Contract Basics for Contractors: Contractor Compensation

By Susan Van Bell, Esq., Consultant, AIA Contract Documents

March 8, 2024

This article will discuss several methods of contractor compensation. The terms of your agreement related to compensation will differ depending on which method you are using. As we have discussed in the previous articles in this series, the size and scope of the project should be considered when determining which compensation method is appropriate to use. We will look at the following: time and materials, fixed price, unit price, cost of the work plus a fee, and guaranteed maximum price.

The time and materials method is relatively straightforward. The contractors’ compensation is based upon payment for cost of labor, equipment, materials, and services plus a fee to cover overhead and profit. The fee might be a percentage figure. This method might be used for small projects or projects where it is difficult to anticipate the exact scope. A downside to this method is that the owner may feel that it is too open-ended. This could be addressed by including a cap on the total cost.

A fixed price contract, also called lump sum or stipulated sum, is one in which the contractor agrees to complete the project for a specific amount that is agreed upon. This sum covers labor, materials, equipment, and overhead and profit. The terms of the contract should specify the conditions upon which the contract sum might be changed, in which case a change order is executed. This method is best used when the scope of the project is well defined, and the contractor can comfortably determine the total that will be needed to cover costs and profit. Owners may like this method because they know if the compensation will be within their budget and it is a fixed amount. An example of a lump sum contract is A101-2017, Standard Form of Agreement Between Owner and Contractor where the basis of payment is a Stipulated Sum.

A unit price contract is similar to a fixed price contract, except that a fixed price is set for a unit of work, which is then repeated for each unit performed.

A cost of the work plus fee agreement, also referred to as “cost-plus” is most often used for large or complex projects. Using this method, the contractor is paid for costs necessarily incurred by the contractor in the proper performance of the work, including labor, costs of materials and equipment, and other items that should be specified in the agreement, such as temporary facilities and miscellaneous costs. In addition to payment for actual costs, the contractor is paid a fee, which can be a lump sum, a percentage of the cost of the work, or determined in some other way. The fee generally is used to cover items such as overhead that are not compensated directly as costs. To give the owner some idea of whether the cost-plus total amount will comport with its budget and to track costs as the project progresses, the contractor will typically provide a control estimate prior to beginning the work. The control estimate is updated when payment applications are submitted.

It is important to note that, in a contract using a stipulated sum for the contractor’s compensation, the owner has agreed to pay a specific amount regardless of the cost incurred by the contractor in the performance of the work. However, when the contractor’s compensation is based on cost of the work, the amount expended by the contractor as a “cost of the work” has a direct economic consequence to the owner. Therefore, the owner has a heightened interest in the efficient and economical performance by the contractor, and the contractor has a consequent responsibility to manage expenditures on the project in keeping with the owner’s interests. The contract may include terms that require the contractor to keep detailed records and accounts related to the cost of the work, to substantiate all costs incurred and to allow the owner and the owner’s auditors access to the contractor’s records and accounts. Thus, there is something of a heightened accountability and greater administrative responsibility on the part of the contractor in this arrangement.

A contract with a guaranteed maximum price (GMP) is one in which the contractor guarantees that the contract sum will not exceed a specified amount, subject to any additions or deductions that may be provided for in the contract documents.  This is referred to as an “at-risk” agreement because the contractor is taking on the risk that the cost may exceed the GMP. On the other hand, many such contracts also include a bonus provision or a shared savings provision for a situation where the project comes in under the GMP. The same additional responsibilities as in other cost-plus agreements, as discussed above, apply to a cost of the work agreement even if there is a GMP.

Examples of cost-plus contracts with and without a guaranteed maximum price are AIA Documents A102-2017, Standard Form of Agreement Between Owner and Contractor where the basis of payment is Cost of the Work Plus a Fee With a Guaranteed Maximum Price  and A103-2017, Standard Form of Agreement Between Owner and Contractor where the basis of payment is Cost of the Work Plus a Fee Without a Guaranteed Maximum Price.

As you can see, there are a variety of considerations to take into account when you determine a compensation method for a project, and the decision will affect the compensation and related provisions that are included in the agreement. We encourage you to work with your financial adviser and construction law attorney when preparing your contract or to assist you if reviewing an owner-provided contract.

Or next article will discuss the payment process.

Susan Van Bell, Esq. was Senior Director of Content for AIA Contract Documents for over ten years. She is currently a consultant.

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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.