Owner's Solution Guide
The Construction Contract's Financial Controls
For Owners of Commercial or Residential Construction Projects
Paraphrasing from a well-known college football coach, nothing is more important than, THE CONTRACT, THE CONTRACT, THE CONTRACT!
The construction contract (Contract) is a legally binding document that establishes the relationship between the construction project owner (Owner) and the contractor. It sets the rules of the game and how the players are expected to play. Without a Contract, the representations and commitments of the lead contractor (i.e., construction manager or general contractor, "CM/GC") will not be documented and therefore will be difficult to establish if the construction project, or the relationship between the CM/GC and the Owner, gets into trouble.
If the Owner is told by a CM/GC that a Contract in not necessary, then the Owner should find another CM/GC. A construction project with a weak, or non-existent, Contract is simply too risky to pursue. We strongly recommend that the Owner, particularly an institution or individual that does not routinely oversee construction, engage a knowledgeable construction attorney to help navigate the details of creating and negotiating a construction contract.
Most Importantly: The Owner must include its proposed Contract in the bid solicitation package it issues to attract bids from potential CM/GC's. That means that the Owner must work with a construction attorney prior to issuing its bid solicitation to the CM/GC community. By doing this the Owner takes control of the CM/GC relationship and can incorporate the necessary cost control language it needs for in the proposed Contract. Once a CM/GC is selected, there will be a negotiation process that may alter certain details in the Contract. However, this situation is far better than the Owner receiving the proposed contract from the CM/GC and then attempting to add the needed cost control language. Remember the CM/GC's are typically called CONTRACTORS not builders. The reason is because the CM/GC has superior experience with contracts that the Owner most likely does not.
This article will focus on the elements of the contract that affect the Owner's financial control of the construction project and ultimately the cost the Owner will pay for the work performed. The nature of the financial control elements will depend on the type of approach the Owner chooses for the project.
There are two basic approaches an Owner can select 1) Fixed-Price, and 2) Cost-Based:
- Fixed-Price Contracts are generally either Lump-Sum or Design-Bid-Build.To be successful, the Owner using his approach should have:
- A design that is complete or nearly complete.
- Confidence that the cost of materials of labor will not be volatile (i.e., suffer from escalation or inflation) during the period of construction.
- A comprehensive bid solicitation and selection process.
- A third party estimate of the expected cost of construction.
- Cost-Based Contracts are generally Cost-Plus-Fee or Time-and-Material ("T&M").To be successful, the Owner using his approach should have:
- Expertise required to control the cost of construction either in-house or acquired from an independent third party.
- A comprehensive bid solicitation and selection process.
- A budget with significant Owner contingency.
The approach used (i.e., Fixed-Price versus Cost-Based), and the scope and complexity of the project, will directly impact the nature of the Contract. Generally speaking, most moderate to large construction contracts are cost-based. We believe that the industry will continue to favor cost-based contracts into the foreseeable future.
The outline below lists the most important Contract cost control elements for a cost-based construction project. Following each item is a list of the parameters that each element should cover. This outline is also relevant for Owners of fixed-price projects with the exception of items 4, 5, 6, 7, 8, 10, and 14.
- Contract Price and Allowable Fees:
- Set the price in advance.
- Define the fee percentage.
- Define what the fee is expected to cover.
- Roles of the parties:
- Define the responsibilities of the CM/GC.
- Define the responsibilities of the Owner.
- Scope of General Conditions:
- Define what functions the CM/GC is expected to perform.
- Define how the CM/GC is to be reimbursed for General Conditions' costs.
- Use of companies related to the CM/GC:
- Define what a related party is (e.g., common ownership, family relationship, other).
- We recommend that the Owner not allow related parties to perform work on Cost-Based contracts.However, if the Owner does allow related parties to perform work on the construction project, then the contract must define the bidding protocols so that any 3rd party bidders will not be disadvantaged:
- 3rd party bidders should receive the bid packs with sufficient time to assess the work.
- All bids should be sealed and submitted directly to the Owner.
- The Owner should be responsible for opening the bid submissions.
- It the related party bidder is the lowest responsive bidder then the Owner should have the option to convert the bid price into a GMP.
- Controlling self-performed work by the CM/GC.
- Define what self-performed work is (e.g., any work other than General Conditions, all trade-work, other).
- We recommend that the Owner not allow the CM/GC to self-perform work on Cost-Based contracts.However, if the Owner does allow the CM/GC to self-perform work then the contract must, define the bidding protocols for work that the CM/GC is hoping to self-perform (refer to item 5.b above for details).
- Allowed billable costs (i.e., define the "Cost-of-Work"):
- Define general conditions' labor cost.
- Define general conditions' labor markup.
- Define what costs are allowable and whether the CM/GC must get written permission in advance to incur these costs.
- Costs not allowed:
- Exclude home office costs (i.e., costs incurred off site such as training or home office accounting).
- Exclude legal costs.
- Exclude bonuses and other discretionary labor costs.
- Other costs to be excluded.
- Contractor contingency:
- Define what the contractor's contingency is to cover.
- Define the recordkeeping requirements for contractor contingency funds for both the use of funds and for additions to the Contingency account.
- Stipulate that contractor contingency expenditures must comply with the definition of the cost of work.
- Define how funds are to be disbursed from contractor's contingency.
- Define what happens to unused contingency funds.(i.e., does it go to shared savings or is it a deduction from the GMP?
- Schedule of values (SOV):
- Require that the SOV categories be identified in advance.
- Require that the SOV amounts be identified when the GMP amendment is approved.
- Require the SOV to comply with a specific standard (e.g., the Construction Standards Institute, or other).
- Mandate that the structure of the SOV cannot be changed after it is established.
- Mandate how changes in the SOV values will be tracked and memorialized.
- Mandate that only one subcontractor can be charged to each line on the SOV.
- Buy-out savings and shared savings:
- Define buy-out savings.
- Define shared savings.
- Define when buy-out and shared savings should be recognized.
- Define how to track buy-out savings and shared savings.
- Track all buy-out savings when the funds are moved into Contractor contingency.
- Track all buy-out losses when the funds are taken from Contractor contingency.
- Schedule of work (using either calendar dates or days duration):
- Establish the dates for critical project milestones.
- Establish the date for project completion.
- Substantial completion.
- Building occupancy or approval for occupancy by the governing entity.
- Define excusable delays.
- Design, plans and spec's:
- Define the design parameters.
- Define the quality expectations.
- Define the performance requirements.
- Change management and change order ("CO") pricing.
- Define the overall process (e.g., RFI to PCO to approved PCO to CO).
- Define the requirements for describing the scope of each CO.
- Define how obsoleted scope will be described/documented in the CO.
- Define the categories of CO's allowed and code each change to the appropriate category (i.e., design error, Owner change, value engineering, unanticipated condition encountered, schedule acceleration, work disruption, other).
- What documentation is required to support CO pricing proposal.
- Subcontractor bidding procedures:
- Define the scope of work to be included in each individual work category.
- Identify and pre-qualify the subcontractors to be solicited for each major work category.
- Require fixed price bids from the subcontractors.
- Avoid using two different subcontractors to bill to the same work category.
- Do not allow the CM/GC to perform work or bill work to any work category other than general conditions or general requirements.
- Allow sufficient time for subcontractors to assess the risk contained in the plans and specifications prior to submitting a bid.
- Require each trade to bid 100% of the scope of work in the work category.
- Require three bids for each major work category.
- Initiate the bid solicitation process as soon as the design for the scope of work is reasonably complete.
- Require the CM/GC to prepare bid evaluation tables so that each bidder can be evaluated side-by-side.
- Select the lowest responsive bidder.
- Requirements for subcontracts and flow-down clauses
- Require that all subcontractor contracts contain the same requirements as the CM/GC's contract particularly with regard to records retention and audit rights.
- Do not allow subcontractors to enter into GMP or other cost-based billing approach without the Owner's written approval.
- Pay application submittal and approval procedures:
- Define each milestone in the PA submittal process (e.g., walk-through, pencil copy, final copy, approvals, and payment).
- Define the milestone dates (i.e., what day of the month is each milestone expected to be reached).
- Define form of the Pay Application (e.g., AIA 702 and AIA 703, sworn statement, other).
- Specify other documents that must be submitted with the PA such as:
- Conditional lien waivers for the current month.
- Final lien waivers for the prior month.
- Updated schedule.
- Monthly status report.
- Records retention and audit rights:
- Define the records that the CM/GC is required to retain.
- Define retention period.
- Define protocols to access the records.
- Define the form of the records (e.g., Excel, machine readable, other).
- Define who pays for the audit if the audit reveals overcharges.
- Dispute resolution procedures:
- Define the notice requirements and allowable time limits for asserting a claim.
- Define the steps to be followed if a dispute arises.
- Insurance requirements:
- Define insurance coverages.
- Define insurance deductibles and coverage limits.
- Definition of the construction project's completion:
- Define what constitutes project completion.
- Define when warranty period begins.
- Define what must be established in order to make the final payment and release retention.
Feel free to contact ResX (see contact info. below) if you have any questions on this topic.
This and previous articles for owners of 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
- Monitoring the Contractor Billing Process
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.