What is a guaranteed maximum contract?
A guaranteed maximum contract (also known as a maximum cost contract) is one of several types of contracts used in construction. As a basic definition, a guaranteed maximum contract is an agreement between two parties by which one party agrees to perform work up to an agreed amount. It is therefore one of the most flexible forms of contract available.
A guaranteed maximum contract is generally structured in a way that is compatible with indemnification or warranty protection. This form of contract is (rather obviously) a hybrid between lump sum (fixed price) and cost-plus contracts. A lump sum contract is one where the contractor promises to do a job for a set price , while a cost-plus contract is one where the contractor does the job for the actual costs incurred, plus an additional agreed-upon amount. So while a lump sum contract is pretty straightforward, and a cost-plus probably leaves something to be desired on the level of predictability, a guaranteed maximum contract is a hybrid that seeks to prevent the weaknesses of one or the other from sinking a deal. Generally speaking, when agreed upon, the "maximum" amount cannot be exceeded without raising the price of the contract.
Elements of guaranteed maximum contracts
Guaranteeing the costs of a project under a GMP methodology is not a simple matter of merely stating that anything over an agreed amount will come out of the contractor’s pocket. There are a number of key components that clearly define how GMP is used in a construction agreement.
The term "Maximum Price" refers to the maximum price that may be paid by the owner under the contract for the work at issue, either through a single lump sum or a cost-plus mechanism. The contract may initially set the maximum price at the estimated price of the work, but it must be clear that the contractor is responsible for cost overruns and/or entitled to savings.
Cost savings, sometimes referred to as "the savings provision" or "share in savings", is an adjustment to the contract that gives the contractor the right retain or share in the difference between the actual cost of the work and the GMP. For example, if the GMP is $1 million, and the actual cost is $900,000, then the contractor may be entitled to the $100,000 savings. The GMP agreement should clearly articulate how any savings will be calculated.
Cost overruns, sometimes referred to as "the exposure", is an adjustment to the contract that makes the owner bear the risk of a cost increase to the contractor or to a subcontractor or supplier. A maximum price may be documented to increase, without requiring a change order or cost justification, in the presence of a change of law, owner-initiated change order, or request for change.
In addition to defining the parties’ rights in the event of cost savings and cost overruns, the parties should document their agreement on the specific process by which the GMP is established. In a situation in which the guarantee is issued either prior to contract execution or prior to the architect’s approval of the final plans and specifications, it is common to use a clean copy of the plans simply to estimate the GMP, with the GMP agreement specifically allowing for a revision at some point in the future (i.e., as design progresses.). The GMP legislation often requires that the agreement contain a specific clause concerning notice and/or objection rights in the event that the contractor estimates (or fails to estimate) GMP.
Regardless of how specific the GMP article or provision is crafted in the GMP legislation, it is essential to document the cap on the contract price clearly in the GMP agreement. An owner’s right to rely on a contractor’s GMP is only as high as the roof containing the cap itself.
Advantages and disadvantages of guaranteed maximum contracts
Because of their intrinsic communication, cost-control, and risk-management features, guaranteed maximum contracts are generally advantageous to both contractors and clients. For contractors, these types of contracts can help facilitate proper and consistent budgeting to ensure that necessary constructions funds are available. These contracts also allow contractors to simultaneously solicit multiple bids and select the best one at the best price without committing to an unreliable general contractor.
Conversely, guaranteed maximum contracts also have disadvantages. Because these contracts require so much coordination between the contractor and the client, they are often harder to negotiate than other types of contracts. Additionally, the transactions involved can be increased administrative burden on all parties to the contract.
Situations to consider a guaranteed maximum contract
Guaranteed maximum contracts (also referred to as a GMP, maximum price contract or a target contract) are generally good to use when the owner prefers to have some insurance over future costs. Especially in circumstances where the scope is still uncertain or where parts of the project are not fully fully defined, these types of agreements provide more certainty.
Under a guaranteed maximum contract, the owner is comfortable with the contractor being paid for all costs, but there are limits. The owner isn’t responsible for costs above the GMP. Both parties must agree on the scope of the project before the construction begins, and accurate cost estimates are imperative.
Therefore, these types of contracts are very useful when an owner has a big-picture idea of what they want, but many things about the project are not fully delineated at the start. For example, on large design-build projects, the owner often wants the contractor to be in charge of the entire project, including the design, and an entirely detailed scope of work may not be possible at the beginning. On these projects, the owner trusts the contractor to manage the budget, coordinate the team, order the materials, and make the choices that need to be made.
Similarly, these types of contracts are best suited for an owner who is likely getting value from some risk of the schedule or budget being broken. A delay or cost over run would be less of a headache, and defective work would be less of a loss, for a contractor who is getting a set fee regardless. The opposite experiences are true for an owner; an owner who has a fixed fee bid is more likely to face a claim for defective work by the contractor after the fact, because the contractor’s profit depends on the costs remaining low.
These types of contracts also provide more security to an owner who is concerned that the costs of a part of the project will be subject to change, like on a complicated renovation of an older building. The contractor is able to provide assurances about the ultimate cost of the project because it will keep the costs down to remain under the GMP. The predetermined fee percentage that the contractor earns regardless reduces the logical incentive to make costly mistakes.
We have experience with a guaranteed maximum contract that was used for an interior renovation of a popular restaurant in a busy downtown. The owner wanted to reconfigure the space and renew the interior, but didn’t know how best to do that. It was also a bonus for the owner that this type of contract provided insurance over the costs. The project ended up with a significant amount of change orders because the owner made many design decisions on the fly. However, it all ended up on budget, and the fee that the contractor made for completing the work on time made them more motivated to jump on an extra weekend of work.
How to effectively negotiate a guaranteed maximum contract
A recent industry survey conducted by the Construction Financial Management Association, a leading provider in education for construction financial professionals, found that over 31% of respondents were using guaranteed maximum contracts for their total revenue. In addition to the GAAP standard codifications of C1 and C2 that fit into this definition, other variations on the theme exist, including GMPs and limited GMPs. It is imperative that you act as a client to negotiate and understand how much of the total cost is guaranteed and what items are excluded from the guarantee. For example, are you including a limited GMP for overtime hours? With a fixed amount, contractors know that they have a guaranteed profit in a project. The maximum price should be based upon your ability to efficiently manage field personnel, labor, and productivity. It should be calculated on the basis of overhead, profit, and your estimates of time and material.
It is most important when negotiating a GMP to keep the field superintendents and estimators in close contact with the front office staff. The estimator must set a realistic total price. In addition to a good estimator, it is in any construction firm’s best interest to have a strong contract administrator who analyzes the contract and puts together a specific scope of work . Preparations of a well thought out, detailed, and accurate scope will go a long way in avoiding insurance exclusions and contract disputes. It is vital that you establish the pricing on a realistic unit cost that will allow subcontractors to perform their work in a cost effective way. It is always better to overestimate productivity and resource allocation, and reward the workers with a bonus when their performance exceeds expectations.
Do not be surprised if the maximum price is set by the insurance or surety provider, or is determined as a result of bidding. The more information and detail you have about your costs, and the more that detail is backed by sufficient documentation, the more you will reduce/dispel the potential of a disagreement later in the process. Subcontractors may not be eating enough overhead to cover their costs. Vague language should be avoided when negotiating liability and indemnification agreements.
It is very important that you give the staff responsible for negotiation ample time to do a thorough job. Be sure that they completely understand who their client is. There is a big difference between whether that client is the owner of a piece of real estate or the General Contractor doing fix-up work for a property management group.
Legal aspects of guaranteed maximum contracts
In the realm of construction contracting, the language of a contract can be as important as the work itself. This is especially true for guaranteed maximum contracts. The legal intricacies of these agreements can quickly spiral into costly and time-consuming disputes if not properly addressed from the outset. It is essential that both parties ensure that the contract language is crystal clear, to avoid ambiguity, confusion or disagreement later on.
When drafting a guaranteed maximum contract, all concerns must be addressed from the outset in order to mitigate the need for costly negotiations or litigation when issues, as they so often do, arise. Prime among these is the scope of the contracted work, which includes a statement of what the contractor is and is not responsible for completing. This leads directly to the schedule to which the contractor and subcontractor will be held. Once the work is clear, it is important to spell out how the contractor will bill for completed work and provide supporting documentation, as well as how the contractor will handle progress payments and final payment.
As no agreement is likely to cover all possible contingencies, both parties should follow best practices and engage in a review process. While it may be uncomfortable to consider a contractual relationship falling apart, it is to their mutual benefit that both parties understand the potential need for arbitration or other dispute resolution. As a result, many agreements contain a procedure that specifies how to address the expected or unexpected problems that might arise. A comprehensive review of the contract allows parties to understand their rights and obligations in a contractual relationship. If the contract does go into a dispute, words, phrases or even an entire section could tip the scales one way or another.
As a type of construction contract, the guaranteed maximum is bound to experience a variety of legal issues in the course of its existence. Therefore, it is in the interests of all parties to protect themselves by ensuring legal considerations are properly thought through in its creation. From defining issues such as scope of work to spelling out dispute resolution procedures, the ability to recognize and address potential issues before they arise is essential for reducing or limiting the impact of any problems.
Examples of guaranteed maximum contracts
To illustrate the effectiveness of the guaranteed maximum price methodology, we can look at the University of Nebraska’s National Strategic Research Institute (NSRI) construction. The project budget, as planned, was $20.5 million for a two-year project. However, the school was able to get the project done for just under $16 million, and they completed it 11 months ahead of schedule. Their director of facilities says, "With earlier IPD efforts, we had much less engagement from the contractors and a major problem was that none of the contractors had any sympathy for the AIA 2011 C191 Small Project Guide."
The International Markting Group’s (IMG’s) HQ is a case study in GMP pricing . When IMG came to Kansas in 1999, it didn’t have the land on which to build its new green HQ, but there was a 25-acre golf course owned by Johnson County Parks and Recreation that was available to lease for 35 years. IMG’s architects worked hard at developing a design that helped IMG enjoy the golf course and meet its needs. By completely embedding the building into the landscape, IMG and JCPR were able to use the building footprint in a way that saved the golf course during construction. Not only did the building save the golf course, but also, in the end, the project was left with a 5.5-acre natural area, a small lake, and the existing nature trail around the entire community perimeter.