Gaille Energy Blog Issue 93 explained the following four types of construction/services compensation and the incentives created by each:
- Lump Sum
- Unit Price
- Time & Materials (T&M)
- Actual Cost
This issue discusses how incentive-based compensation mechanisms can be added to Actual Cost and T&M commercial structures.
In Lump Sum and Unit Price contracts, a contractor is paid for achieving defined results:
(i) Lump Sum = successful completion of all of the work; or
(ii) Unit Price = successful completion of an item of work.
As such, a contractor bears (most of) the cost of poor productivity (and reaps the rewards of good productivity).
In contrast, under the T&M and Actual Cost approaches, a contractor is paid for the amount of time or dollars it spends on a project—not the results. This means that the project owner is at risk of bearing the costs of poor productivity (nor does the contractor enjoy any additional profits from good productivity). In an effort to improve these incentives, the industry has developed a variety of contractual approaches, including:
- Actual Cost, Fixed Fee [No Additional Fee for Cost Overruns]. When using the Actual Cost approach, a contractor’s profit and overhead can either be paid as a percentage of dollars spent or as a fixed fee that is calculated based on the initial estimate of the project’s cost. Under the percentage approach, the amount of the contractor’s fee is determined by how much it actually spends over the course of the project (e.g., 15% multiplied by whatever it spends); under the fixed fee approach, the amount of a contractor’s fee is determined when the contract is signed using the estimated cost of the project and does not vary thereafter based on what the contractor actually spends (e.g., 15% multiplied by the estimated cost of the project on day one). This creates a soft incentive for a contractor to control costs because, as a practical matter, it makes no profit on expenditures in excess of the original estimate. The contractor also makes a higher percentage profit if it spends less than the original estimate. The below figure illustrates this approach.
- Reduced T&M Rates [No Additional Fee for Cost Overruns]. When using the T&M approach, a contractor’s profit and overhead are built into its rates. Even so, an owner can create a similar incentive to the Actual Cost fixed fee by using a rate discount. For example, after a contractor’s total billings have exceeded the original estimate, each rate can be discounted by 15%. This creates an incentive for the contractor to control costs because it makes no profit on expenditures above the original estimate.
- Actual Cost, Target Price [Contractor Profit & Overhead at Risk + Opportunity to Earn a Bonus]. For owners desiring a stronger incentive, the contract can include an adjustment mechanism that increases or decreases the fixed fee based on whether a contractor spends more or less than the original estimate (which can be referred to as the “target price”). The contract can dial up or down the percentage to calibrate the strength of the incentive. Under this approach, the worst case for a contractor is that its fixed fee is entirely lost; the best case may be that the fixed fee has doubled. As such, the contractor places some or all of its fixed fee at risk in exchange for the possibility of earning a larger fixed fee if it spends less than the target price. The below figure illustrates this approach.
- T&M, Target Price [Contractor Profit & Overhead at Risk + Opportunity to Earn a Bonus]. Although T&M rates include an imbedded fee within the rates themselves, it also is possible to create a target price mechanism using the original T&M estimate. For example, the parties could assume that 15% of the original estimate represents the contractor’s fee (profit and overhead). This 15% amount is then placed “at risk” in a manner similar to how a contractor’s fixed fee is placed at risk in the Actual Cost, target price approach. At the end of the project, a bonus is paid or a deduction is made based on whether the actual T&M charges were less than or greater than the original estimate. The amount of the bonus or deduction cannot exceed 15% of the T&M costs, thereby placing only the contractor’s profit and overhead at risk.
- Guaranteed Maximum Price [Contractor Profit, Overhead & Costs at Risk Above the GMP + Opportunity to Earn a Bonus]. Guaranteed Maximum Price (“GMP”) agreements can operate in conjunction with either T&M or Actual Cost commercial structures. In both cases, a contractor submits invoices containing either T&M or Actual Cost charges, which are paid up to the amount of the GMP. The GMP is thus the maximum amount that the contractor can get paid for the project. Once the GMP is reached, the contractor receives no further payments and must complete the remaining work at its sole cost. The tradeoff for contractor accepting a GMP is the opportunity to earn a “shared savings payment,” but only if and to the extent that the contractor’s billings are less than the GMP. The shared savings payment is calculated as a percentage of the “savings” achieved when the contractor spends less than the GMP. In the most generous case, a contractor may receive up to 50% of the difference between the GMP and its invoices (although the percentage is usually less). The below figure illustrates this approach.
- Not-to-Exceed [Contractor Profit, Overhead & Costs at Risk Above the Not-to-Exceed Amount]. A not-to-exceed amount can be used in either a T&M or Actual Cost agreement. It operates similar to a GMP but without any opportunity for the contractor to earn a bonus. The contractor receives its T&M rates or Actual Costs until the not-to-exceed amount is reached. Once the contractor has been paid the not-to-exceed amount, no further payments are made and the contractor must complete the remaining work at its sole cost. This structure gives the owner all of the benefits of the Lump Sum (no cost overruns are paid) while also allowing the owner to retain all of the savings (when cost savings occur).
- Compensation Ceiling. I have started using a different defined term—“compensation ceiling”—to describe a not-to-exceed amount that is substantially higher than the estimated cost. For example, a “compensation ceiling” may be 1.2x or 1.3x the original estimate, thereby providing a contractor with a comfortable margin for overruns. The primary purpose of such a compensation ceiling is to establish a worst-case backstop for the owner while providing a contractor with a cushion to incur cost overruns without penalty. The secondary purpose of the compensation ceiling is to change the contractor’s mindset regarding T&M or Actual Cost reimbursement. The existence of a payment ceiling—even one that is much higher than the expected cost of the work—incentivizes the contractor to control costs during the early stages of the project (at some point, however, the incentive diminishes because the contractor has completed enough of the project within budget to no longer be at risk of exceeding the ceiling). The existence of a compensation ceiling should also make the contractor’s project estimate more accurate. I recently negotiated a T&M contract that proposed a compensation ceiling calculated as 120% of the contractor’s original estimate. During the first negotiation session, the contractor objected to using its estimate in this way, describing its estimate as a “back-of-the-envelope” number. When one considers that owners rely on estimates for budgeting and board approval purposes, compensation ceilings serve an important purpose of helping to discourage sloppy estimating (and also, potentially, underbidding in T&M or Actual Cost situations).
Keep in mind that parties to construction and services agreements typically use Actual Cost and T&M commercial structures when conditions of uncertainty make it difficult for contractors to accurately bid a Lump Sum or Unit Price—or lead to contractors inflating the Lump Sum or Unit Prices with excessive contingency to compensate for such uncertainty. Under conditions of uncertainty, contractors are more willing to risk some or all or their profit and overhead—as long as they are certain to have their out-of-pocket costs reimbursed. It is easier to risk breaking even than bankruptcy. The below figure illustrates how the selection of contractual approaches varies with cost uncertainty:
Finally, it is important to consider that conditions of uncertainty can also be addressed via price adjustment clauses. For example, if a contractor is concerned about the risk of bad weather increasing costs, the parties could still select a Lump Sum commercial structure but add a provision granting the contractor price adjustments (i.e., increases to the Lump Sum) for costs caused by bad weather. The choice between addressing cost uncertainty through price adjustments versus commercial structure depends on how many types of cost uncertainty exist, how easy it is to define them, and how frequently they are expected to arise. At some point, there may be such a high and varied quantity of uncertainty at sufficient frequencies of occurrence that it is more efficient to shift to an Actual Cost approach than to manage the uncertainties through price adjustments.
About the Gaille Energy Blog. The Gaille Energy Blog (view counter = 167,229) discusses issues in the field of energy law, with periodic posts at www.gaillelaw.com. Scott Gaille is a Lecturer in Law at the University of Chicago Law School, an Adjunct Professor in Management at Rice University’s Graduate School of Business, the author of three books on energy law (Construction Energy Development, Shale Energy Development, and International Energy Development), and co-author of the award-winning travel compilation, Strange Tales of World Travel (Bronze Medalist, IPPY Awards for Best 2019 Travel Essay; ForeWord Magazine Finalist for Best Travel Book of 2019; North American Travel Journalists’ Honorable Mention for Best Travel Book of 2019).
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