Owner's Solution Guide
Managing the Contractor Billing Process
For Owners of Commercial and Residential Construction Projects
Cash is the fuel that drives all construction projects. Cash is needed to pay the lead-contractor, subcontractors, building materials/supplies, and other necessary expenses (e.g., insurance, permits, designers, engineers). Most of these payments are managed by the lead-contractor (i.e., construction manager or general contractor, collectively referred to as "CM/GC") based on cash received from the project's owner ("Owner").
It is critically important for Owners to pay the CM/GC on a timely basis in order to facilitate the progress of the construction project (Project).
Contractors generally will not work for free. Experienced Owners know this and are keen to be sure the contractors are paid according to the agreed upon payment process ("Payment Process"). It is critical to ensure the Payment Process properly fuels the Project with the cash it needs.
To establish a successful Payment Process the Owner must first be sure it can afford the Project the CM/GC is being asked to build. Nonpayment due to an Owner's lack of funds should not be the CM/GC's problem. Nonpayment of a CM/GC's legitimate request for payment can be interpreted as the Owner's breach of contract and may result in deceleration of Project schedule, the possible abandonment of the project by the CM/GC or its subcontractors, the filing of liens, and the possibility of litigation against the Owner.
Once the Owner knows it can afford the Project, the Owner must focus on how to structure the Payment Process. This will greatly depend on the contract payment approach established in the construction contract ("Contract"). There are two basic types of payment approaches:
- "Fixed-Price" approach such as:
- "Cost-Based" approach, such as:
- Cost-Plus-Fee ("CPF")
- Time-and-Material ("T&M")
- Guaranteed-Maximum-Price ("GMP")
Attributes Unique to the Fixed-Price Approach
The Fixed-Price approach is based on the premise the Owner will pay a final fixed amount for the Project. This price must be known in advance and agreed to by both the Owner and the CM/GC. This approach usually involves a Payment Process in which payments are made based on the Project's percent complete or based on payments that are made when certain Project milestones are reached. In either case, the Owner's primary concern will be to ensure the evaluation of the percent-complete or the milestone-reached is consistent with the Owners original expectations.
The Owner's expectations will be based on the original plans-and-specifications (modified as necessary by any interim change orders) as well as the planned Project schedule. Since this Payment Process is dependent on the Owner's original expectations, the Owner must establish the CM/GC's commitment to these expectations. The best way to accomplish this is to define these expectations in the Contract. Otherwise, the Owner leaves too much ambiguity in the relationship. This ambiguity allows for the possibility that the Payment Process may become adversarial if there is a disagreement with regard to Owner's expectations.
Attributes Unique to the Cost-Based Approach
The Cost-Based approach usually involves a Payment Process in which payments are made based on the CM/GC's actual cost, or some measure of its actual cost. The Cost-Based Payment Process will necessarily rely on the Contract's definition of the Cost of Work ("COW"), which should include:
- A description of what the CM/GC's fee includes (e.g., profit & overhead, or just profit)
- A description of what activities are included in General Conditions (i.e., site management labor)
- A description of what activities are included in General Requirements (i.e., common site requirements such as safety, clean-up, and hoisting)
- A definition of labor cost
- General conditions labor
- Direct project labor
- Labor used for self-performed-work ("SPW")
- A definition of allowed subcontractor costs
- A definition of allowed costs for miscellaneous items, such as:
- Off-site work
- Off-site storage
- A definition of what is not considered a reimbursable cost (e.g., home office costs, IT costs, or worker training costs)
Additionally, for Cost-Based projects the Contract, should anticipate that the Owner will need information collected on the site that can be used to test the accuracy or reasonableness of the cost claims included in the CM/GC's pay application ("PA"). Refer to ResX's article titled "Monitoring the Construction Site" for details on this topic.
Finally, with regard to a GMP project, the Owner must be sure that the burn rate ("Burn Rate") of the Project's costs does not indicate that the CM/GC will exceed the agreed upon GMP. The Burn Rate of the project can be determined by comparing the CM/GC's interim PA's to the final GMP (i.e., the total PA's to date divided by the Project's current percent complete must be less than or equal to the GMP). If the Burn Rate of the Project indicates the overall cost will exceed the GMP, then the Owner must confront the CM/GC with this information and negotiate a resolution. This may involve a reduction in the Owner's interim payments, termination of the CM/GC, or a negotiated compromise. Remember, contractors do not work for free and if the GMP is burned up before the project is complete, there will be problems. Therefore, it is in the Owner's best interest to anticipate a Burn Rate problem before it becomes too large to be resolved.
Common Attributes of Both Fixed-Price and Cost-Based Approaches
Whether the Owner chooses the Fixed-Price approach or the Cost-Based approach, the Owner should anticipate the Project will likely encounter changes which will be handled with Contract change orders ("CO's"). Therefore, the Contract should also include a definition of how CO's will be processed, negotiated, and priced. Many times the price cannot be agreed to prior to the work being performed. This is referred to as a directed CO ("DCO"). The Contract should insist that a the CM/GC keep track of all DCO work through targeted records (e.g., force account records) and that if a negotiated price is not agreed to prior to completion of the DCO, then the price of the completed DCO should be based on its actual cost as documented by the force account records. CO's that are priced before the work is completed should be priced using the same costs as defined for the COW. The expected labor and material cost should be documented to a level of detail that will allow the Owner to confirm the reasonableness of the CO's price after the CO is completed.
A serious mistake many Owners make is to neglect negotiating change orders on T&M projects because the Owner assumes the cost of the change will be included in the CM/GC's PA due to the nature of the billing approach. The problem with this assumption is the CO is based on a negotiated scope of work. By not negotiating CO's on T&M projects the Owner is effectively relinquishing control of the scope of work to the CM/GC.
Another mistake Owners often make is to neglect to negotiate deductive CO's on Fixed-Price or GMP projects. Deductive CO's occur when the Owner reduces the Project scope or when the Owner decides to purchase and install certain items itself (e.g., fixtures, appliances, or tenant improvements). Deductive change orders reduce price of the project and should be a direct reduction in the final Lump-Sum or the final GMP.
Finally, whether the Owner chooses a Fixed-Price or a Cost-Based approach, the Contract should have a clear definition of the pay application submittal and approval process. This definition should include the following elements:
- Frequency of PA submittals
- Timing of the PA approval and subsequent reimbursement
- Form of the PA:
- Summary invoice with signatures (e.g., AIA 703, Sworn Statement, or both)
- Continuation sheet (e.g. AIA 702)
- Back-up required to support the PA, such as
- Subcontractor invoices
- Purchased material invoices
- Other invoices or cost calculations (e.g., insurance or permits)
- Fee calculation
- Other accompanying documents, such as:
- Lien waivers (both conditional and unconditional)
- Project status report
- Schedule status report
Feel free to contact ResX (see contact info. below) if you have any questions on this topic.
Previous articles for developers or owners of high value residential construction projects authored by ResX can be located on our website (www.ResXpc.com). These include:
- Avoid Contractor Overbilling (a general overview of the issues Owners face)
- Project Design is the First Defense Against Contractor Overbilling
- Obtain Competitive Bids from the Lead Contractor (CM or GC)
- Overseeing the Subcontractor Bidding Process
- Monitoring the Construction Site
Also, look for our final article on Contractor Overbilling that is titled "Critical Elements of the Construction Contract" which is scheduled to appear later in May, 2022.