-working relationship between the contractor and the customer.
A fixed-price, or a lump-sum contract, is one where the contractor furnishesall of the labor and provides all of thematerials for a certain amount of dollars.In the event that the contractor's estimatesare incorrect or unforeseen costs causethe contractor to spend more to complete the project, those costs are absorbedby the contractor and not passed on tothe customer. A fixed-price contractrequires the contractor to be meticulouswhile bidding for the job due to thepotential exposure that may result froman inaccurate bid. Alternatively, if thecontractor is able to complete the project for significantly less than the statedsum of the contract, then the contractorreceives the benefit and the profit associated with the cost savings.
The more complex a construction project, the more difficult it can be for acontractor to estimate labor or costsassociated with subcontracts that maybe vital to completing that project. Acustomer experienced at entering intomore complex or riskier contracts willbe less likely to opt for a contract with
XTRACTS
Exploration of the differences between fixed-price and
cost-plus contracts, their different pricing approaches,
and different levels of risk.
JUANITA FERGUSON is all associate lVilh Beall, Killlle)' &Kormall. with (11/ emphasis olliitigatioll. She has litigated COIIstrllcrioll defects, mechanic's liells, premises liabilities, llegligence, employment alld ifl511rnllCe de/elise mailers, and hasrepresellted both businesses (l11d il1dividunls. For more illformation 01/ Bean Ki1lney, please visit http://lvIVII'.benllkilllley.col11.
JUANITA FERGUSON
It's no secret that construction contracts can and do range from a simple handshake to multipagedocuments that are replete withtechnical and legalistic provisions.
Regardless of the simplicity or the sophis-tication of the contract, it is importantfor the parties to consider, prior to thehandshake or the written commitment,the type of contract that will govern therelationship.
There are basically two types of contracts used for construction projects:fixed-price and cost-plus. Each type ofcontract presents different pricingapproaches and differing levels of risk.For each party to the contract, there areadvantages as well as disadvantages. Having a basic understanding of the prosand the cons of each type of contractprior to entering into an agreement setsthe stage for a positive and productive
14 CONSTRUCTION ACCOUNTING ANOTAXATION SEPTEMBER/OCTOBER 2010
•
a fixed price because of the difficulty ofprojecting all of the actual costs to complete the project. In this type of situation, a fixed-price contract can createtension in the relationship between thecontractor and the customer.
Even if the contractor is effective atminimizing the risk of cost overruns orother unexpected costs, a fixed-price contract can still present risks for a contractor. While unforeseen circumstances canbe problematic for the contractor working under a fixed-price contract, an indecisive customer can also make it difficultfor a contractor to manage such a contract.Excessive change orders may require theapproval of a lender, if the customer borrows funds to complete the constructionproject. Iffunds are inadequate to accommodate the changes that the customerseeks to make to the project, the lendercould require that the customer borrowadditional funds against the equity in theproject. Time spent securing the additional funds could easily result in losttime in completing the project, thereby frustrating the contractor's ability to complete the project in a timely manner.
The alternative to a fixed-price contract is a cost-plus contract. Under thistype of agreement, the contractor agreesto furnish the labor and provide thematerials for a certain amount of dollars, or a stated fee ... plus any extra oradditional charges that may be incurredduring the course of the contract. Thistype of contract provides the contractor with the flexibility to increase theamount of the contract depending on thevarying circumstances that may surfaceafter the parties agree to the termsof an agreement. For example, ademolition company may quote$30,000.00 to demolish a lot. Dur-ing the course of demolition, thecontractor discovers that some ofthe fixtures on the lot extendbeneath the surface of the lot such thatadditional equipment is required to fullyremove the fixtures or address the quality of previous construction. The$30,000.00 quote will escalate by theadditional cost to secure the equipmentas well as the cost of any additionallabor that may be required to addressthe unforeseen issues associated with a
THERE AREADVANTAGES ANDDISADVANTAGES TOA CUSTOMER WHO ISPARTY TO A COSTPLUS AGREEMENT.
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COST-PLUS VS. FIXED-PRICE CONTRACTS SEPTEMBER/OCTOBER 2010 CONSTRUCTION ACCOUNTING AND TAXATION 15
• IT ISBENEFICIAL FOR
THECONTRACTOR
TO BECOMEFAMILIAR WITHTHE SALES TAX
LAWS OF THELOCATION
WHERE THEPROJECT IS TO
BE COMPLETED.
16
complete removal of the fixtures. A costplus contract requires less accuracy during the bidding process, given that thecontractor knows that any unforeseenexpenses will be passed through to thecustomer.
There are different permutations ofcost-plus contracts. With a "cost-plus afee" contract, the contractor is paid theactual costs to complete the construction plus a management fee agreed to bythe parties in advance of the start of theproject. Another type of a cost-plus contract is a guaranteed maximum price("GMP") contract. With this type of agreement, the customer still pays the contractor all of the costs of construction inaddition to a stated fee. However, the contractor agrees that the customer will payno more than a GMP, unless the partiesagree to additional compensation forchange orders or other allowable claims.The third type of cost-plus contract isan estimated maximum price ("EMP")contract. In this type of contract, the customer still pays the actual costs of construction plus a management fee. Thedistinguishing feature of this type of contract is that the parties agree to split allof the costs that exceed the EMP. Likewise,if the project is completed for less thanthe EMP, the parties share in the savings.
There are advantages and disadvantages to a customer who is party to acost-plus agreement. The customer doesnot have to assume the risk of any costoverruns incurred by the contractor, butthe customer does accept the risk thatthe project may cost more than any budget agreed to by the parties. If the project actually costs less than the proposedbudget for the project, then the customer gains the bene fi t of the co s t savings. Other advantages for the customerwho is a party to a cost-plus contract arethat a contractor has little incentive tocut corners and the final cost of a contract can actually be lower than a lumpsum contract because the contractor hasno need to inflate the cost to completethe contract to cover risks such as costoverruns, design deficiencies, or unexpected labor costs.
The obvious disadvantage of a costplus agreement for a customer includes
CONSTRUCTION ACCOUNTING AND TAXATION SEPTEMBER/OCTOBER 2010
the uncertainty of the final cost of a contract. Prior to the start of construction,the customer must ensure that there aresufficient funds available to completethe project. This will require the customer to analyze cost estimates providedby the contractor to ensure accuracy andan appropriate level of consideration forrisks that are expected to be incurred inthe contract. Low-cost bidding as a meansof projecting the final cost of a projectis a risk that could affect the relationshipbetween the parties. Also, a cost-plusagreement requires a heightened levelof oversight of the progress of construction. Otherwise, the customer mayrisk that the contractor exercises inadequate cost controls during construction. Finally, a cost-plus contract doesnot require the same level of efficiencyas a fixed-price contract.
Regardless of whether a constructionproject is fixed-price or cost-plus, the parties must address the issue of sales tax'vvithin the contract. For the contractor,if sales tax is not included in the contract,it may not be possible to seek reimbursement from the customer once thecontract is completed. A simple clausewithin the contract stating that if salestaxes are due or become due, that theyshall be the responsibility of a partiCLllar party to the contract, is usually sufficient to safeguard against non accountability for taxes.
It is beneficial for the contractor tobecome familiar with the sales tax lawsof the location where the project is to becompleted. However, other jurisdictions'tax laws may also affect the project. Forexample, if the contractor is a businessbased in the state of Illinois, purchasesmaterials in the state of Michigan, fabricates materials in the state of Indiana,and then constructs the project in the stateof Indiana, it is important to know thesales rules for each state in order toaddress the sales tax issues within the context of the construction contract.
Sales taxes may be treated differentlydepending upon whether the parties aregoverned by a cost-plus or a fixed-pricecontract. The more expensive the project, the more the necessity to have athorough understanding of the impact
COST-PLUS vs. FIXED-PRICE CONTRACTS
1
of sales taxes on a construction contractprior to agreeing to the type, as well asthe terms, of a particular contract.
It is not uncommon for even the mostexperienced parties to a transaction tobe overwhelmed with all of the factorsthat can and do affect the successfulcompletion of a construction contract.To provide uniformity throughout theconstruction industry with respect toapplication for payment, dispute resolution, and even approval by the architect, the American Institute of Architects("AlA") produced contract forms toaccommodate both cost-plus and fixedprice agreements. AlA Document Ai 0 1is used for lump-sum agreements andAlA Document Alii is used for cost-pluscontracts. While the documents can becharacterized as all-encompassing, it isnonetheless important for parties to aconstruction contract to be careful andto avoid relying on the standardizeddocuments to address all of the particular requirements of their respectiveagreement.
Regardless of whether the parties agreeto a lump-sum or a cost-plus agreement,proper accounting of the costs associatedwith a contract will increase the likeli-
COST-PLUS vs. FIXED-PRICE CONTRACTS
hood that the parties have a productiveworking relationship. Keeping accuraterecords is a necessity, particularly if thecontractor is required to justify the costsof the project to resolve any disputesduring or at the conclusion of the project. In a cost-plus contract, accountingmethods range from the accrual method,to the direct cost recording per job, tothe actual percentage-of completionmethod. The Internal Revenue Service provides resources for contractors and construction accounting professionals tocomply with the rules and regulationsfor reporting costs associated with costplus construction contracts. Attentionto detail during the construction of theproject with a verification of costs is acrucial step in satisfying customer concerns, and in those cases where disputesarise, it is beneficial to proving a claim.Weekly detailed payroll reports, as wellas weekly or monthly breakdown of costsitemized by subcontractors or suppliers, are the types of verification thatminimize the possibility of customerdissatisfaction, eliminate frustration forthe contractor during construction, andprotect all parties' interests long afterthe project is completed.•
SEPTEMBER/OCTOBER 2010 CONSTRUCTION ACCOUNTING AND TAXATION 17