Understanding How Guaranteed Maximum Price Contracts Function

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Guaranteed maximum price contracts are frequently used in construction projects. To learn more, check out Skyscraper Pictures.
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Unless you live in remote areas like the Himalayas or with indigenous tribes in the Amazon, your life is likely governed by various contracts. Purchasing a sweater online? You are now in a contract with the online vendor. Heading to the local theatre to watch Keira Knightley’s latest historical drama? You are bound by the terms of a contract with the theatre owner, which are most likely written in small print on the back of your ticket. Planning to propose with an expensive engagement ring? Before you do, you should know that marriage is a contract. The same goes for a pre-nuptial agreement.

Contracts come in many types, most of which are designed to cater to specific business or personal arrangements. For instance, construction projects are frequently regulated by guaranteed maximum price contracts (GMP). This legal agreement sets a maximum price or ceiling for which a person or entity will pay for a certain project. The contractor, such as a homebuilder, is compensated for the actual costs incurred plus a fixed fee, subject to a maximum amount. As a result, the contractor bears the responsibility for any cost overruns, and any savings resulting from cost underruns are returned to the contractee (the home buyer) [source: Vector Construction].

Suppose, for example, a GMP contract is used for building a patio, and the contractor agrees to actual costs and a $3,000 flat fee, subject to a $10,000 maximum price. Upon completion of the work, the contractor will be paid for all costs, provided the total amount, including the fee, does not exceed $10,000. If the contractor’s costs amount to $8,000, it will not be paid $11,000 ($8,000 in costs + $3,000 fee), but rather the $10,000 maximum price. Conversely, if the contractor’s costs amount to $5,000, it will not be paid the $10,000 maximum price, but rather $8,000.

While this arrangement appears advantageous for the contractee, what about the contractor? Read on to learn about the benefits and drawbacks of a guaranteed maximum price contract and how it compares to other typical construction contracts.

The Advantages, Disadvantages, and Alternatives to a GMP Contract

A guaranteed maximum price contract is an appealing option for individuals looking to hire a contractor for apparent reasons: the contractee is obligated to pay only the maximum contractual price and can recover any cost savings resulting from efficient project control, improvement in subcontractor or supplier pricing, or favorable weather conditions, among other factors. However, this arrangement may result in additional costs not covered by the contract. Specifically, a contractee without construction experience may need to engage an expert to negotiate the terms and review the contractor’s expenses to ensure that the final tally is accurate [sources: Glazov, JMA].

For a contractor, a GMP contract offers the advantage of transferring some of the cost risk to the contractee, as long as it does not exceed the maximum contractual amount. Furthermore, this type of contract encourages both parties to work together to ensure that the scope of work is well-defined: the contractor needs to ensure that all costs are covered, while the contractee seeks an affordable maximum price [sources: Glazov, JMA].

In the construction industry, the GMP contract is a popular legal arrangement for building projects. However, there are other types of contracts used, including cost plus contracts and fixed-price contracts. The cost plus contract is similar to the GMP agreement as compensation is based on costs incurred and a set fee, but it may not have a maximum price. On the other hand, a fixed-price contract sets the contractor’s compensation at the beginning of the project, and any cost savings are typically kept by the contractor. The selection of a contract may depend on the size of the project, with a lump sum contract preferred for smaller projects. The GMP arrangement is chosen for its capped construction costs and the possibility of saving money. Some contracts allow both parties to share in any cost savings. A unit pricing agreement is another legal arrangement where the contractor sets a price for each unit of work. These contracts are commonly used for projects that can be divided into units of work. For more information on construction contracting basics or other common contractual forms, visit the provided links.

FAQ

1. What is a Guaranteed Maximum Price (GMP) contract?

A GMP contract is a type of construction contract where the contractor agrees to complete the project for a set amount, the maximum price, and assumes the financial risk if the project costs exceed that amount.

2. How is the GMP determined?

The GMP is typically determined through a competitive bidding process or negotiation. The contractor submits a proposal that outlines the scope of work and estimated costs. The owner may negotiate with the contractor to arrive at a mutually agreed-upon GMP.

3. What are the benefits of a GMP contract?

A GMP contract helps to provide cost certainty for the owner, as the contractor assumes the risk for any cost overruns. It also incentivizes the contractor to complete the project within budget and on time.

4. What are the risks for the contractor in a GMP contract?

The main risk for the contractor in a GMP contract is that if the actual costs exceed the GMP, they are responsible for covering the difference. This can result in reduced profits or even losses for the contractor.

5. How are changes to the scope of work handled in a GMP contract?

Changes to the scope of work are typically handled through a process called a change order. The contractor submits a proposal for the additional work, and the owner approves or negotiates the cost before the work is performed.

6. Can the GMP be adjusted during the project?

It is possible for the GMP to be adjusted during the project, but only if both parties agree to the change. The contractor would need to provide a detailed explanation of why the change is necessary and how it will impact the overall project cost.

7. How is the project quality ensured in a GMP contract?

The contract typically includes quality standards and specifications that the contractor must meet. The owner may also hire a third-party inspector to ensure that the work meets these standards.

8. What happens if the project is completed under budget?

If the project is completed under budget, the contractor is typically entitled to a portion of the savings as a bonus. The amount of the bonus is typically negotiated in advance and included in the contract.

9. How long does a GMP contract typically last?

The length of a GMP contract varies depending on the scope of work and complexity of the project. It can range from a few months to several years.

10. What types of projects are suitable for GMP contracts?

GMP contracts are most commonly used for large, complex construction projects, such as commercial buildings, hospitals, and government facilities.

11. How does a GMP contract differ from a traditional construction contract?

In a traditional construction contract, the contractor is responsible for all project costs and assumes the financial risk for any cost overruns. In a GMP contract, the contractor assumes the risk for costs up to the maximum price, but the owner assumes the risk for any costs that exceed that amount.

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