear or have not been finalized and articulated in the contract documents. Typically, a qualification or clarification states the contractor’s intent with respect to the filling in of those blanks. Every contract has at its core a quid pro quo. Every contract says, in effect, “I’ll give you this for that.” So, when a contractor is asked to guarantee the price (“this”), it only seems reasonable for a contractor to want to clearly express its understanding of what the work to be performed (“that”) is. In other words, if, when the GMP is agreed to, the drawings and specifications lack the detail needed for the parties to truly have a “meeting of the minds” concerning what is to be built for the GMP that is offered, then the qualifications and clarifications allow the contractor to add some description of its understanding of what it is expecting to build. When the plans and specifications lack clarity or completeness, both Owner and design team are well advised to pay attention to how the contractor intends to interpret, clarify, and complete those details. Problems arise, however, when the contractual impact of such qualifications and clarifications is left unclear, or when they directly contradict contract provisions that place the risk associated with the completion of the design on the contractor. Owners should also be aware that sometimes, if the qualifications and clarifications are extensive, it may be an indication that: (1) It is too early in the design development process to set a GMP, or (2) The contractor is subtly trying to minimize or avoid risk that is properly part of a GMP contract.

Mitigation Strategy: The best way for the parties to mitigate the risk of disputes arising from qualifications and clarifications is to thoroughly talk through them prior to establishing the GMP and make sure that representatives of the design team are present for those discussions. Only in that way can the parties be sure that the design team understands that the choices it makes on behalf of the Owner can result in financial consequences to the Owner.

Unresolved Value Engineering Proposals

Issue: Quite often Owners ask for, or contractors unilaterally offer, value engineering proposals to reduce the GMP proposed without adversely affecting the quality of the project. These proposals require the Owner’s design team to accept and implement changes to their iteration of the project design. Unfortunately, value engineering proposals often are made during the last moments of the negotiations that lead up to the signing of the GMP contract, when there is insufficient time to coordinate those proposals with the portions of the project that may be affected by them. It is entirely foreseeable that the lack of resolution regarding these proposals can lead to problems later on, when that design implementation and coordination takes place and it is discovered that either some part of the value engineering proposal is unacceptable to the design team or leads to cost increases in other aspects of the work that were not contemplated by the contractor.

Mitigation Strategy: The best practice is to complete the implementation of value engineering proposals prior to establishing the GMP. Failing this, however, carefully drafting contract provisions that address the “what ifs” that unresolved value engineering proposals present can at least help avoid later surprises and disputes, when things do not work out exactly as planned.

Scope Changes

Issue: Changes can be problematic on any project, but identifying changes on GMP contracts is uniquely challenging. If, after signing a GMP contract, an Owner decides to add square footage to the building that is the subject of that contract, it is natural to conclude that the GMP will be changed to reflect that addition. That’s an easy one. But changes under a GMP contract are often problematic because the parties fail to recognize that changes need to be analyzed, and should be handled, differently than under the more common forms of design-bid-build lump sum contracts. The most common way of identifying a change on a lump sum contract is simply to compare what the owner now wants to what is shown on the plans or described in the specifications. However, this method of identifying changes does not always apply to GMP contracts. In a GMP contract, the parties have agreed to a price for a whole and complete project, even though the plans and specifications are not whole and complete. In fact, many GMP contracts contain a clause that specifically states that the plans and specifications are incomplete and that the Owner is relying upon the contractor’s expertise and experience to include in its price all that is necessary to provide a project that is complete and fully functional. This fundamental difference in GMP contracts also frequently causes problems between the contractor and its subcontractors, who will insist that their price is based only upon what is clearly shown on the drawings or spelled out in the specifications. A GMP contractor may then find itself in a situation in which its subcontractor is entitled to a price increase under its subcontract, but the contractor is not entitled to one under its GMP contract. Although many GMP contracts have ample language describing how changes will be administered, many fail to provide a definition of a “change” that addresses this fundamental difference. One standard form of agreement, AIA A102, attempts to define changes to the GMP as follows:

5.2.5 To the extent that the Drawings and Specifications are anticipated to require further development by the Architect, the Contractor has provided in the Guaranteed Maximum Price for such further development consistent with the Contract Documents and reasonably inferable therefrom. Such further development does not include such things as changes in scope, systems, kinds and qualities of materials, all of which, if required, shall be incorporated by Change Order. When it comes to determining whether a change should affect the GMP, the essential question is, “What is the baseline against which changes are measured?” Under the language above, the “baseline” includes not only what is shown and described in the drawings and specifications, but also differences that are “consistent” with the contract documents and other developments that are “reasonably inferable” from those documents. This fuzzy baseline is likely to lead to debates over what is “consistent” and “reasonably inferable” and whether “further development[s]” are “changes in scope, systems, kinds and qualities of materials.”

Mitigation Strategy: The best way to meet this challenge of defining the “baseline” against which changes are to be measured is to do all you can to make sure that the parties are on the same wavelength by thoroughly understanding how the Owner, the design team, the contractor, and its subcontractors are interpreting the documents. Parties can help ensure a common understanding in the following ways:

1. From the Owner’s perspective, because GMP contracts are essentially cost-plus contracts with a not-to-exceed price, the Owner has the right to insist upon complete openness from its contractor, and part of this openness should include participation of the Owner and its design team in the scope review of each subcontractor’s proposal. If the review reveals that subcontractors are headed in the wrong direction, addenda can be issued that clarify the Owner’s and the design team’s intent.

2. From the contractor’s perspective, this is where the value of well thought-out and clearly articulated qualifications and clarifications becomes obvious.

Contingencies, Buyout Savings, and Buyout Overruns

Issue: When GMP contracts include a contingency (and they almost always should), problems often arise from the following:

1. The parties disagree over the purposes for which the contingency may be used. For example, they may differ over whether it is available to cover:

a. Material cost escalation

b. Remedial work

c. Buy-out gaps and shortfalls

d. Punch list work

e. Coordination issues

f. Overruns in time-related or other general conditions costs

g. Acceleration costs

2. An Owner may assert that it is available for things that the Owner wants to add or change.

3. Administration of the contingency during the performance of the work is inconsistent with the original intent and leads to the setting of problematic precedents and disagreement. For example:

a. Do buyout savings and buyout overruns on other line items that make up the overall GMP automatically flow into and out of the contingency?

b. Or is the contingency a fixed amount that only is adjusted downward when cost are incurred for work that is specifically covered?

Mitigation Strategies:

1. Regarding costs that are eligible for reimbursement:

a. Spend time during the negotiation phase to discuss and agree upon the costs that are eligible for reimbursement from the contingency. In our experience, escalation will increase material costs; there will be defective work that will need to be corrected; parties will discover “gaps” or omissions in costs estimates; punchlist work that should be performed by subcontractors will be more quickly or more efficiently performed by a punchlist crew put together by the contractor; there will be conflicts in the work of some trade contractors; and additional costs will be incurred to work around those conflicts.

b. Spell out your agreement with respect to these issues in the contract, and, just for good measure, include some examples of the types of costs to be reimbursed.

c. Establish a procedural vehicle for reimbursement that implements your intent. Do not process the payments from the contingency by using “change orders,” as that will only lead to confusion. Label the form that you use for processing contingency funds something like “Form for the Reimbursement of Cost Covered by Contingency,” and make it clear that the payment comes from within the GMP and does not increase the GMP.

2. Clearly distinguish contractor’s contingency from Owner’s contingency.

3. Regarding whether, how, and when buyout savings and buyout overruns flow into or out of the contingency, think these issues through, and make sure the contract provides guidance for how the contingency will be administered. One useful tool may be a monthly commitment report prepared by the contractor that identifies the up-to-date status of the buyout and performs the essential first step of identifying the overruns and “savings” in the various line items that make up the overall GMP. Only after the contractor and Owner are in agreement that the entire scope of any particular line item has been bought should “savings” flow into the contingency.

Shared Savings

Issue: Sometimes, when the project has gotten off to a good start, and some of the big, early trade packages have been bought for amounts lower than the line item amount for those packages in the GMP breakdown, an Owner will want to find a way to spend those “savings” on things that are outside the GMP. While this desire is understandable, this course of action is fraught with peril. Most undesirable surprises occur during the second half of a project, and many have learned that the last 10 percent of a job can often be the toughest.

Mitigation Strategy: If the Owner insists upon having access to these prospective savings early in the project, it is advisable for the contractor to (1) insist that such access be addressed in a change order and (2) seek an increase in its fee, as such action by the Owner increases the financial risk to which the contractor is exposed. Shared savings should be calculated only when the job has been finally accepted and the parties have accounted for all costs. If the Owner has and intends to exercise its audit rights, shared savings should not be calculated until the audit results are finalized. Of course, the parties can always agree to do this sooner, but neither party should have the right to demand its share of the savings until such finalization has occurred.

Progress Payments

Issue: Since GMP contracts are essentially cost-plus contracts, with an agreed-upon, not-to-exceed cap, the progress billings are necessarily cost-based. Cost-based billings are quite different from the “percentage complete” billings that are the norm on traditional lump sum contracts. A single progress billing on a GMP contract, when properly backed-up with supporting documentation, can fill a banker’s box.

Mitigation Strategy: Both the Owner and the contractor need to have staff trained and equipped to properly prepare, review, and administer such billings.

Progress Payments Relating to the Contractor’s Fee

Issues: How the contractor’s fee is paid as part of progress payments varies widely from contract to contract. Some contractual issues that can be overlooked and lead to disputes include:

  • If the fee is a negotiated lump sum, many contracts provide for its payment on a pro rata basis over the anticipated duration of the project. But what happens if there are delays? Should the monthly pay-out be adjusted? Should it make a difference whether those delays are excusable or non-excusable?
  • If the fee is a percentage of the costs incurred (up to the GMP), many contracts provide for a monthly fee payment to be calculated by applying that percentage to the costs incurred during the current month. If retainage is withheld on subcontracts, is the fee payment based on the amount “earned” or the amount paid in the current month? Is retainage held against the fee itself? 
  • The contractor’s pre-construction fee, which is earned before the GMP is agreed to, is typically based upon agreed-upon hourly rates for actual or estimated time spent working on the project. To avoid confusion, this fee should be clearly distinguished from the risk-based fee that accompanies a commitment to a GMP.

Mitigation Strategy: Such distinctions need to be clearly stated in the contract.

Progress Payments for Contractor’s General Conditions

Issues: Some GMP contracts require the contractor to agree to a lump sum amount for its general conditions, while some others treat general conditions as a reimbursable cost but with an agreed upon, not-to-exceed amount. These differences lead to variations in how progress payments for general conditions are made. General conditions ordinarily cover indirect costs that are reasonable and necessary for the performance of the work. Such costs typically include home office, field office, and other on-site or near-site facilities, supervision, and administration.

Mitigation Strategies: To avoid disputes, GMP contracts need to be specific about what is reimbursable and what is not reimbursable under this category, and it is often helpful to cite examples in the contract in addition to the descriptions. Lack of such detail can lead to disputes over such things as whether the costs associated with the following are reimbursable: 

  • Senior-level executives who are stationed at the home office, but who oversee the project and visit the site periodically
  • Part-time or full-time accounting staff
  • Benefits such as paid vacation

The contract should identify and address these distinctions. The contract should also address whether staff costs are to be based on agreed-upon hourly billing rates or actual costs. For example, if an employee works 50 hours in a given week, and the agreement cites an agreed-upon hourly billing rate, the Owner will likely be required to pay for 50 hours at that rate. On the other hand, if payment for that employee is to be based on the contractor’s actual cost, and that employee is an exempt employee who is not paid overtime, the Owner will only pay for 40 hours (that is, the contractor’s actual cost).

Progress Payments for Self- Performed Work

The contract must carefully consider how costs for self-performed work are to be segregated and administered. For example, if the Owner treats work that is self-performed by the contractor as a lump sum subcontract, should a superintendent’s time be considered part of the lump sum price, or should it still be considered a reimbursable cost that is charged to the general conditions?

Owner’s Audit Rights

Issue: Nobody likes to be audited. Yet, given that GMP contracts are basically cost-plus contracts, most GMP contracts provide the Owner with the right to audit the contractor’s costs from time to time or prior to final payment. And if the administrative challenges noted above have not been met during the course of performance of the work, such audits can be complex, timeconsuming, and expensive. Such audits may also not resolve all issues, as the conduct of the parties during the performance of the work may have set precedents that obfuscate otherwise clear contractual intent. If such audits are performed by an advocate hired by one party or the other, or by someone who is not well versed in the nuance of GMP contracts, the disputes are likely to be multiplied.

Mitigation Strategy: If audits are performed in an objective manner by professionals who understand the nuances of GMP contracts, they can take the parties a long way toward resolving any residual disputes.

Summary and Conclusion

Following these guidelines will help you experience smoother sailing on your next GMP project:

  • Within the contract, clearly define how allowances will be addressed. Don’t assume a direct connection between allowances and contingency.
  • Arrange a detailed discussion between the Owner, contractor, and design team regarding the contractor’s qualifications and clarifications before entering into a GMP contract.
  • Be careful when it comes to value engineering. If you can’t complete the implementation of value engineering proposals before establishing the GPM, at least draft contract provisions that address how these proposals might affect the project.
  • Require complete and open communications among Owner, design team, contractor, and subcontractors regarding their interpretation of the documents prior to establishing the GMP. This will lead to better understanding of the scope of the project and fewer surprises.
  • Clearly define how the contingency will be administered. Establish appropriate reimbursement and documentation procedures.
  • Don’t calculate shared savings until the project and any audits are complete.
  • If you choose to perform an audit or find yourself unable to resolve lingering disputes, seek help from an independent third party who understands the nuances of GMP contracting.
  • Consistent and open communication between all parties will help the project stay trouble free.
Formerly Construction Counsel with Perini, Rick Burnham now helps clients avoid and resolve disputes on their projects as Director at Trauner Consulting Services, Inc.
Read 7936 times Last modified on February 07, 2012

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