August 02, 2018
The American Institute of Architects (AIA) has published two forms for cost-plus contracts. AIA A102-2007 is a Standard Form of Agreement between Owner and Contractor where the basis of payment is the Cost of the Work Plus a Fee, with a Guaranteed Maximum Price. AIA A103-2007 is a very similar document but without a Guaranteed Maximum Price. A102 replaced the A111 form from the 1997 set of AIA documents and A103 replaced the A114 form. Both 2007 cost-plus forms are to be used with the AIA Form A201-2007 General Conditions.
These cost-plus contracts reimburse the contractor for its “Costs of the Work” as that term is defined, plus an amount for the contractor’s “Fee”, typically considered the contractor’s overhead and profit. The parties are offered alternatives for identifying the contractor’s Fee, including a specified lump sum, a percentage of the reimbursable costs, or another alternative specified by the parties. Cost-plus contracts allow the owner to control or limit the profit and overhead the contractor can earn in performing the contract.
Owners often prefer cost-plus contracts on jobs where the contractor is likely to include a significant contingency in its price or where the scope of work is not well defined. In such situations, owners may be better off accepting the risk of cost overruns as opposed to paying whatever contingency/profit amount that the contractor may include in its lump sum price. Of course, it is not often easy for an owner to know when the contractor includes a larger than normal contingency amount in a fixed price bid. However, the nature of the job, the amount of detail in the plans, and the intensity of competition are factors that will affect the contractor’s indirect (overhead, contingency and profit) markups.
Owners may prefer a lump sum arrangement on jobs considered to be low-risk (small contingency) or where competition will assure a competitive price. Contractors usually prefer lump sum contracts. The general belief among contractors is that lump sum contracts offer more opportunities to make higher profit. In addition, cost-plus jobs require more time and effort to track and account for reimbursable costs. However, cost-plus contracts will reduce the contractor’s risk of cost overruns since the contractor knows that it will recover all its costs (up to the Guaranteed Maximum Price under the A102 form). As a general rule, for projects where the design is complete and competition is not intense, contractors will be better served trying to negotiate a fixed price contract rather than accepting a cost-plus agreement with a GMP.
The owner typically decides on the type of contract, be in lump sum, cost reimbursable or some other compensation structure. Before deciding on using a cost-plus contract, an owner should recognize that administration of a cost-plus contract is significantly more complicated. The owner and the contractor must track and account for the actual costs of performance based on the contract definition of a “cost” or “Cost of the Work.” Both AIA cost-plus form contracts require the owner to verify the contractor’s costs as often as monthly and audit the contractor’s books upon completion of performance.
A pure “cost-plus” contract has the disadvantage of not limiting the total amount of “costs” the owner may be obligated to reimburse the contractor. The AIA A103 Form is such a contract, having no limit on the owner’s potential liability. However, the A103 form does attempt to offset this disadvantage by requiring the contractor to provide a “Control Estimate” within 14 days of executing the contract. This Control Estimate includes a detailed statement of the estimated Cost of the Work, organized by trade categories or systems, as well as listing the contractor’s fee. AIA A103 ¶ 5.2.2. The A103 form also requires the contractor to “develop and implement a detailed system of cost control that will provide the Owner and Architect with timely information as to the anticipated total Cost of the Work.” AIA A103 ¶ 5.2.5.
The distinguishing characteristic of the AIA Form A102 is that it caps the owner’s total liability for reimbursable costs and the contractor Fee at a “Guaranteed Maximum Price” (GMP). Including a GMP in a cost-plus contract attempts to give the owner some of the advantages of a cost-plus contract while minimizing the disadvantage of open ended liability in the event that costs unexpectedly escalate. The “Guaranteed Maximum Price” is defined in form A102 as:
The Contract Sum is guaranteed by the Contractor not to exceed _______________ Dollars ($______), subject to additions and deductions by Change Order as provided in the Contract Documents. Such maximum sum is referred to in the Contract Documents as the Guaranteed Maximum Price. Costs which would cause the Guaranteed Maximum Price to be exceeded shall be paid by the Contactor without reimbursement by the Owner. (A102-2007, ¶ 5.2.1)
The definition of Guaranteed Maximum Price (or “GMP”) is similar to the definition of the GMP in a design-build or construction management contract. The GMP in the A102 contract operates the same as in a fixed price contract in limiting the owner’s liability. Change orders issued by the owner that increase the cost of the work will justify an increase to the GMP. Note that such an increase in the GMP may or may not be justified in other types of contracts, such as design-build or construction management contracts.
Cost-plus contracts are particularly appropriate on fast track jobs, where the design is not yet complete, or where the contractor is asked to commence work before the final design is completed. A cost-plus arrangement allows work to proceed even though the design is not far enough along to allow the contractor to develop a lump sum price. However, the AIA A102 form would not be the first choice of cost-plus contracts for fast track jobs because of its GMP provisions. A103 is a better choice. Nevertheless, the AIA encourages use of the A102 form, even with its GMP provisions, for situations where the design is not yet complete.
To get around the inherent problem of a contractor being able to develop a GMP without a completed design, A102 includes the following language:
To the extent the Drawings and Specifications are anticipated to require further development by the Architect, the Contractor has provided in the Guaranteed Maximum Price for such further development consistent with the Contract Documents and reasonably inferable therefrom. Such further development does not include such things as changes in scope, systems, kinds and quality of materials, finishes or equipment, all of which, if required, shall be incorporated by Change Order. (A102-2007, ¶ 5.2.5) This provision is not clear enough to address the numerous difficult issues that can arise while the design is completed. Rather than accept this form language that benefits only the owner and designer, contractors would be well served to request use of the A103 form whenever the owner wants to use a cost-plus contract on a fast track job.
AIA contract forms generally favor the architect first and the owner second. The two cost-plus forms are no exceptions. For example, both forms state that the contractor accepts that a “relationship of trust and confidence” is established by the agreement. (A102, Article 3; A103, Article 3) It is unclear exactly what this means and contractors should object to the inclusion of such language.
The two cost-plus AIA contracts are intended to be used in conjunction with the AIA A201 General Conditions. Thus, to fully understand a party’s responsibilities under one of these cost-plus contract forms, one must consider the complex arrangements established by the A201 General Conditions. These General Conditions also favor the architect. For example, the A201 General Conditions attempt to place certain design and supervisory responsibilities on the contractor. One such provision is Section 3.12.10.
Most contractors should try to avoid contract language that places design responsibilities on them. In those limited situations where the contractor is willing to accept certain design responsibilities, the contract language should be specific and limited, with all other design responsibilities expressly given to the design professional.
II. WHAT ARE THE “COSTS OF THE WORK”
The Contract Sum is defined in both the A102 and the A103 contract forms as the “Cost of the Work” (as defined in Article 7) plus the “Contractor’s Fee.” The A102 form also includes a GMP which caps the Contract Sum.
Contractors naturally want to define a reimbursable “cost” as broadly as possible while it is in the owner’s interest to restrict the definition of reimbursable costs to only those direct field costs that are both reasonable and necessary. The AIA cost-plus forms make an effort to define exactly what is and is not a “cost.” It is important that all parties review and only amend these provisions as necessary to make the definition of “cost” fit the specific project and the costs that are likely to be incurred. Contractor expenditures either will be reimbursed as a “Cost of the Work” or must be absorbed within the contractor’s “Fee.” As the definition of “cost” tightens, more and more expenditures fall outside of a reimbursable cost and must be recovered only through the contractor’s Fee. It is therefore important for the contractor to understand those costs that will be reimbursed and those costs that can only be recovered though the contractor’s fee.
Article 7 in both the A102 and A103 forms are nearly identical in defining the “Cost of the Work” for reimbursement purposes. Because the AIA has carefully drafted these provisions, parties should only make changes that have been carefully considered. Otherwise, changes may have unintended affects. Revisions to the standard language will increase the cost risk to one party or the other, depending on the change. In Section 7.1, “Cost of the Work” is defined as costs necessarily “incurred” by the contractor. The GMP contract A102-2007 is designed to compensate the contractor under Article 7 when these costs are incurred, and not just when funds are expended or “paid” by the contractor. The contractor may incur costs without having yet paid those costs. Money flows downhill in the construction process, and the contractor uses funds paid in monthly draw to make payments to subcontractors and suppliers who are listed in the payment application. Unless amended, the title of Article 7 may mislead the owner to believe the contractor must not only incur costs, but also must pay the costs of the work before the owner is required to pay the contractor. It is worth reviewing the owner’s responsibilities as to payment at the front end of the contract.
B. REIMBURSABLE COSTS
Contractors need to study and understand the definitions of reimbursable costs under Article 7. General categories include:
- Labor costs;
- Subcontract costs;
- Costs of materials and equipment incorporated in the completed construction;
- Costs of other materials and equipment, temporary facilities and related items; and
- Miscellaneous Costs
Paragraph 7.1.2 is new in the 2007 versions of A102 and A103. This provision states: “Where any cost is subject to the Owner’s prior approval, the Contractor shall obtain this approval prior to incurring the cost. The parties shall endeavor to identify any such costs prior to executing this Agreement.” This provision attempts to give the owner the right of prior approval for various expenditures. There are no less than 9 references in Article 7 to costs that require the owner’s “prior approval.” These provisions are found in Sections 7.2.2, 7.2.5, 7.5.2, 7.5.5, 7.6.6, 7.6.8, 7.6.9, and, 7.7.1.
For example, wages or salaries of supervisory or administrative personnel when stationed at the project site are reimbursable only “with the Owner’s prior approval.” Another example covers “discretionary payments” such as bonuses, profit sharing or incentive compensation. These expenditures are reimbursable as a cost only with the owner’s prior approval.
Parties should consider which expenditures the owner will have prior approval over. Conceptually contractors would be better protected if they had prior owner approval on all costs incurred. However, that quickly becomes counterproductive as the approval process covers more and more of the work. As a practical matter, contractors probably want to minimize, if not eliminate, obligations to seek advance permission for expenditures.
C. LABOR COSTS
Section 7.2 covers “Labor Costs.” These include wages of workers directly employed by the contractor to perform work at the site, wages or salaries of supervisory personnel at the site (if approved in advance by the owner), and, supervisory personnel engaged at factories, workshops or on the road, but only for that portion of their time devoted directly to work associated with the project.
Section 7.2 also defines those costs commonly referred to as labor burden and makes then reimbursable. Parties are well served to discuss in detail the documentation that will be required to establish labor burden costs. Different contractors address and compute indirect labor costs in different ways. Therefore, the parties should address the contractor’s labor burden costs before a contract is finalized.
D. CONSTRUCTION EQUIPMENT
Contractors must carefully consider how equipment is going to be treated on any cost reimbursable contract. While the cost of rented equipment can be determined from rental invoices, valuing contractor owned equipment can generate major disputes unless the contract clearly spells out the equipment to be used and how charges are to be computed. Both the A102 and A103 forms include Article 5.1.4, which requires the parties to work out equipment rates before the contract is signed. It states:
“5.1.4 Rental rates for Contractor owned equipment shall not exceed __ percent (___%) of the standard rate paid at the place of the project.” The “standard rate” is not defined in the contract and therefore should be addressed and defined by the parties at the time they enter their contract.
These AIA standard cost-plus forms also include the following language:
The total rental cost of any Contractor-owned item may not exceed the purchase price of any comparable item. Rates of Contractor-owned equipment and quantities of equipment shall be subject to Owner’s prior approval. A102/A103, §7.5.2. The language in the above two quoted provisions is somewhat vague and suggests that equipment costs can be unique to the particular project, location and parties. It is important that the parties agree on the types of equipment that will be used on the project and the rates the contractor will be entitled to charge for contractor owned equipment. It is advisable to have a schedule of equipment with agreed upon charges on an hourly, daily and/or monthly basis.
The parties should also consider how equipment operating costs will be charged, including the costs of the operator, fuel, minor maintenance costs, major maintenance costs and other equipment related expenses. Depending on the situation, the parties may agree on an “operated rate” where all costs are covered by the hourly operated rate agreed to by the parties. Otherwise, the contractor will need to track these operating costs and be prepared to submit records to justify them as a “cost”.
The contractor also needs to realize that any time an unanticipated new item of construction equipment is provided to the job, the AIA forms require owner approval of the applicable equipment rates before the contractor will be entitled to charge for the equipment.
E. SUBCONTRACT COSTS
The AIA forms provide that amounts paid to subcontractors “in accordance with the requirements of the subcontracts” are reimbursable expenses. Submitting false subcontractor invoices not only is a breach of the contract but would likely expose the contractor to criminal penalties under many state laws.
Subcontracts may be lump sum or cost plus. If cost plus, the subcontracts should have a definition of what is a reimbursable cost consistent with the principal contract. Article 10 in the A102/A103 contract forms provides the owner with the right to require the contractor to contract with or at least obtain bid prices from subcontractors identified by the owner. If the owner designates one or more subcontractors that the contractor must negotiate with, the provision goes on to state that the owner shall thereafter determine, with the advice of the contractor and architect, which subcontractor bids will be accepted. The contractor will not be required to subcontract with any subcontractor that the contractor has a reasonable objection.
Of course, any subcontractor identified by the owner may have allegiances to the owner. Also, contractors may have concerns that a subcontractor recommended by the owner may or may not have the necessary ability, plant or supervision to perform successfully. Thus, there can be a conflict of interest involving a subcontractor the owner is recommending.
F. RELATED PARTY TRANSACTIONS
Section 7.8, “Related Party Transactions”, is a new addition to the 2007 version of the A102/A103 forms. The purpose of this provision is to address the situation of a contractor attempting to create a profit center by dealing with a related party, either a subcontractor or otherwise. While many cost-plus contracts define and limit the amount of the contractor’s fee, it assumes that any subcontractor is an unrelated party who negotiates an arms-length transaction with the contractor. That is not always the case. Some contractors try to increase their overall fee by renting equipment from or subcontracting a portion of the work with an affiliated company. Profits generated by an affiliated supplier/subcontractor can increase the bottom line to the contractor. The new “Related Party Transaction” provisions attempt to limit the contractor’s right to deal with a “related party” by requiring full disclosure to the owner, which the owner can then use to negotiate a lower fee or require the contractor to extract a lower (or no) fee from its affiliated supplier/subcontractor.
III. OTHER ASPECTS OF THE AIA COST-PLUS CONTRACT FORMS
A. CHANGE ORDERS
Owners have the right to make changes under the AIA cost-plus contracts. Obviously, if a change increases the costs of the work, the owner would have to pay for the increase in the reimbursable costs of the change. These contract forms also provide, in paragraph 5.1.2, that the parties are to agree in advance on the method for adjusting the contractor’s fee as a result of a change. The contract forms anticipate that the parties will work out how to compute the fee component of any change during negotiations. Contractors will want to increase their fee to the extent a change order increases the costs of the work. Fee adjustments may be based on a percentage of the anticipated value of the change, a percentage of the actual costs of the change, or some third alternative.
Contractors want to limit or eliminate any right the owner may have to reduce the contractor’s fee for deductive changes that reduce the anticipated costs to perform the work. Note that the AIA A201 General Conditions provide that an owner is not entitled to a markup for overhead and profit on a deductive change. It is not in the contractor’s interest to allow the owner to change this provision in setting fee adjustments for deductive changes.
Changes under the A102 form are different from A103 because of the GMP provision. Changes that either increase or decrease the costs of the work justify a consistent adjustment to the GMP. A102 provides that adjustments to the GMP for changes can be determined by any of the methods listed in section 7.3.3 of the A201 General Conditions.
Changes under the A102 form contract therefore need to be valued for purposes of adjusting the GMP. While the contractor is paid for a change on a cost-plus basis, it is nevertheless important that the parties agree on the anticipated costs of a change to make a proper adjustment to the GMP. Even though the owner may not be entitled a reduction to the contractor’s fee for a deductive change, the owner nevertheless would be entitled to a reduction in the GMP in line with the anticipated savings arising from a deductive change.
B. PAYMENTS TO THE CONTRACTOR
As should be anticipated, the administration of payments in cost-plus contracts are more complicated than with lump sum contracts. However, the AIA does a good job at simplifying the payment process, at least for progress payments during the course of the work. The A102 form provides that progress payments will be determined based on a percentage of the GMP, adjusted for, among other things, any overpayments made in previous applications. Each month the contractor is required to provide accounting information to demonstrate that cash disbursements previously made equal or exceed previous progress payments, adjusted for amounts that are paid for the contractor’s fee. In other words, documentation demonstrating cash disbursements lag behind payment applications by one pay period.
Under the A102 the contractor can get “overpaid” by a progress payment but the contract provides for a correction by the next pay period. The language provides some flexibility to the contractor but also can create problems when an owner concludes that subsequent applications must be reduced to correct for earlier overbilling. Under the A103 form, each progress payment will be based on the documented “costs of the work” incurred to date, plus that portion of the contractors fee based on how the fee is to be computed, less any retainage the owner is authorized to hold, less any progress payments previously received. Whether and how retainage is to be withheld should be carefully considered.
Section 22.214.171.124 of the A102 (126.96.36.199 of the A103 form) provides for retainage to be held on work the contractor self performs. This provision is new in the 2007 version of these forms. The owner also may withhold retainage from monies that are otherwise payable to subcontractors. The amount of subcontractor retainage is to be negotiated between the contractor and owner. Thus, the contractor does not control how much retainage it can hold from a subcontractor. The owner is the party that actually will hold the retained funds. There are no provisions for withholding retainage from suppliers.
C. THE OWNER’S RIGHT TO AUDIT COSTS
The A102 and A103 forms require the Contractor submit a final accounting of its “Costs of the Work” in conjunction with its application for final payment. Thereafter, the owner is to arrange for a review of this final accounting to either confirm or adjust it. This review will be accomplished within 30 days of its submission and will be performed by the owner’s “auditors.” These form contracts make it clear that the architect is not to be asked or expected to verify the contractor’s costs. The AIA cost-plus form contracts do not identify who the auditors will be or when the contractor will learn the identity of the auditors. If the contractor disagrees with the result of the auditor’s review of the final accounting, the contractor has a right to request mediation of the disputed amounts.