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March 8, 2024
Understanding contractor compensation is crucial when managing a construction project. Different compensation methods directly influence project cost, budgeting, and risk management. This article will break down several common contractor compensation structures, including time and materials, fixed price, unit price, cost-plus, and guaranteed maximum price (GMP) contracts.
Overview of Contractor Compensation Structures
When determining contractor compensation, the size and scope of the project play a major role in choosing the best structure. Let’s explore the most common methods:
1. Time and Materials Contracts
The time and materials method is straightforward: the contractor is paid for labor, materials, equipment, and services used, along with a fee to cover overhead and profit. The fee is often expressed as a percentage of the total costs. This method is commonly used for smaller projects or when the project scope is difficult to predict. One downside to time and materials contracts is that they can feel open-ended to the owner. To avoid this, a cost cap is often included in the agreement.
2. Fixed Price (Lump Sum) Contracts
In a fixed price contract, also called a lump sum or stipulated sum contract, the contractor agrees to complete the project for a predetermined amount. This amount covers all costs, including labor, materials, and profit. Fixed price contracts are ideal when the scope is clearly defined, and the contractor can estimate the required costs with confidence. For the owner, the appeal lies in the certainty of knowing the total price upfront. A popular example of this is the A101-2017 Standard Form of Agreement Between Owner and Contractor, where payment is based on a stipulated sum.
3. Unit Price Contracts
A unit price contract operates similarly to a fixed price contract, but rather than setting a total price, a fixed price is assigned to each unit of work. This method works best when the project involves repetitive tasks, allowing costs to be scaled based on the number of units completed.
4. Cost of the Work Plus Fee Agreement
In cost-plus contracts, the contractor is compensated for actual costs incurred during the project (such as labor, materials, and equipment) plus a fee. The fee may be a lump sum or a percentage of the costs. Cost-plus agreements are often used for large or complex projects where the scope is harder to define. To give the owner insight into the budget, contractors typically provide a control estimate before work begins, which is updated with each payment application.
The owner has a direct interest in managing costs under this structure because they will be responsible for all actual expenses. To ensure accountability, contractors may be required to maintain detailed records, and the owner may have access to these records for review. The contractor, therefore, has a heightened responsibility to manage the project’s costs efficiently and economically.
5. Guaranteed Maximum Price (GMP) Contracts
A Guaranteed Maximum Price (GMP) contract places a cap on the contractor’s compensation, ensuring that the contract sum will not exceed a specified amount. This provides cost certainty for the owner. However, the contractor takes on the risk that costs may exceed the GMP. In some cases, there may be a bonus or shared savings provision if the project is completed for less than the GMP. Many GMP contracts also use a cost-plus framework, so additional record-keeping and accountability apply.
Examples of GMP contracts include A102-2017, which is based on a Cost of the Work Plus a Fee with a GMP, and A103-2017, which applies a Cost of the Work Plus a Fee without a GMP.
Key Considerations for Choosing the Right Compensation Method
Choosing the right compensation method depends on project complexity, scope, and risk tolerance. If the project is well-defined and costs can be accurately predicted, a fixed price or unit price contract may be ideal. For complex projects with changing scopes, cost-plus or GMP contracts are often more appropriate.
Managing Costs and Accountability in Contractor Compensation
When using cost-based compensation methods like cost-plus and GMP, both the contractor and the owner must focus on managing project costs efficiently. Contractors should maintain detailed records, and owners have a vested interest in reviewing these records. A key component of such agreements is ensuring accountability to control costs while still allowing flexibility for necessary changes.
Legal and Contractual Aspects of Contractor Compensation
When selecting a compensation method, it’s essential to work with a financial advisor and a construction law attorney. They can guide you through the legal considerations and help ensure that the compensation method aligns with your project’s goals. For more in-depth assistance, you may want to refer to AIA Contract Documents.
Susan Van Bell, Esq. was Senior Director of Content for AIA Contract Documents for over ten years. She is currently a consultant.
AIA Contract Documents has provided this article for general informational purposes only. The information provided is not legal opinion or legal advice and does not create an attorney-client relationship of any kind. This article is also not intended to provide guidance as to how project parties should interpret their specific contracts or resolve contract disputes, as those decisions will need to be made in consultation with legal counsel, insurance counsel, and other professionals, and based upon a multitude of factors.