Chad I. Michaelson partner with Meyer Unkovic & Scott.

Paying a contractor for its work might appear straightforward, but actually can be complex. While this issue is sometimes overlooked during contract negotiations, early attention and thoughtful drafting can help mitigate the risk of payment disputes that can derail a construction project.

Few contractors will finance a construction project, so most expect to be paid regularly as work is performed. Issues arise, however, in determining how much the contractor should receive before the work is actually complete. When the contract price is a lump sum, it can be difficult to ascertain how much of that amount the contractor has earned while the project is in various stages of completion. Some contracts address this by establishing specific goals, or “milestones,” that, when achieved, trigger the release of partial payment. Others require the contractor to propose a “schedule of values” that divides the lump sum among the items of work. By estimating the stage of completion of each item, the contractor can calculate an interim payment request, and the owner can have assurances it is not paying for work not performed. The schedule of values can be manipulated, however, by over or undervaluing specific items of work. A contractor’s cash flow can be improved by assigning higher values to work performed early in the project, for example, but this creates exposure for the owner if a default occurs.

Other contracts allow the contractor to seek reimbursement of the costs it incurs to perform the work, and to charge a fee to cover its overhead and profit. These “cost-plus” contracts are fully auditable and provide the owner with greater visibility into the cost of construction, but they provide no incentive for the contractor to reduce project costs. To address this, cost-plus contracts can be subject to a guaranteed maximum price (GMP), which makes the contractor responsible for any costs that exceed the GMP. Because this provides the contractor with an incentive to spend every penny of the GMP, many owners will offer to share with the contractor any savings achieved by keeping project costs below the GMP. While these arrangements can be beneficial to the project, they require more sophisticated project controls and place heightened importance on cost accounting.

Calculating interim payments under a cost-plus contract would seem simpler because the contractor need establish only what costs have been incurred. As is often the case, however, the devil is in the details. Construction cost accounting can be complex, and disputes will arise over when a cost was incurred, or whether it is reimbursable. Thus, it is crucial to give special attention to those provisions of the construction contract that define what costs are—and are not—reimbursable.

The contractor will, of course, be entitled to reimbursement for the cost of labor, materials and equipment used on the project. But the parties should agree in advance on the rates to be charged for labor and equipment to ensure they do not include items that are not reimbursable, such as indirect overhead (costs incurred at the contractor’s home office that are not attributable to a specific project) or profit. The contractor’s fee is intended to cover its indirect overhead and profit.  Including these charges in labor or equipment rates will cause an overpayment to the contractor. The contract should also address accounting for the cost of stored materials, as the owner rarely reimburses the contractor for material until it is incorporated into the project.

It is common for the contractor to utilize subcontractors to perform some (or, with a construction manager, substantially all) of the work. These subcontracts are often issued, for good reason, on a lump-sum basis. But this reduces the owner’s visibility into the cost of the work and can provide an opportunity for the contractor to increase its margins. This risk can be minimized by including detailed requirements for competitive bidding (minimum number of bidders, submission of bids from entities affiliated with the contractor, review of bids, negotiations with bidders, etc.) to ensure that the owner has visibility into the bids and the process is not manipulated. Contracts with construction managers should address whether the construction manager may self-perform work on a lump sum basis and, if so, what steps it must take to establish that the lump sum is reasonable.

Besides its labor, equipment, material and subcontract costs, the contractor also is entitled to reimbursement for direct overhead costs incurred at the job site (as opposed to indirect overhead costs incurred at the contractor’s home office) for supervision and administration of the contract.  These costs are often lumped together under the label “general conditions” costs, and include things like superintendent salaries, job site trailer and utilities, field computers, dumpsters and site security. They can be difficult to allocate because they are not attributable to any specific construction activity, and because they can be variable (they increase with the duration of the project) or fixed (e.g., job site sign costs are incurred only once). A great deal of time and effort is required to accurately track, allocate and audit these costs during a project.

The real problem with general conditions costs is one of scale, as they might encompass dozens of different items but represent less than 10% of the overall contract value. On smaller projects, these costs may not be significant enough in the aggregate to justify the administrative effort of tracking, allocating, and auditing them. To avoid this, the cost-plus contract can be modified to treat general conditions as a lump sum, which the contractor can divide equally across the duration of the job. If the components of that lump sum are not well defined, however, the owner may have to pay the lump sum amount and reimburse the contractor for items intended to be subsumed within it.

The cost of required bonds and insurance is also reimbursable, but it can be difficult to allocate the cost of the contractor’s regular insurance program to a specific project. Many contractors address this by billing these costs as a percentage of overall contract revenue. While this is a reasonable approach, the parties need to agree on seemingly minor details like whether these costs should be added only to the cost of the work or to the overall contract sum (which would include the contractor’s fee). More specialized forms of insurance, like subcontractor default insurance, might only be assessed against contract revenue attributable to those specific costs. And because all these items are calculated based on the cost of the work but also are a component of it, the contract should solve the circular nature of that calculation.

Every construction project encounters unanticipated conditions. Cost-plus contracts typically include a line item known as a “contingency” to cover expenses the contractor could not reasonably have anticipated, but which should be included in the cost of the work. When there is an opportunity for shared savings, disputes over the contingency are common because the contractor will share in a portion of the unused contingency. Thus, it is important for the parties to discuss and document their understanding of the purpose of the contingency to avoid disputes about whether the cost of an unforeseen condition should be funded through the contingency or as part of the risk the contractor assumed in agreeing to the GMP.

Some unanticipated conditions do not fall into either category, and instead justify an increase in the lump sum or GMP. This increase is accomplished through a change order, and it can be difficult to determine how to price that work (especially when the work was being performed on a lump-sum basis in the first place). Thus, the parties should include provisions limiting the markup for overhead and profit a contractor or subcontractor can add to such work (something like 10% on labor and 5% on materials or equipment). These provisions should also deal with markups by subcontractors and sub-subcontractors, and should limit the overall markup charged when several tiers of subcontractors are involved.

Besides addressing how the contractor tracks and accounts for its work, cost-plus contracts must also specify the scope of the owner’s right to audit the contractor’s records. Such audits can be onerous, and some owners will require the contractor to pay some audit costs if discrepancies are discovered that exceed a certain percentage of the contract price. Contractors should take care to ensure that the owner’s audit rights do not allow it to discover or challenge sensitive competitive information (like the contractor’s historical productivity data) that goes into lump sum bids.

Clearly, there are many project accounting issues that can and should be addressed at the time of contracting. Taking the time so do so can make the difference between a successful project and one that ends up mired in payment disputes.

Chad I. Michaelson is a trial lawyer who focuses his practice on resolving complex business disputes.He has represented owners, contractors and other parties in construction projects large and small, and litigated complex construction claims valued in the millions of dollars. He also has an interest in green building and chairs the firm’s sustainable development group.