A developer client recently expressed mixed emotions when reflecting on a new project that had been delivered on time and under budget. The investors were happy, and the client had just written a check to the prime contractor for its half of the “savings,” with the other half withheld by the client. At first blush, the client could be charged with taking an unreasonably pessimistic view of its successful project, but upon closer scrutiny the developer’s reservations were reasonable.
Many standard construction contracts, including those published by the American Institute of Architects, include a placeholder for incentives for the contractor, such as early completion bonuses and/or sharing in the project savings, if any. How the savings are calculated varies, but often it is the difference between the guaranteed maximum price (GMP) and the cost of the work. That amount is then allocated to the contractor and owner based on a percentage split between the two. The contractor’s ability to share in the savings can hinge on the contractor completing the project on time. That is, the contractor could deliver the project under the GMP, but it may not earn any savings because it is late.
Through the preconstruction phase of the project, the client and contractor collaborated to refine the scope, develop a schedule, and establish a GMP. As design progressed, the schedule and GMP were vetted, refined, and negotiated. Ultimately, the parties signed a GMP contract with a 50/50 savings split. In the end, the project was delivered approximately six weeks early and almost $1 million under budget. The savings check to the contractor was for approximately $500,000.
From her post-project deliberations, the client’s first reservation was the construction schedule. While delighted that the project was delivered early, she questioned whether her schedule expectations had initially been set properly. Her concern illustrates one of the potential disadvantages of hiring a contractor for preconstruction services and then hiring that same contractor for the project: The contractor created the very baseline against which its own performance would be measured.
Critics of alternative delivery methods, which usually rely on preconstruction services, often suggest it is a “moral hazard” for contractors to establish their own baselines in this way. This is not to suggest that all contractors performing preconstruction services act solely in their own interest—that so many private developers rely on preconstruction services with trusted contractors demonstrates unequivocally that good contractors do add value to a project by, among other things, creating a fair baseline schedule. It merely calls out the inherent conflict of interest in creating the benchmarks against which one’s own performance is measured. In contrast, in a hard bid setting, the owner either provides bidders the expected duration or bidders may propose one in their bids. Durations are then measured against one another.
The client had the same reservations about the GMP. In addition, the client questioned her use of contingency and allowances for the project. Contingency was 5 percent of the GMP and, in the end, most of the shared savings was unused contingency. The biggest risk going into the project was price escalation for lumber. Instead of requiring contingency to be used to cover any such escalation, which was her preference, she reluctantly agreed to treat lumber as an allowance item.
Contingency is usually used for unanticipated costs that are not the basis of a change order. An allowance is a placeholder for a cost that is difficult to quantify. From a developer’s perspective, each approach has pros and cons. When an allowance is exhausted, the contractor will usually be entitled to a change order for additional costs for that item; however, when contingency is exhausted, the contractor is not entitled to a change order for more. Also, while unused contingency may be subject to the savings split, unused allowance amounts usually accrue to the owner’s benefit and result in a dollar-for-dollar reduction in the GMP. That is, if the allowance amount in the GMP is $10 and the actual cost is $7, the GMP would be reduced by at least $3. The contractor fee may or may not also be adjusted. Here, the client’s internal budget included dollars for unanticipated costs outside the GMP, which she used to pay a change order for the price escalation of lumber. In other words, the client paid for the lumber price escalation and she paid for project savings.
When the GMP contract was executed, the client felt confident that her internal budget would not be exceeded and the project would be delivered on time. She was right on both counts. After the project was completed, however, she questioned whether she gave up too much, too early. Moving forward, on the next project, she may keep a second contractor in the wings to provide competitive pricing at 80-90 percent of design. She may also restructure how she approaches savings, contingency, and allowances, by requiring contingency to be exhausted first before signing a change order for overages in allowance items. This would help prevent her paying for allowance overages and savings derived from unused contingency.
Originally published by the Daily Journal of Commerce on July 20, 2023.
