Whether you are planning to build your dream home or a multi-unit commercial complex, the entire project is based on a construction contract. For both the owner and the contractor, the cost of the project is important; however, it is not only the final cost that matters, but how that cost is arrived at as well that is important. In the construction industry, there are several different types of commonly-used pricing structures, including a “guaranteed maximum price” construction contract. If you are a party to a guaranteed maximum price construction contract, it is essential that you understand how pricing is determined, as well as the advantages and disadvantages of using this type of pricing arrangement.

A guaranteed maximum price, or GMP, construction contract is effectively a variation of another type of pricing arrangement known as “cost-plus” pricing. With cost-plus, the owner agrees to pay the contractor for the actual costs involved in the project plus an agreed upon fee. When a GMP contract is used, it essentially works like a cost-plus contract with a cap on the costs that the owner can incur. By way of illustration, let’s assume you are planning to build your dream home. If a cost-plus contract is used, you would agree to pay the contractor for the actual costs incurred during the construction of your home plus a fee – let’s say $100,000 for the sake of our example. Both you and the contractor have estimated the costs to be around $2.5 million; however, when all is said and done the actual costs turn out to be $4.5 million -- $2 million more than the original estimate. You would still be liable to pay the full $4.5 million plus an additional $100,000 under a cost-plus contract. If a GMP contract was used, you might cap the costs at $3.5 million with an estimate of $2.5 million. In that case, you would only be liable for $3.5 million plus the $100,000 even if the actual costs were $4.5 million.

Because of the possibility of cost overruns, contractors often try to inflate the cap on a GMP construction contract to protect them from liability if the project costs run higher than anticipated. One way for an owner to encourage cost savings when using a GMP contract is to include a “shared-savings” clause that agrees to split any savings equally between the contractor and the owner if the final project costs come in under the cap.

When a guaranteed maximum price construction contract is used, it becomes especially important that all terms within the contract are well-defined, because liability for costs will often depend on those definitions. What is included in the “actual costs?” What happens if the owner changes the original plans for the project? What happens if material costs increase dramatically because of an unexpected natural disaster or economic downturn? Whether you are a contractor or an owner, it is extremely important that you have an experienced real estate attorney draft or review the proposed contract before executing it.