Understanding Cost Accounting and Construction Contracts

Paying a contractor for their work might appear straightforward, but actually can be complex.  While this issue is sometimes overlooked during contract negotiations, early attention and thoughtful drafting can help mitigate the risk of payment disputes that can derail a construction project.

Structure

Few contractors will finance a construction project, so most expect to be paid regularly as work is performed. When the contract price is a lump sum, it can be difficult to ascertain how much of that amount the contractor has earned while the project is in various stages of completion, so some contracts establish “milestones,” that, when achieved, trigger the release of partial payment. Others require the contractor to propose a “schedule of values” that divides the lump sum among the items of work.

Other contracts allow the contractor to seek reimbursement of costs incurred to perform the work, and to charge a fee to cover overhead and profit. These “cost-plus” contracts are fully auditable and provide the owner with greater visibility into the cost of construction, but they provide no incentive for the contractor to reduce project costs. To address this, cost-plus contracts can be subject to a Guaranteed Maximum Price (“GMP”), which makes the contractor responsible for any costs that exceed the GMP. Because this provides the contractor with an incentive to spend every penny of the GMP, many owners will offer to share with the contractor any savings achieved by keeping project costs below the GMP. Still, it is crucial to give special attention to contractually define what costs are — and are not — reimbursable.

Subcontractors

It is common for the contractor to utilize subcontractors to perform at least some of the work. These subcontracts are often issued on a lump sum basis. But this reduces the owner’s visibility into the cost of the work and can provide an opportunity for the contractor to increase margins. This risk can be minimized by including detailed requirements for competitive bidding (minimum number of bidders, submission of bids from entities affiliated with the contractor, review of bids, negotiations with bidders, etc.) to ensure that the owner has visibility into the bids and the process is not manipulated.

General conditions

The contractor also is entitled to reimbursement for direct overhead costs incurred at the jobsite (as opposed to indirect overhead costs incurred at the contractor’s home office) for supervision and administration of the contract. These costs are often lumped together under the label “general conditions” costs, and include things like superintendent salaries, jobsite trailer and utilities, field computers, dumpsters, and site security. They can be difficult to allocate because they are not attributable to any specific construction activity, and because they can be variable (they increase with the duration of the project) or fixed (e.g., jobsite signage costs are incurred only once).

The real problem with general conditions costs is one of scale, as they might encompass dozens of different items but represent less than ten percent of the overall contract value, or in smaller projects, they may not be significant enough in the aggregate to justify the administrative effort of tracking, allocating, and auditing them. The cost-plus contract can be modified to treat general conditions as a lump sum, which the contractor can divide equally across the duration of the job. If the components of that lump sum are not well defined, however, the owner may have to pay the lump sum amount and reimburse the contractor for items intended to be subsumed within it.

Contingency

Every construction project encounters unanticipated conditions. Cost-plus contracts typically include a line item known as a “contingency” to cover expenses the contractor could not reasonably have anticipated but should be included in the cost of the work. It’s important for the parties to discuss and document their understanding of the purpose of the contingency to avoid disputes about whether the cost of an unforeseen condition should be funded through the contingency or as part of the risk the contractor assumed in agreeing to the GMP. Some unanticipated conditions do not fall into either category, and instead justify an increase in the lump sum or GMP through a change order.

Audits

Cost-plus contracts must also specify the scope of the owner’s right to audit the contractor’s records.  Such audits can be onerous, and some owners will require the contractor to pay some audit costs if discrepancies are discovered that exceed a certain percentage of the contract price.  Contractors should take care to ensure that the owner’s audit rights do not allow it to discover or challenge sensitive competitive information that goes into lump sum bids.

There are many project accounting issues that can and should be addressed at the time of contracting.  Taking the time so do so can make the difference between a successful project and one that ends up mired in payment disputes.

For more on construction contracts or other business disputes, please reach out to Chad I. Michaelson at cim@muslaw.com.

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