Recently, a client called to ask me about cost-plus contracts. His company is a subcontractor on a new stadium project. Delays, and resulting accelerations, have caused substantial increased expense. Rather than go the claim route, the contract manager agreed to convert their lump sum subcontract to cost plus.
Sounds good? Not necessarily. The company is still losing money, though at a slower rate. How can this be the case? What should the client have done differently?
Varieties of “reimbursable” contracts
There are various types of reimbursable contracts: time and material (T and M); cost plus fixed fee; cost plus fixed fee with a guaranteed maximum; and cost reimbursable, to name a few. The principal differences lie in how “cost” and overhead are defined. (Unit price contracts are a different breed and will be discussed in a future article).
In one contract form, the cost plus aspect is described as:
The term Cost of the Work shall mean costs necessarily incurred by the Contractor in the proper performance of the Work. (Underline added)
With this language, the owner has an argument that he or she need not pay for certain costs if they are unnecessary. So, for example, the owner may argue that the contractor overstaffed the project, or parked too much equipment at the site. The owner also may decline to pay for repairs, rework or punch list work, citing the “proper performance” phrase.
The first issue, involving the word “necessarily,” can be largely overcome by notifying the owner, in advance, of your manpower and equipment plans, and by keeping good records of work performed by labor and equipment. Tying this information with the project schedule is also helpful.
The second issue is more problematic. It is fair to say that all projects eventually end up with a punch list. Because you are required to deliver a “completed” project, the cost of punch lists should be chargeable. The same should be true for minor repairs and other rework that can be reasonably expected on any job.
However, in one American Institute of Architects (AIA) form agreement, costs not to be reimbursed include:
...costs due to the fault or negligence of the contractor ... including but not limited to costs for the correction of damaged, defective or nonconforming work ....
Again, good record keeping, in this case of labor and equipment for repairs, will help detail the exact amount of any nonbillable work and help you focus on the underlying fault.
The overhead problem
Overhead, sometimes referred to as general and administrative (G and A) expenses, is a real cost. Generally, G and A are those cost elements not directly connected to any specific project. This heading usually includes salaries for officers and directors, cost of sales, estimating, annual corporate meeting and retreats, and office mortgage or rent.
Even here, however, there is a certain lack of pure clarity in the concept of “indirects.” Every project puts burdens on the home office, although many companies do not keep records of how their home office staff allocates time between projects.
Some companies are better at this effort. They keep hourly reports, per project, for estimating. Other “overheads,” such as expediters, purchase order manager and schedulers, are allocated to each job.
This kind of in-house accounting is particularly important where your contract has design/build elements and your design/engineering work is substantial. In such instances, make certain you can bill these costs.
The fixed fee problem
With a fixed fee in your contract, the higher the labor, materials and equipment expenditure, the lower the mathematical percentage the fee becomes. So, if you agreed to a $100,000 fixed fee on a job estimated at $1 million and the job escalates to $2 million, your fixed margin has been cut in half.
Making matters worse, if your overhead is included in the fixed fee, you could actually end up losing money with a cost-plus fixed-fee contract. The key here is to have certain overhead items treated as a cost,” and therefore placed in a reimbursement category. Alternatively, you could provide the fixed fee be increased if actual costs exceed a threshold.
Time and material differences
With T and M, markups are built in. One example: Labor rates listed above shall include all costs including, but not limited to, wages, fringe benefits, travel and subsistence, insurance and taxes, overhead, profit, all home office expenses, supervision above general foreman, scaffolding, small tools, consumables . . .
The above language covers most of the typical payroll burdens, but you must make certain to account for all of them as well as the G and A when figuring your labor rates.
T and M agreements are particularly useful for extra work ordered by the owner during construction where the base contract is lump sum. The T and M part, agreed to in advance, eliminates disputes over pricing extra work. In this case, the “extra work” should be defined, prior to its performance, by a work authorization or change order. By doing so, you can help prevent mixing base contract costs with T and M billings. Only detailed records can avoid disputes on this point.
The delay cost problem
In one T and M agreement, there is a provision that no payment will be made for idle equipment. The purpose of this clause is apparent: to stop a contractor from loading up a job with equipment from other nonperforming jobs.
That goal is fine. But what happens if there is a delay? The equipment is now idle and you cannot get paid for it. Similarly, you will not be compensated for extended field and home office overhead.
AIA’s A111, for cost plus fixed fee contracts, addresses this problem in part. A111 provides that where there is a delay, a change order “shall reflect the full extent of any increase in Contract time and ... of any increase of the Contractor’s fee ....” (Underline added.) For a T and M agreement, you must review your base contract’s changes clause to determine whether it provides any relief for delay damages. For example, if a T and M work authorization adversely affects other unchanged work, the resulting resequencing may be compensable under the base contract’s changes or suspension of work clauses.
Cost reimbursable contracts can be beneficial to the owner and contractor. For the owner, they help eliminate the potential for claims, and the increased reporting requirements help the owner stay regularly informed of job costs. For the contractor, the emphasis is somewhat shifted from maintaining the bottom line to getting the job done right.
In order for cost plus to work for, not against you, make sure your overhead will be covered. List overhead items that should be billable, including home office supervision, management and design. Make sure to include your equipment in this list and that field office overhead (trailers, trucks, office equipment, telephones, etc.) are in the accounting.
Need I emphasize again: Read and understand your contract and seek advice if you are in doubt about its coverage. EC