-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